Principal Trading Arrangements: When Are Common Contracts Optimal?
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: (i) market-on-close contracts, which reference the price prevailing at the end of an execution window, and (ii) guaranteed VWAP contracts, which reference the volume-weighted average price (VWAP) prevailing over the execution window. To study such situations, we introduce a stylized model of financial contracting between a client, who wishes to trade a large position, and her dealer. Market-on-close contracts are generally not optimal in this principal-agent problem. In contrast, we provide conditions under which guaranteed VWAP contracts are optimal. These results question the usage of market-on-close contracts in practice, explain the usage of guaranteed VWAP contracts, and also suggest considerations for the design of financial benchmarks. The presentation is based on joint work with Markus Baldauf (University of British Columbia) and Joshua Mollner (Northwestern University).