Liquidity Stress Testing using Optimal Portfolio Liquidation

TL;DR

This paper develops an optimal portfolio liquidation model for OTC markets that minimizes trading costs by choosing the best liquidation time, using a Locally Linear Order Book framework and real market data for illustration.

Contribution

It introduces a new optimal liquidation strategy in OTC markets based on a Locally Linear Order Book model, with a specific formula for optimal terminal time.

Findings

Optimal terminal time is proportional to the square root of the order volume to daily volume ratio.

The model effectively reduces trading costs in simulated and real market scenarios.

Numerical experiments demonstrate the practical applicability of the method.

Abstract

We build an optimal portfolio liquidation model for OTC markets, aiming at minimizing the trading costs via the choice of the liquidation time. We work in the Locally Linear Order Book framework of \cite{toth2011anomalous} to obtain the market impact as a function of the traded volume. We find that the optimal terminal time for a linear execution of a small order is proportional to the square root of the ratio between the amount being bought or sold and the average daily volume. Numerical experiments on real market data illustrate the method on a portfolio of corporate bonds.