the expanded implementation shortfall
TRANSCRIPT
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
1
The Expanded Implementation Shortfall:
“Understanding Transaction Cost Components”
Robert Kissell
May 2006
Abstract:
Transaction costs and transaction cost analysis (TCA) has captured renewed attention in the
financial industry due to the recent increase in electronic orderflow and algorithmic trading.
To assist investors understand these costs and how they affect trading performance we have
unbundled transaction costs into nine components. We provide a categorization scheme to
understand how these costs can be managed during the implementation and a classification
system to understand where and when these costs arise during the investment cycle. This
classification system, the expanded implementation shortfall, is based on the work of Perold
(1988) and Wagner & Edwards (1993), and subsequently serves as foundation for
understanding transaction costs and devising an execution strategy that is consistent with the
overall investment objective.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
2
I. Introduction
There has been a recent renewed interest in transaction costs and transaction cost analysis
(TCA). This is primarily due to the increase in electronic orderflow and algorithmic trading.
Investors (both buy-side and sell-side alike) are eager to better understand transaction costs
in order to properly assess trader, broker, and algorithmic performance. But, unfortunately,
costs are rarely evaluated from the underlying objective of the fund. And improper evaluation
metrics will likely lead to biased analyses and erroneous conclusions. There is also often a
disconnect between the trader’s implementation goals and the portfolio manager’s investment
goals which can lead to an inefficient portfolio mix and further reduced utility (Kissell &
Malamut, 2006b). In order to properly measure implementation performance it is necessary
to have an understanding of all transaction cost components and how they influence trading.
What are transaction costs? Transaction costs are those costs that arise during the
implementation of any business decision. In economic terms they are the costs paid by
buyers but not received by sellers, and/or the costs paid by sellers but not received by buyers.
In the equity markets, financial transaction costs represent the costs incremental to the
decision prices without regards to who receives the incremental payment. For example, a
buyer of stock wishing to transact at $30.00 but ultimately pays $30.25 per share in total
(including commissions, fees, market impact, etc.) incurs total transaction cost of $0.25/share
regardless of who receives this incremental payment (e.g., broker, seller, exchange, etc.).
Similarly, a seller wishing to transact at $25.00 but ultimately receives only $24.90 per share
incurs total transaction cost of $0.10. This definition follows directly from the
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
3
Implementation Shortfall (IS) metric proposed by Perold (1988) and is a good place to begin
our investigation of transaction cost components.
II. Implementation Shortfall
Implementation shortfall is measured as the difference between the dollar return of a paper
portfolio (paper return) where all shares are assumed to transact at the prevailing market
prices at the time of the investment decision and the actual dollar return of the portfolio (real
portfolio return). Mathematically, this is written as:
Return Portfolio Real -Return Paper IS= (1)
To gain a thorough understanding of how these transactions costs effect portfolio returns we
consider three cases of Implementation Shortfall: i) complete execution where all shares are
transacted, ii) incomplete execution where the fund incurs opportunity cost, and iii)
incomplete execution where we differentiate between trading related, investment related, and
opportunity cost (expanded implementation shortfall). This last case of implementation
shortfall classifies costs based on where they occur during the investment cycle. The
technique is attributable to Wagner & Edwards (1993) and is of fundamental importance for
understanding TCA and devising proper performance metrics.
Case I: Complete Execution
A fund wishes to purchase S shares of a stock that is current trading at dP dollars per share.
If at some future period in time such (e.g., the end of trading) the stock price is NP , the total
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
4
dollar paper return is calculated as follows:
dN PSPS ⋅−⋅=Return Paper (2)
Here, dPS ⋅ represents the starting value of the portfolio (e.g., the amount of money to
invest), NPS ⋅ represents the ending value of the portfolio (e.g., the portfolio value at the end
of trading)1.
