Execution of portfolio decisions Flashcards
30.a: Compare market orders with limit orders, including the price and
execution uncertainty of each.
A limit order is an order to trade at the limit price or better. For sell orders, the
execution price must be higher than or equal to the limit price.
30.b: Calculate and interpret the effective spread of a market order and
contrast it to the quoted bid-ask spread as a measure of trading cost.
The effective spread is an actual transaction price versus the midquote of the market
bid and ask prices.
Subtracting the best bid price from the best ask price results in the inside bid-ask spread
or market bid-ask spread. The average of the inside bid and ask is the midquote.
effective spread for a buy order = 2 x (execution price - midquote)
effective spread for a sell order = 2 x (midquote - execution price)
30.c: Compare alternative market structures and their relative advantages.
There are three main categories of securities markets:
- Quote-driven: Investors trade with dealers.
- Order-driven markets: Investors trade with each other without the use of
intermediaries. - Brokered markets: Investors use brokers to locate the counterparty to a trade.
Many markets that trade illiquid securities (e.g., bond markets) are organized as dealer markets because the level of natural liquidity (trading volume) is low.
Order driven
The disadvantage is that because there may not be a dealer willing to maintain an inventory of a security, liquidity may be poor.
order-driven markets: electronic crossing networks,
auction markets, and automated auctions.
Hybrid markets combine features of quote-driven, order-driven, and broker markets.
30.d: Compare the roles of brokers and dealers.
A broker also seeks to earn a profit in exchange for service but the broker has a principal
and agent relationship with the trader.
Provide secrecy.
Provide other services
Support the market.
30.e: Explain the criteria of market quality and evaluate the quality of a
market when given a description of its characteristics.
A security market should provide liquidity, transparency, and assurity **of completion. **
** **a market has small spreads, traders are apt to trade more often. 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, and any deviations from intrinsic value are minimized quickly.
An abundance of buyers and sellers, so traders know they can quickly reverse their trade if necessary.
Investor characteristics are diverse. If every investor had the same information, valuations, and liquidity needs, there would be little trading.
A convenient location or trading platform which lends itself to increased investor
activity and liquidity.
Integrity as reflected in its participants and regulation, so that all investors receive
fair treatment.
To evaluate the quality of a market, one should examine its liquidity, transparency,
and assurity of completion.
30.f: Explain the components of execution costs, including explicit and
implicit costs, and evaluate a trade in terms of these costs.
The explicit costs of trade execution are directly observable and include commissions, taxes, stamp duties, and fees.
Implicit costs are harder to measure, They include the bid-ask spread, market or price impact costs, opportunity costs, and delay costs (i.e., slippage costs)
VWAP has shortcomings.
It is not useful if a trader is a significant part of the trading volume. ( her trading activity will significantly affect the VWAP, a comparison to VWAP is essentially comparing her trades to herself. It does not provide useful information. )
A more general problem is the potential to “game” the comparison. An unethical trader knowing he will be compared to VWAP could simply wait until late in the
day and then decide which trades to execute.
For example, if the price has been
moving down, only execute buy transactions which will be at prices below VWAP. If prices are moving up for the day, only execute sales.
This is related to the more general problem that VWAP does not consider missed
trades.
30.g: Calculate and discuss implementation shortfall as a measure of transaction costs.
It is a conceptual approach that measures transaction costs as the difference in performance of a hypothetical portfolio in which the trade is fully executed with no cost and the
performance of the actual portfolio.
30.h: Contrast volume weighted average price (VWAP) and
implementation shortfall as measures of transaction costs.
Advantages of VWAP:
Easily understood.
Computationally simple.
Can be applied quickly to enhance trading decisions.
Most appropriate for comparing small trades in nontrending markets (where a
market adjustment is not needed).
Disadvantages of VWAP:
Not informative for trades that dominate trading volume (as described earlier).
Can be gamed by traders (as described earlier).
Does not evaluate delayed or unfilled orders.
Does not account for market movements or trade volume.
Advantages of Implementation Shortfall:
• Portfolio managers can see the cost of implementing their ideas.
Demonstrates the tradeoff between quick execution and market impact.
Decomposes and identifies costs.
Can be used in an optimizer to minimize trading costs and maximize performance.
Not subject to gaming.
Disadvantages of Implementation Shortfall:
May be unfamiliar to traders.
Requires considerable data and analysis.
30.i: Explain the use of econometric methods in pretrade analysis to
estimate implicit transaction costs.
Security liquidity: trading volume, market cap, spread, price.
Size of the trade relative to liquidity.
Trading style: more aggressive trading results in higher costs.
Momentum: trades that require liquidity (e.g., buying stock costs more when the
market is trending upward).
Risk.
30.j: Discuss the major types of traders, based on their motivation to
trade, time versus price preferences, and preferred order types.
Trader Types Motivation Time or Price Order Types
Information-motivated Time-sensitive information Time Market
Value-motivated Security misvaluations Price Limit
Liquidity-motivated Reallocation & liquidity Time Market
Passive Reallocation & liquidity Price Limit
30.k: Describe the suitable uses of major trading tactics, evaluate their
relative costs, advantages, and weaknesses, and recommend a trading tactic
when given a description of the investor’s motivation to trade, the size of the
trade, and key market characteristics.
30.l: Explain the motivation for algorithmic trading and discuss the basic
classes of algorithmic trading strategies.
three types of simple logical participation strategies: volume-weighted average price
(VWAP) strategy, time-weighted average price strategy, and percent-of-volume strategy.
In a VWAP strategy, the order is broken up over the course of a day so as to equal or outperform the day’s VWAP.
In a time-weighted average price strategy (TWAP), trading is spread out evenly over the whole day so as to equal a TWAP benchmark.
In the percent-of-volume strategy, the order is traded at 5-20% of normal trading volume
Implementation shortfall strategies, or arrival price strategies, minimize trading costs as defined by the implementation shortfall measure (discussed earlier) or total
execution costs.
opportunity costs result from non-trading, this strategy trades heavier early in the day to ensure order completion. Furthermore, opportunity costs are often measured by the volatility of trade value, which increases over time. So again, opportunity costs can be reduced by trading earlier.
An implementation shortfall strategy is useful when an entire portfolio must be traded
Other algorithmic trading strategies include opportunistic participation strategies and specialized strategies.
Opportunistic participation strategies trade passively over time but increase trading when liquidity is present.
30.m: Discuss the factors that typically determine the selection of a specific algorithmic trading strategy, including order size, average daily trading
volume, bid-ask spread, and the urgency of the order.
an implementation shortfall strategy focuses on trading early to minimize opportunity costs
basis of simple participation strategies is to break up the trade into small pieces so that each trade is a small part of trading volume and market impact costs are minimized
30.n: Explain the meaning and criteria of best execution.
- Best execution cannot be judged independently of the investment decision.
Best execution cannot be known with certainty ex ante (before the fact); it depends on the particular circumstances of the trade.
30.o: Evaluate a firm’s investment and trading procedures, including
processes, disclosures, and record keeping, with respect to best execution.
processes -firms should have policies and procedures that have the intent of maximizing portfolio value using best execution.
Investment management firms should also provide disclosure to their clients and
potential clients regarding (1) general information on their trading techniques, markets,
and brokers and (2) their conflicts of interest related to trading.
record keeping -investment management firms should maintain the documentation supporting (1) the firm’s compliance with its policies and procedures
and (2) disclosures made to its clients.
