Hedge or Rebalance: Optimal Risk Management with Transaction Costs

21 Pages Posted: 23 Aug 2018 Last revised: 7 Sep 2018

See all articles by Florent Gallien

Florent Gallien

Swissquote Bank

Serge Kassibrakis

Swissquote Bank

Semyon Malamud

Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

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

Gallien, Florent and Kassibrakis, Serge and Malamud, Semyon, Hedge or Rebalance: Optimal Risk Management with Transaction Costs (July 4, 2018). Swiss Finance Institute Research Paper No. 18-60, Available at SSRN: https://ssrn.com/abstract=3230622 or http://dx.doi.org/10.2139/ssrn.3230622

Florent Gallien

Swissquote Bank ( email )

Ch. de la Crétaux 33
Gland, Vaud 1196
Switzerland

Serge Kassibrakis

Swissquote Bank ( email )

Ch. de la Crétaux 33
Gland, Vaud 1196
Switzerland

Semyon Malamud (Contact Author)

Ecole Polytechnique Federale de Lausanne ( email )

Lausanne, 1015
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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