A proposal for impact-adjusted valuation: Critical leverage and execution risk
AbstractThe practice of valuation by marking-to-market with current trading prices is seriously flawed. Under leverage the problem is particularly dramatic: due to the concave form of market impact, selling always initially causes the expected leverage to increase. There is a critical leverage above which it is impossible to exit a portfolio without leverage going to infinity and bankruptcy becoming likely. Standard risk-management methods give no warning of this problem, which easily occurs for aggressively leveraged positions in illiquid markets. We propose an alternative accounting procedure based on the estimated market impact of liquidation that removes the illusion of profit. This should curb the leverage cycle and contribute to an enhanced stability of financial markets.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1204.0922.
Date of creation: Apr 2012
Date of revision: Aug 2012
Contact details of provider:
Web page: http://arxiv.org/
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-04-10 (All new papers)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Carlo Acerbi & Giacomo Scandolo, 2008. "Liquidity risk theory and coherent measures of risk," Quantitative Finance, Taylor and Francis Journals, vol. 8(7), pages 681-692.
- Xavier Gabaix & Parameswaran Gopikrishnan & Vasiliki Plerou & H. Eugene Stanley, 2006.
"Institutional Investors and Stock Market Volatility,"
The Quarterly Journal of Economics,
MIT Press, vol. 121(2), pages 461-504, May.
- Xavier Gabaix & Parameswaran Gopikrishnan & Vasiliki Plerou & H. Eugene Stanley, 2005. "Institutional Investors and Stock Market Volatility," NBER Working Papers 11722, National Bureau of Economic Research, Inc.
- J. Doyne Farmer & Austin Gerig & Fabrizio Lillo & Henri Waelbroeck, 2011. "How efficiency shapes market impact," Papers 1102.5457, arXiv.org, revised Sep 2013.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (arXiv administrators).
If references are entirely missing, you can add them using this form.