Portfolio Strategy

North America Market Commentary 23 April 2009

Phil Mackintosh
+ 1 212 325 5263
Laurent Boldrini
+44 20 7888 3128 Evolution of Impact Cost Modeling
Key points
Electronic execution and high frequency
trading has revolutionised markets, but
pre-trade systems evolved far less.
In this report we look at how impact cost
models have evolved over time:
Inventory risk & cost models:
Based on option pricing concepts,
assume a liquidity provider has a one-
sided payoff based mostly on a stocks
volatility risk.
Semi-empirical models: moved
away from option based methodology,
and fit more flexible curves using more
factors of trade cost.
Optimal Schedule models: Split the
concept of risk and return, a big
improvement on inventory models.
They also elegantly solve the trading
trade-off (cost vs risk).
But even with the improvements over time,
we think cost models are still not that
helpful to traders. Specifically, these
models rely far too much on volatility:
Market-wide shifts in volatility cause a
relatively small change in average
execution costs
Real execution risk evolves in a very
non-normal way (unlike stock volatility)
Event risk is more important than
annualized stock volatility
Time decay of alpha is more important
than the time decay of volatility
Trade Strategy
An Evolution Rather than Revolution
Trading costs can be a significant contributor to portfolio performance, and by
inference, stock selection. Not surprisingly, better understanding and
estimating these costs is critical to the success of investors around the world.
Impact Cost estimation methods have changed significantly in the space of a
generation. The advent of computers, with ever increasing capacity, followed
by electronic exchanges and tick databases makes more complex calculations
far easier to complete. However from a mathematical standpoint, this has
been more of an evolution than a revolution as weaknesses caused by key
assumptions were gradually overcome. In this report, we discuss the models
that became industry standards throughout the last two decades.
Cost Estimates Should Affect Stock Selection
We know that smaller trades, and more liquid names, cost less to trade. For
that reason, it is critical that portfolio managers dont naively construct
portfolios based purely on alpha scores. In some cases, round trip costs in
expensive stocks to trade can offset the additional alpha earned from growing
the trade size. Optimising alpha against post-trade-cost returns adds an
additional constraint (and complexity) to the portfolio construction process
but it should resultant in more of the alpha being captured.
Trade Strategy Affect Execution Results
Impact cost models are also important for traders as they help identify
trades that have high expected costs & liquidity as well as providing a
benchmark for normal shortfall. We see proof of trader reliance on pre-
trades in practice in our execution systems. We find an unusually large
proportion of executions are submitted at 20-30% participation, consistent
with the typical conclusion from the latest evolution of cost models that we
discuss in section 4 below.
Exhibit 1: In-line executions mostly use around 20% aggression
20,000
18,000
Count
16,000
14,000
12,000

Additionally, the models reliance on stock 10,000

volatility (a factor consistent to all traders) 8,000

6,000
leads all traders should execute a stock in
4,000
a relatively similar way. We encourage 2,000
traders to customize their execution -
strategy for the alpha in each trade. To do
1
2.5
5

All Day
7.5

6 hours
10

this, they need more information on why

15

3 hours
20
25

1 hour

Participation
30

30 mins
40

5 mins
50

each stock is in each trade list.

75

(%)
30 Sec
100

Duration
Source: Credit Suisse Portfolio Strategy
Portfolio Strategy

Some Inconvenient Truths

Exhibit 2: Impact Cost for same-value trades To provide some important background to the ensuing
Same-Siz e Trades 35
discussions, we refer to our recent report Estimating Execution
(Shortfall as agression changes)
30 Costs. Below we summarize the results. The most important
Average
Shortfall 25
characteristics of how costs behave in the real world are:
(bps )

20 1. Bigger Trade = A lot More Costs

15
As trade size gets larger, the average costs increase, regardless
2 of aggression. In exhibit 2, each color represents an equal sized
1 10
relative trade (relative to ADV) and the colors darken as trade
5
size increases. Clearly relative trade size is a key driver of costs.
20
10

0
2. Trading Faster = A little More Costs
5

Trade
1

7.5 10 15 20 25 30 40
0.1

Size 0 1 2.5 5
Aggression (%)
(ADV%)
Also in chart 2, moving from left to right shows the changes in
impact cost caused by more aggressive execution. This shows
Exhibit 3: Volatile stocks costs more to trade that for each sized [colored] orders, aggression increases cost.
70 70
Low Volatility Stocks
60
High Volatility
Stocks
As the slope of (2) is not as steep as for (1)
60
Average Average above, we conclude aggression has a less
Shortfall Shortfall
(bps)
50
(bps)
50
significant cost than trade size.
40 40

30
3. More Volatile = More Costs
30
Separating the results into volatile and less-
20
15
20
20
20
volatile baskets, we see that more volatile
15
10
7.5
5
10 10
7.5
5
10 stocks cost more to trade (for the same
Trade Size 2
relative trade-size), especially as size
2
1 Trade Size 1
(ADV%) 0.5 0 0
(ADV%) 0.5
25 30 40
1 2.5 5 7.5 10 15
Aggression (%)
20
1 2.5 5 7.5 10 15 20
Aggression (%)
25 30 40
increases (exhibit 3).

