On the Scholes Liquidation Problem

39 Pages Posted: 28 Sep 2009 Last revised: 13 Jul 2023

See all articles by David B. Brown

David B. Brown

Duke University - Decision Sciences

Bruce I. Carlin

University of California, Los Angeles (UCLA) - Anderson School of Management

Miguel Sousa Lobo

INSEAD - Decision Sciences

Multiple version iconThere are 2 versions of this paper

Date Written: September 2009

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.

Suggested Citation

Brown, David B. and Carlin, Bruce I. and Sousa Lobo, Miguel, On the Scholes Liquidation Problem (September 2009). NBER Working Paper No. w15381, Available at SSRN: https://ssrn.com/abstract=1478799

David B. Brown (Contact Author)

Duke University - Decision Sciences ( email )

Durham, NC 27708-0120
United States

Bruce I. Carlin

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Miguel Sousa Lobo

INSEAD - Decision Sciences ( email )

United States

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