A large body of empirical literature has shown that market impact of financial prices is transient. However, from a theoretical standpoint, the origin of this temporary nature is still unclear. We show that an implied transient impact arises from the Nash equilibrium between a directional trader and one arbitrageur in a market impact game with fixed and permanent impact. The implied impact is the one that can be empirically inferred from the directional trader's trading profile and price reaction to order flow. Specifically, we propose two approaches to derive the functional form of the decay kernel of the transient impact model, one of the most popular empirical models for transient impact, from the behavior of the directional trader at the Nash equilibrium. The first is based on the relationship between past order flow and future price change, while in the second we solve an inverse optimal execution problem. We show that in the first approach the implied kernel is unique, while in the second case infinite solutions exist and a linear kernel can always be inferred.

Transient Impact from the Nash Equilibrium of a Permanent Market Impact Game

Cordoni, Francesco
;
Lillo, Fabrizio
2024

Abstract

A large body of empirical literature has shown that market impact of financial prices is transient. However, from a theoretical standpoint, the origin of this temporary nature is still unclear. We show that an implied transient impact arises from the Nash equilibrium between a directional trader and one arbitrageur in a market impact game with fixed and permanent impact. The implied impact is the one that can be empirically inferred from the directional trader's trading profile and price reaction to order flow. Specifically, we propose two approaches to derive the functional form of the decay kernel of the transient impact model, one of the most popular empirical models for transient impact, from the behavior of the directional trader at the Nash equilibrium. The first is based on the relationship between past order flow and future price change, while in the second we solve an inverse optimal execution problem. We show that in the first approach the implied kernel is unique, while in the second case infinite solutions exist and a linear kernel can always be inferred.
2024
Settore SECS-S/06 - Metodi mat. dell'economia e Scienze Attuariali e Finanziarie
Optimal execution; Market impact; Transient impact model; Market microstructure; Game theory
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11384/139262
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