The Indian stock market has grown by akg15343

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									       Are You Getting a Good Deal?
       ‘Overlooked’ Cost of Stock Trading
       The Indian stock market has expanded vastly over the last 10
       years, witnessing a great number of changes in its functioning.
       Perhaps the most important of these are the changes in the area
       of trading costs. Trading costs are, however, often overlooked
       when trading and this adversely affects nearly all the players in
       the stock market.
       BIDISHA CHAKRABARTY,                           brokerage fees, and exchange fee are one
       PANKAJ K JAIN                                  part of it. The more tricky counterparts
                                                      are the implicit costs such as price impact


       T
               he Indian stock market has grown       and bid-ask spread. Bid-ask spread (the
               by more than seven times between       difference between the lowest selling price
               1990 and today, which translates       and highest buying price for a stock)
       into a return of over 18 per cent per annum,   represents the (variable) cost that an
       adjusted for inflation. This phenomenal        investor pays for a (round trip) trade. It
       growth has been facilitated, in no small       is the wedge between the price that an
       measure, by the move away from open            investor pays as a buyer and the price that
       outcry trading on exchange floors to the       she receives as a seller. Thus, the magni-
       introduction of internet-based online trad-    tude of the spread is an important decision
       ing. A pioneer of this change has been the     variable that an investor considers in
       National Stock Exchange (NSE) of India,        choosing a trading venue, as well as the
       with its introduction of the completely        stocks to buy/sell. It also represents the
       automated trading platform that removes        friction in financial markets and measures
       the need for floor brokers and allows          the difficulty with which an asset is traded.
       anonymous investors to directly trade          For example, consider the following
       with each other. This change in trading        situation: On October 21, 2005, Reliance
       technology has greatly affected the            is quoted at Rs 772.80 ask (the price at
       competitive structure and institutional        which an investor can buy one share) and
       design of the stock trading industry. All      Rs 770.40 bid (the price at which an in-
       investors have equal and fair access to        vestor can sell one share). The bid-ask
       the markets through its online trading         spread for Reliance is Rs 2.40. If the investor
       platform based on a forward looking            wants to transact 1,000 shares, the spread
       satellite communication technology, which      will amount to Rs 2,400. Assume the
       represents the industry’s best practice in     broker commission for one round trip
       India and the world. Separation of own-        (one buy plus one sell) trade is Rs 100;1
       ership, management, and trading partici-       the cost for one round trip transaction
       pants on NSE has removed the potential         is Rs 2,500. Some brokers pass on the
       for conflict of interest and perverse in-      service tax (10.2 per cent of the brokerage
       centives of seat-holding brokers, which        fee) on to investors, and in that case it adds
       were otherwise common in many ex-              another Rs 10.20 to the cost. Adding all
       changes. This has a fundamental influence      that up, a Rs 7,71,600 investment in
       on market conditions and the price forma-      Reliance incurs a total cost of approxi-
       tion process. An optimal investment strat-     mately Rs 2,510.20. Now, if the investor
       egy ought to take into account the nuances     has a long-term buy and hold strategy, the
       of this mechanism.                             spread is only incurred once. For day-
                                                      traders who buy and sell several times a
       How Trading Costs Work                         day, the costs multiply accordingly. It
                                                      follows, that the bid-ask spread is a big
         One profound change brought about by         factor determining the demand for and
       the NSE is in the area of trading costs.       supply of a stock.
       Trading costs have a direct bearing on            One factor affecting the spread is the
       net investment returns, particularly for       “tick size” that an exchange mandates. The
       frequent traders. The explicit commissions,    tick size is the minimum price increment


