Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

III. Measuring Transaction Costs with Post-Trade Analysis

through a measure of price reversion. However, whatever the specific post-trade benchmark price, this measure refers only to the temporary impact, because the potential permanent impact is incorporated into future prices and is impossible to isolate. Although their usefulness as measures of cost is limited when taken alone, post-trade benchmarks are more relevant when combined with pre-trade benchmarks to give a measure of missed trade opportunity costs. Such a combination is present in the implementation shortfall approach. Although we assert that an effective measure of implicit transaction costs is the difference between the decision price (its proxy when not available) and the execution price, we know that this assertion has not always won unanimous backing. In this subsection, we offer an in-depth presentation of the transaction cost indicators most often used by the industry. We look at both the advantages and disadvantages of these indicators. (a) Spread midpoint benchmark An indicator based on the spread midpoint relies on the signed difference between the trade price and the average of the bid- and-ask at a given time. Spread midpoint indicators are very popular, essentially because they are very easy to implement and interpret. The cost of a buy at the “ask” (or a sell at the “bid”) is one-half of the spread. Varying the time at which the spread midpoint is determined delivers various indicators. (2) Critical review of the most popular indicators

built on pre-trade benchmarks are quite complete measures, their accuracy varies with the gap between the investment decision time and the time at which the benchmark price is determined. The most accurate cost indicator is built on the price prevailing at the decision time. When this price is unknown, the prior night’s closing price or the opening price is typically used as a proxy for the decision price, but the indicators it delivers are then less accurate. The intraday benchmarks do not provide good measures of the implicit costs. In fact, indicators built on intraday benchmarks do not really give a measure of implicit costs but rather an indication of the execution price relative to the average market price of the day or of a given time period. Indicators built on intraday benchmarks are thus neither proper nor useful cost measures. For example, knowing that a trade has underperformed or outperformed the daily VWAP by a given number of basis points does not provide the investor with any insight into how large the implicit costs are and how they can be better managed. Instead, this information allows the investor to gauge the quality of the price obtained, if we consider that the daily VWAP is a good indicator of the fair market price. As we will see in section V, intraday benchmark prices are best used to assess the trading performance of intermediaries. Like the previous category, the post-trade benchmarks do not really deliver a proper and complete indicator of implicit costs, although they are sometimes used for this purpose. Instead, they can provide an indicator of market impact only

33 An EDHEC Risk and Asset Management Research Centre Publication