Reading 29 Execution of Portfolio Decisions

Question 1

Discuss the adverse selection risk faced by a dealer

Answer 1

When a trader has information that a dealer does not, the trader profits at the dealers expense. Traders are more likely to trade when they have information that others do not. This results in adverse selsection risk for the dealer. The traders profit is the dealer`s loss once the information is revealed to the market.

Question 2

Soft dollars

Answer 2

The use of commissions to buy services other than execution services. Also called soft dollar arrangements or soft commissions.

Question 3

Special types of trades

Answer 3

1. Principal trade. A principal trade is a trade with a broker in which the broker commits capital to facilitate the prompt execution of the trader’s order to buy or sell. Principal trades are used most frequently when the order is larger and/or more urgent than can be accommodated within the normal ebb and flow of exchange trading. A price concession provides an incentive for the broker acting as a principal in the trade.
2. Portfolio trade (or program trade or basket trade). A portfolio trade involves an order that requires the execution of purchases (or sales) in a specified basket (list) of securities at as close to the same time as possible. For example, an S&P 500 index fund manager with new cash to invest could execute a portfolio trade to buy the S&P 500 (the shares in the S&P 500 in their index weights). Portfolio trades are often relatively low cost because the diversification implied by multiple security issues reduces the risk to the other side of the trade.

Question 4

The Trade Management Guidelines

Answer 4

The Trade Management Guidelines are divided into three areas: processes, disclosures, and record keeping:

1. Processes. Firms should establish formal policies and procedures that have the ultimate goal of maximizing the asset value of client portfolios through best execution. A firm’s policies and procedures should provide guidance to measure and manage effectively the quality of trade decisions.
2. Disclosures. Firms should disclose to clients and prospects 1) their general information regarding trading techniques, venues, and agents and 2) any actual or potential trading-related conflicts of interest. Such disclosure provides clients with the necessary information to help them assess a firm’s ability to deliver best execution.
3. Record keeping. Firms should maintain proper documentation that supports 1) compliance with the firm’s policies and procedures and 2) the disclosures provided to clients. In addition to aiding in the determination of best execution, the records may support a firm’s broker selection practices when examined by applicable regulatory organizations.

Question 5

Markets are organized to provide? (main features)

Answer 5

Markets are organized to provide:

1. liquidity (the ability to trade without delay at relatively low cost and in relatively large quantities),
2. transparency (availability of timely and accurate market and trade information),
3. assurity of completion (trades settle without problems under all market conditions—trade settlement involves the buyer’s payment for the asset purchased and the transfer of formal ownership of that asset).

Question 6

Factors that contribute to making a market liquid

Answer 6

Liquidity adds value to the companies whose securities trade on the exchange. Investors will pay a premium for securities that possess the valuable trait of liquidity. Higher security prices enhance corporate value and lower the cost of capital.

Many factors contribute to making a market liquid:

1. Many buyers and sellers. The presence of many buyers and sellers increases the chance of promptly locating the opposite side of a trade at a competitive price. Success breeds success in that the liquidity resulting from many buyers and sellers attracts additional participants to the market. Investors are more willing to hold shares that they can dispose of whenever they choose to do so.
2. Diversity of opinion, information, and investment needs among market participants. If the investors in a given market are highly alike, they are likely to want to take similar investment actions and make similar trades. Diversity in the factors described above increases the chance that a buyer of a security, who might have a positive opinion about it, can find a seller, who might have a negative opinion about it or a need for cash. In general, a large pool of investors enhances diversity of opinion.
3. Convenience. A readily accessible physical location or an easily mastered and well-thought-out electronic platform attracts investors.
4. Market integrity. Investors who receive fair and honest treatment in the trading process will trade again. The ethical tone set by professional market operatives plays a major role in establishing this trust, as does effective regulation. For example, audits of the financial condition and regulatory compliance of brokers and dealers operating in a market increase public confidence in the market’s integrity, as do procedures for the disinterested investigation of complaints about the execution of trades.

Question 7

Implementation shortfall approach

Answer 7

Probably the most exact approach to cost measurement—and one not vulnerable to gaming—is the implementation shortfall approach. The approach involves a comparison of the actual portfolio with a paper portfolio, using a price benchmark that represents the price when the decision to trade is made (when the trade list is cut).

Implementation shortfall is defined as the difference between the money return on a notional or paper portfolio in which positions are established at the prevailing price when the decision to trade is made (known as the decision price, the arrival price, or the strike price) and the actual portfolio’s return. The implementation shortfall method correctly captures all elements of transaction costs. The method takes into account not only explicit trading costs, but also the implicit costs, which are often significant for large orders.

Implementation shortfall can be analyzed into four components:

1. Explicit costs, including commissions, taxes, and fees.
2. Realized profit/loss, reflecting the price movement from the decision price (usually taken to be the previous day’s close) to the execution price for the part of the trade executed on the day it is placed.
3. Delay costs (slippage), reflecting the change in price (close-to-close price movement) over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently.
4. Missed trade opportunity cost (unrealized profit/loss), reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was not filled

The shortfall computation is simply reversed for sells (for sells, the return on the paper portfolio is subtracted from the return on the actual portfolio).

