Measuring and Modeling Execution Cost and Risk

Posted: 21 May 2019

See all articles by Robert F. Engle

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Robert Ferstenberg

Morgan Stanley

Jeffrey R. Russell

University of Chicago - Booth School of Business - Econometrics and Statistics

Multiple version iconThere are 3 versions of this paper

Date Written: July 1, 2008

Abstract

Financial markets are considered to be liquid if a large quantity can be traded quickly and with minimal price impact. Although the idea of a liquid market involves both a cost as well as a time component, most measures of execution costs tend to focus on only a single number reflecting average costs and do not explicitly account for the temporal dimension of liquidity. In reality, trading takes time since larger orders are often broken up into smaller transactions or when limit orders are used. Recent work shows that the time taken to transact introduces a risk component in execution costs. In this setting, the decision can be viewed as a risk/reward tradeoff faced by the investor who can solve for a mean variance utility maximizing trading strategy. We introduce an econometric method to jointly model the expected cost and the risk of the trade thereby characterizing the mean variance tradeoffs associated of different trading approaches given market and order characteristics. We apply our methodology to a novel data set and show that the risk component is a non-trivial part of the transaction decision. The conditional distribution of transaction costs is also used to construct a new measure of liquidation risk that we refer to as liquidation value at risk (LVaR).

Suggested Citation

Engle, Robert F. and Ferstenberg, Robert and Russell, Jeffrey R., Measuring and Modeling Execution Cost and Risk (July 1, 2008). Chicago GSB Research Paper No. 08-09. Available at SSRN: https://ssrn.com/abstract=1211162 or http://dx.doi.org/10.2139/ssrn.1211162

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Robert Ferstenberg

Morgan Stanley ( email )

1585 Broadway
New York, NY 10036
United States

Jeffrey R. Russell (Contact Author)

University of Chicago - Booth School of Business - Econometrics and Statistics ( email )

Chicago, IL 60637
United States
773-834-0720 (Phone)
773-702-0458 (Fax)

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