## Section: Research Program

### Liquidity risk

Participants : Aurélien Alfonsi, Agnès Sulem, Antonino Zanette.

The financial crisis has caused an increased interest in mathematical finance studies which take into account the market incompleteness issue and the liquidity risk. Loosely speaking, liquidity risk is the risk that comes from the difficulty of selling (or buying) an asset. At the extreme, this may be the impossibility to sell an asset, which occurred for “junk assets” during the subprime crisis. Hopefully, it is in general possible to sell assets, but this may have some cost. Let us be more precise. Usually, assets are quoted on a market with a Limit Order Book (LOB) that registers all the waiting limit buy and sell orders for this asset. The bid (resp. ask) price is the most expensive (resp. cheapest) waiting buy or sell order. If a trader wants to sell a single asset, he will sell it at the bid price. Instead, if he wants to sell a large quantity of assets, he will have to sell them at a lower price in order to match further waiting buy orders. This creates an extra cost, and raises important issues. From a short-term perspective (from few minutes to some days), this may be interesting to split the selling order and to focus on finding optimal selling strategies. This requires to model the market microstructure, i.e. how the market reacts in a short time-scale to execution orders. From a long-term perspective (typically, one month or more), one has to understand how this cost modifies portfolio managing strategies (especially delta-hedging or optimal investment strategies). At this time-scale, there is no need to model precisely the market microstructure, but one has to specify how the liquidity costs aggregate.

#### Long term liquidity risk.

On a long-term perspective, illiquidity can be approached via various ways: transactions costs [50] , [51] , [57] , [64] , [67] , [83] , [79] , delay in the execution of the trading orders [84] , [82] , [60] , trading constraints or restriction on the observation times (see e.g. [66] and references herein). As far as derivative products are concerned, one has to understand how delta-hedging strategies have to be modified. This has been considered for example by Cetin, Jarrow and Protter [81] . We plan to contribute on these various aspects of liquidity risk modeling and associated stochastic optimization problems. Let us mention here that the price impact generated by the trades of the investor is often neglected with a long-term perspective. This seems acceptable since the investor has time enough to trade slowly in order to eliminate its market impact. Instead, when the investor wants to make significant trades on a very short time horizon, it is crucial to take into account and to model how prices are modified by these trades. This question is addressed in the next paragraph on market microstructure.

#### Market microstructure.

The European directive MIFID has increased the competition between markets (NYSE-Euronext, Nasdaq, LSE and new competitors). As a consequence, the cost of posting buy or sell orders on markets has decreased, which has stimulated the growth of market makers. Market makers are posting simultaneously bid and ask orders on a same stock, and their profit comes from the bid-ask spread. Basically, their strategy is a “round-trip” (i.e. their position is unchanged between the beginning and the end of the day) that has generated a positive cash flow.

These new rules have also greatly stimulated research on market microstructure modeling. From a practitioner point of view, the main issue is to solve the so-called “optimal execution problem”: given a deadline $T$, what is the optimal strategy to buy (or sell) a given amount of shares that achieves the minimal expected cost? For large amounts, it may be optimal to split the order into smaller ones. This is of course a crucial issue for brokers, but also market makers that are looking for the optimal round-trip.

Solving the optimal execution problem is not only an interesting mathematical challenge. It is also a mean to better understand market viability, high frequency arbitrage strategies and consequences of the competition between markets. For example when modeling the market microstructure, one would like to find conditions that allow or exclude round trips. Beyond this, even if round trips are excluded, it can happen that an optimal selling strategy is made with large intermediate buy trades, which is unlikely and may lead to market instability.

We are interested in finding synthetic market models in which we can describe and solve the optimal execution problem. A. Alfonsi and A. Schied (Mannheim University) [52] have already proposed a simple Limit Order Book model (LOB) in which an explicit solution can be found for the optimal execution problem. We are now interested in considering more sophisticated models that take into account realistic features of the market such as short memory or stochastic LOB. This is mid term objective. At a long term perspective one would like to bridge these models to the different agent behaviors, in order to understand the effect of the different quotation mechanisms (transaction costs for limit orders, tick size, etc.) on the market stability.