How does Perold's implementation shortfall framework measure execution cost?

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AcadiFi · Accepted Answer

Andre Perold's implementation shortfall (IS) measures the total cost of implementing an investment decision: paper portfolio return minus actual portfolio return. It splits into four components. Let decision price = price when PM decided to trade; execution price = average fill price; closing price = price at end of evaluation period; shares desired vs. filled differ when partial. **Four components**: 1. **Delay cost** = (Arrival price − Decision price) × Shares desired. Captures the drift between decision and order submission. 2. **Trading / market impact cost** = (Execution price − Arrival price) × Shares filled. Captures impact during actual execution. 3. **Opportunity cost** = (Closing price − Decision price) × Shares unfilled. Captures missed returns on the unfilled portion. 4. **Explicit costs** = commissions, fees, taxes. ```mermaid flowchart LR A[Decision
Price] --> B[Arrival
Price] B --> C[Execution
Price] C --> D[Close] A -.Delay.-> B B -.Impact.-> C C -.Opp Cost.-> D ``` Example: PM Olenna Farrow decides to buy 100,000 shares at $50 (decision). Order reaches desk at $50.20 (delay 20¢). Fills 80,000 at avg $50.35 (impact 15¢). Remaining 20,000 unfilled; close $51.00 (opp cost $0.80 × 20k). Commissions $400. - Delay: $0.20 × 100k = $20,000 - Impact: $0.15 × 80k = $12,000 - Opportunity: $0.80 × 20k = $16,000 - Explicit: $400 - Total IS: $48,400 on a $5m notional ≈ 97 bps IS is superior to VWAP because it captures opportunity cost — the hidden tax on slow or cautious execution — and anchors to the decision, which is where value was supposed to be created.

How does Perold's implementation shortfall framework measure execution cost?

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