Optimal Trade Execution Under Endogenous Pressure to Liquidate: Theory and Numerical Solutions
European Journal of Operational Research, 2019
31 Pages Posted: 6 Apr 2017 Last revised: 29 Sep 2019
Date Written: April 5, 2017
We study optimal liquidation of a trading position (so-called block order or meta-order) in a market with a linear temporary price impact (Kyle, 1985). We endogenize the pressure to liquidate by introducing a downward drift in the unaffected asset price while simultaneously ruling out short sales. In this setting the liquidation time horizon becomes a stopping time determined endogenously, as part of the optimal strategy. We find that the optimal liquidation strategy is consistent with the square-root law which states that the average price impact per share is proportional to the square root of the size of the meta-order (Bershova and Rakhlin, 2013; Farmer et al., 2013; Donier et al., 2015; Tóth et al., 2016).
Mathematically, the Hamilton-Jacobi-Bellman equation of our optimization leads to a severely singular and numerically unstable ordinary differential equation initial value problem. We provide careful analysis of related singular mixed boundary value problems and devise a numerically stable computation strategy by re-introducing time dimension into an otherwise time-homogeneous task.
Keywords: optimal liquidation, price impact, square-root law, singular boundary value problem, stochastic optimal control
JEL Classification: G11, G12
Suggested Citation: Suggested Citation