Optimal Portfolio Liquidation with Distress Risk

We analyze the problem of an investor who needs to unwind a portfolio in the face of recurring and uncertain liquidity needs, with a model that accounts for both permanent and temporary price impact of trading. We first show that a risk-neutral investor who myopically deleverages his position to meet an immediate need for cash always prefers to sell more liquid assets. If the investor faces the possibility of a downstream shock, however, the solution differs in several important ways. If the ensuing shock is sufficiently large, the non-myopic investor unwinds positions more than immediately necessary and, all else being equal, prefers to retain more of the assets with low temporary price impact in order to hedge against possible distress. More generally, optimal liquidation involves selling strictly more of the assets with a lower ratio of permanent to temporary impact, even if these assets are relatively illiquid. The results suggest that properly accounting for the possibility of future shocks should play a role in managing large portfolios. ∗Duke University, The Fuqua School of Business, 100 Fuqua Drive, Box 90120, Durham, NC 27708-0120, USA, [email protected], +1 919 660-7968. †Anderson School of Management, University of California, Los Angeles, 110 Westwood Plaza Suite C413, Los Angeles, CA 90095, USA, [email protected], +1 310 825-7246. ‡INSEAD, Abu Dhabi Campus, Muroor Road, Street 4, Box 48049, Abu Dhabi, UAE, [email protected], +971 2 651 5337.