Reading 41: Execution of Portfolio Decisions－LOS b effective, interpret, contrast, market

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 14: Execution of Portfolio Decisions
Reading 41: Execution of Portfolio Decisions
LOS b: 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.

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Suppose a trader is quoted a market bid price of $30.00 and an ask of $30.07. The execution price of a buy order is $30.04. What is the effective spread?

A) $0.01.

B) $0.02.

C) $0.06.

D) $0.07.

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Answer and Explanation

If a trader placed a buy order, a dealer may offer a better ask price than the previous ask to earn the traders business. The midquote of the quoted bid and ask prices is $30.035. The effective spread for this buy order would then be calculated as: 2 × ($30.04 - $30.035) = $0.01, which is 6 cents better than the quoted spread of $0.07 ($30.07 - $30.00).

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Suppose a trader is quoted a market bid price of $16.00 and an ask of $16.10. The execution price of a sell order is $16.03. What is the effective spread?

A) $0.04.

B) $0.02.

C) $0.01.

D) $0.03.

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Answer and Explanation

If a trader placed a sell order, a dealer may offer a better bid price than the previous bid to earn the traders business. The midquote of the quoted bid and ask prices is $16.05. The effective spread for this sell order would then be calculated as: 2 × ($16.05 - $16.03) = $0.04, which is 6 cents better than the quoted spread of $0.10 ($16.10 - $16.00).

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Suppose a trader is quoted a market bid price of $40.40 and an ask of $40.49. The execution price of a buy order is $40.47. What is the effective spread?

A) $0.050.

B) $0.025.

C) $0.080.

D) $0.090.

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Answer and Explanation

If a trader placed a buy order, a dealer may offer a better ask price than the previous ask to earn the traders business. The midquote of the quoted bid and ask prices is $40.445. The effective spread for this buy order would then be calculated as: 2 × ($40.47 - $40.445) = $0.05, which is 4 cents better than the quoted spread of $0.09 ($40.40 - $40.49).