Faculty of Economics and Business Administration Publications Database

Asset Allocation and Liquidity Breakdowns: What if your Brocker does not Answer the Phone?

Diesinger, Peter
Seifried, Frank Thomas
Volume: 14
Number: 3
Pages: 343 - 374
Month: September
ISSN-Print: 0949-2984
Link External Source: Online Version
Year: 2010
Keywords: Illiquidity; Blackout period; Portfolio decision; Efficiency loss; Rare disasters
Abstract: This paper analyzes the portfolio decision of an investor facing the threat of illiquidity. In a continuous-time setting, the efficiency loss due to illiquidity is addressed and quantified. For a logarithmic investor, we solve the portfolio problem explicitly. We show that the efficiency loss for a logarithmic investor with 30 years until the investment horizon is a significant 22.7% of current wealth if the illiquidity part of the model is calibrated to the Japanese data of the aftermath of WWII. For general utility functions, an explicit solution does not seem to be available. However, under a mild growth condition on the utility function, we show that the value function of a model in which only finitely many liquidity breakdowns can occur converges uniformly to the value function of a model with infinitely many breakdowns if the number of possible breakdowns goes to infinity. Furthermore, we show how the optimal security demands of the model with finitely many breakdowns can be used to approximate the solution of the model with infinitely many breakdowns. These results are illustrated for an investor with a power utility function.