The problem with measuring implicit transaction costs is that the true measure, which is the difference between the price of the stock in the absence of a money manager's trade and the execution price, is not observable. Furthermore, the execution price is dependent on supply and demand conditions at the margin. Thus, the execution price may be influenced by competitive traders who demand immediate execution or by 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.

There are many ways to measure transaction costs. However, in general this cost is the difference between the execution price and some appropriate benchmark, a so-called fair market benchmark. The fair market benchmark of a security is the price that would have prevailed had the trade not taken place, the no-trade price. Since the no-trade price is not observable, it has to be estimated. Practitioners have identified three different basic approaches to measure the market impact:9

  1. Pre-trade measures use prices occurring before or at the decision to trade as the benchmark, such as the opening price on the same-day or the closing price on the previous day.
  2. Post-trade measures use prices occurring after the decision to trade as ...

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