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Patel and Marti G. Subrahmanya Source: Management Science, Vol. 28, No. 3 (Mar., 1982), pp. 303-314 Published by: INFORMS Stable URL: http://www.jstor.org/stable/2630883 . Accessed: 06/10/2011 05:25

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This method can also be extended to. 28. this implication of portfolio theory does not accord with the observed holdings of securities by investors. among dividend paying stocks. However. the development of modern portfolio theory to optimize selection of portfolios under different scenarios and the other. who typically hold a small number of securities. The only detailed analysis of the fixed transaction costs problem in the portfolio selection literature is by Brennan [2]. Pogue [16]. of Ahmedabad. the question of undiversified portfolios remains unresolved.. 2Stapleton and Subrahmanyam [19] provide an analysis of the effect of fixed transactioni costs on equilibriulll prices. and Zionts [3]). However. 'In a study by Blume. if the structure of returns between securities is such that the pairwise correlation coefficients are approximately the same. Introduction The pioneering work of Markowitz ([13] and [14]) in portfolio analysis has served as the basis for the development of much of modern financial theory. March1980. However. However. INew YorkUniversity. by and large. 1i IndianInstitute Management.2 Assuming that the structure of the Sharpe [18]. 34 per cent held only one stock. it was computed that. Crockett and Friend [1] for the tax year 1971. No. a fairly simple algorithm which requires little computational effort can be employed. they are concerned more with asset prices with this market imperfection and do not deal with the optimal portfolio selection problem directly. PATELt AND MARTI G. PORTFOLIO SELECTION) 1. which are ignored in much of the theory. FINANCE-INVESTMENTS. Levy [10] examine the fixed transaction costs problem indirectly by placing restrictions on the number of securities in the optimal portfolios. One basic implication of most models in portfolio theory is that investors are well diversified in their holdings of securities. A SIMPLE ALGORITHM FOR OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS* NITIN R. and provide only a general rationale for the restriction. SUBRAHMANYAMt The general optimal portfolio selection problem witlh fixed transaction costs is a complex mathematical programming problem.' While there are alternative explanations of this phenomenon. The Itistittite of Management Scietnces . March 1982 Priinted in U. Though some attention has been focussed on the question of variable transaction costs. 303 0025-1909/82/2803/0303$0 1. and Chen. 50 per cent held no more thanitwo anidonly I I per cent listed more thaniten stocks.This paperhas beenwith the authorI monthfor I *Acceptedby MartinJ.25 Copyrigiht 0) 1982. Jen. the derivation of a theory of pricing of capital assets under uncertainty.the case where changes in the information set necessitate a revision of an existing portfolio. Jacob [9]. broadly defined to include both direct costs such as brokerage commissions as well as the costs of analyzing securities. Variable transaction costs render individual securities less desirable but do not inhibit the addition of more securities to a portfolio. Two directions of enquiry have been pursued in the literature: one. (see for example. Based on a sample of individual income tax returns. it is possible to simplify the solutioni of the problem.S. They therefore use an enumilerationi method to solve the portfolio problem in order to determine equilibrium prices. they do not explicitly relate the optimal number of securities to the transaction costs. an important factor is the presence of transaction costs. Specifically. it was foulld that investors hold relatively undiversified portfolios. Mao [12]. 3.received revision. by placing reasonable restrictions on the variance-covariance matrix of returns. Gruber. and more recently.MANAGEMENT SCIENCE Vol. (FINANCE. Fixed transaction costs such as odd-lot commissions do provide an explanation for the phenomenon of reduced portfolio size but this market imperfection has not been modelled in the literature.

