Optimal Trade Execution with a Dark Pool and Adverse Selection

15 Pages Posted: 2 Sep 2014

See all articles by Patrick Cheridito

Patrick Cheridito

ETH Zurich; Swiss Finance Institute

Tardu Sepin

Bank of America Merrill Lynch

Date Written: September 1, 2014


We consider the problem of optimally acquiring a position in a financial asset by submitting orders to a standard exchange and a dark pool. We assume that volatility is stochastic and trading at the standard exchange causes a price impact. Orders sent to the dark pool do not generate price impact. But they are not always filled and are exposed to adverse selection risk. Therefore, an optimal strategy has to find the right balance between favorable transaction prices and guaranteed execution. We consider two different optimality criteria: the expected implementation cost and an expected exponential of the implementation cost. In the first case, the optimal strategy can be given in closed form by a forward-backward system of stochastic equations. In the expected exponential case we characterize the optimal strategy by a Bellman equation that can be solved numerically.Our simulation experiments show that the presence of a dark pool lowers the average implementation cost and that the performance is improving if crossing probabilities in the dark pool increase.

Keywords: Optimal trade execution, dark pool, adverse selection, stochastic volatility, stochastic liquidity, discrete-time stochastic control

JEL Classification: C61, C63, D81

Suggested Citation

Cheridito, Patrick and Sepin, Tardu, Optimal Trade Execution with a Dark Pool and Adverse Selection (September 1, 2014). Available at SSRN: https://ssrn.com/abstract=2490234 or http://dx.doi.org/10.2139/ssrn.2490234

Patrick Cheridito (Contact Author)

ETH Zurich ( email )

Department of Mathematics
8092 Zurich

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4

Tardu Sepin

Bank of America Merrill Lynch ( email )

One Bryant Park
New York, NY 10036
United States

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