CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r31 execution of portfolio decisions IFT notes

To do this he needs to understand:  the market institutions within which traders work, including the different types of trading venues to which traders may direct orders;  the measur

Execution of Portfolio Decisions

1 Introduction 3

2 The Context of Trading: Market Microstructure 3

2.1 Order Types 3

2.2 Types of Markets 4

2.3 The Roles of Brokers and Dealers 7

2.4 Evaluating Market Quality 7

3 The Costs of Trading 8

3.1 Transaction Cost Components 8

3.2 Pretrade Analysis: Econometric Models for Costs 11

4 Types of Traders and Their Preferred Order Types 12

4.1 The Types of Traders 12

4.2 Traders’ Selection of Order Types 12

5 Trade Execution Decisions and Tactics 13

5.1 Decisions Related to the Handling of a Trade 13

5.2 Objectives in Trading and Trading Tactics 13

5.3 Automated Trading 14

6 Serving the Client’s Interests 16

Summary 17

Examples from the Curriculum 23

Example 1 The Effective Spread of an Illiquid Stock 23

Example 2 Market Classifications Are Simplifications 25

Example 3 Assessing Market Quality after a Market Structure Change 25

Example 4 The Market Quality of Electronic Crossing Networks 26

Example 5 Taking Advantage of Weaknesses in Cost Measures 26

Example 6 Commissions: The Most Visible Part of Transaction Costs (1) 27

Example 7 Commissions: The Most Visible Part of Transaction Costs (2) 27

Example 8 An Econometric Model for Transaction Costs 28

Example 9 The Changing Roles of Traders 29

Example 10 Order Fragmentation: The Meat-Grinder Effect 30

Example 11 A Trading Strategy 30

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®

Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

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

products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are

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1 Introduction

The investment process consists of three steps – securities research, portfolio management and

securities trading The focus of this reading is on the third step ‘trading’

Although a portfolio manager is not a professional trader, he needs to:

 communicate effectively with professional traders

 evaluate the quality of the execution services being provided for the firm’s clients; and

 take responsibility for achieving best execution on behalf of clients in his or her role as a

fiduciary

To do this he needs to understand:

 the market institutions within which traders work, including the different types of trading

venues to which traders may direct orders;

 the measurement of trading costs; and

 the tactics and strategies available to the firm’s traders and the counterparties with whom they

deal, including important innovations in trading technology

2 The Context of Trading: Market Microstructure

The market microstructure refers to the structure and processes of a market that affects how orders will

be handled and executed

2.1 Order Types

LO.a: Compare market orders with limit orders, including the price and execution uncertainty of

each

The two major types of orders are: market orders and limit orders

Market order: It is an instruction to execute an order promptly in the public market at the best price

available The emphasis here is on immediacy of execution However, a market order has price

uncertainty (we do not know the price at which the order will execute)

Limit order: It is an instruction to trade at the best price available but only if the price is at least as good

as the limit price specified in the order The emphasis here is on price However, a limit order has

execution uncertainty (we do not know if the order will be executed)

Some other types of orders are:

 Market-not-held order: A variant of market order Here the trader’s agent is given discretion to

not participate in the flow of orders if he believes that he will get a better price in subsequent

trading

 Participate (do not initiate) order: It is a variant of market-not-held order Here the broker

waits for orders of other active traders and responds to their orders (instead of initiating the

orders himself)

 Best efforts order: It gives the trader’s agent even more discretion to work on the order only

when he thinks the market conditions are favourable

 Market on open order: Market order to be executed at market open

 Market on close order: Market order to be executed at market close

2.2 Types of Markets

Markets are organized to provide

 Liquidity: Ability to trade large quantities without delay at minimal cost

 Transparency: Correct and timely availability of market and trade information

 Assurity of completion: Trades are completed without issues

The three main categories of markets are:

 Quote driven markets: Investors trade with dealers

 Order driven markets: Investors trade with each other

 Brokered markets: Investors use broker to find a counterparty to the trade

Let’s look at each market type in detail

LO.c: Compare alternative market structures and their relative advantages

Quote Driven Markets

Here investors trade with dealers rather than directly with one another They are also called dealer

markets A dealer maintains an inventory of an asset He either buys the asset for inventory or sells the

asset from inventory to provide liquidity

The price at which the dealer buys is called the bid price The price at which the dealer sells is called the

ask price The difference between the two prices is called the bid-ask spread A dealer earns profit from

