Managing Transaction Costs in a Dynamic Trading Strategy

45 Pages Posted: 14 Aug 2014 Last revised: 28 Feb 2015

See all articles by James A. Sefton

James A. Sefton

Imperial College London

Sylvain Champonnois

UCSD Rady School of Management

Date Written: February 19, 2015

Abstract

We derive an explicit solution to a continuous time dynamic portfolio problem assuming investors maximize their welfare from a consumption stream in an incomplete market where returns to the securities are predictable but costly to trade. The solution is phrased in terms of a risk-sensitive Riccati equation. We show that the optimal trading strategy is to target a portfolio that is the optimal solution to a frictionless (or 'no-cost') dynamic portfolio problem but where the returns to the assets have been adjusted for costs; that is they have been expressed on a net rather than gross basis. The legacy portfolio (the inherited undesirable positions) are then traded away in line with a backward-looking optimal execution problem.

We show that the utility gradient is a stochastic discount factor that prices the assets net returns. Thus we are able to generalise some of the results of the martingale approach to dynamic portfolio theory to market with frictions.

Keywords: Dynamic Portfolio Theory, Transaction Costs

JEL Classification: G11, G12

Suggested Citation

Sefton, James A. and Champonnois, Sylvain, Managing Transaction Costs in a Dynamic Trading Strategy (February 19, 2015). Available at SSRN: https://ssrn.com/abstract=2480311 or http://dx.doi.org/10.2139/ssrn.2480311

James A. Sefton (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom
+44 (0)20 7594 9128 (Phone)

HOME PAGE: http://www3.imperial.ac.uk/people/j.sefton

Sylvain Champonnois

UCSD Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

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