Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

IV. Estimating Transaction Costs with Pre-Trade Analysis

(2) Market-related information This category contains all the data delivering relevant information regarding the current market conditions for the security to trade. The purpose is here to assess the market risk of the proposed order. If several trading venues are available, comparisons must be made on the conditions prevailing at each venue. The variables most relevant to a description of market conditions are commonly: •  the last trade prices •  the best quotes and the quotation midpoint This list should provide the best possible representation of the current market prices and liquidity available for the security to be traded. The list is exhaustive if the security is traded in transparent liquidity pools; otherwise, it is not. Indeed, in transparent markets, the prevailing liquidity conditions can be easily assessed through the displayed limit order book or market makers’ quotations. In dark liquidity pools, by contrast, no information about trading conditions is disclosed. (3) Trade-specific information This category covers order size, trade direction (buy/sell) and other characteristics of the order to be executed. When time or price constraints are attached to the order, they must be added since they can make implementation harder. For example, if the client wants the trade to be completed before a certain time, this deadline should appear in the list. •  the quoted spread •  the quoted depth •  the recent traded volume •  etc.

With a pre-trade report summarising security-specific, market-related and trade- specific data, investment managers are able to gain a thorough understanding of the trade to be completed. They can then assess its difficulty and know at a glance whether the trade will be subject to substantial market impact (for example, the order is large in comparison with the quoted depth and the average trade) and/or opportunity costs (for example, the liquidity to execute the order immediately is lacking). Difficult trades will require permanent adjustments to the trading strategy. 2. Cost and Risk Estimation The second step of pre-trade TCA is cost decomposition and estimation. Only implicit transaction costs are considered here because they depend on the trading strategy and may thus be controlled during implementation. The same is not true for explicit costs, which are known in advance and do not really vary with the trading strategy, other than with the choice of venue and intermediary. The proper framework for estimating transaction costs attempts to provide a probabilistic distribution of both an expected cost and a risk parameter for a trade to be completed. Two essential principles emerge here and it is essential to understand them clearly. First, cost estimates, unlike transaction cost measures, are not single values. Computing cost estimates involves providing a complete picture of potential costs with their respective risk, where both parameters vary with the implementation strategy. Second, estimating a distribution of cost-risk couples makes it possible to assess alternative strategies and does

41 An EDHEC Risk and Asset Management Research Centre Publication