In an operationally efficient market, investors can obtain transaction services as cheaply as possible, given the costs associated with furnish- ing those services. Commissions are only part of the cost of transacting as we noted above. The other part is the dealer spread. Bid-ask spreads for bonds vary by type of bond. Other components of transaction costs are discussed below.
In an investment era where one-half of one percentage point can make a difference when an asset manager is compared against a performance benchmark, an important aspect of the investment process is the cost of implementing an investment strategy. Transaction costs are more than merely brokerage commissions—they consist of commissions, fees, execution costs, and opportunity costs.
Commissions are the fees paid to brokers to trade securities. Execution costs represent the difference between the execution price of a security and the price that would have existed in the absence of the trade. Execution costs can be further decomposed into market (or price) impact and market-timing costs. Market impact cost is the result of the bid-ask spread and a price concession extracted by dealers to mitigate their risk that an investor’s demand for liquidity is information-motivated. Market-timing cost arises when an adverse price movement of the security during the time of the transaction can be attributed in part to other activity in the security and is not the result of a particular transaction. Execution costs, then, are related to both the demand for liquidity and the trading activity on the trade date.
There is a distinction between information-motivated trades and informationless trades. Information-motivated trading occurs when investors believe they possess pertinent information not currently reflected in the security’s price. This style of trading tends to increase market impact because it emphasizes the speed of execution, or because the market maker believes a desired trade is driven by information and increases the bid-ask spread to provide some protection. It can involve the sale of one security in favor of another. Informationless trades are the result of either a reallocation of wealth or implementation of an investment strategy that utilizes only existing information. An example of the former is a pension fund’s decision to invest cash in the stock market. Other examples of informationless trades include portfolio rebalances, investment of new money, or liquidations. In these circumstances, the demand for liquidity alone should not lead the market maker to demand the significant price concessions associated with new information.
The problem with measuring execution costs is that the true mea- sure—which is the difference between the price of the security in the absence of the investor’s trade and the execution price—is not observable. Furthermore, the execution prices are dependent on supply and demand conditions at the margin. Thus, the execution price may be influenced by competitive traders who demand immediate execution, or other investors with similar motives for trading. This means that the execution price realized by an investor is the consequence of the structure of the market mechanism, the demand for liquidity by the marginal investor, and the competitive forces of investors with similar motivations for trading.
The cost of not transacting represents an opportunity cost. Opportunity costs may arise when a desired trade fails to be executed. This component of costs represents the difference in performance between an investor’s desired investment and the same investor’s actual investment after adjusting for execution costs, commissions, and fees. Opportunity costs have been characterized as the hidden cost of trading, and it has been suggested that the shortfall in performance of many actively managed portfolios is the consequence of failing to execute all desired trades.14 Measurement of opportunity costs is subject to the same problems as measurement of execution costs. The true measure of opportunity cost depends on knowing what the performance of a security would have been if all desired trades had been executed at the desired time across an investment horizon. As these are the desired trades that the investor could not execute, the benchmark is inherently unobservable
Posts Tagged ‘market’
Operational Efficiency
Wednesday, September 1st, 2010Role of Brokers and Dealers in Real Markets (2)
Saturday, August 14th, 2010The fact of imbalances explains the need for the dealer or market maker, who stands ready and willing to buy a financial asset for its own account (add to an inventory of the security) or sell from its own account (reduce the inventory of the security). At a given time, dealers are willing to buy a security at a price (the bid price) that is less than what they are willing to sell the same security for (the ask price).
In the 1960s, economists George Stigler and Harold Demsetz analyzed the role of dealers in securities markets. They viewed dealers as the suppliers of immediacy—the ability to trade promptly—to the market. The bid-ask spread can be viewed in turn as the price charged by dealers for supplying immediacy, together with short-run price stability (continuity or smoothness) in the presence of short-term order imbalances. There are two other roles that dealers play: they provide better price information to market participants, and in certain market structures they provide the services of an auctioneer in bringing order and fairness to a market.
The price-stabilization role relates to our earlier example of what may happen to the price of a particular transaction in the absence of any intervention when there is a temporary imbalance of order. By taking the opposite side of a trade when there are no other orders, the dealer prevents the price from materially diverging from the price at which a recent trade was consummated.
Investors are concerned with immediacy, and they also want to trade at prices that are reasonable, given prevailing conditions in the market. While dealers cannot know with certainty the true price of a security, they do have a privileged position in some market structures with respect to the flow of market orders. They also have a privileged position regarding “limit” orders, the special orders that can be executed only if the market price of the security changes in a specified way.
Finally, the dealer acts as an auctioneer in some market structures, thereby providing order and fairness in the operations of the market. For example, the market maker on organized stock exchanges in the United States performs this function by organizing trading to make sure that the exchange rules for the priority of trading are followed. The role of a market maker in a call market structure is that of an auctioneer. The market maker does not take a position in the traded security, as a dealer does in a continuous market.
One of the most important factors that determine the price dealers should charge for the services they provide (i.e., the bid-ask spread) is the order processing costs incurred by dealers, such as the costs of equipment necessary to do business and the administrative and operations staff. The lower these costs, the narrower the bid-ask spread. With the reduced cost of computing and better-trained personnel, these costs have declined over time.
Dealers also have to be compensated for bearing risk. A dealer’s position may involve carrying inventory of a security (along position) or selling a security that is not in inventory (a short position). There are three types of risks associated with maintaining a long or short position in a given security. First, there is the uncertainty about the future price of the security. A dealer who has a long position in the security is concerned that the price will decline in the future; a dealer who is in a short position is concerned that the price will rise.
The second type of risk has to do with the expected time it will take the dealer to unwind a position and its uncertainty. And this, in turn, depends primarily on the rate at which buy and sell orders for the security reaches the market (i.e., the thickness of the market). Finally, while a dealer may have access to better information about order flows than the general public, there are some trades where the dealer takes the risk of trading with someone who has better information This results in the better-informed trader obtaining a better price at the expense of the dealer. Consequently, in establishing the bid-ask spread for a trade, a dealer will assess whether the trader might have better information. Some trades that we will discuss below can be viewed as “information- less trades.” This means that the dealer knows or believes a trade is being requested to accomplish an investment objective that is not motivated by the potential future price movement of the security.