TRANSACTION COSTS AND EFFICIENCY OF PORTFOLIO STRATEGIES

Some recent results for frictionless economies show that popular dynam ic portfolio strategies such as stop-loss and lock-in are inefficient. I.e. for each of these strategies there exists an alternative portfol io strategy that gives the same final payoff distribution at lower ini tial costs. However, the alternative strategies require considerably m ore active trading than the simple strategies. The results rely heavil y on the assumption of no transaction costs, Under this assumption the initial investment required is a linear function of the prices of the contingent claims that build the final payoff distribution. In this p aper we demonstrate that, even for modest levels of transaction costs, the efficient strategies are more costly than the simple strategies, i.e. a strategy that replicates the final payoff distribution of an ef ficient strategy is excessively costly due to the transaction costs an d the heavy trading involved. Since the initial investment is no longe r a linear function of the contingent claims, the optimization problem s to find the most efficient strategy are complicated combinatorial op timization problems which can only be solved for trees with a small nu mber of steps. In a world without transaction costs, options are redun dant instuments, since all payoff distributions can be replicated by t rading in stocks and bonds. In the second half of this paper we show t hat the use of options in a world with transaction costs enables inves tors to realize final value distributions at lower initial costs than would be possible with trades in stocks an bonds only. Hence, although in theory options do not give rise to other portfolio strategies, the y do in a more restrictive setting with transaction costs.