Stochastic Liquidity Model and Its Applications to Portfolio Selection

Abstract

Liquidity is a classical economic concept derived from an investor’s preference to hold assets that are easier to sell; generally, the greater the uncertainty, the greater the liquidity. Despite the large number of liquidity measures that have been proposed in the scientific literature, the financial market, and the recent international financial crisis, liquidity has played a minor role in the Modern Finance Theory, which focuses substantially on the return-risk trade-off. This study presents a financial engineering approach that deals with the liquidity phenomenon for a portfolio optimization problem. The proposed stochastic model was applied to investment portfolio formation using real data in two different financial markets (Brazil and USA), and its efficiency was tested comparing its results with those of another classical portfolio optimization model. The proposed model presented good out-sample performances in both markets, even when using fewer shares than those used in traditional models.