Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

N ∑

x i i = 1 N ∑ P 0

N ∑

x i i = 1 N ∑ P R

N ∑

x i i = 1 N ∑ P S

N ∑

⎤ ⎦ ⎥ + X − ⎛ ⎝⎜

⎞ ⎠⎟ P T (

⎡ ⎣ ⎢

⎡ ⎣ ⎢

⎡ ⎣ ⎢

⎤ ⎦ ⎥ +

⎤ ⎦ ⎥ +

) + EC

IS =

x i

P R −

P S

P i

− P 0

x i

x i

x i

−

−

i = 1

i = 1

i = 1

i = 1

}

}

}

}

(1)

(2)

(3)

(4)

3. Common Pitfalls and Shortcomings in Transaction Cost Measurement The two approaches that have been described in depth both require an appropriate benchmark price. Identifying this price is not always as easy as it seems. Transaction cost indicators are numerous and their quality often depends on the choice of benchmark. The “ideal” transaction cost indicator should provide an accurate, complete and relevant measure of implicit costs. This definition emphasises several issues that should be considered when building or choosing transaction cost indicators. In a nutshell, the benchmark on which the indicator of transaction costs is built determines what is really measured. Accordingly, different benchmarks serve different purposes. As explained above, benchmark prices can be categorised as pre-trade, intraday and post-trade. Both the completeness and the relevance of the measures they deliver vary greatly. The pre-trade benchmarks provide the best measures of the implicit costs related to the implementation of an investment decision and should be favoured. They include the costs due to spread, market impact, operational and market timing delays; only missed trade opportunity costs are ignored. Although indicators ) − 400 × 21 (1) Which benchmark for which purpose?

In this equation, part (1) measures the operational opportunity cost, part (2) measures the market timing opportunity cost, part (3) measures the cost due to both spread and market impact and part (4) measures the missed trade opportunity cost. To illustrate the degrees of interpretation made possible with this expanded approach, we may apply this formula to the previous example. For this purpose, the following information must be added: P R = 20.5 and P S = 21. As observed before, the missed trade opportunity cost measure is € 200 or € 0.4 per share, while the other implicit costs amount together to € 500 or € 1 per share. In addition, we are now able to split the global cost of 500 into its main components: € 200 for operational opportunity cost, € 200 for market timing opportunity cost and € 100 for both spread and market impact. This breakdown is relevant as it allows an understanding of exactly where costs are incurred. In our simple example, it seems obvious that minimising investor-to- intermediary transmission delays could reduce transaction costs substantially. ] + 400 × 21 − 400 × 20.5 [ ⎤⎦ + 500 − 400 ( ) 22 − 20 ( ) + EC

IS = 400 × 20.5 − 400 × 20 [

] + 200 × 21 + 200 × 21.5 ( ⎡⎣

⎤⎦ + 500 − 400 (

0.5 ] + 200 × 21 + 200 × 21.5 ( ⎡⎣

) − 400 × 21

32

An EDHEC Risk and Asset Management Research Centre Publication