Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

quantity available at the best opposite quote. The spread cost is therefore particularly sensitive to the timing of execution. Figure 2 illustrates the variation of the volume-weighted bid-ask spread across several major European stock exchanges. For a given trading venue, spreads fluctuate across stocks. In general, spreads are negatively associated with market capitalisation and liquidity and positively associated with volatility and information asymmetry. (2) Market impact Market impact is the price to pay for consuming the liquidity available on the market beyond the best quote: to complete their “large” orders, buyers must pay premium prices and sellers must offer discounts. In other words, market impact is the price shift that is due to the trade size. Its main determinants are the trade size and the market liquidity available at the time of the trade. Accordingly, market impact can be viewed as a positive function of the trade size and a negative function of the liquidity available. For a given level of liquidity, market impact increases with the trade size. For a given trade size, market impact increases with the lack of liquidity.

The inventory control cost is compensation for the risk of bearing unwanted inventories (Ho and Stoll 1981). Accommodating other market participants’ trades makes liquidity providers deviate from their optimal inventory based on their own risk-return preference. To restore their optimal position, they adjust their bid-and-ask prices to attract and/or avoid some trades. The adverse selection cost is compensation for the risk of trading with informed traders (Copeland and Galai 1983). Informed traders have a certain amount of private information that allows them to know or better estimate the true value of a security. As liquidity providers lose when they trade with informed traders, they widen their bid-ask spread for all market participants to cover their potential losses. The spread represents the implicit cost of a round-trip for a small trade and, as such, may be measured from market data by the simple difference between the best ask and best bid quotes. The ease of obtaining measures for spread makes some people consider it a visible implicit cost. In any case, this cost component is variable since spreads vary over time according to trading conditions. In limit order book systems, spreads mechanically widen after a large trade consuming more than the

Figure 2: Weighted average bid-ask spreads in %

Euronext Portugal Sweden United Kingdom Italy Euronext Brussels Switzerland Spain Germany Euronext Paris Euronext (Total) Euronext Amsterdam US Nasdaq

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35 0.40

Source: Various public sources, EDHEC-Risk Advisory

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An EDHEC Risk and Asset Management Research Centre Publication

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