Exhibit 4: Longer trades have a wider range of results 4. Trading Slower = More Risk
Deviation
60
We also found that as the duration of a trade increased, the
(bps) 50 dispersion of shortfall results increased (exhibit 4). Importantly:
The magnitude of this variation was non-trivial (large)
4
40

compared to the average costs.

30
The distribution was more peaked than a normal distribution
20
The results seemed independent of aggression or trade
10
strategy
As we explain later, this leads us to conclude that it the variability
1

0
2.5
5
7.5
10
15

of results is mostly caused by exposure to extraneous risks. This

All Day
20

6hours
25

3hours
30

1hour
40

30 mins
50

5mins
75

Participation
30Sec
100

(%) is commonly referred to as trend risk in Impact models however

Duration
we highlight that the results were close to equally distributed
around the mean (they are not always a cost).
Exhibit 5: The trade-off - Impact costs & confidence bands
2% Trade Size - Impact Cone 5. Time = Money: The Trading Trade-Off
90 Especially for active traders, opportunities can be lost if
70 executions are too passive. It becomes the job of the trader to
50 Large reduction in weigh the costs of more aggressive execution with the benefits
Cost (bps)

bad executions
30 from being in the trade before other market participants. Even for
Small cost
increase information-less trades, market trends can also affect shortfall
10
and the slower trades are executed, the more exaggerated this
-10
effect becomes. Put simply, trading becomes a trade-off.
-30
Not surprisingly impact models also treat uncertainty, as a cost in
-50
0 10 20 30 40 50 some way. However many generalize to use a stocks volatility as
Agression (%) a symbol of trend risk. As we show in the following pages this
Source: Credit Suisse: Portfolio & Derivatives Strategy generalization can cause issues for model users.

2
 Portfolio Strategy

1. Inventory Risk Models

Mathematics: Description & History
Impact cost = Fixed Cost + Size Cost The first generation of cost models, based on a paper by Grinold & Kahn, are
known as inventory risk models. In these, the risk of holding inventory
Fixed Cost = Alpha x Bid-Ask Spread depends on the expected time before trading clears the inventory.
Size Cost = k x x (% of daily volume)
Strengths
These models have mathematical similarities to modern portfolio theory,
specifically option pricing and VaR calculations. As we know, Volatility () is
the classic definition a stocks risk, and it evolves as a root function of time.
The distribution of possible outcomes created is what option models rely on to
price options (along with a few other inputs). Additionally, the calculation of
Exhibit 6: Fitting an Inventory Risk curve to volatility is measurable, simple, and unique to each stock.
our latest impact cost data
20 Most importantly, the root function, scaled by relative trade size and volatility,
18 Whole Day Trades gives a curve that matches observed characteristics of real executions, where:
16
Risk Model (Vol:20 K:0.2)
14 Larger orders cost more, in a decreasing rate (see exhibits 2 & 5)
Cost (bps)

12
More volatile stocks do tend to cost more than execute than less volatile
10
8
stocks (Exhibit 3)
6 This can be seen in Exhibit 6, where we fit an inventory risk model to our
4 latest real shortfall data (note: this line looks straight because the bottom axis
2
0
is a quasi-log scale it is actually a root function). This example uses
1 2.5 5 7.5 10 15 20 25 30 40 average volatility of 20% - as our data is from 2006/7, this is reasonable.
Trade Size (% ADV) Weaknesses
Assumes constant aggression
The most obvious, and significant, weakness of this model was its
assumption of a constant aggression level. There is no flexibility to adjust a
trade for execution strategy. This fails to address a key component of
execution analysis the tradeoff between aggression and impact. And it
leaves the model too inflexible for real-world trading decisions.
Some also say these models have a fixed 1-day duration, and in reality many
were calibrated using OTD data (just like we have in Exhibit 6). This is
contrary to the concept of inventory at-risk mathematics as if we assume
1-day trades, it means all executions are at different levels of aggression.
Inventory Risk isnt the same all day
Exhibit 7: Exposure to (Trade & Positions) A key assumption of this model is also that cost evolves in the same way that
140 100 exposure to volatility evolves as a root function of time. This is true for an
Evolution of exposure 90 option, where the whole position expires simultaneously. But there are two
120
(for a Position) 80 important mathematical implications for this model:
100 70
In the calculation above, the term for time (t) is actually just % of daily
Volatility (bps)

