Market Microstructure in Emerging and Developed Markets

CHAPTER 13

Determinants of Trading Costs

YU-CHUAN HUANG

Professor, National Kaohsiung First University of Science and Technology

INTRODUCTION

Traders pay attention to their trading costs because trading costs make implementing their trading strategies expensive. A stock with a high gross return may yield a relatively low net return when trading costs are high. Similarly, a stock with a low gross return can yield a higher net return when trading costs are low. For most active traders, trading costs are the most important determinants of their total returns. Therefore, trading costs play a vital role in portfolio management.

Trading costs are also important for exchanges, brokers, and regulators. For exchanges, using estimates of trading costs is natural when making inferences about the relative efficiency of alternative market mechanisms or trading systems. Brokers, assuming an agency responsibility, need to assure the best execution of a client's trades for which they have fiduciary responsibility. Therefore, they have to conduct studies on trading costs to monitor the performance and to ensure that they get the best execution for their clients. Regulators might be concerned about the relationship between microstructure regulations, such as dual trading restriction, and trading costs (Chang and Locke 1994; Smith and Whaley 1994). Similarly, the analysis of trading costs features prominently in the debate over the relative efficiency of electronic screen-based trading (Fremault-Vila ...