Principal Trading Arrangements: Optimality under Temporary and Permanent Price Impact

78 Pages Posted: 18 Feb 2021 Last revised: 19 Sep 2022

See all articles by Markus Baldauf

Markus Baldauf

University of British Columbia (UBC) - Division of Finance

Christoph Frei

University of Alberta - Department of Mathematical and Statistical Sciences

Joshua Mollner

Northwestern University - Kellogg School of Management

Date Written: September 19, 2022

Abstract

We study the optimal execution problem in a principal-agent setting. A client (e.g., a pension fund, endowment, or other institution) contracts to purchase a large position from a dealer at a future point in time. In the interim, the dealer acquires the position from the market, choosing how to divide his trading across time. Price impact may have temporary and permanent components. There is hidden action in that the client cannot directly dictate the dealer’s trades. Rather, she chooses a contract with the goal of minimizing her expected payment, given the price process and an understanding of the dealer’s incentives. Many contracts used in practice prescribe a payment equal to some weighted average of the market prices within the execution window. We explicitly characterize the optimal such weights: they are symmetric and generally U-shaped over time. This U-shape is strengthened by permanent price impact and weakened by both temporary price impact and dealer risk aversion. In contrast, the first-best solution (which reduces to a classical optimal execution problem) is invariant to these parameters. Back-of-the- envelope calculations suggest that switching to our optimal contract could save clients billions of dollars per year.

Keywords: agency conflict, dealer-client relationship, principal trading, price impact

JEL Classification: G11, G14, G23, D82, D86

Suggested Citation

Baldauf, Markus and Frei, Christoph and Mollner, Joshua, Principal Trading Arrangements: Optimality under Temporary and Permanent Price Impact (September 19, 2022). Available at SSRN: https://ssrn.com/abstract=3778956 or http://dx.doi.org/10.2139/ssrn.3778956

Markus Baldauf

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Christoph Frei

University of Alberta - Department of Mathematical and Statistical Sciences ( email )

Edmonton, Alberta T6G 2G1
Canada

HOME PAGE: http://www.math.ualberta.ca/~cfrei/

Joshua Mollner (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2211 Campus Drive
Evanston, IL 60208
United States

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