If the manager transacted all S shares, e.g., Ss j =∑ , the actual portfolio return is
computed as follows:
fixedpsPS jjN −−⋅= ∑Return Portfolio (3)
where, js is the number of shares executed in the jth transaction, ∑ js is the total number of
shares executed, jp is the price of the jth transaction, and jj ps∑ is the total transaction
value (e.g., cash invested). The fixed fees represent the commission, taxes, clearing and
settlement charges, ticket charges, etc., and results in a reduction in portfolio return. Also,
0, >jsS indicates a buy order (cash investment) and 0, <jsS indicates a sell order (cash
redemption).
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
5
Then, implementation shortfall is then computed as follows:
( ) ( )
fixedSPps
fixedpsPSPSPS
djj
jjNdN
−−=
−−⋅−⋅−⋅=
∑
∑ 4444 34444 2144 344 21Return PortfolioReturnPaper
IS
(4)
Notice that when all shares are executed the implementation shortfall measure is simply the
total transaction value minus the value at the time of the investment decision minus fixed
costs. The measure does not depend on the future stock price NP at all.
Case II: Incomplete Execution (Opportunity Cost)
In a situation where the entire order is not executed, e.g., Ss j <∑ , the paper return is still
computed according to equation (2), but actual portfolio return is computed in a slightly
different manner. This is explained as follows:
The total cash on hand to invest at time dt is dPS ⋅ . If the actual transacted value is∑ jj ps ,
the dollar amount that is not invested in the portfolio is simply the difference of these
amounts, e.g., jjd psSP ∑− . Then, the ending value of the portfolio is equal to the total
number of shares transacted evaluated at the stock price at the end of the trading horizon,
1 In these examples we assume all decisions are buys orders (cash investment), e.g., S>0 and sj>0. In situations
where the decision is a sell order (cash redemption) we simply take the sign of S and sj to be negative, e.g., S<0
and sj<0. This way, the side of the transaction does not change any of the formulations.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
6
e.g., ( ) Nj Ps∑ , plus the amount of cash not invested in the portfolio, e.g., jjd psSP ∑− .
These values are as follows:
{AvailableCash
Value Portfolio Beginning dSP= (5)
( )44 344 2143421
Dollars UninvestedValueStock
Value Portfolio Ending ∑∑ −+= jjdNj psSPPs (6)
Actual portfolio return is then calculated as follows:
( ){ }( ) fixedpsPs
fixedpsSPPsfixed
jjNj
jjdNj
−−=
−−−+=
=
∑∑∑∑ dSP
-ValueBeginning-ValueEnding Return Portfolio
(7)
Implementation shortfall in a situation with unexecuted orders is:
{ } ( ){ }44444 344444 214434421
Return Portfolio
NReturnPaper
PIS fixedpssSPSP jjjdN −−−−= ∑∑ (8)
Expanding on equation (8) we have:
( ) fixedpsSPPsS jjdNj −+−−= ∑∑IS (9)
where ∑− jsS is the number of unexecuted shares.
The number of initial shares S to transact can be written as ( ) ∑∑ +−= jj ssSS .
Therefore, equation (9) can be rewritten as follows:
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
7
( ) ( )( )( ) ( ) ( )
( ) ( )( ) fixedPPsSPsps
fixedpsPsPsSPsS
fixedpsPssSPsS
dNjdjjj
jjdjdjNj
jjdjjNj
−−−+−=
−+−−−−=
−++−−−=
∑∑∑∑∑∑∑
∑∑∑∑IS
(10)
Finally, we have the implementation shortfall measure defined by Perold (1988) that
distinguishes between execution cost and opportunity cost of the order.
( ) ( )( ) fixedPPsSPsps dNjdjjj −−−+−= ∑∑∑ 444 3444 21444 3444 21Costy OpportunitCostExecution
IS (11)
Case III: Incomplete Execution (Investment Related and Trading Related Costs)
Inspection of equation (11) shows that the execution cost component of the implementation
shortfall formula actually spans two time horizons: investment and trading. The investment
horizon is the time period from the investment decision td to the time that trading begins t0.
The trading horizon is the time period from the commencement of trading t0 to the end of
trading tn.
