Execution of Portfolio Decisions
1. Compare market orders with limit orders, including the price and execution uncertainty of each.
– A market order is an order to execute the trade immediately at the best possible price. If the order can not be completely filled in one trade which offers the best price. It is filled by other trades at the best possible prices.
– The emphasis in a market order is the speed of execution.
– The disadvantage of a market order is that the price it will be executed at is not know adead of time, so it has price uncertainty.
– A limit order is an order to trade at the limit price or better. For the sell orders, the execution price must be higher than or equal to the limit price. For buy orders, the execution price must be lower than or equal to the limit price.
– If not filled on or before the specified date, limit orders expire.
– A limit order emphasizes the price of execution. It may not be filled immediately and may even go unfilled or partially unfilled.
– A limit order has execution uncertainty.
2. Calculate and interpret the effective spread of a market order and contrast it to the quoted bid-ask spread as a measure of trading cost.
– The effective spread s compare against the quoted spread to evaluate the cost of trading. It captures both price improvements and the costs of market impact.
Effective spread buy order = 2 . ( execution price – midquote)
Effective spread sell order = 2 . ( midquote – execution price)
3. Compare alternative market structures and their relative advantages.
– Quote-driven markets: Investors trade with dealers.
– Order-driven markets: Investors trade with each other without the use of intermediaries through: Electronic crossing network, auction markets, automated auctions.
– Brokered markets: Investors use brokers to locate the counterparty to a trade. This ofter used when the trader has a large block to sell, when the trader wants to remain anonymous or when the market for the security is small or illiquid.
-A hybrid market: is a combination of the other three markets. For example, the New York Stock Exchange has features of both quote-driven and order- driven markets.
4. Compare the roles of brokers and dealers.
– The relationship between a trader and the broker is one of a principal and agent. The broker acts as the trader’s agent and locates the necessary liquidity at the best price. The broker may also provide record keeping, financing, cash management and other services to the trader.
– The trader and the dealer often have opposing interests. Dealers want to maximize the trade spread while traders want to minimize it. In addition, when a trader has information that the dealer does not have, the trader profits at the dealer expense.
5. Calculate and discuss implementation shortfall as a measure of transaction costs.
– Implementation shortfall is the difference between the actual portfolio’s return and a paper portfolio’s return.
– Total IS can be computed as the difference in the value of the hypothetical portfolio if the trade was fully executed at the DP ( with no costs) and the value of the actual portfolio.
– Missed trade (also called opportunity or unrealized profit/loss) is the difference in the initial DP and CP applied to the nmber of shares in the order not filled.
|CP – DP| . # of share canceled
– Explicit costs ( sometimes just referred to as commissions or fees) can be computed as:
Cost per share . # of shares executed
– Delay ( also called sloppage is the difference in the initial DP and revised benchmark price (BP) if the order is not filled in a timely manner applied to the number of shares in the order subsequently filled.
|BP – DP| . # of shares later executed.
– Market impact ( also called price impact or realized profit/loss) is the difference in EP ( or Eps if there are multiple partial executions) and the initial DP ( or BP if there is delay) and the number of shared filled at the EP.
|EP – DP or BP| . # of shares executed.
6. Explain the motivation for algorithmic trading and discuss the basic classes of algorithmic trading strategies.
– Algorithmic trading is the use of automated, quantitative system that utilize trading rules, benchmark, and constraints to execute orders with minimal risk and costs.
– Algorithmic trading strategies are classified into logical participation strategies ( simple logical and implementation shortfall strategies ), opportunistic strategies, and specialized strategies.
– Simple logical participation strategies seek to trade with market flow so as to not become overly noticeable to the market and to minimize market impact.
– Implementation shortfall strategies, or arrival price strategies, minimize trading costs at defined by the implementation shortfall measure or total market impact.
– Opportunity participation strategies trade passively over time but increase trading when liquidity is present.
– Specialized strategies include passive strategies and other miscellaneous strategies.