i = 1.t i =1 Yi (1) subjectto i=l xi+?xO=W = where the xi are unrestricted in sign. he assumes that all securities have the same systematic risk and the same residual variance. which imply that the standard capital asset pricing model may not be relevant to that investor. . But. n. G. 2. the same expected return. identical systematic risk. ?5 deals with the case where changes in the information set and/or the wealth constraint necessitate a revision in the portfolio. and derives the optimal number of securities. Initially. More importantly. Finally. While this may be a reasonable approximation. Interestingly. xi = amount invested in (risky) security i. . the relationship of additional securities to the existing portfolio has to be taken into account. even with a relatively small number of securities.. this begs the question of superior access to information and consequently different estimates of the parameters of security returns.ai i1 Z1 j=1 x x1sis1p1. and hence. i =1. Ri= 1 ? expected rate of return on security i.304 N. 1. . it is possible to simplify the problem. n. xo= amount invested in the riskless security. Secondly. the Brennan model focusses on the number of securities rather than on individual candidate securities themselves. R. Firstly. There are several difficulties with the Brennan formulation. portfolio selection models are of dubious merit. if the capital asset pricing model were always valid. Indeed. The . . . PATEL AND M. . Brennan presents a model for determining the optimal number of securities in the portfolio. except for the residual variance component which may not be significant. yi = 0 or 1. The Model The portfolio selection problem of the investor in a mean-variance context with fixed transaction costs can be written as: 11 s1 17 n Max i= xiRi + xoR. . this pricing relationship is itself affected when several investors operate under fixed transaction costs as shown by Levy [10]. and through the capital asset pricing model. In this case. the attractiveness or otherwise of an individual security cannot be examined except in the trivial sense that securities with lower residual variance are preferred. in equilibrium. 2. an unattractive feature of many portfolio selection models from the viewpoint of practicing portfolio managers. he needs to assume that the capital asset pricing model holds. the model is discussed and a simplified form of the objective function is presented. The next section derives the algorithm and proves that the simple rules derived are optimal. the solution of the problem can be reduced to a fairly simple algorithm involving very little computational effort. by placing reasonable restrictions on the variance covariance matrix of returns. 2.. Hence. . = 0 otherwise. 2. SUBRAHMANYAM Lintner [11] and Mossin [15] capital asset pricing model holds even under fixed transactions costs. The general optimal portfolio selection problem with fixed transaction costs is a complex mathematical programming problem. Subsequently. n. and xi # 0 only if yi definition of the variables are as follows: = 1 if security i is part of the portfolio.. i = 1. A numerical example is worked out and explained in ?4.. the computation of the optimal number of securities is quite complicated. he relaxes the assumptions of identical residual variance. ceterisparibus. In ?2.

2. empirically. another intuitively appealing simplification. 2. An alternative formulation would be to treat it as a reduction in the resources available for investment. The structure of the single-index model does not permit the decomposition analyzed in this paper. [8]. Surprisingly. . and Urich. In a more recent study by Elton. Equivalently. the forecasting performance of the constant correlation coefficient assumption is tested using a variety of statistical procedures. We have chosen the former alternative. we have chosen to model the fixed transaction cost as leading to a reductioll in the mean end of period caslhflow. there are two possibilities. The performance of this assumption is consistently superior to that of all the alternatives in each of the statistical tests performed. This cost is assumed to be incurred at the end of the period. The first term refers to the mean end of period cash flow to the investor from holdings of risky assets. a = risk aversion factor of the investor (a > 0). . since the interactions due to the integer constrainits become more difficult to handle.4 Suppose we assume that pUj= p for all i. the two approaches are formally equivalent. the fixed transaction cost per security at the beginning of the period is equal to t/R. One possible restriction on the structure of returns is that all pairwise correlation coefficients between security returns are equal. . the most general specification possible. As will be clear in the analysis later on. The next term relates to the return from the riskless asset. while the last term refers to the fixed transaction cost. pij = correlation coefficient between the returns on securities i and j. The third term is the variance of end of period cash flow. However. 4The fixed transaction costs problem using the simplified structure suggested by the single index model of Sharpe [17] will be analyzed in a subsequent paper. n. 3In this formulation. In a study of alternative methods of forecasting the correlation structure of returns. At this point. The constant correlation coefficient assumption will be used in the rest of this paper.OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS 305 R = 1 + rate of return on the riskless security.n. In the Elton and Gruber study. The other method would be to obtain an approximate solution to the problem as formulated. This aspect of the problem complicates it considerably. except for the term involving the fixed transaction cost. Elton and Gruber [4] demonstrate that this assumption produces better estimates of the future correlation structure of security returns than do correlation coefficients based on historical returns which may differ across pairs of securities. j. While this assumption is difficult to justify on any conceptual grounds. Si= standard deviation of the rate of return on security i. in this model.3 However. the assumption of a constant correlation coefficient produced forecasts that were more accurate than nine other specifications that were tested. with the cost appearing in the wealth constraint. i = 1. The first would be to simplify the structure of the model by placing some restrictions on the parameters. . there is a basic difference. the computation of the mean return and the variance of the return of the portfolio takes into account only those securities that are in the portfolio rather than all the securities available in the market. W = initial wealth of the investor. . j = 1. Gruber. i.. it turns out that the solutioni technique for this case is more complex than the case studied here. t = fixed transaction cost incurred for each risky security included in the portfolio. it has been shown to be a reasonable assumption. . the single index approximation of Sharpe [17] does not perform as well as the constant correlation assumption. i #/ j (p > 0). since it becomes a mixed-integer quadratic programming problem for which no simple solution method exists. The above formulation appears to be similar in form to the standard Markowitz model with a riskless asset.