If 0P represents the midpoint of the bid-ask spread at the time the order was entered to the
market (e.g., the arrival price), the price change over the period td to tn can be written in terms
of 0P as follows:
( ) ( ) ( )dNdN PPPPPP −+−=− 00 (12)
Then, equation (11) can be rewritten as:
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
8
( ) ( )( ) ( )( )
( ) ( ) ( )( ) fixedPPsSPspsPPS
fixedPPsSPPsSPsps
NjdjjjN
djNjdjjj
−−−+−+−=
−−−+−−+−=
∑∑∑∑∑∑∑
00
00IS (13)
That is,
( ) ( ) ( )( ) fixedPPsSPspsPPS NjdjjjN −−−+−+−= ∑∑∑ 444 3444 21444 3444 2143421Costy Opportunit
0
Related TradingRelated Investment
0IS Expanded (14)
This is the expanded implementation shortfall metric proposed by Wagner & Edwards (1993)
that makes a distinction between the investment and trading horizons and provides important
insight into specifying appropriate execution strategy. For example, see Almgren & Chriss
(2000), Kissell & Glantz (2003), or Rakhlin & Sofianos (2006).
III. Transaction Cost Classification
As depicted in equation (14) transaction costs can be classified into investment related,
trading related, and opportunity cost. This classification system is described below:
Investment-Related Costs. Investment related transaction costs are those costs that arise
during the investment decision phase of the investment cycle. This constitutes the period of
time from the investment decision to the time the order is released to the market. Investment-
related transaction costs often arise due to lack of communication between the portfolio
manager and trader in deciding upon the proper implementation objective (strategy) or due to
a delay in selecting the appropriate broker, algorithm, or algorithmic parameter. The longer it
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
9
takes for the manager and trader to resolve these issues the more potential there is for adverse
price movement (ultimately making the investment more costly). Traders often spend
valuable time investigating how lists should be implemented and what broker or trading
venue to use. The easiest way to reduce investment related transaction cost is for the manager
and traders to work closely together to determine the strategy most consistent with the
investment objective of the fund. This, however, requires proper pre-trade analysis and
decision-making tools to be able to rapidly evaluate costs, assess strategies, and select
algorithms.
Trading-Related Costs. Trading-related transactions costs comprise the largest subset of
transaction costs and include those costs that arise during the implementation of the
investment decision (the time period from the start of trading to the end of trading). While
these costs cannot be eliminated completely they can be managed via an appropriate
execution strategy. The largest trading related transaction costs are market impact and timing
risk. But these components are conflicting terms. Market impact is highest utilizing an
aggressive trading strategy and lowest utilizing a passive strategy. Timing risk, on the other
hand, is highest with a passive strategy and lowest with an aggressive strategy. Traders,
therefore, need to balance the tradeoff between market impact and timing risk based on the
funds overall risk appetite. Furthermore, they need to ensure that the execution strategy or
algorithm is consistent with the overall investment objectives of the fund. This requires a
thorough cost analysis of the order or trade list and a complete understanding of transaction
cost components.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
10
Opportunity Cost. Opportunity cost represents the foregone profit or loss resulting from not
being able to fully execute the order within the allotted time period. It is measured as the
number of unexecuted shares multiplied by the price change over the period the order was in
the market. That is:
( )( )0O PPsSC Nj −−= ∑ (15)
Opportunity cost will arise either because the trader was unwilling to transact shares at the
existing market prices, because of insufficient market liquidity, or both. The best way to
reduce opportunity cost is for managers and traders to work together to determine if the
market can readily absorb the specified number of shares within the manager’s specified
price range. If the trader determines that the market can not readily absorb the entire order
the manager can modify the order to a size that can be easily transacted in the marketplace
prior to trading and then invest the surplus cash into the next most attractive investment
instrument.
