Execution Costs

Execution costs are vital in the provision of favorable portfolio management. They consist of fixed and variable costs.

A fixed cost is an expense that remains constant in spite of changes in the volume of investment. In contrast, variable cost is the transaction cost that varies from one investment to another depending on the size of an investment.

The variable costs include:

1. Explicit costs: These are the direct payments made in a trade, that is, charges for which a trader receives a receipt in a transaction.
2. Implicit costs: These are indirect trading costs. In other words, implicit costs do not involve direct payments. This means that no receipt is issued in these transactions. Implicit transactions arise in trading instances where buyers raise prices to entice sellers to trade with them. Sellers, on the other hand, reduce prices to enhance their purchasing power.

Sources of Implicit Costs

1. The bid-ask spread: It is the difference between the ask price and the bid prices.
2. The market impact: It is the effect that a market has when it buys or sells an asset.
3. The delay cost: It is the additional cost a trader incurs for failing to complete a transaction at a specified time.
4. The opportunity cost: It is the loss that arises from a trader’s decision to choose one trade at the expense of another. It is the value of the forgone option. Opportunity cost is alternatively referred to as the unrealized profit or loss.

Dealers trade for their accounts when filling customers’ orders. They make a profit by selling at prices higher than the prices at which they bought their goods or services. The bid price is the price at which a dealer will buy a particular quantity of an asset while the ask price is the price at which a dealer will sell a specific amount of an asset. The bid-ask spread is the difference between the ask price and the bid price.

The best bid is the offer to buy at the highest bid price, while the best ask is the offer to sell at the lowest ask price. The market bid-ask spread is the difference between the best bid and best ask prices in a market. The limit order book is a record of the bids and asks ordered from the best to the worst in descending order. Moreover, the midquote price is half the sum of the best market bid and ask prices.

Example: Finding the Market Spread

A company’s manager wants to buy 1,800 shares of a particular asset. Dealers X and Y trade these shares. The limit orders for the dealers are given in the table below:

$$ \begin{array}{c|c|c} \textbf{Dealer} & \textbf{Bid} & \textbf{Shares} \\ \hline X & 105.82 & 1,000 \\ \hline Y & 105.71 & 750 \end{array} $$

$$ \begin{array}{c|c|c} \textbf{Dealer} & \textbf{Ask} & \textbf{Shares} \\ \hline X & 120.98 & 1,100 \\ \hline Y & 120.78 & 800 \end{array} $$

Compute the market spread.

Solution

The bid-ask spreads for dealers X and Y are:

\(X: 120.98-105.82=15.16\)

\(Y: 120.78-105.71=15.07\)

The best bid price is 105.82, and the best ask price is 120.78.

Given the above calculations, the market spread is, \(120.78-105.82=14.96\)

It implies that the manager will purchase 800 shares from dealer Y at 120.78 per share and 1,000 shares from dealer X at 105.82 per share.

Question

A company’s manager wants to buy 1,800 shares of a particular asset. Dealers X and Y trade these shares. The limit orders for the dealers are given in the table below:

$$ \begin{array}{c|c|c} \textbf{Dealer} & \textbf{Bid} & \textbf{Shares} \\ \hline X & 105.82 & 900 \\ \hline Y & 105.71 & 750 \end{array} $$

$$ \begin{array}{c|c|c} \textbf{Dealer} & \textbf{Ask} & \textbf{Shares} \\ \hline X & 120.98 & 1,100 \\ \hline Y & 120.78 & 800 \end{array} $$

The midquote price is closest to:

1. 14.96.
2. 113.30.
3. 56.65.

Solution

The correct answer is B.

The bid-ask spreads for dealers X and Y are:

\(X: 120.98-105.82=15.16\)

\(Y: 120.78-105.71=15.07\)

The best bid price is 105.82, and the best ask price is 120.78.

The midquote price is, \(\frac{120.78+105.82}{2}=113.3\)

Portfolio Construction: Learning Module 6: Trading Costs and Electronic Markets; LOS 6(a): Explain the components of execution costs, including explicit and implicit costs