LOS i: Explain the use of econometric methods in pre-trade analysis to estimate implicit transaction costs.

Q1. Which of the following trades would be predicted to have the highest trading costs using an econometric model?

A)   A small buy order in an upward trending market.

B)   A large buy order in a downward trending market.

C)   A large buy order in an upward trending market.

Q2. Which of the following variables is NOT typically used in econometric models to assess trading costs?

A)   Market model alpha.

B)   Risk.

C)   Momentum.

Q3. Which of the following is TRUE regarding econometric models? Econometric models:

A)   are only useful for forecasting trading costs.

B)   are used to forecast trading costs and assess trading effectiveness.

C)   are not useful for forecasting trading costs or assessing trading effectiveness.

LOS i: Explain the use of econometric methods in pre-trade analysis to estimate implicit transaction costs. fficeffice" />

Q1. Which of the following trades would be predicted to have the highest trading costs using an econometric model?

A)   A small buy order in an upward trending market.

B)   A large buy order in a downward trending market.

C)   A large buy order in an upward trending market.

Correct answer is C)

Econometric models use momentum and trade size relative to available liquidity to predict trading costs. Buying a stock in an upward trending market will incur more costs as will a larger order.

Q2. Which of the following variables is NOT typically used in econometric models to assess trading costs?

A)   Market model alpha.

B)   Risk.

C)   Momentum.

Correct answer is A)

The following are the variables typically used in econometric models:

§   security liquidity – trading volume, market cap, spread, price;

§   size of the trade relative to liquidity;

§   trading style – more aggressive trading results in higher costs;

§   momentum – e.g., buying stock costs more when the market is trending upward; and

§   risk.

Q3. Which of the following is TRUE regarding econometric models? Econometric models:

A)   are only useful for forecasting trading costs.

B)   are used to forecast trading costs and assess trading effectiveness.

C)   are not useful for forecasting trading costs or assessing trading effectiveness.

Correct answer is B)        

They can be used to forecast trading costs and assist portfolio managers in determining the size of the trade. They can also be used to assess trading effectiveness by comparing actual trading costs to forecasted trading costs from the models.