Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

VI. A New Framework: the EBEX Indicators

volume executed by the intermediary. The $EBEX can be viewed as an opportunity cost since it represents the loss of failing to achieve particular trading performance. Suppose, for example, a broker who has executed 100 orders for a single investor with a total traded volume of € 49,827,671. His distribution of absolute EBEX exhibits a median score of 0.50 while he was set a target of 0.75. About eighty of the 100 trades he completed missed the target. Based on these trades, the $EBEX is equal to € 104,586 and corresponds to about 0.21% of the total volume traded. Now suppose another broker who has also executed about 100 orders for the same investor with a slightly lower total volume of € 43,405,588. He too has a median score of 0.50 for the absolute EBEX but his $EBEX amounts to € 182,546, about 0.42% of the total volume he executed. Using $EBEX to compare the two brokers helps the investor to identify that, though the quality of their execution is similar, the second broker’s underperformance is more expensive. (4) Potential adjustments When intermediaries have discretion over how they execute orders within a specified horizon, EBEX indicators based on all market activity traded in that horizon reflect their ability to work orders and seize the best available trading opportunities. However, when intermediaries are given limited discretion, the EBEX indicators computed over the entire trading horizon may lead to noisy performance measures, especially when the constraints set by the investor are not neutral. This is true especially when they force the intermediary to execute at times of the least or most favourable prices.

Constraints are generally dependent on either price or volume. Most correspond to predetermined core trading strategies that are applied manually or, more and more, automatically, as a result of algorithmic trading that has become the must-have in the last few years and delegates the scheduling and execution of an order to a computer programme. We can categorise price constraints as explicit and implicit strategies. Explicit strategies promote trading at a given price or better. The most frequent targets are the closing price of the day (market-on- close orders) or the bid-ask midpoint at the release time (arrival price orders 41 ) but the target may also be a price directly specified by the investor ( € 25, for example). Implicit strategies are mainly VWAP strategies and customised strategies. A VWAP strategy schedules the trade according to the historical average volume profile of the security: it breaks up the order into smaller lots and trades them at every x minutes depending on the volume that has traded historically in that interval. A customised strategy gives a trader who is not benchmarked the ability to stop or cancel the execution of an order during the day or the trading horizon. For example, trading in a particular security may be stopped once a particular price or percentage of traded volume is reached. Volume constraints correspond to participation strategies that schedule the trade by market volumes. These strategies result in executing the order as a specified constant percentage of the actual market volume, regardless of price. The key feature here is that the duration of the trade is determined not by a timeframe, but by the market conditions of the security.

41 - Some algorithm providers refer to them as implementation shortfall orders.

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An EDHEC Risk and Asset Management Research Centre Publication