(5) Multiplying (5) by sj and adding over all j E S. n. 2as1 -p) (I . xi are unrestricted in sign with the proviso that xi #/ 0 only if Yi= 1. j C S. the objective function becomes a concave function of xj. Eliminating xo using the wealth constraint. ]C S. Taking derivatives gives us the following necessary and sufficient5 conditions for optimal levels of xj. . . (R1 . 2.R MEmp E i- wherem=jSj iS so that iES 2a[mp + (I -p)] S s (6) Substituting (6) into (5) yields = (Rj - R)yj pyjEiEs(Ri -R)si 2a(l _ p)S>2 djy] 2a( . R.. then yj = 1 for j C S and yj = Xj= 0 for j 4 S. E i=1 The portfolio selection problem of the investor becomes Max Xi > x.R) or - j 2aps n sixiS-2a(1 _p)s.n n 2a(1-p)s? pyjziE~sciyi 2s 2a(1-p)[(m-1) +p1] j=I1 7 (7) sThe first order condition is sufficient since the objective function after substituting the constraint is concave.. .25 . (3) x. = 2 0O.iji 1... If the securities chosen to form the portfolio belong to some set S c (1. Rj -s( p) PE (i pj y. G. jS E R.. Sincey1 = 1 if and only if xj #0 . given S. . (lp)s j4S jI 4 S.306 N. SUBRAHMANYAM The variance of the end of period cash flow can be written as n p i=1 j=1 n xXjjsjsj + n1 E X12Si i=1 fl i#&j n n1 =p>E i=lj=l E j + (_1p) X)2SI.x1=0. we get ES E sx.RJ ? xOR-t i=1 yi-a E i=1 E xi + x0 = W i= 1 17 n 17 n * x1x1ssj + (1-p) i=1 E p i=1 y =1 xsi2 2 subject to and yA= 0 or 1.p)[(m- I)p + I ]sj j 1 5. xo. n.. PATEL AND M.

our problem is reduced to Max cj2y1 j=ll [(in-I)p and + 1](J yj = m. the objective function becomes n j=1 2. 3. using the wealth constraint. Suppose there is such a j. (9) Substituting for xj from (7) the objective function expressed in terms of y. t. Let S be the set of optimal securities for a given number of securities chosen. Then there is no j E S such that both] .. p.R)/sj represents the excess return of security j over the riskless rate of return as a ratio of the standard deviation of the return of the security.WR. R are constants. j=l subject to yj =0. they may be treated as a single security in our analysis. since a.1 andj + 1 X S. becomes 4a(1l_-p) 1 -' Yj- { [(m- ? I - tm . and rearranging.(8) Substituting for x0 in the objective function.Note if two securities have the same ci. we get p 2 SiS (I sjs~xix~?j+-p) ~~~(Rj -R) j~s. w. y es i e i~~Sj~~S Sje s s]xj2= jx ye Ss 2a 7.2 (i.R)xjl2- tm + WR.7. Let OFV ( Q) denote the objective function value for any set of indices Q. ISj = m and S = (k I Yk = 1}). so that the strict inequalities above do not imply any loss of generality. Multiplying (3) by Xj. Let S' = S .c7 - [(m-I)p ( + 1(is Ec1)/ ( E ci) - (11) -S[(i l)p [ lM 1] cI 2pcki v [i )p? 1] cj* (12) OFV(S'U{]-1})= [(m-2)p + 13 . The Algorithm We are now in a position to derive a simple algorithm for portfolio selection and show that it is optimal. adding over j E S.OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS 307 where cj = (R . and using (8). m >. We argue from contradiction.. > c. THEOREM 1.(j}.l We assume that the securities have been ranked so that cl > C2 .e. (Rj . (10) For fixed m. OFV (S)= S O iES Ec 1. . m.

