On the Scholes Liquidation Problem

41 Pages Posted: 7 Nov 2009

See all articles by David B. Brown

David B. Brown

Duke University - Decision Sciences

Miguel Sousa Lobo

INSEAD - Decision Sciences

Bruce I. Carlin

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

Multiple version iconThere are 2 versions of this paper

Date Written: November 6, 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.

Keywords: Portfolio Choice, Liquidity, Distressed Liquidation, Deleveraging

Suggested Citation

Brown, David B. and Sousa Lobo, Miguel and Carlin, Bruce I., On the Scholes Liquidation Problem (November 6, 2009). INSEAD Working Paper No. 2009/57/DS. Available at SSRN: https://ssrn.com/abstract=1501184 or http://dx.doi.org/10.2139/ssrn.1501184

David B. Brown

Duke University - Decision Sciences ( email )

Durham, NC 27708-0120
United States

Miguel Sousa Lobo (Contact Author)

INSEAD - Decision Sciences ( email )

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

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