CFA 2018 r31 execution of portfolio decisions

Level III Execution of Portfolio Decisions www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved www.ift.world Contents Introduction The Context of Trading: Market Microstructure The Costs of Trading Types of Traders and their Preferred Order Types Trade Execution Decisions and Tactics Serving the Client’s Interests www.ift.world Introduction www.ift.world The Context of Trading: Market Microstructure Emphasize immediacy Some degree of price uncertainty www.ift.world Emphasize price Execution uncertainty www.ift.world www.ift.world Bid-Ask Spread Dealer vs Trader www.ift.world Inside Bid Or Market Bid Inside Ask or Market Ask Market Bid-Ask Spread www.ift.world Bid-Ask Spread Versus Effective Spread as a Measure of Trading Cost Effective Spread = 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: Price Movement: execution within quoted spread Market Impact: tendency for large orders to move prices www.ift.world Bid-Ask Spread = 0.06 Midquote = 20.00 Effective Spread: x (20.01 – 20.00) = 0.02 Average effective spread is the mean effective spread over all transactions in the stock in the period under study www.ift.world 10 Example 8: An Econometric Model for Transaction Costs www.ift.world 32 www.ift.world 33 www.ift.world 34 Types of Traders and Their Preferred Order Types Preferred Order Type Market Limit Market, other order types also used Limit Orders, Portfolio Trades and Crossing Networks (profitably accommodate trading demands of others) www.ift.world 35 Trade Execution Decisions and Tactics Decisions Related to Handling of a Trade Objectives in Trading and Trading Tactics Automated Trading www.ift.world 36 Decisions Related to 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 • Traders should be aware of client trading restrictions, cash balances and brokerage allocations • Objectives in trading and trading tactics: next slide… www.ift.world 37 Objectives in Trading and Trading Tactics www.ift.world 38 Automated (Algorithmic) Trading • Algorithmic trading refers to automated electronic trading subject to quantitative rules and user-specified benchmarks and constraints • Exploit market patterns of trading volume so as to execute orders with controlled risk and costs • Example and Example 10: Break large order into small pieces • Several types of algorithmic trading     Simple logical participation strategies Implementation shortfall strategies Opportunistic strategies Specialized strategies www.ift.world 39 Algorithmic Trading Classification • Simple logical participation strategies  Volume-weighted average price (VWAP) strategy: match or improve upon VWAP for the day Typically the trader attempts to match the expected volume pattern over the day  Time-weighted average price (TWAP) strategy is a simple variant of the VWAP strategy that assumes a flat volume profile • Implementation shortfall strategies  Minimize trading costs as measured by implementation shortfall method  Concerned about opportunity cost related to adverse price movement  transactions are frontloaded www.ift.world 40 Summary output from a trader’s order management system or trade blotter What tactics are appropriate for each order? www.ift.world 41 www.ift.world 42 Serving the Client’s Interests • CFA Institute’s Trade Management Guidelines offer investment managers “a framework from which to make consistently good trade execution suggestions…”  Best execution: the trading process investment management firms apply that seeks to maximize the value of the client’s portfolio  Trade Management Guidelines are divided into three areas: processes, disclosures and record keeping • Ethical focus for portfolio manager and buy-side trader must be the 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 honored; the code is self-enforcing www.ift.world 43 www.ift.world 44 Summary • Market Microstructure   • The Costs of Trading   • • Cost components Cost benchmarks: VWAP, Implementation Shortfall (Exhibit 6) Types of Traders and their Preferred Order Types Trade Execution Decisions and Tactics   • Order Types Market Types and Market Quality Exhibit Algorithmic Trading Ethics  seek best execution for client www.ift.world 45 Conclusion • Examples • Summary • Practice Problems • Learning Objectives www.ift.world 46 ...Contents Introduction The Context of Trading: Market Microstructure The Costs of Trading Types of Traders and their Preferred Order Types Trade Execution Decisions and Tactics Serving the Client’s... Bid-Ask Spread Versus Effective Spread as a Measure of Trading Cost Effective Spread = x deviation of the actual execution price from the midpoint of the market quote at the time an order is entered... Introduction www.ift.world The Context of Trading: Market Microstructure Emphasize immediacy Some degree of price uncertainty www.ift.world Emphasize price Execution uncertainty www.ift.world www.ift.world