Liquidating illiquid collateral (Q2434347)

The author studies a model for the price of a collateral asset of the form \[ P(t) = F(t) + \gamma \big[ X(t) - X(0) \big] + \lambda Y(t), \quad \gamma, \lambda \geq 0, \] where the first term is the fundamental value of the asset, the second term reflects the illiquidity of the collateral asset, and the third term reflects temporary price pressure effects. The author shows that equilibrium trading strategies \(\{ Y_i(t) \}\) take an exponential form \[ Y_i(t) = -a e^{-at} \overline{x}. \] As another result, the author shows that the expected unwind value consists of three terms, namely \[ \Pi(\overline{x},\overline{V}) = F_0 \overline{x} - \frac{\gamma}{2} \overline{x} \overline{X} - \frac{\lambda}{2} a \overline{x} \overline{X}, \] where the first term is the fundamental value of the collateral position at the beginning of the liquidation process, the second term is the loss due to permanent price effects during the liquidation process, and the third term is the loss the lender incurs due to temporary price pressure. Moreover, the author shows that the expected price path overshoots if and only if \[ \phi > \frac{\gamma^2}{\sigma_F^2 \lambda}, \] where \(\phi\) denotes the Lagrange multiplier. Furthermore, the author investigates the effects of the creditor structure and discusses some implications of the model.