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Optimal Portfolio Liquidation with Distress Risk

Author

Listed:
  • 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)

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.

Suggested Citation

  • David B. Brown & Bruce Ian Carlin & Miguel Sousa Lobo, 2010. "Optimal Portfolio Liquidation with Distress Risk," Management Science, INFORMS, vol. 56(11), pages 1997-2014, November.
  • Handle: RePEc:inm:ormnsc:v:56:y:2010:i:11:p:1997-2014
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    File URL: http://dx.doi.org/10.1287/mnsc.1100.1235
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. repec:eee:ejores:v:264:y:2018:i:3:p:1159-1171 is not listed on IDEAS
    2. Irani, Rustom M. & Meisenzahl, Ralf R., 2015. "Loan Sales and Bank Liquidity Risk Management: Evidence from a U.S. Credit Register," Finance and Economics Discussion Series 2015-1, Board of Governors of the Federal Reserve System (U.S.).
    3. Oehmke, Martin, 2014. "Liquidating illiquid collateral," LSE Research Online Documents on Economics 84518, London School of Economics and Political Science, LSE Library.
    4. Li, Yong & Benson, Karen & Faff, Robert, 2016. "Political constraints and trading strategy in times of market stress: Evidence from the chinese national social security fund," Finance Research Letters, Elsevier, vol. 19(C), pages 217-221.
    5. Nyborg, Kjell G. & Östberg, Per, 2014. "Money and liquidity in financial markets," Journal of Financial Economics, Elsevier, vol. 112(1), pages 30-52.
    6. repec:eee:jfinin:v:30:y:2017:i:c:p:71-85 is not listed on IDEAS
    7. repec:fip:fedgfe:2014-115 is not listed on IDEAS
    8. repec:eee:jfinin:v:31:y:2017:i:c:p:30-44 is not listed on IDEAS
    9. Oehmke, Martin, 2014. "Liquidating illiquid collateral," Journal of Economic Theory, Elsevier, vol. 149(C), pages 183-210.
    10. Agarwal, Vikas & Aragon, George O. & Shi, Zhen, 2015. "Funding liquidity risk of funds of hedge funds: Evidence from their holdings," CFR Working Papers 15-12, University of Cologne, Centre for Financial Research (CFR).
    11. Chen, Jingnan & Feng, Liming & Peng, Jiming, 2015. "Optimal deleveraging with nonlinear temporary price impact," European Journal of Operational Research, Elsevier, vol. 244(1), pages 240-247.

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