54 RELATE TO EXECUTION OF PORTFOLIO DECISIONS

Question

Questions 49-54 relate to Execution of Portfolio Decisions: Monitoring and Rebalancing. Somerset Investment Limited is a Singapore-based money management firm that is conducting an appraisal of its investment performance. Cameron Li, CFA, has been charged with conducting the appraisal and is to report back to upper management with his findings. Li is convinced that trade executions play a substantial role in overall portfolio performance, particularly for funds that have a relatively high level of turnover during the year. As a result, he is seeking methods that will allow him to evaluate the quality of trade executions. He knows that the firm's traders use both market and limit orders, and he is wondering if a framework can be developed to ensure that the best order type is used under the specific circumstances for each trade. When he consults with the firm's head trader, Rick Gleeson, Gleeson tells him that market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty. According to Gleeson, rebalancing and liquidity-motivated trades should use limit orders while value-motivated and information-motivated trades should use market orders. Li knows that bid-ask spreads are a major component of trading costs and asks Gleeson for some recent trade data that he can use for analysis and presentation to management. He receives the following data relating to a series of buy trades for Sumatra Natural Resources (SNR), with all currency values in Singapore dollars: Trades of Sumatra Natural Resources Shares Time  Bid Price  Ask Price  Execution Price Bought 10:30  $22.18  $22.36  $22.33  900 11:15  $22.23  $22.43  $22.43  600 13:45  $22.29  $22.48  $22.47  700 15:00  $22.37  $22.63  $22.65  800 Gleeson also tells Li that the portfolio manager had originally made the decision to purchase 5,000 SNR at 10:00 a.m. when the price was $22.36. The closing price for the day was Gleeson's last trade at $22.65, at which point the order for the remaining 2,000 shares was cancelled. ... Which of the following correctly summarizes Gleeson's comments concerning the differences between market and limit orders? A)  He is correct concerning the nature of uncertainty; he is correct concerning when the order types should be used. B)  He is correct concerning the nature of uncertainty; he is incorrect concerning when the order types should be used. C)  He is incorrect concerning the nature of uncertainty; he is correct concerning when the order types should be used. ExplanationGleeson is correct concerning the nature of uncertainty. Market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty. However, he is incorrect concerning when these order types should be used. In most cases, information-motivated and liquidity-motivated trades should use market orders to ensure that execution takes place, while value-motivated and rebalancing trades should use limit orders because price is typically more important than the speed of execution. For Further Reference:  Study Session 16, LOS 31.a  SchweserNotes: Book 5, p.1  CFA Program Curriculum: Vol.6 p.7 Question #50 of 60 Concerning the Sumatra Natural Resources price and execution data, the average effective spread and weighted average effective spread are closest to: Average effective spread  Weighted average effective spread A)    0.1957    0.1975 B)    0.0971    0.0908 C)    0.1975    0.1957 The quoted spread for the first trade = 22.36 - 22.18 = 0.18. The quoted spreads for the remaining three trades are 0.20, 0.19, and 0.26, so the average quoted spread = (0.18 + 0.20 + 0.19 + 0.26) / 4 = 0.2075. The mid-quote for the first trade = (22.36 + 22.18) / 2 = 22.27, and the effective spread = (22.33 - 22.27) × 2 = 0.12. The effective spreads for the remaining three trades are 0.20, 0.17, and 0.30, so the average effective spread = (0.12 + 0.20 + 0.17 + 0.30) / 4 = 0.1975. The weighted average effective spread = (900 / 3,000) × 0.12 + (600 / 3,000) × 0.20 + (700 / 3,000) × 0.17 + (800 / 3,000) × 0.30 = 0.1957. Study Session 16, LOS 31.b  SchweserNotes: Book 5, p.2  CFA Program Curriculum: Vol.6 p.10 Question #51 of 60 Assume that the four trades in Sumatra Natural Resources are the only trades in the security for the day. Determine which of the following statements concerning the volume weighted average price (VWAP) is most correct. A)  The VWAP for the day is 22.470, and the trader's goal would be to have an average cost that is less than the VWAP. B)  The VWAP for the day is 22.468, and the trader's goal would be to have an average cost that is greater than the VWAP. C)  The VWAP for the day is 22.468, and the trader's goal would be to have an average cost that is less than the VWAP. The VWAP for the day = (900 / 3,000) × 22.33 + (600 / 3,000) × 22.43 + (700 / 3,000) × 22.47 + (800 / 3,000) × 22.65 = 22.468, and the trader's goal would be to have an average cost that is less than the VWAP if they are buying. Study Session 16, LOS 31.e  SchweserNotes: Book 5, p.8  CFA Program Curriculum: Vol.6 p.22 Question #52 of 60 Calculate the implementation shortfall assuming total commissions paid by Gleeson when he purchased the 3,000 SNR were $210. A)  0.303%. B)  0.996%. C)  2.027%. The benchmark price and decision price at the time the decision to trade is made is 22.36, and the benchmark quantity is 5,000, so the benchmark investment = 22.36 × 