Optimal Portfolio Liquidation with Distress Risk

David B. Brown (), Bruce Ian Carlin () and Miguel Sousa Lobo ()
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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

Management Science, 2010, vol. 56, issue 11, 1997-2014

Abstract: 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.

Keywords: portfolio management; optimal liquidation; price impact (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (31)

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