CFA level 3 study notebook5 2015

Study Session 16Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio Decisions Answer: Themidquoteof the quoted bid and ask pricesis$11.53[=11.50+ 11.56/2].The effe

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BOOK 5 - TRADING, MONITORING,

Readings and Learning Outcome Statements 3

StudySession16 -Trading,Monitoring,and Rebalancing 8

StudySession 17 -Performance Evaluation 62

StudySession 18 -GlobalInvestmentPerformance Standards 129

Self-Test-GlobalInvestmentPerformance Standards 215

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SCHWESERNOTES™ 2015CFA LEVEL III BOOK5:TRADING, MONITORING,ANDREBALANCING;PERFORMANCE EVALUATION, AND GLOBAL

INVESTMENTPERFORMANCESTANDARDS

Publishedin2014 by Kaplan,Inc

Printedin theUnitedStatesofAmerica

ISBN:978-1-4754-2787-5/1-4754-2787-5

PPN:3200-5566

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

or quality of the products or services offered by Kaplan Schweser.CFA®and Chartered Financial

Analyst®are trademarks owned by CFA Institute.”

Certain materials contained within this text are the copyrighted property of CFA Institute The

following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced

and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.

Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level III Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes.

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READINGS AND

READINGSThefollowingmaterialisareviewoftheTrading, Monitoring, and Rebalancing; Evaluation

andAttribution;and GlobalInvestmentPerformanceStandards(GIPS®)principles designed

toaddress the learningoutcome statements setforthby CFAInstitute

ReadingAssignments

Trading, Monitoring and Rebalancing, CFA Program 2015Curriculum,

Volume6, LevelIII

30.Executionof PortfolioDecisions

31.Monitoring andRebalancing

page8

page 41

ReadingAssignments

PerformanceEvaluation, CFAProgram 2015Curriculum,

Volume6, Level III

32.Evaluating Portfolio Performance page 62

STUDY SESSION 18

ReadingAssignments

GlobalInvestmentPerformanceStandards,CFA Program 2015Curriculum,

Volume6,LevelIII

33.Overviewof the GlobalInvestmentPerformance Standards page129

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Book5 -Trading,Monitoring,and Rebalancing;Performance Evaluation,andGlobal Investment PerformanceStandards

Readingsand Learning Outcome Statements

LEARNING OUTCOME STATEMENTS(LOS)

The CFAInstitutelearningoutcome statementsarelistedinthefollowing Thesearerepeated

ineach topicreview.However,the order may have been changedinorderto getabetterfit

with theflow ofthereview.

The topicalcoveragecorresponds with thefollowingCFA Instituteassigned reading:

30 Executionof PortfolioDecisions

The candidate should be ableto:

a. compare market orders with limitorders,including the price andexecutionuncertaintyofeach,(page8)

b calculate and interpret the effective spread ofamarket order andcontrastitto

the quoted bid-ask spreadas ameasureof tradingcost,(page9)

structuresand their relative advantages, (page12)

c.

d compare the roles of brokers anddealers,(page14)

e. explain thecriteriaof market quality and evaluate the quality ofamarket whengivenadescription ofitscharacteristics,(page14)

f explain thecomponentsofexecutioncosts,including explicit and implicitcosts,

andevaluateatradeintermsof thesecosts,(page15)

g calculate and discuss implementation shortfallas a measureoftransactioncosts.

(page16)

h contrastvolumeweightedaverage price(VWAP)and implementation shortfall

asmeasuresoftransactioncosts,(page20)

i explain theuseofeconometricmethodsinpretrade analysistoestimateimplicit

transactioncosts, (page21)

j discuss themajortypesoftraders,basedontheirmotivationtotrade, timeversuspricepreferences, and preferred ordertypes,(page21)

k describethe suitableusesof major tradingtactics,evaluatetheir relativecosts,

advantages, andweaknesses,andrecommendatradingtacticwhen givena

description of the investor’smotivationtotrade,thesizeof thetrade,and keymarketcharacteristics,(page22)

1 explain themotivationfor algorithmictradingand discussthe basic classes ofalgorithmic trading strategies, (page24)

m discuss thefactors that typically determine the selection ofaspecific algorithmictradingstrategy,including ordersize,averagedaily tradingvolume,bid-askspread, and theurgencyof theorder,(page25)

n. explain the meaning andcriteriaof bestexecution,(page27)

o. evaluateafirm’sinvestmentand trading procedures, including processes,

disclosures,and record keeping, withrespect tobestexecution,(page27)

p discuss the roleof ethicsintrading, (page28)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

31 Monitoring andRebalancingThe candidate should be ableto:

a. discussafiduciary’s responsibilitiesinmonitoringaninvestmentportfolio

(page41)

b discussthe monitoring ofinvestorcircumstances,market/economicconditions,

and portfolio holdings and explain the effects that changesineachof theseareas

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Book5-Trading,Monitoring,and Rebalancing;Performance Evaluation,and GlobalInvestmentPerformance Standards

c. recommend and justifyrevisionstoaninvestor’sinvestmentpolicystatement

and strategicassetallocation,givenachangein investorcircumstances,(page42)

d discussthe benefits andcostsof rebalancingaportfoliototheinvestor’sstrategic

asset allocation,(page42)

e contrastcalendar rebalancingtopercentage-of-portfolio rebalancing, (page43)

f discussthe key determinants of the optimal corridor width ofan assetclassina

percentage-of-portfolio rebalancingprogram,(page44)

g comparethe benefits ofrebalancinganassetclasstoitstargetportfolio weight

versusrebalancing theassetclassto staywithinitsallowed range, (page45)

h explain theperformance consequencesinup,down,and nontrending markets

of1)rebalancingto a constantmixof equities andbills, 2)buying and holdingequities, and3)constantproportionportfolioinsurance (CPPI).(page45)

inguishamong linear,concave,andconvexrebalancing strategies, (page48)

j judge theappropriatenessofconstant mix,buy-and-hold, and CPPI rebalancing

strategies when givenaninvestor’s risk tolerance andasset returnexpectations

(page50)i

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

32 Evaluating Portfolio Performance

The candidate should be ableto:

a. demonstratethe importance ofperformance evaluation from the perspective of

fund sponsors and the perspective ofinvestmentmanagers,(page62)

b explain the followingcomponentsof portfolio evaluation: performance

measurement,performanceattribution,andperformance appraisal, (page63)

c calculate,interpret, andcontrasttime-weightedandmoney-weightedratesof

returnand discuss how eachisaffected by cash contributions and withdrawals

(page65)

d identify and explain potential data qualityissuesasthey relatetocalculating

ratesofreturn,(page69)

e. demonstrate the decomposition of portfolioreturnsintocomponents

attributabletothemarket,tostyle, andtoactivemanagement,(page70)

f discuss the properties ofavalidperformance benchmark and explain advantages

and disadvantages of alternativetypesofbenchmarks,(page71)

g explain thestepsinvolvedinconstructinga customsecurity-based benchmark

(page75)

h discussthe validity of using manageruniversesas benchmarks,(page75)

i evaluate benchmark quality by applyingtestsof qualityto avarietyof possible

benchmarks, (page76)

j discussissuesthatarisewhenassigning benchmarkstohedgefunds,(page77)

k distinguish between macroandmicroperformance attribution and discuss the

inputs typicallyrequired foreach,(page79)

1 demonstrateandcontrasttheuseofmacroandmicroperformance attribution

methodologiestoidentify thesourcesofinvestmentperformance, (page79)

m. discuss theuseof fundamental factor modelsin microperformance attribution

(page87)n

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Book5 -Trading,Monitoring,and Rebalancing;Performance Evaluation,andGlobal Investment PerformanceStandards

o. explain themanagementfactors that contributeto afixed-income portfolio’stotalreturnand interpret the results ofafixed-incomeperformance attributionanalysis, (page88)

,interpret.

including(intheirex post forms)alpha, informationratio,Treynormeasure,

Sharperatio,andM2.(page91)

q explain howaportfolio’s alpha and betaareincorporatedintothe information

ratio,Treynormeasure,and Sharperatio,(page96)

r demonstrate theuseof performance quality control chartsinperformanceappraisal, (page97)

s. discuss theissuesinvolvedinmanagercontinuationpolicydecisions,includingthecostsof hiring and firinginvestment managers,(page98)

t contrastTypeIandTypeIIerrors inmanager continuationdecisions,(page99)

The topicalcoveragecorresponds with thefollowingCFA Instituteassigned reading:

