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arXiv · 0906.0999

The premium of dynamic trading

Chun Hung Chiu·Xun Yu Zhou
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Abstract

It is well established that in a market with inclusion of a risk-free asset the single-period mean-variance efficient frontier is a straight line tangent to the risky region, a fact that is the very foundation of the classical CAPM. In this paper, it is shown that in a continuous-time market where the risky prices are described by Ito's processes and the investment opportunity set is deterministic (albeit time-varying), any efficient portfolio must involve allocation to the risk-free asset at any time. As a result, the dynamic mean-variance efficient frontier, though still a straight line, is strictly above the entire risky region. This in turn suggests a positive premium, in terms of the Sharpe ratio of the efficient frontier, arising from the dynamic trading. Another implication is that the inclusion of a risk-free asset boosts the Sharpe ratio of the efficient frontier, which again contrasts sharply with the single-period case.

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Chun Hung Chiu, Xun Yu Zhou. 2009-06-04. The premium of dynamic trading. https://arxiv.org/abs/0906.0999

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