Trade Duration, Volatility and Market Impact

We perform an empirical investigation of 'market impact' of trades using a large dataset of transactions executed by institutional investors in the US equity market. We find that price variations during trade execution are mainly driven by the aggregate order flow imbalance rather than the direction or size of individual trades. We find the main determinants of the amplitude of these price variations to be market volatility and trade duration. By contrast, trade size and execution speed, as measured by the participation rate, are found to have little or no influence on 'market impact' for orderly trade executions.Conditional on trade duration, trade size is found to have little influence on price variations during execution. We find evidence for a square-root dependence of price changes on duration rather than trade size and propose a simple explanation for this dependence in terms of the well-known square-root scaling of volatility as a function of duration. Our explanation is consistent with previous empirical studies on market impact and provides a simple rationale for the ubiquity of the 'square-root law' in these studies. We also examine the role of the participation rate in determining 'market impact': using evidence from large VWAP trades with high participation rates, we show that, conditional on duration, even large changes in participation rate have negligible influence on market impact, contradicting the assumption, common in optimal execution models, that impact increases with the participation rate. In fact, we provide evidence for the opposite effect: for a given trade size, the slower the execution, the higher the amplitude of price variations during the trade. Our findings highlight the need to revisit some common models of market impact and their use in the design of optimal execution, and suggest that it is more meaningful to focus on the modelling of aggregate order flow dynamics and the management of portfolio volatility during execution rather than the optimisation of 'impact' at a trade-by-trade level