33 Overviewofthe GlobalInvestmentPerformance StandardsThe candidate should be ableto:

a. discuss theobjectives, keycharacteristics,and scope of the GIPS standards andtheir benefitstoprospective clients andinvestmentmanagers,(page130)

b explain the fundamentals of compliance with theGIPS standards,including thedefinition of the firm and the firm’s definitionofdiscretion,(page132)

e. explain the requirements and recommendations of the GIPS standards with

respect tocompositereturncalculations,including methods for asset-weightingportfolioreturns,(page145)

f explain the meaning of “discretionary”inthecontextof compositeconstruction

aportfolioisand,givenadescription

likelytobe considered discretionary, (page149)

g explain the role ofinvestment mandates,objectives,orstrategiesinthe

constructionof composites, (page150)

h explain the requirements and recommendations of the GIPS standards with

respect tocompositeconstruction,including switching portfolios amongcomposites, the timing of the inclusion ofnewportfoliosincomposites, and thetiming of the exclusion of terminatedportfolios from composites, (page150)

i explain the requirements of the GIPS standards forassetclasssegmentscarved

outof multi-class portfolios, (page153)

j explain the requirements and recommendations of the GIPS standards with

respect todisclosure,includingfees,theuseof leverage andderivatives,

conformity with laws and regulations that conflict with theGIPS standards,andnoncompliantperformance periods, (page154)

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Book5-Trading,Monitoring,and Rebalancing;Performance Evaluation,and GlobalInvestmentPerformance Standards

k explain the requirements and recommendations of the GIPS standards with

respect topresentation and reporting, including therequired timeframe

of compliant performance periods, annualreturns,compositeassets,andbenchmarks,(page157)

1 explain the conditions under which theperformance ofa pastfirmoraffiliation

mustbe linkedto orusedto representthe historicalperformance ofanewor

acquiringfirm,(page157)

m. evaluate the relativemeritsof high/low,range,interquartilerange,and

equal-weightedorasset-weighted standard deviationasmeasuresof the internaldispersion of portfolioreturnswithinacomposite for annualperiods, (page157)

n identify thetypesofinvestmentsthataresubjecttothe GIPS standardsfor real

estateand private equity, (page162)

o. explain the provisions of the GIPS standards for realestateand private equity

(page163)

p explain the provisions of the GIPS standards for Wrap fee/Separately Managed

Accounts,(page168)q-

ValuationPrinciples, (page170)

comply with the GIPS Advertisingr.

Guidelines,(page171)

s. discuss thepurpose, scope,andprocessofverification,(page173)

t. discuss challenges relatedtothe calculation ofafter-taxreturns,(page174)

u identify andexplainerrorsandomissions ingiven performance presentations

andrecommendchanges that would bring themintocompliance with GIPSstandards,(page176)

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The following is a review of the Trading, Monitoring, and Rebalancing principles designed to address the

learning outcome statements set forth by CFA Institute This topic is also covered in:

Study Session 16

EXAM FOCUS

Fortheexam,be abletodistinguish between limit and market orders and discuss the

circumstancesunder which eachisappropriateto use.Beabletocalculate midquotes,

effectivespreads, volume-weightedaverage price, andimplementationshortfallcosts.

Motivations fortradinghavealwaysbeenaCFAInstitute favorite,soyoushouldalso

be abletodiscuss major tradertypes,tradingtactics,and implementation shortfallstrategies

MARKETANDLIMIT ORDERS

LOS30.a:Compare market orders with limitorders,includingthe price andexecution uncertaintyof each

CFA®ProgramCurriculum, Volume6,page 7

Market microstructurereferstothestructureandprocesses ofamarketthatmayaffectthe pricing ofsecurities inrelationtointrinsicvalue and theability ofmanagersto executetrades The microstructureofthe market andthe objectivesof the managershouldaffect thetypeof order the manageruses.

Thetwomajortypesofordersaremarket orders andlimitorders Thefirstoffersgreater

certainty of executionandthesecondoffersgreatercertainty of price

A market orderis anorderto executethe tradeimmediatelyatthe bestpossibleprice

Iftheordercannotbecompletely filledinonetrade,it isfilled byothertradesatthenextbest possibleprices Theemphasisinamarket orderisthe speedof execution The

disadvantage ofamarket orderisthat the priceitwill be executedatisnotknown ahead

oftime, soit haspriceuncertainty

Alimitorder isanordertotradeatthelimit priceorbetter.Forsellorders, the

execution pricemustbehigherthanorequaltothelimit price.Forbuyorders,theexecution pricemustbe lower thanorequaltothe limit price Theorder couldbegoodforaspecified period oftimeand thenexpireorcouldbegood untilit iscanceled

Fiowever,if marketpricesdonot move towithin thelimit,the trade willnotbecompleted,soithasexecution uncertainty

1 Theterminologyutilized in this topic review follows industry convention aspresentedin

Reading30 of the2015CFA Level III curriculum.

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StudySession 16 Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio Decisions

THEEFFECTIVESPREAD

LOS30.b:Calculateand interpret the effectivespreadofamarket order and

contrastittothequotedbid-askspreadasameasureoftradingcost.

CFA®ProgramCurriculum,Volume6,page10

The bid priceisthe priceadealer willpayforasecurity, and the bid quantityisthe

amount adealerwillbuy ofasecurity The askorofferprice isthe priceatwhich

adealer will sellasecurityand the ask quantityistheamount adealer will sellofa

security The ask priceminusthe bid price(thebid-ask spread) provides the dealer’s

compensation In theoryit isthe totalcost tobuy and then sell the security

An overviewofsometradingtermswill help illustratesomeof theconceptsinvolved

intrading The pricesadealer offersarelimit orders because they specify the priceat

whichthey willtransact.Adealer’sofferingofsecurities isthus termed thelimitorder

book Several dealersmaytransactinthesame securityandcompeteagainst each other

for the investor’s business The best bid price(thehighest bid price from the trader’s

perspective)isreferredto asthe inside bidormarket bid The best ask price(thelowest

ask price from the trader’s perspective)isreferredto asthe inside askormarket ask The

best bidpriceand the best ask priceinthe marketconstitutetheinsideormarketquote.

Subtracting the best bid price from the best ask price resultsinthe inside bid-ask spread

ormarket bid-ask spread Theaverageof the inside bid and askisthe midquote

The effective spreadisanactualtransactionpriceversusthe midquote of the market

bid and ask prices This differenceisthen doubled.If the effective spreadisless than

themarket bid-asked spread,itindicatesgood tradeexecutionor aliquid security.More

formally:

effectivespread forabuy order=2x (executionprice-midquote)

effective spread forasell order=2x (midquote-executionprice)

Effective spreadisabettermeasureof the effective round tripcost(buy andsell)of

atransactionthan the quoted bid-asked spread Effective spread reflects both price

improvement(sometradesareexecutedatbetter than the bid-asked quote) and price

impact(othertradesaredone outside the bid-asked quote)

Example: Effective spread

Supposeatraderisquotedamarket bid price of $11.50 andanaskof $11.56

Calculateand interprettheeffective spread forabuyorder,givenanexecuted price of

$11.55

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Study Session 16

Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio Decisions

Answer:

Themidquoteof the quoted bid and ask pricesis$11.53[=(11.50+ 11.56)/2].The

effectivespread for this buy orderis: 2x ($11.55-$11.53)=$0.04,whichistwo cents

better than the quoted spread of $0.06(=$11.56-$11.50).Aneffective spread thatis

less than the bid-asked spread indicates theexecutionwassuperior(lower cost)tothequoted spreador averyliquid market

Effective spreadon asingletransaction mayindicate little but bemoremeaningful whenaveragedoveralltransactionsduringaperiodinordertocalculateanaverageeffectivespread Lower average effective spreads indicate better liquidity forasecurityorsuperiortrading

Example: Average effective spreadSuppose therearethree sell orders placed forastock duringaday FigureAshows bidand askquotes atvariouspointsinthe day

FigureA:TradeQuotesDuringaTrading Day

Bid Price BidSize AskPrice AskSize Time

Assume thefollowing trades takeplace:

• At 10 a.m.the trader placedanordertosell100shares Theexecutionpricewas

FigureB:Calculated Quoted Spreads

TimeofTrade Ask Minus Bid Price QuotedSpread

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Study Session 16 Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio Decisions

Theaveragequoted spreadisasimpleaverageof the quoted spreads:($0.06 +$0.07+

$0.08)/3= $0.07

Theeffective spreadforasell order istwicethemidquoteof the market bid and ask

prices minus the execution price

Themidquotefor each tradeiscalculatedasin Figure C

FigureC:Calculated Midquotes

TimeofTrade Midquote

($12.16 + $12.10) /2= $12.13

($12.07+$12.00) / 2=$12,035 ($11.88 + $11.80)12=$11.84

10 a.m.

1 p.m.

2 p.m.

The effectivespreadfor each sell orderisshown in Figure D

FigureD: CalculatedEffective Spreads

TimeofTrade 2 x (Midquote—Execution Price)=EffectiveSpread

Theaverageeffectivespreadis($0.04 +$0.07+ $0.18)13=$0.0967

Aweighted-averageeffectivespreadcanalsobecalculated using the relativesizes of the

orders The total numberof shares transactedover thedayis1,000shares(100 +300

+ 600).Theweighted-average effective spreadisthen(100 /1,000)($0.04) +

(300/1,000)($0.07) + (600/1,000)($0.18)= $0,133.

