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The Cost of Misspecifying Price Impact

Author

Listed:
  • Natascha Hey
  • Jean-Philippe Bouchaud
  • Iacopo Mastromatteo
  • Johannes Muhle-Karbe
  • Kevin Webster

Abstract

Portfolio managers' orders trade off return and trading cost predictions. Return predictions rely on alpha models, whereas price impact models quantify trading costs. This paper studies what happens when trades are based on an incorrect price impact model, so that the portfolio either over- or under-trades its alpha signal. We derive tractable formulas for these misspecification costs and illustrate them on proprietary trading data. The misspecification costs are naturally asymmetric: underestimating impact concavity or impact decay shrinks profits, but overestimating concavity or impact decay can even turn profits into losses.

Suggested Citation

  • Natascha Hey & Jean-Philippe Bouchaud & Iacopo Mastromatteo & Johannes Muhle-Karbe & Kevin Webster, 2023. "The Cost of Misspecifying Price Impact," Papers 2306.00599, arXiv.org.
    • Handle: RePEc:arx:papers:2306.00599
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    References listed on IDEAS

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    1. Jean-Philippe Bouchaud & Yuval Gefen & Marc Potters & Matthieu Wyart, 2004. "Fluctuations and response in financial markets: the subtle nature of 'random' price changes," Quantitative Finance, Taylor & Francis Journals, vol. 4(2), pages 176-190.
    2. Nicolae Gârleanu & Lasse Heje Pedersen, 2013. "Dynamic Trading with Predictable Returns and Transaction Costs," Journal of Finance, American Finance Association, vol. 68(6), pages 2309-2340, December.
    3. Eduardo Abi Jaber & Eyal Neuman, 2022. "Optimal Liquidation with Signals: the General Propagator Case," Working Papers hal-03835948, HAL.
    4. Aur'elien Alfonsi & Antje Fruth & Alexander Schied, 2007. "Optimal execution strategies in limit order books with general shape functions," Papers 0708.1756, arXiv.org, revised Feb 2010.
    5. Aurelien Alfonsi & Antje Fruth & Alexander Schied, 2010. "Optimal execution strategies in limit order books with general shape functions," Quantitative Finance, Taylor & Francis Journals, vol. 10(2), pages 143-157.
    6. Eduardo Abi Jaber & Eyal Neuman, 2022. "Optimal Liquidation with Signals: the General Propagator Case," Papers 2211.00447, arXiv.org.
    7. Gabaix, Xavier & Koijen, Ralph, 2021. "In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis," CEPR Discussion Papers 16290, C.E.P.R. Discussion Papers.
    8. Obizhaeva, Anna A. & Wang, Jiang, 2013. "Optimal trading strategy and supply/demand dynamics," Journal of Financial Markets, Elsevier, vol. 16(1), pages 1-32.
    9. Richard Martin & Torsten Schoneborn, 2011. "Mean Reversion Pays, but Costs," Papers 1103.4934, arXiv.org.
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    Citations

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    Cited by:

    1. Marcel Nutz & Kevin Webster & Long Zhao, 2023. "Unwinding Stochastic Order Flow: When to Warehouse Trades," Papers 2310.14144, arXiv.org.
    2. Marcello Monga, 2024. "Automated Market Making and Decentralized Finance," Papers 2407.16885, arXiv.org.

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