Reading 35: Equity: Markets and Instruments- LOS d(part1)

execution, company, manager, higher, impact

LOS d, (Part 1): Discuss the various components of execution costs (i.e., commissions and fees, market impact, and opportunity cost).

Q1. 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.

Company	Country	Japanese Market Price	U.S. Market Price (ADR)	Japanese Market Commission	U.S. Market Commission	Exchange Rate Per $
Yamato Mining	Japan	1,251 yen	$10.60	0.22%	$50	117.8 yen

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

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

C) The relationship between fund market price and net asset value (NAV).

Q2. If Wallace had her choice, in what kind of market would she trade?

For Neville Partners For Waterford Funds

A) Price-driven markets Price-driven markets

B) Order-driven markets Price-driven markets

C) Price-driven markets Order-driven markets

Q3. Yarborough’s proposal most likely involves:

A) futures contracts.

B) program trading.

C) agency trades.