Transaction Costs and Liquidity Risk
Understanding and managing transaction costs is a critical component of portfolio risk analysis. Optimal rebalancing and hedging policies are heavily affected by consideration of transaction costs. Also, liquidity risk, which is the uncertainty connected to the ability to liquidate or rebalance a portfolio at a “fair price,” is a very important component of portfolio risk, particularly during periods of market turmoil.
Section 12.1 provides some basic definitions. Section 12.2 discusses theoretical and econometric models of transaction costs. Section 12.3 looks at the time-series behavior of transaction costs and liquidity and their correlation with market movements. Section 12.4 considers optimal trading strategies in the presence of transaction costs and liquidity risk.
Markets for trading assets can take various forms: from decentralized search and negotiation (as for houses and used cars) to centralized electronic exchanges. Each market has its own set of rules that determine acceptable order types, priorities for order execution, and other attributes. We do not attempt to discuss all of these features in detail but instead characterize the main features that are common to most organized financial markets.1
So far in this book we have treated each asset price as having a unique value at each point in time. In fact, there are several definitions of an asset price at any time t. A trader may post a limit order, or quote, which is an order either to purchase or to sell a certain amount of an asset at the best price available, subject to a limit on the price. The quote specifies the direction of the trade (buy or sell), the limit price, the size of the trade, the length of time the order should be open, and other features of the order. For example, a limit buy order for 500 shares of XYZ Inc. at a limit price of $50.00 per share executes, or gets filled, if
1 See Harris (2003) for a more detailed treatment of market structures.