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An Optimal Execution Problem with a Geometric Ornstein-Uhlenbeck Price Process

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  • Takashi Kato

Abstract

We study an optimal execution problem in the presence of market impact where the security price follows a geometric Ornstein-Uhlenbeck process, which implies the mean-reverting property, and show that the optimal strategy is a mixture of initial/terminal block liquidation and gradual intermediate liquidation. The mean-reverting property describes a price recovery effect that is strongly related to the resilience of market impact, as described in several papers that have studied optimal execution in a limit order book (LOB) model. It is interesting that despite the fact that the model in this paper is different from the LOB model, the form of our optimal strategy is quite similar to those obtained for an LOB model. Moreover, we discuss what properties cause gradual liquidation as an optimal strategy by studying various cases and find out that not only "convexity of market impact function" but also "price recovery effect" (or, in other words, transience of market impact) are essential to make a trader execute the security gradually to mitigate the effect of market impact.

Suggested Citation

  • Takashi Kato, 2011. "An Optimal Execution Problem with a Geometric Ornstein-Uhlenbeck Price Process," Papers 1107.1787, arXiv.org, revised Jul 2014.
    • Handle: RePEc:arx:papers:1107.1787
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    File URL: http://arxiv.org/pdf/1107.1787
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    References listed on IDEAS

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    1. Aur'elien Alfonsi & Antje Fruth & Alexander Schied, 2007. "Optimal execution strategies in limit order books with general shape functions," Papers 0708.1756, arXiv.org, revised Feb 2010.
    2. Alexander Schied & Torsten Schöneborn, 2009. "Risk aversion and the dynamics of optimal liquidation strategies in illiquid markets," Finance and Stochastics, Springer, vol. 13(2), pages 181-204, April.
    3. Obizhaeva, Anna A. & Wang, Jiang, 2013. "Optimal trading strategy and supply/demand dynamics," Journal of Financial Markets, Elsevier, vol. 16(1), pages 1-32.
    4. Aurelien Alfonsi & Antje Fruth & Alexander Schied, 2010. "Optimal execution strategies in limit order books with general shape functions," Quantitative Finance, Taylor & Francis Journals, vol. 10(2), pages 143-157.
    5. Ajay Subramanian & Robert A. Jarrow, 2001. "The Liquidity Discount," Mathematical Finance, Wiley Blackwell, vol. 11(4), pages 447-474.
    6. Gur Huberman & Werner Stanzl, 2005. "Optimal Liquidity Trading," Review of Finance, Springer, vol. 9(2), pages 165-200, June.
    7. He, Hua & Mamaysky, Harry, 2005. "Dynamic trading policies with price impact," Journal of Economic Dynamics and Control, Elsevier, vol. 29(5), pages 891-930, May.
    8. repec:hal:wpaper:hal-00397652 is not listed on IDEAS
    9. Aurélien Alfonsi & Alexander Schied, 2010. "Optimal trade execution and absence of price manipulations in limit order book models," Post-Print hal-00397652, HAL.
    10. Gur Huberman & Werner Stanzl, 2004. "Price Manipulation and Quasi-Arbitrage," Econometrica, Econometric Society, vol. 72(4), pages 1247-1275, July.
    11. Jim Gatheral, 2010. "No-dynamic-arbitrage and market impact," Quantitative Finance, Taylor & Francis Journals, vol. 10(7), pages 749-759.
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    Citations

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    Cited by:

    1. Takashi Kato, 2014. "VWAP Execution as an Optimal Strategy," Papers 1408.6118, arXiv.org, revised Jan 2017.
    2. Masashi Ieda, 2015. "A dynamic optimal execution strategy under stochastic price recovery," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(04), pages 1-24, December.
    3. Takashi Kato, 2017. "An Optimal Execution Problem with S-shaped Market Impact Functions," Papers 1706.09224, arXiv.org, revised Oct 2017.
    4. Kensuke Ishitani & Takashi Kato, 2015. "Theoretical and Numerical Analysis of an Optimal Execution Problem with Uncertain Market Impact," Papers 1506.02789, arXiv.org, revised Aug 2015.
    5. Masashi Ieda, 2015. "A dynamic optimal execution strategy under stochastic price recovery," Papers 1502.04521, arXiv.org.

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