Question 8

Opportunistic Participation Strategies

Answer 8

Opportunistic participation strategies also involve trading over time. The opportunistic trading strategy involves passive trading combined with the opportunistic seizing of liquidity. The most common examples are pegging and discretion strategies, in which the trader who wishes to buy posts a bid, hoping others will sell to him or her, yielding negative implicit trading costs. If the bid–offer spread is sufficiently small, however, the trader might buy at the ask. This strategy typically involves using reserve or hidden orders and crossing (internally or externally) to provide additional sources of liquidity at low cost. Because trading is opportunistic, the liquidity strategy is not a true participation strategy.

Question 9

Simple Logical Participation Strategies

Answer 9

• One of the most popular logical participation strategies involves breaking up an order over time according to a prespecified volume profile. The objective of this volume-weighted average price (VWAP) strategy is to match or improve upon the VWAP for the day.
• The time-weighted average price (TWAP) strategy is a particularly simple variant that assumes a flat volume profile and trades in proportion to time.
• Percentage-of-volume strategy, in which trading takes place in proportion to overall market volume (typically at a rate of 5–20 percent) until the order is completed.

Question 10

Are econometric models used as ex ante (before the fact) or ex post (after the fact) investment tools?

Answer 10

Actually, they can be used as both. Before the fact, econometric models can assist portfolio managers in determining the size of the trade. After the fact, trading effectiveness can be assessed by comparing actual trading costs to forecasted trading costs from the model.

Question 11

What are some of the problems in estimating the missed trade opportunity cost?

Answer 11

One of the problems in estimating missed trade opportunity cost is that the estimate depends upon when the cost is measured.

The estimate could vary substantially when a different interval is used to measure the missed trade opportunity cost. Another problem in estimating the missed trade opportunity cost is that it does not consider the impact of order size on prices.

Question 12

Characteristics of liquid markets

Answer 12

A liquid market is one that has the following characteristics:

• The market has relatively low bid–ask spreads. Such a market is often called tight. Quoted spreads and effective spreads are low. The costs of trading small amounts of an asset are themselves small. As a result, investors can trade positions without excessive loss of value. If bid–ask spreads are high, investors cannot profitably trade on information except when the information is of great value.
• The market is deep. Depth means that big trades tend not to cause large price movements. As a result, the costs of trading large amounts of an asset are relatively small. Deep markets have high quoted depth, which is the number of shares available for purchase or sale at the quoted bid and ask prices.
• The market is resilient. A market is resilient (in the sense used here) if any discrepancies between market price and intrinsic value tend to be small and corrected quickly.

Question 13

Buy-side tradres, what a portfolio manager has to know/do about executung trading decisions?

Answer 13

Buy-side traders are the professional traders employed by investment managers or institutional investors who place the trades that execute the decisions of portfolio managers. The job of such traders is to execute the desired trades quickly, without error, and at favorable prices.

Execution is the final, critical step in the interlinked investment process: The portfolio decision is not complete until securities are bought or sold.

A portfolio manager is not a professional trader. However, a portfolio manager does need to:

1. communicate effectively with professional traders;
2. evaluate the quality of the execution services being provided for the firm’s clients; and
3. take responsibility for achieving best execution on behalf of clients in his or her role as a fiduciary.

To accomplish those goals, the portfolio manager needs a grounding in:

1. the market institutions within which traders work, including the different types of trading venues to which traders may direct orders;
2. the measurement of trading costs; and
3. the tactics and strategies available to the firm’s traders and the counterparties with whom they deal, including important innovations in trading technology.

Question 14

Main order types

Answer 14

Market orders and limit orders are the two major types of orders that traders use and that portfolio managers need to understand.

1. A market order is an instruction to execute an order promptly in the public markets at the best price available.
   * A market order emphasizes immediacy of execution*. However, a market order usually bears some degree of price uncertainty (uncertainty about the price at which the order will execute). In today’s markets, most market orders are effectively automated from the point of origin straight through to reporting and clearing.
2. A limit order is an instruction to trade at the best price available but only if the price is at least as good as the limit price specified in the order. For buy orders, the trade price must not exceed the limit price, while for sell orders, the trade price must be at least as high as the limit price. An instruction always accompanies a limit order specifying when it will expire.

By specifying the least favorable price at which an order can execute, a limit order emphasizes price. However, limit orders can execute only when the market price reaches the limit price specified by the limit order. The timing of the execution, or even whether the execution happens at all, is determined by the ebb and flow of the market. Limit orders thus have execution uncertainty.

Question 15

A few additional important order types

Answer 15

1. Market-not-held order. This type of order is relevant for trades placed on certain exchanges (regulated trading venues) where an order may be handled by an agent of the trader in executing trades (a broker). This variation of the market order is designed to give the agent greater discretion than a simple market order would allow. “Not held” means that the broker is not required to trade at any specific price or in any specific time interval, as would be required with a simple market order. Discretion is placed in the hands of a representative of the broker (such as a floor broker—an agent of the broker who, for certain exchanges, physically represents the trade on the exchange). The broker may choose not to participate in the flow of orders on the exchange if the broker believes he or she will be able to get a better price in subsequent trading.
2. Participate (do not initiate) order. This is a variant of the market-not-held order. The broker is to be deliberately low-key and wait for and respond to initiatives of more active traders. Buy-side traders who use this type of order hope to capture a better price in exchange for letting the other side determine the timing of the trade.
3. Best efforts order. This type of order gives the trader’s agent even more discretion to work the order only when the agent judges market conditions to be favorable. Some degree of immediacy is implied, but not immediacy at any price.
4. Undisclosed limit order, also known as a reserve, hidden, or iceberg order. This is a limit order that includes an instruction not to show more than some maximum quantity of the unfilled order. For example, a trader might want to buy 200,000 shares of an issue traded on Euronext Amsterdam. The order size would represent a substantial fraction of average daily volume in the issue, and the trader is concerned that share price might move up if the full extent of his or her interest were known. The trader places an undisclosed limit order to buy the 200,000 shares, specifying that no more than 20,000 shares of the unfilled order be shown to the public at a time.
5. Market on open order. This is a market order to be executed at the opening of the market. Similarly, a market on close order is a market order to be executed at the market close. These are examples of orders with an instruction for execution at a specific time. The rationale for using these two types of orders is that the opening and close in many markets provide good liquidity.