Trade Residual

60
80
50
volume. For an order to actually be at risk for this time, would actually
60 Evolution of exposure require the trade to executed at 100%.
40
(for a Trade)
40 30 Trades are usually executed in slices, over time. This incrementally
Residual
20 reduces the actual exposure to volatility throughout the day. Over the life
Trade Exposure
20
Order Exposure 10 of an order, this means that during the day, inventory risk is actually far
0 0 from a root function (see Exhibit 7, which shows the actual root function
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 exposure to (red line) versus the actual exposure to from a trade
Time (Days) (modeled using a 20-vol stock with 10 slices traded TWAP over the day).
However, this latter point is somewhat academic as the root function is a
good fit to observed execution data, and the integral of the outstanding
position can easily be included in the calibration of the constant k.

3
 Portfolio Strategy

2. Inventory Cost Models

Description & History
Mathematics: The second generation models are known as Inventory Cost models. These
overcame the issue of allowing aggression (or trade duration, as they are
The overall formula is similar to the first interlinked) to be a customizable component into an inventory risk model.
generation one, enhanced to allow different
aggression. A key premise of the inventory-cost approach is that liquidity will be provided
immediately at cost in an efficient market, by liquidity providers such as
Size Cost = k x Volatility x (time, based on broker-dealers. This is arrived at using the following assumptions:
aggression)
A market maker provides additional liquidity for orders exceeding the
The Dr. Portfolio inventory cost model has quoted size and by doing so creates a long or short inventory.
the following formula is as follow: On average, the market maker has no directional view (his expectation of
trend cost is zero), but he expects a certain variation around that zero
mean (commonly known as the volatility of a stocks return).
The model still assumes the variation will go against the market maker
when estimating inventory cost. Market maker then must minimize
With KBidAsk = 0.4 and KVolatility = 1.4. shortfall by splitting the trade into parcels small enough to cause no or
Also see: Minimizing Trading Costs Via the Inventory Model
little impact, but large enough to allow him to unwind as quickly as
possible to avoid any unnecessary trend cost. However the model does
not suggest what duration this should be. In this sense, the model is
Exhibit 8: Volatility & Trend cost closely related to the Inventory risk concept.
Strengths
This model builds on the mathematical strengths of the inventory risk model,
with a calibration of cost as a root function of time, just as volatility evolves
over time. It also produces cost curves where larger orders cost more, at a
decreasing rate, to execute (consistent with actual results in exhibits 2 & 5).
However this model is enhanced to fix two of the issues of the Inventory Risk
model namely:
This model resolves the fixed participation issue. By expanding the
variables in the time component of the model to include a changeable,
and more realistic, aggression level.
At the same time, this mathematical change also allows customization of
duration by using different participation rate for each stock, dependent
Source: Credit Suisse Portfolio Strategy
on each stocks average-daily-volumes
Weaknesses
Exhibit 9: Volatility vs Exposure vs Actual
shortfall 1. Adjusts for aggression the wrong way!!
100 12.0 According to this model, increasing aggression will reduce the time to
90 execute. Mathematically, shorter trade duration (t) means less exposure to
Actual Cost 10.0
80 volatility, and therefore the lower expected volatility cost (See exhibit 8).
Estimated Cost [bps]

Model Cost
Days to complete

70
8.0 Ultimately, increasing aggression actually reduces the expected cost.
60 Model Time

50 6.0 This is the opposite of what we observe in the market! We see in Exhibit 9,
40 for very patient executions, the modeled costs (blue line) also increase
30
4.0 exponentially, while observed costs (blue bars in exhibit 9) are falling.
20
2.0 2. Confusing risk, with cost?
10
Our main complaint with these two models however is the use of volatility,
0 -
1% 5% 10% 15% 20% 25% 30% 35% 40%
most commonly associated with risk, to calculate cost and the implied
Aggression assumption that variation will go against the market maker. We discuss this
Source: Credit Suisse Portfolio Strategy in more detail on the next page.

