Fairness in Trading: A Microeconomic Interpretation

Abstract

This article shows that nonlinear transaction costs generate external effects between accounts due to trade-volume-dependent marginal transaction costs. For an asset manager with multiple clients, this raises the question of fairness: How do I ensure that all clients are treated fairly? In general, two possible solutions exist. The first is the so-called COURNOT/NASH solution, where each account is optimized under the assumption that trading in the remaining accounts is given. However, in a COURNOT/NASH equilibrium, each client pays the average costs of trading but creates higher marginal costs (under the assumption of nonlinear transaction costs) on the “community” of accounts. Ignoring this interdependence will hurt performance in all accounts. The authors model optimal trading with mean variance preferences as a duopoly game. This allows the use of well-developed microeconomic tools for analyzing the optimal trading problem and linking it with the literature on external effects and their solution, i.e., the COASE theorem.

TOPICS: Factor-based models, statistical methods, portfolio construction