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Implementation Shortfall

Implementation Shortfall

The implementation shortfall approach involves taking the difference between the prevailing price when a buy or sell decision is made concerning security and the final execution price. 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 keeping implementation shortfall small 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 was a slight delay in the trader’s request. The trader finally gets the order at $56.42.

Compute the implementation shortfall for this transaction.

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. Upon order submission, the price was $15.11 bid for 4,000 shares, and the offer was made at $15.16 for 4,000 shares. Another order B to sell 5,000 shares executed at the cost of $15.14. Upon submission of the order, the price was $15.15 bid for 4,000 shares, and the offer was 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 44: Trading Cost and Electronic Markets

LOS 44 (c) Describe the implementation shortfall approach to transaction cost measurement.

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