Seminar – Principal trading arrangements: Optimality under temporary and permanent price impact

We study the optimal execution problem in a principal-agent setting. A client contracts to purchase a large position from a dealer at a future date. The dealer first buys the position from the market, creating temporary and permanent price impact. The client chooses a contract, which specifies  payment as a function of market prices; hidden action precludes her from conditioning on the dealer’s trade sequence. Weighted-average-price contracts are commonly-used. We explicitly characterize the optimal weights: they are symmetric and generally U-shaped over time. Back-of-the-envelope calculations suggest that switching to our optimal contract significantly reduces transaction costs.

REC M4.02