Transaction Costs

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Transaction Costs</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="1%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="99%" align="left" valign="top"><p class="word_list"> <a href="#impact costs">impact costs</a><p class="word_list"> <a href="#opportunity costs">opportunity costs</a><p class="word_list"> <a href="#Perolds implementation shortfall">Perold's implementation shortfall</a><p class="word_list"> <a href="#timing risk costs">timing risk costs</a><p class="word_list"> <a href="#Transaction costs">transaction costs</a><p class="word_list"> <a href="#VWAP">VWAP</a><p class="word_list"> <a href="#volume-weighted average price">volume-weighted average price</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><b><a name="Transaction costs">Transaction costs</a></b> are direct costs associated with transacting trades. Indirect costs, such as staff salaries, computer systems or overhead are not included. Some transaction costs are visible and explicit: </p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">commissions paid as compensation to brokers acting as agents,</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">exchange fees, and</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10">stamp taxes or other duties governments (rarely) apply to transactions.</p> <p>Not as transparent are implicit costs, which include </p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/spreads.htm">bid-ask spreads</a>, </p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="impact costs">impact costs</a></b>, and</p> <p class="bullet"><img border="0" src="../images/bullet.gif" width="20" height="10"><b><a name="timing risk costs">timing risk costs</a></b>.</p> <p class="body">The cost due to a bid-ask spread is generally calculated as half the spread between the best ask price and the best bid price available in the market. As an implicit cost, bid-ask spreads are paid by <a href="../articles/liquidity.htm">liquidity</a> demanders and compensate liquidity provides such as market makers or parties who place limit orders.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table6"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">Impact costs are implicit costs also paid by liquidity demanders to liquidity providers. Generally, the best bid and ask prices quoted in the market are for only small transactions. Larger transactions must be executed at even less favorable prices. Such large transactions are said to "move" the market, which is why the additional cost is called an impact cost.</p> <p class="body">Traders try to mitigate impact costs by disguising the size of an order. They will split an order into pieces and transact trades at different times or through different brokers or dealers. This extends the period over which the order is fulfilled, and the market may move during that period for reasons unrelated to the order's impact. The resulting cost or savings is called the timing risk cost. Of course, distinguishing an impact cost from a cost resulting from a market move that "would have happened anyway" is largely impossible. The distinction between impact and timing risk costs is conceptual.</p> <p class="body">Finally, in addition to explicit and implicit transaction costs are <b> <a name="opportunity costs">opportunity costs</a></b>. Large orders may take several days to fill. If part of an order remains unfilled at the end of the day on which it was placed, any missed profit or loss arising from the unfilled portion is considered opportunity cost.</p> <p class="body">Institutional investors spend considerable effort in tracking and mitigating their transaction costs. If they employ outside portfolio mangers or brokers, they will also scrutinize their transaction costs. Explicit transaction costs are known, so analyses tend to focus on estimating implicit, and occasionally even opportunity costs. Actual analyses will depend upon the size of an order as well as available information. For example, the exact timing of an order or trade may not always be known, which makes it more difficult to assign transaction costs.</p> <p class="body">If the timing of a trade is known, a simple analysis is to compare the trade price with the average of the bid and ask prices (what is called the <a href="../articles/spreads.htm">mid-offer price</a>) at the time the trade was made. This captures the transaction cost due to the bid-ask spread but not due to impact costs or timing risk costs. If a broker is given discretion as to the timing of a trade, this analysis will not indicate if his timing was good or bad. The approach is most suitable for very small orders that can be executed rapidly and won't be broken down into smaller trades.</p> <p class="body">Another approach is to compare the trade price (or the average trade price, if an order is broken into pieces) with the mid-offer price at the time the order was passed to the trader or broker. This, of course, requires that those times be recorded. The advantage of the approach is that it reflects transaction costs due to bid-ask spreads, impact costs and timing risk costs. It is also applicable to orders that are split.