Execution and block trade pricing with optimal constant rate of participation

TL;DR

This paper develops a model for executing large trades using constant participation rate strategies, deriving optimal rates and pricing methods for block trades, and compares these with other execution strategies.

Contribution

It introduces a closed-form solution for the optimal participation rate in POV strategies and a microfounded risk-liquidity premium for better cost and risk assessment.

Findings

Closed-form optimal participation rate expression

A new risk-liquidity premium for block trade pricing

Comparison of IS and POV strategies in terms of risk and cost

Abstract

When executing their orders, investors are proposed different strategies by brokers and investment banks. Most orders are executed using VWAP algorithms. Other basic execution strategies include POV (also called PVol) -- for percentage of volume --, IS -- implementation shortfall -- or Target Close. In this article dedicated to POV strategies, we develop a liquidation model in which a trader is constrained to liquidate a portfolio with a constant participation rate to the market. Considering the functional forms commonly used by practitioners for market impact functions, we obtain a closed-form expression for the optimal participation rate. Also, we develop a microfounded risk-liquidity premium that permits to better assess the costs and risks of execution processes and to give a price to a large block of shares. We also provide a thorough comparison between IS strategies and POV strategies in terms of risk-liquidity premium.