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CFA Level III > Trading, Monitoring, and Rebalancing > Flashcards

Trading, Monitoring, and Rebalancing Flashcards

1
Q

Effective Spread

A

ES for buy = 2 * (execution price - midquote)
ES for sell = 2 * (midquote - execution price)

ES reflects price movement and price impact

Example: bid 11.50, ask 11.56, buy executed price 11.55

midquote = 11.53
ES buy = 2 * (11.55-11.53) = 0.04
This is less than 11.56 means execution was superior (lower cost)

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2
Q

Types of Market Structures

A
  1. Quote-Driven: trade with dealers
    1. Offers liquidity
    2. Good for bond markets
  2. Order-Driven: trade directly with each other
    1. Results in competition (better prices)
    2. Liquidity may be poor
  3. Brokered markets: use brokers to locate counterparty
  4. Hybrid market
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3
Q

Types of Order-Driven Markets

A
  1. ECN - Institutions
    1. Low costs
    2. Don’t pay bid-ask spreads
    3. Don’t know counter party
  2. Auction Markets
    1. Traders compete for orders
    2. Have price discovery
  3. Automated Auctions
    1. Trades based on rules
    2. Have price discovery
    3. Don’t know counter-party
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4
Q

Brokers and Dealers

A

Dealers are matchmakers earning a profit (provides liquidity)

Brokers are hired by the investor. They can:

  • Represent the order
  • Find counterparties to the trade
  • Provide secrecy
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5
Q

Market Quality

A
  • High liquidity
    • narrow spreads
    • lots of buyers/sellers (depth)
  • High transparency
  • Good trade settlement
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6
Q

Execution Costs

Explicit
Implicit
VWAP

A

Explicit: commissions, taxes, fees

Implicit: spread, opportunity costs, delay costs

VWAP - just average costs

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7
Q

Advantages/Disadvantages of VWAP

A

Advantages Disadvantages

Easily understood Not good for large trades
Can be applied quickly Can be manipulated
Best for small trades Ignores delay and missed trade costs

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8
Q

Implementation Shortfall (IS)

A

Measures difference between actual and theoretical portfolio

4 Types:

  • *Delay (slippage):** cost for slow execution
  • *Price impact (RGL):** costs after delay
  • *Missed trade opportunity (UGL):** any portion not traded
  • *Explicit costs:** commissions, etc.

Example: Limit order for 1000 shares at 47.39, closing price 47.30
500 sold at 47.44, 500 at 47.39, commission of 50

Hypothetical portfolio = 1000 * 47.39 = 47,300
actual portfolio = (500 * 47.44) + (500 * 47.39) - 50 = 47,365
IS = 47,300 - 47,365 = -65 Per share: -65/1000 = -0.065
bps = -65/47,300 = -.14% or 14 bps

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9
Q

Components of IS

Missed trade opportunity

A

Its the unrealized profit/loss

[(CP - DP)/DP] * (% canceled)

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10
Q

Components of IS

Delay/slippage costs

A

Only applies to day that order went unfilled

[(BP - BP)/DP] * % executed

benchmark price = the NEXT daily closing price

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11
Q

Components of IS

Price/market impact

A

This is the realized gain/loss

[(EP - BP)/DP] * % executed

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12
Q

Advantages/Disadvantages of Implementation Shortfall(IS)

A

Advantages

Can see full cost of an idea
Can see market impact vs execution
Cannot be “gamed”

Disadvantages

Requires lots of data and analysis

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13
Q

Trading costs should be lower when?

A

Based on Econometric Models

  1. in liquid markets
  2. less volatility
  3. smaller trades
  4. buying in a falling market
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14
Q

Types of Traders

A

Types Motivation Time/Price Order Type

Information time-sensitive time market

value misvaluations price limit

liquidity reallocation time market

Passive reallocation price limit

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15
Q

Types of Trading Tactics

A

Tactic Strength Weakness

Trustworthy agent low advertising uncertain exec.

Advertise liquidity good on large trades front running

Low cost low trading costs uncertain timing

Liquidty-at-cost quick execution info leakage

Costs-dont-matter quick execution high trade cost

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16
Q

Types of Algorithmic Trading

A
  1. Logical participation
    1. Simple - best for small trades
    2. VWAP, TWAP, % of volume
    3. IS - best for urgency (front loads trades)
  2. Opportunistic
    1. reacting to changing market volume
  3. Specialized
    1. Hunter - wait until favorable conditions
    2. Target closing price (trade at end of day)
17
Q

Trading Procedures

A
  1. Process documented
  2. Disclosure to clients
  3. Record keeping
18
Q

What is adverse selection risk?

A

A dealer faces adverse selection risk because a trader has more information and can profit at the dealer’s expense

19
Q

Calendar vs % Rebalancing (PoPR)

A

Calendar
On specific date rebalance to weights.
Drawback: deviation between dates unknown

PoPR
Once asset class out of bands, rebalance all asset classes
Benefit: lower transaction costs
Drawback: requires daily monitoring

Can combine both

20
Q

Factors in Setting a Tolerance Band

A

Factors positively correlated:

  1. Transaction costs: ↑ costs ↑ band
  2. Risk tolerance: ↑ risk ↑ band
  3. Correlation: ↑ correlation ↑ band

Factors negatively correlated:

  1. Volatility on asset class: ↑ volatility ↓ band (to control risk)
  2. Volatility of other asset classes: ↑ volatility ↓ band
21
Q

Managers Must Monitor Changes in:

A
  1. Client circumstances
  2. Capital market expecations
  3. Portfolio (change in allocations)
22
Q

Types of Rebalancing Strategies

A
  1. Buy and Hold
  2. Constant Mix
  3. Constant Porportion
23
Q

Buy and Hold Rebalance

A
  • Do nothing, let assets grow
  • Middle results between CM and CPPI
  • Risk tolerance goes up/down with risky assets
  • Floor = amount in Rf

Good when:

  • risk tolerance is correlated to wealth and return
  • Tax and transaction cost efficient (no trades)
24
Q

Constant Mix Rebalance

A

AKA contrarian strategy

  • Does well in mean reverting environment (concave payoff)
  • Good for investors with constant risk tolerance
  • Dimished upside
  • Floor is $0
  • Less tax and transaction cost efficient
25
Q

Constant Proportion Rebalance

A

AKA momentum (double-down)

  • Good for investors with risk tolerance up/down rapidly with wealth
  • Accelerates updside
  • Floor value > % in Rf
  • Formula: Multiplier * (total assets - floor)
26
Q

Best Rebalance Strategy per Market

A
  1. Up/down trending
    1. Best: CPPI (buy winners and sell losers)
  2. Mean Reverting
    1. Best: Constant mix (selling high and buying low)
  3. Remember BH is most tax and transaction efficient
27
Q

When do use what type of trade execution tactic?

A

VWAP: low volume, not urgent, narrow bid/ask

IS: low volume, urgent, narrow bid/ask

CFA Level III (13 decks)

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