4
Portfolio Strategy

Confusing Greeks: Risk () vs Cost ()

Our main complaint with both models is the use of volatility, most
commonly associated with risk, to calculate cost and the
Exhibit 10: Volatility Cone vs Exposure implied assumption that variation will go against the market maker.
There are many parallels between these models and option market
pricing specifically, stock volatility and time to expiry is a major
VWAP - Past 2 Years
component in an option price, and will affect the risk of each
F re q u e n c y

Normal, Std Dev: 30 bps

Trend is not always a cost!
holding during an execution

But options payoffs really are one sided and put-call parity proves
that stocks are (almost) as likely to go up, as to go down.
We also find that execution results are (almost) as likely to be
positive, as negative (Exhibit 10). Over most execution timeframes
-200 -175 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 we find that a trader has around a 44% chance of actually beating
Implementation shortfall (bps)
Source: Credit Suisse Portfolio arrival price. Consequently, the correct way to interpret stock
Strategy volatility and its effects on execution results is to look at Exhibit Y3
in two dimensions:
The average () represents the expected cost.
The the stocks volatility () describes the distribution of results
Non-normality reduces confidence anyway!
Although the returns of a stock are said to be stochastic (random and assumed to be normally distributed), the execution results
are clearly non-normal. Compare the normal curve [exhibit 10, red line] with the actual results distribution [blue bars].
The fact that intraday returns are also far from normal contributes to this. In an earlier report we highlighted the pointy
mountains of single stock daily returns (Looking for Alpha in All the Wrong Places - Part 2, see exhibit 11). This shows that
most stock returns are far more boring (stable) than predicted by a normal distribution but some of the time, stocks move far
more than we expect. This is typically called a fat-tailed distribution.
This feature has implications for any model using a standard volatility calculation. As these imply that stock returns will evolve in
a normal way, real execution outliers will be fewer than predicted, but will have far more impact on the P&L.
Exhibit 11: Actual distribution of daily stock returns
8000

Actual Distribution
7000
Normal Distribution
600
6000
Actual Distribution
Normal Distribution
Observations

500
5000
400
Observations

4000
300

3000
200

2000
100

1000 0
2 3 4 5 6
0 Standard Deviations

-5 -4 -3 -2 -1 0 1 2 3 4 5

Standard Deviations
Source: Credit Suisse Portfolio Strategy

5
Portfolio Strategy

Crash testing the Vol () Factor

The past 6 months have seen almost unprecedented volatility in the market
(on a realized and implied basis, as shown in Exhibit 12, below). This has
provided an exceptional opportunity to crash test impact cost models. We
look at changes in actual slippage versus the models predictions below.
Exhibit 12: Global Volatility at exceptional levels

Calibration period for

Estimating Execution
Costs (2005 - 2007)

Source: Credit Suisse Portfolio Strategy

Exhibit 13: Changes to impact cost during the crisis

Model says: Shortfall Rises with Volatility (according to Inventory cost model, Asian basket)
One of the key mathematical implications of a typical inventory
cost model is that a market-wide increase in volatility equates
to a broad-based increase transaction costs.
The results in Exhibit 13 are calculated for a sample basket
using our own inventory cost model (Dr Portfolio) during the
worst of the market volatility. This shows that the impact
estimate increased more than 4-fold, roughly in line with the
increase in underlying volatility.
The question we are now able to ask is is this true in the
real world? Source: Credit Suisse Portfolio Strategy

Survey says: Spreads rise with Volatility Exhibit 14: Average Bid-Ask spreads for S&P500 stocks,
Our recent analysis in As The Dust Settles: Analyzing compared to the VIX
Microstructure Changes, showed that spreads were clearly
affected by, and very correlated to, volatility (exhibit 14).
However, spread costs are reasonably certain and easy to
calculate so they are usually a separate component of an
impact cost model.
Additionally, although spreads increased, their contribution to
total impact cost is usually a small fraction and the
magnitude would not explain the change in Exhibit 13.

Source: Credit Suisse Portfolio Strategy

6
Portfolio Strategy

Survey also says: Volatile stocks do cost more

Recall from Exhibit 3 that more volatile stocks do tend to cost Exhibit 15: US Average slippage vs VIX index
more than execute than less volatile stocks. Consequently, 50 80
45 Total Impact Cost
volatility is generally used as a factor to calibrate and 70
40 Spread
differentiate impact for single stock executions. VIX 60

Impact Cost (bps)

