A Review of Trading Cost Models

Abstract

Over the last few years, transaction cost analysis has been one of the biggest areas of investment for both the buy and sell side of the equity industry. This increased focus has led to intensification of research in this field. At the same time, there has been an enormous leap in the provision of tools to aid measuring and predicting costs. As a precursor to modeling transaction costs, we felt it would be useful to the reader to compile a literature review that takes the reader from the very early attempts of modeling market microstructure through to some techniques used today. Although many of the early (classical) studies may seem inappropriate to today's electronic order books, many of the concepts developed are still relevant at present. Until recently, the focus of the investment community has been on commissions, taxes, and spreads. In this article, we have not gone into any detail regarding these fixed costs, but we have focused on the so-called “hidden” costs of trading.