When Is the Transaction Cost Optimal?

Abstract

Transaction costs play a significant role in financial markets, and many studies have been conducted on this topic to date. Research on this topic may be divided into two categories. The first category of studies examines the optimal trading strategy of the investor who has to pay transaction costs. The second group investigates the optimal transaction costs that ensure the market operates as smoothly as possible, while retaining the profits of the market maker. We consider simultaneous optimization by the investor and the market maker, and analyse the impact of market parameters on the optimized transaction costs. As the answer of the simultaneous optimization, we could show the optimal transaction cost exists, when the market maker decides to make the market for sufficiently long term. Further, we also derive the fact that the optimal transaction cost increases when the market is profitable for investors, but it decreases when the opposite situation appears.

Keywords: Transaction costs; Optimal trading strategy; Investor; Market maker

JEL Classification: G10: G11; G14