+ .I .E.* is optimal.2. . . Subtracting (b) from (a) we have [ (m -2)p + I I(Ci+ I.OFV(S'U{j ? 1}) > 0 leads to (cj+I-cj){2p E ci-[(m-2)p 1(cI + + c) >0 i E-sI and since cj+I . Since u.) t2p ci .(m + 1) + u*1 + 1 =n-rm u U. n} where l*= n-m + u* + 1.2)p + I ] (cj-. 2.D. the optimal S is of the form l 1 {1. We shall therefore say that an optimal portfolio is u* to mean that the securities in the portfolio are {1. . .. the expression in curly brackets (call it (c)) > 0.+ n.cj > 0. We conclude from Theorem 1 that for a given m. an optimal portfolio can be represented by the single number u. SUBRAHMANYAM OFV(S'U { j(j 2P 1}) > 0 [ (m-1)p + 1 or lcj) iE c .+ C \i= ? ) [ (i - + ) 2)p + 1] (c. since u. n} where u + n-I + = m. PATEL AND M. 1*. u*.*+? ? u* ?2. if u* = m. l* = n + 1 and the portfolio represented in this case will be { 1. . + 1.* + 1 with security objective function value cannot irncrease. v THEOREM Let u. m}.. U*1 + be optimalportfolios of sizes m and m + 2.c.s*+. u. the expression within the curly brackets above.[ (m -2)p + I ] (CJ_lc /-) > O (ci. if we exchange security u. R. + n-rn +?u* + 1 and i+H = n . . 2.l* + 1.+ 1 respectively.Let u* + . 1*l= U*[ + > u* +l + 2. increasing 1/*7and u.+.. We argue from contradiction..*7? is optimal. we conclude 0 t{221 [/tI1+I fl the (c.* both by 1 cannot increase the objective function value.l*.* if p > 0 and c1 > 0. . . .. . For m > 2. so that U. . Under the hypothesis. . Q.ci. G. since 1 = n .m + u + 1.. 1.2)p + 1](cl C"* + > ?. A similar argument using OFV(S) . ci [( .From this. + n-m + ?. )I Since the first factor above > 0.nm + 2 > n - m + U.*)*. (call it (b)).*.*7 1 > u. (i) We first show u. In fact. 1= Then u* + 1 > U. suppose u. . . .* - c.. + cj)) > O (14) and since cj. the expression within the curly brackets above (call it (a)) must be greater than or equal to zero.. ? 1= l..[ (m .*?1){2(12p t c+ i= i=l ?2 ci + i=l.) >1 .*. must be less than or equal to zero. the first factor above > 0 which implies cj+I > cl which is a contradiction.308 Since OFV(S) - N..cj < 0. From this we conclude cl (C - cl*){ 2p (Eci /. Also.* + ? cl*) ? 0. .l .

