Equity Valuation and Portfolio Management

KEY POINTS

• Trading and execution are integral components of the investment process. A poorly executed trade can eat directly into portfolio returns because of transaction costs.
• Transaction costs are typically categorized in two dimensions: fixed costs versus variable costs, and explicit costs versus implicit costs.
• In the first dimension, fixed costs include commissions and fees. Bid-ask spreads, taxes, delay cost, price movement risk, market impact costs, timing risk, and opportunity cost are variable trading costs.
• In the second dimension, explicit costs include commissions, fees, bid-ask spreads, and taxes. Delay cost, price movement risk, market impact cost, timing risk, and opportunity cost are implicit transaction costs.
• Implicit costs make up the larger part of the total transaction costs. These costs are not observable and have to be estimated.
• Liquidity is created by agents transacting in the financial markets by buying and selling securities.
• Liquidity and transaction costs are interrelated: In a highly liquid market, large transactions can be executed immediately without incurring high transaction costs.
• A limit order is an order to execute a trade only if the limit price or a better price can be obtained.
• A market order is an order to execute a trade at the current best price available in the market.
• In general, trading costs are measured as the difference between the execution price and some appropriate fair market benchmark. The fair market benchmark of a security ...