Optimal portfolio choice and the valuation of illiquid securities

Traditional models of portfolio choice assume that investors can continuous ly trade unlimited amounts of securities. In reality, investors face liquid ity constraints. I analyze a model where investors are restricted to tradin g strategies that are of bounded variation. An investor facing this type of illiquidity behaves very differently from an unconstrained investor. A liq uidity-constrained investor endogenously acts as if facing borrowing and sh ort-selling constraints, and one may take riskier positions than in liquid markets. I solve for the shadow cost of illiquidity and show that large pri ce discounts can be sustained in a rational model.