Similarly, financial markets transactions also incur transaction costs. If an investor wants to buy or sell shares of a stock, the broker charges a fee, as does the stock exchange that facilitates the transaction. In addition, investors have to consider their time to communicate with the broker to initiate the purchase or sale of a stock as an (opportunity) cost.
Brokerage and Market-Maker Commissions, direct costs: Still, the transaction costs for selling . financial instruments are much lower than they are for most other goods. Let’s look at a few reasons why. First, even if you want to buy (or sell) $1 million worth of stock, some Internet brokers now charge as little as $10 per transaction. Your round-trip transaction, which is a buy and a sale, costs only $20 in broker’s commission. In addition, you have to pay the spread (the difference between the bid and the ask price) to the stock exchange. For example, a large company stock like PepsiCo (ticker symbol PEP) may have a publicly posted price of $50 per share. But you can neither buy nor sell at $50. Instead, the $50 is really just the average of two prices: the bid price of $49.92, at which another investor or the exchange’s market-maker is currently willing to buy shares; and the ask price of $50.08, at which another investor or the exchange’s market-maker is currently willing to sell shares. Therefore, you can (probably) purchase shares at $50.08 and sell them at $49.92, a loss of “only” 16 cents which amounts to round-trip transaction costs of ($49.92 − $50.08)/$50.08 ≈ −0.32%. You can compute the total costs of buying and selling 20,000 shares ($1,000,000 worth) of PepsiCo stock as This is not exactly correct, though, because the bid and ask prices that the exchange posts (e.g., on Yahoo!Finance or the Wall Street Journal ) are only valid for 100 shares. Moreover, some transactions can occur inside the bid-ask spread, but for most large round-trip orders, chances are that you may have to pay more than $50.08 or receive less than $49.92. So 0.32% is probably a bit too small. (In fact, if your trade is large enough, you may even move the publicly posted exchange price away from $50!) Your buy order may have to pay $50.20, and your sell may only get you $49.85. In real life, the true round-trip transaction cost on a $1 million position in PEP is on the order of magnitude of 50 basis points.
The above applies primarily to a market order, in which you ask your broker to buy or sell at the prevailing market price. A limit order can specify that you only wish to buy or sell at $50.00, but you are patient and willing to take the chance that your order may not get executed at all. There is a common belief that limit orders are “cheaper” in terms of transaction costs, but also “riskier.” For example, if you have a standing limit order to buy at $50, and the company reveals that it has managed earnings, so its value drops from $51 to $20, your limit order could still easily execute at $50.
Indirect and Opportunity Costs: Investors do not need to spend a lot of time to find out the latest price of the stock: it is instantly available from many sources (e.g., from the Internet such as Yahoo!Finance). So, the information research costs are very low: unlike a house, the value of a stock is immediately known. Finally, upon demand, a buyer can be found practically instantaneously, so search and waiting costs are also very low. Recall the often multi-month waiting periods if you want to sell your house.
Compare the financial securities transaction costs to the transaction costs in selling a house.Broker fees alone are typically 6%: for the $100,000 equity investment in the $500,000 house, this comes to $30,000 for a round-trip transaction. Add the other fees and waiting time to this cost and you are in for other transaction costs, say, another $10,000. And houses are just one example: Many transactions of physical goods or labor services (but not all) can incur similarly high transaction costs.
In contrast, if you want to buy or sell 100 shares in, say, Microsoft stocks, your transaction costs are relatively tiny. Because there are many buyers and many sellers, financial transaction costs are comparably tiny. Even for a $100,000 equity investment in a medium-sized firm’s stock, the transaction costs are typically only about $300–$500. To oversimplify, this blog will make the incorrect, but convenient assumption that financial transaction costs are zero (unless otherwise described). For individuals buying and selling ordinary stocks only rarely (a buy-and-hold investor), a zero transaction cost assumption is often quite reasonable. But if you are a day trader—someone who buys and sells stocks daily—you better read another blog!
Inflation admin
We have now discussed all violations from the assumptions necessary for our perfect market Utopia. So, what are we doing now? If you return to our perfect markets assumptions, you will see that “no inflation” was not among them. Inflation is the process by which goods cost more in the future than they cost today—in which the price level is rising and money is losing its value.
So, inflation is actually not a market imperfection per se. If today we quoted everything in dollars, and tomorrow we quote everything in cents—so that an apple that cost 1 currency unit today will cost 100 currency units tomorrow, an inflation of 10,000%—would it make any difference? Not really. The apple would still cost the same in terms of foregone other opportunities, whether it is 1 dollar or 100 cents.
However, we have made a big assumption here—inflation applied equally to everything, and especially applied equally to all contracts across time. See, if you had contracted to deliver apples at 1 currency unit tomorrow, whatever currency units may be, you could be in big trouble—you would have promised to sell your apples at 1 cent (1 currency unit) instead of $1. Most financial contracts are denominated in such “nominal” terms—that is, in plain currency units—so inflation would matter. Of course, inflation would not be much of a concern for a financial contract that would be “inflation-indexed.”
What effect does inflation have on returns? On (net) present values? This is the subject of this post. As before, we start with interest rates and then proceed to net present values.