Chapter 3 - Algorithmic Transaction Cost Analysis

Abstract

This chapter provides a detailed investigation into transaction cost analysis (TCA). The chapter begins with a thorough investigation into the nine components of financial transaction costs: commissions, taxes, fees, spreads, delay, price appreciation, market impact, timing risk, and opportunity cost. We expand on Perold’s implementation shortfall methodology by incorporating pre-trade costs to better identify and classify total trading costs based on where, when, and how they arise during the investment cycle. The chapter introduces the reader to the “trader’s dilemma,” that is, the difficulties encountered by traders each day in managing the conflicting transaction cost components of market impact cost and timing risk. We continue the chapter with methodologies and best in class practices to measure trading costs and evaluate trader, broker, and algorithmic performance. The chapter concludes with a thorough investigation into some of the more advanced statistical algorithmic evaluation techniques, and presents a framework for investors to objectively measure, compare, and evaluate algorithms across brokers and vendors.