. (If we include the effort involved in sorting the securities in increasing order of ci. 1.. Since p > 0. OFV(S*. 2.*+ 1 the objective function is larger. .+ I ci - 2 i=U. .1 + 1. then to find u* for which value of the pair u.[(m -2)p + I ](cI. 2 * U.) > 2p ci..) < 0.l . Theorems 1 and 2 directly suggest an algorithm for finding the optimal portfolios for different values of m. 2.*..?I) = (c.D. + I-.* + Xtil +I E i l. we have 2p i = l. we conclude that u* + 1 > u*+ (ii) To show that u. 0 where S' = 1. . I' + X n-rn + tu.* + 2 > u*1 and hence. Let S. It follows that u.E. we need only to check This theorem tells us that if we have u. for m = 1. Then securities 1.n}. S*. very efficient.11+i - i=n-m+u.[((m - 2)p + I] (c.If expression (10) has a maximum value for Sk*i then Sk is the optimal portfolio. S.+ ci= i=.. the algorithm is O(n log n)... It is easy to show that the computational complexity of the algorithm is 0(n) and is.*. .2.*..OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS 309 The first factor above being < 0.. f..1 + 1.. since ci > 0.) - OFV(S.1 I c.. u. . Now (c lcl. therefore.+ cl.1. 3. . m.u -l. Next we prove an interesting characteristic of optimal portfolios... S.)} l. .) Once the optimal portfolios S*.. . . Q.2.n. so that 2p E ci.u. .. + > u*.*t+Il by 1. we can determine that best portfolio for a given a and t by evaluating expression (10) for S*..= { l.u- + c. n are sold short. i=ti*+2 ci) <0 since c.. u are bought long and 1. Since S* is optimal.2.+2) ci > 0. I l. implies that the expression in the curly brackets (call it (d)) < 0. 1. . . S*. we follow an exactly analogous argument but decreas- ing u + l and '. . . for each value of m are obtained.. . . the above expression is less than n-rnm+. n} be the optimal set of securities THEOREM for a fixed m (l > u + 1).*.* E +2 ci= i = n7-77n + ti* +2 E ci- E i = t* +2 ci> 0. This algorithm is flow-charted in Figure 1. . . However. .*. Subtracting (d) from (c). l.. Sm 1={l..) < 0 i (= sI or ](cl [(m-2)p + IlI _I + cl. its objective function value is not less than for the portfolio .) {2p E ci ._1+ i < ciThis leads to a contradiction.* ci1+2 i=u*+2 ci E (C.. .

Cj so that Xj*> O for all j = 1. Sl 2X*+2>*** SX. . > cl_ I.. The Algorithm. [ (m-1 I)p + I ]pZE c.*c.*. > An analogous argument shows that x* . it follows that xl* Now for all j u. Sincec11 > c. SUBRAHMANYAM Start OFVt= OFV( I) l.XI* and s.p+ I>c"[ (M )p + I>p E i (E s... [ From (7) c.xl > s X* > Q. - + + -1') es > OFV( S. U1[( - + 1]=- ~~~~~No + I -p)+[( I Ul)*p 1] ? S....D. . Since c. .. n. < O and hence Xj*< O for all j = 1..*.+ x* 1.~~~~~~~~~~~~~~~~~~~~~~1 |OFV.[(M-l)p (m-l2)p+l1]ci - l)>p + Ici] i s IIl 2as" (I1-p) < + I ]-p PZE -s.. PATEL AND M.. [ (m-1 I)p + I Since both numerator and denominator are greater than zero.<.. R. 2. Note also that s . G.( S-*p)U[( -*l FIUE.*. f l No Yes FIGURE 1.x* > s.E. u.[(m -2)p + I] 2as" (I1-p) sc 0.1I + s X* > ***> S.*a+. +. Cj[ (M 1).310 N. Algorthm OFV( +. (The proo>olw ill fro (7)). .Te S.

C17 = 0. C3= 0.1859 31.2.2] [1. The Cjwere chosen randomly in the interval (0. 14.1735 41.719. 0. 17 to 20] [I to 4.4762 40.0642 41.8696.209.15. X*= . 11 to 20] [I to 9.2477 6.6496 6. X =*= x = - 22.17. 13 to 20] [Ito 6.3.5393 Expression (10) 18.429.2.0362.4439 8.7151 40. 16 to 20] [I to 4. 14. 152.875.0362. C14 =0. 120.7539 10. p = 0.8888 20] 2.9204 36. = 0.6303 38..5362.585.* 0.16. C6 = 0.1894 9. c8 = 0. X = 33.1414 3.17.2137. 1). .839. 15 to 20] [I to 4.0471. c13 = cX = 0.19. t = 1.1371 40.8108 11. x*0= -21. x*= -20. 12 to 20] [I to7. given by S= [1. 13 to 20] [I to 7. c9 = 0.01 and sj = 1 forj = 1.4594 0. 142.3384 37.0365 8.2828 10.331. i.0278 5.9329 34. C15 = 0. a = 0.4529.6090 9. 18 to 20] [I to 3. . 168.6939 I 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 [I to 3. C19 0.245.312. C4 = 0.1408 24.16.0009 39. C7 = 0.0542. 13 to 20] [I to 7.2574 29. C16 = 0.4. 20. The optimal investment in the riskless security is x = 20 W- jxi = W. 0.7029. A NuI11erical ExaInple We give below illustrative results for a hypothetical problem in which n = 20. .2.18.326.2137.9341 The optimum value of m is 10 with the best portfolio S*. 14 to 20] [I to 5.3904 1.40.7720 35.8823 1. c2 = 0.OPTI-MALPORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS 311 4. C12 =0.464. 14 to 20] [I to 5. 1Ito 20] [I to 20] 3.9295 35.3901 5.231. x*= . From (7) the optimal investments in the securities are: x = 46.20] [I to 3.062.413.1 I cI c10 = 0. C20 = 0.080- C5= C18= 0.6991 37. x 2* 43.0002 40. =I .8688 7.7304 4. 17 to 20] [1 to4.8788 41.20].4. 11 to 20] [I to 8. in] Sfl* [1] [1.2137.3495 38.20] [I to 3? 19? OFV.

