The Market Impact Puzzle
19 Pages Posted: 27 Feb 2018
Date Written: February 4, 2018
Finding a universal market impact formula remains one of the most fascinating puzzles in finance. This paper reviews two possible approaches for imposing restrictions on this formula. First, restrictions can be obtained from a system of economic equations using trading volume and volatility, as suggested by Kyle and Obizhaeva (2017a). Second, restrictions can be derived using dimensional analysis and leverage neutrality, as suggested by Kyle and Obizhaeva (2017b). Except for the knife-edged case of the square root market impact function, additional assumptions related to market microstructure invariance are needed to apply the same market impact formula to all assets simultaneously. This results in a tightly parameterized universal market impact formula suitable for empirical testing.
Keywords: Market microstructure, invariance, liquidity, square root model, market impact, transaction costs, dimensional analysis, leverage neutrality, volume, volatility
JEL Classification: G10, G14, G23
Suggested Citation: Suggested Citation