EXECUTION COSTS AND EFFICIENT EXECUTION FRONTIERS

Dilip B. Madan ()
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Dilip B. Madan: Robert H. Smith School of Business, 4409 Van Munching Hall, University of Maryland, College Park, MD 20742, USA

Annals of Financial Economics (AFE), 2012, vol. 07, issue 01, 1-18

Abstract: Single period risks acceptable to the market at zero cost are modeled by a convex set of random variables leading to bid and ask prices that are trade size dependent. The theory of nonlinear expectations is employed to construct dynamically consistent sequences of bid and ask unit size prices that are size and trade date contingent. We then study the optimal design of spot and forward trading to minimize execution costs. Finally, we illustrate the construction of a two period execution cost frontier trading a decrease in execution costs for additional exposure to price risk. Most structured products already have prices that depend on the direction of the trade. Additionally markets already exist for large block trades with their own price structure that takes account of the time allowed for its execution. This paper outlines arbitrage free mechanisms for generating such price structures that could lead to automating quotation systems for such markets. Additionally, we describe the tradeoffs implicit in seeking to commit to trades now as opposed to assuming the price risk implicit in delaying commitments. Such an explicit analysis could lead to the development of optimal execution algorithms that economize on the level of price risk absorbed into the execution strategies.

Keywords: Market impact; concave distortion; non-linear expectation; bid ask functionals; JEL Classifications: G10; JEL Classifications: G12; JEL Classifications: G13 (search for similar items in EconPapers)
Date: 2012
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DOI: 10.1142/S2010495212500029

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