Implementation Shortfall

The implementation shortfall approach involves taking the difference between the prevailing price and the final execution price when a buy or sell decision is made concerning security. This technique solves the challenges of the effective spread method. It consists of market impact costs, delay costs, and opportunity costs.

The prevailing price is the midquote price at the time the trade decision is made. Investors aim at minimizing implementation shortfall for them to maximize profits.

Example: Computing the Implementation Shortfall

The bid-ask spread in a market is $56.34/$56.38. A trader places an order to purchase 1,000 shares expecting the buy order to fill at $56.38. There is a slight delay in the trader’s request and the trader finally gets the order at $56.42.

The implementation shortfall for this transaction is closest to:

Solution

$$ \begin{align*} \text{Implementation shortfall} & = \text{Actual price}-\text{Expected price} \\ & =$56.42-$56.38 \\ & =$0.04 \end{align*} $$

Question

An order A to sell 3,000 shares executed for $15.12 is made. At the time the order is submitted, the price is a $15.11 bid for 4,000 shares, and the offer is made at $15.16 for 4,000 shares. There is yet another order, B, to sell 5,000 shares executed at the cost of $15.14. At the time the order is subimtted, the price is a $15.15 bid for 4,000 shares, and the offer is made at $15.18 for 4,000 shares.

The implementation shortfall for each transaction is closest to:

1. A=$0.03; B=$0.05.
2. A=$0.05; B=$0.03.
3. A=$0.04; B=$0.04.

Solution

The correct answer is B.

$$ \begin{align*} \text{Implementation shortfall} &=\text{Actual price}-\text{Expected price} \\ \text{For order A } & : $15.16-$15.11=$0.05 \\ \text{For order B } & : $15.18-$15.15=$0.03 \end{align*} $$

Reading 46: Trading Cost and Electronic Markets

LOS 46 (c) Describe the implementation shortfall approach to transaction cost measurement.