Financial markets mostly serve as a bridge that is crossed every day by individual investors, borrowers, mutual funds, insurance companies, hedge funds, and many other big bullies under the sun. We often use “bid-ask spread” to measure how well a particular financial market is handling the daily traffic. A tight bid-ask spread is good for smooth flow. But there is another criterion called the “impact cost”, which we can use to measure the depth of a market. The real test of a bridge comes when around 500kg is on the move.
Johnny: If I remember correctly, we have talked about bid-ask spread before. But you never mentioned the impact cost. So could you explain what it is?
Jinny: The impact cost, or what is also called “market impact”, measures the effect of a big order on the price of a financial instrument. In efficient financial markets, we expect the prices to increase or decrease in response to the available “information”. Any movement in price just because buyers are not able to find sellers or vice versa is considered a market inefficiency. In other words, we expect efficient markets to continuously match demand with equally powerful supply. But in reality we do come across market friction. A big order to buy might suck out every ounce of available supply. Likewise, a big order to sell might dwarf the available demand. In both the cases, the price would change due to mismatch in demand and supply. A big order to buy would push the price upwards, whereas a big order to sell would push the price downwards. The impact cost measures the deterioration in price faced by a buyer or seller while placing a big order.
Illustration: Jayachandran / Mint
Johnny: That sounds like becoming a victim of your own bullet. But can you be more specific—I mean, how big should the order be to have an impact cost?
Jinny: Big or small are relative terms and to get a more specific understanding let’s talk only about the stock market. The first thing to keep in mind is that every stock listed on a stock exchange would have a different impact cost depending upon its trading volume. A stock that has a good number of buyers and sellers could handle a big size order with lower impact cost.
Second, the impact cost of a stock increases or decreases depending on the size of the order. As a general rule, the bigger the order size, the higher would be the impact cost.
Third, the impact cost for buying and selling the same stock may be different. A stock may have a different impact cost when someone is placing a big order to buy and a different impact cost when someone is placing a big order to sell.
Fourth, we must also keep in mind that impact cost never remains static and it varies depending upon day-to-day market situations. Stock exchanges use orders of a particular size for measuring the impact cost. For instance, the National Stock Exchange (NSE) measures the impact cost by using an order size of Rs50 lakh for doing a trade in all stocks included in the Nifty in exactly the same proportion as that of the index. It helps in finding out how much the price of the underlying stocks deteriorates if anybody tries to place an order size of Rs50 lakh for the entire index. NSE makes it mandatory for any stock included in the Nifty to have an impact cost of less than 0.75% for a basket trade of Rs50 lakh.
Johnny: Can you tell me how impact cost is measured in terms of numbers?
Jinny: Numbers can be best explained by taking an example. Suppose the best buy order for a stock in the trading system is currently Rs99 and the best sell order is Rs101. The difference of Rs2 between the best buy and the best sell order is what we also call bid-ask spread. The ideal price to buy or sell the stock should be Rs100, which is the average of the best buy and best sell order present in the trading system before your order was placed. But when you place a big order to buy or sell, it doesn’t get executed at what we deem to be the ideal price. A big order to buy would, in fact, push the average buying price upwards by creating more demand than the supply. Suppose you ended up paying an average buying price of Rs102, what’s your impact cost? Since you paid Rs2 more than the ideal buy and sell price of Rs100, your impact cost is 2%. So in terms of numbers, impact cost is measured as the percentage change between the average execution price and the ideal price.
Johnny: So much for big orders. I wanted to know how higher impact cost ultimately affects the market. But, for now, let’s take a break.
What: ‘Impact cost’ measures the deterioration in price faced by a buyer or seller while placing a big order.
Why: The prices deteriorate due to mismatch in demand and supply.
How: ‘Impact cost’ is measured as the percentage change between the ideal price (average of best buy and sell price) before the order was placed and the average execution price.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com