Ang, Chapter 13: Illiquid Assets - Asset Allocation with Transaction Costs

[Stuti]

Hi,

I am unable to understand this section of the chapter:

Constantinides proved that the optimal strategy is to trade whenever risky asset positions hit upper or lower bounds. Within these bounds is an interval of no trading. The no-trading band straddles the optimal asset allocation from a model that assumes you can continuously trade without frictions. The no-trade interval is a function of the size of the transactions costs and the volatility of the risky asset.

Constantinides estimates that for transactions costs of 10%, there are no-trade intervals greater than 25% around an optimal holding of 25% for a risky asset with a volatility of 35%. That is, the asset owner would not trade between (0%, 50%) – indeed, very large fluctuations in the illiquid asset position. Illiquid asset investors should expect to rebalance very infrequently.

Also do we have a question set for this chapter?

 

[QuantMan2318]

Hi @Stuti

You see, Illiquid Assets are a different ball game from what we are used to, like Liquid and Tradeable securities. The Author Ang as well as Constantinides feel that Illiquid Assets involve extremely high transaction costs per transaction as there are not enough counterparties on the other side whenever we need them, therefore, these Assets can or should be traded only when the situation gets serious (i.e.) beyond the lower most or the upper most limit of what we want to tolerate as the value. Therefore, they say that these higher transaction costs are justified and the transaction goes beyond breakeven only if the value of the Asset goes extremely low, the lower bound where we may buy the Asset or extremely high, the Upper Bound, where we may sell. between these two is the zone of no transaction.

Constantinides says that the bound is a function of volatility of the Asset (35%) and the Transaction Cost (10%) , therefore it can be anything like 35 +10 = 45% or some other number, therefore within this bound (0 to 45 or even 50 based on the function), there are no transactions.

My Understanding is as follows, if its wrong, members who are in the know may correct me
This no trade zone, will cover (enclose) the model based on continuous trading without frictions ( limitations ) as the trade and position suggestions given by the Continuous trade models will be rendered useless by the above Transaction Cost based model as most of the positions under, say Markowitz will fall under the No trade/No Transaction zone.

Hope this helps and Best of Luck for the exams!

 

[Stuti]

Hi @Stuti

You see, Illiquid Assets are a different ball game from what we are used to, like Liquid and Tradeable securities. The Author Ang as well as Constantinides feel that Illiquid Assets involve extremely high transaction costs per transaction as there are not enough counterparties on the other side whenever we need them, therefore, these Assets can or should be traded only when the situation gets serious (i.e.) beyond the lower most or the upper most limit of what we want to tolerate as the value. Therefore, they say that these higher transaction costs are justified and the transaction goes beyond breakeven only if the value of the Asset goes extremely low, the lower bound where we may buy the Asset or extremely high, the Upper Bound, where we may sell. between these two is the zone of no transaction.

Constantinides says that the bound is a function of volatility of the Asset (35%) and the Transaction Cost (10%) , therefore it can be anything like 35 +10 = 45% or some other number, therefore within this bound (0 to 45 or even 50 based on the function), there are no transactions.

My Understanding is as follows, if its wrong, members who are in the know may correct me
This no trade zone, will cover (enclose) the model based on continuous trading without frictions ( limitations ) as the trade and position suggestions given by the Continuous trade models will be rendered useless by the above Transaction Cost based model as most of the positions under, say Markowitz will fall under the No trade/No Transaction zone.

Hope this helps and Best of Luck for the exams!

Thank you