Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

This fall is reported by Domowitz et al. (2001) in an analysis of equity trading costs in a sample of forty-two countries. Boussema et al. (2001) also document this fall in transaction costs. For a sample of trades included in the Sinopia Asset Management database, the authors find that total transaction costs amounted to about 0.38% from 1996 to 1999 while they fell to 0.18% from 1999 to 2000. We observe a similar finding in Munck (2005), a more recent study devoted to transaction costs at the larger stock exchanges in Europe and in the north. Munck shows that total transaction costs have dropped in recent years. He attributes this drop to the significant drop in explicit costs. Figure 6 shows that the explicit costs of trading on the OMX exchanges, Euronext and Deutsche Börse have fallen over the past eight years and are fairly clustered. The higher explicit costs on the London Stock Exchange are the result of a special stamp duty of fifty basis points on all buy trades. Figure 7 shows the pattern of implicit costs over the same period. Although there are fluctuations, it is clear that costs at these exchanges are clustered. In late 2004, implicit costs ranged from ten to fifteen basis points. Today, withMiFID just inplace, it is expected that execution fees will keep falling in Europe. The impact of the Directive on total transaction costs, however, is not so obvious, as implicit costs depend on the efficiency of market structures, on which the long-term implications of MiFID are as yet unknown. 3

opportunity to make an investment in the security requested.

The contribution of opportunity costs to total implicit costs is not independent of market impact. Attempting to reduce one can lead to the increase of the other. For example, splitting large orders over time to reduce market impact can lead to larger opportunity costs and vice versa. This issue is summarised in figure 5. Minimising market impact and reducing opportunity costs form a set of conflicting objectives usually referred to as “the trader’s dilemma”. Balancing these conflicting costs is a real challenge.

Figure 5: Relationship between market impact and opportunity costs

3 - For a discussion about the long-term impact of MiFID on the European trading landscape, see D’Hondt and Giraud (2007).

Source: Giraud (2004)

4. Transaction cost magnitude Several empirical studies have examined the relative importance of explicit and implicit transaction costs. Most have focused on the costs of equity trading for institutional investors. We can draw several conclusions from these empirical findings. First, transaction costs have fallen dramatically in recent years, essentially due to technological innovations and increased competition among trading venues and among intermediaries.

23 An EDHEC Risk and Asset Management Research Centre Publication

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