Question 16

Automated Trading

Answer 16

Algorithmic trading refers to automated electronic trading subject to quantitative rules and user-specified benchmarks and constraints. Related, but distinct, trading strategies include using portfolio trades, in which the trader simultaneously executes a set of trades in a basket of stocks, and smart routing, whereby algorithms are used to intelligently route an order to the most liquid venue. The term automated trading is the most generic, referring to any form of trading that is not manual, including trading based on algorithms.

The underlying logic behind algorithmic trading is to exploit market patterns of trading volume so as to execute orders with controlled risk and costs. This approach typically involves breaking large orders up into smaller orders that blend into the normal flow of trades in a sensible way to moderate price impact.

Meat-grinder effect: In order for a large equity order to get done, it must often be broken up into many smaller orders.

Question 17

Chief ways trading is organized

Answer 17

The chief ways trading is organized:

• Quote-driven (or dealer) markets, in which members of the public trade with dealers rather than directly with one another.
• Order-driven markets, in which members of the public trade with one another without the intermediation of dealers.
• Brokered markets, in which the trader relies on a broker to find the other side of a desired trade.

Question 18

Summary of Trading Motivations, Time Horizons, and Time versus Price Preferences

Answer 18

1. Information-motivated trader

Motivation: New information

Trading Time Horizon: Minutes to hours

Time versus Price Preference: Time

2. ​Value-motivated trader

Motivation: Perceived valuation errors

Trading Time Horizon: Days to weeks

Time versus Price Preference: Price

3. Liquidity-motivated trader

Motivation: Invest cash or divest securities

Trading Time Horizon: Minutes to hours

Time versus Price Preference: Time

4. ​Passive trader

Motivation: Rebalancing, investing/divesting cash

Trading Time Horizon: Days to weeks

Time versus Price Preference: Price

5. ​Dealers and day traders

Motivation: Accommodation

Trading Time Horizon: Minutes to hours

Time versus Price Preference: Passive, indifferent

Question 19

Order-Driven Markets

Answer 19

Order-driven markets are markets in which transaction prices are established by public limit orders to buy or sell a security at specified prices. Such markets feature trades between public investors, usually without intermediation by designated dealers (market makers).

For equity markets, a worldwide trend has favored order-driven markets at the expense of quote-driven markets. Various types of order-driven markets are distinguished:

1. Electronic Crossing Networks

In using crossing networks, both buyer and seller avoid the costs of dealer services (the bid–ask spread), the effects a large order can have on execution prices, and information leakage. Commissions are paid to the crossing network but are typically low. However, crossing participants cannot be guaranteed that their trades will find an opposing match: The volume in a crossing system is determined by the smallest quantity submitted.

Crossing networks provide no price discovery. Price discovery means that transaction prices adjust to equilibrate supply and demand.

! Crossing networks maintain complete confidentiality not only in regard to the size of the orders and the names of the investors placing the orders, but also in regard to the unmatched quantities.

2. Auction Markets

Many order-driven markets are auction markets—that is, markets in which the orders of multiple buyers compete for execution. Auction markets can be further categorized into periodic auction markets or batch auction markets (where multilateral trading occurs at a single price at a prespecified point in time) and continuous auction markets (where orders can be executed at any time during the trading day).

In contrast to electronic crossing markets, auction markets provide price discovery, lessening the problem of partial fills that we illustrated above for crossing networks.

3. Automated Auctions (Electronic Limit-Order Markets)

Electronic communications networks (ECNs) - these are computer-based auctions that operate continuously within the day using a specified set of rules to execute orders.

Automated auctions have been among the fastest-growing segments in equity trading. ECNs in particular have blurred the traditional difference between order-driven markets and quote-driven dealer markets. In an ECN, it can be difficult to distinguish between participants who are regulated, professional dealers and other participants who, in effect, are also attempting to earn spread profits by providing liquidity. Hedge funds or day traders, for example, might actively supply liquidity to the market to capture the dealer-like spread profits. From the perspective of an investor, the result is added liquidity and tighter spreads.

Question 20

Direct market access, the key function of trade desk organization

Answer 20

Direct market access (DMA) refers to platforms sponsored by brokers that permit buy-side traders to directly access equities, fixed income, futures, and foreign exchange markets, clearing via the broker. Trades executed via DMA now represent a substantial fraction of buy-side equity order volume in a number of developed markets.

The key function of trade desk organization is to prioritize trading. Good desks quickly identify the dangerous trades and assign the priority. They know how their managers think, in general and in relation to the specific individual trade. They attune the mix of brokers to their trading needs, often concentrating trading to increase their clout. Finally, they are constantly innovating and experimenting, trying new trade routes and refining desk processes.

