2019 CFA level 3 qbank reading 35 execution of portfolio decisions answers

Study Session 18, Module 35.6, LOS 35.k Related Material SchweserNotes - Book 5 Question #14 of 68 In the discussion concerning the use of econometric methods in estimating trading costs

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Question #1 of 68

Which of the following characterizes a need-trustworthy-agent trading focus?

A) High commissions and potential leakage of information.

B) High commissions and concealment of information.

C) Low commissions and concealment of information.

Explanation

In a need-trustworthy-agent trading focus, the trader employs a broker to skillfully execute a

large trade The broker may need to trade over a period of time, so such orders are not

appropriate for information traders This strategy allows the broker to learn their trade

intentions, which may not be in the trader's best interests It also requires high commissions

(Study Session 18, Module 35.5, LOS 35.j)

The explicit costs in a trade are readily discernable and include commissions, taxes, stamp

duties, and fees Implicit costs sometimes cannot be measured as easily but do exist They

include the bid-ask spread, market or price impact costs, opportunity costs, and delay costs

(a.k.a slippage costs)

(Study Session 18, Module 35.4, LOS 35.e)

Related Material

SchweserNotes - Book 5

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Which of the following is least accurate regarding the CFA Institute's Trade Management

Guidelines? They state that investment management rms should:

A) have policies and procedures that assist in best execution.

B) provide general information on their trading techniques, markets, and brokers.

C) hire independent outside consultants to ensure best execution.

Explanation

The CFA Institute's Trade Management Guidelines do not require that investment

management rms hire independent outside consultants to ensure best execution

(Study Session 18, Module 35.7, LOS 35.n)

Jack Steele has just determined using analysis that the prospects for Titan Steel are favorable

He would like to trade before other investors realize Titan's prospects What type of trade

Steele is an information-motivated trader These traders have information that is time

sensitive, and if they do not trade quickly, the value of their information will expire They use

market orders to execute quickly and because these orders are less noticeable

(Study Session 18, Module 35.5, LOS 35.i)

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Which of the following statements best characterizes a limit order? A limit order has:

A) reduced price uncertainty but retains execution uncertainty.

B) price uncertainty but not execution uncertainty.

C) price uncertainty and execution uncertainty.

Explanation

A limit order is an order to trade at the best possible price, subject to the price satisfying the

limit price A limit order emphasizes the price of execution (the reduction of price

uncertainty) It however, may not be lled immediately and may even go un lled or partially

un lled A limit order thus has execution uncertainty

(Study Session 18, Module 35.1, LOS 35.a)

In an electronic crossing network, orders are executed at the average of the bid and ask

quotes Prices do not adjust based on supply and demand

(Study Session 16, Module 35.1, LOS 35.c)

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A) An implementation shortfall strategy.

B) A simple logical participation strategy based on VWAP.

C) A simple logical participation percent-of-volume strategy.

Explanation

Implementation shortfall strategies minimize trading costs as de ned by the implementation

shortfall measure Because opportunity costs result from non-trading, this strategy trades

heavier early in the day to ensure order completion An implementation shortfall strategy is

useful when an entire portfolio must be traded Simple logical participation strategies

patiently trade throughout the day and may not be able to ll the order

(Study Session 18, Module 35.6, LOS 35.k)

Which of the following is least accurate regarding VWAP? VWAP:

A) does not account for market movements or trade volume.

B) does not evaluate delayed or un lled orders.

C) is applicable to small and large trades.

Explanation

The advantages of VWAP are that it is easily understandable, computationally simple, can be

applied quickly to enhance trading decisions, and is most appropriate for small trades in

nontrending markets The disadvantages of VWAP are that it is not informative for trades that

dominate trading volume, it can be gamed by traders, it does not evaluate delayed or un lled

orders, and does not account for market movements or trade volume

(Study Session 18, Module 35.4, LOS 35.g)

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A trade's volume is a small percentage of average daily trading volume The trade has low

spreads and is urgent Which of the following would be the best method of lling the trade?

A) Placing the trade in a crossing system.

B) The use of a simple logical participation strategy based on VWAP.

C) The use of an implementation shortfall strategy.