Note: The bids are ordered from highest to lowest, while the asks are ordered from lowest to highest These

orderings are from best bid or ask to worst bid or ask

Important terminology to note are:

 Inside Bid or Market Bid: This is the highest and best bid In our example, this is 98.85 from

 Midquote: Halfway point between the market bid and market ask In our example, (100.49 +

98.85)/2 = 99.67

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

LO.b: Calculate and interpret the effective spread of a market order and contrast it to the quoted

bid–ask spread as a measure of trading cost

One way to measure the trading costs is to calculate the size of the market bid-ask spread as a

proportion of the mid-quote However, the drawback of this measure is that the quoted bid-ask spread

may be different from the spread at which a trader actually transacts To overcome this drawback we

use the effective 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

2 Market Impact: tendency for large orders to move prices

Exhibit 2 provides a hypothetical market bid-ask spread for a security

Bid Price Bid Size Ask Price Ask Size

$19.97 400 $20.03 1,000

Based on this information a trader enters a market order to buy 500 shares The order executes at

$20.01 Exhibit 3 shows the market bid ask spread when the order executes

Bid Price Bid Size Ask Price Ask Size

$19.97 400 $20.01 500

From Exhibit 2 we see that the quoted bid–ask spread is $20.03 – $19.97 = $0.06 The midquote is

($20.03 + $19.97)/2 = $20.00 The effective spread is 2 × ($20.01 – $20.00) = 2 × $0.01 = $0.02, which is

$0.06 – $0.02 = $0.04 less than the quoted spread

Average effective spread is the mean effective spread over all transactions in the stock in the period

under study

Refer to Example 1 from the curriculum

Empirical research shows that bid ask spreads are low in high volume securities Whereas, spreads are

wider for riskier and less liquid securities

Order driven markets

Here investors trade with each other without the use of any intermediaries The transaction prices are

established by public limit orders to buy or sell a security at specified prices The three main types of

order-driven markets are: 1) electronic crossing networks, 2) auction markets and 3) automated

auctions

Electronic crossing networks

Here orders are batched together and crossed at a specific point in time, at the average of the bid and

ask quotes By using electronic crossing networks, investors can avoid the costs of dealer services (the

bid-ask spread), the effect a large order can have on execution prices and information leakages

However, investors cannot be guaranteed that their trades will find an opposing match

Refer to Exhibit 4 which illustrates how trades on a crossing network are executed

Trader Identity Buy Orders Sell Orders

Trader A wishes to buy 10,000 shares of a stock Traders B and C wish to sell 3,000 and 4,000 shares

respectively The market bid and ask prices of the stock are €30.10 and €30.16, respectively

In this example, total volume is 7,000 shares and the execution price is at the midquote (halfway

between the prevailing bid and ask prices) of €30.13 = (€30.10 + €30.16)/2 Both sellers have their

orders executed in full, but buyer A receives a partial fill of 7,000 shares

Crossing networks do not provide price discovery Price discovery means that transaction prices adjust

to equilibrate supply and demand In our example, prices could not adjust upward to fully satisfy trader

A’s demand to buy

Auction market

Here orders of multiple buyers compete for execution Auction markets can be

 Periodic or batch auction markets: Trading occurs at a single price at a pre-specified point in

time

 Continuous auction markets: Trading takes place throughout the day

As compared to electronic crossing networks, auction markets provide price discovery, which lessens

the problem of partial fills

Automated auctions

These markets operate throughout the trading day and trades are executed based on a specified set of

rules Electronic communications networks (ECNs), such as the NYSE Arca Exchange in the United States

and the Paris Bourse in France, are examples of automated auctions for equities

Like crossing networks, ECNs provide anonymity Unlike crossing networks, they operate continuously

and provide price discovery

Brokered Markets

In these markets investors use brokers to find counterparties for the trade In exchange for these

services, the broker collects a commission

These markets are important in countries where the underlying public exchanges are relatively small or

where liquidity is low for large orders Hence brokered markets are mostly used for block transactions

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

from dealers

Refer to Example 2 from the curriculum

Hybrid Markets

These are a combination of the previously described market types For example the New York Stock

Exchange (NYSE), offers elements of batch auction markets (e.g., the opening) and continuous auction

markets (intraday trading), as well as quote-driven markets (the important role of NYSE dealers, who are

known as specialists)

2.3 The Roles of Brokers and Dealers

Broker

A broker is an agent of the investor (trader) He 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