Question 21

Objectives in Trading and Trading Tactics

Answer 21

1. Liquidity-at-Any-Cost Trading Focus

• Information traders who believe they need to trade in institutional block size with immediacy use these trading techniques.
• These trades demand high liquidity on short notice. They may overwhelm the available liquidity in the market and cause prices to move when their presence is detected. Traders who use these techniques usually recognize that these methods are expensive but pay the price in order to achieve timely execution.

2. Costs-Are-Not-Important Trading Focus

• Market orders and the variations on this type (such as market on close) are examples of orders resulting from a costs-are-not-important focus.
• Traders who use market orders trust the competitive market to generate a fair price. For many orders, fair market price is a reasonable assumption.
• Market orders work best for smaller trades and more liquid stocks. They are sometimes called “no-brainers” because they require little trading skill on the part of the buy-side trader or the broker. Because they require little effort or risk taking by market makers, they are inexpensive for a broker to execute and have been used to produce “soft dollar” commissions in exchange for broker-supplied services.
• The weakness of market orders is that all trader discretion is surrendered. The trader has no control over the trade, and the broker exercises only the most rudimentary cautions.

3. Need-Trustworthy-Agent Trading Focus

• Buy-side traders often need to execute larger orders than the exchange can accommodate at any given moment, particularly when dealing with thinly traded issues.
• The trader passes control of the order to the broker, who then controls when and at what price the orders execute. The trader frequently does not know how much of an order was cleared until after the market closes.

4. Advertise-to-Draw-Liquidity Trading Focus

• Implied in agency orders is an authorization to do some low-level advertising on the exchange floor. Advertising lets the market know that a willing buyer or seller is around.

5. Low-Cost-Whatever-the-Liquidity Trading Focus

• Limit orders are the chief example of this type of order, particularly limit orders that specify prices that are “behind the market”: either a limit buy order at a price below the best bid, or a limit sell order at a price above the best ask price. The objective is to improve on the market bid or the market ask, respectively. Minimizing trading costs is the primary interest of buy-side traders who use this type of order. This order type is best suited to passive and value-motivated trading situations.

Question 22

Implementation Shortfall Strategies

Answer 22

Recently, a newer logical participation strategy, the so-called implementation shortfall strategy (or arrival price strategy), has gained popularity. Unlike simple logical participation strategies, implementation shortfall strategies solve for the optimal trading strategy that minimizes trading costs as measured by the implementation shortfall method.

This method is best for trades that: have smal size, small spread and high urgency. Furthermore, this strategy trades a large volume early in the day.

Question 23

Effective spread

Answer 23

The size of the quoted bid–ask spread (reflecting the market quote), particularly as a proportion of the quote midpoint, is one measure of trading costs. However, the quoted bid–ask spread may be different from the spread at which a trader actually transacts. The trader’s focus is therefore often on the effective spread.

The effective spread is two times the deviation of the actual execution price from the midpoint of the market quote at the time an order is entered. (If parts of the order execute at different prices, the weighted-average execution price is used in computing the deviation from the midpoint.) The quoted spread is the simplest measure of round-trip transaction costs for an average-size order. The effective spread is a better representation of the true cost of a round-trip transaction because it captures both price improvement (i.e., execution within the quoted spread at a price such that the trader is benefited) and the tendency for larger orders to move prices (market impact).

The price improvement has resulted in an effective spread that is lower than the quoted spread.

The average effective spread is the mean effective spread (sometimes dollar weighted) over all transactions in the stock in the period under study. The average effective spread attempts to measure the liquidity of a security’s market.

! The difference between quoted spreads and effective spreads reflects the price improvement provided by dealers. If the effective spreads are lower than the quoted spreads, dealers are providing price improvements.

Question 24

Example of implementation shortfall approach (the idea)

Consider the following facts:

• On Monday, the shares of Impulse Robotics close at £10.00 per share.
• On Tuesday, before trading begins, a portfolio manager decides to buy Impulse Robotics. An order goes to the trading desk to buy 1,000 shares of Impulse Robotics at £9.98 per share or better, good for one day. The benchmark price is Monday’s close at £10.00 per share. No part of the limit order is filled on Tuesday, and the order expires. The closing price on Tuesday rises to £10.05.
• On Wednesday, the trading desk again tries to buy Impulse Robotics by entering a new limit order to buy 1,000 shares at £10.07 per share or better, good for one day. That day, 700 shares are bought at £10.07 per share. Commissions and fees for this trade are £14. Shares for Impulse Robotics close at £10.08 per share on Wednesday.
• No further attempt to buy Impulse Robotics is made, and the remaining 300 shares of the 1,000 shares the portfolio manager initially specified are never bought.

Answer 24

The paper portfolio traded 1,000 shares on Tuesday at £10.00 per share. The return on this portfolio when the order is canceled after the close on Wednesday is the value of the 1,000 shares, now worth £10,080, less the cost of £10,000, for a net gain of £80. The real portfolio contains 700 shares (now worth 700 × £10.08 = £7,056), and the cost of this portfolio is 700 × £10.07 = £7,049, plus £14 in commissions and fees, for a total cost of £7,063. Thus, the total net gain on this portfolio is –£7. The implementation shortfall is the return on the paper portfolio minus the return on the actual portfolio, or £80 – (–£7) = £87. More commonly, the shortfall is expressed as a fraction of the total cost of the paper portfolio trade, or £87/£10,000 = 87 basis points.

