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finance question and need support to help me learn. WEEK 9: INTERACTIVE LEARNING ACTIVITY 9.1 Learning Outcomes: 1. Describe the three types of markets and their characteristics. 2. Describe the factors that contribute to market liquidity and define transparency as a market characteristic. 9.2 Action Required: Read the chapter 10 to answer the question below- 9.3 Test your Knowledge (Question): Explain two types of market What are the factors that contribute to market liquidity? 9.4 Instructions · Answer the question available in the “Test your Knowledge” section. Requirements: 100 words CHAPTER10EXECUTIONOFPORTFOLIODECISIONSAnanthMadhavanBarclaysGlobalInvestorsSanFrancisco,CaliforniaJackL.TreynorTreynorCapitalManagement,Inc.PalosVerdesEstates,CaliforniaWayneH.WagnerPlexusGroup,Inc.LosAngeles,California1.INTRODUCTIONTheinvestmentprocesshasbeendescribedasathree-leggedstoolsupportedequallybysecuritiesresearch,portfoliomanagement,andsecuritiestrading.Ofthethree,tradingisoftentheleastunderstoodandleastappreciatedfunction.Aswewillshow,adeeperappreciationforthetradingfunctioncanbeapowerfulhelpinachievinginvestmentsuccess.Inthischapter,wewillbuildtheknowledgeandexplaintheconceptsneededtounderstandhowmanagersandtradersinteractwithmarkets,choosetradingstrategiesandtactics,andmeasuretheirsuccessintrading.Ourperspectiveischie?ythatofaportfoliomanager(orinvestmentadviser)whoseobjectiveistoexecuteportfoliodecisionsinthebestinterestsoftheclient.Theportfoliomanager’sagentsindoingsoarethe?rm’straders.Thesebuy-sidetradersaretheprofessionaltradersemployedbyinvestmentmanagersorinstitutionalinvestorswhoplacethetradesthatexecutethedecisionsofportfoliomanagers.Thejobofsuchtradersistoexecutethedesiredtradesquickly,withouterror,andatfavorableprices.Executionisthe?nal,criticalstepintheinterlinkedinvestmentprocess:Theportfoliodecisionisnotcompleteuntilsecuritiesareboughtorsold.637 638ManagingInvestmentPortfoliosAportfoliomanagerisnotaprofessionaltrader.However,aportfoliomanagerdoesneedto:•Communicateeffectivelywithprofessionaltraders.•Evaluatethequalityoftheexecutionservicesbeingprovidedforthe?rm’sclients.•Takeresponsibilityforachievingbestexecutiononbehalfofclientsinhisorherroleasa?duciary.Toaccomplishthosegoals,theportfoliomanagerneedsagroundingin:•Themarketinstitutionswithinwhichtraderswork,includingthedifferenttypesoftradingvenuestowhichtradersmaydirectorders.•Themeasurementoftradingcosts.•Thetacticsandstrategiesavailabletothe?rm’stradersandthecounterpartieswithwhomtheydeal,includingimportantinnovationsintradingtechnology.Thechapterisorganizedasfollows.Section2presentsessentialinformationfortheportfoliomanageronthetypesoforders,thevarietyofmarketvenueswhereordersareexecuted,therolesofdealersandbrokers,andtheevaluationofmarketquality.Section3addressesthecostsoftrading.Thenexttwosectionsdiscusstopicsrelevanttotradingstrategy:thetypesoftradersandtheirpreferredordertypes(Section4)andtradeexecutiondecisionsandtactics(Section5).Section6discussesservingtheclient’sinterestsintradingandisfollowedbyconcludingremarks(Section7).2.THECONTEXTOFTRADING:MARKETMICROSTRUCTURETheportfoliomanagerneedstobefamiliarwithmarketmicrostructure:themarketstructuresandprocessesthataffecthowthemanager’sinterestinbuyingorsellinganassetistranslatedintoexecutedtrades(representedbytradepricesandvolumes).Knowledgeofmarketmicrostructurehelpsaportfoliomanagerunderstandhoworderswillbehandledandexecuted.Theformulationoftradingstrategiesdependsonaccuratemicrostructureinformation.Suchinformationcanalsohelpthepractitionerunderstandthefrictionsthatcancauseassetpricestodivergefromfull-informationexpectationsofvalue,possiblysuggestingopportunitiesandpitfallsintrading.Theportfoliomanageralsoneedstounderstandthecharacteristicsofthemajorordertypesasheorshecommunicateswiththetradingdeskonsuchmattersastheemphasistoputonspeedofexecutionversuspriceofexecution.Thenextsectionpresentssomeessentialinformationonordertypes.2.1.OrderTypesMarketordersandlimitordersarethetwomajortypesofordersthattradersuseandthatportfoliomanagersneedtounderstand.1.Amarketorderisaninstructiontoexecuteanorderpromptlyinthepublicmarketsatthebestpriceavailable.Forexample,anordertobuy10,000sharesofBPp.l.c.directedtotheLondonStockExchange(LSE)wouldexecuteatthebestpriceavailablewhentheorderreached