Question

Scenario:

The New York Stock exhange impose a fee of $.0025 per share in addition to all existing fees and costs of on all transactions carried out on exchange.

Question:

Suppose Rabbit Inc. now trades for 24 1/8 bid, 24 1/4 asked. While Turtle Inc. trades at 25 3/4 bid 27 asked. What differnces would you observe between investors holding Rabbit Inc. and those holding Turtle Inc.? Which of these two securities would find its returns most affected by the additional cost of trading? (explain)

Answer 1

What differnces would you observe between investors holding Rabbit Inc. and those holding Turtle Inc.?

Rabbit Inc now trades at 24 1/8 bid and 24 1/4 ask = (24*1/8) bid and (24*1/4) ask = 24.125 bid and 24.250 ask. (For understanding purposes, bid price referes to the price that buyers in the market are willing to pay and the ask price is the price that sellers are willing to sell).

The spread (Ask - bid) for Rabbit Inc. is at 0.125 (24.250-24.125)

Turtle Inc now trades at 25 3/4 bid and 27 ask = (25*3/4) bid and 27 ask = 25.75 bid and 27 ask.

The spread (Ask - bid) for Turtle Inc. is at 1.25 (27-25.75).

The spread of Turtle Inc at 1.25 is wider than that of Rabbit Inc at 0.125. This indicates that Turtle Inc stocks are thin and not liquid and hence market makers would want to compensate themselves by higher ask rate for assuming the risk of holding low-volume securities. Thus, the investors who would have bought will find it difficult to sell (as the spread gap is wide) and hence tend to hold the stocks for long.

On the other hand,Rabbit Inc stocks have a normal spread and hence are active and have high liquidity.Thus investors who would bought this stock can find buyers frequently and hence can trade more on the stock and need not hold the stocks for long.

Introduction of trasaction costs

If the Newyork stock exchange impose additional transactional fee of $.0025, this would further increase the spread gap.This is because, to absorb this additional cost, the buyer would further lower the bid price and seller will increase the ask price resulting in the spread becoming more wider.

Since the spread of Turtle Inc is already wider, introduction of this additional transactional fee will impact Turtle more as the wider spread will further reduce the stock price and its returns.