35
Survey also says: Volatile regimes dont cost more! 30 50

VIX (Pts)
However, our findings in exhibit 15 seem to show that a 25 40
higher volatility regime, on its own, didnt affect average 20 30
shortfall much at all. 15
20
In fact, during the crisis period we also saw that (especially for 10
5 10
VWAP orders):
0 0
Shortfall increased most across more aggressive May-08 Aug-08 Sep-08 Nov-08 Nov-08 Feb-09
strategies (as they crossed the spread more often) and Source: Credit Suisse Portfolio Strategy
Exhibit 16: Changes to shortfall during the crisis period
The amount of degradation in performance was close to
-
the actual increase in spreads (see exhibit 16)

Shortfall Deterioration in
(2)
And was far from the 4x increase that the market
(4)

Crisis (bps)
experienced (and expected in Exhibit 12)
(6)
Very passive orders (which cross the spread less) were Inline
(8)
roughly in line with historic shortfall. VWAP
(10)
This seems to indicate that market-wide shifts in volatility
(12)
increase trading costs mostly because they increase spreads. Agressive Moderate Passive
This means that inventory cost models would have Execution Style
systematically overstated expected cost during the crisis. Source: Credit Suisse Portfolio Strategy

A Beta way to Calibrate? Exhibit 17: Example Changes to 6 month Volatility & Beta
It seems that although volatility is a useful tool to 80% 7
rank the relative trading impact between stocks it
is actually not as important to determine absolute 70% Volatility 6
impact especially during a market-wide volatility 60% Beta
regime shift. 5
50%
Volatility

A better way to calibrate stock impact could be to 4

Beta
normalize for market volatility (m). Doing this 40%
effectively would remove the impact of market-wide 3
30%
volatility increases, but retain the relationships of 2
higher and lower volatility stocks 20%
Potentially, replacing with Beta, which could 10% 1
achieve this. Beta includes stock volatility (s) as 0% 0
well as a market volatility divisor of (m). Our results Jul-07 Dec-07 May-08 Oct-08 Mar-09
show that this was a far more stable metric over the
recent market sell off (see Exhibit 17) . Source: Credit Suisse Portfolio Strategy

7
Portfolio Strategy

3. Semi-Empirical Models
Description & History
Mathematics: In a paper published in the Journal of Risk in 2005; Almgren, Thum,
Almgren et al tested a variety of descriptive Hauptmann and Li proposed that impact is a 3/5 power law, with specific
factors and fit a curve to the average dependence on trade duration, daily volume, volatility and shares outstanding.
shortfall observed from actual executions. (See: Almgren Impact Cost 2005)
They discovered the importance of liquidity, This model does away with the assumptions of inventory cost, where
aggression and duration to trade cost exposure to a stocks volatility over time is responsible for the accurate pricing
of an execution. Instead, they prove by regression that what factors had the
They considered execution to have 2 most descriptive power:
components:
Relative Turnover is important: measured as ADV/shares outstanding,
Permanent cost: created by the
information from a trades direction and Aggression is important: measured as trade/total shares traded
size. This introduced the concept of Duration is important: Espcially as combined with agression it reflects
signalling risk trade size
Temporary cost: reflecting the Stock volatility is important.
market move required to attract Market cap is not important.
liquidity in a short timeframe.
Bid Ask Spread was not important
A generic formula for these models is:
The best curve was a 3/5th power: compared to the root curves used

Cost = (X/ V)*( / V) + sgn(X) |
X.
|
3/ 5 in inventory models this has slightly lower costs for small orders, but
VT with higher costs for large trades.
Where = 0.314 Consequently, these are considered empirical (cost) models.
= 0.142
X = Trade (Shares) Strengths
V = Avg Daily Volume
Critically, because this model sought to fit a curve to the data, the cost of very
T = Time (Duration)
= Shares Outstanding passive executions was shown to be smaller than for larger orders.
This was also instrumental in highlighting other important drivers of cost. In
addition to volatility and normalized trade size (trade/ADV). It also led to their
separation of the permanent and temporary costs which highlighted the
trade-off between duration (more signaling) and aggression (less time for
traders to provide offsetting liquidity).

Weaknesses
On its own, this model typically suggests that all executions should be
executed very slowly as that reduces the temporary impact. However this
solution ignores losses created by trend and opportunity costs.
However, we highlight that a solution to this problem (summarized in part 4,
over) was actually published (also by Almgren) well before this 2005 paper.

