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David vs Goliath (You against the Markets), A dynamic programming approach to separate the impact and timing of trading costs

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  • Kashyap, Ravi

Abstract

We develop a fundamentally different stochastic dynamic programming model of trading costs. Built on a strong theoretical foundation, our model provides insights to market participants by splitting the overall move of the security price during the duration of an order into the Market Impact (price move caused by their actions) and Market Timing (price move caused by everyone else) components. We derive formulations of this model under different laws of motion of the security prices, starting with a simple benchmark scenario and extending this to include multiple sources of uncertainty, liquidity constraints due to volume curve shifts and relating trading costs to the spread.

Suggested Citation

  • Kashyap, Ravi, 2020. "David vs Goliath (You against the Markets), A dynamic programming approach to separate the impact and timing of trading costs," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 545(C).
    • Handle: RePEc:eee:phsmap:v:545:y:2020:i:c:s0378437119316206
    DOI: 10.1016/j.physa.2019.122848
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    More about this item

    Keywords

    Trading cost; Market impact; Execution; Zero sum game; Uncertainty; Simulation; Dynamic programming; Stochastic; Bellman equation; Implementation Shortfall;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games

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