Opportunity cost can be viewed as an investment related and trading related cost. This can be
shown by tracing the price trajectory ( )dN PP − over the entire time horizon ( )dN tt − . It is
shown mathematically as follows:
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
11
( )( )( ) ( ) ( )[ ]( )( ) ( )( )
444 3444 21444 3444 21Horizon Trading
0
Horizon Investment
0
00
O
∑∑∑∑
−−+−−=
−+−−=
−−=
jNdj
dNj
dNj
sSPPPPsS
PPPPsS
PPsSC
(16)
IV. Transaction Cost Categorization
Financial transaction costs are comprised of fixed and variable components and consist of
both visible and hidden (non-transparent) fees. The fixed-variable categorization of costs
follows the more traditional economics breakdown of costs and the visible-hidden
categorization follows the more traditional financial description of transaction costs.
Fixed cost components are those costs that are not dependent upon the implementation
strategy. They cannot be managed or reduced during implementation. Variable cost
components, on the other hand, do vary during implementation of the investment decision
and are a function of the underlying implementation strategy. Variable cost components
make up the majority of total transaction costs. Money managers, traders, and brokers can
add considerable value to the implementation process simply by controlling these variable
components in a manner consistent with the overall investment objective of the fund.
Financial transaction costs are also categorized as visible or hidden cost components. Visible
or transparent costs are those costs whose fee structure is known in advance. For example,
visible costs may be stated as a percentage of traded value, as a $/share cost applied to total
volume traded, or even as some percentage of realized trading profit. Visible cost
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
12
components are primarily attributable to commissions, fees, spreads, and taxes. Hidden or
non-transparent transaction costs are those costs whose fee structure is not known in advance
with any degree of exactness. For example, the exact cost for a block order will not be known
until after the transaction has been completed (if executed via agency) or until after the bid
has been requested (if principal bid). The cost structures for these hidden components are
typically estimated using statistical models. For example, market impact costs are often
estimated via non-linear regression estimation.
Non-transparent transaction costs comprise the greatest portion of total transaction cost and
provide the greatest potential for performance enhancement. Traders and/or algorithms need
to be especially conscious of these components in order to add value to the implementation
process. If they are not properly quantified and controlled, they can cause a superior
investment opportunity to become only marginally profitable and/or a profitable opportunity
to turn bad.
V. Unbundled Transaction Cost Components
Investors can gain significant insight into how transaction costs influence trading by
unbundling these costs into their basic components. In total, there are nine distinct cost
components: commissions, taxes, fees, spreads, delay cost, price appreciation, market impact,
timing risk, and opportunity cost. Each of these is described below.
1. Commission
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
13
Commission is payment made to broker-dealers for executing trades. It is generally
expressed on a per share basis (e.g., cents per share) or based on total transaction value (e.g.,
some basis point of transaction value). While commission charges are known in advance,
they do vary from broker to broker. At times, they may vary based on trading difficulty
where easier trades receive a lower rate and the more difficult trades are charged a higher
rate. Commissions are categorized as a fixed and visible transaction cost component.
2. Fees
Fees charged during execution of the order include ticket charges assessed by floor brokers,
exchange fees, clearing and settlement costs, SEC transaction fees. Very often brokers
bundle these fees into the total commissions charge. Fees are a fixed and visible transaction
cost component.
3. Taxes
Taxes are a levy assessed to funds based on realized earnings. Tax rates vary by investment
and type of return. For example, capital gains, long-term earnings, dividends, and short-term
profits can all be taxed at different rates. Taxes are a visible and variable cost component.
They are visible because tax rates are known in advance and variable because the exact
transaction price dictates the total tax quantity.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
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4. Spreads
Spread cost is the difference between best offer (ask) and best bid price. It is intended to
compensate broker-dealers for matching buyers with sellers, for risks associated with
acquiring and holding an inventory of stocks (long or short) while waiting to unwind the
position, and for the potential of adverse selection resulting from transacting with informed
investors. Spreads represent the round-trip cost of transacting for small orders (e.g., 100
share lots) but do not accurately represent the round-trip cost of transacting blocks (e.g.,
10,000+ shares). Spread cost is a visible and variable transaction cost component. They are
visible because they are easily observed from the market at any point in time. They are
variable because they do at times vary across the day. For example, spreads for some stocks
tend to be larger at the open and close than during midday.
