Measuring and Modeling Execution Cost and Risk

Abstract

Financial markets are considered to be liquid if a large quantity can be traded quickly and with minimal price impact. Although the idea of a liquid market involves both a cost as well as a time component, most measures of execution costs tend to focus on only a single number reflecting average costs and do not explicitly account for the temporal dimension of liquidity. In reality, trading takes time since larger orders are often broken up into smaller transactions or when limit orders are used. Recent work shows that the time taken to transact introduces a risk component in execution costs. In this setting, the decision can be viewed as a risk/reward tradeoff faced by the investor who can solve for a mean variance utility maximizing trading strategy. We introduce an econometric method to jointly model the expected cost and the risk of the trade thereby characterizing the mean variance tradeoffs associated of different trading approaches given market and order characteristics. We apply our methodology to a novel data set and show that the risk component is a non-trivial part of the transaction decision. The conditional distribution of transaction costs is also used to construct a new measure of liquidation risk that we refer to as liquidation value at risk (LVaR).