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

Comparison of Market Orders with Limit Orders Execute an order promptly in the public market at the best price available.. Emphasis is on immediacy of execution There is price uncertaint

Level III

Execution of Portfolio Decisions

Summary

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Comparison of Market Orders with Limit Orders

Execute an order promptly in the public market at the

best price available

Emphasis is on immediacy of execution

There is price uncertainty

Trade at the best price available but only if the price is at least as good as the limit price specified in the order Emphasis is on price

There is execution uncertainty

Comparison of Alternate Market Structures

Quote driven (dealer) markets Order driven markets Brokered markets

Investors trade with dealers rather

than directly with one another

Dealer maintains inventory; buys or

sells asset from inventory to provide

liquidity

Dealer buys at bid price; sells at ask

price

Difference is the bid-ask spread

Investors trade with each other

Transaction prices are established by public limit orders to buy or sell a security at specified prices

Three main types of order-driven markets are: 1) electronic crossing networks, 2) auction markets and 3) automated auctions

Investors use brokers to find counterparties for the trade

Broker collects a commission

These markets are important when underlying public exchanges are relatively small or where liquidity is low for large orders

Brokered markets are mostly used for block (large) transactions

2008 8 A

Bid-Ask Spread and Effective Spread

Measure the trading costs: size of the market bid-ask spread as a proportion of the mid-quote

Drawback: 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

Bid Price Bid Size Ask Price Ask Size

Based on this information a trader enters a market

order to buy 500 shares The order executes at $20.01

Bid Price Bid Size Ask Price Ask Size

Quoted bid–ask spread is $20.03 – $19.97 = $0.06 Midquote is ($20.03 + $19.97)/2 = $20.00

Effective spread is 2 × ($20.01 – $20.00) = $0.02 This is $0.04 less than the quoted spread

4

Electronic crossing networks: orders are batched together and crossed at a specific point in time, at the

average of the bid and ask quotes

Benefits: 1) Low cost (investors can avoid the costs of dealer services), 2) avoid the effect a large order can

have on execution prices and 3) low information leakage (anonymity)

Disadvantages: 1) investors cannot be guaranteed that their trades will find an opposing match and 2)

crossing networks do not provide price discovery

Auction market: 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

Auction markets provide price discovery

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

2010 8 C

Three Types of Order Driven Markets

Comparison of Brokers and Dealers

A broker is an agent of the investor (trader)

Broker receives a commission and provides various

execution services, such as:

• Representing the order

• Finding the opposite side of the trade

• Supplying market information

• Providing discretion and secrecy

• Providing other supporting investment services

• Supporting the market mechanism

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)

6

Market Quality

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

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; more trading hours

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)

Assurity of Completion: Buyers and sellers are confident that trade will be completed To ensure assurity, brokers or

clearing entities might provide guarantees to both buyers and sellers

2012 3 A

Execution Costs

Transaction execution 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 execution costs are:

 Market impact: 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 cost: 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 cost: 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

8

Volume weighted average price (VWAP): 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

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

Measures of Transaction Costs

Implementation Shortfall Example

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

10

We can break this implementation shortfall down further:

 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

10.07 − 10.05

 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

10.05 − 10.00

price The calculation is based on the amount of the order that was not filled:

300

10.08 − 10.00

2010 8 D

2014 10 D

Volume Weighted Average Price Implementation Shortfall

Advantages

execution

non-trending markets

Advantages

 Links trading to portfolio manager activity; can relate cost to the value of investment ideas

price

 Allows attribution of costs

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

Disadvantages

canceled

proportion of trading volume

 Not sensitive to trade size or market conditions

Disadvantages

interpretation

traders

12

Use of Econometric Models to Estimate Transaction Costs

By using 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)

 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

Trader Motivation Trading Time Horizon Time versus Price Preference

Information-motivated

investing/divesting cash

Dealers and day

traders

Profitably accommodate trading demands of others

Types of Traders

14

Focus Uses Costs Advantages Weaknesses

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

Need trustworthy

agent (Possible

hazardous trading

situation)

Large-scale trades; low-level advertising

Higher commission;

possible leakage of information

Hopes to trade time for improvement in price

Loses direct control of trade

Costs are not

important

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

Market-determined price for large trades

More difficult to administer;

possible leakage to front-runners

Low cost whatever the

liquidity

Non-informational trading; 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

Trading Tactics

Algorithmic Trading

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

Simple logical participation strategy: 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

Opportunistic Participation Strategies: these strategies trade passively, but opportunistically increase trading when

liquidity is high