A dealer is a counterparty to the investor (trader) Since the dealer tries to earn profits from the bid-ask

spread, there is an inherent conflict of interest between the dealer and the investor

A dealer faces adverse selection risk, which is the risk of trading with a more informed trader

Buy-side traders are often strongly influenced by sell-side traders such as dealers (Sell-side refers to

institutions such as brokerage firms which sell services Buy-side traders work at investment

management firms or for other institutional investors)

2.4 Evaluating Market Quality

LO.d: Explain the criteria of market quality and evaluate the quality of a market when given a

description of its characteristics

A security market should provide liquidity, transparency and assurity of completion

Liquidity

Liquid markets have the following characteristics:

1 Low bid-ask spread

2 Market is deep: Big trades tend not to cause large price movements

3 Market is resilient (efficient): Any discrepancies between market price and intrinsic value tend

to be small and corrected quickly

The advantages of high liquidity are:

1 Traders can trade rapidly without impacting price

2 Lower cost of capital for corporations Since investors are willing to pay premiums for securities

with high liquidity This leads to higher security prices, which enhances corporate value and

lowers the cost of capital

The factors contributing to market liquidity are:

1 Many buyers and sellers

2 Diversity of opinion, information and investment needs among market participants

3 Convenience: The physical location or trading platform is easily accessible

4 Market integrity: Investors receive fair and honest treatment

Transparency

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

Assurity of Completion

Buyers and sellers confident that trade will be completed To ensure assurity, Brokers or clearing entities

might provide guarantees to both buyers and sellers

Refer to Example 3 from the curriculum

Refer to Example 4 from the curriculum

3 The Costs of Trading

Trading costs represent negative performance Hence it is important to understand trading costs

3.1 Transaction Cost Components

LO.e: Explain the components of execution costs, including explicit and implicit costs, and evaluate a

trade in terms of these costs

Transaction costs include explicit costs and implicit costs Explicit costs are the direct costs of trading

and include broker commission costs, taxes, stamp duties, and fees Implicit costs include indirect costs

such as the impact of the trade on the price received

The components of trading costs are:

 Bid-ask spread

 Market impact: It is the effect of a trade on transaction prices For example, suppose a trader

enters a large market order to buy a security at $100 A portion of the order is filled at $100,

before the rest of the order is filled, the price rises to $101, so the rest of the order is filled at

the higher price The trader effectively moved the price higher

 Missed trade opportunity costs: It arises from the failure to execute a trade in a timely manner

For example, suppose a trader enters a limit order to buy the security at $100 when the market

price is $101 The price rises and the order is left unfilled If the security closes at $105, the

trader has missed an opportunity to profit The opportunity cost is $105 - $101 = $4

 Delay costs: It arises from the inability to complete the desired trade immediately due to its size

relative to the liquidity of the markets It is often measured on the portion of the order carried

over from one day to the next Delays can be costly, because information that the trader has

could leak into the market

Volume weighted average price

Implicit costs are usually measured against some benchmark, like the time of trade midquote An

alternative is to use the volume weighted average price as the benchmark The VWAP of a security is the

average price at which the security traded during the day, where each trade price is weighted by the

fraction of the day’s volume associated with the trade

The two drawbacks of VWAP are: 1) this measure is less informative for very large trades and 2) it can be

gamed

Refer to Example 5 from the curriculum

Implementation shortfall

LO.f: Calculate and discuss implementation shortfall as a measure of transaction costs

To overcome the drawbacks of VWAP we can use another measure called implementation shortfall

Implementation shortfall is defined as the difference between the money return on a notional or paper

portfolio in which positions are established at the prevailing price when the decision to trade is made

(known as the decision price, the arrival price, or the strike price) and the actual portfolio’s return

The four components of implementation shortfall are:

1 Explicit costs: Includes commissions, taxes, and fees

2 Realized profit/loss: Reflecting the price movement from the decision price to the execution

price for the part of the trade executed on the day it is placed

3 Delay costs (slippage): Reflecting the change in price (close-to-close price movement) over the

day an order is placed when the order is not executed that day; the calculation is based on the

amount of the order actually filled subsequently

4 Missed trade opportunity cost (unrealized profit/loss): Reflects the price difference between the

trade cancellation price and the original benchmark price based on the amount of the order that

was not filled

The following example from the curriculum illustrates the calculation of implementation shortfall

Consider the following facts:

