karoliukas

In which of the following relationships does the adverse selection risk problem pertain?

A) Trader and broker.

B) Trader and dealer.

C) Trader and investor.

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A trader is more likely to trade with a dealer when he has information that the dealer does not. This results in adverse selection risk for the dealer. The trader’s profit is the dealer’s loss once the information is revealed to the market.

karoliukas

In which of the following is there a principal-agent relationship?

A) Trader and broker.

B) Broker and dealer.

C) Trader and dealer.

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A principal-agent relationship exists between a trader and the broker. The broker acts as the trader’s agent and locates the necessary liquidity at the best price. The trader can also extract information from the broker regarding the depth of a market and the identity of other traders.

karoliukas

Which of the following relationships is adversarial?

A) Broker and dealer.

B) Trader and broker.

C) Trader and dealer.

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The relationship between a trader and a dealer is adversarial. The dealer would like to maximize the trade spread and the trader would like to minimize it. Also, when a trader has information that the dealer does not, the trader profits at the dealer’s expense.

karoliukas

Which of the following is NOT a characteristic of a liquid market?

A) Integrity.

B) Homogenous traders.

C) An abundance of traders.

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The factors contributing to liquidity are an abundance and diversity of traders, convenience, and integrity. Homogenous traders are not diverse.

karoliukas

Market A has average bid and ask sizes of 400 shares. Market B has average bid and ask sizes of 600 shares. Market C has average effective spreads of $0.034. Market D has average effective spreads of $0.039. Comparing A to B and C to D, which markets are of the highest quality?

A) B and D.

B) A and C.

C) B and C.

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Lower quoted and effective spreads as well as higher bid and ask sizes indicate greater liquidity and greater market quality.

karoliukas

Which of the following is NOT a relevant measure of market quality?

A) Liquidity.

B) Assurity of completion.

C) Market prevalence.

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A security market should be judged on the basis of its liquidity and assurity of completion.

karoliukas

Which of the following trading costs is NOT an explicit cost?

A) Market impact costs.

B) Commissions.

C) Stamp duties.

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The explicit costs in a trade are readily discernable and include commissions, taxes, stamp duties, and fees. Implicit costs sometimes cannot be measured as easily but do exist. They include the bid-ask spread, market or price impact costs, opportunity costs, and delay costs (a.k.a. slippage costs).

karoliukas

Which of the following trading costs results when an order is not filled?

A) Delay costs.

B) Market impact costs.

C) Price impact costs.

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When an order is not filled, delay or slippage costs result. These costs can be substantial if information regarding the security is released while the order sits unfilled.

karoliukas

If the volume-weighted average price (VWAP) during a day was $21 and 100 shares were bought at $20.40, which of the following statements regarding the costs of trading is most accurate?

A) The implicit costs are -$60.

B) The implicit costs are $60.

C) The explicit costs are -$60.

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Implicit costs are usually measured using some benchmark, such as the VWAP. VWAP is a weighted average of security prices during a day, where the weight applied is the proportion of the day’s trading volume. If the VWAP during a day was $21 and 100 shares were bought at $20.40, then the estimate of the implicit cost would be 100 × ($20.40-$21.00) = -$60. The explicit costs in a trade are the commissions, taxes, stamp duties, and fees.

