Forecasting Market Impact Costs and Identifying Expensive Trades
Often, 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.
|Date of creation:||Mar 2006|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: http://www.dnb.nl/en/
More information through EDIRC
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.:
- Bikker, Jacob A. & Spierdijk, Laura & van der Sluis, Pieter Jelle, 2007.
"Market impact costs of institutional equity trades,"
Journal of International Money and Finance,
Elsevier, vol. 26(6), pages 974-1000, October.
- Jacob A. Bikker & Laura Spierdijk & Pieter Jelle van der Sluis, 2004. "Market Impact Costs of Institutional Equity Trades," DNB Working Papers 001, Netherlands Central Bank, Research Department.
- Jacob A. Bikker & Laura Spierdijk & Pieter Jelle van der Sluis, 2004. "Market Impact Costs of Institutional Equity Trades," DNB Staff Reports (discontinued) 125, Netherlands Central Bank.
- Chan, Louis K C & Lakonishok, Josef, 1997. " Institutional Equity Trading Costs: NYSE versus Nasdaq," Journal of Finance, American Finance Association, vol. 52(2), pages 713-35, June.
- Donald B. Keim & Ananth Madhavan, .
"The Cost of Institutional Equity Trades,"
Rodney L. White Center for Financial Research Working Papers
08-98, Wharton School Rodney L. White Center for Financial Research.
- Donald B. Keim & Ananth Madhavan, . "The Cost of Institutional Equity Trades," Rodney L. White Center for Financial Research Working Papers 8-98, Wharton School Rodney L. White Center for Financial Research.
- repec:fth:pennfi:68 is not listed on IDEAS
- Chan, Louis K C & Lakonishok, Josef, 1995. " The Behavior of Stock Prices around Institutional Trades," Journal of Finance, American Finance Association, vol. 50(4), pages 1147-74, September.
When requesting a correction, please mention this item's handle: RePEc:dnb:dnbwpp:095. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Rob Vet)
If references are entirely missing, you can add them using this form.