## **Learning Outcomes**

This article explains how bid-ask spreads, market impact, and slippage generate and interact as trading costs within real-world market microstructure, including:

- distinguishing explicit versus implicit transaction costs and linking each category to specific CFA curriculum examples  
- computing quoted and effective bid-ask spreads, expressing them in percentage terms, and interpreting what they imply about liquidity and dealer behavior  
- decomposing the spread into order-processing, inventory-risk, and adverse-selection components and relating these to market conditions  
- defining market impact and slippage precisely, contrasting them with commissions and fees, and identifying when each cost is most significant  
- applying simple calculations to quantify market impact and slippage from trade data, such as arrival price, execution prices, and VWAP benchmarks  
- evaluating how order size, trading urgency, and choice of market versus limit orders affect realized execution prices and implementation shortfall  
- assessing practical execution techniques—order slicing, algorithmic trading, use of dark pools, and timing of trades—to minimize total transaction costs while maintaining best execution obligations.

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand how transactions costs affect trade execution and portfolio performance, with a focus on the following syllabus points:

- Describe the components of transaction costs, distinguishing between explicit and implicit costs
- Explain how the bid-ask spread is computed and decomposed into primary sources
- Identify the effects of market impact and slippage on realized trade prices
- Evaluate and compare the effects of trading strategies and execution methods on overall trading costs
- Apply transaction cost analysis to evaluate best execution and cost minimization

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What are the two main sources of implicit trading costs in financial markets?
2. How is the quoted bid-ask spread calculated, and what are its main components?
3. Define market impact and explain how it differs from slippage.
4. If a buy order for 10,000 shares is executed in multiple trades, each at a higher price, what type of cost is being observed?

## **Introduction**

Efficient portfolio management and performance assessment require a clear understanding of trading costs in real-world markets. The difference between what an investor wants to transact at and the final net result often comes down to microstructure effects—specifically, the bid-ask spread, market impact, and slippage.

These costs—some visible, others less obvious—affect realized investment performance and are essential for trade strategy selection and best execution. This article examines how each cost arises, how to measure them, and practical implications for exam candidates.

## **Transaction Cost Components: Explicit vs Implicit Costs**

A trading desk faces both direct and indirect costs when executing orders.

> **Key Term: explicit transaction cost**
> The visible, easily-measured costs of trading, such as commissions, exchange fees, and taxes.
>
> **Key Term: implicit transaction cost**
> The hidden costs of trading—comprising the bid-ask spread, market impact, and slippage—that are realized through price movement or execution conditions.

## **Bid-Ask Spread and Its Decomposition**

When a security is traded, buyers pay the ask (offer) while sellers receive the bid.

> **Key Term: bid-ask spread**
> The difference between the lowest offer price (ask) and highest price a buyer will pay (bid) for a security at a given moment.

The size of the spread is affected by:

- Order processing costs (dealer compensation)
- Inventory risks faced by liquidity providers
- Adverse selection (risk that the counterparty has superior information)

Bid-ask spreads may be quoted as an absolute difference or as a percentage of the mid-price:
Bid-ask spread = Ask price – Bid price
Spread % = (Ask – Bid) / Midpoint

## **Market Impact and Slippage**

Large or impatient trades move prices as liquidity is consumed.

> **Key Term: market impact**
> The price movement caused directly by a participant’s own trade, as their order absorbs available liquidity.
>
> **Key Term: slippage**
> The gap between the average price actually achieved on a trade and the price at the time the order was initiated.

These effects are typically more pronounced for large orders, illiquid stocks, or when urgency forces traders to cross the spread multiple times, walking the book.

### **Worked Example 1.1**

A fund manager wants to buy 15,000 shares of SmallCap Ltd, showing a best bid of \$41.90 and an ask of \$42.10. The manager submits a buy order for 15,000 shares, filling:

- 4,000 at \$42.10
- 6,000 at \$42.20
- 5,000 at \$42.40

> **Answer:**
> The average price paid is higher than the initial ask (\$42.10). The manager paid up to \$42.40 due to the market impact of absorbing available liquidity, and the additional cost over the initial ask is recorded as market impact and slippage.

## **Sources of the Bid-Ask Spread**

Liquidity providers (dealers or market makers) quote spreads to compensate for risk and effort. The spread includes:

- Processing costs (administration, technology)
- Inventory risk premium (price fluctuation during inventory holding)
- Adverse selection (risk of trading against more informed or urgent counterparties)

During times of high volatility or low liquidity, dealers widen spreads to manage these risks. In active, large-cap stocks, competition and high turnover result in tighter spreads.

### **Worked Example 1.2**

The best quoted bid for a bond is \$99.80. The best ask is \$100.00. A client wants to buy and then immediately sell 500 bonds.

- What is the round-trip transaction cost per bond?

> **Answer:**
> The round-trip spread per bond is \$0.20. The investor pays \$100.00 to buy and could only sell at \$99.80, losing \$0.20 for each bond round-trip before any external fees.

## **Market Impact: Order Size and Execution Urgency**

Market impact depends on:

- Order size relative to average daily volume
- Market depth and liquidity (number of orders at best prices)
- Execution urgency (market vs limit order)

Traders minimize market impact by breaking orders into smaller pieces, using limit orders, or executing over longer periods. However, excessive order breaking can lead to information leakage and adverse price drift.

### **Worked Example 1.3**

A trader must sell 50,000 shares of a thinly-traded stock. They place market orders in blocks of 2,500 shares each over the day, causing the price to fall with each execution.

- What cost is this trader incurring?

> **Answer:**
> Each block pushes the price down, so the trader observes negative price movement due to their own actions—market impact is the realized cost of each block transacted below the initial price.

## **Slippage Calculation**

Slippage can be measured relative to:

- The last traded price before the order was submitted (“arrival price”)
- The average expected execution price
- A benchmark price (such as VWAP, Volume Weighted Average Price)

Slippage is positive for more favorable executions and negative (a cost) when trades are filled at less advantageous prices.

### **Exam Warning**

> A common misunderstanding is to consider only explicit trading costs when analyzing transaction efficiency. Implicit costs from market impact and slippage often exceed commissions, especially for large or illiquid trades. Always account for both in CFA exam calculations and written responses.

## **Minimizing Transaction Costs in Practice**

Traders and portfolio managers may:

- Use limit orders instead of market orders when possible
- Break larger trades into smaller lots (order slicing or algorithms)
- Schedule trades during periods of high liquidity
- Seek liquidity providers or dark pools with tighter spreads

However, these strategies may introduce the risk of partial execution or opportunity cost if price moves away during execution.

## **Summary**

Bid-ask spreads, market impact, and slippage together represent the major, often hidden, trading costs faced by investors. Understanding each component, their source, and methods of measurement and minimization is essential for achieving best execution. For the CFA exam, you must be able to decompose and evaluate all transaction cost components and apply that analysis to calculations and strategy decisions.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define explicit and implicit transaction costs and distinguish between them
- Calculate the bid-ask spread and identify main risk sources for liquidity providers
- Explain market impact and its relation to trade size, execution style, and urgency
- Describe slippage and calculate it relative to benchmarks for actual trades
- Evaluate practical methods to minimize bid-ask spread, market impact, and slippage
- Analyze how cumulative trading costs can affect portfolio performance

## **Key Terms and Concepts**

- explicit transaction cost
- implicit transaction cost
- bid-ask spread
- market impact
- slippage

Market microstructure and costs - Bid-ask spread market impact and slippage