The premium of dynamic trading

TL;DR

This paper demonstrates that in continuous-time markets, dynamic trading with a risk-free asset yields a higher Sharpe ratio and a positive premium, contrasting with single-period models where the efficient frontier is tangent to risky assets.

Contribution

It establishes that dynamic mean-variance efficient portfolios must involve risk-free assets at all times, leading to a strictly superior efficient frontier in continuous-time settings.

Findings

Dynamic efficient frontier lies above the risky region.

Inclusion of a risk-free asset increases the Sharpe ratio.

Efficient portfolios require continuous allocation to the risk-free asset.

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.