Trading, Monitoring, and Rebalancing Flashcards Preview

CFA Level III > Trading, Monitoring, and Rebalancing > Flashcards

Flashcards in Trading, Monitoring, and Rebalancing Deck (27):
1

Effective Spread

ES for buy = 2 * (execution price - midquote)
ES for sell = 2 * (midquote - execution price)

ES reflects price movement and price impact

 

Example: bid 11.50, ask 11.56, buy executed price 11.55

midquote = 11.53
ES buy = 2 * (11.55-11.53) = 0.04
This is less than 11.56 means execution was superior (lower cost)

2

Types of Market Structures

  1. Quote-Driven: trade with dealers
    1. Offers liquidity
    2. Good for bond markets
  2. Order-Driven: trade directly with each other
    1. Results in competition (better prices)
    2. Liquidity may be poor
  3. Brokered markets: use brokers to locate counterparty
  4. Hybrid market

3

Types of Order-Driven Markets

  1. ECN - Institutions
    1. Low costs
    2. Don't pay bid-ask spreads
    3. Don't know counter party
  2. Auction Markets
    1. Traders compete for orders
    2. Have price discovery
  3. Automated Auctions
    1. Trades based on rules
    2. Have price discovery
    3. Don't know counter-party

4

Brokers and Dealers

Dealers are matchmakers earning a profit (provides liquidity)


Brokers are hired by the investor. They can:

- Represent the order
- Find counterparties to the trade
- Provide secrecy

5

Market Quality

  • High liquidity
    • narrow spreads
    • lots of buyers/sellers (depth)
  • High transparency
  • Good trade settlement

6

Execution Costs

Explicit
Implicit
VWAP

Explicit: commissions, taxes, fees


Implicit: spread, opportunity costs, delay costs

 

VWAP - just average costs

7

Advantages/Disadvantages of VWAP

          Advantages                          Disadvantages

Easily understood                      Not good for large trades
Can be applied quickly             Can be manipulated
Best for small trades                 Ignores delay and missed trade costs

 

8

Implementation Shortfall (IS)

Measures difference between actual and theoretical portfolio

4 Types:

Delay (slippage): cost for slow execution
Price impact (RGL): costs after delay
Missed trade opportunity (UGL): any portion not traded
Explicit costs: commissions, etc.

Example: Limit order for 1000 shares at 47.39, closing price 47.30
500 sold at 47.44, 500 at 47.39, commission of 50

Hypothetical portfolio = 1000 * 47.39 = 47,300
actual portfolio = (500 * 47.44) + (500 * 47.39) - 50 = 47,365
IS = 47,300 - 47,365 = -65      Per share: -65/1000 = -0.065
bps = -65/47,300 = -.14% or 14 bps

9

Components of IS

Missed trade opportunity

Its the unrealized profit/loss

[(CP - DP)/DP] * (% canceled)

10

Components of IS

Delay/slippage costs

Only applies to day that order went unfilled

[(BP - BP)/DP] * % executed

 

benchmark price = the NEXT daily closing price

11

Components of IS

Price/market impact

This is the realized gain/loss

[(EP - BP)/DP] * % executed

 

12

Advantages/Disadvantages of Implementation Shortfall(IS)

          Advantages                         

Can see full cost of an idea                  
Can see market impact vs execution
Cannot be "gamed"

Disadvantages

Requires lots of data and analysis

13

Trading costs should be lower when?

Based on Econometric Models

  1. in liquid markets
  2. less volatility
  3. smaller trades
  4. buying in a falling market

 

14

Types of Traders

Types            Motivation     Time/Price  Order Type

Information   time-sensitive    time          market

value             misvaluations    price         limit

liquidity         reallocation       time          market

Passive         reallocation       price         limit

15

Types of Trading Tactics

Tactic                          Strength                     Weakness 

Trustworthy agent   low advertising    uncertain exec.

Advertise liquidity   good on large trades   front running

Low cost                  low trading costs          uncertain timing

Liquidty-at-cost      quick execution            info leakage 

Costs-dont-matter  quick execution           high trade cost 

16

Types of Algorithmic Trading

  1. Logical participation
    1. Simple - best for small trades
    2. VWAP, TWAP, % of volume
    3. IS - best for urgency (front loads trades)
  2. Opportunistic
    1. reacting to changing market volume
  3. Specialized
    1. Hunter - wait until favorable conditions
    2. Target closing price (trade at end of day)

17

Trading Procedures

  1. Process documented
  2. Disclosure to clients
  3. Record keeping

18

What is adverse selection risk?

A dealer faces adverse selection risk because a trader has more information and can profit at the dealer's expense

19

Calendar vs % Rebalancing (PoPR)

Calendar
On specific date rebalance to weights.
Drawback: deviation between dates unknown

PoPR
Once asset class out of bands, rebalance all asset classes
Benefit: lower transaction costs
Drawback: requires daily monitoring

Can combine both

 

20

Factors in Setting a Tolerance Band

Factors positively correlated:

  1. Transaction costs: ↑ costs ↑ band
  2. Risk tolerance: ↑ risk ↑ band
  3. Correlation: ↑ correlation ↑ band

Factors negatively correlated:

     4. Volatility on asset class: ↑ volatility ↓ band (to control risk)
     5. Volatility of other asset classes: ↑ volatility ↓ band

21

Managers Must Monitor Changes in:

  1. Client circumstances
  2. Capital market expecations
  3. Portfolio (change in allocations)

22

Types of Rebalancing Strategies

  1. Buy and Hold
  2. Constant Mix
  3. Constant Porportion

23

Buy and Hold Rebalance

  • Do nothing, let assets grow
  • Middle results between CM and CPPI
  • Risk tolerance goes up/down with risky assets
  • Floor = amount in Rf

 

Good when:

  • risk tolerance is correlated to wealth and return
  • Tax and transaction cost efficient (no trades)

A image thumb
24

Constant Mix Rebalance

AKA contrarian strategy

  • Does well in mean reverting environment (concave payoff)
  • Good for investors with constant risk tolerance
  • Dimished upside
  • Floor is $0
  • Less tax and transaction cost efficient

A image thumb
25

Constant Proportion Rebalance

AKA momentum (double-down)

  • Good for investors with risk tolerance up/down rapidly with wealth
  • Accelerates updside
  • Floor value > % in Rf
  • Formula: Multiplier * (total assets - floor)

A image thumb
26

Best Rebalance Strategy per Market

  1. Up/down trending
    1. Best: CPPI (buy winners and sell losers)
  2. Mean Reverting
    1. Best: Constant mix (selling high and buying low)
  3. Remember BH is most tax and transaction efficient

27

When do use what type of trade execution tactic?

VWAP: low volume, not urgent, narrow bid/ask

IS: low volume, urgent, narrow bid/ask