1. “Defining and Measuring Trading Costs,” Wayne Wagner, Execution Techniques, True
Trading Costs, and the Microstructure of Markets (AIMR, 1993)
Purpose:
To test the candidate’s knowledge of the nature, size, and time frame of the various costs implicit in
the execution of security trades.
LOS: The candidate should be able to
“Defining and Measuring Trading Costs” (Session 16)
• illustrate how hidden transaction costs, such as market impact, timing, and opportunity costs,
affect investment management results.
Guideline Answer:
Measurement of each of the three costs implicit in the execution of trades is as follows:
i. Market impact cost is measured by the change in a stock’s price between the time an order is
presented to the (sell-side) broker and actual execution of the trade. It is sometimes described as
the “cost of buying liquidity.” The time required to complete the trade associated with this cost
is relatively short – intraday or one day – regardless of any interim movement in the stock’s
price.
ii. Timing cost is measured as the change in a stock’s price while part or all of the order is being
held on the buy-side trading desk. It is sometimes described as the “cost of seeking liquidity.”
The time required to complete the trade associated with this cost is somewhat longer than that
for market impact – interday or up to several days.
iii. Opportunity cost is measured as the change in a stock’s price from the time the order was
presented to the buy-side trader to the price at a point in the future that would have resulted in a
profit had the order been executed. It is sometimes described as “liquidity failure,” because it is
the absence of liquidity that resulted in the order not being executed at all. Because the trade
never takes place, the time required to complete the trade associated with this cost is undefined.
The opportunity cost can also be measured from the time the order was placed until it is
cancelled.
Level III: Question 15
Topic: Portfolio Management: Risk Measurement and Management
Minutes: 24
Reading References:
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