Risk Premia and Optimal Liquidation of Credit Derivatives

TL;DR

This paper develops a comprehensive model for the optimal timing of liquidating credit derivatives, considering stochastic interest rates, market-investor price discrepancies, and various trading constraints, providing practical liquidation strategies.

Contribution

It introduces a unified framework incorporating stochastic interest rates and risk premia variations for optimal liquidation and extends to sequential trading with constraints.

Findings

Optimal liquidation policies depend on market conditions and risk premia.

The model captures the impact of price discrepancies on liquidation timing.

Extensions include sequential trading strategies with and without short-sale constraints.

Abstract

This paper studies the optimal timing to liquidate credit derivatives in a general intensity-based credit risk model under stochastic interest rate. We incorporate the potential price discrepancy between the market and investors, which is characterized by risk-neutral valuation under different default risk premia specifications. We quantify the value of optimally timing to sell through the concept of delayed liquidation premium, and analyze the associated probabilistic representation and variational inequality. We illustrate the optimal liquidation policy for both single-named and multi-named credit derivatives. Our model is extended to study the sequential buying and selling problem with and without short-sale constraint.