Transaction Cost Analysis & Effective Transaction Profile

Transaction cost analysis helps you to calculate explicit and implicit costs involved in a transaction. Explicit costs include commissions, taxes, etc. while implicit costs include price changes, market moves and opportunities lost. This way you can find out the most efficient trading methods for valuable transactions.

Besides, the transaction cost analysis determines the effectiveness of your transaction profile. It results in a value between two possible transaction values; one which a manager wants to pay and the other on which transaction is finalized. The difference between the two values is called slippage.

Benefits of Transaction Cost Analysis

A valid transaction profile tells that the transaction is being done at favorable prices. The favorable rates for a seller and a purchaser can be different. When you are paying your transaction profile would be favorable at lower prices. However, when you sell your transaction profile would be favorable at higher rates.

The transaction cost analysis is essential not only for managers but also for investors, brokers and exchange agents to determine whether their trade is generating the required results. You can tune your future transactions accordingly to make your transaction profile favorably.

This also helps you to dig out whether trade price is less or more in a market as per existing circumstances. You will have to compare your trade price with benchmarks to find out an average price. A purchase at a higher price from the average is considered including transaction cost. A sale on less than average price makes a transaction cost lower. We try to sell goods on an expensive price and purchase on a cheaper price.

Good managers don’t ignore the opportunity cost of the incomplete trade or foregone opportunities. Otherwise, it is possible that if the opportunity cost is more than the profits, the cost can be dangerous for portfolio performance.

The most important use of the transaction cost analysis is that it can help us to collect data of explicit as well as implicit costs related to a transaction including commission, kick-backs, taxes, legal investment costs, legal expenditures, etc. The explicit costs are readily available, but implicit costs need special measurements and knowledge to reach a correct transaction cost. For example, if we ignore the opportunity cost, we may have to face grave trouble to recover it later.

You should not forget the cliche, "There is no free lunch." Even provision of information in this age of the internet is not free of cost. While reading this information, you may feel it free, but it is not free. There are specific explicit as well as implicit costs which you have to pay while reading this article. You could have saved your time and money for other opportunities which could give better financial results.

You must not ignore that there are necessary expenditures which make a transaction acceptable to both parties. Many times such spending may involve externalities. For example, you may find different Google advertisement on this website. They are useful to the users interested in good quality information and resources. It involves an externality for the webmaster who earns money to help you to find the required information. Then there is hard work of the webmaster behind every page and every paragraph. These are negative externalities for the webmasters.

Definitions of Transaction Cost

A transaction is a cost which is paid or be included in some commercial exchange.

Ronald Coase, in his article, “The problem of social costs” states:

“In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.”

Steven N. S. Cheung has broadly defined the transaction costs as any costs that are not conceivable in a "Robinson Crusoe economy." In other words, the transaction costs arise due to the existence of institutions.

According to Investopedia:

“Expenses incurred when buying or selling securities. Transaction costs include brokers' commissions and spreads (the difference between the price the dealer paid for a security and the price the buyer pays). The transaction costs to buyers and sellers are the payments that banks and brokers receive for their roles in these transactions. There are also transaction costs in buying and selling real estate. These fees include the agent's commission and closing costs such as title search fees, appraisal fees, and government fees.”

According to Business Dictionary:

1. A fee charged by a financial intermediary such as a bank, broker, or underwriter.

2. Economics: The cost is associated with the exchange of goods or services and incurred in overcoming market imperfections. Transaction costs cover a wide range: communication charges, legal fees, informational cost of finding the price, quality, and durability, etc., and may also include transportation costs. Transaction costs are a critical factor in deciding whether to make a product or buy it. Also called frictional cost.

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