Market Impact Cost

CFA Level III
#1

Can anyone please clarify how to calculate market impact cost (cost from realized profit/loss). I see some ambiguity at different places. The formula stated is:

Market Impact cost = (EP - DP)/ DP * Number of shares filled/Total number of shares, where

EP = Execution Price

DP = Decision Price

At some other places, I see the formula as (EP-DP)/ BP * Number of shares filled/Total number of shares, where BP is the benchmark price.

Also, is the decision price taken as of the day order is filled or is it the closing price of the previous day before order gets filled?

Thanks a lot in advance.

#2

Use (EP-DP)/ BP as BP and DP can be different if an actual trade executes on a day AFTER the day the original decision to trade occurs.

Example:

Previous close 10. Before the open, a trader decides to buy 5,000 shares (BP is 10). A limit order is entered to buy 5,000 at 9.95 and the price never hits it. The stock closes at 10.50.

The next day, trader enters a new order to buy 5,000 and 2,500 shares execute at 10.75. The remainder goes unfilled, the stock closes at 11 and the remainder of the order is canceled. The decision price here is the previous close of 10.50, as a new decision to trade was entered on the next day.

Realized Profit/Loss: (10.75 - 10.50) / 10 x 2,500/5,000 In this case, DP and BP are different. Sometimes they will be the same like in the 2014 AM exam and they try to trick you by giving you an irrelevant previous day’s close (curse you Institute!).

The way I try to think of it is, BP gets determined at the original decision to trade. DP can be this price, but if the trade carries over into the next day, be on the lookout for more information in the case as you will likely be using a new DP.

#3

I thought it was the other way around. DP is the original decision price, BP* is if there was a delay in execution?

#4

I know it’s friggin confusing right? So, check out the example on page 25 of reading 29, and pay particular attention to the wording they use. A couple of standouts:

Notice they specifically label 10.00, the previous day’s close, as the benchmark price in bullet #2. Then notice in the calculation of realized profit/loss they say "…difference between the execution price and the relevant decision price (here, the closing price of the previous day).

The previous day in this case was Tuesday’s close which determined the decision price. But the original decision to trade was before open on Tuesday, so Monday’s close was the STARTING decision price, aka the benchmark price.

#5

Thanks. This is useful.

So I believe this is the rule of thumb:

  1. Use the formula (EP-DP/DP) * No of shares filled/Total number of shares, if the decision to execute the trade is made any day AFTER the first day, where decision price will be mentioned in the question (as on the same day when order gets placed as well as filled), and

  2. Use the formula (EP-DP)/BP * No of shares filled/Total number of shares, if the decision to execute the trade comes ON the very first day. In this case, decision price becomes previous day’s closing price (previous day w.r.t the day on which actual trade gets partially/fully filled) and benchmark price is the opening price of the first day.