[MUSIC] Over the last few videos, we have discussed the importance of transaction costs, the two types of transaction costs, and how to calculate them using various benchmarks. One particular way of calculating transaction costs, is the implementation shortfall method. It measures costs from decision time and also includes an opportunity cost for the unexecuted part of an order. In this video, we will break down the implementation shortfall method into four separate components, namely delay costs, change in midpoint cost, effective spread cost, and opportunity cost. This will help us better pinpoint what is likely causing our transaction cost to be very high or very low. We will illustrate computation of these four components using an example. Let's first define the four components of the implementation shortfall method, and how to compute them. Then we will revisit our example from last time, and calculate the value of each of these components. First component is the delay cost, which captures the cost due to the delay between deciding to trade, and the order's arrival in the market. To compute the delay cost, we need the bid-ask midpoint at decision time, as well as at arrival time. The delay cost is the total order size, capital X, times order direction, times the difference between arrival time bid-ask midpoint, n0, and the decision time midpoint. In arrival time and execution time, for each trade it is the trade size Xj, times the order direction, times the difference between the execution midpoint, mj, and arrival time midpoint m0. This is summed up across all your trades. The third component is the effective spread cost, this is something we have already discussed. For each trade, it is a trade size, Xj, times the order direction, times the difference between trade price, Pj, and execution time midpoint, nj. This is summed up across all your trades. Finally, the opportunity cost is the loss due to the non executed part of your order. It is the difference between the order size, capital X, and the total quantity traded, which is the sum of all Xjs, times the order direction, times the price of the last trade of the day, pn, minus the arrival time mid point, m0. Let's revisit our earlier example. Your order size capital X is for 1,200 shares. Your order direction is +1, as you want to buy shares. Decision time midpoint, md, is 46.065. Arrival time midpoint, m0, is 46.15. Midpoint at the time of your first trade is 46.035. That at the time of your second trade is 46.01, and the price of the last trade of the day, bn, is 40 [INAUDIBLE]. The delay cost is 1,200 times 46.15, minus 46.065, which is $102. Prices increase after your decision to buy, and hence there is a huge delay cost of $102. Had prices decreased during this period, the delay cost would have been negative. Change in midpoint cost is 468 times 46.035. Change in midpoint cost is 468 times 46.035, minus 46.15, plus 530, times 46.01, minus 46.15, which is a negative 127.8. Your change in midpoint costs are negative, as the midpoint decreased between order arrival and order execution. Since you are buying, this price decrease is favorable, and is represented by a negative cost. The third component is the effective spread cost. We already calculated this to be $17.50 last time. The final component of the implementation shortfall method is the opportunity cost. We already saw that 210 shares of your order were not bought. So the opportunity cost is 210, times 46.03, minus 46.15, which is a negative 25.2. Adding the four components of 102, minus 127.1, plus 17.5, minus 25.2, we get a negative 32.8. Which is the same number we got when we calculated transaction cost using the implementation shortfall method. The decomposition helps pinpoint that dealer costs were huge in this case. Transaction costs could have been lower, if there had been a smaller delay between decision and order arrival. This brings us to the end of this course. This course focuses on the building blocks of trading. This included learning how to read financial statements and understand a company's current financial health by examining its financial ratios. We next discuss the risk return relationship, the idea of diversification, and some common asset pricing models. Finally, we looked at some of the mechanics of trading. Specifically, we looked at what orders a trader can use, and how the order book worked. We then focused on transaction cost, which are real costs born by traders. These costs reduce returns earned by investors. Later in this specialization, you will use these topics that we have covered in this course. I hope you enjoyed the course as much as I did bringing it to you, goodbye. [MUSIC]
