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Optimal Portfolio Liquidation with Distress Risk

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Author Info

  • David B. Brown

    ()
    (Fuqua School of Business, Duke University, Durham, North Carolina 27708)

  • Bruce Ian Carlin

    ()
    (Anderson School of Management, University of California, Los Angeles, Los Angeles, California 90095)

  • Miguel Sousa Lobo

    ()
    (INSEAD, Abu Dhabi Campus, Abu Dhabi, United Arab Emirates)

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    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 nonmyopic 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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    File URL: http://dx.doi.org/10.1287/mnsc.1100.1235
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 56 (2010)
    Issue (Month): 11 (November)
    Pages: 1997-2014

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    Handle: RePEc:inm:ormnsc:v:56:y:2010:i:11:p:1997-2014

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    Related research

    Keywords: portfolio management; optimal liquidation; price impact;

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    Cited by:
    1. Kjell G. NYBORG & Per OSTBERG, 2009. "Money and Liquidity in Financial Markets," Swiss Finance Institute Research Paper Series 10-25, Swiss Finance Institute, revised Jun 2010.
    2. Oehmke, Martin, 2014. "Liquidating illiquid collateral," Journal of Economic Theory, Elsevier, vol. 149(C), pages 183-210.

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