Trade Cost: Handicapping on PAR

Abstract

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%.

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