Dynamic portfolio choice with frictions

Abstract

We show that the optimal portfolio can be derived explicitly in a large class of models with transitory and persistent transaction costs, multiple signals predicting returns, multiple assets, general correlation structure, time-varying volatility, and general dynamics. Our continuous-time model is shown to be the limit of discrete-time models with endogenous transaction costs due to op-timal dealer behavior. Depending on the dealers ’ inventory dynamics, we show that transitory transaction costs survive, respectively vanish, in the limit, cor-responding to an optimal portfolio with bounded, respectively quadratic, vari-ation. Finally, we provide equilibrium implications and illustrate the model’s broader applicability to economics. ∗We are grateful for helpful comments from Kerry Back, Darrell Duffie, Pierre Collin-Dufresne,