The Cost of Misspecifying Price Impact

14 Pages Posted: 2 Jun 2023

See all articles by Natascha Hey

Natascha Hey

École Polytechnique - Chair of Econophysics and Complex System

Jean-Philippe Bouchaud

Capital Fund Management

Iacopo Mastromatteo

Capital Fund Management

Johannes Muhle-Karbe

Imperial College London - Department of Mathematics

Kevin Webster

Columbia University

Date Written: May 31, 2023

Abstract

Portfolio managers’ orders trade off return and trading cost predictions. Return predictions rely on alpha models, whereas price impact models quantify trading costs. This paper studies what happens when trades are based on an incorrect price impact model, so that the portfolio either over- or under-trades its alpha signal. We derive tractable formulas for these misspecification costs and illustrate them on proprietary trading data. The misspecification costs are naturally asymmetric: underestimating impact concavity or impact decay shrinks profits, but overestimating concavity or impact decay can even turn profits into losses.

Keywords: Nonlinear price impact, model misspecification, optimal trading

JEL Classification: C51, C61, G11

Suggested Citation

Hey, Natascha and Bouchaud, Jean-Philippe and Mastromatteo, Iacopo and Muhle-Karbe, Johannes and Webster, Kevin, The Cost of Misspecifying Price Impact (May 31, 2023). Available at SSRN: https://ssrn.com/abstract=4465282 or http://dx.doi.org/10.2139/ssrn.4465282

Natascha Hey (Contact Author)

École Polytechnique - Chair of Econophysics and Complex System ( email )

Palaiseau
France

Jean-Philippe Bouchaud

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France
+33 1 49 49 59 20 (Phone)

Iacopo Mastromatteo

Capital Fund Management ( email )

France

Johannes Muhle-Karbe

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
Imperial College
LONDON, SW7 1NE
United Kingdom

HOME PAGE: http://www.ma.imperial.ac.uk/~jmuhleka/

Kevin Webster

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

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