Analysis:

In the first trade, therewasprice improvementbecausethe sellorderwasexecutedat a

bid price higher than the quoted price.Hence,the effective spreadwaslower than the

quoted spread Inthesecondtrade,thequoted priceand executionpricewereequalas

werethequoted andeffectivespread.In the lasttrade,the tradesizeof 600waslarger

than thebidsizeof 300 Thetrader hadto“walkdown”the limitorderbooktofillthe

tradeat anaverage execution pricethatwasless favorable than that quoted.Notethat

the effective spreadinthiscase washigher than that quoted

Overall,theaverageeffective spreads(bothsimple and weighted)werehigher than the

averagequotedspread, reflectingthehighcostof liquidityinthelast trade

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transparency—correctandup-to-date tradeand marketinformation;assurity of

completion—trouble-free tradesettlement(i.e.,thetradeiscompleted and ownershipis

transferred withoutproblems)

There are threemaincategoriesof securities markets:

1 Quote-driven:Investorstrade with dealers

2 Order-driven markets:Investorstrade witheach otherwithout theuseof

intermediaries

3 Brokeredmarkets:Investorsusebrokerstolocate thecounterparty to atrade

Afourthmarket,ahybridmarket, isacombinationof the other three markets

Additionally,newtradingvenueshaveevolved, and theelectronic processing of trades

has becomemore common.

Quote-Driven MarketsQuote-drivenmarketsoffer liquidity.Traderstransactwithdealers(a.k.a.marketmakers)

whopostbidand ask prices,soquote-drivenmarketsare sometimescalleddealermarkets Adealermaintains aninventory of securitiesandpostsbid and askprices

where he will buyorsell.Thedealerisproviding liquidity by being willingtobuyorselland seekingto earn aprofit from the spread

Many markets that tradeilliquidsecurities(e.g., bondmarkets)areorganizedasdealermarkets because the levelof natural liquidity (tradingvolume) islow.Insuchmarkets,

dealerscanprovide immediate liquiditywhennonewouldotherwiseexistbecause they

arewillingtomaintainan inventory of securities Dealers alsoprovide liquidityforsecuritieswhoseterms arenegotiated (e.g.,swapand forwardmarkets) Notethat thedealer that offers the best priceisnotalways theone to get atrader’s business becausecredit riskismoreimportantinsomemarkets(e.g.,currency markets) than price

Insomedealermarkets,the limit order bookisclosed totheaverage investor.In these

closed-bookmarkets, aninvestormusthireabrokertolocate the bestquote.

Order-Driven MarketsOrder-drivenmarketsmay havemorecompetition resultinginbetter prices Traders

transactwith other traders Thereare nointermediarydealersastherearein

quote-drivenmarkets Dealers maytradein these marketsbutas atrader, pricesare setby

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StudySession 16 Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio Decisionssupply and demand The disadvantageisthat because theremaynotbeadealer willing

tomaintainaninventoryofasecurity,liquiditymaybepoor.Inanorder-drivenmarket,

orders drive the market and theactivityof traders determines the liquidity forasecurity

Executionofatradeisdetermined byamechanicalrule,suchasmatchingprices

betweenawilling buyer and seller

Therearethreemaintypesof order-driven markets: electronic crossingnetworks,

auction markets,and automatedauctions Inanelectronic crossingnetwork,the typical

traderisaninstitution.Ordersarebatched together and crossed(matched)atfixed

pointsin timeduring the dayattheaverageof the bid and askquotes.Thecostsof

tradingarelow becausecommissions arelow and traders donotpayadealer’s bid-ask

spread.Atrademaynotbe filledormaybe only partially filled if thereisinsufficient

tradingactivity

The trader usually doesnotknow the identity of thecounterpartyorthecounterparty’s

tradesize in anelectronic crossing network.Becauseofthis,thereisnoprice discovery

(i.e.,prices donotadjusttosupply and demandconditions).This also resultsintrades

unfilledoronly partially filled because prices donotrespondtofill the traders’ orders

Inanauction market,tradersputforth their ordersto competeagainst other orders for

execution An auctionmarketcanbeaperiodic(a.k.a batch) market,where trading

occursat asingle priceat asingle point during the day,oracontinuous auction market,

where trading takes place throughout the day.Anexample of the formeristhe open and

closeofsomeequity markets.Auctionmarkets provide price discovery, which resultsin

lessfrequent partial filling of orders thaninelectronic crossing networks

Automatedauctionsarealso knownaselectronic limit-order markets Examples include

theelectroniccommunicationnetworks(ECNs)of the NYSE AreaExchangeinthe

United Statesand theParisBourse in France.These markets trade throughout the day

and tradesareexecuted basedona setof rules Theyaresimilartoelectronic crossing

networksinthat theyarecomputerized and the identity of thecounterpartyisnot

known Unlike electronic crossingnetworks,theyareauctionmarkets and thus provide

pricediscovery

Brokered Markets

Inbrokeredmarkets,brokersact astraders’agents tofind counterparties for the traders

HybridMarkets

Hybrid markets combinefeatures of quote-driven,order-driven,and broker markets

The New York Stock Exchange, for example, has features of both quote-driven and

order-driven markets.It has specialist dealerssoittradesas aquote-driven market It

also trades throughout the dayasinacontinuous auctionmarket and tradesas abatch

auctionmarketatthe opening of the exchange

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Study Session 16

BROKERSAND DEALERSLOS 30.d:Compare the roles of brokers and dealers

CFA®Program Curriculum,Volume6,page18

Dealersarejustother tradersinthe market seekingto earn aprofit by offeringaservice

When taking the other side ofa transaction,the dealeris anadversaryinthesensethat

anybuyer and sellerareadversaries seekingtoearnprofit Thedealer,asdiscussedearlier,

offers liquidity

Abroker also seekstoearnaprofitinexchange forservicebut the broker hasaprincipalandagentrelationship with the trader The brokeracts asthe trader’sagent,whichimposesalegal obligationto actinthe bestinterestsof the trader(theprincipal) As thetrader’sagentthe brokercan:

• Represent the order and advise the traderonlikely prices and volume that could beexecuted

• Find counterpartiestothetrade The broker will frequently havecontactsandknowledgeof others whomaybe interestedintakingthe other sideof the trade

The broker couldevenstepintothe roleof the dealer and take the other side of thetrade It would be importanttoknow if thisisoccurring because the brokernow

becomesadealer andreverts tothe typical adversarial buyerversusseller role

• Providesecrecy Atradermaynot wantotherstoknow their identity.Perhaps theirultimate goalistoacquirethecompany.Asanagent,the broker keeps the trader

anonymous

• Provide otherservicessuchasrecord keeping, safe keeping ofsecurities,cash

management,andsoforth;butnotliquidity, whichisthe roleofadealer

• Support themarket.Whilenot adirect benefittoanysingleclient,brokers helpmarkets function

MARKET QUALITY

LOS 30.e:Explainthecriteriaof marketqualityand evaluate thequalityofa

market when givenadescriptionofitscharacteristics

A securitymarket should provideliquidity,transparency,and assurityofcompletion

Accordingly, the markets should be judgedtotheextentthat they succeedin providingthesetotraders

Aliquid market has small bid-ask spreads, market depth, and resilience Ifamarket hassmall spreads, tradersare apt totrademoreoften Market depth allows larger ordersto

trade without affecting security prices much.Amarketisresilient ifassetpricesstayclose

totheirintrinsic values,andanydeviationsfromintrinsicvalueareminimized quickly

Inaliquidmarket,traders with information trademorefrequently andsecurityprices

are moreefficient Corporationscan raisecapitalmorecheaply and quickly,asmore

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liquidity lowers the liquidity risk premium forsecurities.Investors,corporations, and

securities increaseinwealthorvalueinliquid markets

Thereareseveralfactorsnecessaryforamarkettobe liquid, including:

• Anabundanceof buyers andsellers,sotraders know theycanquicklyreversetheir

trade ifnecessary

• Investorcharacteristicsarediverse Ifevery investorhad thesameinformation,

valuations,and liquidityneeds,there would be little trading

• A convenientlocationortradingplatform which lends itselftoincreasedinvestor

activity andliquidity

• Integrityasreflectedin itsparticipants and regulation,sothat allinvestors receive

fairtreatment.

Ina transparentmarket, investorscan,withoutsignificantexpense ordelay, obtain

both pre-trade information (regardingquotesand spreads) and post-trade information

(regardingcompletedtrades).Ifamarket doesnothavetransparency,investorslose faith

inthe market and decrease their tradingactivities

Whenmarkets haveassurityof completion,investorscanbe confident that the

counterpartywill upholditsside of the tradeagreement.To facilitatethis,brokers and

clearingbodiesmayprovideguarantees toboth sides of the trade

Toevaluate the quality ofamarket,oneshouldexamine itsliquidity,transparency,

and assurity ofcompletion Whiletransparencyand assurity of completionrequirea

qualitativeassessment,liquiditycanbe measured by the quoted spread, effective spread,

and ask and bidsizes.Lowerquoted and effective spreads indicategreaterliquidity and

market quality Higher bid and asksizesindicategreatermarket depth,greaterliquidity,

andhighermarket quality

EXECUTION COSTS

LOS 30.f:Explainthecomponentsofexecutioncosts,including explicitand

implicitcosts,and evaluateatradeintermsof thesecosts.