Chapter10ExecutionofPortfolioDecisions639thatmarket.SupposethatwhentheorderreachestheLSE,thelowestpriceatwhichasellerisreadytosellBPsharesis642p(pence)inquantityupto8,000shares(forabuyer,thelowertheprice,thebetter).Thesecond-lowestpriceis643pinquantityupto6,000shares.Thus,8,000sharesofthemarketorderwouldbe?lled(executed)at642pandthebalanceof10,000-8,000=2,000shareswould?llat643p.Amarketorderemphasizesimmediacyofexecution.However,amarketorderusuallybearssomedegreeofpriceuncertainty(uncertaintyaboutthepriceatwhichtheorderwillexecute).Intoday’smarkets,mostmarketordersareeffectivelyautomatedfromthepointoforiginstraightthroughtoreportingandclearing.2.Alimitorderisaninstructiontotradeatthebestpriceavailablebutonlyifthepriceisatleastasgoodasthelimitpricespeci?edintheorder.Forbuyorders,thetradepricemustnotexceedthelimitprice,whileforsellorders,thetradepricemustbeatleastashighasthelimitprice.Aninstructionalwaysaccompaniesalimitorderspecifyingwhenitwillexpire.Supposethatinsteadofthemarketorderabove,thetraderplacesanordertobuy10,000sharesofBPp.l.c.at641plimit(whichmeansatapriceof641porlower),goodforoneday(theorderexpiresattheendoftradingthatday).Supposethatthisbuyorder’spriceishigherthanthatofanyotherlimitbuyorderforBPsharesatthetime.Ifthatisthecase,then641pbecomesthebestavailablebid,ormarketbid,forBPshares.Ifamarketsellorderfor6,000sharesofBParrivestheinstantafterthetrader’sbuylimitorderfor10,000shares,itwillexecuteagainstthatlimitorder.Thetraderwillgeta?ll(execution)for6,000sharesat641p,leaving4,000sharesoftheorderun?lled.Atthatpoint,favorablenewsonBPmightreachthemarket.Ifso,thepriceofBPcouldmoveupsharplyandnottradeatorbelow641pfortheremainderoftheday.Ifthatisthecase,attheendoftheday,thetraderwillhave4,000sharesofhisorherorderun?lledandtheorder,whichwasgoodforoneday,willexpire.Byspecifyingtheleastfavorablepriceatwhichanordercanexecute,alimitorderemphasizesprice.However,limitorderscanexecuteonlywhenthemarketpricereachesthelimitpricespeci?edbythelimitorder.Thetimingoftheexecution,orevenwhethertheexecutionhappensatall,isdeterminedbytheebband?owofthemarket.Limitordersthushaveexecutionuncertainty.Eachtradingvenuespeci?esthetypesoforderspermittedandothertradingprotocols.Theprofessionaltraderneedstoknowtherangeofordertypespermitted.Thelistofallpossiblekindsofordersislong,butmostordertypesrepresentvariationsontheelementalmarketandlimitorders.1Someoftheseordertypesmayservetoenlisttheexperience,presence,andknowledgeofthetrader’sagent(broker)inexecutingatrade.Othersmayservetoconcealthequantityofasecuritythatthetraderwantstobuyorsell,orservesomeotherpurpose.Afewadditionalimportantordertypesareasfollows:•Market-not-heldorder.Thistypeoforderisrelevantfortradesplacedoncertainexchanges(regulatedtradingvenues)whereanordermaybehandledbyanagentofthetraderinexecutingtrades(abroker).Thisvariationofthemarketorderisdesignedtogivetheagentgreaterdiscretionthanasimplemarketorderwouldallow.‘‘Notheld’’meansthatthebrokerisnotrequiredtotradeatanyspeci?cpriceorinanyspeci?ctimeinterval,aswouldberequiredwithasimplemarketorder.Discretionisplacedinthehandsofarepresentative1SeeHarris(2003)foranin-depthtreatmentofordertypes. 640ManagingInvestmentPortfoliosofthebroker(suchasa?oorbroker—anagentofthebrokerwho,forcertainexchanges,physicallyrepresentsthetradeontheexchange).Thebrokermaychoosenottoparticipateinthe?owofordersontheexchangeifthebrokerbelievesheorshewillbeabletogetabetterpriceinsubsequenttrading.