CFA 2018 r31 execution of portfolio decisions

The Context of Trading: Market Microstructure 3.. The Context of Trading: Market Microstructure Emphasize immediacy Some degree of price uncertainty... Inside Bid Or Market Bid Inside

Level III

Execution of Portfolio Decisions

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Contents

1 Introduction

2 The Context of Trading: Market Microstructure

3 The Costs of Trading

4 Types of Traders and their Preferred Order Types

5 Trade Execution Decisions and Tactics

6 Serving the Client’s Interests

1 Introduction

2 The Context of Trading: Market Microstructure

Emphasize immediacy

Some degree of price uncertainty

Bid-Ask Spread

Dealer vs Trader

Inside Bid Or Market Bid

Inside Ask or Market Ask

Market Bid-Ask Spread

Effective Spread = 2 x deviation of the actual execution price from the midpoint of the

market quote at the time an order is entered

Effective spread is a better representation of actual transaction cost because it captures both:

1 Price Movement: execution within quoted spread

Bid-Ask Spread Versus Effective Spread as a Measure of Trading Cost

Bid-Ask Spread = 0.06 Midquote = 20.00

Effective Spread:

2 x (20.01 – 20.00)

= 0.02 Average effective spread is the

mean effective spread over all

1 For each of these market orders, compute the quoted spread Also, compute the average quoted spread for the stock for the day

2 For each order, compute the effective spread Also, compute the average effective spread and the share-volume-weighted effective spread for the stock for the day

3 Discuss the relative magnitudes of quoted and effective spreads for each of the three orders

1

2

3

Factors like price and time determine which

orders are executed

Crossing networks provide no price discovery

Partial fill

Block order is an order to sell or buy in a quantity that is large relative to the liquidity

ordinarily available from dealers

Broker is an agent of the investor (trader) Receives a commission and provides various

execution services, such as:

1 Representing the order

2 Finding the opposite side of the trade

3 Supplying market information

4 Providing discretion and secrecy

5 Providing other supporting investment services

6 Supporting the market mechanism

Dealer is a counterparty to the investor (trader) There is an inherent conflict of interest

Dealer faces adverse selection risk: the risk of trading with a more informed trader

Liquid markets have the following characteristics:

1) Low bid-ask spread

2) Market is deep

3) Market is resilient (efficient)

Advantages of high liquidity:

1 Traders can trade rapidly without impacting price

2 Lower cost of capital for corporations

Factors contributing to market liquidity:

1 Many buyers and sellers

2 Diversity of opinion, information and investment

needs among market participants

3 Convenience

4 Market integrity

Participants can easily, quickly and inexpensively obtain information about

quotes and trades (pre-trade transparency)

and details on completed trades are quickly reported to the public (post-trade

transparency)

Low transparency compromises market integrity

Buyers and sellers confident that trade will

be completed Brokers or clearing entities might provide guarantees

Assurity of Completion

3 The Cost of Trading

• Trading costs represent negative performance

• Understand trading costs

• Transaction cost components

Traders measure implicit costs (i.e., costs excluding commissions) with reference to a

benchmark

Time-of-trade midquote

Volume weighted average price (VWAP): weighted average price at which the security

traded during the day

Less informative for relatively large trades

Can be gamed

Implementation shortfall is possibly the best cost measurement approach

Calculation of implementation shortfall: paper portfolio return – actual return

Say market has gone up by 1% over trading period and stock beta = 1  predicted return on share =1%

Read Example 6 and Example 7

Many people focus on commission costs because these are

observable

We should recognize that major parts of transaction costs are unobservable

Estimated cost function can be used in two ways:

Example 8: An Econometric Model for Transaction Costs

4 Types of Traders and Their Preferred Order Types

Preferred Order Type

Market

Limit Market, other order types also used

5 Trade Execution Decisions and Tactics

Decisions Related to Handling of a Trade

Objectives in Trading and Trading Tactics

Automated Trading

Decisions Related to Handling of a Trade

market access (DMA) and algorithmic trading

securities

brokerage allocations

Objectives in Trading and Trading Tactics

Automated (Algorithmic) Trading

quantitative rules and user-specified benchmarks and constraints

controlled risk and costs

 Simple logical participation strategies

Algorithmic Trading Classification

match or improve upon VWAP for the day Typically

the trader attempts to match the expected volume

pattern over the day

simple variant of the VWAP strategy that assumes a

flat volume profile

implementation shortfall method

adverse price movement  transactions are

front-loaded

Summary output from a trader’s order management system or trade blotter

What tactics are appropriate for each order?

6 Serving the Client’s Interests

“a framework from which to make consistently good trade execution

suggestions…”

to maximize the value of the client’s portfolio

and record keeping

interests of the client

 Buy-side trader acts in a fiduciary capacity, with access to the client’s assets

 Code of both buy-side and sell-side traders is that verbal agreements will be

Summary