Equity Valuation and Portfolio Management

MARKET IMPACT COSTS

The market impact cost of a transaction is the deviation of the transaction price from the market (mid) price² that would have prevailed had the trade not occurred. The price movement is the cost, the market impact cost, for liquidity. Market impact of a trade can be negative if, for example, a trader buys at a price below the no-trade price (i.e., the price that would have prevailed had the trade not taken place). In general, liquidity providers experience negative costs while liquidity demanders will face positive costs.

We distinguish between two different kinds of market impact costs, temporary and permanent. Total market impact cost is computed as the sum of the two. The temporary market impact cost is of transitory nature and can be seen as the additional liquidity concession necessary for the liquidity provider (e.g., the market maker) to take the order, inventory effects (price effects due to broker/dealer inventory imbalances), or imperfect substitution (for example, price incentives to induce market participants to absorb the additional shares).

The permanent market impact cost, however, reflects the persistent price change that results as the market adjusts to the information content of the trade. Intuitively, a sell transaction reveals to the market that the security may be overvalued, whereas a buy transaction signals that the security may be undervalued. Security prices change when market participants adjust their views and perceptions as they ...