•Participate(donotinitiate)order.Thisisavariantofthemarket-not-heldorder.Thebrokeristobedeliberatelylow-keyandwaitforandrespondtoinitiativesofmoreactivetraders.Buy-sidetraderswhousethistypeoforderhopetocaptureabetterpriceinexchangeforlettingtheothersidedeterminethetimingofthetrade.•Besteffortsorder.Thistypeofordergivesthetrader’sagentevenmorediscretiontoworktheorderonlywhentheagentjudgesmarketconditionstobefavorable.Somedegreeofimmediacyisimplied,butnotimmediacyatanyprice.•Undisclosedlimitorder.Alsoknownasareserve,hidden,oricebergorder.Thisisalimitorderthatincludesaninstructionnottoshowmorethansomemaximumquantityoftheun?lledorder.Forexample,atradermightwanttobuy200,000sharesofanissuetradedonEuronextAmsterdam.Theordersizewouldrepresentasubstantialfractionofaveragedailyvolumeintheissue,andthetraderisconcernedthatsharepricemightmoveupifthefullextentofhisorherinterestwereknown.Thetraderplacesanundisclosedlimitordertobuythe200,000shares,specifyingthatnomorethan20,000sharesoftheun?lledorderbeshowntothepublicatatime.•Marketonopenorder.Thisisamarketordertobeexecutedattheopeningofthemarket.Similarly,amarketoncloseorderisamarketordertobeexecutedatthemarketclose.Theseareexamplesoforderswithaninstructionforexecutionataspeci?ctime.Therationaleforusingthesetwotypesofordersisthattheopeningandcloseinmanymarketsprovidegoodliquidity.Theabovetypesofordersdescribehowanordertobuyorsellwillbepresentedtothemarket.Thefollowingdescribespecialtypesoftrades:•Principaltrade.Aprincipaltradeisatradewithabrokerinwhichthebrokercommitscapitaltofacilitatethepromptexecutionofthetrader’sordertobuyorsell.Principaltradesareusedmostfrequentlywhentheorderislargerand/ormoreurgentthancanbeaccommodatedwithinthenormalebband?owofexchangetrading.Apriceconcessionprovidesanincentiveforthebrokeractingasaprincipalinthetrade.•Portfoliotrade(orprogramtrade,orbaskettrade).Aportfoliotradeinvolvesanorderthatrequirestheexecutionofpurchases(orsales)inaspeci?edbasket(list)ofsecuritiesatasclosetothesametimeaspossible.Forexample,anS&P500indexfundmanagerwithnewcashtoinvestcouldexecuteaportfoliotradetobuytheS&P500(thesharesintheS&P500intheirindexweights).Portfoliotradesareoftenrelativelylowcostbecausethediversi?cationimpliedbymultiplesecurityissuesreducestherisktotheothersideofthetrade.Withsomeessentialinformationonordertypesinhand,wecandiscussmarketstructuresfortrading.2.2.TypesofMarketsMarketsareorganizedtoprovideliquidity(theabilitytotradewithoutdelayatrelativelylowcostandinrelativelylargequantities),transparency(availabilityoftimelyandaccuratemarketandtradeinformation),andassurityofcompletion(tradessettlewithoutproblemsunderallmarketconditions—tradesettlementinvolvesthebuyer’spaymentfortheassetpurchasedandthetransferofformalownershipofthatasset). Chapter10ExecutionofPortfolioDecisions641Inwhatfollows,wedescribethechiefwaystradingisorganized:•Quote-driven(ordealer)markets,inwhichmembersofthepublictradewithdealersratherthandirectlywithoneanother.•Order-drivenmarkets,inwhichmembersofthepublictradewithoneanotherwithouttheintermediationofdealers.•Brokeredmarkets,inwhichthetraderreliesonabrokerto?ndtheothersideofadesiredtrade.Thesedistinctionsarevaluableinunderstandingthedynamicsoftradingandpriceformation,although,aswediscusslater,thelinesbetweenthecategoriesareoftenblurry.Furthermore,marketsevolve,andtheportfoliomanagerneedstokeepabreastofimportantnewdevelopments.Fixed-incomeandequitymarketshaveevolvedveryrapidlyoverthe1990sandearly2000s.Therearemanymorechoicesastowheretotradesuchbondsandequitiesthanwasthecasehistorically—aphenomenonthathasbeencalledmarketfragmentation.Anothertrendistheincreasingamountoftradingthatispartlyorfullyautomated,inthesensethattheexecutionofatrader’sorderafterentryrequiresminimalornohumaninterventionortrader-to-tradercommunication.Re?ectingtheconcerntominimizesettlementerrorsandcostsinsecuritymarkets,thesettlementofthetradeafterexecutionmayalsobeautomatedwithinagiventradingsystemorvenue(straightthroughprocessing,orSTP).Forwardandfuturesmarketsarealsointransition.Forexample,attheChicagoBoardofTrade(CBOT,aU.S.commoditiesexchange),anautomatedtradingsystem(e-cbot)operatesalongsideatypeofmarketdatingbackcenturies(anopenoutcryauctionmarket).Inanopenoutcryauctionmarket,representativesofbuyersandsellersmeetataspeci?edlocationonthe?oorofanexchange,withvoicesraised(‘‘openoutcry’’)sotheycanbeheard,toconductauctionsto?llcustomers’orders.Alternativeinvestmentmarketshavealsobeenaffectedbychanges.Forexample,hedgefunds(looselyregulatedpooledinvestmentvehicles)havebeenaggressiveinexploitingadvancesintradingtechnology.Alltheabovedevelopmentsarebetterunderstoodwhenthestructuresbywhichtradingisorganizedaregrasped.The?rsttypeofmarketthatwewilldiscussiscalledaquote-drivenordealermarket.2.2.1.Quote-Driven(Dealer)MarketsQuote-drivenmarketsrelyondealerstoestab-lish?rmpricesatwhichsecuritiescanbeboughtandsold.Thesemarketsarethereforealsocalleddealermarkets,astradesareexecutedwithadealer.Adealer(sometimesreferredtoasamarketmaker)isabusinessentitythatisreadytobuyanassetforinventoryorsellanassetfrominventorytoprovidetheothersideofanordertobuyorselltheasset.Inthetraditionalview,marketmakersordealerspassivelyprovideimmediacyorbridgeliquidity,thepriceofwhichisthebid–askspread(theaskpriceminusthebidprice).Adealer’s(oranytrader’s)bidprice(orbid)isthepriceatwhichheorshewillbuyaspeci?edquantityofasecurity.Adealer’s(oranytrader’s)askprice(orask,orofferprice,oroffer)isthepriceatwhichheorshewillsellaspeci?edquantityofasecurity.Ontheprincipleofbuyinglowandsellinghigh,adealer’saskpriceisgreaterthanhisbidprice.Thequantityassociatedwiththebidpriceisoftenreferredtothebidsize;thequantityassociatedwiththeaskpriceisknownastheasksize.Fromtheperspectiveofatraderexecutinganordertobuyasecurityfromadealer,aloweraskfromthedealerisfavorabletothetrader.Ifthetraderisexecutinganordertosellasecuritytoadealer,ahigherbidfromthedealerisfavorabletothetrader. 642ManagingInvestmentPortfoliosSupposethataportfoliomanagergivesthe?rm’stradingdeskanordertobuy1,000sharesofEconomicalChemicalSystems,Inc.(ECSI),whichistradedinadealermarket,andthatthreedealers(codedA,B,andC)makeamarketinthoseshares.AtthetimethetraderviewsthemarketinECSIonhiscomputerscreen,10:22a.m.,thethreedealershaveputinthefollowingquotes:•DealerA:bid:98.85for600shares;ask:100.51for1,000shares.•DealerB:bid:98.84for500shares;ask:100.55for500shares.•DealerC:bid:98.82for700shares;ask:100.49for800shares.Thus,thebid–askspreadsofDealersA,B,andCare,respectively,•100.51-98.85=1.66•100.55-98.84=1.71•100.49-98.82=1.67ThetradermightseethequoteinformationorganizedonhisscreenasshowninExhibit10-1.InExhibit10-1,thebidsandasksareorderedfrombesttoworstandtime-stamped.Theseareactuallylimitordersbecausethepricesatwhichthedealersarereadytotradearespeci?ed.BecauseExhibit10-1listslimitorders,itiscalledalimitorderbook.Theinsidebid,ormarketbid,whichisthehighestandbestbid,is98.85fromDealerA.However,DealerCisquotingtheinsideask,ormarketask,whichisthelowestask,at100.49.Theinsidequote,ormarketquote,istherefore98.85bid,100.49ask.Theinsidebid–askspread,ormarketbid–askspread(orinsidespreadormarketspreadforshort),is100.49-98.85=1.64,whichinthiscaseislowerthananyindividualdealer’sspread.(Prevailingisalsousedforinsideormarketinalltheseexpressions.)Thetraderalsonotesthatthemidquote(halfwaybetweenthemarketbidandaskprices)is(100.49+98.85)/2=99.67.Ifthetraderexecutesamarketbuyorderfor1,000shares,thetraderwouldpurchase800sharesfromDealerCat100.49pershareand200sharesfromDealerAat100.51pershare.However,insomemarkets,itisalsopossibleforthetradertodirectthebuyordertoaspeci?cdealer—forexample,DealerA.Thetradermaydosoforavarietyofreasons.Forexample,thetradermaybelievethatDealerAisreliableinstandingbehindquotesbutthatDealerCisnot.Asoneexample,currencymarketsaredealermarkets,andinstitutionsactiveinthosemarketsmayscreencounterpartiesoncreditcriteria.Insomedealermarkets,apublictradermightnothavereal-timeaccesstoallquotesinthesecurityasinourexample;thatis,thelimitorderbookisnot‘‘open,’’meaningvisibleinrealtimetothepublic.Insuchclosed-bookmarkets,thetraderwouldrelyonabrokertolocatethebestaskprice,payingthebrokeracommission.AnothernotablepointconcernsEXHIBIT10-1TheLimitOrderBookforEconomicalChemicalSystems,Inc.BidAskDealerTimeEnteredPriceSizeDealerTimeEnteredPriceSizeA10:21a.m.98.85600C10:21a.m.100.49800B10:21a.m.98.84500A10:21a.m.100.511,000C10:19a.m.98.82700B10:19a.m.100.55500Note:Thebidsareorderedfromhighesttolowest,whiletheasksareorderedfromlowesttohighest.Theseorderingsarefrombestbidorasktoworstbidorask. Chapter10ExecutionofPortfolioDecisions643limitorders.Historically,indealermarkets,ruleswouldrestrictalimitorderfromapublictraderfromcompetingwithdealers’bidsandasksforotherpublictrades.Ina‘‘pure’’dealermarket,adealerisacounterpartytoeverytrade.However,insomequote-drivenmarkets,suchastheU.S.NASDAQmarketforequities,publictraders’limitordersaredisplayedandcompetewithdealers’bidsandasks.2Iftheportfoliomanagercommunicatedthatheorshehadafocusonpriceratherthanimmediacy,thetradermightconsiderplacingalimitorderwithinthemarketspread—forexample,anordertobuy1,000sharesat100limit.Thetrader’slimitorderinamarketsuchasNASDAQwouldestablishanewmarketbidat100,andtherevisedmarketquotewouldbe100bid,100.49ask.Ifnothingelsehadchanged,anincomingmarketordertosellECSIshareswould‘‘hit’’thetrader’sbidof100.Thetradermightalsohopethatoneofthedealerswouldrevisetheaskdownwardand?llpartorallofthetrader’sorder.However,itisalsopossiblethatthetrader’slimitorderwouldexpireun?lled.Dealershaveplayedimportantrolesinbondandequitymarketsbecausedealerscanhelpmarketsoperatecontinuously.Bondmarkets,inparticular,areoverwhelminglydealermarkets.Theexplanationliesinalackofnaturalliquidityformanybonds.(Naturalliquidityisanextensivepoolofinvestorswhoareawareofandhaveapotentialinterestinbuyingand/orsellingasecurity.)Manybondsareextremelyinfrequentlytraded.Ifaninvestorwantedtobuysuchabond,theinvestormighthaveaverylongwaitbeforetheothersideofthetrade(aninteresttosell)appearedfromthepublic.Dealershelpmarketsinsuchsecuritiesoperatemorenearlycontinuouslybybeingreadytotaketheoppositesideofatrade.AstudyofU.S.corporatebondmarketshighlightstheissueoflackofnaturalliquidity.In2003,approximately70,000U.S.corporatebondissuespotentiallytradableindealermarketswereoutstanding.3However,only22,453issues,about23percentofthetotal,tradedatleastoncein2003.Ofthebondsthatdidtradeatleastonce,the‘‘active’’bondissues,themediannumberoftradesperdaywaslessthanone.Only1percentofactivebondstradedonaveragemorethanabout22timesperday.4Evenintherelativelyfrequentlytradedissues,anopportunityisthuscreatedforanentity—thedealer—to‘‘make’’themarket(i.e.,createliquiditywhennonaturalliquidityexists).Amarketismadewhenthedealerstandsreadytoprovidebridgeliquiditybybuyingstockofferedbyasellerandholdingituntilabuyerarrives,inreturnforearningaspread.Similarconsiderationsoftenoperateinequities.Forexample,theLondonStockExchangehasaquote-driven,competingdealermarketcalledSEAQforinfrequentlytradedshares.Dealersalsoplayimportantrolesinmarketsrequiringnegotiationofthetermsoftheinstrument,suchasforwardmarketsandswapmarkets,whereotherwise?ndingacounterpartytotheinstrumentwouldoftennotbefeasible.Thesizeofthequotedbid–askspread(re?ectingthemarketquote),particularlyasaproportionofthequotemidpoint,isonemeasureoftradingcosts.However,thequotedbid–askspreadmaybedifferentfromthespreadatwhichatraderactuallytransacts.Thetrader’sfocusisthereforeoftenontheeffectivespread.2ThedisplayofpubliclimitordersonNASDAQfollowedaU.S.reformin1997thatwastriggeredbyacontroversyaboutdealercollusioninsettingquotes.3SeeEdwards,Harris,andPiwowar(2004).TheestimatecomesfromthenumberofU.S.corporatebondswhosetradesmustbereportedtotheTRACE(TradeReportingandComplianceEngine)bondpricereportingsystem,whichhasbeenoperativesinceJuly1,2002.4SeeEdwardsetal.,Table10-2. 