MARKET IMPACT COSTS
The market impact cost of a transaction is the deviation of the transaction price from the market (mid) price2 that would have prevailed had the trade not occurred. The price movement is the cost, the market impact cost, for liquidity. Market impact of a trade can be negative if, for example, a trader buys at a price below the no-trade price (i.e., the price that would have prevailed had the trade not taken place). In general, liquidity providers experience negative costs while liquidity demanders will face positive costs.
We distinguish between two different kinds of market impact costs, temporary and permanent. Total market impact cost is computed as the sum of the two. The temporary market impact cost is of transitory nature and can be seen as the additional liquidity concession necessary for the liquidity provider (e.g., the market maker) to take the order, inventory effects (price effects due to broker/dealer inventory imbalances), or imperfect substitution (for example, price incentives to induce market participants to absorb the additional shares).
The permanent market impact cost, however, reflects the persistent price change that results as the market adjusts to the information content of the trade. Intuitively, a sell transaction reveals to the market that the security may be overvalued, whereas a buy transaction signals that the security may be undervalued. Security prices change when market participants adjust their views and perceptions as they observe news and the information contained in new trades during the trading day.
Traders can decrease the temporary market impact by extending the trading horizon of an order. For example, a trader executing a less urgent order can buy or sell his position in smaller portions over a period and make sure that each portion only constitutes a small percentage of the average volume. However, this comes at the price of increased opportunity costs, delay costs, and price movement risk.
Market impact costs are often asymmetric; that is, they are different for buy and sell orders. Several empirical studies suggest that market impact costs are generally higher for buy orders. Nevertheless, while buying costs might be higher than selling costs, this empirical fact is most likely due to observations during rising/falling markets, rather than any true market microstructure effects. For example, a study by Hu shows that the difference in market impact costs between buys and sells is an artifact of the trade benchmark.3 (We discuss trade benchmarks later in this chapter.) When a pre-trade measure is used, buys (sells) have higher implicit trading costs during rising (falling) markets. Conversely, if a post-trade measure is used, sells (buys) have higher implicit trading costs during rising (falling) markets. In fact, both pre-trade and post-trade measures are highly influenced by market movement, whereas during- or average-trade measures are neutral to market movement.
Despite the enormous global size of equity markets, the impact of trading is important even for relatively small funds. In fact, a sizable fraction of the stocks that compose an index might have to be excluded or their trading severely limited. For example, RAS Asset Management, which is the asset manager arm of the large Italian insurance company RAS, has determined that single trades exceeding 10% of the daily trading volume of a stock cause an excessive market impact and have to be excluded, while trades between 5% and 10% need execution strategies distributed over several days.4 According to RAS Asset Management estimates, in practice funds managed actively with quantitative techniques and with market capitalization in excess of €100 million can operate only on the fraction of the market above the €5 million, splitting trades over several days for stocks with average daily trading volume in the range from €5 million to €10 million. They can freely operate only on two-thirds of the stocks in the MSCI Europe.