Contracting for Financial Execution

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: (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.