644ManagingInvestmentPortfoliosEXHIBIT10-2AMarketBid–Askat10:03:14(OrderEntry)BidPriceBidSizeAskPriceAskSize$19.97400$20.031,000EXHIBIT10-3AMarketBid–Askat10:03:18(OrderExecution)BidPriceBidSizeAskPriceAskSize$19.97400$20.01500Theeffectivespreadistwotimesthedeviationoftheactualexecutionpricefromthemidpointofthemarketquoteatthetimeanorderisentered.(Ifpartsoftheorderexecuteatdifferentprices,theweighted-averageexecutionpriceisusedincomputingthedeviationfromthemidpoint.)Thequotedspreadisthesimplestmeasureofround-triptransactioncostsforanaverage-sizeorder.Theeffectivespreadisabetterrepresentationofthetruecostofaround-triptransactionbecauseitcapturesbothpriceimprovement(i.e.,executionwithinthequotedspreadatapricesuchthatthetraderisbene?ted)andthetendencyforlargerorderstomoveprices(marketimpact).5Exhibit10-2givesthemarketbid–askinahypotheticalcommonequityissuethatwecanusetoillustratethedifferencebetweenthesetwokindsofspreads.WiththeinformationinExhibit10-2beforehim,atraderwithinstructionstobuy500shareswithminimaldelayentersamarketorderfor500shares.Astheorderisreceivedinthesystemat10:03:18,adealerintheissueentersaquoteof$19.96bid(bidsize:100shares)and$20.01ask(asksize:500shares)toimproveon(‘‘stepinfrontof’’)thepriorbestaskpriceof$20.03andtaketheincomingmarketorder.Thiscanhappenbecausethedealerquicklydecidesthatthepro?tfromthetradeissatisfactory.Exhibit10-3showsthemarketbid–askat10:03:18,whentheorderexecutes.Thus,500sharesofthetrader’smarketorderexecuteat$20.01,whichrepresentsapriceimprovementof$0.02relativetothemarketaskof$20.03thatthetradersawwhentheorderwasentered.(Thelowerpurchasepricerepresentsapriceimprovementforthebuyer.)FromExhibit10-2weseethatthequotedbid–askspreadis$20.03-$19.97=$0.06.Themidquoteis($20.03+$19.97)/2=$20.00.Theeffectivespreadis2×($20.01-$20.00)=2×$0.01=$0.02,whichis$0.06-$0.02=$0.04lessthanthequotedspread.Thepriceimprovementhasresultedinaneffectivespreadthatislowerthanthequotedspread.Theaverageeffectivespreadisthemeaneffectivespread(sometimesdollarweighted)overalltransactionsinthestockintheperiodunderstudy.Theaverageeffectivespreadattemptstomeasuretheliquidityofasecurity’smarket.EXAMPLE10-1TheEffectiveSpreadofanIlliquidStockCharlesMcClung,portfoliomanagerofaCanadiansmall-capequitymutualfund,isreviewingwithhis?rm’schieftradertheexecutionofatickettosell1,000sharesof5Priceimprovementhappenswhenatraderimproveson(or‘‘stepsinfrontof’’)thebestcurrentbidoraskpricetotaketheothersideofanincomingmarketorder. Chapter10ExecutionofPortfolioDecisions645AlphaCompany.Theticketwassplitintothreetradesexecutedinasingledayasfollows:A.Amarketordertosell200shareswasexecutedatapriceofC$10.15.Thequotethatwasineffectatthattimewasasfollows:AskPriceAskSizeBidPriceBidSizeC$10.24200C$10.12300B.Amarketordertosell300shareswasexecutedatapriceofC$10.11.Thequotethatwasineffectatthattimewasasfollows:AskPriceAskSizeBidPriceBidSizeC$10.22200C$10.11300C.Amarketordertosell500shareswasexecutedatanaveragepriceofC$10.01.Thequotethatwasineffectatthattimewasasfollows:AskPriceAskSizeBidPriceBidSizeC$10.19200C$10.05300Thisorderexceededthequotedbidsizeand‘‘walkeddown’’thelimitorderbook(i.e.,afterthemarketbidwasused,theordermadeuseoflimitorder(s)tobuyatlowerpricesthanthemarketbid).1.Foreachoftheabovemarketorders,computethequotedspread.Also,computetheaveragequotedspreadforthestockfortheday.2.Foreachoftheabove,computetheeffectivespread.Also,computetheaverageeffectivespreadandtheshare-volume-weightedeffectivespreadforthestockfortheday.3.Discusstherelativemagnitudesofquotedandeffectivespreadsforeachofthethreeorders.SolutiontoProblem1:Thequotedspreadisthedifferencebetweentheaskandbidprices.So,forthe?rstorder,thequotedspreadisC$10.24-C$10.12=C$0.12.Similarly,thequotedspreadsforthesecondandthirdordersareC$0.11andC$0.14,respectively.Theaveragequotedspreadis(C$0.12+C$0.11+C$0.14)/3=C$0.1233.SolutiontoProblem2:Effectivespreadforasellorder=2×(Midpointofthemarketatthetimeanorderisentered-Actualexecutionprice).Forthe?rstorder,themidpointofthemarketatthetimetheorderisentered=(C$10.12+C$10.24)/2=C$10.18.So,theeffectivespread=2×(C$10.18-C$10.15)=C$0.06.Theeffectivespreadforthesecondorder=2×[(C$10.11+C$10.22)/2-C$10.11]=C$0.11. 