Reading 45: Execution of Portfolio Decisions Los g~Q1-10

should

LOS g: Calculate, interpret, and explain the importance of implementation shortfall as a measure of transaction costs.

Q1. 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 She states that the paper portfolio’s return is based on the security price when the decision to trade is originally made.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.

Q2. Regarding Walker’s statement concerning the implementation shortfall:

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

B) Walker is correct.

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

Q3. What is the realized profit and loss component of the implementation shortfall measure Walker should calculate for the Brucker Industries trade?

A) 0.09%.

B) 0.16%.

C) 0.12%.

Q4. What is the delay costs component of the implementation shortfall measure Walker should calculate for the Brucker Industries trade?

A) 0.18%.

B) 0.12%.

C) 0.24%.

Q5. 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) 0.09%.

C) 0.18%.

Q6. What is the implementation shortfall Walker should calculate for the Brucker Industries trade?

A) 0.51%.

B) 0.44%.

C) 0.37%.

Q7. Which of the following implementation shortfall components is NOT influenced by market-wide movements?

A) Missed trade opportunity cost.

B) Realized profit and loss.

C) Explicit costs.

Q8. Use the following information to calculate the implementation shortfall components:

On Wednesday, the stock price closes at $40 a share.
On Thursday morning before market open, the portfolio manager decides to buy Megawidgets and transfers a limit order for $39.95 a share, for 1,000 shares. The price never falls to $39.95 during the day and the order expires unfilled. The stock closes at $40.04.
On Friday, the order is revised to a limit of $40.05. The order is partially filled that day as 700 shares are bought at $40.05. The commission is $17. The stock closes at $40.08 and the order is cancelled.

A) The opportunity costs are 0.06% and the total implementation shortfall is 0.19%.

B) The opportunity costs are 0.06% and the total implementation shortfall is 0.15%.

C) The opportunity costs are 0.07% and the total implementation shortfall is 0.19%.

Q9. Which of the following statements regarding the implementation shortfall components is least accurate?

A) Missed trade opportunity cost is weighted by the portion of the order that is filled.

B) Missed trade opportunity cost represents the difference between the price at which the order is cancelled and the original price.

C) Realized profit and loss represents the difference between the execution price and the previous day's closing price.

Q10. If the market return was 1.2% over the time period of trading, the risk-free rate was 0.1%, the stock beta was 1.3, and the shortfall implementation cost is 0.48% for trading in the stock, then what is the shortfall implementation cost to which the manager should be held accountable?

A) -1.07%.

B) 1.07%.

C) -1.08%.