L4 - Trading and Financing

Question 1

Transaction Costs?

Answer 1

• Direct –> commissions and other direct costs
• Indirect –> bid-ask spread, market impact costs

Question 2

What is market liquidity risk?

Answer 2

The risk of episodic spikes in transaction costs

Question 3

What are the trading implications of market liquidity?

Answer 3

• Implementation costs have several implications –
  
  • which trading rule is best
  • Whether or not a strategy is profitable
  • Which securities to trade
  • How large to scale the trade
• The more frequent the trades the more the investors need to worry about transaction costs
• The larger and more leveraged the position a trader takes the more important are implementation costs
• A high-turnover trading rule may be the best on paper, without taking transaction costs into account, it may be a poor trading strategy in practice.

Question 4

How do you calculate Effective Spread?

Answer 4

The Effective Spread measures dollar transaction costs versus pre-trade price.

• For buys:

TC$ = P^execution – P^before

– P^execution is the price you paid, on average, for all the shares you bought, and P^before is the mid-quote (i.e., the average of the bid and ask prices) just before you started trading.

• For sell orders:

TC$= – ( P^execution – P^before )

Question 5

How do you calculate Percentage Effective Spread (Transaction Costs)?

Answer 5

TC = TC$/ P^before

Question 6

What is the problem of measuring Transaction costs over a long period of time?

Answer 6

TC is measured with substantial noise.

This is because prices move for many reasons that are unrelated to your own trading, which introduces noise into the execution price

Question 7

How do you calculate the bid-ask spread in both monetary terms and as basis points of the mid price?

Answer 7

Monetary terms –> ask-bid

Bps of mid price –> (ask - bid)/ mid price then *10000

Question 8

VWAP calculation?

Answer 8

Sum of (price*Volume)/ Sum of Volume

Question 9

What is the most important part of a hedge funds balance sheet?

Answer 9

Equity capital –> for a particular hedge fund it is called the net asset value (NAV)

Unlike equity capital in a regular company, hedge fund’s equity capital is not permanent since investors can withdraw their money.

Question 10

Is the equity in a hedge fund owned and kept by them?

Answer 10

Not permanent as investors can withdraw money

• Although withdrawals are subject to lock-up provisions and redemption notice periods e.g. Lock up for 1 year, or 45 day redemption notice

Notice period is important for hedge funds since they often invest in illiquid securities and therefore need to trade out of position slowly to minimise transaction costs

Question 11

What does a hedge funds balance sheet look like?

Answer 11

• NAV is the sum of all equity in the hedge fund - total equity

Each block in assets is matched with the liability that funds it

• Long position is funded by a margin loan from prime brokers and their own equity
• Light red is held in escrow for safekeeping –> margining shorting account –>cash generated from selling shorted securities + good faith margin

Question 12

What is the total formula for P&L?

Answer 12

Question 13

What determines margin requirements?

Answer 13

Question 14

What determines the limits of leverage?

Answer 14