A Hot-Potato Game Under Transient Price Impact and Some Effects of a Transaction Tax [Schied, Zhang]

Alexander Schied
University of Mannheim

Tao Zhang
University of Mannheim

May 16, 2013

Abstract:
Building on observations by Schöneborn (2008), we consider a Nash equilibrium between two high-frequency traders in a simple market impact model with transient price impact and additional quadratic transaction costs. We show that for small transaction costs the high-frequency traders engage in a “hot-potato game,” in which the same asset position is sold back and forth. We then identify a critical value for the size of the transaction costs above which all oscillations disappear and strategies become buy-only or sell-only. Numerical simulations show that for both traders the expected costs can be lower with transaction costs than without. Moreover, the costs can increase with the trading frequency when there are no transaction costs, but decrease with the trading frequency when transaction costs are sufficiently high. We argue that these effects occur due to the need of protection against predatory trading in the regime of low transaction costs.

Schied, Alexander and Zhang, Tao, A Hot-Potato Game Under Transient Price Impact and Some Effects of a Transaction Tax (May 16, 2013). Available at SSRN: http://ssrn.com/abstract=2256510 or http://dx.doi.org/10.2139/ssrn.2256510