Optimal Execution of Multiasset Block Orders under Stochastic Liquidity

Naoki Makimoto and Yoshihiko Sugihara
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Naoki Makimoto: Professor, Graduate School of Business Sciences, University of Tsukuba (E-mail: makimoto@gssm.gsbs.tsukuba.ac.jp)
Yoshihiko Sugihara: Deputy Director and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: yoshihiko.sugihara@boj.or.jp)

No 10-E-25, IMES Discussion Paper Series from Institute for Monetary and Economic Studies, Bank of Japan

Abstract: In this paper, we develop a multiasset model of market liquidity and derive the optimal strategy for block order execution under both liquidity and volatility risk. The market liquidity flowing into and out of an order book is modeled as a mean-reverting stochastic process. Given the shape of the order book for each asset, we express the market impact of an execution as a recursive impact that recovers gradually with associated uncertainty. We then derive the optimal execution strategy as a closed-form solution to the mean-variance problem that optimizes the trade-off between the market impact and the volatility/liquidity risk given investor risk aversion. Using our model, we analyze some implications of the optimal execution strategy with comparative statics and simulations. We also discuss whether we avoid price manipulation with our optimal execution strategy.

Keywords: optimal execution strategy; market impact; transaction cost; stochastic liquidity; limit order book; price manipulation; mean-variance optimization (search for similar items in EconPapers)
JEL-codes: C61 G11 G12 (search for similar items in EconPapers)
Date: 2010-11
New Economics Papers: this item is included in nep-cmp and nep-mst
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Citations: View citations in EconPapers (2)

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