Building and Evaluating a Transaction Cost Model: A Primer

It is well known that incorporating transaction costs into the portfolio construction process is important and often leads to different investment decisions and, ultimately, investment performances. However, it is obviously not sufficient to just blindly pick any arbitrary transaction cost model that is available. A bad transaction cost model can do more harm than good if it does not represent reality in terms of “true” average realized transaction costs. Consequently, if one uses a transaction cost model, it is crucial to be aware of the sources of transaction costs, to know which parts/components of transaction costs are modeled and which not, and to know how the model is defined, estimated, and, most importantly, tested and calibrated. This article sheds light on these considerations and discusses existing challenges along with possible remedies.