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) guaranteed VWAP contracts, which reference the volume-weighted average price (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 her 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. The presentation is based on joint work with Markus Baldauf (University of British Columbia) and Joshua Mollner (Northwestern University).
Bio: Christoph Frei is an associate professor of mathematical finance at the University of Alberta. He grew up in Switzerland and studied mathematics at ETH Zurich. During his PhD studies in mathematical finance at ETH Zurich, he worked in the financial industry. After receiving his PhD degree, he was a researcher at École Polytechnique in Paris before joining the University of Alberta in 2010. He has several ongoing collaborations with the financial industry in the areas of machine learning and risk management. His current research is in quantitative finance (algorithmic trading and risk management) as well as mathematical economics (contract theory and over-the-counter markets).