The explicitcostsof tradeexecutionaredirectly observable and includecommissions,

taxes, stampduties,and fees.Implicitcosts areharderto measure,but theyarereal

They include the bid-ask spread,marketorprice impactcosts,opportunitycosts,and

delaycosts (i.e.,slippagecosts).Theymustbeinferred by measuring the results of the

tradeversusareference point

Volume-WeightedAveragePrice (VWAP)

Implicitcosts aremeasured usingsomebenchmark,suchasthe midquote usedto

calculate the effective spread.AnalternativeistheVWAP VWAP isaweightedaverage

ofexecution pricesduringaday, where theweightappliedistheproportionofthe day’s

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Study Session 1 6

Forexample,assumetheonly trades forasecurityduring the dayare:

• At 10a.m.100sharestradeat$12.11

VWAPhas shortcomings

• Itis notuseful ifatraderis asignificantpartof thetrading volume.Because her

tradingactivitywill significantly affect theVWAP, acomparisontoVWAP is

essentially comparing her tradestoherself It doesnotprovide useful information

• Amoregeneralproblemisthepotentialto“game” the comparison.Anunethical

trader knowinghe will becomparedtoVWAPcould simplywaituntillate in the

day andthendecide which tradesto execute.Forexample, ifthe price has been

movingdown,onlyexecutebuytransactionswhich will beatprices belowVWAP.Ifpricesaremovingupfor the day, onlyexecutesales

• Thisisrelatedtothemoregeneral problemthat VWAP doesnotconsidermissed

isaconceptual approach thatmeasurestransactioncosts asthe differenceinperformance

ofahypotheticalportfolioinwhich the tradeisfully executed withno costand theperformanceof the actualportfolio

IScanbe reportedinseveralways.TotalIScanbe calculatedas an amount(dollarsor

othercurrency).Foraper shareamount,this totalamount isdivided bythenumberofshares in theinitial order.Fora percentage orbasis point(bp)result,thetotalamount

canbedivided by the market valueofthe initial order TotalIScanalso be subdivided

intocomponent costs,which willsum uptothe totalISif additionalreference pricesare

assumed

TotalIS isbasedon aninitial trade decision and subsequentexecutionprice Insome

cases, atrade maynotbe completedina mannerdefinedastimely bythe userorthe

entiretrademaynotbecompleted.Forall of theIScomponents tobecomputed,

revisionstothe initialpricewhentheorderwasoriginated and/oracancelationpricefor

theorder will be needed Keytermsinclude:

• Decisionprice(DP):The market price of the security when theorderisinitiated

Often ordersareinitiated when the marketisclosed and theprevioustrading day’sclosing priceisusedastheDP

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• Execution price (EP):Thepriceorpricesatwhich the orderisexecuted

• Revised benchmark price(BP*):Thisisthe market price of thesecurityif the order

isnotcompletedinatimelymanner asdefined by theuser.A manager whorequires

rapidexecutionmight definethisaswithinanhour Ifnototherwise stated, it is

assumedtobewithinthetrading day

• Cancelation price(CP):The market price of thesecurityif the orderisnotfully

executed and the remaining portion of the orderiscanceled

Forthe Exam: The CFAtextdoesnot use consistentterminologyorformulasin this

section Instead,youareexpectedtounderstand andbe abletoapplytheconcepts to

thecasespecifics andquestions Wedo apply standardized terminology and formulas

inourNotestoassist inlearningtheconcepts,butyouwill needtowork practice

questionstodevelopthe skillstoapplythe ISapproach

BasicConcepts of Calculation

IScalculationsmustbecomputedinamountandalsointerpreted:

• Forapurchase:

Anincreasein priceis a cost.

Adecreasein priceis an accountbenefit(anegativecost).

• Forasale:

An increase inpriceisan accountbenefit(anegativecost).

A decrease in priceis a cost.

TotalIScanbe computedasthe differenceinthe valueofthehypothetical portfolio

if the tradewasfully executedattheDP (withno costs)and the valueof the actual

portfolio

Missed trade(alsocalled opportunity,orunrealized profit/loss)isthe differencein

the initial DPandCPappliedtothenumberof shares in theordernotfilled Itcan

generallybecalculatedas

|CP—DP|x #of sharescanceled

Explicitcosts (sometimesjustreferredto as commissions orfees)can becomputedas:

costpersharex #of shares executed

Delay(alsocalled slippage)isthe differenceinthe initialDPand revised benchmark

price(BP*)if the orderisnotfilledinatimelymanner,appliedtothe numberof shares

in theorder subsequentlyfilled.Itcangenerallybecalculatedas:

|BP*—DP|x #ofshareslaterexecuted

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Study Session 16

Market impact(alsocalled price impactorrealized profit/loss)isthe differenceinEP (orEPsif therearemultiple partialexecutions)and the initial DP(orBP*if thereisdelay)and the number of shares filledattheEP.Itcangenerally be calculatedas:

|EP-DPorBP*|x #of shares executedatthat EPExample:Ofimplementationshortfall anddecomposition

• OnWednesday, the stock price for Megabites closesat$20ashare

• OnThursday morning beforemarket open, theportfolio manager decidestobuyMegabites and submitsalimit order for1,000sharesat$19.95 Theprice never

fallsto$19.95during the day,sothe order expires unfilled The stock closesat

$20.05

• OnFriday, the orderisrevisedto alimit of $20.06 The orderispartially filledthatdayas800 shares areboughtat$20.06 Thecommission is$18 The stockclosesat$20.09 and the order for the remaining200sharesiscancelled

Answer:

TheDP is$20.00 Therewas adelay,inthiscaseduetotheuseofalimit ordertobuybelow the market price TheBP* is $20.05.Theincreaseof$0.05 isa costinabuyorder The orderispartially filledat anEP of $20.06 and thereismissed tradecost.

200shareswerenotfilled and the CPis20.09.Commissions were$18.00

The gainorlossonthepaperportfolioversusthe actual portfolio gainorlossisthetotal implementation shortfall Thepaperportfolio would have purchased all thesharesatthe decision price withnocosts.

• Theinvestmentmade by thepaperportfoliois1,000 x$20.00=$20,000.

• The terminal valueof thepaperportfoliois1,000 x$20.09=$20,090.Thisis

basedonthe price when the tradeiscompleted, whichinthiscaseiswhenit is

canceled

• The gainonthepaperportfoliois$20,090-$20,000=$90

The gainorlossonthe real portfolioisthe actual ending value of the portfolioversus

the actual expenditures, includingcosts.

• Theinvestmentmade by the real portfoliois(800 x $20.06) +$18=$16,066

• The terminal valueof the real portfoliois800x$20.09=$16,072

• The gainonthe real portfoliois $16,072- $16,066=$6

Total implementation shortfallisthedifferenceinresultsof the hypothetical andactual portfolio of $84.00 The smaller actual gainisa cost.

Onapersharebasis,thisisallocatedtothefull orderof1,000shares:

$84 /1,000=$0,084pershare

Aspercentageand bp, thisisallocatedtothe hypothetical portfoliocostof$20,000 (= 1,000 x $20.00):

$84 /$20,000= 0.42% =42 bp

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TheIScomponents are:

Missed tradeistheCPversusDPon200shares The priceincreased,whichisa cost on

PriceimpactisEPversusDPorin thiscase versusBP*becausetherewas adelayon

800shares Theprice increased,whichisa cost on apurchase:

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Study Session 16

Adjustingfor Market Movements

We canusethe market modeltoadjust for marketmovements,where the expected

return on astockis itsalpha,a;,plusits beta,/3;,multiplied by the expectedreturn on

themarket,E(Rÿ:

costsareactually negative

Negativecostmeansabenefittothe portfolio The purchasewasexecuted above theoriginal benchmark price(DP) but,when the generalincrease inmarket pricesisconsidered,theexecutionwas morefavorable than expected

VWAPvs IMPLEMENTATIONSHORTFALL

LOS 30.h: Contrast volumeweightedaverageprice(VWAP)and

implementationshortfallas measuresoftransactioncosts.

Asmentionedpreviously, VWAP hasitsshortcomings.Itsadvantagesanddisadvantages,

aswellasthosefor implementationshortfall, aresummarizedasfollows:

Advantages of VWAP:

• Easily understood

• Computationallysimple

• Canbe applied quicklytoenhance trading decisions

• Mostappropriate for comparing small tradesinnontrending markets(wherea

market adjustmentisnotneeded)

Disadvantages of VWAP:

• Notinformativefor trades that dominate trading volume(asdescribedearlier)

• Canbe gamed by traders(asdescribedearlier)

• Doesnotevaluate delayedorunfilled orders

• Doesnot accountfor marketmovementsortrade volume

Advantages ofImplementation Shortfall:

• Portfolio managerscanseethecostof implementing their ideas

• Demonstratesthe tradeoff between quickexecutionand market impact

• Decomposes and identifiescosts.

