Reading 23

Question 1

Alpha Decay

Answer 1

deterioration in alpha once an investment decision has been made. managers with higher rates of alpha decay need to trade in shorter time frames and hence have greater trade urgency managers with long term company fundamentals will have lower rates of alpha decay and therefore a lower trade urgency

Question 2

cash drag

Answer 2

low levels of return of cash cause the fund to underperform the benchmark

Question 3

equitization strategies

Answer 3

when to avoid cash drag, liquid securities such as ETFs or derivatives are used to gain market exposure while the investment in underlying securities occurs over time.

Question 4

Market Impact Costs

Answer 4

adverse effect of the order on prices

Question 5

execution risk

Answer 5

risk of adverse price movements over the trading horizon from moving too slowly

Question 6

trader’s dilemma

Answer 6

alleviating market impact causes execution risk and vice versa

Question 7

Decision price

Answer 7

price at the time when the portfolio manager made the decision

Question 8

Ref price and execution method for: Short term alpha?

Answer 8

price target benchmark linked to the manager’s estimate of fair value combined with an arrival price benchmark for orders when placed in the market; use computer algo for execution

Question 9

Ref price and execution method for: long term alpha?

Answer 9

difficult to use reference prices

execution: sell securities gradually over a few weeks in small parts to avoid information leakage and pressure on dealer’s prices

Question 10

Ref price and execution method for: risk rebalance?

Answer 10

Low urgency, since the trader is both buying and selling, which lowers execution risk. execution risk would be higher for trades on only one side of the book since then the trader has directional exposure

reference price: TWAP

Question 11

Ref price and execution method for: redemptions and creations

Answer 11

reference: MOC

Question 12

execution strategy for new trade mandate

Answer 12

obtain immediate exposure to index through a long position in index futures to eliminate cash drag. build underlying stock positions over time to reduce market impact, while simultaneously unwinding the futures position. 2 problems though:
1. there may not be a closing auction for the futures contract, in which case the futures trade would need to be done as close to the market close as possible.
2. the mandate must allow derivatives positions.

Question 13

Principal trades (broker risk trades)

Answer 13

dealers or market makers assume all or some of the risk relating to executing the order, which is prices into the spread. Quote-driven, OTC or off-exchange markets are primarily principal trade markets. RFQ also.

Question 14

Profit seeking algorithms

Answer 14

use real time market data to determine which securities to buy and sell and are employed by electronic market makers, quant funds and HFTs

Question 15

execution algorithms

Answer 15

trade according to the rules specified by the manager to meet the objective

Question 16

scheduled algorithms

Answer 16

POV, VWAP, TWAP

Question 17

disadvantage of scheduled algorithm

Answer 17

force trades in times of low liquidity or trade too little in times of high liquidity

Question 18

liquidity seeking algorithms

Answer 18

aka opportunistic algorithms - aim to take advantage of favorable liquidity conditions when offered by the market. eg for a buyer, the algo would wait until a large sell order enters the market. these orders use both lit and dark vanues.

Question 19

when are liquidity-seeking algos best for?

Answer 19

larger orders in less liquid markets with higher urgency while trying to mitigate the market impact. they are also appropriate when a manager is concerned that displaying limit orders may lead to information leakage, or when liquidity is typically thin with sporadic episodes of high liquidity.

Question 20

what are scheduled algos best for?

Answer 20

relatively small orders in liquid markets for managers with less urgency ie greater risk tolerance for longer execution periods and/or who are concerned with minimizing the market impact eg a risk rebalancing trade executed over a trading day.

Question 21

what are arrival price algos best for?

Answer 21

small orders in liquid markets for managers who believe prices are likely to move against them during the trade horizon and therefore wish to trade more aggressively eg profit seeking manager. they are also appropriate for more risk-averse managers who want to minimize execution risk

Question 22

whom are dark strategies/ liquidity aggregators best for?

Answer 22

large orders in illiquid markets and arrival price or scheduled algorithms would likely lead to high market impact. since there is a lower chance of execution in dark pools, these strategies are for managers that do not need to execute the full order immediately.

Question 23

what are SORs best for?

Answer 23

small orders with low market impact where the market can move quickly or for small limit orders with low information leakage where there are multiple potential execution venues.

Question 24

Clustering

Answer 24

machine learning technique whereby a computer learns to identify which algorithm is optimal for different types of trades based on the key features of trades. the term clustering refers to the technique of grouping trades together with similar attributes eg size as a fraction of ADV.

Question 25

best execution strategy for fixed income

Answer 25

high touch brokered approach since fixed income markets outside of treasuries and corporate bonds typically use high touch brokered execution methods. there is unlikely to be an algorithmic or DMA available for agency MBS.