5. Delay Cost
Delay cost represents the loss in investment value between the time the managers makes the
investment decision dt and the time the order is released to the market 0t . Managers who buy
rising stocks and sell falling stocks will incur a delay cost. Any delay in order submission in
these situations will result in less favorable execution prices and higher costs. Delay costs
can arise for many reasons. First, delay cost may arise because traders hesitate in releasing
the orders to the market. Second, delay cost may arise due to trader uncertainty regarding
who are the “capable” brokers for the particular order or trade list. Some brokers are more
capable at transacting certain names or more capable in certain market conditions. Third,
traders may incorrectly anticipate market direction and wait for better prices. But if the
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
15
adverse trend persists the delay cost can be quite large. Fourth, traders may unintentionally
convey information to the market that they need to transact shares causing adverse price
movement prior to order submission. Fifth, overnight price change is another reason for
delay cost. For example, stock price often changes from the close to the open. Investor can
not participate in this price change so the difference results in a sunk cost in times of adverse
change or a savings in times of a favorable change. Delay cost is a non-transparent and
variable transaction cost component.
Example: Delay Cost
A fund manager instructs the trader to buy 250,000 shares of a stock that is currently trading
at $30. The trader then investigates who is most capable broker to handle the order. However,
by the time the trader chooses a broker and submits the order to the market the price has risen
to $30.25 per share. In this case, the trader’s hesitation cost the fund $0.25 per share or 83
basis points. This 83bp is an avoidable delay cost. In another situation, after the market close
a manager uncovers an undervalued stock with closing price of $50 and instructs the trader to
purchase 50,000 shares. The trader submits a buy order prior to the market open the next day
but because the stock opens at a higher price the execution occurs at $50.50 resulting in a
delay cost of $0.50 or 100bp. In this case the delay cost may be due to the market drawing
the same conclusion as the manager about the stock being undervalued and adjusting its
price. Here the delay cost is an unavoidable cost.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
16
6. Price Appreciation
Price appreciation represents the natural price movement of stock. For example, how the
stock price would evolve in a market without any uncertainty. Price appreciation is also often
referred to as price trend, drift, momentum, or alpha. It represents the cost (savings)
associated with buying stock in a rising (falling) market or selling (buying) stock in a falling
(rising) market. Price appreciation is dependent upon the stock trend and implementation
strategy. Price appreciation is a non-transparent variable transaction cost component.
Example: Price Appreciation
A manager decides to buy 250,000 shares of XYZ currently trading at $30 and expected to
increase 20% annually. Assuming a linear trend the stock will increase $0.04/day. If the
trader were to buy 50,000 shares a day over next five days they can expect to realize an
average price of $50.08 per share. Total price appreciation cost in this example is $.08/share
or 16bp.
7. Market Impact
Market impact cost represents the movement in the price of the stock caused by a particular
trade or order. Market impact is one of more costly transaction cost components and always
causes adverse price movement and results in a drag on performance. Market impact is often
incorrectly referred to as slippage or erosion. While it does constitute a part of these terms it
certainty does not comprise the entire portion. Market impact costs will occur for two
reasons: i) the liquidity demands of the investor, and ii) the information content of the order.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
17
The liquidity demand of the order requires a payment (premium for buys or a discount for
sells) to attract additional buyer or sellers into the market. The information content of the
trade typically signals to the market that the stock is under- or over-valued. Market impact
cost is dependent on size, volatility, side of transaction, prevailing market conditions over the
trading horizon such as liquidity and intraday trading patterns, and specified implementation
strategy. Market impact is a non-transparent variable transaction cost component.
Mathematically, the market impact cost of an order is the difference between the price
trajectory of the stock with the order and the price trajectory that would have occurred had
the order had not been released to the market. Unfortunately, we can not simultaneously
observe both price trajectories - it is only possible to observe the evolution of price with the
order or the evolution of price without the order. It is not possible to construct a controlled
experiment to simultaneously observe both circumstances of price evolution. As a result,
market impact has often been described as the Heisenberg uncertainty principal of finance.