We can break this implementation shortfall down further:

• Commissions and fees are calculated naturally as £14/£10,000 = 0.14%.
• Realized profit/loss reflects the difference between the execution price and the relevant decision price (here, the closing price of the previous day). The calculation is based on the amount of the order actually filled:

700/1,000*((10.07−10.05)/10.00)=0.14%

• Delay costs reflect the price difference due to delay in filling the order. The calculation is based on the amount of the order actually filled:

700/1,000*((10.05−10.00)/10.00)=0.35%

• Missed trade opportunity cost reflects the difference between the cancellation price and the original benchmark price. The calculation is based on the amount of the order that was not filled:

300/1,000*((10.08−10.00)/10.00)=0.24%

• Implementation cost as a percent is 0.14% + 0.14% + 0.35% + 0.24% = 0.87%, or 87 bps.

Question 25

Objectives in Trading summary (uses, costs, advantages, weaknesses)

Answer 25

Focus: Liquidity at any cost (I must trade)

Uses: Immediate execution in institutional block size

Costs: High cost due to tipping supply/demand balance

Advantages: Guarantees execution

Weaknesses: High potential for market impact and information leakage

______________________________

Focus: Need trustworthy agent (Possible hazardous trading situation)

Uses: Large-scale trades; low-level advertising

**Costs: **Higher commission; possible leakage of information

Advantages: Hopes to trade time for improvement in price

Weaknesses: Loses direct control of trade

______________________________

Focus: **Costs are not important

Uses: Certainty of execution

Costs: Pays the spread; may create impact

**Advantages: **Competitive, market-determined price

Weaknesses: Cedes direct control of trade; may ignore tactics with potential for lower cost

______________________________

Focus: Advertise to draw liquidity

**Uses: **Large trades with lower information advantage

Costs: High operational and organizational costs

Advantages: Market-determined price for large trades

Weaknesses: More difficult to administer; possible leakage to front-runners

______________________________

Focus: Low cost whatever the liquidity

Uses: Non-informational trading; indifferent to timing

Costs: Higher search and monitoring costs

Advantages: Low commission; opportunity to trade at favorable price

Weaknesses: Uncertainty of trading; may fail to execute and create a need to complete at a later, less desirable price

Question 26

Transaction Cost Components

Answer 26

Trading costs can be thought of as having two major components: explicit costs and implicit costs. Explicit costs are the direct costs of trading, such as broker commission costs, taxes, stamp duties, and fees paid to exchanges. They are costs for which a trader could be given a receipt. Implicit costs, by contrast, represent indirect trading costs. No receipt could be given for implicit costs; they are real nonetheless. Implicit costs include the following:

• The bid–ask spread.
• Market impact (or price impact) is the effect of the trade on transaction prices.
• Missed trade opportunity costs (or unrealized profit/loss) arise from the failure to execute a trade in a timely manner. Missed trade opportunity costs are difficult to measure.
• Delay costs (also called slippage) arise from the inability to complete the desired trade immediately due to its size and the liquidity of markets. Delay costs are often measured on the portion of the order carried over from one day to the next. One reason delay can be costly is that while a trade is being stretched out over time, information is leaking into the market.

Question 27

Liquidity-Motivated Traders

Answer 27

Many liquidity-motivated traders believe that displaying their true liquidity-seeking nature works in their favor. When trading with a liquidity-motivated trader, dealers and other market participants can relax some of the protective measures that they use to prevent losses to informed traders.

Question 28

A trade`s volume is small percentage of average daily trading volume. The trade has low speads and is urgent. What would be the best method of filing the trade?

Answer 28

Trades that are a small portion of average daily trading volume, with low spreads, and high urgency should be traded with an implementation shortfall strategy. These strategies trade early in the day and sould accomodate an urgent trade.

Question 29

Hybrid Markets

Answer 29

Hybrid markets are combinations of the previously described market types. A good example is the New York Stock Exchange (NYSE), which offers elements of batch auction markets (e.g., the opening) and continuous auction markets (intraday trading), as well as quote-driven markets (the important role of NYSE dealers, who are known as specialists).

Question 30

The Roles of Dealers

Answer 30

In contrast to the agency relationship of the broker with the trader, the relationship between the trader and a dealer is essentially adversarial. Like any other merchant, the dealer wants to sell merchandise at a higher price (the ask) than the purchase price (the bid). Holding trade volume constant, a dealer gains by wider bid–ask spreads while the trader gains by narrower bid–ask spreads. The dealer is wary of trading with a better-informed counterparty.

Adverse selection risk - the risk of trading with a more informed trader.

Dealers want to know who is active in the market, how informed traders are, and how urgent their interest in transacting with the dealer is, in order to manage profits and adverse selection risk. The tension occurs because the informed or urgent trader does not want the dealer to know those facts.

Buy-side traders are often strongly influenced by sell-side traders such as dealers (the sell side consists of institutions that sell services to firms such as investment managers and institutional investors).