• Canbe usedin an optimizertominimizetradingcostsandmaximizeperformance

• Not subjecttogaming

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Study Session 16 Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio DecisionsDisadvantages of Implementation Shortfall:

• May be unfamiliartotraders

• Requiresconsiderable data and analysis

ECONOMETRIC MODELS

LOS30.i:Explaintheuseofeconometricmethodsinpretradeanalysis to

estimateimplicittransactioncosts.

CFA®ProgramCurriculum, Volume6,page30Econometricmodelscanbe usedtoforecasttransactioncosts.Using market

microstructuretheory,ithas been shown that tradingcosts arenonlinearly relatedto:

• Security liquidity: tradingvolume, market cap,spread,price

• Sizeofthetrade relativetoliquidity

• Trading style:moreaggressivetrading resultsinhighercosts.

• Momentum: trades that requireliquidity (e.g., buyingstockcosts morewhenthe

market istrending upward)

• Risk

The analystwould usethesevariablesandaregressionequationtodeterminethe

estimatedcostofatrade

The usefulnessofeconometricmodelsistwofold.First,trading effectivenesscanbe

assessed bycomparing actualtradingcosts toforecasted tradingcostsfrom themodel

Second, it can assistportfoliomanagers indeterminingthesizeof thetrade.For

example, ifatradeof100,000sharesisprojectedtoresultin round-trip tradingcostsof

4% and thestrategyisprojectedto return 3%,then thetradesizeshouldbe decreasedto

wheretradingcosts arelower and thestrategyisprofitable

LOS30.j:Discussthe majortypesoftraders,basedontheirmotivationto

trade, time versuspricepreferences,andpreferredordertypes

CFA®ProgramCurriculum, Volume6,page32

The firsttypeof tradersweexamineareinformation-motivated traders These traders

have information thatis timesensitive,and if they donottrade quickly, the value of

the information will expire.They thereforeprefer quicktrades thatdemand liquidity,

tradinginlargeblocks Informationtradersmaytrade withadealerto guarantee an

execution price.Theyarewillingtobearhigher tradingcosts aslongasthe valueof

their informationishigher than the tradingcosts.Information traders willoftenwant to

disguise themselvesbecause other traders will avoidtradingwiththem Theyusemarket

ordersto executequicklybecause thesecommonlyused ordersareless noticeable

Value-motivatedtradersuse investmentresearchto uncovermisvaluedsecurities.They

do tradeoftenandarepatient, waiting for the market come them with security

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Study Session 16

prices that accommodate their valuations Assuch,they willuselimit orders becauseprice,notspeed,istheirmainobjective

Liquidity-motivated traderstransact to converttheirsecuritiestocashorreallocatetheir portfolio from cash Theyareoften thecounterparts toinformation-motivated andvalue-motivated traders who have superior information Liquidity-motivated tradersshould be cognizant of the value they provide other traders They freely reveal theirbenignmotivationsbecause they believeittobetotheir advantage They utilize marketorders and tradesoncrossing networks and electroniccommunicationnetworks(ECNs)

Liquidity-motivated traderspreferto executetheir order withinaday

Passivetraders trade for index funds and other passiveinvestors,tradingtoallocatecashor convert tocash.Theyaresimilartoliquidity-motivated traders butaremore

focusedonreducingcosts.Theycanaffordtobeverypatient Their tradesarelikethoseof dealersinthatthey let other traderscometothemso as to extract afavorabletrade price They favor limit orders and tradesoncrossing networks This allows for low

commissions,low market impact, price certainty, and possible elimination of the bid-askspread

A summaryof themajortradertypes,including theirmotivationsand orderpreferences,

ispresentedinFigure1.Figure1:Summary of TraderTypesand TheirMotivationsand Preferences

Time or Price PrimaryPreferred

Information-motivated Time-sensitiveinformation

Securitymisvaluations

Reallocation &liquidity

Market Time

Value-motivatedLiquidity-motivated

Passive

Market Time

Other tradertypesinclude day traders and dealers Dealerswerediscussed earlier andseektoearnthe bid-asked spread and short-term profits Day tradersaresimilarinthatthey seek short-term profits from pricemovements.

TRADING TACTICS

LOS 30.k: Describe the suitableusesof majortradingtactics,evaluate theirrelativecosts,advantages,andweaknesses,and recommendatradingtacticwhen givenadescriptionof the investor’smotivationtotrade,thesizeof thetrade,andkeymarketcharacteristics

CFA®Program Curriculum,Volume6,page 37

Mostportfoliomanagershave different trading needsatdifferenttimes.Fewcanpursue

thesametradingstrategyall thetime.Inthe materialtofollow,wediscussvarious

tradingtactics

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Inaliquidity-at-any-cost tradingfocus,the tradermust transact alarge block of shares

quickly The typical traderinthiscaseisaninformation trader butcanalso beamutual

fund thatmustliquidateitsshares quicklytosatisfy redemptionsin itsfund.Most

counterparties shyawayfrom taking the other side ofaninformation trader’s position

The liquidity-at-any-cost tradermaybe abletofindabrokerto representhim though

becauseof the information the broker gainsinthe process.In anyevent,this trader

mustbe readytopayahigh price for tradingintheform of either market impact,

commissions, orboth

Inacosts-are-not-important tradingfocus,the trader believes that exchange markets

willoperatefairly and efficiently such that theexecutionprice theytransact atisat

bestexecution.These ordersare appropriateforavarietyof trademotivations.Trading

costsarenotgivenconsideration,and the trader pays average tradingcostsfor quick

execution.The trader thususesmarketorders,whicharealso useful for disguising the

trader’sintentionsbecause theyare so common.The weaknessofamarket orderisthat

the traderloses controloverthe trade’sexecution

Inaneed-trustworthy-agenttradingfocus,the trader employsabrokertoskillfully

execute alarge tradeinasecurity, whichmaybe thinly traded The brokermayneedto

tradeoveraperiod oftime, sothese ordersarenotappropriate for information traders

The trader cedes controltothe broker andisoftenunawareof trade details until after

the order has executed The weakness of thisstrategyisthatcommissions maybe high

and the tradermayreveal his tradeintentionstothebroker,whichmaynotbeinthe

trader’s bestinterests

Inanadvertise-to-draw-liquidity tradingfocus,the tradeispublicizedinadvanceto

draw counterpartiestothe trade.Aninitial public offeringisanexample of this trade

type.The weaknessof thisstrategyisthat another tradermayfrontrunthetrade,buying

inadvanceofabuyorder,for example,tothen sellat ahigher price

Inalow-cost-whatever-the-liquidity tradingfocus,the trader placesalimit order

outside of thecurrentbid-askquotesinordertominimizetradingcosts.Forexample,

atradermayplacealimitbuy orderat aprice below thecurrentmarketbid The

strength of thisstrategyisthatcommissions,spreads, and market impactcoststendto

be low.Passiveand value-motivated traders willoften pursue thisstrategy.Patience is

required for thisstrategy,and indeeditsweaknessisthatit maynotbe executedatall

Additionally, ifit is executed,thereasonmaybe that negative information has been

released Forexample,abuy order of thistypemayonly be executed when badnewsis

released about thefirm

A summaryof tradingtactics ispresentedinFigure2.Note that themotivationsfor

need-trustworthy-agent and advertise-to-draw-liquiditytacticsarenonspecific but would

exclude information-basedmotivations

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Study Session 1 6

Figure2:Summary ofTradingTactics

Usual Trade

Motivation

Quick, certain execution

Highcosts &leakage

of information

Quick, certain

execution at market price

Costs-are-not-Broker uses skill &

time to obtain lower price

Themotivationforalgorithmic tradingis to executeorders withminimal riskandcosts.

Theuseofalgorithmic tradingofteninvolves breakingalarge tradeintosmaller pieces

toaccommodate normal market flow andminimizemarketimpact.This automated

processmustbemonitored, however,sothat the portfolio doesnotbecomeover¬

concentratedinsectors.This might happen ifcertainsectors are moreliquid than others

Algorithmic tradingstrategiesareclassifiedintologicalparticipation strategies,

opportunistic strategies, andspecializedstrategies Oflogical participationstrategies, there

are twosubtypes:simple logicalparticipation strategiesand implementationshortfall

strategies.We examinethese subtypes first

Simple logicalparticipation strategies seektotrade with market flowso as to not

become overly noticeabletothe market andtominimizemarketimpact Wediscuss

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threetypesof simple logical participation strategies: volume-weighted average price

(VWAP)strategy,time-weightedaveragepricestrategy,andpercent-of-volumestrategy.

