Reading 41: Execution of Portfolio Decisions－LOS g interpret

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

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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.

D) Delay or slippage costs represent the difference between the closing prices on the day an order was not filled and the previous day closing price.

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Answer and Explanation

Missed trade opportunity cost is weighted by the portion of the order that is not filled. It is calculated using the difference between the price at which the order is cancelled and the original price. Realized profit and loss uses the difference between the execution price and the previous day's closing price. This is divided by the original price and weighted by the portion of the order filled. Delay or slippage costs use the difference between the closing prices on the day an order was not filled and the previous day closing price. It is weighted by the portion of the order filled.

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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 0.15%.

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

C) The opportunity costs are 0.07% and the total implementation shortfall is 0.15%.

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

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Answer and Explanation

To decompose the implementation shortfall, we calculate the following:

• Explicit costs the commission as a percent of the paper portfolio investment is $17/$40,000 = 0.04%.
• Realized profit and loss is calculated using the execution price minus the decision price, which is usually measured as the previous days closing price. This is divided by the original price and weighted by proportion of the order filled. It is (700/1000) × ($40.05 - $40.04)/$40.00 = 0.02%.
• Delay costs are calculated using the difference between the closing prices 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 (700/1,000) × ($40.04 - $40.00)/$40.00 = 0.07%.
• 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 (300/1,000) × ($40.08 - $40.00)/$40.00 = 0.06%.

The sum of the components is the total implementation cost: 0.04% + 0.02% + 0.07% + 0.06% = 0.19%.

To decompose the implementation shortfall, we calculate the following:

• Explicit costs the commission as a percent of the paper portfolio investment is $17/$40,000 = 0.04%.
• Realized profit and loss is calculated using the execution price minus the decision price, which is usually measured as the previous days closing price. This is divided by the original price and weighted by proportion of the order filled. It is (700/1000) × ($40.05 - $40.04)/$40.00 = 0.02%.
• Delay costs are calculated using the difference between the closing prices 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 (700/1,000) × ($40.04 - $40.00)/$40.00 = 0.07%.
• 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 (300/1,000) × ($40.08 - $40.00)/$40.00 = 0.06%.

The sum of the components is the total implementation cost: 0.04% + 0.02% + 0.07% + 0.06% = 0.19%.

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

A) Realized profit and loss.

B) Explicit costs.

C) Delay costs.

D) Missed trade opportunity cost.

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Answer and Explanation

The realized profit and loss, delay costs, and missed trade opportunity cost are all affected by market movements that the manager should not be held accountable for. For example, if the security increases due to market-wide movements, the trader should not be held responsible for this non-security specific change in price. Market-wide movements can be adjusted for by the market model.

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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) -1.08%.

C) 1.07%.

D) -0.80%.

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Answer and Explanation

The realized profit and loss, delay costs, and missed trade opportunity cost of the implementation shortfall are all affected by market movements that the manager should not be held accountable for. The implementation shortfall should be adjusted for market-wide movements, resulting in the a market-adjusted implementation shortfall. Over a few days, the alpha term is assumed to be zero, so no adjustment for the risk-free rate is necessary. If the market return was 1.2% over the time period of this trading and the beta was 1.3 for the stock, then the expected return for it would be 1.2% ×1.3 = 1.56%. Subtracting this from the 0.48% results in a market-adjusted implementation shortfall of 0.48% - 1.56% = -1.08%.