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Optimal Portfolio Liquidation with Distress Risk

  • 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)

Registered author(s):

    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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    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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    1. Bruce Ian Carlin & Miguel Sousa Lobo & S. Viswanathan, 2007. "Episodic Liquidity Crises: Cooperative and Predatory Trading," Journal of Finance, American Finance Association, vol. 62(5), pages 2235-2274, October.
    2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2004. "Predatory Trading," NBER Working Papers 10755, National Bureau of Economic Research, Inc.
    3. Alberto Manconi & Massimo Massa & Ayako Yasuda, 2010. "The Behavior of Intoxicated Investors: The role of institutional investors in propagating the crisis of 2007-2008," NBER Working Papers 16191, National Bureau of Economic Research, Inc.
    4. Schied, Alexander & Schoeneborn, Torsten, 2008. "Risk aversion and the dynamics of optimal liquidation strategies in illiquid markets," MPRA Paper 7105, University Library of Munich, Germany.
    5. Alberto Manconi & Massimo Massa & Ayako Yasuda, 2010. "The Behavior of Intoxicated Investors: The Role of Institutional Investors in Propagating the Crisis of 2007-2008," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
    6. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
    7. Madhavan, Ananth & Cheng, Minder, 1997. "In Search of Liquidity: Block Trades in the Upstairs and Downstairs Markets," Review of Financial Studies, Society for Financial Studies, vol. 10(1), pages 175-203.
    8. Sadka, Ronnie, 2006. "Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk," Journal of Financial Economics, Elsevier, vol. 80(2), pages 309-349, May.
    9. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, vol. 1(1), pages 1-50, April.
    10. Holthausen, Robert W. & Leftwich, Richard W. & Mayers, David, 1990. "Large-block transactions, the speed of response, and temporary and permanent stock-price effects," Journal of Financial Economics, Elsevier, vol. 26(1), pages 71-95, July.
    11. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
    12. Manconi, Alberto & Massa, Massimo & Yasuda, Ayako, 2010. "The Behavior of Intoxicated Investors: The Role of Institutional Investors in Propagating the Crisis of 2007-2008," Working Papers 10-22, University of Pennsylvania, Wharton School, Weiss Center.
    13. Peter M. DeMarzo & Branko Uro, 2006. "Ownership Dynamics and Asset Pricing with a Large Shareholder," Journal of Political Economy, University of Chicago Press, vol. 114(4), pages 774-815, August.
    14. Kraus, Alan & Stoll, Hans R, 1972. "Price Impacts of Block Trading on the New York Stock Exchange," Journal of Finance, American Finance Association, vol. 27(3), pages 569-88, June.
    15. Chenghuan Sean Chu & Andreas Lehnert & Wayne Passmore, 2009. "Strategic Trading in Multiple Assets and the Effects on Market Volatiliy," International Journal of Central Banking, International Journal of Central Banking, vol. 5(4), pages 143-172, December.
    16. Myron S. Scholes, 2000. "Crisis and Risk Management," American Economic Review, American Economic Association, vol. 90(2), pages 17-21, May.
    17. Tobias Adrian & Hyun Song Shin, 2008. "Financial intermediary leverage and value at risk," Staff Reports 338, Federal Reserve Bank of New York.
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