Handbook of Finance: Investment Management and Financial Management

Chapter 28. Quantitative Modeling of Transaction and Trading Costs

PETTER N. KOLM, PhD

Clinical Associate Professor and Deputy Director of the Mathematics in Finance M.S. Program, Courant Institute, New York University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

SERGIO M. FOCARDI

Partner, Intertek Group

Abstract: Trading costs can be classified as fixed versus variable transaction costs and explicit versus implicit transaction costs. Portfolio managers and traders need to be able of effectively model the impact of trading costs of their portfolios and trades. In doing so, they seek to minimize the total transaction costs. There are several approaches for the modeling of transaction costs in portfolio optimization models and optimal execution applications.

Keywords: implicit transaction costs, market impact cost, asset allocation models, optimal trading

Trading and execution is an integral component of the investment process. A poorly executed trade can eat directly into portfolio returns. Simulations that seek to verify investment strategies can produce misleading results if transaction costs are not incorporated into the analysis. Optimization models that do not properly account for transaction costs can produce suboptimal allocations.

Probably the easiest way to understand and distinguish transaction costs is to categorize them in terms of fixed versus variable transaction costs, and explicit versus implicit transaction costs; see, for ...