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Principal Trading Arrangements: When Are Common Contracts Optimal?

Author

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  • Markus Baldauf

    (Sauder School of Business, University of British Columbia, Vancouver, British Columbia V6T 1Z2, Canada)

  • Christoph Frei

    (Department of Mathematical and Statistical Sciences, University of Alberta, Edmonton, Alberta T6G 2G1, Canada)

  • Joshua Mollner

    (Kellogg School of Management, Northwestern University, Evanston, Illinois 60208)

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.

Suggested Citation

  • Markus Baldauf & Christoph Frei & Joshua Mollner, 2022. "Principal Trading Arrangements: When Are Common Contracts Optimal?," Management Science, INFORMS, vol. 68(4), pages 3112-3128, April.
    • Handle: RePEc:inm:ormnsc:v:68:y:2022:i:4:p:3112-3128
    DOI: 10.1287/mnsc.2021.4022
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    References listed on IDEAS

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