TRADE STRATEGY AND EXECUTION

Question 1

Explain what is alpha decay and what it incurred for managers.

Answer 1

alpha decay is the deterioration of alpha once an investment decision has been made. Managers with high alpha decay (like managers that trades on daily news) have high alpha decay. They have a high trade urgency.

Question 1

Identify the four categories that motivates a manager of executing a trade.

Answer 1

1. Profit Seeking
2. Risk Management and hedging needs
3. Cash flow needs
4. Corporate actions, margin calls, and index reconstitution

Question 2

what is information leakage and how can we mitigate it.

Answer 2

Information leakage is when we alert the market that the security is mispriced through trading activities. Manager should execute their trade in multiple venues (that can include dark pools) to remove the risk.

Question 3

Describe how the following factors affects the market impact cost of the trade : order size, security liquidity, and rate of alpha decay

Answer 3

A larger order size will most likely lead to a higher market impact cost; the trader will have to trade at more adverse prices to execute a larger transaction.

Higher liquidity results in narrower bid-ask spreads and higher market depth, both contributing to lower market impact cost; the trader will likely be able to execute the trade close to current market prices.

Higher alpha decay prompts traders to trade quickly, leading to a higher market impact cost.

Question 4

What is included in a pre-trade benchmarks (reference prices)

Answer 4

1- Decision price : price at the time the manager made the investment decision

2- Previous close : Price at the previous market close.

3- Opening price : opening price of the day

4 - arrival price : Price when the manager submitted the trade.

Question 5

What is included in a intraday benchmarks (reference prices) and described.

Answer 5

Volume weighted average price : average price weighted by volume over the trading horizon.

Time weighted average price : Equal weighted average price of all trade executed over the trading horizon.

Question 6

What is included in a post trade benchmarks

Answer 6

Determined after the trade has been completd. Usually we take the closing price, for manager who want to minimize the tracking error of the fund.

Question 7

What is included in a price target benchmarks

Answer 7

Prices used by profit seeking managers aiming to generate short term alpha, related to manager’s view of fair value of the market price. Example, if the managers thinks that a stock is worth 10.50$ and is now price at 10$, that manager could use a strategy to purchase a many shares possible below that threshold.

Question 8

What type of reference prices would be appropriate for the following trade types : Short-term alpha, long term alpha risk rebalance, cash flow driven

Answer 8

Short term alpha : price target benchmarks

Long term Alpha : Difficult to use

Risk rebalance : time weighted average

Cash-Flow : Closing price

Question 9

What execution method would be appropriate for the following trade types : Short-term alpha, long term alpha risk rebalance, cash flow driven

Answer 9

Short term alpha : Computer algorithm

Long term alpha : sell securities over a few weeks in small parts to avoid information leakage

risk rebalance : Algorithmically target TWAP over the next couple of days.

Cash flow (client redemption) : Execute a reasonable amount of liquidity in the closing auction. the remainder will be execute before the close of trading day.

Cash flow (new trade mandate) : obtain immediate exposure to index through a long position in index future to remove cash drag effect.

Question 10

Explain the trade implementation approach : High-touch approaches

Answer 10

Involve high levels of human involment.

Required for large trades.

Inlcudes:

-Principal trades : Where dealer or market makers assume assume all or some of the risk related to executing the trade.

Quote driven OTC

Agency trades : this is whre the broker finds the other side of the trade.

Question 11

Identify types of trade execution algorithmic trading

Answer 11

Scheduled algorithms : Includes POV, VWAP, TWAP algorithms

Liquidity seeking algorithm : aim to take advantage of favorable liquidity conditions

Arrival price algorithm : Seek to trade close to market prices prevailing at the time the order is entered.

Dark strategies/Liquidity aggregators : Execute trade in dark pools

Smart order routers : algorithms that determines the best destination for the trade (lit or dark pools) to get the best results.

Question 12

what type of algorithms is appropriate for relatively small order in liquid market with less urgency :

Answer 12

Scheduled algorithms

Question 13

What type of algorithms are appropriate for larger trades in less liquid market with higher urgency

Answer 13

Liquidity seeking algorithms

Question 14

What type of algorithms is appropriate when a manager is concerned that displaying limit orders may lead to information leakage

Answer 14

Liquidity seeking algorithms

Question 15

What type of algorithms is appropriate for relatively small orders in liquid markets for managers who believe prices are likely to move against them during the trade horizon

Answer 15

Arrival price

Question 16

What type of algorithms is appropriate for large orders in illiquid markets, and that arrival price or scheduled algorithms would likely lead to high market impact.

Answer 16

Dark strategies- liquidity aggregators

Question 17

What type of algorithms is appropriate for small market 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.

Answer 17

Smart order routers

Question 18

Identify the decomposition of implementation shortfall (IS)

Answer 18

Execution Cost : Trade got executed at a less favorable price than the original decision price. Can be broken down into delay cost and trading cost.

Delay cost : price movements in the time between the portfolio manager submitting the order to the trader and the time the trader releases it to the market. This delay is usually due to the time it takes the trading desk to determine the optimal execution strategy for the trade.

Trading cost : due to the market impact of executing the trade.

Opportunity cost : cost of not trading any unfilled part of the order

fixed fees : any explicit commissions or fees

Question 19

How do we calculate absolute cost of a trade againts the benchmark

Answer 19

Absolute Cost = (side) * (execution price - benchmark price) * # shares

If you want in basis point value : (side) * ((execution price - benchmark price) / benchmark price)) * 10 000

Question 20

How can we remove the impact of market movements on trade cost ?

Answer 20

Market-adjusted cost

Index cost (bps) : (side) ((VWAP index - index arrival price) / index arrival price )) * 10 000

Market-adjusted cost : Arrival cost - Beta * index costs

Question 21

What are the key areas that should be specify in the trade policy of the asset manager.

Answer 21

1. Meaning of Best Execution
2. Factor that determine the optimal execution approach
3. List of eligible broker and execution venues
4. Process for monitoring execution arrangements

Question 22

What are the factors that determine best execution when it comes to an asset manager’s trading

Answer 22

-Execution price
-Trading cost
-Speed and likelihood of execution and settlement
-Order size and liquidity
-Nature of the trade

Question 23

What are the factors that determine the optimal execution approach needed to be communicated in the trade policy.

Answer 23

-Urgency and size of order
-Liquidity of security and nature of security
-Characteristics of available execution venues
-Investment strategy objectives
-Reason for the trade