Implementation Shortfall with Transitory Price Effects

Terrence Hendershott, Charles M Jones and Albert J Menkveld

At the time of writing, regulators and some large investors have raised concerns about temporary or transitory volatility in highly automated financial markets.¹¹See, for example, the US Securities and Exchange Commission’s 2010 concept release on equity market structure (Release No. 34-61358). It is far from clear that high-frequency trading, fragmentation and automation are contributing to transitory volatility, but some institutions have complained that their execution costs are increasing. In this chapter, we introduce a methodology for decomposing the price process of a financial instrument into its permanent and transitory components, and we explore the insights from applying this methodology to execution cost measurement. Our methodology allows an institutional investor to accurately measure the contributions of transitory price movements to its overall trading costs. The methodology is particularly applicable to an investor that splits a large order into small pieces and executes it gradually over time.

The importance of transitory price impact has been well known in the academic literature since the early work on block trading (see, for example, Kraus and Stoll 1972).²²S