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CFA Level 3 > 16-30 Execution > Flashcards

16-30 Execution Flashcards

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CFA flashcards
0
Q

Formula.

Effective spread for a sell order

A

= 2 x ( Midquote - Execution price)

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1
Q

Formula.

Effective Spread for a buy order

A

Effective Spread for buy order
= 2 x (Execution price - Midquote)

Midquote is average of inside bid and inside ask

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2
Q

What is an Effective Spread?

A

The true cost of a round-trip transaction (supposedly a better measure than the quoted bid-ask spread).

If lower than the quoted spread, indicates better liquidity for a security or superior (i.e. lower cost) execution

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3
Q

Purpose of securities markets

A

Provide liquidity, transparency and assurity of completion

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4
Q

4 types of securities markets

A
  1. Quote driven market
  2. Order driven market
  3. Brokered market
  4. Hybrid market
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5
Q

3 Types of Order-Driven Market

Characteristics of each

A
  1. Electronic crossing network
    - institutional trades
    - guarantees anonymity
    - no price discovery so prices can’t adjust according to supply and demand
    - low liquidity so leads to unfilled orders
    - trades at one point in time
  2. Auction market
    - trades at one moment or throughout day
    - provides price discovery so more filled orders
  3. Automated auction market (i.e. electronic communication network or electronic limit-order market)
    - provides anonymity
    - provides price discovery
    - trades throughout day
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6
Q

Characteristics of Broker’s agency relationship (fiduciary duty) with Trader

A
  • Represent order and advise trader
  • Find counterparty to trade
  • Provide market information
  • Provide anonymity
  • Other services like safe keeping of security and cash management (but not liquidity)
  • Support market (i.e. helps market function)
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7
Q

3 characteristics of liquid market

A
  1. small bid-ask spread (lets traders find capital cheaply and quickly)
  2. depth (market can accept large volume trades without much price impact)
  3. resilience (deviations from intrinsic prices are minimized quickly)
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8
Q

Factors necessary to have a liquid market

A
  • Abundance of buyers and sellers
  • Diverse investor base with diverse needs and information
  • Convenient place to trade
  • Market integrity which means all investors are treated fairly
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9
Q

Components of execution costs: explicit and implicit

A
  1. explicit cost
  2. implicit cost
    - market impact cost
    - delay cost
    - opportunity cost
    - bid-ask spread
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10
Q

Potential benchmarks for implicit costs

A
  • midquote
  • VWAP
  • opening and closing prices
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11
Q

What is VWAP

Formula

A

Weighted average of execution prices during a day where weights are proportion of day’s trading volume (% of number of shares traded that day)

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12
Q

4 Advantages of VWAP

A
  • easily understood
  • computationally simple
  • can be applied quickly to make trading decisions
  • most appropriate for comparing small trades in nontrending markets
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13
Q

4 disadvantages of VWAP

A
  • not informative for traders that dominate trading volume
  • can be gamed by traders
  • doesn’t evaluate delayed or unfilled orders
  • doesn’t account for market movements or trade volume
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14
Q

5 advantages of Implementation Shortfall

A
  • not subject to gaming by traders
  • decomposes and identifies costs
  • can see cost of implementing ideas
  • shows trade off between quick execution and market impact
  • can use to optimize trading costs and performance
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15
Q

2 disadvantages of Implementation Shortfall

A
  • unfamiliar to some traders

- requires considerable data and analysis

16
Q

Describe 4 components of Implementation Shortfall

Include formulas

A
  1. Explicit cost = commissions or fees
  2. Market impact cost = I EP - DP or BP*I x shares executed = impact on market of seeking quick execution
  3. Opportunity cost aka missed trade aka unrealized profit/loss = I CP - DP I x shares cancelled = change in market price on any part of order never executed
  4. Delay cost = I BP* - DP I x shares later executed = change in market price if order is not executed quickly on shares later executed
17
Q

What is Market-adjusted implementation shortfall?

Formula

A

IS removed of the effect of the return on the market, i.e., post-trade IS

= IS - expected return on market

If negative, it’s a benefit to the portfolio and the shortfall is actually negative

18
Q

What is an econometric model?

A

A model used to forecast transaction costs using market microstructure theory

19
Q

Based on the Econometric model, trading costs are nonlinearly related to 5 factors:

A
  • security’s liquidity
  • risk
  • trading style (more aggressive trading results in higher cost)
  • size of trade relative to liquidity
  • momentum (e.g. it’s more costly to buy when market is trending up)
20
Q

4 types of traders based on motivation to trade, time vs price preferences and preferred order types

A

1 information-motivated traders (time-sensitive info, time preference, market order)

  • have time sensitive information so need to trade quickly before value of info expires
  • prefer quick trades and large block size with guarantee of execution, so willing to bear higher trading cost
  • timing cost low but market impact cost high

2 value motivated traders (security misvaluations, price preference, limit order)

  • uncovered mispricings through research and analysis
  • prefer to parcel out large block trade and wait for market to come to them
  • market impact cost low but timing cost high - may take a long time to execute

3 liquidity motivated traders (realloc & liquidity, market order, crossing networks and electronic communication networks)

  • need to convert securities to cash or reallocate portfolio from cash
  • often are counterparts to information motivated or value motivated traders
  • ant to execute within a day
  • timing cost low but market impact cost high

4 passive traders (realloc & liquidity, limit order, crossing networks)

  • trading to convert to cash or allocate cash
  • similar to liquidity motivated traders but more focused on reducing costs so can afford to be patient
21
Q

5 trading tactics

  • strengths
  • weaknesses
  • usual trade motivation
A

Liquidity-at-any-cost

  • quick, certain execution
  • high cost and leakage of information
  • information

Costs-are-not-important

  • quick, certain execution at market price
  • loss of control of trade costs
  • variety of motivations

Need-trustworthy-agent

  • broker uses skill and time to obtain lower price
  • higher commission and potential leakage of trade intention
  • not information

Advertise-to-draw-liquidity

  • market-determined price
  • higher admin costs and possible front running
  • not information

Low-cost-whatever-the-liquidity

  • lower trading costs
  • uncertain timing of trade and possibly trading into weakness
  • passive and value

CFA Level 3 (8 decks)

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