Dynamic portfolio choice with intertemporal hedging and transaction costs
File(s)
Accepted version
Author(s)
Muhle-Karbe, Johannes
Sefton, James
Shi, Xiaofei
Type
Journal Article
Abstract
When returns are partially predictable and trading is costly, utility maximising investors track a target portfolio at a constant trading speed. The target portfolio is optimal for a frictionless market, where asset returns are scaled back to account for trading costs and volatilities are adjusted to proxy the ``execution risk'' of holding assets that are costly to trade and exposed to volatile states. The trading speed solves an optimal execution problem, which describes how the legacy portfolio inherited from the past is traded towards the target portfolio in an optimal manner. Unlike for period-by-period mean-variance preferences as in Garleanu and Pedersen (2013), the target portfolio hedges changes in investment opportunities, and both it and the trading speed are linked and depend on execution risk. We set the problem out first in an 'absolute' framework - price shocks independent of the price level and investors have CARA preferences - and then in a 'relative' framework, with price shocks scaled by price levels and CRRA preferences. We illustrate the practical implications of these results for the model of Koijen et al. (2009), where return predictions are based on a short-term momentum and a long-term value signal.
Date Issued
2023-07-29
Date Acceptance
2025-07-03
Citation
Management Science, 2023
ISSN
0025-1909
Publisher
Institute for Operations Research and Management Sciences
Journal / Book Title
Management Science
Copyright Statement
Subject to copyright. This paper is embargoed until publication. Once published the author’s accepted manuscript will be made available under a CC-BY License in accordance with Imperial’s Research Publications Open Access policy (www.imperial.ac.uk/oa-policy).
License URL
Publication Status
Accepted