Explanation

Trades that are a small portion of average daily trading volume, with low spreads, and high

urgency should be traded with an implementation shortfall strategy These strategies trade

early in the day and would accommodate an urgent trade

(Study Session 18, Module 35.6, LOS 35.l)

A security market should be judged on the basis of its liquidity and assurity of completion

(Study Session 18, Module 35.3, LOS 35.d)

George White, CFA, and Elizabeth Plain, CFA, manage an account for Briggs and Meyers

Securities In managing the account, White and Plain use a variety of strategies, and they trade

in di erent markets They use econometric analysis to estimate costs, for example, and

algorithmic methods to execute the strategies White and Plain also use both market orders

and limit orders Their supervisor has asked them to compose a summary of their trading

records to see how the various strategies have worked

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The supervisor asks about how to assess the costs and risks of the various types of trades The

supervisor speci cally asks White and Plain to explain the di erence in the risks associated with

market and limit orders After White and Plain explain how limit orders can give a better price,

the supervisor asks why they wouldn't always use limit orders White explains the details of

execution uncertainty and price uncertainty and how they relate to market and limit orders As

part of the discussion, Plain explains the principle of the e ective spread that is associated with

market orders She uses a recent example where the quoted bid and ask price of GHT stock

was $25.40 and $25.44 respectively When White and Plain put in a buy order for 300 shares of

GHT stock, at that quoted spread, the order was immediately executed at $25.45 She then

calculates the e ective spread

In summarizing transactions costs, White explains how transactions costs include both implicit

and explicit costs He describes a recent situation where he and Plain placed a large buy order

for CRD stock Only half of the trade was executed on the day the order was made, and the

second half of the buy order for CRD was executed on the following day This occurred because

the order was for a large number of shares and CRD stock traded in a relatively illiquid market

The supervisor asks if there are methods for analyzing and predicting costs associated with the

size of the order and the liquidity of the market White and Plain use an econometric model as

part of their pre-trade analysis to estimate implicit transactions costs Their econometric

models use the following inputs: market capitalization, volume, and measures of momentum

White says that linear econometric models have proven the most e ective because the inputs

are fairly normally distributed Plain says that in addition to simply estimating the costs of a

proposed trade, the model can also indicate the optimal size of the trade

White and Plain also explain their algorithmic methods of trading They engage in passive

trading combined with pegging and discretion strategies that are designed to seize liquidity

They recently decided to trade GHT stock using algorithmic methods White said that GHT was a

good stock to trade this way because their trades of the stock are very small in relation to the

volume of the stock in the whole market Plain adds by saying that GHT has a large spread, and

this also makes algorithmic trading ideal for this stock

Which of the following statements regarding market orders is most accurate? Market orders:

A) have price uncertainty, and limit orders have execution uncertainty.

B) have execution uncertainty, and limit orders have price uncertainty.

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C) and limit orders both have execution uncertainty and no price uncertainty.

Explanation

This is true because a market order can be executed at any price The limit order may never

get executed if the price does not fall into the speci ed range

The e ective spread is twice the di erence between the execution price and the average of

the bid/ask spread at the time of the order: $0.06=2 × [$24.45 –($24.44 + $24.40)/2]

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The term delay costs refers to the inability to complete the desired trade immediately

because of its size and the liquidity of markets Delay costs are often measured on the

portion of the order carried over from one day to the next

In the discussion concerning the use of econometric methods in estimating trading costs, White

commented on the use of linear methods, and Plain commented on using the models to

estimate the optimal trade size With respect to these statements:

A) both White and Plain were correct.

B) White was incorrect and Plain was correct.

C) White was correct and Plain was incorrect.

Explanation

White was wrong because non-linear models can be more e ective than linear models Plain

is correct because the models can estimate the optimal size of the trade

With respect to the reasons given for using algorithmic methods for trading GHT stock:

A) White was correct and Plain was incorrect.

B) White and Plain were both correct.

C) Plain was correct and White was incorrect.

Explanation

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Algorithmic trading is ideal for a stock that has a low bid/ask spread The trades should have

a low urgency level and be small with respect to the average volume of that stock

The best classi cation of the algorithmic method used by White and Plain is:

A) simple logical participation strategy.

B) opportunistic participation strategies.

C) implementation shortfall strategy.

Explanation

Opportunistic participation strategies involve passive trading combined with the

opportunistic seizing of liquidity The most common examples are pegging and discretion

strategies In these strategies, the potential buyer posts a bid and hopes others will sell to

him and that this will yield negative implicit trading costs

A market order has:

A) price uncertainty but not execution uncertainty.

B) both price uncertainty and execution uncertainty.

C) execution uncertainty but not price uncertainty.

Explanation

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A market order is an order to execute the trade immediately at the best possible price The

emphasis in a market order is the speed of execution (the reduction of execution

uncertainty) The disadvantage of a market order is that the price it will be executed at is not

known ahead of time, it thus has price uncertainty

(Study Session 18, Module 35.1, LOS 35.a)

A) A large buy order in an upward trending market.

B) A small buy order in an upward trending market.

C) A large buy order in a downward trending market.

