DEFINITION of 'Solvency Cone'

A model that considers the impact of transaction costs while trading financial assets. The solvency cone at a certain time ("t") is the set of those positions that can be exchanged into a non-negative portfolio at time t after taking bid-ask prices into consideration. The spread between bid and ask prices is a very significant component of transaction costs.

BREAKING DOWN 'Solvency Cone'

Classical financial models generally do not take transaction costs into account, which hampers their application in the real world, since these costs are a significant factor in trading decisions. The solvency cone eliminates this drawback by taking transaction costs into account in its model. The concept finds a great deal of application in markets such as foreign exchange. While bid-ask spreads can be quite narrow in the foreign exchange market, the large position sizes in the interbank and institutional segments of the forex market can result in significant transaction costs.

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