Measuring Immediate Price Impact Using Nonparametric Models

61 Pages Posted: 25 Jan 2015  

Manh Cuong Pham

Monash University - Department of Econometrics & Business Statistics

Huu Nhan Duong

Monash University - Department of Banking and Finance; Financial Research Network (FIRN)

Paul Lajbcygier

Monash University - Department of Banking & Finance

Date Written: January 24, 2015

Abstract

As a consequence of recent technological advances and the proliferation of high-frequency trading and other forms of algorithmic trading, the cost of trading in financial markets has irrevocably changed. One important change relates to how trading affects prices; this is known as price impact. Understanding price impact is vital as it helps in evaluating different trading strategies and hence leads to optimal execution strategies that minimize trading costs. Besides evaluating established parametric price impact models in the literature, this paper proposes a novel nonparametric approach, known as Generalized Additive Models, to estimate price impact. This paper provides the first empirical analysis of the performance of different immediate price impact models for individual trades using out-of-sample predictions. The study finds that the nonparametric model outperforms all other models both in- and out-of-sample. The outperformance comes from (1) the appropriate price-impact normalization, (2) the greater data-fitting flexibility inherent in nonparametric frameworks, and (3) the incorporation of new explanatory variables which cannot easily be accommodated analytically.

Keywords: Market Impact, Indexing, High Frequency Trading, Nonparametric, Generalized Additive Models

JEL Classification: G12, C14

Suggested Citation

Pham, Manh Cuong and Duong, Huu Nhan and Lajbcygier, Paul, Measuring Immediate Price Impact Using Nonparametric Models (January 24, 2015). Available at SSRN: https://ssrn.com/abstract=2554908 or http://dx.doi.org/10.2139/ssrn.2554908

Manh Cuong Pham

Monash University - Department of Econometrics & Business Statistics ( email )

Wellington Road
Clayton, Victoria 3168
Australia

Huu Nhan Duong

Monash University - Department of Banking and Finance ( email )

Melbourne
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Paul Lajbcygier (Contact Author)

Monash University - Department of Banking & Finance ( email )

23 Innovation Walk
Wellington Road
Clayton, Victoria 3800
Australia

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