Implementation Shortfall with Transitory Price Effects

Regulators and some large investors have recently raised concerns about temporary or transitory volatility in highly automated financial markets. It is far from clear that high-frequency trading, fragmentation, and automation are contributing to transitory volatility, but some institutions complain that their execution costs are increasing. In this chapter, we introduce a methodology for decomposing the price process of a financial instrument into its permanent and transitory components, and we explore the insights from applying this methodology to execution cost measurement. Among other things, our methodology allows an institutional investor to accurately measure the contributions of transitory price movements to its overall trading costs. The methodology is particularly applicable to an investor that splits a large order into small pieces and executes it gradually over time. The importance of transitory price impact has been well-known in the academic literature since early work on block trading (e.g., Kraus and Stoll (1972)). While it is fairly straightforward to measure the transitory price impact of a block trade, it is a much greater challenge to measure the transitory price impact when a large institutional parent order is executed in perhaps hundreds of smaller child order executions. The key innovation of our approach is that we estimate the temporary component at each point in time, and in particular whenever a child order executes. By summing over all child orders, we can thus measure the effect of the temporary component on overall trading costs. To be more precise, we extend the classic Perold (1988) “implementation 1See for example the US Securities and Exchange Commission’s 2010 concept release on equity market structure (Release No. 34-61358). 2See Duffie (2010) for an extensive discussion of temporary price impacts from large informationless demands for liquidity.