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What Is Transaction Cost Analysis?

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  • Written By: M. Walker
  • Edited By: Allegra J. Lingo
  • Last Modified Date: 19 November 2016
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Transaction cost analysis (TCA) is a trade process in which the cost of a transaction is measured and compared to other outcomes. It is often used to determine the most cost effective trading methods and the best value by examining explicit costs, such as commissions and fees, and implicit costs, such as opportunity cost and price changes. Transaction cost analysis is often computed by various firms using algorithms to pin down specific areas of costs in an attempt to control trading costs.

One of the main uses of transaction cost analysis is its ability to gather data on both explicit and implicit costs. Explicit costs refer to upfront fees associated with trading, which include trading commissions paid to brokers, search costs for finding the right investments, and legal costs to enforce various policies. These costs are frequently readily available to be analyzed because the data is fairly straightforward.

Implicit costs, however, involve the added costs in the event of a stock price change or the opportunity costs incurred during different trading practices. These costs are more difficult to estimate because they cover more indirect information. For example, if an investor missed out on a good trading opportunity due to other financial or time commitments, he or she would have incurred an implicit cost.

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Transaction cost analysis is able to estimate both explicit and implicit costs via complex computation strategies, taking into account multiple sources of cost for investors. This is usually accomplished by comparing the amount that would have occurred had the transaction been processed instantaneously as well as the amount that actually occurred, including extra fees and commissions. The difference between the two values is referred to as slippage.

Higher slippage rates increase the overall costs experienced by investors. In turn, this can diminish returns and the amount of money investors are able to reinvest, creating overall negative effects. Especially when compounding interest is used, a small cost incurred at one point in time can frequently impact future finances by a larger degree.

Many investors will trust transaction cost analysis to help them determine the best investment choices with the least amount of slippage. Not only will they be more aware of both implicit and explicit costs, they will also be able to maximize the returns of their investments. It also enables individuals to discover the greatest sources of cost within a given trading system, whether it be direct commission fees or indirect opportunity costs.

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