Explanation

Econometric models use momentum and trade size relative to available liquidity to predict

trading costs Buying a stock in an upward trending market will incur more costs as will a

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The following are the variables typically used in econometric models:

security liquidity – trading volume, market cap, spread, price;

size of the trade relative to liquidity;

trading style – more aggressive trading results in higher costs;

momentum – e.g., buying stock costs more when the market is trending upward; andrisk

(Study Session 18, Module 35.5, LOS 35.h)

Which of the following trade motivations would most likely use a

low-cost-whatever-the-liquidity trading focus?

A) Passive and value-motivated.

B) Liquidity and information-motivated.

C) Liquidity and value-motivated.

Explanation

In a low-cost-whatever-the-liquidity trading focus, the trader places a limit order outside of

the current bid-ask quotes in order to minimize trading costs The strength of this strategy is

that commissions, spreads, and market impact costs tend to be low Passive and

value-motivated traders will often purse this patient strategy Information and liquidity value-motivated

trades need more immediate execution and thus would not use this strategy

(Study Session 18, Module 35.5, LOS 35.j)

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C) Electronic crossing networks.

Explanation

In brokered markets, brokers nd the counterparties to a trade This service is valuable when

the trader has a large block to sell, when they want to remain anonymous, and/or when the

market for the security is small or illiquid Brokered markets are important in countries

where public capital markets are not well developed

Which of the following is least accurate regarding best execution?

A) Each party to a trade determines what best execution is.

B) Best execution can be measured for a single trade.

C) Best execution cannot be judged separately of the investment decision.

Explanation

Although best execution can be measured ex post over time, it cannot be measured for a

single trade Best execution cannot be judged independently of the investment decision Best

execution cannot be known with certainty ex ante, it depends on the particular circumstances

of the trade Each party to a trade determines what best execution is

(Study Session 18, Module 35.7, LOS 35.m)

Which of the following is least accurate regarding best execution?

A) Best execution can determine a trader’s e ectiveness over time.

B) Best execution prevents high cost trades from taking place.

C) Best execution can be measured after the fact for a series of trades.

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Some strategies might have high trading costs but that does not mean they should not be

pursued if in net they enhance portfolio value Best execution can be measured after the fact

for a series of trades

(Study Session 18, Module 35.7, LOS 35.m)

Market A has average bid and ask sizes of 400 shares Market B has average bid and ask sizes

of 600 shares Market C has average e ective spreads of $0.034 Market D has average e ective

spreads of $0.039 Comparing A to B and C to D, which markets are of the highest quality?

A) A and C.

B) B and C.

C) B and D.

Explanation

Lower quoted and e ective spreads as well as higher bid and ask sizes indicate greater

liquidity and greater market quality

(Study Session 18, Module 35.3, LOS 35.d)

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The CFA Institute's Trade Management Guidelines are split into three parts: processes,

disclosures, and record keeping These guidelines are meant to assist investment

management rms in achieving best execution and maximum portfolio value for their clients

Which of the following is least accurate regarding the CFA Institute's Trade Management

Guidelines? They state that investment management rms:

A) should strive for best execution.

B) must not disclose documentation concerning policies and procedures to outside

parties

C) must disclose their con icts of interest related to trading.

Explanation

Documentation concerning policies and procedures to outside parties should be disclosed to

outside regulators, not held within the rm The CFA Institute's Trade Management

Guidelines state that in regard to record keeping, investment management rms should

maintain the documentation supporting: 1) the rm's compliance with its policies and

procedures; and 2) disclosures made to its clients In doing so, the rm provides evidence to

regulators as to how the rm pursues best execution for its clients

In which of the following markets is an order most likely to go un lled or partially lled?

A) Electronic crossing networks.

B) Electronic limit-order markets.

C) Auction markets.

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In an electronic crossing network, trades are executed at the average of the bid and ask

quotes They do not adjust based on supply and demand As such, prices do not adjust to ll

orders In an auction market and automated auctions (also known as electronic limit-order

markets), orders compete for execution and prices can adjust to ll orders

As the senior portfolio manager for the Calvert Pension Fund, Jill Hohlman is responsible for

the investment decisions as well as the execution of trades Debbie Walker is responsible for

the equity portion of the Calvert Pension Fund portfolio It is Hohlman's belief that her portfolio

managers should be able to measure trading costs as well as have a complete understanding of

available trading techniques

Discussing the types of trading cost benchmarks, Hohlman states that the volume-weighted

average price (VWAP) is a weighted average of security prices during a day, where the weight

applied is the proportion of the day's trading volume She states further that the

volume-weighted average price is preferred to the trading cost benchmark alternative of the opening

day's stock price because the opening price can be gamed to a greater extent by traders,

relative to the volume-weighted average price She also mentions that the e ective spread is

another useful alternative to the opening price because the e ective spread cannot be gamed