</p> <p class="body">A popular approach, especially if information on the timing of orders or trades is not available, is to compare the average trade price to the <b><a name="volume-weighted average price"> volume-weighted average price</a></b> (<b><a name="VWAP">VWAP</a></b>) for that day. The VWAP of a <a href="../articles/security.htm">security</a> or other traded instrument is simply the average price paid for that instrument in all trading of that instrument:</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table7"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/transaction_costs_VWAP.gif" width="277" height="78"></td> <td width="5%" align="right">[1]</td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table8"> <tr> <td align="right" width="9" height="14"></td> <td width="336" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336">  <p style="margin-top: 0; margin-bottom: 2" class="ad_legend"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82402;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82402"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82402;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> </table> <p class="body">where the sums are taken over all trades during that day. </p> <p class="body">VWAP was first proposed by Berkowitz, Logue and Noser (<a href="#Berkowitz">1988</a>). Traders like it because it is simple and allows them to be compared with their "peers." It is especially relevant for large orders that are split, since trades will be transacted at various points during the day. However, it can be misleading if an order is so large that its trade prices dominate the VWAP. In the limiting case where an order represents the only trading in an instrument for the day, the average trade price for the order will equal the VWAP irrespective of transaction costs.</p> <p class="body">Perold (<a href="#Perold">1988</a>) published a comprehensive <a href="../articles/risk_metric_and_risk_measure.htm">metric</a> of transaction costs that is known as <b> <a name="Perolds implementation shortfall">Perold's implementation shortfall</a></b>. Perold wrote in the context of portfolio management. He included among transaction costs any change in price that occurs between the time when a portfolio manager decides on a transaction and the time when she actually passes the order to a trader. </p> <p class="body">Perold's metric is a sum of four components:</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table9"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/transaction_costs_shortfall.gif" width="444" height="58"></td> <td width="5%" align="right">[2]</td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table10"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">The cost due to manager's delay is simply the volume of the order multiplied by the change in the mid-offer price between the time when the portfolio manager decides on the transaction and the time when she passes the order to a trader. Explicit costs are known. They are the sum of actual brokerage commissions, fees, etc. Implicit costs are calculated as the total value paid/received for that portion of the order filled during the day minus the total value that would have been paid/received if all those trades had been executed at the mid-offer price when the order was placed. Opportunity cost is calculated as the total value of that portion of the order that remains unfilled at the end of the day based on the closing mid-offer price minus its value based on the mid-offer price when the order was placed.</p> <p class="body">Typically, an investor will apply the model each day to calculate the total transaction costs across all its orders that were open at any point during the day. If an order remains unfilled at the end of the day, the balance is carried forward and treated like a new order placed at the market open for calculating that day's transaction costs.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table12"> <tr> <td width="100%"> <p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/exchange_traded.htm">exchange traded</a> Traded on a formal exchange such as the New York Stock Exchange or Chicago Board of Trade.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/liquidity.htm">liquidity</a> Used in various senses, all relating to availability of, access to, or convertibility into cash.</strong><p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/settlement.htm">settlement</a> In finance, performance on a contractual obligation.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/soft_dollars.htm">soft dollars</a> A sometimes controversial inducement brokers offer investment managers to place trades through them.</p> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table13"> <tr> <td width="100%"> <p class="explanatory_text">Harris (<a target="_blank" href="http://www.riskbook.com/link/harris_larry_(2003).htm">2003</a>) is an outstanding book on all aspects of trading. 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Logue and Eugene A. Noser, Jr. (1988). The total cost of transactions on the NYSE, <i>Journal of Finance</i>, 43 (1), 97–112.<p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15"><a name="Perold">Perold</a>, Andre F. (1988), The implementation shortfall: paper vs. reality, <i>Journal of Portfolio Management</i>, 14 (Spring), 4–9.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I2"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Forum Discussions</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table19"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_bullhorn_narrow.gif" align="left" width="27" height="22"><a target="_top" href="http://www.contingencyanalysis.com/archive/link_thread/04-2/0000064b.htm">Mark to Market</a> <i>02 Mar 2004</i><br> Accounting for transaction costs market values.</td> </tr> </table> </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table20"> <tr> <td width="100%" bgcolor="#FFFFFF"> <p align="center"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com"> http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 2004</td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div> </body>