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On Portfolio Choice, Liquidity, and Short Selling: A Nonparametric Investigation

  • Eric Ghysels
  • João Pereira

This paper studies the time series effect of changes in liquidity on optimal portfolio allocations. Using a nonparametric approach, we are able to handle models that are analytically intractable. Specifically, we directly estimate optimal portfolio weights for a CRRA investor as functions of liquidity. Liquidity is measured by turnover, dollar volume, or price impact. We consider three different investment horizons: daily, weekly, and monthly. Using a sample of NYSE stocks from 1963-2000, we document a very interesting temporal dimension to the effects of changes in liquidity: whereas optimal weights are strongly increasing functions of liquidity at the very short daily and weekly horizons, they become decreasing functions of liquidity at longer monthly horizons. Overall, the dependence of optimal weights on liquidity is most noticeable for small stocks at short investment horizons. Finally, the optimal conditional portfolio weights documented in this paper are never negative, which may help explain the low level of short selling observed in the US stock market. Nous estimons des décisions de choix de portefeuille en fonction de mesures de liquidité à l'aide de méthodes non paramétriques. Nous trouvons que les parts optimales de portefeuilles sont surtout influencées par la liquidité pour des horizons à court-terme. Par ailleurs, ces parts optimales sont toujours positives, ce qui pourrait expliquer le peu de vente à découvert observé sur le marché américain.

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File URL: http://www.cirano.qc.ca/files/publications/2003s-27.pdf
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Paper provided by CIRANO in its series CIRANO Working Papers with number 2003s-27.

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Length: 35 pages
Date of creation: 01 May 2003
Date of revision:
Handle: RePEc:cir:cirwor:2003s-27
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  1. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
  2. John Y. Campbell & Sanford J. Grossman & Jiang Wang, 1992. "Trading Volume and Serial Correlation in Stock Returns," NBER Working Papers 4193, National Bureau of Economic Research, Inc.
  3. Michael W. Brandt, 1999. "Estimating Portfolio and Consumption Choice: A Conditional Euler Equations Approach," Journal of Finance, American Finance Association, vol. 54(5), pages 1609-1645, October.
  4. Pástor, Luboš & Stambaugh, Robert F., 2002. "Liquidity Risk and Expected Stock Returns," CEPR Discussion Papers 3494, C.E.P.R. Discussion Papers.
  5. D'Avolio, Gene, 2002. "The market for borrowing stock," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 271-306.
  6. Inoue, Atsushi & Shintani, Mototsugu, 2006. "Bootstrapping GMM estimators for time series," Journal of Econometrics, Elsevier, vol. 133(2), pages 531-555, August.
  7. Yacine Ait-Sahalia & Michael W. Brandt, 2001. "Variable Selection for Portfolio Choice," NBER Working Papers 8127, National Bureau of Economic Research, Inc.
  8. Geczy, Christopher C. & Musto, David K. & Reed, Adam V., 2002. "Stocks are special too: an analysis of the equity lending market," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 241-269.
  9. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July.
  10. Blake LeBaron, . "Persistence of the Dow Jones Index on Rising Volume," Working papers _006, University of Wisconsin - Madison.
  11. Guillermo Llorente & Roni Michaely & Gideon Saar & Jiang Wang, 2001. "Dynamic Volume-Return Relation of Individual Stocks," NBER Working Papers 8312, National Bureau of Economic Research, Inc.
  12. Ryan Sullivan & Allan Timmermann & Halbert White, 1999. "Data-Snooping, Technical Trading Rule Performance, and the Bootstrap," Journal of Finance, American Finance Association, vol. 54(5), pages 1647-1691, October.
  13. Simon Gervais & Ron Kaniel & Dan Mingelgrin, . "The High Volume Return Premium," Rodney L. White Center for Financial Research Working Papers 1-99, Wharton School Rodney L. White Center for Financial Research.
  14. Mehra, Rajnish & Prescott, Edward C., 2003. "The equity premium in retrospect," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 14, pages 889-938 Elsevier.
  15. Conrad, Jennifer S & Hameed, Allaudeen & Niden, Cathy, 1994. " Volume and Autocovariances in Short-Horizon Individual Security Returns," Journal of Finance, American Finance Association, vol. 49(4), pages 1305-29, September.
  16. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
  17. Almazan, Andres & Brown, Keith C. & Carlson, Murray & Chapman, David A., 2004. "Why constrain your mutual fund manager?," Journal of Financial Economics, Elsevier, vol. 73(2), pages 289-321, August.
  18. Longstaff, Francis A, 2001. "Optimal Portfolio Choice and the Valuation of Illiquid Securities," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 407-31.
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