Finacial poster

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.

So, if you are an entrepreneur who wants to start a company, what can you do to reduce the expected cost of capital? The answer is that it is in your interest to disclose to the lender all the information you can, provided you are the type of entrepreneur who is likely to pay back the loan. You want to reduce the lender’s doubt about future repayment. Unfortunately, this can be very difficult. The lender can neither peer into your brain, nor give you a good lie detector test. Attempts to convey information credibly in the real world are many, but there will always be residual information differences—they are just a fact of life. Still, if you can reduce the information differences, your firm will be able to enjoy lower costs of capital. Also, if you as borrower fail to give your best try to convince the lender of your quality, then the lender should not only assume that you are an average company, but instead assume you are the very worst—or else you would have tried to communicate as much as possible.
There are at least three important mechanisms that have evolved to alleviate such information differences. The first mechanism is covenants, which specify upfront what a debtor must do to maintain credit. This can include such requirements as the maintenance of insurance or a minimum corporate value. The second mechanism is collateral—something that the creditor can repossess if payments are not made. But anything that inflicts pain on the debtor will do. For example, if defaulting debtors were thrown into debtor’s prison (as they often were until the 19th century), the promise to repay would be more credible and lenders would be more inclined to provide funding at lower rates. Of course, for the unlucky few who just happened to suffer incredibly bad luck ex-post, debtors’ prison has some definite drawbacks.
The third mechanism to alleviate repayment uncertainty are credit rating agencies, which keep a history of past payments to help assess the probability of future default. This is why you need to give your social security number if you want to take out a substantial personal loan—the lender will check up on you. The same is true for large corporations. It may be easier to judge corporate default risk for large companies than personal default risk, but it is still not easy and it costs both time and money. The two biggest bond credit rating agencies for corporations are Moody’s and Standard&Poors. (The other two are Duff and Phelps and Fitch.) For a fee that the corporate borrower pays, they will rate the bond’s quality, which reflects the issuer’s probability that the bonds will default. This fee depends on a number of factors, such as the identity of the issuer, the desired detail in the agencies’ investigations and descriptions, and the features of the bond (e.g., a bond that will pay off within one year is usually less likely to default before maturity than a bond that will pay off in thirty years; thus, the former is easier to grade). The credit rating agencies ultimately do not provide a whole set of default probabilities (e.g., 1% chance of 100% loss, 1.2% chance of 99% loss, etc.), but just an overall rating grade. It is up to the ratings’ reader to translate the rating into an appropriate compensation for default risk. The top rating grades are called investment grade, while the bottom grade are called speculative grade (or junk).
There is often a sharp difference in quoted interest rates between the worst investment grade bond and the best speculative grade bond, partly also because many investing institutions are allowed to hold only investment grade bonds.
So, is there a difference between bonds of different rating quality? Yes! Altman studied corporate bonds from 1971 to 2003 and reported default and recovery rates. Very few investment grade bonds default—and especially right after issue when they would have still carried the original credit rating. However, many speculative bonds will eventually miss at least one coupon payment (which is considered default). Upon default, an AAA or AA bond price was worth about 75 cents on the dollar; an A bond price was worth about 50 cents on the dollar; and lower rated bonds were worth about 30 cents on the dollar.
Unfortunately, although bond rating agencies will update their rating if the condition of the firm changes, the empirical evidence suggests that these bond ratings are not very good in helping an investor earn superior rates of returns. In fact, the ratings seem to respond more to drops in the value of the underlying bonds than vice-versa. The bond rating agencies seem to be more reactive than proactive.
How do bond ratings translate into differences in promised (quoted) bond yields? lists the borrowing rates of various issuers in May 2002. (Many other current interest rates can be found at www.bloomberg.com/markets/rates/index.html and bonds.yahoo.com/rates.html.) Most of the differences between these borrowers’ promised interest rates and Treasury interest rates are due to default risk, which compensates lenders for differential default probabilities.