Forecasting Market Impact Costs and Identifying Expensive Trades
AbstractOften, a relatively small group of trades causes the major part of the trading costs on an investment portfolio. For the equity trades studied in this paper, executed by the world's second largest pension fund, we find that only 10% of the trades determines 75% of total market impact costs. Consequently, reducing the trading costs of comparatively few expensive trades would already result in substantial savings on total trading costs. Since trading costs depend to some extent on controllable variables, investors can try to lower trading costs by carefully controlling these factors. As a first step in this direction, this paper focuses on the identification of expensive trades before actual trading takes place. However, forecasting market impact costs appears notoriously difficult and traditional methods fail. Therefore, we propose two alternative methods to form expectations about future trading costs. The first method uses five 'buckets' to classify trades, where the buckets represent increasing levels of market impact costs. Each trade is assigned to a bucket depending on the probability that the trade will incur high market impact costs. The second method identifies expensive trades by considering the probability that market impact costs will exceed a critical level. When this probability is high, a trade is classified as potentially expensive. Applied to the pension fund data, both methods succeed in filtering out a considerable number of trades with high trading costs and substantially outperform no-skill prediction methods. The results underline the productive role that model-based forecasts can play in trading cost management.
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Bibliographic InfoPaper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 095.
Date of creation: Mar 2006
Date of revision:
market impact costs; forecasting; institutional trading; trading cost management.;
Other versions of this item:
- Jacob A. Bikker & Laura Spierdijk & Roy P. M. M. Hoevenaars & Pieter Jelle Van der Sluis, 2008. "Forecasting market impact costs and identifying expensive trades," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 27(1), pages 21-39.
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-04-22 (All new papers)
- NEP-FMK-2006-04-22 (Financial Markets)
- NEP-FOR-2006-04-22 (Forecasting)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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