2015 Volume 58 Issue 2 Pages 165-183
We formulate a short-selling strategy of a stock and seek the optimal timing of short covering in the presence of a random recall and a loan fee rate in an illiquid stock loan market. The aim is to study how the optimal trading strategy of the short-seller is influenced by the relevant features of the stock loan market. We characterize the optimal timing of short covering depending on the conditions that lead to different costs and benefits of keeping the position. Depending on the parameters, not only a put-type problem but also a call-type problem emerges. The solution to the optimal stopping problem is obtained in a closed form. We present explicitly what actions the investor should take. A comparative analysis is conducted with numerical examples.