Module Quiz 35.1, 35.2, 35.3
1. A limit order has execution uncertainty because it is not known when the order will be filled, if at all. If the limit price cannot be satisfied in the current market, the order will go unfilled. Because limit orders have an expiration date, the limit may go unfilled or partially unfilled if it cannot be satisfied prior to expiration.
(Module 35.1, LOS 35.a)
2. The quoted spread for each order is the difference between the ask and bid prices:
The average quoted spread is a simple average of the quoted spreads: ($0.08 +
$0.10 + $0.12) / 3 = $0.10.
The effective spread for a sell order is twice the midquote of the market bid and ask prices minus the execution price.
The midquote for each trade is calculated as:
The effective spread for each sell order is:
The average effective spread is ($0.04 + $0.04 + $0.18) / 3 = $0.0867.
The weighted-average effective spread is (200 / 1,000)$0.04 + (300 / 1,000)$0.04 + (500 / 1,000)$0.18 = $0.11.
In the first and second trade, there was price improvement because the sell orders were executed at bid prices higher than the quoted prices. Hence, the effective spread was lower than the quoted spread. In the last trade, the trade size was larger than the bid size. The effective spread in this case was higher than that quoted due to the market impact of the large order.
Overall, the simple average effective spread was lower than the average quoted spread, reflecting the price improvement in the first two trades. The weighted- average effective spread was higher than the average quoted spread, reflecting the market impact of the last trade, which was larger than either of the first two trades.
(Module 35.2, LOS 35.b)
3. The market probably most suitable is a brokered market. A broker can place the order without revealing his client’s identity. He can discreetly shop the stock and find the necessary liquidity. He may even take a position in the stock with his own capital.
An electronic crossing network might be another possibility because traders usually do not know the identity of their counterparty or their trade size. The question states, however, that the stock is an emerging market stock for which brokered markets are particularly suited. Brokered markets are important in countries where public capital markets are not well developed. (Module 35.3, LOS 35.c)
4. Market A is of higher quality. The larger the bid and ask sizes (the number of shares offered by a dealer or trader at a specified price), the greater the market depth and the greater the liquidity. (Module 35.3, LOS 35.d)
Module Quiz 35.4
1. The trader who makes up the majority of the trading volume will dominate the determination of VWAP. That trader’s execution prices will, on average, be close to VWAP, so the trader’s execution will appear as high quality. Evaluation of the other trader’s results will be random versus VWAP. (LOS 35.g)
2. First, organize the information. The trade decision was made while the market was closed, making DP the previous close of 50.00. There was a one-day delay in execution making BP* 50.05. There was an unexecuted trade portion and a CP of 50.09. EP was 50.07. Total explicit costs are given as $23. (Note that a limit price is not a direct part of IS calculations, though it may affect EP and create delays.)
Explicit cost—the commission as a percentage of the paper portfolio investment is $23 / $50,000 = 0.05%.
Realized profit and loss is EP – DP (or BP*). This is divided by the DP and weighted by proportion of the order filled. It is (700 / 1,000) × ($50.07 –
$50.05) / $50.00 = 0.03%.
Delay cost is BP* – DP and then divided by the DP. It is weighted by the portion of the order filled. It is (700 / 1,000) × ($50.05 – $50.00) / $50.00 = 0.07%.
Missed trade opportunity cost is CP – DP and then divided by the DP. It is weighted by the portion of the order that is not filled. It equals (300 / 1,000)
× ($50.09 – $50.00) / $50.00 = 0.05%.
The sum of the components is the total implementation cost: 0.05% + 0.03% + 0.07% + 0.05% = 0.20%. (LOS 35.g)
3. The best measurement would be the implementation shortfall measure. VWAP can be gamed by traders, who might time their trades until the VWAP makes their trading costs appear favorable. The effective spread can also be gamed. A trader can trade at favorable bids and asks by waiting for orders to be brought to the trader. In both cases, a trader might forgo profits through delay. (LOS 35.g) Module Quiz 35.5
1. Value-motivated and passive traders prefer limit orders because their primary motivation is to minimize trading costs and transact at favorable prices. They do not need the immediate execution of market orders and can afford to be patient.
(LOS 35.i)
2. 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.
Momentum markets can make their execution problematic though. If, for
example, a trader has placed a buy order and the market trends upward, the order may never be filled. If the market trends downward, the trader’s order may be filled, but the stock price may keep trending downward. (LOS 35.j)
Module Quiz 35.6
1. The firm is likely using an implementation shortfall strategy. These strategies trade heavier early in the day to ensure order completion, reduce opportunity costs, and minimize the volatility of trading costs. (LOS 35.k)
2. When a trade is of relatively large size and has a large spread, it should be traded through a broker or a crossing system in order to minimize the spread. (LOS 35.l) Module Quiz 35.7
1. Actually, they can be used as both. Before the fact, econometric models can assist portfolio managers in determining the size of the trade. After the fact, trading effectiveness can be assessed by comparing actual trading costs to forecasted trading costs from the models. (LOS 35.m)
2. Booker is perhaps overreacting. It is difficuslt to judge a trader’s performance over just one day. The market conditions may have been so severe that
measurement of trading costs would be flawed. Although best execution can be measured ex post over time, it cannot be legitimately measured over a short time period. (LOS 35.m)
3. First, the popularity of electronic trading venues has provided more anonymity for traders. A trader who gains information from another trader can use this
information against the other trader discreetly. Second, brokerage commissions have fallen dramatically. The temptation is for a trader to shift costs to those that are implicit, rather than explicit. (LOS 35.o)