Hedge or Rebalance: Optimal Risk Management with Transaction Costs
21 Pages Posted: 23 Aug 2018 Last revised: 7 Sep 2018
Date Written: July 4, 2018
Abstract
We solve the problem of optimal risk management for an investor holding an illiquid, alpha generating fund and hedging his position with a liquid futures contract. When the investor is subject to a drawdown constraint, he is forced to reduce the total risk of his portfolio after a drawdown. In this case, he faces a tradeoff of either paying the transaction costs and deleveraging, or keeping his current position in the illiquid instrument and hedging away some of the risk while keeping the residual, unhedgeable risk on his balance sheet. We explicitly characterize this tradeoff and study its dependence on asset characteristics. In particular, we show that higher alpha and lower beta typically widen the no-trading zone, while the impact of volatility is ambiguous.
Keywords: Optimal Portfolio Choice, Transaction Costs, Hedging, Drawdown Constraints
JEL Classification: G11, C61
Suggested Citation: Suggested Citation