Portfolio Selection with Transaction Costs and Default Risk

Purpose: The purpose of this paper is to investigate the effect of default risk and transaction costs on the investor's asset allocation and the liquidity premium. More precisely, it aims at answering the following question: can default risk generate a first-order effect on the investor's asset allocation and a liquidity premium of the same order of magnitude as transaction costs? Design/methodology/approach: The author proposes a very simple consumption-investment model in which an infinitely-lived investor allocates her wealth between a risky asset and a riskless security, and incurs in proportional transaction costs when exchanging them. In addition, the risky asset may default at some random time, thus reducing the available wealth of the agent. Two different scenarios of default risk are considered. In the total default scenario, the value of the risky asset drops to zero when default occurs whereas, in the partial default case, the proceeds from the liquidation of the risky asset amount to 50% of its value. Findings: The paper shows that default risk can generate a first-order effect on the investor's asset allocation. On the contrary, the liquidity premium is one order of magnitude smaller than the transaction costs, implying that the additional source of risk determined by the possibility of default is not able to generate a first-order effect on asset pricing. Originality/value: To the author knowledge, this is the first paper that investigates the interaction of default risk and transaction costs on the investor's asset allocation and its effects on the liquidity premium