5,000 = $111,800. The terminal benchmark value at the cancellation price of 22.65 is 22.65 × 5,000 = $113,250, and the benchmark gain = 113,250 - 111,800 = $1,450. The actual portfolio cost at the various execution prices is (900 × 22.33) + (600 × 22.43) + (700 × 22.47) + (800 × 22.65) = 67,404. With commissions of 210, this is a total cost of $67,614. The actual portfolio terminal value = 22.65 × 3,000 = $67,950, and the actual gain = 67,950 - 67,614 = $336. The implementation shortfall = (1,450 - 336) / 111,800 = 0.00996 or 0.996%. Study Session 16, LOS 31.f  SchweserNotes: Book 5, p.9  CFA Program Curriculum: Vol.6 p.24 Question #53 of 60 Which of the following statements concerning implementation shortfall and VWAP is incorrect? A)  Implementation shortfall is greater than zero if any portion of the original order goes unfilled and is cancelled. B)  For small trades in non-trending markets, VWAP is more appropriate than implementation shortfall. C)  Implementation shortfall can be adjusted to accurately account for movements in the general market. In general, implementation shortfall will be positive (i.e., profits will be foregone) if prices are rising when the trader is attempting to buy, or if prices are falling when the trader is attempting to sell, and all of the order is not completed. Cancellation of a buy order prior to a fall in price, or cancellation of a sell order prior to a rise in price will give rise to a negative implementation shortfall (i.e., the trader will be made better off by the cancellation). Question #54 of 60 Determine which of the following statements concerning an algorithmic trading strategy is most incorrect. An algorithmic trading strategy: A)  ensures that the portfolio does not become over-concentrated (in specific assets or sectors) because it is based on quantitative rules. B)  involves the use of automated processes based on quantitative measures, such as the ratio of the trade size to average daily volume, to guide trading decisions. C)  known as simple logical participation, breaks trades into small pieces to avoid detection and to minimize market impact costs. Because an algorithmic trading strategy involves mechanical rules to guide trading, one of the concerns is that the portfolio can become over-concentrated. For example, the portfolio could become over-concentrated in sectors that are more liquid and easier to trade when buying, and the opposite problem could occur when selling (i.e., the most liquid assets are sold first, leaving the portfolio over-concentrated in illiquid securities). Study Session 16, LOS 31.l  SchweserNotes: Book 5, p.18  CFA Program Curriculum: Vol.6 p.45 Question #55 of 60

Answer

Questions 49-54 relate to Execution of Portfolio Decisions: Monitoring and Rebalancing. Somerset Investment Limited is a Singapore-based money management firm that is conducting an appraisal of its investment performance. Cameron Li, CFA, has been charged with conducting the appraisal and is to report back to upper management with his findings. Li is convinced that trade executions play a substantial role in overall portfolio performance, particularly for funds that have a relatively high level of turnover during the year. As a result, he is seeking methods that will allow him to evaluate the quality of trade executions. He knows that the firm's traders use both market and limit orders, and he is wondering if a framework can be developed to ensure that the best order type is used under the specific circumstances for each trade. When he consults with the firm's head trader, Rick Gleeson, Gleeson tells him that market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty. According to Gleeson, rebalancing and liquidity-motivated trades should use limit orders while value-motivated and information-motivated trades should use market orders. Li knows that bid-ask spreads are a major component of trading costs and asks Gleeson for some recent trade data that he can use for analysis and presentation to management. He receives the following data relating to a series of buy trades for Sumatra Natural Resources (SNR), with all currency values in Singapore dollars: Trades of Sumatra Natural Resources Shares Time  Bid Price  Ask Price  Execution Price Bought 10:30  $22.18  $22.36  $22.33  900 11:15  $22.23  $22.43  $22.43  600 13:45  $22.29  $22.48  $22.47  700 15:00  $22.37  $22.63  $22.65  800 Gleeson also tells Li that the portfolio manager had originally made the decision to purchase 5,000 SNR at 10:00 a.m. when the price was $22.36. The closing price for the day was Gleeson's last trade at $22.65, at which point the order for the remaining 2,000 shares was cancelled. ... Which of the following correctly summarizes Gleeson's comments concerning the differences between market and limit orders? A)  He is correct concerning the nature of uncertainty; he is correct concerning when the order types should be used. B)  He is correct concerning the nature of uncertainty; he is incorrect concerning when the order types should be used. C)  He is incorrect concerning the nature of uncertainty; he is correct concerning when the order types should be used. ExplanationGleeson is correct concerning the nature of uncertainty. Market orders have price uncertainty but no execution uncertainty, while limit orders eliminate price uncertainty but have execution uncertainty. However, he is