2-Financial Markets Page 33 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 33than merely brokerage commissions—they consist of commissions, fees,
execution costs, and opportunity costs.^9
Commissions are the fees paid to brokers to trade securities. Execu-
tion costs represent the difference between the execution price of a secu-
rity 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-moti-
vated. 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 transac-
tion. 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 inves-
tors 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 observ-
able. 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 struc-
ture of the market mechanism, the demand for liquidity by the marginal(^9) For a further discussion of these costs, see Bruce M. Collins and Frank J. Fabozzi,
“A Methodology for Measuring Transaction Costs,” Financial Analysts Journal
(March-April 1991), pp. 27–36.