Doctoral thesis

Essays in asset allocation


108 p

Thèse de doctorat: Università della Svizzera italiana, 2014

English This thesis consists of two chapters. In the first chapter, I analyze the optimal allocation of wealth to cash, bonds, and stocks when the interest rate is stochastic and the stock index has a time-varying mean. I find that, under certain economic conditions, the investor may optimally increase investments in stocks and bonds at the same time, which is due to the dynamic trading policies and the correlation between the asset classes. I also find that in different economic regimes, short-term investors have very different investment policies than long-term investors. Thus, dynamic asset allocation with nonzero bond-stock correlation helps explain why, during extreme market conditions such as the recent financial crisis, some investors sold all types of assets short, whereas other investors considered it an unprecedented buying opportunity. In the second chapter, I study the impact of time-varying bid-ask spreads in the optimal portfolio allocation. Relying on transaction- level data for a broad panel of bonds from 2004 through 2012, I find that the estimated bid-ask spread of bonds are highly time-varying and mean-reverting. The spread estimator peaks in 2008 during the credit market crisis and has a substantial volatility in 2011 and 2012 during the sovereign debt crisis. I further show that the hedge demand for liquidity risk for finite horizon investors may be as much as 50 percent larger than the demand for hedging interest rate risk.
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