InaVWAPstrategy,the orderisbroken upoverthecourseofadayso as toequalor

outperform the day’sVWAP.Atthe beginning of the day, trading laterin the dayis

uncertain, soVWAPfor later periodsispredicted using historical dataormodels

Inatime-weightedaveragepricestrategy (TWAP),tradingisspreadoutevenlyoverthe

wholedayso as toequalaTWAPbenchmark Thisstrategyisoften used forathinly

traded stock that hasvolatile,unpredictable intraday trading volume Total trading

volumecanbe forecasted using historical dataorpredictive models

Inthe percent-of-volumestrategy,the orderistradedat5-20% of normal trading

volume until the orderisfilled

Implementation shortfall strategies,orarrival price strategies,minimizetrading

costs asdefined by the implementation shortfallmeasure (discussed earlier)ortotal

executioncosts.Bothmeasures useaweightedaverageof opportunitycostsand market

impactcosts.Because opportunitycostsresultfrom non-trading, thisstrategytrades

heavierearlyinthedaytoensureorder completion.Furthermore,opportunitycosts

areoften measured by the volatility of tradevalue,whichincreasesover time.So again,

opportunitycosts canbe reduced by trading earlier.Animplementation shortfallstrategy

isuseful whenan entireportfoliomustbe traded

Other algorithmic trading strategies include opportunistic participation strategies and

specialized strategies Opportunistic participation strategies trade passivelyovertime

butincreasetrading when liquidityispresent.Itisnot a trueparticipationstrategydue

toitsopportunisticnature.Specialized strategies include passive strategies and other

miscellaneous strategies

CHOOSINGANALGORITHMIC TRADING STRATEGY

LOS 30.m:Discussthefactors thattypicallydetermine the selectionofa

specific algorithmic tradingstrategy,includingordersize,averagedaily trading

volume,bid—askspread,and the urgency of the order

CFA®ProgramCurriculum,Volume6,page 45The basisof simple participation strategiesistobreak up the tradeintosmall piecesso

that each tradeisasmallpartof trading volume and market impactcosts areminimized

Incontrast,animplementation shortfallstrategyfocusesontrading earlytominimize

opportunitycosts.Furthermore,anobjective functioncanbe specified using

implementation shortfall that seekstominimizemarket impactcostsand opportunity

costs, aswellasthevarianceof thecostof trading Theminimizationof thisvariance

also providesan incentivefor the implementation shortfallstrategy totrade early

Notethat satisfying this objective functionissimilartoportfolio optimization because

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Study Session 1 6

Insum, animplementation shortfallstrategytypicallyexecutesthe order quickly whereas

asimple participationstrategybreaks the tradeintosmall pieces and trades throughout

theday Keep thisin mindfortheexampleinFigureA below,whichrepresents atrader’sordermanagement system.

Example: Choosingtheappropriate algorithmicstrategy

Figure A: OrderManagementSystem

AverageDailyVolume

Firstcalculate each tradesize as a percentageof averagedailyvolume,asinFigureB

Figure B: Trade Sizesas aPercentageof AverageDailyVolume

Stock Ticker Trade Size as a PercentageofAverageDailyVolume

50,000 / 125,000=40%

150,000 / 2,500,000=6%

LMNO WXYZ

Althoughthe tradefor stockWXYZisthelargestin absolutesize,itisthe smallest

in relativeterms.Thetradefor stock ABCDisalsorelativelysmall,andin bothcases

thespreadsarefairly low.The ABCDtradeisoflowurgencyandcanbe tradedover

time.Itisthus suitableforasimple participationstrategybasedonVWAPoranotherbenchmark.TheWXYZtradeisof highurgency, however, and shouldbe tradedmore

quicklyusinganimplementationshortfallstrategy.

The LMNO tradeisofrelatively largesizeand hasalargespread.Because of thesecharacteristics,itshouldbetraded throughaskilledbrokerorthroughacrossing

system to minimizethespread

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BEST EXECUTION

LOS 30.n:Explainthe meaning andcriteriaof bestexecution

Best execution isanimportantconceptbecauseitimpacts the client’sportfolio

performance TheCFA Institutehas published Trade Management Guidelines for

pursuing bestexecution.2TheInstitute comparesbestexecutiontoprudence Prudence

referstoselecting thesecuritiesmostappropriate foraninvestor,whereas bestexecution

referstothe bestmeans tobuyorsell thosesecurities.Theyaresimilarinthat they both

attempt toimproveportfolioperformance andmeetfiduciaryresponsibilities

TheInstitutereportspecifies four characteristics of bestexecution:

1 Bestexecutioncannotbe judged independently of theinvestmentdecision.A

strategymight have high tradingcosts,but that alone doesnotmeanthestrategy

shouldnotbe pursuedaslongasitgeneratesthe intended value

2 Best executioncannotbe known with certaintyex ante(beforethefact); itdepends

ontheparticularcircumstancesof the trade Eachparty to atrade determines what

bestexecution is

3 Bestexecutioncanonly be assessedex post(afterthefact).Whilecost canbe

measured foranysingletrade,quality ofexecution isassessedovertime.Thecostof

asingle tradeexecution is verydependentonthe referenceordecision price usedin

itscalculation Therecanalways be distortions Butovertimeandmultipletrades,

thosecostscanbe usedtoindicatethe quality ofexecution

4 Relationships and practicesareintegraltobestexecution Best execution isongoing

and requires diligence and dedicationtotheprocess

EVALUATINGTRADING PROCEDURES

LOS 30.o:Evaluateafirm’sinvestmentandtrading procedures, including

processes,disclosures,and recordkeeping,withrespectto bestexecution

CFA®ProgramCurriculum,Volume6,page49The CFA Institute’s TradeManagementGuidelinesaresplitintothreeparts:processes,

disclosures,and record keeping These guidelinesaremeant toassist investment

managementfirmsinachieving bestexecutionandmaximumportfolio value for their

clients

Inregardtoprocesses, firms should havepolicies and procedures that have theintentof

maximizingportfolio value using bestexecution.These policies and procedures should

also help firmsmeasureandmanagebestexecution

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Study Session 16

Investmentmanagementfirms should also provide disclosuretotheir clients andpotential clients regarding(1)general informationontheir trading techniques,markets,

and brokers and(2)their conflictsofinterestrelatedtotrading This information should

beprovided periodicallytoclientstohelp themassessthe firm’sabilitytoprovide best

execution

Inregardtorecord keeping,investmentmanagementfirms shouldmaintainthedocumentation supporting(1)the firm’s compliance withitspolicies and proceduresand(2)disclosures madetoitsclients.Indoingso,the firm also provides evidenceto

regulatorsas tohow the firmpursuesbestexecutionforitsclients

LOS 30.p:Discussthe roleof ethicsintrading.

CFA®ProgramCurriculum, Volume6,page 49Tradingisbasedonwordof honor Buy-side and sell-side tradersmusthonor theirverbalagreementsorthey will quickly find thatno onewants totake the opposite side oftheir trade The development of complex trading techniques and the declineinexplicit

commissionshave increased the opportunity and temptationto actunethically

Regardless of these developments, buy-side traders should alwaysactinthe bestinterests

of their clients Buy-side traders and portfolio managers haveafiduciary dutyto

maximizethe valueof their client’s portfolio The buy-side trader’s relationships withsell-side tradersmustnever comebefore theinterestsof the trader’s clients

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KEY CONCEPTS

LOS30.a

Amarket orderisanorderto executethe trade immediatelyatthe best possible price

Ifthe ordercannotbecompletely filledin onetrade whichoffers the best price,it is

filled by other tradesatthenextbest possible prices The emphasisinamarket orderis

the speed ofexecution.The disadvantage ofamarket orderisthat the priceitwill be

executedatisnotknown aheadoftime, soithas priceuncertainty

Alimit orderisanordertotradeatthe limit priceorbetter.Forsellorders,the

executionpricemustbe higher thanorequaltothe limit price.Forbuyorders,the

executionpricemustbe lower thanorequaltothe limit price Ifnotfilledon orbefore

thespecifieddate,limit orders expire.Alimit order emphasizes the price ofexecution It

howevermaynotbe filled immediately andmay even gounfilledorpartially unfilled.A

limit order thus hasexecution uncertainty

LOS30.b

The effective spreadiscompared against the quoted spreadtoevaluate thecostof

trading Itcapturesboth price improvements and thecostsof market impact:

effectivespreadbuyorcler=2x(executionprice-midquote)

effectivespreadsellordcr=2x(midquote- executionprice)

LOS30.c

• Quote-driven markets:Investorstrade with dealers

• Order-driven markets:Investorstrade with each other without theuseof

intermediaries Therearethreemaintypes:

1 In anelectronic crossing network, ordersarebatched together and crossed

(matched)atfixedpoints in timeduring the dayatthe average of the bid andaskquotes.