Question 26

if a large equity trade is not urgent, you should use?

Answer 26

scheduled algorithm

Question 27

Implementation shortfall

Answer 27

Paper return - actual return

paper return: return on hypothetical portfolio if the trade were executed at the original decision price with zero cost.

actual portfolio return: net of all costs

usually expressed as basis points of the total cost of the paper portfolio

Question 28

execution cost:

Answer 28

occurs due to executing shares a ta less favorable price than the original decision price. can be further broken down into delay cost and trading cost

Question 29

trading cost

Answer 29

cost due to market impact of executing the trade

Question 30

opportunity cost

Answer 30

cost of not trading any unfilled part of the order. paper portfolio assumes that all shares are executed immediately at the original decision price - the actual trade may have only filled part of the order, and the lost profit on the unfilled portion is the opportunity cost.

Question 31

absolute cost of trading

Answer 31

side * (execution price - benchmark prices) * shares executed

side = +1 for buy order and -1 for sell order

Question 32

trade cost (in bps)

Answer 32

side * [(execution price - benchmark price) / benchmark price ] * 10,000

Question 33

index cost

Answer 33

cost due to general market index movements

index cost (bps) = side * [(index vwap - index arrival price)/ index arrival price] * 10,000

Question 34

market adjusted cost

Answer 34

ensures a trader is not penalized or rewarded for general market movements over the trade horizon by subtracting the index costs adjusted for the security’s beta

market adjusted cost (bps) = arrival cost (bps) - Beta * index cost (bps)

arrival cost - arrival cost of the trade based on an arrival price benchmark
beta - beta of security versus index used to calculate index cost

Question 35

added value (bps)

Answer 35

arrival cost (bps) - estimated pre-trade cost (bps)

negative cost means benefit and the trader has added value through trading decisions.

Question 36

key areas of trade policy

Answer 36

1. meaning of best execution
2. factors tat determine the optimal trading approach
3. a listing of approved brokers and execution venues
4. details of the monitoring processes used by the asset manager

Question 37

a PM who wishes to execute a trade passively over a trading day and mitigate the impact of outliers should use which of the following reference prices as benchmark?

Answer 37

TWAP

Question 38

RFQ are most likely to be used to implement trading strategies in which of the following markets?

Answer 38

Fixed Income

Question 39

Price benchmark where reference price for benchmark ignores outliers

Answer 39

TWAP

Question 40

If a PM has inflow in a rising market, how can they avoid cash drag or minimize it?

Answer 40

To minimize cash drag on a portfolio, or fund underperformance from holding uninvested cash in a rising market, Barker may use a strategy known as equitization. In this case, equitization refers to temporarily investing cash using futures or ETFs to gain the desired equity exposure before investing in the underlying securities longer term. Equitization may be required if large inflows into a portfolio are hindered by lack of liquidity in the underlying securities. So, if the Pengwyn Fund’s large inflow cannot be invested immediately, Barker can equitize the cash using equity futures or ETFs and then gradually trade into the underlying positions and trade out of the futures/ETF position.

Question 41

What is delay cost

Answer 41

Qty done * (decision price - arrival price)

Question 42

Market Adjusted cost

Answer 42

arrival cost - (Beta * index cost)

Question 43

arrival cost

Answer 43

= (value done - value at arrival for same qty)/ value at arrival for same qty

Question 44

index cost

Answer 44

(index vwap - index arrival)/ index arrival

Question 45

sell order for small position in a lightly traded name - no expectations of adverse price movement and wants to minimize market impact, but also complete the order. which algo should he use?

Answer 45

TWAP because VWAP might not complete

Question 46

Which is incorrect?

Theme 1: We should determine an optimal execution approach and apply that approach to each asset class managed.

Theme 2: In aggregating trades for pooled accounts, any partially executed orders need to be allocated on a pro-rata basis.

Theme 3: The principles behind our process to find a broker should be consistent across each asset class managed.

Theme 4: To act in our clients’ best interests, we need to disclose all trade errors to them.

Answer 46

Theme 1 is inappropriate because the optimal execution approach may differ by asset class, level of security liquidity, and security trading mechanism (order-driven markets, quote-driven markets, and brokered markets). Green Savannah’s trade policy document should describe the factors used in determining how an order can be executed in an optimal manner for a given scenario.

Theme 4 is inappropriate because as part of a suitable policy for the treatment of trade errors, those errors and any resulting gains/losses need to be disclosed to Green Savannah’s compliance department and documented in a trade error log. The priority is to ensure errors are resolved in a way that prevents adverse impact for the client, not to ensure complete disclosure.