Execution of Portfolio Decisions - R39

Question 1

Compare market orders with limit orders, including the price and execution uncertainty of each.

Answer 1

Market order: immediately execute at best possible price. Emphasis is speed. Disadvantage is price uncertainty.

Limit order: trade at limit price or better. If not filled before specific date, the order will expire. Emphasis is price. Disadvantage is execution uncertainty.

Question 2

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.

Answer 2

Effective Spread compares the transacted price against the midquote of the market bid/ask prices.

e. s. for a buy = 2 x (execution price - midquote)
e. s. for a sell = 2 x (midquote - execution price)

The midquote is the average of the bid/ask.

Question 3

Compare alternative market structures and their relative advantages

Answer 3

• Quote-driven markets: investors trade with dealers (Bond market)
  
  • Adv: Dealers help markets operate continuously (eg very illiquid securities)
• Order-driven markets: investors trade with each other w/o intermediaries (TSX)
  
  • More liquidity, tighter spreads
  • incl. auction and ECNs
• Brokered markets: investors use brokers to locate the counterparty to a trade.
  
  • Block transactions, EM and other small/illiquid markets
• Hybrid market - combination of the 3 (NYSE).

Securities markets provide liquidity, transparency, and assurity of completion.

Question 4

Compare the roles of brokers and dealers.

Answer 4

Brokers assist the trader, and act as their agent to find counterparties to their trades. The buy-side trader exchanges information with the dealer.

The dealer-trader relationship is essentially adversarial. (Dealer market aka quote-driven market). The term adverse selection risk arises when a dealer trades with a more informed trader (ie, the PM dumped some bond that has now gone down and the dealer didn’t get rid of it)

Question 5

Explain the criteria of market quality and evaluate the quality of a market when given a description of its characteristics.

Answer 5

A liquid market has small bid-ask spreads, market depth, and resilience. Depth allows larger orders to trade w/o affecting prices. Resilience is if prices stay close to intrinsic values, and deviations are minized quickly.

In a transparent market, investors can obtain both pre-trade info (quotes/spreads) and post-trade info (re: completed trades). Without transparency, investors lose faith.

When markets have assurity of completion, investors can be confident that the counterparty will uphold their agreement. Most brokers/clearing bodies will guarantee both sides.

Question 6

Explain the components of execution costs, including explicit and implicit costs, and evaluate a trade in terms of these costs.

Answer 6

Explicit costs:

• commissions
• taxes
• stamp duties
• fees

Implicit costs:

• bid-ask spread
• market/price impact costs
• opportunity costs
• delay costs (slippage)

Question 7

Calculate and discuss implementation shortfall as a measure of transaction costs.

Know the formulas and how to calculate all of them.

Answer 7

Implementation shortfall has four elements:

1. Explicit costs
   
   • comms, taxes, fees
2. Realized profit/loss
   
   • diff between exec. price and closing price on the preceding day divided by benchmark price and weighted by portion of order filled
3. Delay or slippage costs
   
   • diff b/t closing p on the day the order was not filled and the previous day’s closing p. Weighted by portion of order that is filled.
4. Missed trade opportunity cost (MTOC)
   
   • diff b/t closing p on the day order cancelled and benchmark price. Weighted by portion of order not filled.

Implementation shortfall = [paper portfolio gain - real portfolio gain] / paper portfolio investment

Explicit costs = commission / paper port. investment

Realized p/l = [(execution p - prev. d close)/benchmark price] x [shares purchased/shares ordered]

Delay costs = [(prev d close p - bench close)/bench price] x [shares purchased/shares ordered]

MTOC = [(cancel price - bench price)/bench price] x [shares not purchased/shares ordered]

sum of the components equals the total implmentation cost.

Question 8

Contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs

Answer 8

Question 9

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

Answer 9

Econometric models can be used to forecast transaction costs, because trading costs are nonlinearly related to:

• 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
• Risk

The estimated cost function can be used in 2 ways:

• Helps form a pre-trade estimate to compare against when completed
• Helps the PM gauge the right trade size.

Question 10

Discuss the major types of traders, based on their motivation to trade, time vs price preferences, and preferred order types.

Answer 10

Question 11

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.

Answer 11

Question 12

Explain the motivation for algorithmic trading and discuss the basic clases of algorithmic trading strategies.

Answer 12

Motivation is to execute orders with minimal risks and costs.

Simple logical participation strategies (SLP) - seek to trade with market flow so as to not become overly noticeable to the market and to minimize market impact.

In a VWAP SLP, 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 bench.

Implementation shortfall strategies - or arrival price strategies, minimize trading costs as defined by the implmentation shortfall measure or total execution costs. Both measures use a weighted average of opportunity costs and market impact costs.

SLPs break trades into small pieces and trade throughout the day to minimize market costs.

ISS focuses on trading early to minimize opportunity costs (and executes the order quickly).

Opportunistic

Pegging / discretion strategies. Opportunistic seizing of liquidity.

Specialized - e.g. passive, hunter.