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Risk Premia and Optimal Liquidation of Credit Derivatives

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  • Tim Leung
  • Peng Liu

Abstract

This paper studies the optimal timing to liquidate credit derivatives in a general intensity-based credit risk model under stochastic interest rate. We incorporate the potential price discrepancy between the market and investors, which is characterized by risk-neutral valuation under different default risk premia specifications. We quantify the value of optimally timing to sell through the concept of delayed liquidation premium, and analyze the associated probabilistic representation and variational inequality. We illustrate the optimal liquidation policy for both single-named and multi-named credit derivatives. Our model is extended to study the sequential buying and selling problem with and without short-sale constraint.

Suggested Citation

  • Tim Leung & Peng Liu, 2011. "Risk Premia and Optimal Liquidation of Credit Derivatives," Papers 1110.0220, arXiv.org, revised Oct 2012.
  • Handle: RePEc:arx:papers:1110.0220
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    1. 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.
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    5. Tim Leung & Michael Ludkovski, 2010. "Optimal Timing to Purchase Options," Papers 1008.3650, arXiv.org, revised Apr 2011.
    6. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
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    Cited by:

    1. Kim, Jinbeom & Leung, Tim, 2016. "Pricing derivatives with counterparty risk and collateralization: A fixed point approach," European Journal of Operational Research, Elsevier, vol. 249(2), pages 525-539.
    2. Tim Leung & Xin Li & Zheng Wang, 2014. "Optimal Starting-Stopping and Switching of a CIR Process with Fixed Costs," Papers 1411.6080, arXiv.org.
    3. Brian Bulthuis & Julio Concha & Tim Leung & Brian Ward, 2017. "Optimal execution of limit and market orders with trade director, speed limiter, and fill uncertainty," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 4(02n03), pages 1-29, June.
    4. Tim Leung & Jiao Li & Xin Li, 2018. "Optimal Timing to Trade along a Randomized Brownian Bridge," IJFS, MDPI, vol. 6(3), pages 1-23, August.
    5. Jiao Li, 2016. "Trading VIX futures under mean reversion with regime switching," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 1-20, September.
    6. Tim Leung & Jiao Li & Xin Li & Zheng Wang, 2016. "Speculative Futures Trading under Mean Reversion," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 23(4), pages 281-304, December.
    7. Tim Leung & Xin Li & Zheng Wang, 2015. "Optimal Multiple Trading Times Under the Exponential OU Model with Transaction Costs," Papers 1504.04682, arXiv.org.
    8. Tim Leung & Peng Liu, 2013. "An Optimal Timing Approach to Option Portfolio Risk Management," Palgrave Macmillan Books, in: Jonathan A. Batten & Peter MacKay & Niklas Wagner (ed.), Advances in Financial Risk Management, chapter 17, pages 391-404, Palgrave Macmillan.
    9. Tim Leung & Yoshihiro Shirai, 2015. "Optimal derivative liquidation timing under path-dependent risk penalties," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(01), pages 1-32.
    10. Tim Leung & Xin Li, 2015. "Optimal Mean Reversion Trading With Transaction Costs And Stop-Loss Exit," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-31.
    11. Jiao Li, 2016. "Trading VIX Futures under Mean Reversion with Regime Switching," Papers 1605.07945, arXiv.org, revised Jun 2016.

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