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Optimal Asset Rebalancing in the Presence of Transactions Costs


  • Hayne Leland.


We examine the optimal trading strategy for an investment fund which wishes to maintain two assets in fixed proportions, e.g. 60/40 in stocks and bonds. Transactions costs are assumed to be proportional to the amount of each asset traded. We show that the optimal policy involves a band about the target stock proportion. As long as the actual stock/bond ratio remains inside this band, no trading should occur. If the ratio goes outside the band, trading should be undertaken to move the ratio to the nearest edge of the band. We compute the optimal band and resulting annual turnover and tracking error of the optimal policy, as a function of transactions costs, asset volatility, the target asset mix, and other parameters. We show how changes in transactions costs and other parameters affect the size of the no-trade band, turnover, and tracking error. Compared to a quarterly rebalancing strategy an example demonstrates that the optimal strategy can reduce turnover by almost 50 percent.
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Suggested Citation

  • Hayne Leland., 1996. "Optimal Asset Rebalancing in the Presence of Transactions Costs," Research Program in Finance Working Papers RPF-261, University of California at Berkeley.
  • Handle: RePEc:ucb:calbrf:rpf-261

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    References listed on IDEAS

    1. Leland, Hayne E, 1985. " Option Pricing and Replication with Transactions Costs," Journal of Finance, American Finance Association, vol. 40(5), pages 1283-1301, December.
    2. George M. Constantinides, 2005. "Capital Market Equilibrium with Transaction Costs," World Scientific Book Chapters,in: Theory Of Valuation, chapter 7, pages 207-227 World Scientific Publishing Co. Pte. Ltd..
    3. Dumas, Bernard, 1991. "Super contact and related optimality conditions," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 675-685, October.
    4. Dumas, Bernard & Luciano, Elisa, 1991. " An Exact Solution to a Dynamic Portfolio Choice Problem under Transactions Costs," Journal of Finance, American Finance Association, vol. 46(2), pages 577-595, June.
    5. Hayne Leland and Gregory Connor., 1995. "Optimal Cash Management for Investment Funds," Research Program in Finance Working Papers RPF-244, University of California at Berkeley.
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    Cited by:

    1. Hiroatsu Tanaka & Naohiko Baba, 2003. "Optimal Timing in Trading Japanese Equity Mutual Funds: Theory and Evidence," Bank of Japan Working Paper Series 03-E-2, Bank of Japan.
    2. repec:wsi:qjfxxx:v:02:y:2012:i:03:n:s2010139212500115 is not listed on IDEAS
    3. Gandolfi, G. & Sabatini, A. & Rossolini, M., 2007. "PID feedback controller used as a tactical asset allocation technique: The G.A.M. model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 383(1), pages 71-78.

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