2 Inauctionmarkets,trader orderscompeteforexecution

3 Automatedauctionsarecomputerizedauctionmarkets and provide price

discovery

• Brokered markets:Investorsusebrokerstolocate thecounterparty to atrade This

service isvaluable when the trader hasalarge blocktosell,when the traderwants to

remain anonymous,and/or when the marketfor thesecurity issmallorilliquid

• Ahybrid marketisacombinationof the other three markets.Forexample, theNew

York StockExchangehasfeatures of both quote-driven and order-driven markets

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Study Session 16

LOS30.dThe relationship betweenatrader and the brokerisoneofaprincipal andagent.Thebrokeracts asthe trader’sagentand locates thenecessaryliquidityatthe best price

The brokermay eventakeapositioninthe securitytofacilitate the trade Many side tradersprefer theiranonymityso as not totip off other traderstotheiractions.Atthesametime,the tradermaybe ableto extractinformationfrom the brokeronthedepth of the market forasecurity and theidentity of other traders The brokermayalsoprovide record keeping, financing, cashmanagement,and otherservicestothe trader

buy-Incontrast,the trader and the dealeroften haveopposinginterests.Forexample, dealers

want tomaximizethe trade spread while traderswant tominimize it.Inaddition,when

atrader has information that the dealer doesnothave,the trader profitsatthe dealer’sexpense Whenatraderentersthe market with information others donothave,theresultisadverse selection riskfor the dealer Itis inthe trader’sinteresttoconceal her

intent,whileit isinthe dealer’sinteresttofindoutwho the informed tradersare.

LOS30.e

A securitymarket should provide liquidity,transparency,andassurityof completion

Aliquid market has small bid-ask spreads, market depth, and resilience Market depthallows larger orderstotrade without affecting security prices much.Amarketisresilient

ifassetpricesstayclosetotheirintrinsicvalues

Ina transparentmarket, investorscan,without significantexpenseordelay, obtainboth pre-trade information andpost-trade information Ifamarketdoesnothave

transparency,investorslose faithinthe market and decrease their tradingactivities

Whenmarkets haveassurityof completion,investorscanbe confident that thecounter¬

partywill uphold their side of the tradeagreement.To facilitatethis,brokers and clearingbodiesmayprovideguarantees toboth sidesof the trade

LOS30.fThe explicitcostsinatradearereadily discernible and includecommissions, taxes,

stampduties,andfees Implicitcosts areharderto measure,but theyarereal Theyinclude the bid-askspread, marketorprice impactcosts,opportunitycosts,and delaycosts(i.e.,slippagecosts).

LOS 30.g

Implementation shortfallisthe difference between the actual portfolio’sreturnanda

paperportfolio’sreturn.

• Forapurchase:

An increase inpriceisa cost.

Adecreaseinpriceisan accountbenefit(anegativecost)

• Forasale:

An increase inpriceisanaccountbenefit(anegativecost)

A decreaseinpriceisa cost.

Total IScanbe computedasthe differenceinthe valueof the hypothetical portfolio

if the tradewasfully executedattheDP (with no costs)and the valueof the actualportfolio

Trang 31

Missed trade(alsocalled opportunity,orunrealized profit/loss)isthe differencein

the initial DP andCPappliedtothe numberof sharesinthe ordernotfilled Itcan

generally be calculatedas

|CP-DP|x #of shares canceled

Explicitcosts(sometimesjust referredto ascommissionsorfees)canbe computedas:

costpersharex #of shares executed

Delay(alsocalled slippage)isthe differenceinthe initial DP and revised benchmark

price(BP*)if the orderisnotfilledinatimelymannerappliedtothe numberof shares

inthe order subsequently filled Itcangenerallybe calculatedas:

|BP*-DP|x #of shares later executed

Market impact(alsocalled price impactorrealizedprofit/loss)isthe differenceinEP(or

EPs iftherearemultiple partialexecutions)and the initial DP(orBP*if thereisdelay)

and the numberof shares filledattheEP.Itcangenerally be calculatedas:

|EP-DPorBP*|x #of shares executed

LOS30.h

Advantages ofVWAP:

• Easily understood

• Computationallysimple

• Canbe applied quicklytoenhance trading decisions

• Mostappropriate for comparing small tradesinnontrending markets(wherea

marketadjustmentisnotneeded)

Disadvantages ofVWAP:

• Notinformative for trades that dominate trading volume

• Canbe gamed by traders

• Doesnotevaluate delayedorunfilled orders

• Doesnot accountfor marketmovementsortrade volume

Advantages of Implementation Shortfall:

• Portfolio managerscanseethecostof implementing their ideas

• Demonstratesthe tradeoff between quickexecutionand market impact

• Decomposes and identifiescosts.

• Canbe usedin anoptimizertominimizetradingcostsandmaximizeperformance

• Not subjecttogaming

Disadvantages ofImplementation Shortfall:

• May be unfamiliartotraders

• Requires considerable data and analysis

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Study Session 16

LOS30.iEconometricmodelscanbe usedtoforecasttransactioncosts.Using market

microstructuretheory,ithas been shown that tradingcosts arenonlinearly relatedto:

• Security liquidity:tradingvolume,marketcap,spread, price

• Sizeof the trade relativetoliquidity

• Trading style:moreaggressive trading resultsinhighercosts.

• Momentum:trades that require liquidity [e.g., buying (selling) when the marketis

trending upward(downward)]

Value-motivated tradersuseinvestmentresearchtouncovermisvaluedsecurities.Theywilluselimit orders because price,notspeed,istheirmainobjective

Liquidity-motivated traderstransact to converttheirsecuritiestocashorreallocatetheir portfolio from cash They utilize market orders and tradesoncrossing networksand electroniccommunicationnetworks(ECNs).Liquidity-motivated traderspreferto executetheir order withinaday

Passivetraders tradefor index funds and other passiveinvestors.They favor limit ordersand tradesoncrossing networks This allows for lowcommissions,low market impact,price certainty, andpossible elimination of the bid-ask spread

LOS30.k

Inaliquidity-at-any-cost tradingfocus,the tradermust transact alarge block of sharesquickly The typical traderinthiscaseisaninformation trader butcanalso beamutualfund thatmustliquidateitsshares quicklytosatisfy redemptionsinitsfund.This

tradermustbe readytopayahigh price for tradingintheform of market impact,

commissions, orboth

Inacosts-are-not-importanttradingfocus,the trader believes that exchange markets

willoperatefairly and efficiently such that theexecutionprice theytransact atisatbest

execution.The trader thususesmarket orders

Inaneed-trustworthy-agent tradingfocus,the trader employsabrokertoskillfully

execute alarge tradeinasecurity,whichmaybe thinly traded The weakness of this

strategyisthatcommissions maybe high and the tradermayreveal his tradeintentions

tothe broker

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In anadvertise-to-draw-liquidity tradingfocus,the tradeispublicizedinadvanceto

draw counterpartiestothe trade The weaknessof thisstrategyisthat another trader

mayfrontrunthetrade,buyinginadvance ofabuy order

Inalow-cost-whatever-the-liquidity tradingfocus,the trader placesalimit order outside

of thecurrentbid-askquotesinordertominimizetradingcosts.Passiveand

value-motivated traders willoftenpursuethisstrategy.

LOS30.1

Algorithmic tradingistheuseofautomated,quantitativesystemsthat utilize trading

rules, benchmarks,andconstraintsto executeorders with minimalrisk andcosts.

Algorithmic trading strategiesareclassifiedintological participation strategies (simple

logical andimplementation shortfall strategies), opportunistic strategies, and specialized

strategies

Simple logical participation strategies seektotrade with market flowso as to notbecome

overly noticeabletothe market andtominimizemarket impact

Implementation shortfall strategies,orarrival price strategies,minimizetradingcosts as

defined by the implementation shortfallmeasureortotalexecutioncosts.

Opportunisticparticipationstrategies trade passivelyover timebutincreasetrading

when liquidityispresent.

Specialized strategies include passive strategies and other miscellaneous strategies

LOS30.m

The basisof simple participation strategiesistobreakupthe tradeintosmall piecesso

that each tradeisasmallpartof trading volume and market impactcostsareminimized

Incontrast, animplementation shortfallstrategyfocusesontrading earlytominimize

opportunitycosts.Furthermore, anobjectivefunctioncanbespecified using

implementation shortfall that seekstominimizemarketimpactcostsand opportunity

costs, aswellasthevarianceof thecostof trading Theminimizationof thisvariance

also providesanincentivefor the implementation shortfallstrategy totrade early

Notethatsatisfyingthisobjectivefunctionissimilartoportfolio optimization because

portfolio valueismaximized

Insum, animplementation shortfallstrategytypicallyexecutesthe order quickly,

whereasasimple participationstrategybreaks the tradeintosmall pieces and trades

throughout the day

LOS30.n

CFAInstitute comparesbestexecutiontoprudence Prudence referstoselecting the

securitiesmostappropriate foraninvestor,whereas bestexecutionreferstothe best

meanstobuyorsell thosesecurities.Theyaresimilarinthat they bothattempt to

improveportfolio performance andmeetfiduciary responsibilities

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Study Session 16

Fourcharacteristicsof bestexecution:

1 Itdependsonthe value addedof the tradeversus cost.

2 Bestexecutionand value addedcannotbe knownex ante.

3 Best executionandcost canonly be calculatedex post.Assessing value addedmay

takeevenlongertoevaluate if the idea worksout.