karoliukas

As the senior portfolio manager for the Calvert Pension Fund, Jill Hohlman is responsible for the investment decisions as well as the execution of trades. Debbie Walker is responsible for the equity portion of the Calvert Pension Fund portfolio. It is Hohlman’s belief that her portfolio managers should be able to measure trading costs as well as have a complete understanding of available trading techniques.
Discussing the types of trading cost benchmarks, Hohlman states that the volume-weighted average price (VWAP) is a weighted average of security prices during a day, where the weight applied is the proportion of the day’s trading volume. She states further that the volume-weighted average price is preferred to the trading cost benchmark alternative of the opening day’s stock price because the opening price can be gamed to a greater extent by traders, relative to the volume-weighted average price. She also mentions that the effective spread is another useful alternative to the opening price because the effective spread cannot be gamed.
Discussing the types of trading cost benchmarks further, Walker states that the implementation shortfall, which is the difference between the actual portfolio’s return and a paper portfolio’s return, is probably the most accurate measure of trading costs. She states that the paper portfolio’s return is based on the security price when the decision to trade is originally made. She mentions that it is not subject to gaming, and incorporates both explicit and implicit trading costs.
Hohlman asks Walker to evaluate a trade made last week for the Calvert Pension Fund, using the implementation shortfall measure. The trade was a buy order for the stock of Brucker Industries. Brucker Industries is a small cap stock, which Hohlman thinks is a timely buy given recent announcement about the firm’s prospects. On Wednesday, Brucker Industries stock price closed at $20.00 a share. On Thursday morning before the market opened, the portfolio manager for the Calvert Pension Fund decided to buy Brucker Industries and transferred a limit order for $19.97 a share for 1000 shares to the trader. The order expired unfilled. The Brucker Industries stock closed at $20.03 on Thursday. On Friday, the order was revised to a limit of $20.07. The order was partially filled that day as 800 shares were bought at $20.07. The commission was $14. The stock closed at $20.09 on Friday and the order was cancelled.Regarding Hohlman’s statement concerning trading cost benchmarks:

A) Hohlman is correct.

B) Hohlman is incorrect because the effective spread can be gamed.

C) Hohlman is incorrect because the opening price cannot be gamed more than the volume-weighted average price.

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Hohlman is incorrect because the effective spread can be gamed. A trader may wait for other traders to come to them, i.e. when another trader is seeking liquidity. By doing so, the trader can trade at favorable bid and ask prices. However, the trader’s delay may cost the investor foregone profits. She is correct though that the volume-weighted average price is preferred to the opening day’s stock price because the opening price can be gamed to a greater extent by traders, relative to the volume-weighted average price. This is because the opening price is known with more certainty than the VWAP. (Study Session 16, LOS 39.f)

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Regarding Walker’s statement concerning the implementation shortfall:

A) Walker is correct.

B) Walker is incorrect because the implementation shortfall does not incorporate implicit trading costs.

C) Walker is incorrect because the implementation shortfall is subject to gaming.

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Walker is correct. The implementation shortfall is perhaps the most accurate measure of trading costs, it is not subject to gaming, and incorporates both explicit and implicit trading costs. (Study Session 16, LOS 39.g)

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What is the realized profit and loss component of the implementation shortfall measure Walker should calculate for the Brucker Industries trade?

A) 0.16%.

B) 0.09%.

C) 0.12%.

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The realized profit and loss is calculated using the execution price minus the decision price, which is usually measured as the previous day’s closing price. This is divided by the original price and weighted by the proportion of the order filled. It is (800/1000) x ($20.07-$20.03)/$20.00 = 0.16%. The positive value means that there is a loss (a cost) here. (Study Session 16, LOS 39.g)

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What is the delay costs component of the implementation shortfall measure Walker should calculate for the Brucker Industries trade?

A) 0.18%.

B) 0.24%.

C) 0.12%.

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The delay costs are calculated using the difference between the closing price on the day an order was not filled and the previous day closing price. It is weighted by the portion of the order filled. It is (800/1000) x ($20.03-$20.00)/$20.00 = 0.12%. (Study Session 16, LOS 39.g)

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What is the missed trade opportunity cost component of the implementation shortfall measure Walker should calculate for the Brucker Industries trade?

A) 0.12%.

B) 0.18%.

C) 0.09%.

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The missed trade opportunity cost is calculated using the difference between the price at which the order is cancelled and the original price. It is weighted by the portion of the order that is not filled. It equals (200/1000) x ($20.09-$20.00)/$20.00 = 0.09%. (Study Session 16, LOS 39.g)

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What is the implementation shortfall Walker should calculate for the Brucker Industries trade?

A) 0.44%.

B) 0.51%.

C) 0.37%.

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To calculate the implementation shortfall, we must also add in the explicit costs, which are the commission as a percent of the paper portfolio investment: $14/$20,000 = 0.07%. The total implementation cost is the sum of the explicit costs, the realized profit and loss, the delay costs component, and the missed trade opportunity cost component: 0.07%+0.16%+0.12%+0.09% = 0.44%. (Study Session 16, LOS 39.g)