incorrect concerning when these order types should be used. In most cases, information-motivated and liquidity-motivated trades should use market orders to ensure that execution takes place, while value-motivated and rebalancing trades should use limit orders because price is typically more important than the speed of execution. For Further Reference:  Study Session 16, LOS 31.a  SchweserNotes: Book 5, p.1  CFA Program Curriculum: Vol.6 p.7 Question #50 of 60 Concerning the Sumatra Natural Resources price and execution data, the average effective spread and weighted average effective spread are closest to: Average effective spread  Weighted average effective spread A)    0.1957    0.1975 B)    0.0971    0.0908 C)    0.1975    0.1957 The quoted spread for the first trade = 22.36 - 22.18 = 0.18. The quoted spreads for the remaining three trades are 0.20, 0.19, and 0.26, so the average quoted spread = (0.18 + 0.20 + 0.19 + 0.26) / 4 = 0.2075. The mid-quote for the first trade = (22.36 + 22.18) / 2 = 22.27, and the effective spread = (22.33 - 22.27) × 2 = 0.12. The effective spreads for the remaining three trades are 0.20, 0.17, and 0.30, so the average effective spread = (0.12 + 0.20 + 0.17 + 0.30) / 4 = 0.1975. The weighted average effective spread = (900 / 3,000) × 0.12 + (600 / 3,000) × 0.20 + (700 / 3,000) × 0.17 + (800 / 3,000) × 0.30 = 0.1957. Study Session 16, LOS 31.b  SchweserNotes: Book 5, p.2  CFA Program Curriculum: Vol.6 p.10 Question #51 of 60 Assume that the four trades in Sumatra Natural Resources are the only trades in the security for the day. Determine which of the following statements concerning the volume weighted average price (VWAP) is most correct. A)  The VWAP for the day is 22.470, and the trader's goal would be to have an average cost that is less than the VWAP. B)  The VWAP for the day is 22.468, and the trader's goal would be to have an average cost that is greater than the VWAP. C)  The VWAP for the day is 22.468, and the trader's goal would be to have an average cost that is less than the VWAP. The VWAP for the day = (900 / 3,000) × 22.33 + (600 / 3,000) × 22.43 + (700 / 3,000) × 22.47 + (800 / 3,000) × 22.65 = 22.468, and the trader's goal would be to have an average cost that is less than the VWAP if they are buying. Study Session 16, LOS 31.e  SchweserNotes: Book 5, p.8  CFA Program Curriculum: Vol.6 p.22 Question #52 of 60 Calculate the implementation shortfall assuming total commissions paid by Gleeson when he purchased the 3,000 SNR were $210. A)  0.303%. B)  0.996%. C)  2.027%. The benchmark price and decision price at the time the decision to trade is made is 22.36, and the benchmark quantity is 5,000, so the benchmark investment = 22.36 × 5,000 = $111,800. The terminal benchmark value at the cancellation price of 22.65 is 22.65 × 5,000 = $113,250, and the benchmark gain = 113,250 - 111,800 = $1,450. The actual portfolio cost at the various execution prices is (900 × 22.33) + (600 × 22.43) + (700 × 22.47) + (800 × 22.65) = 67,404. With commissions of 210, this is a total cost of $67,614. The actual portfolio terminal value = 22.65 × 3,000 = $67,950, and the actual gain = 67,950 - 67,614 = $336. The implementation shortfall = (1,450 - 336) / 111,800 = 0.00996 or 0.996%. Study Session 16, LOS 31.f  SchweserNotes: Book 5, p.9  CFA Program Curriculum: Vol.6 p.24 Question #53 of 60 Which of the following statements concerning implementation shortfall and VWAP is incorrect? A)  Implementation shortfall is greater than zero if any portion of the original order goes unfilled and is cancelled. B)  For small trades in non-trending markets, VWAP is more appropriate than implementation shortfall. C)  Implementation shortfall can be adjusted to accurately account for movements in the general market. In general, implementation shortfall will be positive (i.e., profits will be foregone) if prices are rising when the trader is attempting to buy, or if prices are falling when the trader is attempting to sell, and all of the order is not completed. Cancellation of a buy order prior to a fall in price, or cancellation of a sell order prior to a rise in price will give rise to a negative implementation shortfall (i.e., the trader will be made better off by the cancellation). Question #54 of 60 Determine which of the following statements concerning an algorithmic trading strategy is most incorrect. An algorithmic trading strategy: A)  ensures that the portfolio does not become over-concentrated (in specific assets or sectors) because it is based on quantitative rules. B)  involves the use of automated processes based on quantitative measures, such as the ratio of the trade size to average daily volume, to guide trading decisions. C)  known as simple logical participation, breaks trades into small pieces to avoid detection and to minimize market impact costs. Because an algorithmic trading strategy involves mechanical rules to guide trading, one of the concerns is that the portfolio can become over-concentrated. For example, the portfolio could become over-concentrated in sectors that are more liquid and easier to trade when buying, and the opposite problem could occur when selling (i.e., the most liquid assets are sold first, leaving the portfolio over-concentrated in illiquid securities). Study Session 16, LOS 31.l  SchweserNotes: Book 5, p.18  CFA Program Curriculum: Vol.6 p.45 Question #55 of 60