week 8

Question 1

 Investment Cycle

Answer 1

o Asset Allocation
o Portfolio Construction
o Implementation
o Portfolio Attribution

Question 2

o Asset Allocation

Answer 2

 Distributing investment dollars across stocks, bonds, cash and other investment vehicles in order to achieve a target level of return within a specified level of risk exposure and tolerance

Question 3

o Portfolio Construction

Answer 3

 Selecting the actual instruments to hold in each asset classes

Question 4

o Implementation

Answer 4

 Selecting an appropriate broker/dealer
 Execution
 Now inc. specification algorithms and algorithmic trading rules

Question 5

o Portfolio Attribution

Answer 5

 Performance analysis
• Evaluate performance of the fund to distinguish between market movement and skilled decision-making ability

 Transaction Cost Analysis

 Difficult to measure trading costs independent of investment decisions

Question 6

 Why Transaction Cost Analysis

Answer 6

o For buy side traders; to determine whether brokers are working effectively on their behalf

o To confirm they are getting value for their brokerage commissions

o To determine whether
they should be trading more or less aggressively
 Trading aggressively leads to different transaction costs

o To better understand why they are competing with other traders who are trading on the same information

o To inform their portfolio managers about liquidity conditions in various securities

Question 7

 Evaluating Investment portfolio Performance

Answer 7

o	Measure the increase in asset or portfolio value relative to the initial asset value during a given time frame
o	Returns can be measured
	Dollar-weighted return
	Time-weighted average return
	Need to think of portfolio

o Returns adjusted by or compared to a relevant benchmark
o Refers to stock selection, based on these ratios we will evaluate the stock performance
 Sharpe ratio
 Treynor Ratio
 Jensen Measure

Question 8

 Evaluating Investment Portfolio Performance

Answer 8

o Market timing refers to the ability of the investor to shift their portfolio’s betas

o Suppose we have a risk-free asset and risky asset
 Market downturn -> allocate more money in the risk-free asset
• Shifting returns closer to Rf

 Market upswing -> more money allocated into the risky asset
• Increase portfolio beta

Question 9

 Ways to examine market timing

Answer 9

o	Quadratic variable approach
	Increase the beta when the market is good, decrease when its bad
	Yg is expected to be positive
o	Dummy Variable approach
	D=1 when its in a bad market

 Do we expect gamma q to be negative when the market is bad?
• Quadratic variable approach
 Expect gamma q to be negative in a positive market

Question 10

 Transaction cost components

Answer 10

o	Explicit costs
	Contractual costs which include
•	Brokerage commissions
•	Clearing and settlement cost
•	Taxes / stamp duties
	Easiest to measure

o	Implicit costs
	Price effects
•	Bid/ask spreads
•	Market impacts
	Hard to measure

o Missed trade opportunity costs
 Informed traders lose profits when their orders go unfilled
 Unfilled orders may also hurt uninformed traders
 Hard to measure
o To measure these costs, need to estimate the price without the trade occurring

Question 11

 Two approaches

Answer 11

o Benchmark comparison
 Difference between the benchmark price and traded price

 Benchmark price: arrival price, VWAP, close price and others
 Many different benchmark prices

o Implementation shortfall
 Most effective means of measuring transaction costs
 Involves assessing the impact of trading on portfolio returns by computing the difference between the net returns on a paper portfolio and those on a real portfolio

o Looking at these two, they are essentially the same as it is comparing two prices

Question 12

 A general transaction cost measurement framework

Answer 12

o Difference between the trade price and a price benchmark may contain information about transaction cost

o For a buy
 TC/Unit = TP-BP

o For a sell
 TC/unit = BP-TP

o The ideal price benchmark would estimate the price that would have been observed if not for the trade
 Your trade is not included
 No one can confidently specify a price not including your trade

Question 13

 Common Price Benchmarks

Answer 13

o Arrival price – spread midpoint at the time of trade
o VWAP – Average price around the trade
o Closing or opening prices

