Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

counterintuitive because market impact is mainly associated with adverse price movement. The main shortcomings of the effective spread are twofold. First, it can provide a measure of market impact but without a distinction between temporary and permanent parts. Second, the effective spread may be a poor indicator of market impact for large orders completed through multiple trades. When orders are split into smaller lots, the indicator should measure the total impact of executing the entire order and not simply add up the cost of each lot. As the first lots impact the market, they make the remaining lots more expensive. An indicator based on the effective spread will underestimate the total market impact costs if a different midpoint is used for each trade. The realised spread is based on a post- trade quotation midpoint. It equals twice the signed difference between the trade price and the midpoint observed at a specified time after the trade. Like the effective spread, this indicator attempts to measure market impact. However, this measure misses the permanent impact cost, as previously explained. Furthermore, the greater the time gap between trade execution and midpoint determination, the noisier the cost indicator will be. (b) VWAP The volume-weighted average price (VWAP) indicator is the signed difference between the trade price and the market volume-weighted average price computed over a given interval. The most frequently used indicator relies on the daily VWAP, i.e. , the volume-weighted average of all prices in the trading day. Nowadays, almost all data vendors as well as some

The quotation midpoint prevailing at the investment decision time is the reference price for computing the implementation shortfall . The implementation shortfall is the most effective of the indicators of transaction costs founded on the spread midpoint. The only disadvantage of this indicator is that it requires a large amount of data, i.e. , intraday quotation data as well as decision time and order data. Collecting all this data and dealing with it can be difficult or quite costly for investment managers. In practice, time- stamped information on individual trades may be incomplete or not gathered in one place but held in different systems and perhaps not in the same firm. Therefore, the implementation shortfall indicator indirectly requires that data acquisition and treatment costs not be a consideration. The effective spread relies on the quotation midpoint prevailing at the time of the trade execution. The effective spread is twice the liquidity premium, which is the signed difference between the trade price and the time-of-trade midpoint. This indicator ignores all the opportunity costs but gives a measure of market impact when compared with the quoted spread. When the trade is completed at the quoted price (a buy at the ask/a sell at the bid), the effective spread equals the quoted spread and market impact is zero. When the trade is completed outside the spread (the large order is filled at prices outside the best quote), the effective spread is larger than the quoted spread and market impact is positive. When price improvements mean that the trade can be completed inside the spread, the effective spread is smaller than the quoted spread and market impact is negative. This last case may be a little

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An EDHEC Risk and Asset Management Research Centre Publication