 On Monday, the shares of Impulse Robotics close at £10.00 per share

 On Tuesday, before trading begins, a portfolio manager decides to buy Impulse Robotics An

order goes to the trading desk to buy 1,000 shares of Impulse Robotics at £9.98 per share or

better, good for one day The benchmark price is Monday’s close at £10.00 per share No part of

the limit order is filled on Tuesday, and the order expires The closing price on Tuesday rises to

£10.05

 On Wednesday, the trading desk again tries to buy Impulse Robotics by entering a new limit

order to buy 1,000 shares at £10.07 per share or better, good for one day That day, 700 shares

are bought at £10.07 per share Commissions and fees for this trade are £14 Shares for Impulse

Robotics close at £10.08 per share on Wednesday

 No further attempt to buy Impulse Robotics is made, and the remaining 300 shares of the 1,000

shares the portfolio manager initially specified are never bought

The paper portfolio traded 1,000 shares on Tuesday at £10.00 per share The return on this portfolio

when the order is canceled after the close on Wednesday is the value of the 1,000 shares, now worth

£10,080, less the cost of £10,000, for a net gain of £80 The real portfolio contains 700 shares (now

worth 700 × £10.08 = £7,056), and the cost of this portfolio is 700 × £10.07 = £7,049, plus £14 in

commissions and fees, for a total cost of £7,063 Thus, the total net gain on this portfolio is – £7 The

implementation shortfall is the return on the paper portfolio minus the return on the actual portfolio, or

£80 – (– £7) = £87 More commonly, the shortfall is expressed as a fraction of the total cost of the paper

portfolio trade, or £87/£10,000 = 87 basis points

We can break this implementation shortfall down further:

 Commissions and fees are calculated naturally as £14/£10,000 = 0.14%

 Realized profit/loss reflects the difference between the execution price and the relevant

decision price (here, the closing price of the previous day) The calculation is based on the

amount of the order actually filled:

700

1,000(

10.07 − 10.0510.00 ) = 0.14%

 Delay costs reflect the price difference due to delay in filling the order The calculation is based

on the amount of the order actually filled:

700

1,000(

10.05 − 10.0010.00 ) = 0.35%

 Missed trade opportunity cost reflects the difference between the cancellation price and the

original benchmark price The calculation is based on the amount of the order that was not

filled:

1,000(

10.08 − 10.0010.00 ) = 0.24%

 Implementation cost as a percent is 0.14% + 0.14% + 0.35% + 0.24% = 0.87%, or 87 bps

LO.g: Contrast volume weighted average price (VWAP) and implementation shortfall as measures of

transaction costs

Exhibit 6 compares VWAP and implementation shortfall

Volume Weighted Average Price Implementation Shortfall Advantages  Easy to compute

 Recognizes the tradeoff between immediacy and price

 Allows attribution of costs

 Can be built into portfolio optimizers to reduce turnover and increase realized performance

 Not sensitive to trade size or market conditions

 Can be gamed by delaying trades

 Requires extensive data collection and interpretation

 Imposes an unfamiliar evaluation framework on traders

Refer to Example 6 from the curriculum

Refer to Example 7 from the curriculum

3.2 Pretrade Analysis: Econometric Models for Costs

LO.h: Explain the use of econometric methods in pretrade analysis to estimate implicit transaction

costs

By using the post-trade shortfall estimates and econometric models we can forecast trading costs

Microstructure theory suggests that trading costs are related to the following factors:

 stock liquidity characteristics (e.g., market capitalization, price level, trading frequency, volume,

index membership, bid–ask spread);

 risk (e.g., the volatility of the stock’s returns);

 trade size relative to available liquidity (e.g., order size divided by average daily volume);

 momentum (e.g., it is more costly to buy in an up market than in a down market);

 trading style (e.g., more aggressive styles using market orders should be associated with higher

costs than more passive styles using limit orders)

The forecasted trading costs can be used in two ways:

