A proposal for impact-adjusted valuation: Critical leverage and
execution risk

The practice of valuation by marking-to-market with current trading prices is
seriously flawed. Under leverage the problem is particularly dramatic: due to
the concave form of market impact, selling always initially causes the expected
leverage to increase. There is a critical leverage above which it is impossible
to exit a portfolio without leverage going to infinity and bankruptcy becoming
likely. Standard risk-management methods give no warning of this problem, which
easily occurs for aggressively leveraged positions in illiquid markets. We
propose an alternative accounting procedure based on the estimated market
impact of liquidation that removes the illusion of profit. This should curb the
leverage cycle and contribute to an enhanced stability of financial markets.