Execution of Portfolio Decisions

Question 1

What is the effective spread for a buy order?

Answer 1

2 x (execution price - midquote)

Question 2

What is the effective spread for a sell order?

Answer 2

2 x (midquote - execution price)

Question 3

What is a quote-driven market?

Answer 3

Investors deal with dealers.

Question 4

What is an order-driven market?

Answer 4

Investors trade with each other without the use of intermediaries.

Question 5

What are the three main types?

Answer 5

1. Electronic crossing network, orders are batched together and crossed (matched) at fixed pints in time during the day at the average of the bid and ask quote.
2. In auction markets, traders orders compete for execution.
3. Automated auctions are computerized auction markets and provide price discovery.

Question 6

What is a brokered market?

Answer 6

Investors use brokers to locate the counterparty to a trade. This is valuable when the trader has a large block to sell.

Question 7

What is a hybrid market?

Answer 7

Have features of both quote-driven and order-driven markets (e.g., NYSE).

Question 8

What is the criteria for market quality?

Answer 8

Liquidity, transparency, and assurity of completion.

Question 9

Describe the qualities of a liquid market.

Answer 9

A liquid market has small bid-ask spreads, market depth, and resilience. Market depth allows larger orders to trade without affecting security prices much. A market is resilient if asset prices stay close to their intrinsic values.

Question 10

Describe a transparent market.

Answer 10

In a transparent market, investors can, without significant expense or delay, obtain both pre-trade information and post-trade information. If a market does not have transparency, investors lose faith in the market and decrease their trading activities.

Question 11

Describe a market that has assurity of completion.

Answer 11

Investors can be confident that the counterparty will uphold their side of the trade agreement.

Question 12

What are the components of explicit trade cost?

Answer 12

Commissions, taxes, stamp duties, and fees.

Question 13

What are the components of implicit trade cost?

Answer 13

Bid-ask spread, market or price impact costs, opportunity costs, and delay costs (a.k.a. slippage cost).

Question 14

What are the opportunity cost of a trade?

Answer 14

When an order is not filled an the security price later moves such that the trader would have profited.

Question 15

What is implementation shortfall?

Answer 15

Implementation shortfall is the difference between the actual portfolio’s return and a paper portfolio’s return. It can be calculated as a total nominal value or as a percentage. It can be broken down into explicit costs, realized profit/loss, delay or slippage cost, missed trade opportunity cost.

Question 16

What are the advantages of Volume-Weighted Average Price (VWAP)?

Answer 16

1. Easily understood.
2. Computationally simple.
3. Can be applied quickly to enhance trading decisions.
4. Most appropriate for comparing small trades in nontrending markets (where a market adjustment is not needed).

Question 17

What are the disadvantages of Volume-Weighted Average Price (VWAP)?

Answer 17

1. Not informative for trades that dominate trading volume.
2. Can be gamed by traders.
3. Does not evaluate delayed or unfilled orders.
4. Does not account for market movements or trade volumes.

Question 18

What are the advantages of Implementation Shortfall?

Answer 18

1. Portfolio managers can see the cost of implementing their ideas.
2. Demonstrates the tradeoff between quick execution and market impact.
3. Decomposes and identified costs.
4. Can be used in an optimizer to minimize trading costs and maximize performance.
5. Not subject to gaming.

Question 19

What are the disadvantages of Implementation Shortfall?

Answer 19

1. May be unfamiliar to traders.

2. Requires considerable data and analysis.

Question 20

Explain the use of econometric methods in pretrade analysis to estimate implicit transaction costs.

Answer 20

Using market microstructure theory, it has been shown that trading costs are nonlinearly related to:

1. Security liquidity: trading volume; market cap; spread; price.
2. Size of the trade relative to liquidity.
3. Trading style: more aggressive trading results in higher cost.
4. Momentum: trades that require liquidity [e.g., buying (selling) when the market is trending upward (downward)].
5. Risk

The analyst uses these variables and a regression equation to forecast the estimated cost of a trade.

Question 21

What are the usefulness of econometric models in pretrade analysis to estimate implicit transactions.

Answer 21

1. Trading effectiveness can be assessed by comparing actual trading costs to forecasted trading cost.
2. It can assist the portfolio managers in determining the size of the trade.

