Abstract
Many financial arrangements reference market prices that are yet to be realized at the time of contracting and consequently susceptible to manipulation. Two of the most common such arrangements are as follows: (i) guaranteed volume-weighted average price (VWAP) contracts, which reference the VWAP prevailing over an execution window, and (ii) market-on-close contracts, which reference the price prevailing at the window’s end. To study such situations, we introduce a stylized model of financial contracting between a client, who wishes to trade a large position, and the client’s dealer. We provide conditions under which guaranteed VWAP contracts are optimal in this principal-agent problem. In contrast, market-on-close contracts generally cannot be optimal. These results explain the use of guaranteed VWAP contracts in practice, question the use of market-on-close contracts, and suggest considerations for the design of financial benchmarks.
| Original language | English (US) |
|---|---|
| Pages (from-to) | 3112-3128 |
| Number of pages | 17 |
| Journal | Management Science |
| Volume | 68 |
| Issue number | 4 |
| DOIs | |
| State | Published - Apr 2022 |
Funding
History: Accepted by Haoxiang Zhu, finance. Funding: M. Baldauf and C. Frei gratefully acknowledge support by the Social Sciences and Humanities Research Council of Canada [Grants IDG 430-2018-00100 and IG 435-2018-0049, respectively]. The authors also acknowledge support from the 2019 SFS Cavalcade Best Paper in Asset Pricing Award. Supplemental Material: The online appendices are available at https://doi.org/10.1287/mnsc.2021.4022.
Keywords
- benchmark manipulation
- dealer-client agency conflict
- front-running
- principal trading
- volume-weighted average price (VWAP)
ASJC Scopus subject areas
- Strategy and Management
- Management Science and Operations Research