Working Paper: NBER ID: w12633
Authors: Eduardo S. Schwartz; Claudio Tebaldi
Abstract: The presence of illiquid assets, such as human wealth or a family owned business, complicates the problem of portfolio choice. This paper is concerned with the problem of optimal asset allocation and consumption in a continuous time model when one asset cannot be traded. This illiquid asset, which depends on an uninsurable source of risk, provides a liquid dividend. In the case of human capital we can think about this dividend as labor income. The agent is endowed with a given amount of the illiquid asset and with some liquid wealth which can be allocated in a market where there is a risky and a riskless asset. The main point of the paper is that the optimal allocations to the two liquid assets and consumption will critically depend on the endowment and characteristics of the illiquid asset, in addition to the preferences and to the liquid holdings held by the agent. We provide what we believe to be the first analytical solution to this problem when the agent has power utility of consumption and terminal wealth. We also derive the value that the agent assigns to the illiquid asset. The risk adjusted valuation procedure we develop can be used to value both liquid and illiquid assets, as well as contingent claims on those assets.
Keywords: illiquid assets; optimal portfolio; asset allocation; human wealth; risk-adjusted valuation
JEL Codes: G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| characteristics of illiquid asset (G33) | optimal allocation to liquid assets (G11) |
| characteristics of illiquid asset (G33) | consumption (E21) |
| correlation between liquid and illiquid assets (G19) | allocation to risky liquid asset (G11) |
| human wealth correlation with stock market (G19) | allocation to risky liquid asset (G11) |
| elasticity of consumption with respect to liquid and illiquid wealth (E21) | propensity to consume from liquid wealth (E21) |
| elasticity of consumption with respect to liquid and illiquid wealth (E21) | propensity to consume from illiquid wealth (E21) |