Optimal Portfolio Liquidation with Distress Risk

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 mee...

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Bibliographic Details
Published inManagement science Vol. 56; no. 11; pp. 1997 - 2014
Main Authors Brown, David B., Carlin, Bruce Ian, Lobo, Miguel Sousa
Format Journal Article
LanguageEnglish
Published Hanover, MD INFORMS 01.11.2010
Institute for Operations Research and the Management Sciences
SeriesManagement Science
Subjects
Applied sciences
Cash
Economic models
Exact sciences and technology
Financial leverage
Financial portfolios
Investment
Investment risk
Investors
Liquid assets
Liquidation
Liquidity
Operational research and scientific management
Operational research. Management science
optimal liquidation
Optimal solutions
Portfolio management
Portfolio theory
price impact
Price shocks
Prices
Risk
Studies
Trade
United States
optimal liquidation
Uncertain system
Stock exchange
Pricing
price impact
Portfolio management
Modeling
Downstream
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Summary: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.
Bibliography:ObjectType-Article-2
SourceType-Scholarly Journals-1
ObjectType-Feature-1
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ISSN:0025-1909
1526-5501
DOI:10.1287/mnsc.1100.1235