Reading 38- LOS c ～ Q1－6

1.Danvers Ventures, a small brokerage and money-management boutique, has higher execution costs than most of its competitors. Helen Wallace, manager of the trading desk at Danvers, is trying to improve the company’s trading operations.

Wallace has solicited suggestions from the traders on her staff in an effort to reduce execution costs. John Yarborough and Bill Beale, traders who have both been with Danvers for more than five years, have put together proposals describing trading strategies that they believe would reduce execution costs.

Yarborough’s plan would tap into high liquidity to reduce opportunity costs, but the price for that cost reduction is the assumption of basis risk. Beale’s proposal would eliminate the middle man, cutting costs drastically. But using Beale’s plan would make pricing more difficult, and potentially raise ethical questions.

International trading is another issue that concerns Wallace. A number of Danvers’ institutional clients like to purchase shares of large-cap foreign stocks in bulk. When possible, Wallace prefers not to deal in closed-end country funds because of the problems and inefficiencies with such investments, and would rather put clients into individual stocks.

When it comes to individual foreign stocks, clients do not have a preference for American Depositary Receipts (ADRs) or shares purchased directly from foreign exchanges. Danvers’ CEO sees little difference between ADRs and foreign shares from a portfolio-management perspective, so he has asked Wallace to determine which type of transaction is cheaper. To help with her decision, Wallace assembles the following data concerning Yamato Mining, a stock sought by a number of Danvers clients in the U.S. She assumes Danvers will need to purchase 10,000 shares of the company, and one ADR represents one share of the issuing company’s stock.

Wallace believes the opportunities for equity profits vary little from country to country. This belief is based upon the assumption that portfolio managers use the same, disciplined stock-selection system in every market. Instead, she sees increased trading efficiency as the best way to generate excess returns. With that in mind, she considers two major clients, hedge-fund operators with very specific trading needs.

Neville Partners has four trading goals, in no particular order:

§ High efficiency on large trades.

§ Frequent pricing updates.

§ Freedom to make large numbers of limit orders.

§ Highly automated system.

Waterford Funds has set five trading goals, also in no particular order:

§ Low-cost trading.

§ Complete anonymity.

§ High-speed execution.

§ Guaranteed pricing.

§ Ability to screen outstanding limit orders.

Wallace puts a high value on market efficiency. In the context of market efficiency, which characteristic would Wallace find least unattractive about closed-end country funds?

A)   The relationship between fund market price and NAV.

B)   The relationship between fees for closed- and open-end funds.

C)   Correlation between fund market prices and U.S. equities.

D)   Foreign investment restrictions.

The correct answer was B)

Closed-end funds tend to trade at a discount to the NAV. The more efficient the market, the closer the market price will be to the NAV. The relatively higher correlation between country funds (versus that of the underlying securities held by the fund) and U.S. equities reflects an apparent market inefficiency. The funds react more slowly than the underlying securities used to compute the NAV. Foreign investment restrictions will often distort the fund’s price relative to NAV. Fees for closed-end funds are often higher than the fees for open-end funds. However, while this disparity may affect investors’ decisions, it is not an issue with regard to market efficiency.

2.If Wallace had her choice, in what kind of market would she trade?

A)     Price-driven markets             Price-driven markets

B)     Price-driven markets            Order-driven markets

C)     Order-driven markets             Order-driven markets

D)     Order-driven markets                  Price-driven markets

The correct answer was B)

Price-driven markets meet all of Neville Partners’ trading goals. Order-driven markets meet all of Waterford Funds’ goals except guaranteed pricing. But four out of five isn’t bad.

3.Yarborough’s proposal most likely involves:

A)   agency trades.

B)   futures contracts.

C)   program trading.

D)   internal crossing.

The correct answer was B)

Futures contracts are highly liquid instruments that allow the portfolio manager to gain exposure to a market index. However, using futures contracts can expose a portfolio to basis risk, as the securities may not be perfectly correlated with the underlying market index.

4.Beale’s proposal most likely involves:

A)   external crossing.

B)   program trading.

C)   principal trades.

D)   internal crossing.

The correct answer was D)

Internal crossing occurs when buy and sell orders for the same security are matched within a firm. This definitely has the potential to reduce execution costs, but could call into question the fairness of the transaction price (which is now set by the firm). This also has the potential to raise various ethical issues, particularly when one of the firm’s portfolio managers is buying or selling the same stock.

5.In her drive to keep execution costs low, Wallace’s easiest target is most likely:

A)   market impact.

B)   taxes.

C)   opportunity cost.

D)   currency adjustments.

The correct answer was B)

Tangible costs are easier to observe and measure than intangible costs. Therefore, they are easier to track and to manage. Not only are market impact and opportunity costs intangibles that are difficult to measure independently (which makes it difficult to assess whether any actions taken actually reduce the costs), but by reducing one you tend to increase the other. This relationship makes it difficult to come up with substantial and practical cost reductions. Currency adjustments have no bearing on execution costs.

6.Danvers’ clients can save:

A)   0.23% by purchasing Yamato direct from the Tokyo Exchange.

B)   0.40% by purchasing Yamato as an ADR.

C)   0.03% by purchasing Yamato direct from the Tokyo Exchange.

D)   0.36% by purchasing Yamato as an ADR.

The correct answer was D)

To buy 10,000 Yamato ADRs, a U.S. investor must pay 10,000 × $10.60 + $50 = $106,050.

To buy 10,000 Yamato shares on the Tokyo market the cost is 10,000 × 1,251 yen × 1.0022 = 12,537,522 yen. At the exchange rate of 117.8 yen per dollar, the U.S. investor must exchange 12,537,522 / 117.8 = $106,431.

The ADR transaction saves $381, or 0.36%, relative to a purchase on the Tokyo market.