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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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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. Sullivan, Ryan & Timmermann, Allan G & White, Halbert, 1998. "Data-Snooping, Technical Trading Rule Performance and the Bootstrap," CEPR Discussion Papers 1976, C.E.P.R. Discussion Papers.
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  13. 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.
  14. 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.
  15. 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.
  16. 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.
  17. Blake LeBaron, . "Persistence of the Dow Jones Index on Rising Volume," Working papers _006, University of Wisconsin - Madison.
  18. John Y. Campbell & Sanford J. Grossman & Jiang Wang, 1993. "Trading Volume and Serial Correlation in Stock Returns," The Quarterly Journal of Economics, Oxford University Press, vol. 108(4), pages 905-939.
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