The Impact of an Increase in Volatility on Trading Costs

Abstract

The current low volatility environment keeps trading costs low. But what if volatility increases? In this paper, we discuss how an increase in volatility will affect execution strategies and estimate its impact on portfolio trading costs. We derive our estimates by simulating the Goldman Sachs PortX algorithm. PortX derives the optimum execution strategy by balancing the cost-risk trade-off and therefore allows us to examine how an increase in volatility changes the optimum strategy. Our simulations suggest that doubling volatility will increase the expected trading cost on large cap portfolios by 20% to 25% (depending on trading aggressiveness) and by almost 50% on small cap portfolios. In our simulations, doubling volatility increases trading costs both directly (for a fixed execution horizon) and indirectly: the resulting increase in execution risk reduces the optimum execution horizon further increasing trading costs.

TOPICS: Exchanges/markets/clearinghouses, volatility measures, portfolio construction