Illiquid assets and optimal portfolio choice

The presence of illiquid assets, such as human wealth or a family owned business, complicates theproblem of portfolio choice. This paper is concerned with the problem of optimal asset allocation andconsumption in a continuous time model when one asset cannot be traded. This illiquid asset, whichdepends on an uninsurable source of risk, provides a liquid dividend. In the case of human capitalwe can think about this dividend as labor income. The agent is endowed with a given amount of theilliquid asset and with some liquid wealth which can be allocated in a market where there is a riskyand a riskless asset. The main point of the paper is that the optimal allocations to the two liquid assetsand consumption will critically depend on the endowment and characteristics of the illiquid asset,in addition to the preferences and to the liquid holdings held by the agent. We provide what we believeto be the first analytical solution to this problem when the agent has power utility of consumption andterminal wealth. We also derive the value that the agent assigns to the illiquid asset. The risk adjustedvaluation procedure we develop can be used to value both liquid and illiquid assets, as well as contingentclaims on those assets.