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Are You Getting a Good Deal?

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.

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, PANKAJ K JAIN

T
he Indian stock market has grown by more than seven times between 1990 and today, which translates into a return of over 18 per cent per annum, adjusted for inflation. This phenomenal growth has been facilitated, in no small measure, by the move away from open outcry trading on exchange floors to the introduction of internet-based online trading. A pioneer of this change has been the National Stock Exchange (NSE) of India, with its introduction of the completely automated trading platform that removes the need for floor brokers and allows anonymous investors to directly trade with each other. This change in trading technology has greatly affected the competitive structure and institutional design of the stock trading industry. All investors have equal and fair access to the markets through its online trading platform based on a forward looking satellite communication technology, which represents the industry’s best practice in India and the world. Separation of ownership, management, and trading participants on NSE has removed the potential for conflict of interest and perverse incentives of seat-holding brokers, which were otherwise common in many exchanges. This has a fundamental influence on market conditions and the price formation process. An optimal investment strategy ought to take into account the nuances of this mechanism.

How Trading Costs Work

One profound change brought about by the NSE is in the area of trading costs. Trading costs have a direct bearing on net investment returns, particularly for frequent traders. The explicit commissions, brokerage fees, and exchange fee are one part of it. The more tricky counterparts are the implicit costs such as price impact and bid-ask spread. Bid-ask spread (the difference between the lowest selling price and highest buying price for a stock) represents the (variable) cost that an investor pays for a (round trip) trade. It is the wedge between the price that an investor pays as a buyer and the price that she receives as a seller. Thus, the magnitude of the spread is an important decision variable that an investor considers in choosing a trading venue, as well as the stocks to buy/sell. It also represents the friction in financial markets and measures the difficulty with which an asset is traded. For example, consider the following situation: On October 21, 2005, Reliance is quoted at Rs 772.80 ask (the price at which an investor can buy one share) and Rs 770.40 bid (the price at which an investor can sell one share). The bid-ask spread for Reliance is Rs 2.40. If the investor wants to transact 1,000 shares, the spread will amount to Rs 2,400. Assume the broker commission for one round trip (one buy plus one sell) trade is Rs 100;1 the cost for one round trip transaction is Rs 2,500. Some brokers pass on the service tax (10.2 per cent of the brokerage fee) on to investors, and in that case it adds another Rs 10.20 to the cost. Adding all that up, a Rs 7,71,600 investment in Reliance incurs a total cost of approximately Rs 2,510.20. Now, if the investor has a long-term buy and hold strategy, the spread is only incurred once. For daytraders who buy and sell several times a day, the costs multiply accordingly. It follows, that the bid-ask spread is a big factor determining the demand for and supply of a stock.

One factor affecting the spread is the “tick size” that an exchange mandates. The tick size is the minimum price increment

Economic and Political Weekly November 18, 2006

for a stock. The prevailing tick size on the NSE is Re 0.05. Thus, a stock that is trading at Rs 90.10 cannot see its next trade price as, say, Rs 90.13. The smallest step change has to be Rs 90.15 or Rs 90.05. It is clear then that if an exchange mandates a higher tick size than a competing exchange for the same stock, it de facto sets a floor on the stock’s spread, thus increasing the trading cost. The trading platform and supervisory regime that an exchange offers impacts the bid-ask spread for a stock. Research has shown that firms with higher quality disclosures have lower bidask spreads. The ownership concentration of a firm also impacts the spread of its stock – concentrated or pyramid shareholding has been shown to widen a stock’s bid-ask spread. These factors affect the availability of capital and thus, economic growth.

Are You Getting a Good Deal?

Once we acknowledge the importance of the spread as a metric of trading cost, the next question that arises is how do the Indian financial markets compare with the developed western markets in providing the investor a good “deal” in terms of a lower bid-ask spread? While this question is of enormous importance to investors, the 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 traded in March 2004. We find that the average (rupee) spread based on all trades for all stocks listed on the NSE is Rs 2.17, which is about 3.2 per cent of the average price. This is much larger than the average percentage spreads observed in international markets such as the NYSE and NASDAQ. Comparing this to the tick size of Re 0.05 (same across all stocks as per NSE regulations), the spread to tick ratio is 43.4, which is again large by international standards. By contrast, the median spread is only Re 0.72. Thus, a significant part of this unusually high spread can be attributed to stocks with low trading volumes. Rupee trading volume is extremely skewed with the mean = Rs 62,545,287 and the median = Rs 96,802. Stocks with higher trading volumes have lower spreads, even after controlling for share price.

An important development in the stock markets is the supreme transparency of the limit order book both in real time and on a historical basis. Research shows that investors use real time information to strategically submit their orders. For example, when information uncertainty is high (for example around earnings announcements), investors who have private information want to trade larger quantities. Thus, knowing the intra-day patterns of trading in the market can help individual investors time their trades better. Regulators can conduct an audit trail using the historical information, which in turn improves market quality.

We investigate intra-day patterns of the bid-ask spread in the NSE. Using snapshots of the state of the market taken four times a day at 11:00, 12:00, 13:00 and

14:00 hours yield the median bid-ask spread in the limit order book (LOB) of Re 0.45, which is 0.77 per cent of the median LOB price. Since the LOB snapshots are not collected for the opening and closing sessions of the market, lower LOB spreads, compared to estimated spreads, are consistent with spreads being higher during the opening and closing sessions. Coupled with the drop in the spread from 11 am to 2 pm that we document in our LOB analysis, we conclude that the familiar U-shaped pattern of intra-day spreads is evident in the Indian equity markets making it more sensible to trade in the middle of the trading period when the order book is thick.

In our judgment, the knowledge of these patterns can benefit four different groups of market participants: investors, firms, regulators, and the stock exchange management.

  • (a) Liquidity and transactions costs directly affect the investors’ net returns from their equity portfolios. Transaction costs also influence the portfolio selection strategy of investors if they can pick stocks with low spreads among comparable alternatives.
  • (b) Firms’ listing choice can possibly take these costs into account. Although, the listing fee of a particular exchange is the direct cost paid by the firm, a much more important (indirect) issue is the liquidity in a firm’s stocks. Improved liquidity can potentially reduce the cost of equity for listed firms. Further, as has been explained before, the bid-ask spread is arguably the most important metric that captures liquidity.
  • (c) Results of this study will also help achieve the policy goals of lawmakers who want to increase the efficiency of securities markets.
  • (d) Stock exchanges can become more competitive and attract more investors for trading, and more firms for listing their stocks, once they are aware of the dynamics of trading costs.
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    Economic and Political Weekly November 18, 2006

    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 increases in trading costs around corporate information events: e g, stock repurchases and corporate acquisition announcements. 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 documented 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 magnitude 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.

    Economic and Political Weekly November 18, 2006

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