Week 8 - Evaluating trading strats & performance

Question 1

What is the investment cycle for a fund manager?

Answer 1

1. Asset allocation
2. Portfolio construction
3. Implementation
4. Portfolio attribution

Question 2

Define best execution

Answer 2

trader receiving the most favourable terms for their trades

Question 3

What are the three components of transaction costs?

Answer 3

1. Explicit costs
   - fees of trade
2. Implicit costs
   - Price effects
3. Missed opportunity costs

Question 4

What are the two approaches to analyse transaction costs?

Answer 4

1. Benchmark comparisons
   - Difference between benchmark prices and traded price
2. Implementation shortfall method
   - Transaction costs if order executes
   +
   - Missed opportunity costs if order does not execute

Question 5

What are the common benchmark prices?

Answer 5

1. Arrival price
2. VWAP
3. Closing/opening prices

Question 6

How is arrival price calculated

What are the issues?

Answer 6

calculated by the midpoint of bid-ask spread at the time of trade (bid-ask*0.5)

issues:
1. does not evaluate the effectiveness of timing
2. Large orders require multiple quotes at different prices

Question 7

How are transaction costs caluclated from a benchmark for buy side and sell side?

Answer 7

Buy side
TP-BP = TC/unit

Sell Side
BP-TP = TC/unit

Question 8

How is VWAP calculated?
What are the pros and cons?

Answer 8

VWAP = Total traded value / total volume

Pros
- simple summary of all trades in a day

Cons
- If only one trade => TC = 0
- Large orders push TC/unit closer to 0

Question 9

What is the trading strategy for a momentum trader?

What is the issues of using the VWAP method?

Answer 9

buy in upward trend and sell in downward trends

Issues
positive transaction costs as TP > VWAP

Question 10

What is the trading strategy for a contrarian trader?

What is the issues of using the VWAP method?

Answer 10

buy in downward trends and sell in upward trends

issues
Negative transaction costs as TP < VWAP

Question 11

How is the closing price benchmark calculated?

What are the pros and cons?

Why is it gaining popularity?

Answer 11

Transaction costs = TP - closing price

Pros
Closing price is publicly available

Cons
informed traders = negative transaction costs
Brokers can execute at closing price= 0 TC

Gaining popularity as fund managers can gain lower transaction costs estimates easily

Question 12

What is included in the implementation short fall method?

What are the pros and cons?

Answer 12

Measures
1. Transaction costs
2. Opportunity costs if not executed

Pros
- Separates portfolio selection performance from implementation performance
- Brokers cannot game the method

Cons
- Requires data relating to decision time and order size
- Estimates large opportunity costs for large orders