The maximization problem in equation (2) can be modified as n fl Max di i=Ii (xi +di)Ri+ n (afl (xo + dO)R. from other income or due to consumption needs. Specificially. While this accurately describes the initial portfolio problem of the investor. 2..t yi I n1s E12 x 1(2+dyss l-)E(x js | (5 n subject to Ed + do = W' where W' is the additional amount available for investment and with the proviso that Yi = 1 if di #. there may be a reluctance on the part of the investor to decrease the holding of a particular security in light of adverse information on. It should be noted that W' could be zero. R. (16) ( n 171 A K . W' would be zero. . . it does not properly reflect the costs of changing the optimal holdings over time. positive or negative and does not impose any restrictions on the problem.. SUBRAHMANYAM 5. say.312 N.2. Suppose xi is the amount already invested in the security i (the present portfolio) and di is the change in this amount (the new portfolio). The portfolio problem can be rewritten by grouping separately the terms involving the di's. i = 1. where 12 i= 1.s1+ did sisj) + (I p) d + do = W'. n.~~~~~ xi_ss 1 xiRi+ xoR7-a p) i _ 1) . n. its expected return since there are fixed transaction costs incurred in selling this security as well as investing the proceeds in one or more other securities. W' would be positive or negative respectively. n n Max di= d1Ri+ doR-t - y I -a tpL n (dxjsisj + d)x1s. the decision variables. G. It may be reasonably hypothesized that the optimal holdings of securities in the portfolio after revision will be biased in favour of securities that are initially included in the portfolio. It turns out that the portfolio revision problem can be modelled with minor changes in the earlier analysis. if there are additions to or redemptions from the portfolio.0. Xi2si2 . . PATEL AND M. in (15). The Portfolio Revision Problem The analysis presented in the previous section deals with the case where an investor optimizes his portfolio holdings of risky securities with fixed transaction costs under the assumption that the investor's initial wealth is in the form of cash. i= I 2dixis2 + d2SJ2j + K subject to Yi= I if di ::--0. If the problem is one of portfolio revision merely due to changes in the information set. .

