Traditional models of portfolio choice assume that investors can continuously trade unlimited amounts of securities. In reality, investors face liquidity constraints. I analyze a model where investors are restricted to trading strategies that are of bounded variation. An investor facing this type of illiquidity behaves very differently from an unconstrained investor. A liquidity-constrained investor endogenously acts as if facing borrowing and short-selling constraints, and one may take riskier positions than in liquid markets. I solve for the shadow cost of illiquidity and show that large price discounts can be sustained in a rational model.

Journal Article Optimal Portfolio Choice and the Valuation of Illiquid Securities Get access Francis A. Longstaff Francis A. Longstaff University of California, Los Angeles Address correspondence to Francis A. Longstaff, Anderson School, UCLA, Box 951481, Los Angeles, CA 90095-1481, or e-mail [email protected]. Search for other works by this author on: Oxford Academic Google Scholar The Review of Financial Studies, Volume 14, Issue 2, April 2001, Pages 407–431, https://doi.org/10.1093/rfs/14.2.407 Published: 21 June 2015

In the absence of frictions, the value of the underlying asset implied by option prices must equal its actual market value. With frictions, however, this requirement need not hold. Using S&P 100 index options data, I find that the implied cost of the index is significantly higher in the options market than in the stock market, and is directly related to measures of transaction costs and liquidity. I show that the Black-Scholes model has strong bid-ask spread, trading volume, and open interest biases. Option pricing models that relax the martingale restriction perform significantly better.

[In the absence of frictions, the value of the underlying asset implied by option prices must equal its actual market value. With frictions, however, this requirement need not hold. Using S&P 100 index options data, I find that the implied cost of the index is significantly higher in the options market than in the stock market, and is directly related to measures of transaction costs and liquidity. I show that the Black-Scholes model has strong bid-ask spread, trading volume, and open interest biases. Option pricing models that relax the martingale restriction perform significantly better.]

We study the valuation of state-issued tax-exempt municipal bonds and find that there are significant convenience premia in their prices. These premia parallel those identified in Treasury markets. We find evidence that these premia are tax related. Specifically, the premia are related to measures of tax and fiscal uncertainty, forecast flows into state municipal bond funds, and are directly linked to outmigration from high-tax to low-tax states and to other measures of tax aversion such as IRA and retirement plan contributions. These results suggest that investors are willing to pay a substantial premium to avoid taxes.

We use the prices of credit card asset-backed securities to study the market risk premium associated with unsecured consumer credit risk. We find that the market incorporates a substantial credit risk premium into the prices of these securities. Furthermore, there has been a major repricing of unsecured consumer credit risk since the 2007–2009 financial crisis. We find evidence that this increase is linked to balance-sheet costs imposed by postcrisis changes in regulations that have placed credit card securitizations back onto issuer balance sheets. These regulatory changes may have added more than 100 basis points to the cost of unsecured household credit.

A long-standing asset pricing puzzle is that the funding rates in derivatives contracts often differ from those in cash markets. We propose that the cost of renting intermediary balance sheet space may help resolve this puzzle. We study a persistent basis in what is arguably the largest derivatives market, namely, the interest rate futures market. This basis is strongly related to exogenous measures of intermediary balance sheet usage and proxies for the balance sheet costs imposed by debt overhang problems and capital regulation. These results extend to the cash derivatives bases documented in many of the other largest financial markets.

[This article studies the central role of the credit market. We show that the credit market facilitates optimal risk sharing by allowing less risk-averse investors to take on levered positions and consume more risk. The equilibrium amount behaves procyclically when aggregate consumption is low but countercyclically when it is high. The varying size of the credit market modifies the amount of risk sharing, which in turn influences asset prices such as expected stock returns, stock return volatility, and the term structure of interest rates. Our article provides a frictionless benchmark for the role and the behavior of the credit market.]

We derive the optimal investment policy of a risk-averse investor in a market where there is a textbook arbitrage opportunity, but where liabilities must be secured by collateral. We find that it is often optimal to underinvest in the arbitrage by taking a smaller position than collateral constraints allow. Even when the optimal policy is followed, the arbitrage portfolio typically experiences losses before the final convergence date. In fact, its initial performance may be indistinguishable from that of a conventional portfolio with a poor track record. These results have important implications for the role of arbitrageurs in financial markets.

This article presents a simple yet powerful new approach for approximating the value of American options by simulation. The key to this approach is the use of least squares to estimate the conditional expected payoff to the optionholder from continuation. This makes this approach readily applicable in path-dependent and multifactor situations where traditional finite difference techniques cannot be used. We illustrate this technique with several realistic examples including valuing an option when the underlying asset follows a jump-diffusion process and valuing an American swaption in a 20-factor string model of the term structure.