Question 31

The Roles of Brokers

Answer 31

A broker is an agent of the investor. As such, in return for a commission, the broker provides various execution services, including the following:

1. Representing the order. The broker’s primary task is to represent the order to the market. The market will accommodate, usually for a price, someone who feels he or she must trade immediately.
2. Finding the opposite side of a trade. If interest in taking the opposite side of a trade is not currently evident in the market, it usually falls to the broker to try to locate the seller for the desired buy, or the buyer for the desired sale. Often this service requires that the broker act as a dealer and actively buy or sell shares for the broker’s own account. The broker/dealer does not bear risk without compensation. Depending on the dealer’s inventory position, this service may come at a high cost.
3. Supplying market information. Market information includes the identity of buyers and sellers, the strength of buying and selling interest, and other information that is relevant to assessing the costs and risks of trading. This market intelligence, which can be provided by the broker, is very valuable to buy-side traders as they consider their trading tactics.
4. Providing discretion and secrecy. Buy-side traders place great value on preserving the anonymity of their trading intentions. Notice, however, that such secrecy does not extend to the selected broker, whose stock in trade is the knowledge of supply and demand. That an investor is willing to trade is a very valuable piece of information the broker gains as result of his or her relationship with the trader.
5. Providing other supporting investment services. A broker may provide a range of other services, including providing the client with financing for the use of leverage, record keeping, cash management, and safekeeping of securities. A particularly rich set of supporting services, often including introduction to potential clients, is provided in relationships that have come to be known as prime brokerage.
6. Supporting the market mechanism. Brokerage commissions indirectly assure the continuance of the needed market facilities.

Question 32

Value-Motivated Traders

Answer 32

The typical value-motivated trader uses limit orders or their computerized institutional market equivalent. An attractive price is more important than timely activity. Thus, price is controlled but timing is not. Even though value-motivated traders may act quickly, they are still accommodative and pay none of the penalties of more anxious traders.

Question 33

Main trends in markets

Answer 33

Fixed-income and equity markets have evolved very rapidly over the 1990s and 2000s. There are many more choices as to where to trade such bonds and equities than was the case historically—a phenomenon that has been called market fragmentation.

Another trend is the increasing amount of trading that is partly or fully automated, in the sense that the execution of a trader’s order after entry requires minimal or no human intervention or trader-to-trader communication. Reflecting the concern to minimize settlement errors and costs in security markets, the settlement of the trade after execution may also be automated within a given trading system or venue (straight-through processing, or STP).

Question 34

Which of the following markets (electronic limit-order, auction, electronic crossing networks) does NOT provide price discovery?

Answer 34

In an electronic crossing networks, there is no price discovery because trades are executed at the average of the bid and ask quotes. The trader usually does not know the identity of thier counterparty or of their trade size.

In an auction market and automated auctions (also known as electronic limit-order markets), orders complete for execution and provide price discovery.

Question 35

Information-Motivated Traders

Answer 35

Information traders believe that they need to trade immediately and often trade large quantities in specific names. Demands for high liquidity on short notice may overwhelm the ready supply of stock in the market, triggering adverse price movements as the effect of these demands reverberates through the market.

Information-motivated traders may wish to disguise their anxious trading need. Where possible, they use less obvious orders, such as market orders, to disguise their trading intentions. This behavior has led information traders to be called “wolves in sheep’s clothing.”

Question 36

Trading costs are systematically related to what factors according to the theory of market microstructure?

Answer 36

The theory of market microstructure suggests that trading costs are systematically related to certain factors, including the following:

1. stock liquidity characteristics (e.g., market capitalization, price level, trading frequency, volume, index membership, bid–ask spread);
2. risk (e.g., the volatility of the stock’s returns);
3. trade size relative to available liquidity (e.g., order size divided by average daily volume);
4. momentum (e.g., it is more costly to buy in an up market than in a down market);
5. trading style (e.g., more aggressive styles using market orders should be associated with higher costs than more passive styles using limit orders).

Given these factors, we can estimate the relation between costs and these variables using regression analysis. Since theory suggests a nonlinear relationship, we can use nonlinear methods to estimate the relationship. The key point to note is that the estimated cost function can be used in two ways:

• to form a pretrade estimate of the cost of trading that can then be juxtaposed against the actual realized cost once trading is completed to assess execution quality, and
• to help the portfolio manager gauge the right trade size to order in the first place.

Question 37

Passive Traders

Answer 37

Low-cost trading is a strong motivation of passive traders, even though they are liquidity-motivated in their portfolio-rebalancing operations. As a result, these traders tend to favor limit orders, portfolio trades, and crossing networks. The advantages, in addition to certainty of price, are low commissions, low impact, and the possible reduction or elimination of bid–ask spread costs. The major weakness is the uncertainty of whether trades will be completed within a reasonable time frame. These orders and markets are best suited to trading that is neither large nor heavily concentrated.

Question 38

Discuss two recent developments that could make the relationship between buy-side and sell-side traders more problematic

Answer 38

• First, the popularity of electronic trading venues has provided more anonumity for traders. A trader who gains information from another trader can use this information against the other trader discreetly.
• Second, brokerage commissions have fallen dramatically. The temptation is for a trader to shift costs to those that are implicit, rather than explicit.

Question 39

Quote-Driven (Dealer) Markets

Answer 39

Quote-driven markets rely on dealers to establish firm prices at which securities can be bought and sold. These markets are therefore also called dealer markets, as trades are executed with a dealer. A dealer (sometimes referred to as a market maker) is a business entity that is ready to buy an asset for inventory or sell an asset from inventory to provide the other side of an order to buy or sell the asset.

