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The Impact of Short-Sale Constraints on Asset Allocation Strategies via the Backward Markov Chain Approximation Method

  • Carl Chiarella
  • Chih-Ying Hsiao

This paper considers an asset allocation strategy over a finite period under investment uncertainty and short-sale constraints as a continuous time stochastic control problem. Investment uncertainty is characterised by a stochastic interest rate and inflation risk. If there are no short-sale constraints, the optimal asset allocation strategy can be solved analytically. We consider several kinds of short-sale constraints and employ the backward Markov chain approximation method to explore the impact of short-sale constraints on asset allocation decisions. Our results show that the short-sale constraints do indeed have a significant impact on the asset allocation decisions.

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File URL: http://hdl.handle.net/10.1007/s10614-006-9036-4
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Article provided by Society for Computational Economics in its journal Computational Economics.

Volume (Year): 28 (2006)
Issue (Month): 2 (September)
Pages: 113-137

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Handle: RePEc:kap:compec:v:28:y:2006:i:2:p:113-137
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  1. Jarrow, Robert & Yildirim, Yildiray, 2003. "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(02), pages 337-358, June.
  2. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
  3. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March.
  4. Tapiero, Charles S & Sulem, Agnes, 1994. "Computational Aspects in Applied Stochastic Control," Computational Economics, Society for Computational Economics, vol. 7(2), pages 109-46.
  5. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
  6. Michael J. Brennan & Yihong Xia, 2002. "Dynamic Asset Allocation under Inflation," Journal of Finance, American Finance Association, vol. 57(3), pages 1201-1238, 06.
  7. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
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