SS16 - Execution of Portfolio Decisions Flashcards
(38 cards)
What is market microstructure?
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.
What are the two major order types?
- 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
- trade at the limit price or better
Which types of uncertainty do each of the two major order types have?
- market order: price uncertainty
- limit order: execution uncertainty
What is the bid and ask?
- 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
How do you calculate the inside bid-ask spread?
The inside bid-ask spread spread is calculated by subtracting the best bid price from the best ask price.
best ask - best bid
How is the **midquote **calculated?
The **midquote **is the average of the inside bid-ask spread.
What is the effective spread?
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)
What are the three main categories of securities markets?
- quote-driven: investors trade with dealers
- order-driven: investors trade with each other. no intermediaries
- brokered markets: investors use brokers to locate the counterparty to a trade
What is the most important feature offered by quote-driven markets?
Quote driven markets offer **liquidity. ** Dealer exists and stands ready to take either side of a trade.
What are some additional features of quote-driven markets?
- 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
What is the most important feature of an order-driven market?
Order-driven markets may have more competition resulting in better prices.
What are some additional features of order-driven markets?
- 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
What are the three main types of order-driven markets?
- 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
- 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?
- automated auction
- “electronic limit-order market”
- NYSE Arca, Paris Bourse
- like ECNs in most ways, but unlike ECNs, they provide price discovery
What is the difference between a dealer and a broker?
- 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)
What are some of the services a broker can/does provide in the principal-agent relationship with the trader?
- 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
What are the top three things that a securities market should provide?
- liquidity
- transparency
- assurity of completion
What are some attributes of a market that is liquid?
- 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.
What are the **necessary factors **for a market to be liquid?
- 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)
How can the top three attributes of a market be evaluated?
- transparency: qualitative
- assurity of completion: qualitative
- liquid: quantitative
- quoted spread
- effective spread
- bid and ask sizes
What are the components of execution costs?
- explicit costs
- commissions, taxes, stamp duties, fees
- implicit costs
- bid-ask spread
- market impact
- opportunity costs
- delay costs (slippage)
What is market impact cost?
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.
What is opportunity cost?
Opportunity cost occur when an order is not filled and the price later moves such that the trader would have profited.
What are **delay **or slippage costs?
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.
How is Volume-Weighted Average Price (VWAP) calculated?
- 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
