SS16 - Execution of Portfolio Decisions

Question 1

What is market microstructure?

Answer 1

Market microstructure refers to the struct and processess of a market that **may affect the pricing of securities in relation to intrinsic value **and the ability of managers to execute trades.

Question 2

What are the two major order types?

Answer 2

• market orders
  
  • execute immediately at the best possible price
• limit orders
  
  • trade at the limit price or better
    
    • for sells, execution price must be >= limit price
    • for buys, execution price must be <= limit price

Question 3

Which types of uncertainty do each of the two major order types have?

Answer 3

• market order: price uncertainty
• limit order: execution uncertainty

Question 4

What is the bid and ask?

Answer 4

• bid price: **price **dealer will **pay **for a security
• bid quantity: **amount **dealer will buy of a security
• ask price: **price **dealer will **sell **a security
• ask quantity: **amount **dealer will **sell **of a security

Question 5

How do you calculate the inside bid-ask spread?

Answer 5

The inside bid-ask spread spread is calculated by subtracting the best bid price from the best ask price.

best ask - best bid

Question 6

How is the **midquote **calculated?

Answer 6

The **midquote **is the average of the inside bid-ask spread.

Question 7

What is the effective spread?

Answer 7

The effective spread is the actual execution price vs the midquote. If the effective spread **is less than **the midquote, it indicates good trade execution or a liquid security.

for buys: 2 * (exe price - midquote)

for sells: 2 * (midquote - exe price)

Question 8

What are the three main categories of securities markets?

Answer 8

1. quote-driven: investors trade with dealers
2. order-driven: investors trade with each other. no intermediaries
3. brokered markets: investors use brokers to locate the counterparty to a trade

Question 9

What is the most important feature offered by quote-driven markets?

Answer 9

Quote driven markets offer **liquidity. ** Dealer exists and stands ready to take either side of a trade.

Question 10

What are some additional features of quote-driven markets?

Answer 10

• dealer maintains inventory
• dealer posts bid and ask prices
• used in markets that trade illiquid securities
• if limit order book is closed to the average investor, that is called a closed-book market

Question 11

What is the most important feature of an order-driven market?

Answer 11

Order-driven markets may have more competition resulting in better prices.

Question 12

What are some additional features of order-driven markets?

Answer 12

• prices are set by supply and demand. there is no dealer.
• liquidity may be poor
• execution of a trader is determined by a mechanical rule

Question 13

What are the three main types of order-driven markets?

Answer 13

1. electronic crossing network
   
   • typical trader is an institution
   • orders are matched at fixed points during the day at average of the bid and ask
   • costs are low; no dealer bid-ask spread to pay
   • anonymous
2. auction market
   
   • traders submit orders to compete agains other orders for execution
   • periodic (batch) or continuous
   • provide price discovery. results in less partial fills than ECNs. why?
3. automated auction
   
   • “electronic limit-order market”
   • NYSE Arca, Paris Bourse
   • like ECNs in most ways, but unlike ECNs, they provide price discovery

Question 14

What is the difference between a dealer and a broker?

Answer 14

• dealers are just other traders offering a service (liquidity) to earn a profit
• brokers act as trader’s agent (imposes legal obligation to act in best interests of the trader)

Question 15

What are some of the services a broker can/does provide in the principal-agent relationship with the trader?

Answer 15

• represent the order: advise on prices and volume
• find counterparties: using brokers contacts; broker may also step in and act as a dealer
• provide secrecy
• other services: record keeping, safe keeping, cash management (but not liquidity)
• support market: they help markets function in general

Question 16

What are the top three things that a securities market should provide?

Answer 16

1. liquidity
2. transparency
3. assurity of completion

Question 17

What are some attributes of a market that is liquid?

Answer 17

• small bid-ask spreads
  
  • makes traders apt to trade more often
• market depth
  
  • allows larger orders/trades without affecting security prices much
• resilence
  
  • prices stay close to their intrinsic values; any deviations are quickly minimized.

Question 18

What are the **necessary factors **for a market to be liquid?

Answer 18

• abundance of buyers and sellers. allows traders to quickly reverse if necessary
• diverse investor characteristics. if all traders had the same view, there would be little trading
• convenient location or trading platform
• integrity (from participants and regulation)

Question 19

How can the top three attributes of a market be evaluated?

Answer 19

• transparency: qualitative
• assurity of completion: qualitative
• liquid: quantitative
  
  • quoted spread
  • effective spread
  • bid and ask sizes

Question 20

What are the components of execution costs?

Answer 20

• explicit costs
  
  • commissions, taxes, stamp duties, fees
• implicit costs
  
  • bid-ask spread
  • market impact
  • opportunity costs
  • delay costs (slippage)

Question 21

What is market impact cost?

Answer 21

Market impact cost is the **effect of the order on market prices. **

Example: a large sell order might get a portion filled at price X, but then the rest filled at a price lower than X.

Question 22

What is opportunity cost?

Answer 22

Opportunity cost occur when an order is not filled and the price later moves such that the trader would have profited.

Question 23

What are **delay **or slippage costs?

Answer 23

When an order is not filled or only partial filled. These costs can be substatial if information regarding the security is released while the order is unfilled.

