Colombo Stock Exchange | Measuring Liquidity Using Impact Cost

Measuring Liquidity Using Impact Cost

Impact Cost

Introduction to Liquidity

Liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular security without causing a significant movement in the price.

In a liquid market investors will be able to buy or sell a large amount of securities immediately, at a price close to the observed price. There are several measures to evaluate liquidity. Some of the liquidity measures are as follows.

Bid Ask Spread
Trading Volume
Trading Frequency
Quote Size
Trade Size
Impact Cost

However, the measures are not equally effective, and each has its advantages and disadvantages. Impact cost (IC) is the most practical and operational measure of liquidity.

Impact cost

Impact cost can be defined as the percentage change between the average execution price and Ideal price (average of best buy and best sell). It tells us that how much extra we have to pay if market is not perfectly liquid.

The lower the cost, the higher the liquidity and vice-versa. It shows the rise/fall in the stock price (in percent) against buying/selling the desired quantity of security compared to its ideal price. Impact cost can be calculated for both Buyer side and Sellers side. In a perfect market impact cost for any quantity size, should be close to 0.

Impact cost value can be calculated as follows.

For decision-making CSE assumed that securities, which have an impact cost of less than 2% for an average trade size is liquid.

Advantages of Impact Cost

Impact cost captures trade size information as well as price information. This measure provides ex ante (prior to trade) information on the price change at any point of trading time.

Calculate the Impact Cost

E.g. To calculate impact cost of a security, snapshot of a particular security's order book at a particular time is taken.

Suppose an Investor wants to buy 1000 shares. What is the impact cost?

Buy Order Book		Sell Order Book
Quantity	Price	Quantity	Price
700	83	800	84
1200	82	1500	85
100	80	200	90

Ideal price = (Best Buy Price + Best Sell Price)/ 2

Ideal Price = (83+84)/2 = 83.50

Calculate Average Execution Price for 1000 shares

Calculate Average Execution Price
Quantity	Price	Value
800	84	67200
200	85	17000
Average Execution Price		84.20

It means you incurred a cost of 0.84 percent to buy 1,000 shares because of the liquidity conditions in that stock.

Similarly Impact Cost for seller side (using buy order book) can be calculated.

Sellers Average Execution Price for 1000 shares = (700*83+300*82)/1000=82.7

Sellers Impact Cost for 1000 shares = (82.7-83.50)/83.50*100
= -0.958%

Methodology to Calculate Impact Cost for one-month period

For the purpose of computation of impact cost, eight snapshots at different times are taken everyday of the month being considered from the order book in the capital market segment for all securities (snapshots at 30 minute time gap starting from 10:00 am)
Impact cost is calculated separately for the buy side and the sell side for each snapshot's different trade sizes
Where sufficient number of shares are not available on either the buy side or the sell side in a snapshot, the impact cost for such observations are given a penalty value which is equal to the maximum impact cost of that security's particular size
in that month and plus 5%.
The buy side impact cost (or sell side impact cost) is the simple average of the buy side impact cost (or sell side impact cost) computed for all the snapshot observations in the month.
To get a general idea about liquidity of securities the Average Impact Cost has been calculated.