Efficient Trading Strategies in the Presence of Market Frictions
September 1999
Elyès Jouini, Hédi Kallal
ABSTRACT
In this paper we provide a price characterization of efficient consumption bundles in multiperiod economies with
market frictions. Efficient consumption bundles are those that are chosen by at least one rational agent with monotonic
state-independent and risk-averse preferences and a given future endowment. Frictions include dynamic market incompleteness,
proportional transaction costs, short selling costs, borrowing costs, taxes, and others. We characterize the inefficiency
cost of a trading strategy -the difference between the investment it requires and the largest amount required by
any rational agent to obtain the same utility level - and we propose a measure of portfolio performance based on
it. We also show that the arbitrage bounds on a contingent claim to consumption cannot be tightened based on efficiency
arguments without restricting preferences or endowments. We examine the efficiency of common investment strategies
in economies with borrowing costs due to asymmetric information, short selling costs, or bid-ask spreads. We find
that market frictions generally change and typically shrink the set of efficient investment strategies, shifting
investors away from well-diversified strategies into low cost ones, and for large frictions into no trading at
all. Hence we observe strategies that become inefficient with market frictions, as well as strategies that are
rationalized by market frictions.
Subject: Investment/Market efficiency, Economics/Theory
Classification: Theoretical
Jouini : (212) 998-0279 ejouini@stern.nyu.edu
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