Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

IV. Estimating Transaction Costs with Pre-Trade Analysis

This section is devoted to the second mission of TCA—transaction cost estimation. Its primary purpose is to forecast both transaction costs and risk associated with strategies for a given trade or trade list not yet executed. This assumes that the implicit costs of future orders can be estimated from the implicit costs of past trades, using trade-specific variables (order size, price limit, etc.), market-related variables (spread, depth, recent volume, recent price change, etc) and security-specific variables (average volume, capitalisation, volatility, etc.). Since transaction cost estimation is done ex ante and is more than the mere provision of cost estimates, it is often referred to as pre-trade TCA or simply pre-trade analysis. It is essential for investment managers who want to offer competitive portfolio returns to do pre-trade analysis before acting on investment decisions. It helps them assess the difficulty of trades, compare trading strategies, and develop appropriate strategies for particular market circumstances. In line with these three objectives, we can present pre-trade TCA as a three-step process: •  Collection and analysis of pre-trade data •  Cost and risk estimation • Optimisation of trading strategies Each step needs an appropriate approach that requires a large amount of data and particular tools as well as the development of relatively complex models. We provide a detailed description of each step below. 1. Collection and Analysis of Pre-Trade Data The first step of pre-trade TCA involves collecting and analysing pre-trade data

to understand the characteristics of the proposed trade and assess the degree of difficulty. The concept of “difficulty” is primordial, as it predicts the amount of work that will be required to execute the order and the overall need to adjust the trading strategy to changing market conditions. 11 All the data gathered frompre-trade analytics is usually presented in a pre-trade report wherein information may be categorised as security-specific, market-related and trade- specific. We review each category below and provide insight into how it can help gauge the difficulty of the order to execute. (1) Security-specific information All the data delivering relevant information about the security to trade fall into this category. It includes: •  the country in which the security was issued •  the economic sector •  the market capitalisation •  the venues where the security is traded •  some fundamentals such as price-to- earnings and price-to-book ratios •  the index the security belongs to, if any •  the recent historical price movement •  the price momentum •  the historical average daily trading volume •  the historical price volatility •  the average trade size •  the intraday volume pattern •  etc. This list provides a quick reading of the risk associated with the security to be traded. It is not exhaustive and any variable investment managers consider relevant could be added.

11 - Kissell and Glantz (2003) define trading difficulty as a function of the amount of work required to execute an order and the overall need for traders to adjust to changing market conditions and make modifications to the specified trading strategy.

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An EDHEC Risk and Asset Management Research Centre Publication