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Published byMarian Watson Modified over 8 years ago
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Brokerage Costs Most explicit, but by far the smallest component Bid-Ask Spread Price Impact The change in price an investor can create through price pressure Opportunity Cost – cost of waiting to trade Price moving against you while you wait 2
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Must provide dealer with a reasonable return and cover dealer’s costs Costs that the dealer faces Risk of holding inventory Cost of processing orders Cost of trading with more informed investors 3
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Mkt. Cap Smalle st 2345678Largest Ave. Price $4.58$10.3 0 $15.1 6 $18.27$21.8 5 $28.3 1 $35.4 3 $44.34$52.40 Ave. Sprea d $0.30$0.42$0.46$0.34$0.32 $0.27$0.29$0.27 Pct. Sprea d 6.55%4.07 % 3.03 % 1.86%1.46 % 1.13 % 0.76 % 0.65%0.52% 4
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Spreads on Treasuries are the lowest – usually less than 0.1% of the price Higher Rated Corporate Bonds generally have narrower spreads than those that are lower rated Non-U.S. equities generally have much higher spreads than those traded on NYSE and Nasdaq 5
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The recent increase in electronic trading has led to much lower quantity quotes in the inside spread – often only 100 shares Large trades create an imbalance between buy and sell orders which create a price change Large trades attract attention and are viewed as informational by other investors – thus changing prices 6
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Assets which have a high bid-ask spread tend to be assets where trading can have a significant price impact as well. Larger portfolios tend to trade in larger blocks – this means a strategy which yields excess returns for a small portfolio might not for a large one. 9
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If there is no cost, every trade should be broken up into small quantities so as to not affect the price or spread While waiting to trade though, the asset the investor wants to buy may go up in price. The cost of waiting and the cost of price impact tend to conflict with each other. 10
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Trades based on private information (not necessarily illegal) generally have a greater cost of waiting as others may discover the information Trades based on valuation generally have a lower cost of waiting Trades based on a contrarian strategy tend to have a lower waiting cost than those based on a momentum strategy 11
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Return on active money management = Risk adjusted expected return + Trading returns – Trading costs The average active money manager makes about 1% less than the market. Trading returns are a zero-sum game, so average trading return must equal zero This implies that average trading costs are about 1% if collectively, they are the market 12
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Develop a clear investment philosophy and a consistent investment strategy Estimate the cost of waiting given the investment strategy Consider alternatives available to minimize transactions costs, given the cost of waiting Keep the portfolio size manageable Consider costs when looking at returns 13
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