 Compare actual realized costs to estimated costs once trading is completed to assess execution

quality

 Calculate the right trade size to order

Refer to Example 8 from the curriculum

4 Types of Traders and Their Preferred Order Types

LO.i: Discuss the major types of traders, based on their motivation to trade, time versus price

preferences, and preferred order types

4.1 The Types of Traders

Exhibit 8 provides a summary of the types of traders

Trading Time Horizon

Time versus Price Preference

Information-motivated

New information Minutes to hours Time

Value-motivated Perceived valuation errors Days to weeks Price

Liquidity-motivated

Invest cash or divest securities Minutes to hours Time

Passive Rebalancing, investing/divesting

cash

Days to weeks Price

Dealers and day

traders

Accommodation Minutes to hours Passive, indifferent

4.2 Traders’ Selection of Order Types

The following table shows the preferred order type of the various traders

Trader Preferred order type

Information-motivated Market order

Value-motivated Limit order

Liquidity-motivated Market order, other order types also used

Passive Limit order; portfolio trades and crossing networks

5 Trade Execution Decisions and Tactics

5.1 Decisions Related to the Handling of a Trade

Small, liquidity-oriented trades can be packaged up and executed via direct market access (DMA) and

algorithmic trading DMAs are broker-sponsored platforms which allow buy-side traders to directly

access securities

Large, information laden trades demand immediate skilled attention Senior traders are needed to

manage the trade-off between impact and delay costs

In addition to seeking best execution, traders should also be aware of client trading restrictions, cash

balances and brokerage allocations

5.2 Objectives in Trading and Trading Tactics

LO.j: Describe the suitable uses of major trading tactics, evaluate their relative costs, advantages,

and weaknesses, and recommend a trading tactic when given a description of the investor’s

motivation to trade, the size of the trade, and key market characteristics

Exhibit 9 provides a summary of the various objectives in trading

Liquidity at any

cost (I must

trade)

Immediate execution in institutional block size

High cost due to tipping

supply/demand balance

Guarantees execution

High potential for market impact and information leakage

Higher commission;

possible leakage of information

Hopes to trade time for improvement in price

Loses direct control

of trade

Costs are not

important

Certainty of execution

Pays the spread;

may create impact

Competitive, market-determined price

Cedes direct control

of trade; may ignore tactics with potential for lower cost Advertise to

draw liquidity

Large trades with lower information advantage

High operational and organizational costs

determined price for large trades

Market-More difficult to administer; possible leakage to front-runners

Low cost

whatever the

liquidity

informational trading;

Non-indifferent to timing

Higher search and monitoring costs

Low commission;

opportunity to trade at favorable price

Uncertainty of trading; may fail to execute and create a need to complete at a later, less desirable price

5.3 Automated Trading

LO.k: Explain the motivation for algorithmic trading and discuss the basic classes of algorithmic

trading strategies

Algorithmic trading refers to automated electronic trading subject to quantitative rules and

user-specified benchmarks and constraints The motivation for algorithmic trading is to exploit market

patterns of trading volume so as to execute orders with controlled risk and costs

Refer to Example 9 from the curriculum

Refer to Example 10 from the curriculum

Algorithmic trading strategies can be classified into:

 Simple logical participation strategies

 Implementation shortfall strategies

 Opportunistic strategies

 Specialized strategies

Simple logical participation strategy

These strategies try to participate in overall market volumes without being overly noticeable

In a volume-weighted average price (VWAP) strategy, the order is broken up over time according to

pre-specified volume profile so as to match or improve upon the day’s VWAP

In a time-weighted average price strategy (TWAP), the order is spread out evenly over the entire day so

as to match or beat a time-weighted or equally weighted average price

In a percentage of volume strategy, order is traded in proportion to overall market volume, usually

5-20% until the order is completed

Implementation short fall strategy

These strategies try to minimize trading costs as measured by the implementation shortfall method

Here we are mainly concerned about opportunity costs resulting from non-trading and subsequent

adverse price movement Therefore, these strategies trade more early in the day (front-loaded) to

ensure that orders are filled completely

Exhibit 11 shows the hypothetical trade schedule for an implementation shortfall algorithmic order

Notice that most of the order is executed early in the trading day

Opportunistic Participation Strategies

These strategies trade passively, but opportunistically increase trading when liquidity is high

Specialized Strategies

This is a combination of passive strategies and other miscellaneous strategies

Choosing an algorithmic trading strategy

LO.l: Discuss the factors that typically determine the selection of a specific algorithmic trading

strategy, including order size, average daily trading volume, bid–ask spread, and the urgency of the

order

Exhibit 12 shows summary output from a trader’s order management system (OMS) or trade blotter

indicating trade size (in shares), various market attributes, and an urgency level from the portfolio

The first order in ABC is largest in shares and value However, it is the smallest as a percentage of

average daily volume It also has low spread and low urgency level Therefore we can use a VWAP

algorithm to execute this order

The second order in DEF is large relative to the average daily volume The spread is also high Therefore

it would be appropriate to use a broker or crossing system to execute this order