Question 14

 The Spread Midpoint Benchmark Price

Answer 14

o Estimate the benchmark price by the average of the bid and ask at the time of the trade

o Refers to the arrival price
 The cost of a buy at the ask (or a sell at the bid) is one half of the spread

o Issue: the spread midpoint benchmark does not indicate whether the trade is well timed
o Doesn’t necessarily show that you traded at a better price
o Other issues
 Large orders may require many trades between which quotes typically trade
 Total transaction cost will be underestimated if a different midpoint benchmark is used for each trade
 Brokers may defer the trade until it can be done when the spread is narrow
• May end up with worse trade price for the investor

Question 15

 Volume-weighted average price

Answer 15

o The price benchmark is the volume-weighted average price for the day of the trade

o Negative transaction cost in this scenario with vwap shows positive returns
 You are trading at a lower price than the average traded price for the day

o Advantages
 Simple summary statistic of all trades in a day
 Transaction cost measure can be computed from volume-weighted average cost trade confirmations

o Issues
 If you are the only buyer (or seller) in the interval
• Transaction cost estimate is zero
 The selection/implementation decomposition is burred
• Momentum traders estimate positive costs
• Contrarian traders estimate negative costs
 Inherent drawbacks of VWAP
• Trading strategy induces it to be positive/negative if you are a momentum/contrarian trader

Question 16

 Momentum/Contrarian

Answer 16

o Buy in an upward trend
o Sell in a downward trend
o E.g. join the trading session at a later time when there is momentum in an upward trend
 At the end of the day, you most likely end up with a positive cost due to the average trading price being very low at the start of the day
o Contrarian
 Buy in a downward trend, sell in an upward trend

Question 17

 The closing price benchmark

Answer 17

o Estimate transaction costs by the difference between the trade price and the closing price on the day of the trade
o Easy to observe
o Closing price advantages
 Closing prices are obtained easily
o Issues
 Informed traders estimate negative transaction costs
• Selection and implementation decomposition blurred
• Informed trader knows where the price will end up -> have a negative flow
• You are not a good trader, you just know the private information
 Brokers can execute orders only at or very close to the close to have zero transaction cost estimates
• Brokers tend to trade at the end of the session because they know that’s their benchmark
• Tend to have lower transaction costs due to trading price being very close to the market close price

Question 18

 Implementation shortfall measures

Answer 18

o Transaction costs, if the order trades
o Lost opportunity costs – if the order does not trade
 Failure to submit realistic orders
o Timing
 The change in quote midpoint between decision and first execution
o Market impact
 The difference between the first execution quote midpoint and the average trade price
o Opportunity cost
 The loss suffered if the order did not execute
o Price impact
 Trade amount * (Trading price – first trading price)

Question 19

 Implementation Shortfall: advantages and disadvantages

Answer 19

o Advantages
 The implementation shortfall separates portfolio selection performance from implementation performance
• Does not favour brokers who handle informed order flow
 Brokers cannot game the implementation shortfall measure
o Issues
 The implementation shortfall requires decision time and order size data
• These data are not generally available
 It estimates large opportunity costs for unrealistically large orders

Question 20

 General observations

Answer 20

o Statistical properties of measures
 All transaction cost estimation methods produce noisy results when applied to single trades
o Average transaction costs, measured over many transactions, are more reliable indicators
 Averaging does not solve bias or gaming problems
o Traders who offer liquidity tend to have negative transaction costs
o Only implementation shortfall method measures lost opportunities of trades not done

Question 21

 Evaluating Trading performance

Answer 21

o Brokerage evaluation requires baseline data for similar problems
 Difficult problems are more expensive to solve than simple ones
 Comparisons across brokers are meaningful only when they are given similar trading problems
o Expected trading costs should be integrated into portfolio composition decisions
 The trader should advise the manager of what is feasible
o A well-informed trader should be willing to incur transaction costs