The portfolio revision problem is shown to be similar in structure to the problem of the portfolio optimization starting with cash holdings. CHEN. J.. even fairly large problems can be solved by hand.. ." J. Vol. n. C.xij 11 11 A 11 + doR-t fi-af p~2 ' 2 d.. E. Vol. pp. .2. 31. J. AND ZIONTS. Assuming that the pairwise correlation coefficient is the same across all securities. BRENNAN. 4.. 10.Intuitively. 6. 25? No. J. S." J. as convergence to the optimal solution is rapid. CoIiclusions This paper derives simple decision rules for optimal portfolio selection under fixed transaction costs. AND PADBERG. pp. No. 51-61. it is shown that the optimal portfolio can be chosen without directly solving the complex mixed-integer quadratic programming problem. 5 (December 1973).. I.1d. pp. Vol. 16-40. 1 (January 1971). 1341-1357. J. round trip transaction costs lead to a reluctance to revise the portfolio unless the gains are correspondingly greater.. 3 (September 1975). "Estimating the Depenidenice Structurle of Slhare Pr-ices. Blusiniess. Vol.. W. pp. It pays to revise the existing holdings of a particular asset only if the round trip transaction costs can be recouped by revising the portfolio. Finance. J. 44.' have to be taken into account in the latter case. References 1. y= i =1. . Y. perhaps an intuitive understanding to the solution of a fairly complex problem can be gained. "The Optimal Portfolio Revisioni Policy. JEN. "Simiple Criteria for Optimal Portfolio Selectioni With Upper Bounlds." J. This is of the same form as the original problem in (2). 952-967.. 54. 483-496. 28. BLUME. 11 (November 1974). the ratio of the excess return to the standard deviation of return of the security. Equation (16) can be rewritten as Max. M. AND . the difference being that in the former case. pp. 6 (November-December 1977)." Survey of ClurenitBusiness. M. Vol. "The Optimal Numllber Securities in a Risky Asset Portfolio WheniThere Are Fixed of Costs of Transacting: Theory and Some Empirical Results. E. Thus. No.[R - 2aps(1 1 r xs- 2a(1 -p)s. A. No. 1203-1232. No.. 3. 5.. ELTON. The interesting feature of the model is that securities can be ranked on the basis of a simple index. M.2x1 The rest of the analysis would be similar and the same procedure as before can be used to solve for the optimal d1's.i#0. except that = [R - 2apsi( x - 2a(I - A). Even for cases where the assumption of equal correlation coefficients is not valid. F.. AND GRUBER. 2. CROCKETT.s1sj+(1 -p) 2 aj2s7 9(17) subjectto E= 1=1 4j+d 1 if d.dj. "Stock Ownership in the United States: Characteristics and Trenids. M. the only difference between the initial problem and the portfolio revision problem is that the interactions of each security with the existing portfolio as reflected in the definition of R. 5 (December 1976). 6. AND FRIEND. Finance." OperationsRes. H.OPTIMAL PORTFOLIO SELECTION WITH FIXED TRANSACTION COSTS 313 which is unaffected by the portfolio revision. No. "Simple Criteria for Optimal Por-tfolio Selection". pp. Finianicial QlanititativeAnial. . Vol.

.. "Market Inperfections. 14. Vol. No. I (March 1952). Vol.. E. pp. pp." J. Vol. Vol. LEVY. 425-442. 4 (October 1966). 9. G. MARKOWITZ. Vol. "Are Betas Best?" J. Vol.Vol.. Finance. 11." Econometrica. pp. 51. G. Finance. 4 (September 1978).. 9. pp. . No.. M. Rev. 3 (September 1977). Short Sales. 1959. 768-783. No. G. Case. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio. 8. 4 (September 1964). pp. JACOB. 1375-1384." Rev.. . 2 (January 1963). L. 5 (December 1970).314 7." Management Sci. 18. T. "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. 277-293. "Essentials of Portfolio Diversification Strategy. No. 15. "Portfolio Selection. Vol. M. "Simple Rules for Optimal Portfolio Selection: The Multi Group 17. Vol.H. 16. 12. 643-658. Finance." J. J. MAO. 19. 307-320. pp. J. pp. T. C. 1005-1028. R. 77-91. J." J. Vol. . No. J. No. Capital Market Equilibrium and Corporation Finance..J. AND SUBRAHMANYAM. 1109-1121..H. Vol. 13. A. SHARPE. 19.. 25. Econom." Amer. 329-345.. "A Limited-Diversification Portfolio Selection Model for the Small Investor. POGUE. 13-37. LINTNER. SUBRAHMANYAM ELTON. F. . 34. Finance. Finance. No. 25. "An Extension of the Markowitz Portfolio Selection Model to Include Variable Transaction Costs. Statist." J. 29. New York. Econom.. No.Wiley.N. AND GRUBER. "Equilibrium in a Capital Asset Market. pp. Vol. No." J. 68. 32. PATEL AND M. N. 7. 2 (May 1977).. pp.R. I (February 1965). No." J. STAPLETON.." J. Leverage Policies and Taxes. 33. J. 10. "A Simplified Model for Portfolio Analysis.. pp. Finance. Financial QuantitativeAnal. 5 (December 1978). 847-856. pp. 12. 5 (December 1970). Finance. "Capital Assets Prices: A Theory of Market Equilibrium Under Conditions of Risk. Portfolio Selection: Efficient Diversificationof Investments. C. pp. No. 3 (June 1974).W. MOSSIN. AND URICH. No.

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