Risk Premia and Optimal Liquidation of Defaultable Securities

by Tim Leung of Columbia University, and
Peng Liu of Johns Hopkins University

September 25, 2012

Abstract: This paper studies the optimal timing to liquidate credit derivatives in a general intensitybased credit risk model under stochastic interest rate. We incorporate the potential price discrepancy between the market and investors, which is characterized by risk-neutral valuation under di erent default risk premia specifications. We quantify the value of optimally timing to sell through the concept of delayed liquidation premium, and analyze the associated probabilistic representation and variational inequality. We illustrate the optimal liquidation policy for both single-named and multi-named credit derivatives. Our model is extended to study the sequential buying and selling problem with and without short-sale constraint.

JEL Classification: G12, G13, C68.

Keywords: optimal liquidation, credit derivatives, price discrepancy, default risk premium, event risk premium.

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