Portfolio allocation problem and quantity constraints : an analysis of the Warsaw Stock Exchange

After the political changes in 1989 the economy in Eastern and Central Europe turned from a centrally planned system to market-based one. The transformation program required substantial institutional reforms, one of the results being a new security law which in 1991 established the Warsaw Stock Exchange (WSE). In this thesis I analyse rates of returns on the WSE and try to examine the existence of the optimal portfolio on an emerging stock market with quantity constraints.;On the WSE, according to regulation, there exists a one-period returns limit, so prevailing models used for finding the level of assets risk seem to be inappropriate. The risk reduction effect of lower or upper limits institutionally imposed on stock exchange price movements are analyzed. As the result of the maximisation of traders' utility function subject to expected quantity constraints, a new empirical model similar to the capital asset pricing model (CAPM) is developed, where the observed returns are corrected for the appearance of quantity constraints for the securities which constitute the market portfolio. An empirical analysis of returns from twenty-one securities traded on the Warsaw Stock Exchange has been carried out. The model with uncorrected returns has been estimated by the two-limit Tobit model and compared with the results for the corrected returns, as obtained by the unconstrained maximum likelihood method. The proposed model is tested using a second-pass cross-section regression and stronger tests based on the derivation of the security market line (SML). Results show that the imposition of trade barriers tends to increase rather than decrease the portfolio risk and it is therefore suggested that such barriers should be abolished.