Question 24

How is Volume-Weighted Average Price (VWAP) calculated?

Answer 24

• 10 AM: 100 shares at $12.11
• 1 PM: 300 shares at $12.00
• 2 PM: 600 shares at $11.75

VWAP = (100/1000) * 12.11 + (300/1000) * 12.00 + (600/1000) * 11.75 = 11.86

Question 25

What are some ways to measure implicit costs?

Answer 25

• use midquote to calcuate the effective spread
• use Volume-Weighted Average Price (VWAP)
• use Implementation Shortfall (IS)

Question 26

What are the shortcomings of VWAP?

Answer 26

• not useful if trader is significant part of trading volume
• potentially gamed
• does not consider missed trades

Question 27

What is implementation shortfall (IS)?

Answer 27

Implementation shortfall is the difference between the actual portfolio return and a hypothetical paper portfolio’s return of trades executed at no cost.

The return on the paper portfolio is based on the decision price, which is the market price of the security at the time the decision to trade is made.

Question 28

What are the four components of IS?

Answer 28

1. explicit costs
   
   • commission, fees, taxes
2. realizes profit/loss
   
   • difference between execution price and the relevant benchmark price (usually the decision price)
3. delay or slippage costs
   
   • cost from not being able to fill the orer during the trading day when order is initiated
4. missed trade opportunity cost
   
   • opportunity loss or gain due to inability to complete the trade
   • difference between cancellation price and decision price

Question 29

What are the **advantages and disadvantages **of VWAP?

Answer 29

Advantages:

• easily understood
• computationally simple
• can be applied quickly to enhance trading decisions
• most appropriate for comparing **small trades **in nontrending markets

Disadvantages:

• not useful for trades that dominate trading volume
• can be gamed
• does not evaluate delayed or unfilled orders
• does not account for market movements or trade volume

Question 30

What are the advantages and disadvantages of IS?

Answer 30

Advantages:

• PMs can see the cost of implementing their ideas
• demonstrates tradeoof between execution and market impact
• decomposes and identifies costs
• can be used with an optimizer to minimize costs
• not subject to gaming

Disadvantages:

• may be unfamiliar to traders
• requires considerable data and analysis

Question 31

How would **econometric methods **be used pretrade to estimate implicit transaction costs?

Answer 31

An analyst could use the below variables in a gregression equation to determine the estimated cost of a trade.

Trading costs have a non-linear relatonship with:

• security liquidity: trading volume, market cap, spread, price
• size of trade relative to liquidity
• trading style: more aggressive –> higher costs
• momentum: buying stock costs more when the market is trending upward
• risk

Question 32

What is the **usefulness **of econometric models?

Answer 32

Twofold:

1. trading effectiveness can be assessed by comparing actual trading costs to forecasted trading costs from the model
2. can assist PMs in determining the size of a trade

Question 33

What are the four types of traders?

Answer 33

• information-motivated
  
  • motivation: has time sensitive information
  • preference: time
  • order type: market
• value-motivated
  
  • motivation: security misvaluations
  • preference: price
  • order-type: limit
• liquidity-motivated
  
  • motivation: reallocation and liquidity
  • preference: time
  • order type: market
• passive
  
  • motivation: reallocation and liquidity
  • preference: price
  • order type: limit

Question 34

What are the major trading tactics (different trading needs PMs need at different times)?

Answer 34

• liquidity-at-any-cost
  
  • transact in large blocks quickly
  • usually an information trader
• costs-are-not-important
  
  • believes markets operate fairly and efficiently
  • pays average trading costs in exchange for quick execution
  • uses market orders
• need-trustworthy-agent
  
  • employs a broker to skillfully execute large trade
  • security may be thinly traded
  • may need to be done over time; not appropriate for information traders
  • cede control to broker
  • commissions may be high
• advertise-to-draw-liquidity
  
  • publicized in advante to draw counterparties
  • IPO
  • others may front run
• low-cost-whatever-the-liquidity
  
  • limit order outside the current bid-ask quotes
  • useful for passive and value-motivated traders
  • patience required
  • order my never be executed

Question 35

What is the motivation for using algorithmic trading?

Answer 35

To execute orders with minimal risk and costs.

Question 36

What are the types of algorithmic trading strategies?

Answer 36

• logical participation strategies
  
  • simple strategies
    
    • VWAP
    • TWAP
    • Pct of Volume
  • implementation shortfall strategies
• opportunistic strategies
• specialist strategies

Question 37

What are the four characteristics of best execution?

Answer 37

1. cannot be judged independently of the investment decision
2. cannot be known with certainty ex-ante
3. can only be assessed after the face
4. relationships and practicies are integral to best execution

Question 38

What are the **three **parts of CFAI’s Trade Management Guidelines?

Answer 38

1. processes
   
   • firms should have policies and procedures that have intent of maximizing portfolio value using best ex.
2. disclosures
   
   • general information regarding trading techniques, markets, and brokers
   • conflicts related to trading
3. record keeping
   
   • maintain documentation supporting:
     
     • firms compliance with policies and procedures
     • disclosures made to its clients