Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

At each stage between the investment decision and the execution of the trade, there are potential delays and thus price movements that could positively or negatively affect portfolio returns. Opportunity costs are consequently invisible and variable implicit costs that depend greatly on the speed of execution. As the source of the time between trade decision and execution can vary, opportunity costs can be broken down into three components: •  operational costs Operational opportunity costs arise when the time required to trade is operational and unintended (transmission delays between buy and sell sides, for example). When the delay results from market timing under the control of the broker (for example, the broker splits the order into small lots over a period to minimise market impact), we refer to market timing opportunit y costs. Operational and market timing costs are sometimes both considered delay costs. We prefer the distinction as it enables identification of the party responsible for the costs incurred: the investor or his intermediary. Finally, missed trade opportunity costs are incurred when investors fail to fill their orders. Some trades may not be fully completed either because pricemovements have led to the cancellation of the initial trading decision or because there is no more security available (lack of liquidity). If a predetermined trading strategy is not completed, the resulting opportunity cost can be high. Failing to trade can be costly for the investor, who will have missed the • market timing costs • missed trade costs

Figure 4: Average costs by turnover

Market Impact

0.15

0.10

0.05

0.0

Turnover 1 2 3 4 5 6

* Share turnover = average volume traded during the previous month/Number of shares outstanding. The classes of liqudity are defined as follows:

Class 1: Turnover < 0.019%; Class 2: 0.019% =< Turnover <0.026%; Class 3: 0.026% =< Turnover <0.034%; Class 4: 0.034% =< Turnover <0.046%; Class 5: Turnover >= 0.046

Source: Boussema et al. (2002)

(3) Opportunity costs The decision to trade and the actual trade do not usually take place at the same time. Market prices can move for or against the proposed trade. The costs related to price fluctuation during the time required to act on an investment decision are opportunity costs. They arise when prices move between the time the trading decision is made and the time the order is executed. In general, two elements are responsible for changes in opportunity costs during the time required to complete the trade: price appreciation and timing risk. Price appreciation represents the natural price trend of the security. Timing risk has to do with the uncertainty associated with the price movement. In other words, the first element has to do with expected price movements and the second has to do with unexpected price movements.

22

An EDHEC Risk and Asset Management Research Centre Publication