Optimal Trading with Speed-Dependent Transaction Cost Rates: A Nonparametric Model

Abstract

The effective transaction cost rate (TCR) incurred by a large trade often depends on the execution speed. We propose a continuous-time work-horse model to study optimal trading strategies with speed-dependent TCRs. The TCR function is largely non-parametric and can approximate general TCR functions of trading speeds. Applying our framework to order execution problems, we theoretically characterize the structure of the optimal trading strategy and numerically analyze it extensively after calibration. When the order to be executed is large, our model implies simultaneously order-shredding strategy and U-shaped trading speeds over time, both of which are commonly observed in practice. Moreover, we show that adopting some intuitive but suboptimal trading strategies can be costly.

Keywords: Portfolio Choice, Transaction Cost, Liquidation, Acquisition

JEL Classification: C02, G11