Chapter 4 - Market Impact Models

Abstract

This chapter introduces the reader to the concept of market impact. Market impact is defined as the movement in the price of the financial instrument caused by the order or trade. We compare and contrast two leading theories and market impact models (Almgren and Chriss, 1997 and Kissell and Malamut 1998), and provide a detailed derivation of our preferred market impact modeling approach noted as “I-Star.” The chapter shows how the proposed I-Star impact model can easily accommodate single and multiple investor transactions, is easily expanded to various strategies and benchmarks, and is suitable for single stock and basket trading, and is appropriate across the various asset classes. This model serves as the building block and foundation for later chapters and more advanced algorithmic trading processes. For example, developing optimal agency execution strategies as well as constructing blind risk bids.