8
 Portfolio Strategy

Mathematics: 4. Optimal Execution Schedules

Almgren & Chriss developed an approach Description & History
that separates impact and trend risk. The latest execution models do a much better job of addressing (&
Using differentiation, they were able to separating) the inter-relationship of execution risk and execution cost:
solve for the minima of the combined Impact cost is calibrated empirically from real executions data (see red
function, creating a solution for the line in Exhibit 19).
efficient trading frontier for each risk level Trend cost (risk) is estimated using assumptions similar to that in the
This provided a mathematical solution for inventory cost model where risk is assumed to be a random varuiable,
the trading trade-off. with a mean = 0 (see blue line in Exhibit 19).
A generic formula for these models is: An elegant solution to optimize the trade-off between risk and cost was then
proposed by Almgren & Chriss, in a paper published in the Journal of Risk in
Cost = E(x) = f(t,$) 2000 (see: Optimal Execution). These models also are a combination of both
Where f: is a function of aggression an empirical (cost) and theoretical (risk) model.
and trade size
Risk = V(x) = k x x t
Strengths
See Inventory risk model 1. Math Captures the Traders Trade-Off
Optimal Execution = Min[E(x) + V(x)] The most important improvement over prior models is the specific separation
of risk and cost terms (see exhibit 18). As a result, the estimated cost
function can be continuously increasing as trade size & aggression both
increase. Consistent with real execution results (page 2).
Exhibit 18: Implementation shortfall
Additionally, their calculation made adjustments for the gradual reduction of
decomposition
residuals, and the weighted exposure to volatility that results (see exhibit 9).
Implementation Shortfall
2. Allows for Mathematical Optimization of Risk & Return
Impact Cost Trend Cost A neat additional solution that they developed was an efficient execution
frontier. Inclusion of a customizable risk aversion factor means the optimum
aggression level can be found for each traders levels of risk aversion.
Participation rate Duration/Size and Spread Participation rate Stock Volatility We demonstrated this in graphically below (Exhibits 19 & 20):
The optimum trade fronteir can be created by adding: impact + .risk
(see red line + blue line = green line, exhibit 19).
Im p a c t C o s t

T re n d C o s t

Lambda () represents the level of risk aversion. This term is important

because it also recognises that a unit of risk is a unit of return (because
the expected return for risk = 0, See Exhibit 10)
Its then possible to find the minimum of this function through
Participation rate Participation rate differentiation. This minima represents the optimal tradeoff for risk and
Source: Credit Suisse Portfolio Strategy
return (cost) for each risk tolerance selected (see Ehibit 20).

Exhibit 19: Almgren Chriss in Theory Exhibit 20: Optimum paths for different risk aversion

140 Risk 140 Fronteir (High Risk)

120 Efficient Fronteir (L=0.2%) 120 Fronteir (Mod. Risk)
Impact Cost Fronteir (Low Risk)
100 100
Cost (bps)

Cost (bps)

80 80
60 60
40 40
20 20 Optimum
- -
0 10 20 30 40 50 60 70 0 10 20 30 40 50 60 70
Agression (%) Agression (%)

Source: Credit Suisse Portfolio Strategy

9
Portfolio Strategy

Weaknesses
The major weakness of this approach is that a naive application of the
process can result in suboptimal trading and as we show on the next page,
more aggressive trading than needed. For reasons detailed below we think
an intuitive understanding and use of this model is difficult.
This model also use a linear impact assumption however as we discussed in
section 3, Almgren has since created a better cost curve.
1. Optimal solution is not the lowest cost
The fact this model has an optimal solution is very neat, and quite elegant
mathematically. However we think many traders confuse the risk term with
trend cost and assume the optimal cost is actually the sum of both terms,
rather than the trade-off between risk and return. In fact, Almgren & Chriss
specifically note that the expected value of the risk term = 0 (exhibit 21).
2. How do you calibrate ?
Perhaps more importantly, Almgren & Chris talk about optimizing for all levels
of risk aversion. Used correctly, the term would change be lower for
cashflow or delta neutral trades, and higher for event driven or single sided
trades (as they exhibit different amounts of execution risk).
In practice this is rarely done. Partly because it is difficult to interpret the
term especially because it is expressed in $2 which means the value of
tends be un-intuitive (its just a very small number).
We also think this explains one of the more unusual observations from page 1
why such a high proportion of in-line executions target 20% participation
(see exhibit 1). This is likely because all traders use a similar generalized
term leading to the same optimal aggression level. In the real world, trade
dynamics should create a lot more dispersion (or granularity) of execution
strategies, as we discuss more in later pages.
3. Still Uses Stock Volatility as Risk Proxy
Finally, these models still calibrate their risk term using each stocks historic
volatility. As we discussed on page 5, execution results are both non-normal
& actually far lower than the exposure to volatility x t, even after
accounting for incremental executions over time. Basically, the inventory
cost has made a reappearance as the execution risk. But we can see from
Exhibit 22 how different actual execution dispersion (green line) is to the
estimate using x t (blue line) and full day exposure (red line)
Exhibit 21: Slippage over execution time Exhibit 22: Slippage over execution time
1.4%
Volatility Exposure
1.2% Working Order Slippage
VWAP - Past 2
Years Observed Slippage
1.0%
Std Dev of Prices