In the traditional view, market makers or dealers passively provide immediacy or bridge liquidity, the price of which is the bid–ask spread (the ask price minus the bid price). A dealer’s (or any trader’s) bid price (or bid) is the price at which he or she will buy a specified quantity of a security. A dealer’s (or any trader’s) ask price (or ask, or offer price, or offer) is the price at which he or she will sell a specified quantity of a security. On the principle of buying low and selling high, a dealer’s ask price is greater than his bid price. The quantity associated with the bid price is often referred to as the bid size; the quantity associated with the ask price is known as the ask size. From the perspective of a trader executing an order to buy a security from a dealer, a lower ask from the dealer is favorable to the trader. If the trader is executing an order to sell a security to a dealer, a higher bid from the dealer is favorable to the trader.

Dealers can help markets operate continuously. Bond markets, in particular, are overwhelmingly dealer markets. The explanation lies in a lack of natural liquidity for many bonds. (Natural liquidity is an extensive pool of investors who are aware of and have a potential interest in buying and/or selling a security.) Many bonds are extremely infrequently traded. If an investor wanted to buy such a bond, the investor might have a very long wait before the other side of the trade (an interest to sell) appeared from the public.

Question 40

Why do value-motivated and passive traders prefer limit orders?

Answer 40

Value-motivated and passive traders prefer limit orders because their primary motivation is to minimize trading costs and transact at favorable prices. They do not need the immediate execution of market orders and can afford to be patient.

Question 41

Advantages of VWAP and Implementation Shortfall

Answer 41

Volume Weighted Average Price:

• Easy to compute.
• Easy to understand.
• Can be computed quickly to assist traders during the execution.
• Works best for comparing smaller trades in nontrending markets.

Implementation Shortfall

• Links trading to portfolio manager activity; can relate cost to the value of investment ideas.
• Recognizes the tradeoff between immediacy and price.
• Allows attribution of costs.
• Can be built into portfolio optimizers to reduce turnover and increase realized performance.
• Cannot be gamed.

Question 42

A market observer notices that a particular trading firm tends to execute its trades early in the day, with volume falling off later in the day. What type of algorithmic trading system is the firm likely using?

Answer 42

The firm is likely using an implementation shortfall strategy. These strategies trade heavier early in the day to ensure order completion, reduce opportunity costs, and mininmize the volatility of trading costs.

Question 43

Brokered Markets

Answer 43

A broker is an agent of the buy-side trader who collects a commission for skillful representation of the trade. The broker may represent the trade to dealers in the security or to the market order flow. However, the term brokered markets refers specifically to markets in which transactions are largely effected through a search-brokerage mechanism away from public markets. Typically, these markets are important in countries where the underlying public markets (e.g., stock exchanges) are relatively small or where it is difficult to find liquidity in size. Consequently, brokered markets are mostly used for block transactions.

A block order is an order to sell or buy in a quantity that is large relative to the liquidity ordinarily available from dealers in the security or in other markets. The trader might use the services of a broker to carefully try to uncover the other side of the trade in return for a commission; the broker might occasionally position a portion of the block. (To position a trade is to take the other side of it, acting as a principal with capital at risk.) Brokers can also provide a reputational screen to protect uninformed or liquidity-motivated traders. For example, the broker might “shop the block” only to those potential counterparties that the broker believes are unlikely to front-run the trade (trade ahead of the initiator, exploiting privileged information about the initiator’s trading intentions). These attributes of brokerage markets facilitate trading and hence add value for all parties to the transaction.

Question 44

The Reasoning behind Logical Participation Algorithmic Strategies

Answer 44

• A large body of empirical evidence suggests that the price impact of equity trades is an increasing function of order size.
• An implementation shortfall strategy involves minimizing a weighted average of market impact costs and missed trade opportunity costs. Missed trade opportunity cost refers to the risk of not executing a trade because of adverse price movements. A common proxy for such costs is the volatility of trade value or trade cost, which increases with trading horizon. Intuitively, the sooner an order is made available to the market, the greater the opportunity it usually has to find the opposing side of the trade.
• The logic for implementation shortfall strategies differs from that of the more traditional participation strategy. Recall that breaking up an order yields the lowest market impact cost. However, there is a cost to extending trade duration by breaking the order very finely, namely, risk. The implementation shortfall strategy—after the user specifies a weight on market impact cost and opportunity cost or risk—solves for the optimal trading strategy. The intuition is straightforward. If the trader is very risk averse, then the strategy will trade aggressively in early periods to complete the order quickly to avoid undue risk.

Question 45

Best Execution

Answer 45

Best execution as “the trading process Firms apply that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints.”

1. Best execution is intrinsically tied to portfolio-decision value and cannot be evaluated independently (The purpose of trading is to capture the value of investment decisions. Thus, the definition has strong symmetry to the definition of prudent expert that guides fiduciary decisions).
2. Best execution is a prospective, statistical, and qualitative concept that cannot be known with certainty ex ante (Trading is a negotiation, with each side of the trade having equal standing. Both buyer and seller—or their appointed agents—jointly determine what “best execution” is for every trade.)
3. Best execution has aspects that may be measured and analyzed over time on an ex post basis, even though such measurement on a trade-by-trade basis may not be meaningful in isolation (Trading occurs in a volatile environment subject to high statistical variability. One would not evaluate a card player on an individual hand; one would need to observe a sequence of hands to determine skill; similarly for traders. Despite the variability, overall trades contain some information useful in evaluating the process. By compiling trade data, one can deduce useful information about the quality of the process.)
4. Best execution is interwoven into complicated, repetitive, and continuing practices and relationships. (Trading is a process, not an outcome. The standards are behavioral.)

