R35 Execution of Portfolio Decisions

Question 1

R35

What are the two main types of order and their use?

Answer 1

Market Order - an instruction to execute an order promptly in the public markets at the best price available.

Limit Order - to trade at the best price available but only if the price is at least as good as the limit price specified in the order

Question 2

R35

What is a Market Not Held Order

Answer 2

A variation of the market order designed to give the agent greater discretion than a simple market order would allow. “Not held” means that the floor broker is not required to trade at any specific price or in any specific time interval.

Question 3

R35

What is a Principle Trade

Answer 3

A trade with a broker in which the broker commits capital to facilitate the prompt execution of the trader’s order to buy or sell. Often used when order is large / urgent.

Question 4

R35

What is a Participate (do not initiate) order

Answer 4

A variant of the market-not-held order. The broker is deliberately low-key and waits for and responds to the initiatives of more active traders. Buy-side traders who use this type of order hope to capture a better price in exchange for letting the other side determine the timing of the trade.

Question 5

R35

What is a Best Efforts order

Answer 5

A type of order that gives the trader’s agent discretion to execute the order only when the agent judges market conditions to be favorable. Some degree of immediacy is implied, but not immediacy at any price.

Question 6

R35

What is a Market on Open / Close Order

Answer 6

A market order to be executed at the opening / closing of the market. Many markets provide good liquidity. at open or close.

Question 7

R35

What is a Portfolio Trade?

Answer 7

A trade in which a number of securities are traded as a single unit. Also called program trade or basket trade. Often low cost. The diversifcation in the basket reduces risk to counterparty.

Question 8

R35

What is inside Bid-Ask spread

Answer 8

Market (Inside) ask (The lowest available ask price) price minus market (inside) bid (The highest available bid price) price.

Also called market bid–ask spread, inside spread, or market spread.

Question 9

R35

What is effective spread for a buy and sell order?

Answer 9

Effective spread for a sell order = 2 × (Midquote – execution price). Effective spread for a buyorder = 2 × ( execution price - Midquote ).

Question 10

R35

What is midquote?

Answer 10

bid+ask / 2

Question 11

R35

What is a quote driven Market?

Answer 11

Dealers establish firm prices at which securities can be bought and sold. Also called dealer markets, as trades are executed with a dealer. A dealer (market maker) is ready to buy an asset for inventory or sell an asset from inventory to provide the other side of an order to buy or sell the asset.

Question 12

R35

What is an order driven market?

Answer 12

Markets in which transaction prices are established by public limit orders to buy or sell a security at specified prices. Usually no involvement of market makers and trades are with public investors.

Question 13

R35

The four components if Implementation Shortfall

Answer 13

1. Explicit costs, including commissions, taxes, and fees.
2. Realized profit/loss, reflecting the price movement from the decision price (usually taken to be the previous day’s close) 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), reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was not filled.

Question 14

R35

Advantages of VWAP

Answer 14

1. Easy to compute.
2. Easy to understand.
3. Can be computed quickly to assist traders during the execution.
4. Works best for comparing smaller trades in nontrending markets.

Question 15

R35

Disadvantages of VWAP

Answer 15

1. Does not account for costs of trades delayed or cancelled.
2. Becomes misleading when trade is a substantial proportion of trading volume.
3. Not sensitive to trade size or market conditions.
4. Can be gamed by delaying trades

Question 16

R35

Advantages of Implementation Shortfall

Answer 16

1. Links trading to portfolio manager activity; can relate cost to the value of investment ideas.
2. Recognizes the tradeoff between immediacy and price.
3. Allows attribution of costs.
4. Can be built into portfolio optimizers to reduce turnover and increase realized performance.
5. Cannot be gamed.

Question 17

R35

Disadvantages of Implementation Shortfall

Answer 17

1. Requires extensive data collection and interpretation.
2. Imposes an unfamiliar evaluation framework on traders.

Question 18

R35

Roll of Broker (6)

Answer 18

1. Representing an order
2. Find the opposite side of a trade
3. Supplying Market information
4. Providing descretion and secrecy
5. Providing other supporting investment services (Prime Brokerage)
6. Supporting the Market mechanism

Question 19

R35

Characteristics of a Liquid Market

Answer 19

1. The market has relatively low bid–ask spreads.
2. The market is deep. (Big trades do not cause big price movements. High quoted depth)
3. The market is resilient. (Discepencies between price and value corrected quickly)

Question 20

R35

Factors that make a Market Liquid

Answer 20

1. Many buyers and seller
2. Diversity of opinion, information, and investment needs among market participants
3. Convenience.
4. Market integrity.

Question 21

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3 Main qualities of a Market

Answer 21

1. Liquidity
2. Transparency (pretrade - quotes and trades & Posttrade - reporting)
3. Assurity of Completion (Assurity of contract - parties fulfill their obligations)

Question 22

R35

4 Major types of traders

Answer 22

1. Information-motivated traders (who trade on information with limited time value. Very short trading time horizons and are more sensitive to time than price in execution)
2. Liquidity-motivated traders (who trade based on liquidity needs. Very short trading time horizons and are more sensitive to time than price in execution)
3. Value-motivated traders (who trade on valuation judgments. Have longer trading time horizons and are more sensitive to price than time in execution. )
4. Passive traders (who trade for indexed portfolios. Have longer trading time horizons and are more sensitive to price than time in execution. )

Question 23

R35

5 Objectives in Trading

Answer 23

1. Liquidity at any cost (I must trade. Often Market Orders)
2. Need trustworthy agent (Possible hazardous trading situation. Use a floor broker to skillfully “work” such orders by placing a best efforts, market-not-held, or participate order)
3. Costs are not important
4. Advertise to draw liquidity (Risk of front running)
5. Low cost whatever the liquidity (Often Limit Orders)

Question 24

R35

Imp Shortfall detailed calculation

Answer 24

Total Imp Shortfall =

Paper gain - Real gain / Paper Investment