Lecture 7

Understanding and Measuring Transaction Costs

Trading Cost

Cost of implementing a trading strategyContractual costMarket impact

Difference between the trade price and the underlying fundamental value at the time of the trade

Lost opportunity cost

Trading cost depends on the order size. Time to execute the order is also important.

Retail investors vs. Institutional investors

Contractual Costs

Commissions (deregulated in 1975 in the US). For retail investors.

Online brokers are cheaper (~$5-20 / trade) E*Trade, AmeriTrade, Schwab etc.

Full-service brokers are much more expensive, but are bundled with services

Merrill, Dean Witter, A.G.Edwards, Edward Jones etc. For institutional investors (usually fixed per share).

For listed stocks, it is 2-5 cents per share. For Nasdaq stocks, commissions were built into prices as brokers often

filled these orders on a principal basis (“net” trading). Since the late 1990’s brokers started trading on the agency basis as well.

Market fees (small) SuperDOT fee ECN access fee

Historical commissions per share – Greenwich Associates DataInstitutional investor average cents-per-share commission, 1977-2004.

0

4

8

12

16

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Cents

per

share

1997

2003

0

50000

100000

150000

200000

250000

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0

commission - cents per share

freq

uen

cy

Institutional Commissions on a grid of $0.01; 1997

Full service commissionsExecution only

0

100000

200000

300000

400000

500000

600000

700000

800000

900000

1000000

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0

commission - cents per share

fre

qu

en

cy

Institutional Commissions on a grid of $0.01; 2003

Full service commissionsExecution only

Evolution of Commissions

Commissions were traditionally paying for other services (e.g. research, IPO) as well.

Over time there is a proliferation of alternative trading systems that only provide execution.

Unbundling of the execution from research.Decline in commission revenue for the large

institutional brokers.

Soft Dollars

Accounts into which brokers deposit excess commissions and from which the manager can pay for research, equipment, sales expenses, Potential conflicts of interest and failure of the fiduciary

duty of the broker to get the best execution.

Mutual funds rarely publish trading cost information SEC is investigating this practice, but has not ruled yet. UK has already banned the practice for mutual funds.

Market Impact (MI)

MI = Trade Price – Value for Buys

Value – Trade Price for Sells Fundamental value is a conceptual variable; so we

have to measure it somehow: Average of the bid and offer (mid-quote) just before the

trade; VWAP (Value Weighted Average Price) - Abel/Noser

methodology; Closing or opening price; Mid-quote around the time of the order submission.

Lost Opportunity Costs

Delay cost Cost of not executing on time (important for traders

with information and for hedgers – impatient) Prices can become unfavorable; Liquidity may dry up.

Unfilled order cost Cost of not filling the desired quantity on time

Higher transaction costs later on. Unfavorable change in fundamental parameters.

Plexus Iceberg of Costs for a Large Institutional Order

Implementation Shortfall (IS)

Identify the value of a paper portfolio using the mid-quote at the time the decision is made

IS = Difference between the value of the paper portfolio and the actual portfolio Transaction costs

Timing = change in mid-quote between the decision and the first execution.

Market impact = difference between the first execution mid-quote and the average trade price.

Lost opportunity costs Actual portfolio value only includes the value of the

completed trades

Implementation ShortfallAn Example of how not to do it.

Time Action Prevailing Market Quote

Trade Price

9:45 am Fidelity manager wants to buy 50,000 shares of Amalgamated

29.50 – 30.50 (mid-quote=30)

9:47 am Decision released to Brokers are US (BAU, a broker)

29.50 – 30.50 (mid-quote=30)

10:05 am BAU buys 10,000 shares 30 – 31 (mid-quote = 30.50)

31

10:15 am BAU buys 10,000 shares 31 - 32 (mid-quote = 31.50)

32

10:25 am BAU buys 10,000 shares 32 - 33 (mid-quote = 32.50)

33

10:27 am BAU buys 10,000 shares 33 - 34 (mid-quote = 33.50)

34

10:29 am BAU buys the last 10,000 shares

34 - 35 (mid-quote = 34.50)

35

Implementation Shortfall

Cost of the paper portfolio at the time the decision was madeDecision size x Mid-quote at the time of the decision50,000 x $30 = $1,500,000

Actual cost of the portfolio after the entire order was filled (10,000 x 31) + (10,000 x 32) + (10,000 x 33) +

(10,000 x 34) + (10,000 x 35) = 1,650,000Average fill price = $33

Trading Cost Breakdown

Cost of trading strategy = $150,000 1,650,000 – 1,500,000 Timing cost = Decision size x (MQDecision – MQFirst trade)

50,000 x (30 – 30.50) = $25,000

Market impact = Traded size x (Average trade price - MQFirst trade)

50,000 x (33 – 30.50) = $125,000

Lost opportunity costs = Unfilled decision size x (Average trade price - MQFirst trade)

Is zero because the entire decision was completed.

Cost for Retail Investors Quoted spread is a good measure of trading cost for an

impatient retail investors. A tight spread indicates a low trading cost, a liquid market.

Often, trades take place inside the spread. Market orders buy (sell) at less (more) than offer (bid) because of order flow competition. That is, market orders are price improved

We use the effective spread instead of quoted spread then 2 x (Trade price – Mid-quote) for buys 2 x (Mid-quote – Trade price) for sells For example, the bid and offer for a stock are 10 and 10.50. You

place a market buy order that trades at 10.40 instead of 10.50. Effective spread = 2 x (10.40-10.25) = 0.30 < 0.5.

Many firms try to offer price improvement as a bait to attract uninformed order flow.

New Rules on Disclosure of Execution Quality

SEC Rule 11 Ac1-5Each market center / participant is obligated to publish information about effective spreads for different order sizes/types for each stock on a monthly basis

Difficulties

Quoted spreads are much easier to calculate by an outside observer (econometrician) than the effective ones.

Effective spreads require matching of the time of trades and quotes:Time stamps may be off;How do one know which trade was a buy?

Internal calculations are much more accurate.

Summary

In the last decade the trading costs became the focal point of the institutional investors, at the expense of research.

We are witnessing the reduction of these costs along with proliferation of new conceptually different trading venues.

The trend is likely to continue, yet the decline in transaction costs is likely to stop soon.