Normal, Std Dev: 30

bps 0.8%
F req u en cy

0.6%
E[f()] = 0
0.4%

0.2%

0.0%
-200 -175 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 0.0 0.2 0.4 0.6 0.8 1.0
Implementation shortfall (bps) Time (Days)
Source: Credit Suisse Portfolio Strategy
Source: Credit Suisse Portfolio Strategy

10
Portfolio Strategy

Almgren & Chriss: in Practice

Exhibit 23: Actual impact & risk trade-off 1. The Greeks:
Recall the results the results of our real shortfall testing,
10% Trade Size - Impact Cone
which we discussed earlier (see page 2 & exhibit 10)
90
which show:
70
50
Executions with a duration (smaller agression) had a far
Cost (bps)

higher range of actual results (execution risk), thanks to

30 the longer time theyre exposed to market factors
10 such as trend risk (blue range = ).
-10
But Cost (red line = ) increased as agression
-30 increased
-50 One of the key points made by Almgren & Chriss is how
0 10 20 30 40 quickly a small increase in aggression can reduce total risk.
Agression (%)
This is clearly demonstrated with real results (exhibit 23).
Source: Credit Suisse Portfolio Strategy Increasing aggression from 1% to 5% reduces the risk (blue
range) by around 75bps, whereas impact cost (red line)
Exhibit 24: Impact + Risk = Optimal Frontier increases just 10bps). At this point, the risk/return tradeoff
10% Trade Size - Actual Fronteir is convincing for almost all trades.
40
By comparison, increasing aggression from 30 to 40%
35
provides far less risk reduction.
30
2. Adding a Hypothetical Execution Frontier
Cost (bps)

25
20 Execution Risk
Using real results (for cost and risk) and Almgren & Chriss
15 Impact Cost approach, we can estimate the frontier for our real
Efficient Fronteir executions:
10
5 Note that the Almgren and Criss optimization first
- converts risk (Blue area) to $2 shrinking its value
0 10 20 30 40 versus impact cost.
Agression (%)
Our hypothetical real fronteir (green line) = Cost + x
Source: Credit Suisse Portfolio Strategy Risk.
For our selected level of risk aversion, this shows that the
Exhibit 25: Frontier with theoretical () exposure frontier is optimal around 5% aggression.
10% Trade Size - Model Fronteir
70 3. But Almgren & Chriss use Theoretical Risk
60 Risk However in their model, Almgren & Chriss use theoretical
Efficient Fronteir
50 Impact Cost
risk based on the stocks exposure to its volatility () over
time. This is similar conceptually to what the inventory risk
Cost (bps)

40
models called cost, as the risk component reduces as in
30 proportion to time.
20
Not surprisingly, this curve actually starts higher, and
10 decays slower, than our real execution results. As a result,
- the models optimal result is much more aggressive (see
0 10 20 30 40 50 60 70 exhibit 25).
Agression (%)
Source: Credit Suisse Portfolio Strategy

11
 Portfolio Strategy

A Better Way to Look at Trend Risk

As we have discussed at length above, and show in exhibit 21, the distribution
of execution results is roughly a random (stochastic) process although it is
far from normal! In addition, it increases with trade duration implying that it
is related to the time an order is exposures to the market - but not as time.
Over a trade timeframe, assume trend = 0
We have also discussed the fact that considering this exposure risk as a
cost is erroneous, as:
The expected return = 0, so
Adding it to costs results will overstate total expected slippages.
This view is consistent with the way Almgren & Chriss established their 2-
component model. Execution risk explains the general lack of accuracy of
any impact cost model for single execution results.
Our Impact Cost Data Assumes Information = Zero
One of the conclusions we reached in our earlier report Estimating Execution
Costs, was that we had a broad enough collection of 2 sided data, that we
could assume the average information content of our results was at (or close
to) = 0. Consequently, the data used to calibrate our cost model represents
the base case for an information less trade, and the general confidence levels
around that value.
Exhibit 276: Maximum average alpha (per signal)
Price Reversal Its not Vegaits Alpha!
Earnings Momentum However, this is frequently not the case. Opportunity cost and alpha are real
1.60% Relative Value
concepts that are expected to exist in most trade-lists. In calibrating their risk
1.40% aversion factor , Almgren & Chriss also discuss the considering the different
1.20% reasons people trade.
For example, consider why people trade:
Total Alpha

