Optimal execution with liquidity risk in a diffusive order book market

Abstract

We study the optimal order placement strategy with the presence of a liquidity cost. In this problem, a stock trader wishes to clear her large inventory by a predetermined time horizon T. A trader uses both limit and market orders, and a large market order faces an adverse price movement caused by the liquidity risk. First, we study a single period model where the trader places a limit order and/or a market order at the beginning. We show the behavior of optimal amount of market order, [Formula: see text], and optimal placement of limit order, [Formula: see text], under different market conditions. Next, we extend it to a multi-period model, where the trader makes sequential decisions of limit and market orders at multiple time points.