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

Level III Execution of Portfolio Decisions Summary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Comparison of Market Orders with Limit Orders Market orders 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 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 = 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 Bid Price $19.97 Bid Size 400 Ask Price $20.03 Ask Size 1,000 Based on this information a trader enters a market order to buy 500 shares The order executes at $20.01 Quoted bid–ask spread is $20.03 – $19.97 = $0.06 Midquote is ($20.03 + $19.97)/2 = $20.00 Effective spread is × ($20.01 – $20.00) = $0.02 This is $0.04 less than the quoted spread Bid Price Bid Size Ask Price Ask Size $19.97 400 $20.01 500 Three Types of Order Driven Markets 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 not provide price discovery 2010 C 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 Continuous auction markets: Trading takes place throughout the day 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 Comparison of Brokers and Dealers Broker Dealer A broker is an agent of the investor (trader) 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 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 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) Market Quality Liquidity: Liquid markets have the following characteristics: Low bid-ask spread Market is deep: Big trades tend not to cause large price movements 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: Traders can trade rapidly without impacting price Lower cost of capital for corporations The factors contributing to market liquidity are: Many buyers and sellers Diversity of opinion, information and investment needs among market participants Convenience: The physical location or trading platform is easily accessible; more trading hours 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 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:  Bid-ask spread  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 Measures of Transaction Costs 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: Explicit costs: Includes commissions, taxes, and fees 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 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 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 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 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 10.07 − 10.05 ( ) = 0.14% 1,000 10.00  2014 10 D 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 ( ) = 0.35% 1,000 10.00  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: 300 10.08 − 10.00 ( ) = 0.24% 1,000 10.00  2010 D Implementation cost as a percent is 0.14% + 0.14% + 0.35% + 0.24% = 0.87%, or 87 bps 10 Volume Weighted Average Price Advantages  Easy to compute  Easy to understand  Can be computed quickly to assist traders during the execution  Works best for comparing smaller trades in nontrending markets Implementation Shortfall Advantages  Links trading to portfolio manager activity; can relate cost to the value of investment ideas  Recognizes the tradeoff between immediacy and price  Allows attribution of costs  Can be built into portfolio optimizers to reduce turnover and increase realized performance  Cannot be gamed Disadvantages  Does not account for costs of trades delayed or canceled  Becomes misleading when trade is a substantial proportion of trading volume  Not sensitive to trade size or market conditions  Can be gamed by delaying trades Disadvantages  Requires extensive data collection and interpretation  Imposes an unfamiliar evaluation framework on traders 2008 B C, 2010 C, 2012 B 11 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)  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 12 Types of Traders Trader Informationmotivated Value-motivated Motivation New information Trading Time Horizon Minutes to hours Time versus Price Preference Time Perceived valuation errors Days to weeks Price Liquidity-motivated Invest cash or divest securities Minutes to hours Time Passive Rebalancing, investing/divesting cash Profitably accommodate trading demands of others Days to weeks Price Minutes to hours Passive, indifferent Dealers and day traders Trader Information-motivated Value-motivated Liquidity-motivated Passive Preferred order type Market order Limit order Market order, other order types also used Limit order; portfolio trades and crossing networks 13 Trading Tactics Focus Uses Costs Liquidity at any cost (I must trade) Immediate execution in institutional block size High cost due to tipping Guarantees supply/demand balance execution High potential for market impact and information leakage Need trustworthy agent (Possible hazardous trading situation) Large-scale trades; lowlevel advertising 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- Cedes direct control of trade; may determined price ignore tactics with potential for lower cost Advertise to draw liquidity Large trades with lower information advantage High operational and organizational costs Market-determined More difficult to administer; price for large trades possible leakage to front-runners Higher search and monitoring costs Low commission; opportunity to trade at favorable price Low cost whatever the Non-informational liquidity trading; indifferent to timing Advantages Weaknesses Uncertainty of trading; may fail to execute and create a need to complete at a later, less desirable price 14 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 15 Selecting an Algorithmic Trading Strategy Symbol ABC DEF GHIJ Side B S B Size (Shares) 100,000 30,000 25,000 Avg Daily Volume 2,000,000 60,000 250,000 Price 55.23 10.11 23.45 Spread (%) 0.05 0.55 0.04 Urgency Low Low High 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 The third order in GHIJ is just 10% of the daily volume But given the high level of urgency, an implementation shortfall algorithm would be appropriate to execute this order 2010 C: crossing system versus VWAP versus implementation shortfall 2014 10 C 16 CFA Institute’s Trade Management Guidelines offer investment managers “a framework from which to make consistently good trade execution suggestion”  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 Processes: Firms should establish formal policies and procedures that have the ultimate goal of maximizing the asset value of client portfolios through best execution A firm’s policies and procedures should provide guidance to measure and manage effectively the quality of trade decisions Disclosures: Firms should disclose to clients and prospects 1) their general information regarding trading techniques, venues, and agents and 2) any actual or potential trading-related conflicts of interest Such disclosure provides clients with the necessary information to help them assess a firm’s ability to deliver best execution Record keeping: Firms should maintain proper documentation that supports 1) compliance with the firm’s policies and procedures and 2) the disclosures provided to clients In addition to aiding in the determination of best execution, the records may support a firm’s broker selection practices when examined by applicable regulatory organizations 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 17 Characteristics Required for Best Execution Characteristic Best execution is intrinsically tied to portfoliodecision value and cannot be evaluated independently Best execution is a prospective, statistical, and qualitative concept that cannot be known with certainty ex ante Best execution has aspects that may be measured and analyzed over time on an ex post basis, even though such measurement on a trade-by-trade basis may not be meaningful in isolation Best execution is interwoven into complicated, repetitive, and continuing practices and relationships Explanation The purpose of trading is to capture the value of investment decisions Thus, the definition has strong symmetry to the definition of prudent expert that guides fiduciary decisions Trading is a negotiation, with each side of the trade having equal standing Both buyer and seller—or their appointed agents—jointly determine what “best execution” is for every trade Trading occurs in a volatile environment subject to high statistical variability One would not evaluate a card player on an individual hand; one would need to observe a sequence of hands to determine skill; similarly for traders Despite the variability, overall trades contain some information useful in evaluating the process By compiling trade data, one can deduce useful information about the quality of the process Trading is a process, not an outcome The standards are behavioral 18 ... 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. .. goal of maximizing the asset value of client portfolios through best execution A firm’s policies and procedures should provide guidance to measure and manage effectively the quality of trade decisions. .. such as the impact of the trade on the price received The components of execution costs are:  Bid-ask spread  Market impact: effect of a trade on transaction prices For example, suppose a trader