Dynamic Portfolio Choice with Frictions

Nicolae Garleanu, Lasse Heje Pedersen

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Abstract

We show how portfolio choice can be modeled in continuous time with transitory and persistent transaction costs, multiple assets, multiple signals predicting returns, and general signal dynamics. The objective function is derived from the limit of discrete-time models with endogenous transaction costs due to optimal dealer behavior. We solve the model explicitly and the intuitive solution is also the limit of the solutions of the corresponding discrete-time models. We show how the optimal high-frequency trading strategy depends on the nature of the trading costs, which in turn depend on dealers' inventory dynamics. Finally, we provide equilibrium implications and illustrate the model's broader applicability to micro- and macro-economics, monetary policy, and political economy.
Original languageEnglish
JournalJournal of Economic Theory
Volume165
Pages (from-to)487-516
Number of pages30
ISSN0022-0531
DOIs
Publication statusPublished - Sep 2016

Keywords

  • Dynamic trading
  • Frictions
  • Transaction costs
  • Continuous time
  • Predictability
  • Equilibrium

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