Working Paper: NBER ID: w15381
Authors: David B. Brown; Bruce Ian Carlin; Miguel Sousa Lobo
Abstract: How should an investor unwind a portfolio in the face of recurring and uncertain liquidity needs? We propose a model of portfolio liquidation in two periods to investigate this question, initially posed by Myron Scholes following the fall of Long Term Capital Management. We show that when the expectation of future liquidity needs is low, the optimal solution involves selling assets that have low permanent and temporary price impacts of trading. However, when there is a high probability of a large future liquidity need, the optimal solution involves retaining assets that have a small temporary impact of trading. In the face of potential future adversity, there is a high option-value to the temporary component of liquidity. The permanent component of liquidity does not share this feature, so that investors will prefer to sell assets with a low ratio of permanent to temporary price impact in the early stages of a crisis, and to hold on to assets with a high ratio of permanent to temporary price impact to protect themselves against an aggravation of the crisis.
Keywords: liquidity; portfolio management; liquidation; Scholes problem
JEL Codes: G01; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low liquidity needs (E41) | liquidation of less impactful assets (G33) |
| high probability of significant future liquidity need (G33) | retain assets with small temporary price impact (G19) |
| selling more liquid assets first during crises (G33) | limit immediate losses (G33) |
| selling more liquid assets first during crises (G33) | expose investor to greater risk in subsequent periods (G11) |