Optimal portfolio liquidation with distress risk
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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. © 2010 INFORMS.
Published Version (Please cite this version)10.1287/mnsc.1100.1235
Publication InfoBrown, DB; Carlin, BI; & Lobo, MS (2010). Optimal portfolio liquidation with distress risk. Management Science, 56(11). pp. 1997-2014. 10.1287/mnsc.1100.1235. Retrieved from https://hdl.handle.net/10161/4429.
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Professor of Business Administration
David B. Brown is a professor at the Fuqua School of Business at Duke University. He has been at Fuqua as a member of the Decision Sciences area since receiving his Ph.D. in Electrical Engineering and Computer Science from MIT in 2006. Professor Brown’s research focuses on the development of effective methods for dealing with uncertainty in large-scale decision-making problems. This includes systems in which information is revealed sequentially over time and ones in which error