Liquidity Risk Integration in Portfolio Choice: the Bid Efficient Frontier

International audienceThe objective of this paper is to propose a tractable solution to integrate partially market liquidity risk in portfolio choice. The fundamental idea of this paper is that investor behavior must integrate liquidity environment. Actually, even if illiquidity frightens investors, in peculiar cases, liquidity can give a really interesting premium and this duality of market liquidity risk is difficult to integrate in portfolio choice, even in mean-variance framework. I reveal that bid prices, instead of closing prices, can capture it partially. This paper suggests therefore one first step to find a simple and very tractable solution which tries to completeMarkowitz paradigm with liquidity risk management. Empirical results show that the bid efficient frontier aims to propose efficient allocations with more liquid stocks (large capitalizations) under stressed conditions and more illiquid stocks (small capitalizations) under normal conditions to take advantage of the liquidity risk premium