Working Paper: NBER ID: w19436
Authors: Andrew Ang; Dimitris Papanikolaou; Mark Westerfield
Abstract: We present a model of optimal allocation over liquid and illiquid assets, where illiquidity is the restriction that an asset cannot be traded for intervals of uncertain duration. Illiquidity leads to increased and state-dependent risk aversion, and reduces the allocation to both liquid and illiquid risky assets. Uncertainty about the length of the illiquidity interval, as opposed to a deterministic non-trading interval, is a primary determinant of the cost of illiquidity. We allow market liquidity to vary from `normal' periods, when all assets are fully liquid, to 'illiquidity crises,' when some assets can only be traded infrequently. The possibility of a liquidity crisis leads to limited arbitrage in normal times. Investors are willing to forego 2% of their wealth to hedge against illiquidity crises occurring once every ten years.
Keywords: Illiquidity; Asset Allocation; Risk Aversion
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| illiquidity (G33) | increased state-dependent risk aversion (D81) |
| increased state-dependent risk aversion (D81) | reduces allocation to both liquid and illiquid risky assets (G11) |
| uncertainty regarding the length of the illiquidity interval (C41) | increased cost of illiquidity (G19) |
| expected time between liquidity events increases (C41) | decreases allocation to illiquid assets (G11) |
| investor's allocation to illiquid assets decreases (G11) | mitigates risk of reaching states with zero liquid wealth (D14) |
| utility cost of illiquidity is highest for agents unwilling to substitute across time (E41) | highlights complex interplay between risk aversion and consumption smoothing (D15) |