4720                                  Economic and Political Weekly          November 18, 2006
for a stock. The prevailing tick size on       limit order book both in real time and on        the trading period when the order book
the NSE is Re 0.05. Thus, a stock that         a historical basis. Research shows that          is thick.
is trading at Rs 90.10 cannot see its          investors use real time information                 In our judgment, the knowledge of these
next trade price as, say, Rs 90.13. The        to strategically submit their orders. For        patterns can benefit four different groups
smallest step change has to be Rs 90.15        example, when information uncertainty is         of market participants: investors, firms,
or Rs 90.05. It is clear then that if an       high (for example around earnings                regulators, and the stock exchange
exchange mandates a higher tick size           announcements), investors who have               management.
than a competing exchange for the same         private information want to trade larger         (a) Liquidity and transactions costs directly
stock, it de facto sets a floor on the         quantities. Thus, knowing the intra-day          affect the investors’ net returns from their
stock’s spread, thus increasing the trad-      patterns of trading in the market can help       equity portfolios. Transaction costs also
ing cost. The trading platform and super-      individual investors time their trades better.   influence the portfolio selection strategy
visory regime that an exchange offers          Regulators can conduct an audit trail using      of investors if they can pick stocks with low
impacts the bid-ask spread for a stock.        the historical information, which in turn        spreads among comparable alternatives.
Research has shown that firms with             improves market quality.                         (b) Firms’ listing choice can possibly take
higher quality disclosures have lower bid-       We investigate intra-day patterns of the       these costs into account. Although, the
ask spreads. The ownership concentration       bid-ask spread in the NSE. Using snap-           listing fee of a particular exchange is the
of a firm also impacts the spread of its       shots of the state of the market taken four      direct cost paid by the firm, a much more
stock – concentrated or pyramid share-         times a day at 11:00, 12:00, 13:00 and           important (indirect) issue is the liqui-
holding has been shown to widen a              14:00 hours yield the median bid-ask spread      dity in a firm’s stocks. Improved liquidity
stock’s bid-ask spread. These factors          in the limit order book (LOB) of Re 0.45,        can potentially reduce the cost of equity
affect the availability of capital and thus,   which is 0.77 per cent of the median LOB         for listed firms. Further, as has been ex-
economic growth.                               price. Since the LOB snapshots are not           plained before, the bid-ask spread is
                                               collected for the opening and closing            arguably the most important metric that
Are You Getting a Good Deal?                   sessions of the market, lower LOB spreads,       captures liquidity.
                                               compared to estimated spreads, are con-          (c) Results of this study will also help
   Once we acknowledge the importance          sistent with spreads being higher during         achieve the policy goals of lawmakers
of the spread as a metric of trading cost,     the opening and closing sessions. Coupled        who want to increase the efficiency of
the next question that arises is how do the    with the drop in the spread from 11 am to        securities markets.
Indian financial markets compare with the      2 pm that we document in our LOB analy-          (d) Stock exchanges can become more
developed western markets in providing         sis, we conclude that the familiar U-shaped      competitive and attract more investors for
the investor a good “deal” in terms of a       pattern of intra-day spreads is evident in       trading, and more firms for listing their
lower bid-ask spread? While this question      the Indian equity markets making it              stocks, once they are aware of the dynamics
is of enormous importance to investors, the    more sensible to trade in the middle of          of trading costs.
lack of real time trading data did not allow
any scientific investigation of this issue
until recently. We examine this question
using data from the NSE for all stocks
                                                                           EPW CD-ROM 2005
traded in March 2004. We find that the            The digital version of Economic and Political Weekly is now available for 2005
average (rupee) spread based on all trades        on a single disk.
for all stocks listed on the NSE is Rs 2.17,
which is about 3.2 per cent of the average        This electronic edition contains the complete content of all the issues published
                                                  in 2005. The CD-ROM 2005 comes equipped with a powerful search as well
price. This is much larger than the average
                                                  as utilities to make your browsing experience productive. The contents are
percentage spreads observed in inter-             indexed and organised as in the print edition, with articles laid out in individual
national markets such as the NYSE and             sections in each issue. Users can browse through the sections or use the
NASDAQ. Comparing this to the tick                sophisticated search facility to locate articles and statistics of interest.
size of Re 0.05 (same across all stocks
as per NSE regulations), the spread to tick       Price for CD-ROM 2005 (in INDIA)
                                                  Individuals – Rs 220 (Rs 200 plus postage and handling charges of Rs 20)
ratio is 43.4, which is again large
                                                  Institutions – Rs 420 (Rs 400 plus postage and handling charges of Rs 20)
by international standards. By contrast, the
median spread is only Re 0.72. Thus, a            International – US$ 40 (including airmail postage)
significant part of this unusually high           Also available 2003 and 2004 on two separate CDs, individual CD price
spread can be attributed to stocks with low       as above
trading volumes. Rupee trading volume is
                                                  Any queries please email: circulation@epw.org.in
extremely skewed with the mean =
Rs 62,545,287 and the median = Rs 96,802.         To order the CD-ROMs (please specify the year) send a bank draft payable
Stocks with higher trading volumes have           at Mumbai in favour of Economic and Political Weekly to:
lower spreads, even after controlling for                                  Circulation Manager,
share price.                                                          Economic and Political Weekly
   An important development in the stock            Hitkari House, 284 Shahid Bhagatsingh Road, Mumbai 400 001, India
markets is the supreme transparency of the


Economic and Political Weekly         November 18, 2006                                                                               4721
   A firm’s trading characteristics such as
higher trading volume, number of trades,
and its market value reduce trading costs.
That is because the increased volume and
number of trades makes it more likely to
locate a counterparty to trade and also
reduces the necessity of holding a large
and expensive inventory for very long.
Larger capitalisation firms have more
information, reducing uncertainty and
hence have a lower spread. A stock’s return
variance is positively related to its spread,
mostly for information reasons. Apart from
trading characteristics, the informational
environment of a firm also affects the
spread. Earnings announcements’ periods
impact the bid-ask spread by increasing
the adverse selection component of the
spread. Similarly, one should expect in-
creases in trading costs around corporate
information events: e g, stock repurchases
and corporate acquisition announce-
ments. Finally, trading mechanisms and
market design also impact the spread.
Higher tick size also increases the spread.
Spreads in specialist markets (like the
NYSE) are smaller than in dealer markets
(such as the NASDAQ). All these docu-
mented empirical regularities regarding
the bid-ask spread are a testimonial to the
fact that this is arguably the single-most
important metric that captures trading
costs. Our characterisation of the magni-
tude and intra-day patterns of the bid-ask
spread for stocks trading in the Indian
financial markets documents is that there
is ample scope for improving liquidity
and providing investors a better (lower
cost) deal. EPW

Email: bidisha.chakrabarty@gmail.com

Note
[This article is a summary of the findings of a
study that the authors conducted under the
NSE’s Research Initiative and the authors
acknowledge the NSE’s grant. The complete
article can be found at http://www.nseindia.com/
content/research/comppaper128.pdf. Chakrabarty
acknowledges financial support from the John
Cook Business School and Jain acknowledges
financial support from the Morgan Keegan
Professorship.]

1 Some brokers will give you a direct percentage
  while others levy a fixed amount per Rs 100.
  For example ICICI direct charges 0.75 per
  cent per transaction and India Infoline,
  0.5 per cent. Sharekhan charges 50 paise per
  Rs 100 and Motilal Oswal charges 40 paise per
  Rs 100.


4722                                               Economic and Political Weekly   November 18, 2006

								
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