Block trade contracting

Markus Baldauf, Christoph Frei, Joshua Mollner

Journal of Financial Economics · 2024 · Volume 160

DOI: 10.1016/j.jfineco.2024.103901

Abstract

We study the optimal execution problem in a principal–agent setting. A client contracts to purchase from a dealer. The dealer hedges, buying 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 conditioning on the dealer’s hedging trades. We show the first-best benchmark is theoretically achievable with an unrestricted contract set. We then consider weighted-average-price contracts, which are commonly used. In the continuous-time limit, the optimal weighting entails a constant density at interior times and discrete masses at the extremes.

Keywords

Block trading, Contracting, Agency conflict, Price impact, Dealer–client relationship

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