Optimal portfolio liquidation with distress risk (RV of 2009/57/DS)
Author: Brown, David B. ; Carlin, Bruce Ian ; Sousa Lobo, MiguelINSEAD Area: Decision Sciences Series: Working Paper ; 2010/49/DS (revised version of 2009/57/DS) Publisher: Fontainebleau : INSEAD, 2010.Language: EnglishDescription: 39 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: We analyze the problem of an investor who needs to unwind a portfolio in the face of recurring and uncertain liquidity needs, with a model that accounts for both permanent and temporary price impact of trading. We first show that a risk-neutral investor who myopically deleverages his position to meet an immediate need for cash always prefers to sell more liquid assets. If the investor faces the possibility of a downstream shock, however, the solution differs in several important ways. If the ensuing shock is sufficiently large, the non-myopic investor unwinds positions more than immediately necessary and, all else being equal, prefers to retain more of the assets with low temporary price impact in order to hedge against possible distress. More generally, optimal liquidation involves selling strictly more of the assets with a lower ratio of permanent to temporary impact, even if these assets are relatively illiquid. The results suggest that properly accounting for the possibility of future shocks should play a role in managing large portfolios. Previous title: On the scholes liquidation problem - Brown, David B.;Carlin, Bruce Ian;Lobo, - 2009 - INSEAD Working Paper| Item type | Current location | Collection | Call number | Status | Date due | Barcode | Item holds |
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Digital Library | Available | BC009236 |
We analyze the problem of an investor who needs to unwind a portfolio in the face of recurring and uncertain liquidity needs, with a model that accounts for both permanent and temporary price impact of trading. We first show that a risk-neutral investor who myopically deleverages his position to meet an immediate need for cash always prefers to sell more liquid assets. If the investor faces the possibility of a downstream shock, however, the solution differs in several important ways. If the ensuing shock is sufficiently large, the non-myopic investor unwinds positions more than immediately necessary and, all else being equal, prefers to retain more of the assets with low temporary price impact in order to hedge against possible distress. More generally, optimal liquidation involves selling strictly more of the assets with a lower ratio of permanent to temporary impact, even if these assets are relatively illiquid. The results suggest that properly accounting for the possibility of future shocks should play a role in managing large portfolios.
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