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Definition of 'Impact Cost'


Definition: Impact cost is the cost that a buyer or seller of stocks incurs while executing a transaction due to the prevailing liquidity condition on the counter. In other words, it represents the cost of executing a transaction of a given security, with a specific predefined order size, at any given point in time.

Description: It is a realistic measure of liquidity of the stock or security and is deemed to be closer to the true cost of execution faced by a trader in comparison to the bid-ask spread (difference between the best buy and the best sell orders). It is the percentage markup observed while buying or selling a desired quantity of shares with reference to its ideal price.

The ideal price can be illustrated by an example.

Suppose a buyer wants to purchase 3,000 shares of, say, ABC. If the best buy order for 1,000 shares is placed at Rs 237 and the best sell order for 1,500 shares is placed at Rs 239, the ideal price for the deal should be:

(239+237)/2 = Rs 238

At this price, one can expect the buyer to ideally get the desired quantity of ABC shares.



But suppose that the buyer was able to buy 3,000 ABC shares at an average cost of Rs 239.67 (see the above table)

Average cost: [(1500x 239) + (1000 x 240) + (500 x 241)]/3000

Or (3,58,500+ 2,40,000+ 1,20,500)/3000 = 239.83

The impact cost, therefore, would be 0.70 per cent. To find the impact cost, the formula is:

(Actual cost - ideal cost)/ideal cost*100 (#)

In our example, the ideal price is Rs 238, but the average acquisition price for that buyer is Rs 239.67.

By formula (#), the impact cost should thus be:

(239.67 - 238)/239.67*100 = 0.70

This is a cost that the buyers incur due to lack of market liquidity. The importance of impact cost can be judged from the fact that it is one of the criteria to select a stock for inclusion in the NSE’s benchmark index Nifty50.

For a stock to qualify for possible inclusion into Nifty50, it has to have traded at an average impact cost of 0.50 per cent or less during the last six months for 90 per cent of the observations for a basket size of Rs 2 crore.

It must be note that impact cost does vary for different transaction sizes. It is dynamic in nature and depends on the outstanding orders. Lastly, a penal impact cost is applicable if a stock is not sufficiently liquid.
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