Madhavan (2000) provides a nice description of market impact cost for a sell order. This is
illustrated in Figure 1. In this example, the stock is trading at around $10.00. An investor
enters a sell order into the market which exerts downward pressure on the price and the order
is subsequently traded at $9.80. Shortly thereafter, the transaction the price rebounds to
$9.95. It does not revert all the way back to $10 because the market infers the sell order to be
a signal that the stock was likely overvalued and adjusts it price to a lower level. In this
example the total market impact cost of the trade is $0.20 computed as the original price
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
18
minus the transaction price. Permanent market impact cost is $0.05 (since the price was
originally $10 and reverted to $9.95), and temporary market impact cost is $0.15 (computed
as the difference between total and permanent impact).
A second description of market impact cost can be illustrated through traditional economic
supply-demand curves (Figure 2). Suppose the stock is currently in equilibrium with q*
shares transacting at price of p*. A buyer enters the market with an incremental ∆q shares
which results in a shift in the market demand curve from D to D’ (to reflect increased
demand). The information content associated with this buy order signals to the market that
the stock is undervalued and causes an upward shift in the market supply curve from S to S’
(to reflect the higher price). Therefore, the transaction price for the incremental ∆q shares
will be p1.
After those shares are transacted in the market there is then uncertainty as to what will occur
next. We know that demand will decrease since those ∆q shares have been transacted. But
what will be the new post trade level of demand?
In one scenario, demand is expected to revert back to its original level q*, e.g., there will be a
shift in the market demand curve from D’ to D”. Then the new equilibrium point will be q*
shares (the same as the original) but a new equilibrium price of p2. This is determined from
the intersection of D’’ and S’. Hence, total market impact cost is p1 – p*, temporary market
impact cost is p1 – p2 and permanent market impact cost is p2 – p*. In this scenario, the
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
19
assumption is that the buyers will still be willing to transact shares at the higher prices. For
example, index managers often need to transact shares that are in the benchmark index
regardless of the prices.
A second possible scenario states that since the price increased after the trade (due to the
information content of the buy order) there will be fewer participants willing to transact at
higher prices. Therefore, there will be a post trade decrease in demand. For example, many
value managers will only transact in stocks that are incorrectly priced in the market, so once
the market adjusts the prices to the true intrinsic value the opportunity for superior returns is
reduced and decreased demand for transaction.
This scenario is explained through the market demand curve shifting from D’ back to D.
Then the new equilibrium price will be p3 (still higher than the original level of p* but lower
than in the first scenario of p2) but a lower equilibrium demand of q’. This equilibrium point
is determined by the intersection of D and S’. In this example, the market impact cost is
exactly the same as the first scenario, e.g., p1 – p*. But temporary market impact cost is
higher p1 – p3 and permanent market impact cost is lower p3-p*.
The uncertainty in the new equilibrium level of demand and price is a major reason behind
the difficulty in distinguishing between temporary and permanent market impact cost.
Unfortunately, it is rarely addressed in the financial literature.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
20
Figure 1 Market Impact Illustration – Sell Order
Market Impact Illustration - Sell Order
Time
Price
Total Impact Temporary
Permanent10.00
9.80
9.95
Trade
Figure 1: Market Impact Illustration – Sell Order. The diagram shows the stock price fluctuating at around
$10.00 until an investor sells shares and pushes the price down to $9.80. Immediate after the transaction the
price rebounds back to $9.95. The total market impact of this transaction is $0.20 per share ($10.00-
$9.80=$0.20). Temporary market impact is $0.15 ($9.95 – $9.90 = $0.15), and permanent market impact is
$0.05 ($10.00-$9.95=$0.05).
