Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

) 22 − 20 ( To measure transaction costs and properly identify where they occur, the investor can consider four points on the time line: the investment decision time, the order release time, the time at which the broker begins to implement the trade and the time at which the broker stops trading. With the method below, the investor can then identify four reference prices to calculate the implementation shortfall: X = total quantity to execute (total trade size) x i = number of shares executed at price i X , x i > 0 for a buy; X , x i < 0 for a sell P 0 = quotation midpoint at the time of the investment decision P R = quotation midpoint at the time the order is released to the broker P S = quotation midpoint at the time the broker starts working the order P T = quotation midpoint at the end of trading P i = execution price of i th trade EC = all the explicit costs associated with the trade ) + EC (2) Expanded framework There are several ways to expand Perold’s approach to fine-tune the measurement of transaction costs. Some are presented in Kissell and Glantz (2003). The expanded version we propose here is adjusted for the classification of implicit cost components provided in section II.

We can illustrate this primary version of the implementation shortfall with a very simple example. Suppose an investment decision to buy 500 shares on a given security traded in € whose implementation details are the following: X = 500 x 1 =200 and x 2 =200 P 0 = 20 P T = 22 P 1 = 21 and P 2 = 21.5 Based on the above data, the implementation shortfall is calculated as follows: IS = 200 × 21 + 200 × 21.5 ( ) − 400 × 20 ⎡⎣ ) + EC For this investment decision, the missed trade opportunity cost measure is € 200 or € 0.4 per share, while the other implicit costs (spread, market impact, operational and market timing opportunity costs) amount together to € 500 or € 1 per share. These cost measures can also be expressed in basis points (bp). In this case, we obtain 200bp for the missed trade opportunity cost and 500bp for the other implicit costs. As we have seen, the implementation shortfall is easily understood and implemented. Although it seems to be an effective means of measuring transaction costs, Perold’s framework delivers interesting information about how large transaction costs are but not really about where they are incurred. To better identify where they are incurred, the original version must be expanded. ⎤⎦ + 500 − 400 ( ) 22 − 20 (

⎤⎦ + 500 − 400 (

S = 200 × 21 + 200 × 21.5 ( ⎡⎣

) − 400 × 20

31 An EDHEC Risk and Asset Management Research Centre Publication