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Encyclopedia of Financial Models, 3 Volume Set by Frank J. Fabozzi

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Modeling Market Impact Costs

PETTER N. KOLM, PhD

Director of the Mathematics in Finance Masters Program and Clinical Associate Professor, Courant Institute of Mathematical Sciences, New York University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Portfolio managers and traders need to be able to effectively model the impact of trading costs on their portfolios and trades.

Trading is an integral component of the equity investment process. A poorly executed trade can eat directly into portfolio returns. This is because equity markets are not frictionless, and transactions have a cost associated with them. Costs are incurred when buying or selling stocks in the form of, for example, brokerage commissions, bid-ask spreads, taxes, and market impact costs.

In recent years, portfolio managers have started to more carefully consider transaction costs. The literature on market microstructure, analysis and measurement of transaction costs, and market impact costs on institutional trades is rapidly expanding.1 One way of describing transaction costs is to categorize them in terms of explicit costs such as brokerage and taxes, and implicit costs, which include market impact costs, price movement risk, and opportunity cost. Market impact cost is, broadly speaking, the price an investor has to pay for obtaining liquidity in the market, whereas price movement risk is the risk that the price of an asset increases or decreases from the time the investor ...

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