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
21
Figure 2 Supply Demand Illustration
Supply-Demand Equilibrium - Buy Order
Quantity
Price
D′
S
D
S′
D′′
q*+?qq*
p
p*
q'
pp
Figure 2: Supply-Demand Equilibrium – Buy Order. The stock price is initially in equilibrium at q* shares
and a price of p*. A buyer enters the market causing an imbalance of ∆q shares which shifts the market
demand curve from D to D’. This action signals to sellers that the price is undervalued so sellers increase
their market price (e.g., resulting in a shift of the market supply curve from S to S’). Therefore, the
execution price of the incremental ∆q shares is p1. But after the ∆q shares have been transacted there is
uncertainty regarding what might occur. One scenario expects that buying demand will returns to its normal
level of q* thus the market demand curve shifts back from D’ to D’’. This results in a new equilibrium
price of p2 and q* shares. Another scenario expects that since market prices have increased due to the
information content of the order there will be fewer buyers willing to transact. This results in a decrease in
demand from the original levels (e.g., the market demand curve shifting from D’ back to D) and a new
equilibrium point with price p2 and quantity q’.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
22
Example 1: Temporary Market Impact
A trader receives a buy order for 50,000 shares of RLK. Market quotes, however only have
1,000 shares at the best ask of $50. There is another 2,000 shares at $50.25, 3,000 shares at
$50.50, and 4,000 shares at $50.75. The trader can only execute 1,000 shares at the best
available price and another 9000 shares at the higher prices for an average price of $50.50,
but only executes 10,000 shares of the original 50,000 share order. To attract the additional
liquidity into market the trader needs to offer a premium, hence, incurring market impact
cost. This cost stems from the liquidity demand that causes an imbalance in supply-demand
equilibrium (see Figure 2). Liquidity demand is an example of temporary market impact cost.
Example 2: Permanent Market Impact
A trader receives a buy order for 250,000 shares of RLK. But inadvertently, this information
is released to the market which signals to participants that the stock is likely undervalued.
Thus, investors who currently own stock will be unwilling to sell shares at the undervalued
price and will adjust their price upwards to reflect the new intrinsic value. Information
content is an example of permanent market impact.
8. Timing Risk
Timing risk refers to the uncertainty surrounding the estimated transaction cost. It is due to
price volatility and liquidity risk. Price volatility will cause the stock price to be either higher
or lower than estimated due to forces independent of the order. Liquidity risk will cause the
market impact cost to be either higher or lower than estimated. The liquidity portion of
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
23
timing risk is dependent upon volumes, intraday trading patterns, and cumulative market
impact cost caused by other market participants. Timing risk is a hidden variable transparent
cost component.
Example: Timing Risk
If a stock is currently trading at $50 we can be reasonable sure that it will be trading between
$49.90 and $50.10 over near term (say next few minutes or hours) but we do not have the
same level of confidence that the stock will still be trading between $49.90 and $50.10 after a
couple of days. A more realistic price range for this time period is likely to be between
$48.50 and $51.50. When investors execute orders over time, prices will likely become
higher or lower due to factors not related to the order. Assume a trader receives a buy order
for 100,000 shares of ABC and decides to trade the list passively by slicing the order over
several days. If the price moves favorably they will receive better prices but if the price
moves adversely they will receive worse prices. During times of higher market volume
traders will incur less market impact costs and during times of lower market volume traders
will incur higher market impact cost. Timing risk is intended to provide a reasonable range
surrounding the estimated transaction cost of the order. It is not intended to provide a range
surrounding the stock price at the end of trading.
9. Opportunity Cost
Opportunity cost represents the forgone profit of not being able to completely execute the
investment decision. The reason is usually due to insufficient liquidity, adverse price
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
24
movement, or both. In situations where managers are buying stocks that are rising and selling
stocks that are falling, the inability to fully execute an investment decision results in a missed
profiting opportunity. It represents a cost to the fund and results diminished portfolio returns.
Opportunity cost is a hidden variable transaction cost component.
Example: Opportunity Cost
A manger discovers an undervalued stock currently trading at $50 per share and instructs a
trader to buy 250,000 shares. The trader executes the order using a slicing strategy in order to
minimize market impact but is only able to 200,000 shares by the end of day. At that time,
the price increased to $51 and is no longer undervalued so the manager cancels the remaining
shares. The opportunity cost of not being able to execute this entire order is $50,000. This is
computed as 50,000 multiplied by the $1/share price movement.
VI. Unbundled Transaction Costs Categorization
The categorization of the nine unbundled transaction cost components is shown in Table 2.1.