4 Relationships and practicesareintegraltobestexecution.Best execution isongoingand requires diligence and dedicationtothe process

LOS30.o

The CFA Institute’s Trade Management Guidelinesaresplitintothreeparts:

1 Processes: Firmsshould have policies/procedures that have theintentof maximizingportfolio value using bestexecution.These should help firms determine andmanage

so,the firm also provides evidencetoregulatorsas tohow the firm pursues best

executionforitsclients

LOS30.p

Tradingisbasedonwordof honor Buy-side and sell-side tradersmusthonor theirverbalagreements orthey will quickly find thatnoonewants totake the opposite side oftheir trade The development of complex trading techniques and the declineinexplicit

commissionshave increased the opportunity and temptationto actunethically

Regardless of thesedevelopments, buy-side traders should alwaysactinthe bestinterests

of their clients Buy-side traders and portfolio managers haveafiduciary dutyto

maximizethe valueof their client’s portfolio The buy-side trader’s relationships withsell-side tradersmustnever comebefore theinterestsof the trader’s clients

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CONCEPT CHECKERS

Discusswhyalimit order hasexecutionuncertainty

Therewerethree sell orders placed forastock duringaday The followingare

the quoted bid and askquotes atvariouspointsinthe day

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Study Session 1 6

Ananalystiscomparingtwomarkets MarketAhas higheraveragebid and ask

sizesthan MarketB Discusswhich market has the higher quality and why

5

Suppose thereisanilliquid stock thathasalimited marketof buyersandsellers

Infact,the majorityoftradingin thisfirm’s stockisdominated byonetrader

Discusstheuseof thevolume-weightedaverage price(VWAP) tocompare this

tradertoanother trader

6

Use thefollowinginformationtocalculatetheimplementationshortfallandits

components as a percentage.

• OnWednesday, the stock price closesat$50ashare

• OnThursdaymorning before marketopen, theportfoliomanager decidesto

buy Megawidgets andtransfersalimitorderfor1,000sharesat$49.95.The

orderexpiresunfilled.The stock closesat$50.05

• OnFriday, the orderisrevisedto alimit of $50.07 The orderispartiallyfilledthat dayas700 sharesareboughtat$50.07.Thecommission is$23

The stock closesat$50.09 and the order is cancelled

7

Supposeafirmwasconcernedthatitstradersweregamingitstradingcosts

analysis.Suggesta measurementoftradingcoststhatislesssusceptibleto

gaming

8.

Are econometricmodels usedas ex ante(beforethefact)or ex post(afterthe

fact) investmenttools?

9

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StudySession 16 Cross-Reference to CFA InstituteAssigned Reading#30-Execution of Portfolio DecisionsWhy do value-motivated and passive tradersprefer limit orders?

10

Explain whymomentummarkets would be problematic forathe-liquidity trading focus

low-cost-whatever-11

Amarket observernoticesthataparticular trading firm tendsto executeits

trades earlyinthe day, with volumefallingoff laterinthe day Whattypeofalgorithmic tradingsystemisthe firm likely using?

12

Whatisthe primary indication thatatrader shouldnotutilize algorithmictrading and insteaduse abrokeroracrossing network?

13

JohnBookerisamanagerat atrading firm.He isquiteupsetbecause yesterdaya

junior trader hadexcessivetradingcosts.Critique Booker’s perspective

14

Discusstwo recentdevelopments that could make the relationship between side and sell-side tradersmoreproblematic

buy-15

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Study Session 1 6

vO

§

A limit order has execution uncertainty because it is not known when the order will be

filled, if at all If the limit price cannot be satisfied in the current market, the order will

go unfilled Because limit orders have an expiration date, the limit may go unfilled or

partially unfilled ifit cannot besatisfiedprior to expiration.

Themidquotefor each trade is calculated as:

TimeofTrade Midquote

The effectivespreadfor each sell order is:

TimeofTrade 2 x(Midquote—Execution Price)=EffectiveSpread

The average effectivespreadis ($0.04 + $0.04 + $0.18) / 3= $0.0867.

Theweighted-averageeffectivespreadis (200 / 1,000)$0.04 + (300 / 1,000)$0.04 +

(500 / 1,000)$0.18=$0.11.

In the first and second trade, there was price improvement because the sell orders were

executed at bid priceshigherthan thequotedprices Hence, the effectivespreadwas

lowerthanthequotedspread In the last trade, thetradesize waslargerthan thebidsize.

The effectivespreadin this case washigherthan thatquoteddue to the market impact

of thelargeorder.

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Overall, thesimpleaverage effectivespreadwas lower than the averagequoted spread,reflectingthe price improvement in the first two trades Theweighted-averageeffective spread washigherthan the averagequoted spread, reflectingthe market impact of the last trade, which waslargerthan either of the first twotrades

The marketprobablymostsuitableis a brokered market A broker canplacethe order withoutrevealinghis client’s identity He can discreetlyshopthe stock and find the necessary liquidity He may even take a position in the stock with his owncapital

3.

An electronic crossing networkmightbe anotherpossibilitybecause traders usually

donot know theidentityof their counterparty or theirtradesize The question states,

however, that the stock is an emerging market stock for which brokered markets are

particularlysuited Brokered markets are important in countries wherepublic capital

markets are notwelldeveloped

4 When a trader has information that the dealer does not, the traderprofitsat the dealers

expense.Tradersare morelikelytotradewhentheyhave information that othersdonot.

This results in adverse selection risk for the dealer The trader’sprofitis the dealer’s loss

once the information is revealed to the market.

Market A is ofhigher quality.Thelargerthe bid and ask sizes (the number of shares

offered byadealeror trader at aspecifiedprice), the greater the marketdepthand the

greater theliquidity

5

It isdifficultto use VWAP to compare two traders, one of whichdoesnotdominatethe markets for the securities he trades in and the other does.Ifa trader dominatestrading

in a security, VWAP will be close to the trade price The trader will have appeared to

minimize costs, evenifhetradedatunfavorableprices Thistraderwill appear better than another trader who does not dominate thetrading

6.

Todecomposetheimplementationshortfall, we calculate thefollowing:

• Explicitcosts—the commission as a percentage of the paperportfolioinvestment is

$23 / $50,000=0.05%.

• Realized profit andloss iscalculatedusing the execution price minus thedecision

price, which is usually measured as the previousday’s closingprice This is divided

by theoriginalprice andweightedby proportion of the order filled It is (700 / 1,000) x ($50.07 - $50.05) / $50.00=0.03%.

• Delaycosts are calculated using the difference between theclosingprices on the day an order was not filled and the previous dayclosingprice It isweightedby the portion of the order filled It is (700 / 1,000) x ($50.05 - $50.00) /$50.00 =

0.07%.

• Missed trade opportunity cost is calculated using the difference between the price at

which the order is cancelled and theoriginalprice It isweightedby the portion of the order that is not filled.Itequals (300 / 1,000) x ($50.09—$50.00) /$50.00 =

0.05%.

7.

The sum ofthecomponents is the totalimplementationcost: 0.05% + 0.03% +0.07%

+ 0.05%=0.20%.

The best measurement would be theimplementationshortfall measure VWAP can be

gamedby traders, whomighttime their trades until the VWAP makes theirtradingcosts

appearfavorable.The effective spread can also begamed.A trader can trade atfavorablebids andasksbywaiting forordersto bebroughtto thetrader.In both cases, atradermight forgo profits throughdelay.

8.

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Study Session 1 6

Actually, they can be used as both Before the fact, econometric models can assist

portfoliomanagers indeterminingthe size of the trade After the fact,tradingeffectivenesscan beassessed bycomparingactual tradingcosts toforecasted tradingcosts

from themodels

9.

Value-motivated and passive traderspreferlimit orders because their primary motivation

is to minimizetradingcosts and transact at favorable prices They do not need the immediate execution of market orders and can afford to be patient.

10.

In a low-cost-whatever-the-liquiditytradingfocus, the trader places a limit order outside

of the currentbid-askquotes inorderto minimize trading costs Momentum markets

can make their executionproblematic though.If, forexample,a trader hasplaceda

buy order and the market trendsupward,the order may never be filled If the market trends downward, thetrader’s ordermay be filled, but the stock price may keeptrendingdownward

11.

Thefirmislikelyusing animplementationshortfall strategy These strategiestrade

heavierearlyin thedayto ensure ordercompletion,reduce opportunity costs, and

minimize the volatility oftradingcosts.

12.

When a trade is of relativelylargesize and has alarge spread,it should be tradedthrough

a broker or a crossing system inorderto minimize thespread

13.

Booker is perhaps overreacting It is difficult tojudgea trader’sperformanceover just

oneday.The market conditions may have been so severe that measurement oftrading

costs would be flawed.Althoughbest execution can be measured ex post over time, it

cannot belegitimatelymeasured over a short timeperiod

14.

First, thepopularityof electronictradingvenues hasprovidedmore anonymity for

traders.Atraderwho gains information from anothertradercan use this information against the other traderdiscreetly.Second,brokeragecommissions have fallen dramatically The temptation is for a trader to shift costs to those that areimplicit,

rather than explicit.

15

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