Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

Figure 4 focuses on the relationship between market impact and liquidity. Here, market liquidity is measured by turnover, defined as the ratio of the average daily volume to the total number of shares outstanding. As we can see, the lack of liquidity becomes expensive when turnover falls below 0.026% in the sample.

Trades affect market prices for two main reasons. First, if the trade is large relative to the available liquidity, the trade causes a market supply-demand imbalance and mechanically shifts the market price towards less favourable prices because it needs to attract additional liquidity (consumption of several quotes in the order book). This mechanical market impact lasts until liquidity is replenished. Second, trades can affect prices when they are perceived as motivated by new information. When the trade brings new information to the marketplace, a market correction occurs and the related market impact is permanent. Market impact is one of the most costly implicit components because it generates mainly adverse price movements and therefore reduction in portfolio returns. It is an invisible and variable transaction cost: invisible because it cannot be easily determined before the execution of the trade and variable because it depends greatly on the trade size, the available liquidity and the specified trading strategy. Figures 3 and 4 illustrate the relationship between market impact and trade size or liquidity. They are built on statistics based on the Sinopia Asset Management databases spanning sixteen developed countries and refer to trades executed during the period from 1999 to 2000. Figure 3 shows the relationship between market impact and the trade relative size. The latter is defined as the size of trade (expressed in number of shares) divided by the daily average volume for the stock. Market impact increases greatly from class four—trade size approaching or in excess of 1% of average daily volume—onwards.

Figure 3: Average costs by trade relative size

Market Impact

0.25

0.20

0.15

0.10

0.05

0.0

Relative Size 1 2 3 4 5 6

* The classes are defined as follows: Class 1: Relative Size < 0.05%; Class 2: 0.05% =< Relative Size <0.2%; Class 3: 0.2% =< Relative Size <0.4%; Class 4: 0.4% =< Relative Size <1%; Class 5: 1% =< Relative Size <5%; Class 6: Relative Size >= 5%

Source: Boussema et al (2002)

21 An EDHEC Risk and Asset Management Research Centre Publication