Discussing the types of trading cost benchmarks further, Walker states that the implementation

shortfall, which is the di erence between the actual portfolio's return and a paper portfolio's

return, is probably the most accurate measure of trading costs She states that the paper

portfolio's return is based on the security price when the decision to trade is originally made

She mentions that it is not subject to gaming, and incorporates both explicit and implicit

trading costs

Hohlman asks Walker to evaluate a trade made last week for the Calvert Pension Fund, using

the implementation shortfall measure The trade was a buy order for the stock of Brucker

Industries Brucker Industries is a small cap stock, which Hohlman thinks is a timely buy given

recent announcement about the rm's prospects On Wednesday, Brucker Industries stock

price closed at $20.00 a share On Thursday morning before the market opened, the portfolio

manager for the Calvert Pension Fund decided to buy Brucker Industries and transferred a limit

order for $19.97 a share for 1000 shares to the trader The order expired un lled The Brucker

Industries stock closed at $20.03 on Thursday On Friday, the order was revised to a limit of

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$20.07 The order was partially lled that day as 800 shares were bought at $20.07 The

commission was $14 The stock closed at $20.09 on Friday and the order was cancelled

Regarding Hohlman's statement concerning trading cost benchmarks:

A) Hohlman is incorrect because the opening price cannot be gamed more than the

volume-weighted average price

B) Hohlman is correct.

C) Hohlman is incorrect because the e ective spread can be gamed.

Explanation

Hohlman is incorrect because the e ective spread can be gamed A trader may wait for other

traders to come to them, i.e when another trader is seeking liquidity By doing so, the trader

can trade at favorable bid and ask prices However, the trader's delay may cost the investor

foregone pro ts She is correct though that the volume-weighted average price is preferred

to the opening day's stock price because the opening price can be gamed to a greater extent

by traders, relative to the volume-weighted average price This is because the opening price

is known with more certainty than the VWAP

(Study Session 18, Module 35.4, LOS 35.f)

B) Walker is incorrect because the implementation shortfall is subject to gaming.

C) Walker is incorrect because the implementation shortfall does not incorporate

implicit trading costs

Explanation

Walker is correct The implementation shortfall is perhaps the most accurate measure of

trading costs, it is not subject to gaming, and incorporates both explicit and implicit trading

costs

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What is the realized pro t and loss component of the implementation shortfall measure Walker

should calculate for the Brucker Industries trade?

A) 0.16%.

B) 0.12%.

C) 0.09%.

Explanation

The realized pro t and loss is calculated using the execution price minus the decision price,

which is usually measured as the previous day's closing price This is divided by the original

price and weighted by the proportion of the order lled It is (800/1000) x

($20.07-$20.03)/$20.00 = 0.16% The positive value means that there is a loss (a cost) here

What is the delay costs component of the implementation shortfall measure Walker should

calculate for the Brucker Industries trade?

A) 0.24%.

B) 0.12%.

C) 0.18%.

Explanation

The delay costs are calculated using the di erence between the closing price on the day an

order was not lled and the previous day closing price It is weighted by the portion of the

order lled It is (800/1000) x ($20.03−$20.00)/$20.00 = 0.12%

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What is the missed trade opportunity cost component of the implementation shortfall measure

Walker should calculate for the Brucker Industries trade?

A) 0.09%.

B) 0.18%.

C) 0.12%.

Explanation

The missed trade opportunity cost is calculated using the di erence between the price at

which the order is cancelled and the original price It is weighted by the portion of the order

that is not lled It equals (200/1000) x ($20.09-$20.00)/$20.00 = 0.09%

To calculate the implementation shortfall, we must also add in the explicit costs, which are

the commission as a percent of the paper portfolio investment: $14/$20,000 = 0.07% The

total implementation cost is the sum of the explicit costs, the realized pro t and loss, the

delay costs component, and the missed trade opportunity cost component:

0.07%+0.16%+0.12%+0.09% = 0.44%

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Which of the following is least accurate regarding the role of ethics in trading?

A) The relationship between buy-side and sell-side traders is becoming less

adversarial

B) Trust has become more important.

C) Buy-side traders have a duciary duty to maximize the value of the client’s portfolio.

Explanation

Brokerage commissions have fallen dramatically The temptation is to shift costs to those

that are implicit, rather than explicit Thus, trading between buy-side and sell-side traders is

becoming more adversarial Furthermore, the disclosure of information in a trade can be

used against a trader later on, especially with the advent of electronic trading venues where

trader identity can be kept con dential Thus, trust has become more important given the

potential negative rami cations of trading with an unscrupulous trader

(Study Session 18, Module 35.7, LOS 35.o)

Suppose a trader is quoted a market bid price of $30.00 and an ask of $30.07 The execution

price of a buy order is $30.04 What is the e ective spread?

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