Volume 30, Issue 3 (Autumn 2025)
JEPR 2025, 30(3): 3-35 |
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Feghhi M. (2025). The Implications of Financial Market Frictions and Tax Code Convexity for Dynamic Risk Budgeting. JEPR. 30(3), 3-35.
URL: http://eprj.ir/article-1-2393-en.html
URL: http://eprj.ir/article-1-2393-en.html
Assistant Professor, Department of Economics, Allameh Tabatabaee University, Tehran, Iran , feghhi@ir.ac.atu
Abstract: (1414 Views)
Risk management is central to the operations of economic enterprises—particularly financial institutions—and is critical for long-term viability and for maintaining dynamic consistency with constraints imposed by available economic capital. These considerations have intensified scholarly and managerial interest in risk budgeting frameworks. This study focuses on dynamic risk budgeting within a parsimonious analytical setting that explicitly incorporates key real-world characteristics and structural determinants. To this end, a time-consistent continuous-time dynamic stochastic partial equilibrium model of agents’ decision-making is developed to examine how financial market frictions and tax code convexity affect dynamic risk budget adjustments and optimal hedging strategies. The analysis demonstrates that, under certain conditions, market frictions and distortionary policy interventions generate distributional effects on hedged returns, thereby influencing dynamic risk budgeting outcomes. The interaction between market frictions and tax convexity is further explored, along with its implications for policy design and financial regulation. Quantitative simulations are used to assess the role of transaction costs in each setting, highlighting their impact on risk budgeting dynamics.
Keywords: Risk Budgeting, Financial Market Frictions, Tax Code Convexity, Conditional Value at Risk, Hedging Costs, Transaction Costs
Type of Study: Research |
Subject:
financial economics
Received: Aug 15 2025 | Accepted: Dec 30 2025 | ePublished: May 23 2026
Received: Aug 15 2025 | Accepted: Dec 30 2025 | ePublished: May 23 2026
References
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30. Ai, H., Li, J. E., Li, K., & Schlag, C. (2020). The collateralizability premium. The Review of Financial Studies, 33(12), 5821-5855. [DOI:10.1093/rfs/hhaa063]
31. Becker, M., & Löffler, A. (2024). Arbitrage and non-linear taxes. Review of Managerial Science, 18(12), 3487-3514. [DOI:10.1007/s11846-023-00721-1]
32. Campbell, R., Huisman, R., & Koedijk, K. (2001). Optimal portfolio selection in a Value-at-Risk framework. Journal of Banking & Finance, 25(9), 1789-1804. [DOI:10.1016/S0378-4266(00)00160-6]
33. Cetingoz, A. R., Fermanian, J. D., & Guéant, O. (2022). Stochastic Algorithms for Advanced Risk Budgeting (No. hal-03857964). HAL.
34. Dou, W. W., Fang, X., Lo, A. W., & Uhlig, H. (2023). Macro-finance models with nonlinear dynamics. Annual Review of Financial Economics, 15(1), 407-432. [DOI:10.1146/annurev-financial-110921-112053]
35. Graham, J. R., & Smith, C. W. (1999). Tax incentives to hedge. The Journal of Finance, 54(6), 2241-2262. [DOI:10.1111/0022-1082.00187]
36. Horan, S. M. (2007). Applying after-tax asset allocation. The Journal of Wealth Management, 10(2), 84. [DOI:10.3905/jwm.2007.690951]
37. Lei, A. C., Yick, M. H., & Lam, K. S. (2013). Does tax convexity matter for risk? A dynamic study of tax asymmetry and equity beta. Review of Quantitative Finance and Accounting, 41(1), 131-147. [DOI:10.1007/s11156-012-0303-2]
38. Lei, A. C., Yick, M. H., & Lam, K. S. (2014). The effects of tax convexity on default and investment decisions. Applied Economics, 46(11), 1267-1278. [DOI:10.1080/00036846.2013.870653]
39. Leibowitz, M. L., & Kogelman, S. (1991). Asset allocation under shortfall constraints. Risk, 3(2), 5. [DOI:10.3905/jpm.1991.409309]
40. Maillard S, Roncalli T, Teıletche J (2010). On the properties of equally weighted risk contribution portfolios.The Journal of Portfolio Management 36(4):60-70. [DOI:10.3905/jpm.2010.36.4.060]
41. Merton, R. (1969). Lifetime portfolio selection under uncertainty: the continuous-time case. Review of Economics and Statistics 51 (3), 247-25 [DOI:10.2307/1926560]
42. Merton, R. (1971). Optimum consumption and portfolio rules in a continuous-time model. Journal of Economic Theory 3, 373-413. (Cited on page 2) [DOI:10.1016/0022-0531(71)90038-X]
43. Mossin, J. (1968). Optimal multi-period portfolio policies. Journal of Business 41 (2), 215-229. [DOI:10.1086/295078]
44. Pesenti, S. M., Jaimungal, S., Saporito, Y. F., & Targino, R. S. (2025). Risk budgeting allocation for dynamic risk measures. Operations Research, 73(3), 1208-1229., Cornel University, arXiv:2305.11319 and SSRN.4452742 [DOI:10.1287/opre.2023.0299]
45. Qian E (2005). Risk parity portfolios: Efficient portfolios through true diversification. Panagora Asset Management.
46. Qian E (2011). Risk parity and diversification. The Journal of Investing 20(1):119-127 [DOI:10.3905/joi.2011.20.1.119]
47. Reichenstein, W. (2001). Rethinking the Family's Asset Allocation. Journal of Financial Planning, 14(5).
48. Richard, J. C., & Roncalli, T. (2019). Constrained risk budgeting portfolios: Theory, algorithms, applications & puzzles. arXiv preprint arXiv:1902.05710. [DOI:10.2139/ssrn.3331184]
49. Roncalli, T. (2013). Introduction to risk parity and budgeting. CRC press. [DOI:10.2139/ssrn.2272973]
50. Roncalli, T., & Weisang, G. (2016). Risk parity portfolios with risk factors. Quantitative Finance, 16(3), 377-388. [DOI:10.1080/14697688.2015.1046907]
51. Roy, A. D. (1952). Safety first and the holding of assets. Econometrica: Journal of the econometric society, 431-449. [DOI:10.2307/1907413]
52. Samuelson, P. (1969). Lifetime portfolio selection by dynamic stochastic programming. Review of Economics and Statistics 51, 239-46 [DOI:10.2307/1926559]
53. Sarkar, S. (2008). Can tax convexity be ignored in corporate financing decisions?. Journal of Banking & Finance, 32(7), 1310-1321. [DOI:10.1016/j.jbankfin.2007.11.007]
54. Smith, C. W., & Stulz, R. M. (1985). The determinants of firms' hedging policies. Journal of financial and quantitative analysis, 20(4), 391-405. [DOI:10.2307/2330757]
55. Strassberger, M. (2006). Capital Requirement, Portfolio Risk Insurance, and Dynamic Risk Budgeting. Investment Management and Financial Innovations [DOI:10.2139/ssrn.672302]
56. Unger, A. (2014). The use of risk budgets in portfolio optimization. Springer. [DOI:10.1007/978-3-658-07259-9]
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