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JOT Fall 2012 Bloomberg
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W W W. I I J O T. C O M
FALL2012VOLUME7NUMBER4
Trade Cost:
Handicapping on PAR
VLAD RASHKOVICH AND ARUN VERMA
Sponsored by:
Goldman Sachs
Morgan Stanley
D R ASHKOVICH
UBS
global
business
Article Abstract
Trade Cost: Handicapping on PAR
Vlad Rashkovich and Arun Verma
We analyze the prevailing approach to estimating implicit trade costs and suggest improvements
that create greater precision. Our model studies buy-side parent orders to prove that Size/ADV is
a sublinear factor, which means that doubling an order does not double the trade cost. The same
precision cannot be achieved from the child order data available to the sell side. After improving
on existing methods, we cast doubt on whether it is realistic to delineate permanent and temporary costs when numerous market participants influence prices simultaneously. As a result, we
introduce a new highly accurate pre-trade cost model with predictive power (R2) of up to 26%.
Trade Cost:
Handicapping on PAR
Vlad Rashkovich and Arun Verma
Vlad R ashkovich
is the global business
manager of trade analytics at Bloomberg, L.P.
in NewYork, NY.
vrashkovich1@bloomberg.net
A run Verma
is a senior quantitative
analyst at Bloomberg,
L.P. in New York, NY.
averma3@bloomberg.net
Exhibit 1
To address the drawbacks of Almgrens assumptions about timing and constant reversion, we introduce
Participation Arrival Reversion (PAR), a dynamic way
to determine how long to wait to measure the impact
of the trade.
Once the order hits the market, we start listening.
The higher the participation rate, the greater the temporary impact we expect, and thus the longer we wait
to capture the impact. Our research shows that if the
participation rate is 5%, we should wait five minutes to
capture the temporary impact. If participation is 30%,
then we should wait 30 minutes to capture the temporary
impact. Instead of waiting for 30 minutes after
the trade, our model measures the impact right
after the order starts and does so dynamically
based on participation rate.
There are a number of practical considerations for computing PAR. The most important one is that PAR cannot be more than half
the duration of the order. Otherwise, the temporary impact could be larger than the entire
implementation shortfall.
To ensure we include enough trades close
to the end of the trading day, we have Winsorized the data for all values above a 30%
participation rate. So, for all trades with participation >30%, we measure PAR after 30
minutes.
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Exhibit 2
Instant Impact
(2)
(3)
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Exhibit 3
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(7)
Exhibit 4
b. Order level data for size/ADV, given the nonlinearity of permanent impact.
c. Precise calibration of the spread in the instant impact
by allowing it to scale with participation rate from
a negative quarter to a positive half vis--vis the
midpoint.
d. Two-step optimization, which unleashes predictive power hidden in both parent orders and child
orders.
simplified Methodology
If we look at the trade cost components delineation that current models use, we cannot help but note
that the market is a complex combination of cause and
effect reactions triggered by numerous participants. The
separation between permanent and temporary cost thus
might be theoretical and indistinguishable.
If we simplify the goal and try to solve for trade
cost as a whole, then we can do it with single optimization of the same three factors on the parent order
level:
bidask spread % +
(participation %/100) 1 (T) 2
+ (size/ADV) (10)
In essence, our simplified parametric form has two
logical components: order size and execution strategy.
Order size is defined by the amount of shares that an
investor has to trade relative to ADV. Execution strategy
is defined by the traders choice of participation rate,
which drives duration and depth of crossing into the
bidask spread.
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Exhibit 5
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References
Almgren, R., and C. Neil. Optimal Execution of Portfolio
Transactions. Journal of Risk, Vol. 3, No. 2 (2000), pp. 5-39.
. Optimal Execution with Nonlinear Impact Functions
and Trading-Enhanced Risk. Applied Mathematical Finance,
Vol. 10, No. 1 (2003), pp. 1-18.
Almgren, R., T. Chee, H. Emmanuel, and L. Hong. Equity
Market Impact. Risk ( July 2005), pp. 57-62.
Huberman, G., and W. Stanzl. Price Manipulation and
Quasi-Arbitrage. Econometrica, Vol. 72, No. 4 ( July 2004),
pp. 1247-1275.
Levenberg, K. A Method for the Solution of Certain NonLinear Problems in Least Squares. Quarterly of Applied Mathematics, 2 (1944), pp. 164-168.
Marquardt, D. An Algorithm for Least-Squares Estimation
of Nonlinear Parameters. SIAM Journal on Applied Mathematics, Vol. 11, No. 2 (1963), pp. 431-441.
Mehta, N. A New Way to Judge the Buyside. Traders Magazine, Vol. 22, No. 292 (March 2009), p. 48.
Perold, A.F. The Implementation Shortfall: Paper vs.
Reality. The Journal of Portfolio Management, 14 (Spring 1988),
pp. 4-9.
To order reprints of this article, please contact Dewey Palmieri
at dpalmieri@ iijournals.com or 212-224-3675.
Fall 2012