Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

2. Implementation shortfall This method, widely recognised as the most effective means of measuring transaction costs, was initially proposed by Perold (1988) and its principle is easily understood. It involves assessing the impact of trading on portfolio returns by computing the difference between the net returns on a paper portfolio and those on a real portfolio. (1) Original framework Determining implementation shortfall is a two-step process. First, at the time of the investment decision, the investor needs to build and price a paper portfolio. This portfolio will be an imaginary holding consisting of all the security positions the investor decides to take. It is assumed that these positions are acquired at the price on the market at the time it was decided to acquire them. Consequently, the resulting paper portfolio, unlike the corresponding actual portfolio, does not incur any transaction costs. The difference between the paper portfolio return and the actual portfolio return is the “implementation shortfall”. Figure 10 gives a summary overview of the method.

(2) Indicators built upon intraday benchmarks These indicators are based on benchmark prices that represent a kind of average market price for the day of the trade execution. The most frequent are based on the following benchmark prices, depending on whether they focus on the exact time of execution or not: Absolute indicators: • Daily VWAP: the volume-weighted average price of the day • Daily LHOC: the average of the lowest, highest, opening and closing prices of the day • Midpoint H/L: the median of the highest and lowest prices of the day Time-related indicators: • Available VWAP: the VWAP computed from the market opening to the trade time •  Interval VWAP: the VWAP calculated over a fixed time interval around the trade execution time 4 This final category contains indicators referring to benchmark prices that prevail on the market after the execution of the trade. These indicators are less heterogeneous than in the two previous categories and the most frequently used in the industry are listed below. Absolute indicators: •  T Close: closing price of the day (3) Indicators built upon post-trade benchmarks

4 - The VWAP computed over a certain long period of time ( n days) around the trade execution time also exists. This multi-day VWAP can be relevant for trades on very illiquid securities.

Time-related indicators: • Next mid bid-ask: next bid-ask average

29 An EDHEC Risk and Asset Management Research Centre Publication