As shown in the table, each of these costs is categorized as fixed or variable and as visible or
non-transparent. Notice that the majority of these costs are non-transparent and variable. This
represents both good and bad news for investors. It is good news because the costs are
primarily variable and can be controlled during implementation via an appropriate trading
strategy or algorithm, so traders who practice fiduciary transaction cost management during
implementation can add significant value to the process. But unfortunately, the bad news is
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
25
that the cost structure is unknown so investors need to estimate these cost structures and
develop proper and accurate transaction cost models. And this is no easy task.
To the extent that the cost structure estimation model and parameters is estimated accurately
investors will be able to reduce overall costs. But incorrect specification of these parameters
ould result in improper strategy selection, higher cost, and reduced performance.
Table 2.1 Unbundled Transaction Costs
Fixed Variable
Visible: Commission SpreadsFees Taxes
Non-Transparent: n/a Delay CostPrice AppreciationMarket ImpactTiming RiskOpportunity
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
26
Table 2.2 Transaction Cost Classification
Transaction Costs
Investment Costs Trading Costs Opportunity Cost
- Taxes - Commission - Opportunity Cost- Delay Cost - Fees
- Spreads- Price Appreciation- Market Impact- Timing Risk
VII. Conclusion
The recent increase in electronic orderflow and algorithmic trading has caused a renewed
interest in transaction costs and transaction cost analysis (TCA). But a complete
understanding of these costs is required in order to be positioned to specify appropriate
execution strategies and algorithms. For example, some of the more sophisticated trading
algorithms have been designed to manage transactions costs (most notably market impact and
timing risk) over the specified trading horizon while adapting to changing market conditions
and prices (Malamut & Kissell, 2006a). So if these cost components are not fully understood
it is unlikely that the investor specified algorithmic trading rules will be able to provide
implementation that is consistent with the underlying investment objectives of the fund.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
27
To assist investors better understand costs we provided a system that unbundled transaction
costs into nine components and then categorized these costs as fixed or variable and as
hidden or transparent in order to understand which costs can be managed via an effective
trading strategy. Furthermore, we provided a transaction cost classification system based on
where and when these costs occur during the investment cycle (e.g., investment related,
trading related, and opportunity cost) in order to gain insight into whose role it is to manage
what costs (e.g., portfolio manager, trader, or broker). This classification scheme, denoted in
this paper as the expanded implementation shortfall, combines the seminal work of Perold
(1988) and Wagner & Edwards (1993). As shown above, the expanded implementation
shortfall metric is of fundamental importance for understanding transaction costs. It also
serves as the basis for managing transaction costs and ensuring that the underlying execution
strategy is consistent with the overall investment objective of the fund.
VIII. References
Almgren, R., and N. Chriss, (2000) "Optimal execution of portfolio transactions," Journal of
Risk (3) 2, pg. 5-39.
Kissell, R., M. Glantz (2003). Optimal Trading Strategies, AMACOM, Inc., New York.
Kissell, R., and R. Malamut (2006a),"Algorithmic Decision Making Framework," Journal of
Trading, Winter 2006, Vol. 1, No. 1, pg, 12 – 21.
Kissell, R., and R. Malamut (2006b),"Unifying the Investment and Trading Theories,”
unpublished manuscript.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Forthcoming: Robert Kissell, Journal of Trading, Summer 2006
28
Madhavan, A. (2000). “Market Microstructure – A Survey,” Journal of Financial Markets 3,
pg. 205-258.
Perold, A. F. (1988), “The implementation shortfall: Paper versus reality,” Journal of
Portfolio Management Vol. 14, No. 3 (Spring), pg. 4-9.
Rakhlin, D., and G. Sofianos (2006), “The Impact of an Increase in Volatility on Trading
Costs,” Journal of Trading, Spring 2006, Vol. 1, No. 2, pg. 43- 50.
Wagner, W., and H. Edwards (1993). “Best Execution,” Financial Analyst Journal, Vol. 49,
No. 1, Jan/Feb 1993, pg 65-71.