Question 46

Disadvantages of VWAP and Implementation Shortfall

Answer 46

Volume Weighted Average Price

• Does not account for costs of trades delayed or canceled.
• Becomes misleading when trade is a substantial proportion of trading volume.
• Not sensitive to trade size or market conditions.
• Can be gamed by delaying trades.

Implementation Shortfall

• Requires extensive data collection and interpretation.
• Imposes an unfamiliar evaluation framework on traders.

Question 47

The Types of Traders

Answer 47

Traders can be classified by their motivation to trade, as follows.

1. Information-motivated traders trade on information that has limited value if not quickly acted upon. Accordingly, they often stress liquidity and speed of execution over securing a better price. They are likely to use market orders and rely on market makers to accommodate their desire to trade quickly. They must execute their orders before the information on which they are buying or selling becomes valueless. Information traders often trade in large blocks. Their information frequently concerns the prospects of one stock, and they seek to maximize the value of the information. Successful information-motivated traders are wary of acquiring a public reputation for astute trading, because if they did, who would wish to trade against them? Accordingly, information traders often use deceptive actions to hide their intentions.
2. Value-motivated traders act on value judgments based on careful, sometimes painstaking research. They trade only when the price moves into their value range. As explained earlier, they trade infrequently and are motivated only by price and value. They tend to accumulate and distribute large positions quietly over lengthy trading horizons. Value-motivated traders are ready to be patient to secure a better price.
3. Liquidity-motivated traders do not transact to reap profit from an information advantage of the securities involved. Rather, liquidity-motivated transactions are more a means than an end; such transactions may, for example, release cash proceeds to facilitate the purchase of another security, adjust market exposure, or fund cash needs. Lacking the information sensitivity of the information and value traders, liquidity-motivated traders tend to be natural trading counterparties to more knowledgeable traders. Thus, they need to be aware of the value their liquidity brings to knowledgeable traders.
4. Passive traders, acting on behalf of passive or index fund portfolio managers, similarly seek liquidity in their rebalancing transactions, but they are much more concerned with the cost of trading. They tend to use time-insensitive techniques in the hope of exchanging a lack of urgency for lower-cost execution. Passive traders have the flexibility to use lower-cost trading techniques. Because of the types of orders and markets they use, these traders resemble dealers in the sense that they allow the opposing party to determine the timing of the trade in exchange for determining the acceptable trade price.
5. Dealers, whose profits depend on earning bid–ask spreads, have short trading time horizons like information-motivated traders. Given that a transaction is profitable, however, they have no specific emphasis on time versus price. Arbitrageurs are sensitive to both price of execution and speed of execution as they attempt to exploit small price discrepancies between closely related assets trading in different markets. Day traders rapidly buy and sell stocks in the hope that the stocks will continue to rise or fall in value for the seconds or minutes they are ready to hold a position. Like dealers, they often seek to profitably accommodate the trading demands of others.

Question 48

John Booker is a manager at a trading firm. He is quite upset because yesterday a junior trader had excessive trading costs. Critique his perspective.

Answer 48

Booker is perhaps overreacting. It is difficult to judge a trader`s performance over just one day. The market conditions mat have been so severe that measurement of trading costs would be flawed. Although best execution can be measured ex post over time, it can not be legitimately measured over a short time period.

Question 49

Market microstructure

Answer 49

Market microstructure - the market structures and processes that affect how the manager’s interest in buying or selling an asset is translated into executed trades (represented by trade prices and volumes).

Question 50

VWAP

Answer 50

Most traders measure implicit costs (i.e., costs excluding commissions) with reference to some price benchmark or reference point. We have already mentioned one price benchmark: the time-of-trade midquote (quotation midpoint), which is used to calculate the effective spread. When such precise information is lacking, the price benchmark is sometimes taken to be the volume-weighted average price (VWAP). The VWAP of a security is the average price at which the security traded during the day, where each trade price is weighted by the fraction of the day’s volume associated with the trade. The VWAP is an appealing price benchmark because it allows the fund sponsor to identify when it transacted at a higher or lower price than the security’s average trade price during the day.

VWAP is less informative for trades that represent a large fraction of volume. In the extreme, if a single trading desk were responsible for all the buys in a security during a day, that desk’s average price would equal VWAP and thus appear to be good, however high the prices paid. Another limitation of VWAP (and of the effective spread) is that a broker with sufficient discretion can try to “game” this measure. (To game a cost measure is to take advantage of a weakness in the measure, so that the value of the measure may be misleading.)

In contrast to the VWAP, which is partly determined as the trading day progresses, the opening price is known with certainty at any point into the trading day, making it easier to game.

To address the possibility of gaming VWAP, VWAP could be measured over multiple days (spanning the time frame over which the order is executed), because traders would often be expected to try to execute trades within a day. However, the cost of measuring VWAP over a longer time frame is less precision in estimating trading costs.

If the trade is of low urgency and can be traded over time it is thus suitable for VWAP based strategy.

+ VWAP does not consider missed trades!!!

Question 51

Summary of trading tactics

Answer 51