1.00%
0.80% A cashflow trade may have no new information, especially if it is into an
0.60% index fund.
0.40% A value fund may find that they have a lot of valuable information but
0.20% that the market takes months to adjust for it
0.00% A momentum trader may find that their information decays faster, over a
Source: Credit Suisse Quant Research, Portfolio Strategy matter of weeks.
An event driven trader may have a huge expected return, but must trade
quickly before the event they anticipate becomes public.
Total Alpha differs by signal
Exhibit 27: Days before Alpha maximizes We can quantify this effect by looking at the performance of the alpha factors
100%
from our Quant Research team (see exhibit 26 & 27). These show that total
90% alpha varies across factor. Reversion strategies have the highest alpha Value
80% the lowest.
70%
But pre-trade alpha of just 100bps can easily be reduced significantly by
Alpha Decay

60%
trading costs especially for very large trades. The selection of aggression
50%
may be critical to retain more alpha.
40%
30% Price Reversal And Alpha Decay Varies by signal
20% Earnings Momentum In addition, different alpha signals decay at different rates. For example, 60%
10% Relative Value of the factor performance occurs in:
0%
3 days for their price reversal factor
0 10 20 30 40 50 60 70 80 90 100 110 120
Days 3 weeks for their momentum factor
Source: Credit Suisse Quant Research, Portfolio Strategy
Around 3 months for their value factor.

12
 Portfolio Strategy

In this instance, optimal trading strategies are pretty clear from the different
dynamics of quant factors and are clearly more related to the alpha factors
Exhibit 28: Correlation increases as traders than dispersion of execution results:
focus more on broad economic news, and less
The factor with the most alpha also has the fastest alpha decay. This
on stock specific news
clearly lends itself to faster trading which is required to minimize
opportunity cost, but can be borne thanks to the stronger expected
performance.
Conversely value trades have less alpha, but also need to be owned for
months to capture the alpha. Slowing these executions may save more
costs than the alpha that would accumulate.
X-Treme Traders? Event Driven get Aggressive
Most investment strategies rely on new information in some form-or-other to
generate their outperformance. But event driven traders have some of the
most significant alpha (and fastest rates of alpha decay).
The addition of news can lead to an instantaneous revaluation of a company,
Source: Credit Suisse Quant Research, Portfolio Strategy industry, or even the whole market. Sometimes this causes the market to
gap; even when markets are closed (no signaling is required). [This also
explains why stock markets are not entirely random (or normal), why
Exhibit 29 Earnings Surprises vs Price Moves in correlations, beta & volatility change over time; and also why stock returns are
Q4-08 (Market Adjusted) fat tailed (see exhibit 28)].
less than -50%

-50% to -40%
Some typical event driven trades include earnings releases & takeover
-40% to -30%
announcements (see exhibits 29 & 30), and they affect all traders in a stock:
-30% to -20%
For event driven traders the eventual arrival of news should create
-20% to -10% Avg negative
-10% to -1% surprise px increased urgency to complete and adverse or unexpected news, a
0%
reaction (-3.7%)
reason to aggressively exit a position.
Avg positive
1% to 10%
surprise px Even for other (nave) traders, it significantly increases execution risk
10% to 20% reaction (1.7%)

20% to 30%
which could be reduced by trading the specific stock with more urgency
30% to 40%
than the alpha signal may suggest.
40% to 50%

more than 50%

Want More Alpha? Increase your Information Ratio
-15% -10%
If investors want better trading results, we encourage them to focus more on
-5% 0% 5% 10%
the reasons why theyre trading the Alpha & Alpha decay for each stock.
Exhibit 30: A typical trading pattern for a stock This is likely to lead to better trade selection than using a generic, volatility
with earnings or event news based optimization, which is unrelated to their investment process.
Mid-day Earnings Release

14.0
(TCHC May 6, 2008)
80,000
However this means portfolio managers need better understand their trade-
70,000
lists and traders will need more information from them. It also means
13.5

60,000
traders need work harder, as execution strategies might ultimately need to be
13.0
different for each stock in a trade-list.
Volume (shares)

50,000
12.5
Price

40,000
12.0
30,000

11.5
20,000

11.0 10,000

10.5 -
9:30 10:30 11:30 12:30 13:30 14:30 15:30

Sources: Credit Suisse Portfolio Strategy

13
Source: Credit Suisse Portfolio Strategy
Portfolio Strategy

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