NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

On the Scholes Liquidation Problem

David B. Brown, Bruce Ian Carlin, Miguel Sousa Lobo

NBER Working Paper No. 15381
Issued in September 2009
NBER Program(s):   AP

How should an investor unwind a portfolio in the face of recurring and uncertain liquidity needs? We propose a model of portfolio liquidation in two periods to investigate this question, initially posed by Myron Scholes following the fall of Long Term Capital Management. We show that when the expectation of future liquidity needs is low, the optimal solution involves selling assets that have low permanent and temporary price impacts of trading. However, when there is a high probability of a large future liquidity need, the optimal solution involves retaining assets that have a small temporary impact of trading. In the face of potential future adversity, there is a high option-value to the temporary component of liquidity. The permanent component of liquidity does not share this feature, so that investors will prefer to sell assets with a low ratio of permanent to temporary price impact in the early stages of a crisis, and to hold on to assets with a high ratio of permanent to temporary price impact to protect themselves against an aggravation of the crisis.

download in pdf format
   (453 K)

email paper

This paper is available as PDF (453 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w15381

Users who downloaded this paper also downloaded these:
Goldsmith, Lipsey, and Mendelson Introduction to "Studies in the National Balance Sheet of the United States, Vol. 2"
Reinhart and Sbrancia w16893 The Liquidation of Government Debt
Gorton and Metrick w15223 Securitized Banking and the Run on Repo
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us