Question 22

Discuss a information-motivated trader’s characteristics based on motivation, time versus price preference, and preferred order type.

Answer 22

Motivation: Trades based on time-sensitive information.
Time versus price preference: Time
Preferred order type: Market order

Question 23

Discuss a value-motivated trader’s characteristics based on motivation, time versus price preference, and preferred order type.

Answer 23

Motivation: Research to uncover misvalued securities.
Time versus price preference: Price
Preferred order type: Limit order

Question 24

Discuss a liquidity-motivated trader’s characteristics based on motivation, time versus price preference, and preferred order type.

Answer 24

Motivation: Transact to convert their securities to cash or reallocate their portfolio from cash.
Time versus price preference: Time
Preferred order type: Market order
Use crossing networks of electronic communication networks.

Question 25

Discuss a passive-motivated trader’s characteristics based on motivation, time versus price preference, and preferred order type.

Answer 25

Motivation: Trade for index funds and other passive investors.
Time versus price preference: Price
Preferred order type: Limit order
Use crossing networks.

Question 26

What are the major trading tactics?

Answer 26

1. Liquidity-at-any-cost
2. Costs-are-not-important
3. Need-trustworthy-agent
4. Advertise-draw-liquidity
5. Low-cost-whatever-the-liquidity

Question 27

Describe the liquidity-at-cost trading focus, evaluate its relative costs, advantages, and weakness.

Answer 27

The trader must transact a large block of shares quickly.
The typical trader is an information trader but can also be a mutual fund that must liquidate quickly to satisfy redemptions.
Must be ready to pay a high price in the form of commissions and market impact.

Question 28

Describe the costs-are-not-important trading focus, evaluate its relative costs, advantages, and weakness.

Answer 28

The trader believes that exchange markets will operate fairly and efficiently such that the execution price they transact at is at best execution. The trader uses market orders.

Question 29

Describe the need-trustworthy-agent trading focus, evaluate its relative costs, advantages, and weakness.

Answer 29

The trader employs a broker to skillfully execute a large trade in a security, which may be thinly traded. The weakness of this strategy is that commissions may be high and the trader may reveal his trade intentions to the broker.

Question 30

Describe the advertise-draw-liquidity trading focus, evaluate its relative costs, advantages, and weakness.

Answer 30

The trade is publicized in advance to draw counterparties to the trade. The weakness of this strategy is that another trader may front run the trade, buying in advance of a buy order.

Question 31

Describe the low-cost-whatever-the-liquidity trading focus, evaluate its relative costs, advantages, and weakness.

Answer 31

The trader places a limit order outside of the current bid-ask quotes in order to minimize trading costs. Passive and value motivated traders will often pursue this strategy.

Question 32

What is algorithmic trading?

Answer 32

Algorithmic trading is the use of automated, quantitative systems that utilize trading rules, benchmarks, and constraints to execute orders with minimal risk and costs.

Question 33

List the algorithmic trading strategies.

Answer 33

1. Logical participation strategies
   a) Simple logical
   b) Implementation shortfall
2. Opportunistic strategies
3. Specialized strategies

Question 34

Describe the simple logical participation strategy.

Answer 34

Break up the trade into small pieces so that each trade is a small part of trading volume and market impact costs are minimized.

Question 35

Describe the implementation shortfall strategy.

Answer 35

Focuses on trading early to minimize opportunity costs. Furthermore, an objective function can be specified using implementation shortfall that seeks to minimize market impact costs and opportunity costs, as well as the variance of the cost of trading. The minimization of this variance also provides an incentive for the implementation shortfall strategy to trade early.

Question 36

Explain best execution.

Answer 36

Best execution refers to the best means to buy and sell a security. It is similar to prudence in that they both attempt to improve portfolio performance and meet fiduciary responsibilities.

Question 37

What are the four characteristics of best execution?

Answer 37

1. Best execution cannot be judged independently of the investment decision. Some strategies might have high trading costs but in net still enhance portfolio value.
2. Best execution cannot be known with certainty ex ante; it depends on the particular circumstances of the trade. Each party to a trade determines what best execution is.
3. Best execution can only be assessed ex post. Cost is measured for any single trade, quality execution is assessed over time.
4. Relationships and practices are integral to best execution. Best execution is ongoing and requires diligence and dedication to the process.