646ManagingInvestmentPortfoliosTheeffectivespreadforthethirdorder=2×[(C$10.05+C$10.19)/2-C$10.01]=C$0.22.Theaverageeffectivespread=(C$0.06+C$0.11+C$0.22)/3=C$0.13.Theshare-volume-weightedeffectivespread=[(200×C$0.06)+(300×C$0.11)+(500×C$0.22)]/(200+300+500)=(C$12.00+C$33.00+C$110.00)/1,000=C$155.00/1,000=C$0.155.SolutiontoProblem3:Inthe?rsttrade,therewasapriceimprovementbecausethesharesweresoldatapriceabovethebidprice.Therefore,theeffectivespreadislessthanthequotedspread.Inthesecondtrade,therewasnopriceimprovementbecausethesharesweresoldatthebidprice.Also,therewasnoimpactontheexecutionpricebecausetheentireorderwasful?lledatthequotedbid.Accordingly,theeffectiveandquotedspreadsareequal.Inthethirdtrade,theeffectivespreadisgreaterthanthequotedspreadbecausetheordersizewasgreaterthanthebidsizeandtheorderhadtowalkdownthelimitorderbook,resultinginaloweraveragepriceforthesaleandthereforeahighereffectivespread.Empiricalresearchcon?rmsthateffectivebid–askspreadsarelowerinhigher-volumesecuritiesbecausedealerscanachievefasterturnaroundininventory,whichreducestheirrisk.Spreadsarewiderforriskierandlessliquidsecurities.Laterresearchprovidedadeeperunderstandingoftradingcostsbyexplainingvariationinbid–askspreadsaspartofintradaypricedynamics.Thisresearchshowedthatmarketmakersarenotsimplypassiveprovidersofimmediacybutmustalsotakeanactiveroleinpricesettingtorapidlyturnoverinventorywithoutaccumulatingsigni?cantpositionsononesideofthemarket.Pricemaydepartfromexpectationsofvalueifthedealerislongorshortrelativetodesired(target)inventory,givingrisetotransitorypricemovementsduringtheday—andpossiblyoverlongerperiods.Thisintuitiondrivesthemodelsofinventorycontroldevelopedby,amongothers,MadhavanandSmidt(1993).2.2.2.Order-DrivenMarketsOrder-drivenmarketsaremarketsinwhichtransactionpricesareestablishedbypubliclimitorderstobuyorsellasecurityatspeci?edprices.Suchmarketsfeaturetradesbetweenpublicinvestors,usuallywithoutintermediationbydesignateddealers(marketmakers).ThelimitorderbookshowninExhibit10-1forthehypotheticalEconomicalChemicalSystems,Inc.,wouldalsobeapossiblelimitorderbookforthecompanyifitweretradedinanorder-drivenmarket,buttypicallywithpublictradersreplacingdealers(dealersmaytradeinorder-drivenmarketsbutdosoalongsideothertraders).Theremightbemorecompetitionfororders,becauseatraderdoesnothavetotransactwithadealer(asina‘‘pure’’dealermarker).Butitisalsopossiblethatatradermightbedelayedinexecutingatradeorbeunabletoexecuteitbecauseadealerwithaninventoryofthesecurityisnotpresent.Ordersfromthepublic‘‘drive,’’ordetermine,liquidity,explainingthetermorder-drivenmarkets.Inorder-drivenmarkets,atradercannotchoosewithwhomheorshetradesbecauseaprespeci?edsetofrules(basedonfactorssuchaspriceandtimeoforderentry)mechanicallygovernstheexecutionoforderssubmittedtothemarket.Examplesoforder-drivenmarketsincludetheTorontoStockExchangeforequities,theInternationalSecuritiesExchangeforoptions,andHotspotFXforforeignexchange. Chapter10ExecutionofPortfolioDecisions647Forequitymarkets,aworldwidetrendhasfavoredorder-drivenmarketsattheexpenseofquote-drivenmarkets.Varioustypesoforder-drivenmarketsaredistinguished:2.2.2.1.ElectronicCrossingNetworksElectroniccrossingnetworksaremarketsinwhichbuyandsellordersarebatched(accumulated)andcrossedataspeci?cpointintime,usuallyinananonymousfashion.Electroniccrossingnetworksexecutetradesatpricestakenfromothermarkets.AnexampleofacrossingnetworkisthePOSITtradingsystem,whichmatchesbuyersandsellersattheaverageofprevailingbidandaskpricesat?xedpointsintheday.Crossingnetworksservemainlyinstitutionalinvestors.6Inusingcrossingnetworks,bothbuyerandselleravoidthecostsofdealerservices(thebid–askspread),theeffectsalargeordercanhaveonexecutionprices,andinformationleakage.Commissionsarepaidtothecrossingnetworkbutaretypicallylow.However,crossingparticipantscannotbeguaranteedthattheirtradeswill?ndanopposingmatch:Thevolumeinacrossingsystemisdeterminedbythesmallestquantitysubmitted.Toillustratehowtradesonacrossingnetworkareexecuted,wewillsupposethataninvestmentmanager,codedAinExhibit10-4,wishestobuy10,000sharesofastock.Atthesametime,twodifferentmutualfundtraders,codedBandC,wishtosell3,000and4,000shares,respectively.Thecrossingofordersoccursat12:00p.m.oneachbusinessday.Themarketbidandaskpricesofthestockare¤30.10and¤30.16,respectively.Inthisexample,totalvolumeis7,000sharesandtheexecutionpriceisatthemidquote(halfwaybetweentheprevailingbidandaskprices)of¤30.13=(¤30.10+¤30.16)/2.Bothsellershavetheirordersexecutedinfull,butbuyerAreceivesapartial?llof7,000shares.Thebuyerhastheoptionofsendingtheremaining3,000sharesbacktothecrossingsystemforanotherattemptatexecutionatthenextscheduledcrossingortryingtotradethisremainderintheopenmarket.Noneoftheparticipantsobservestheidentitiesororiginalsubmissionsizesoftheothersinthematchpool.Crossingnetworksprovidenopricediscovery.Pricediscoverymeansthattransactionpricesadjusttoequilibratesupplyanddemand.Becausethecrossingnetworkdidnotprovidepricediscovery,pricecouldnotadjustupwardtouncoveradditionalsellinginterestandfullysatisfytraderA’sdemandtobuy.2.2.2.2.AuctionMarketsManyorder-drivenmarketsareauctionmarkets—thatis,mar-ketsinwhichtheordersofmultiplebuyerscompeteforexecution.Auctionmarketscanbefurthercategorizedintoperiodicorbatchauctionmarkets(wheremultilateraltradingEXHIBIT10-4ElectronicCrossingNetwork:CrossingofOrdersat12:00p.m.(numericalentriesarenumbersofshares)TraderIdentityBuyOrdersSellOrdersA10,000B3,000C4,0006IndiscussionsofU.S.equitymarketsinparticular,atermthatisoccasionallyusedfordirecttradingofsecuritiesbetweeninstitutionalinvestorsisthefourthmarket;thefourthmarketwouldincludetradingonelectroniccrossingnetworks. 648ManagingInvestmentPortfoliosoccursatasinglepriceataprespeci?edpointintime)andcontinuousauctionmarkets(whereorderscanbeexecutedatanytimeduringthetradingday).ExamplesofbatchauctionmarketsaretheopenandcloseofsomestockexchangesandthereopeningoftheTokyoStockExchangeafterthemiddaylunchbreak;atthesetimes,ordersareaggregatedforexecutionatasingleprice.Incontrasttoelectroniccrossingmarkets,auctionmarketsprovidepricediscovery,lesseningtheproblemofpartial?llsthatweillustratedaboveforcrossingnetworks.2.2.2.3.AutomatedAuctions(ElectronicLimit-OrderMarkets)Thesearecomputer-basedauctionsthatoperatecontinuouslywithinthedayusingaspeci?edsetofrulestoexecuteorders.Electroniccommunicationsnetworks(ECNs),suchasIslandandArchipelagoExchangeintheUnitedStatesandtheParisBourseinFrance,areexamplesofautomatedauctionsforequities.Likecrossingnetworks,ECNsprovideanonymityandarecomputer-based.Incontrasttocrossingnetworks,ECNsoperatecontinuouslyand,asauctionmarkets,providepricediscovery.(Followingusualpractice,theacronym‘‘ECN’’isreservedtorefertoelectroniccommunicationsnetworks.)Automatedauctionshavebeenamongthefastest-growingsegmentsinequitytrading.ECNsinparticularhaveblurredthetraditionaldifferencebetweenorder-drivenmarketsandquote-drivendealermarkets.InanECN,itcanbedif?culttodistinguishbetweenparticipantswhoareregulated,professionaldealersandotherparticipantswho,ineffect,arealsoattemptingtoearnspreadpro?tsbyprovidingliquidity.Hedgefundsordaytraders,forexample,mightactivelysupplyliquiditytothemarkettocapturethedealer-likespreadpro?ts.Fromtheperspectiveofaninvestor,theresultisaddedliquidityandtighterspreads.72.2.3.BrokeredMarketsAbrokerisanagentofthebuy-sidetraderwhocollectsacommissionforskillfulrepresentationofthetrade.Thebrokermayrepresentthetradetodealersinthesecurityortothemarketorder?ow.However,thetermbrokeredmarketsrefersspeci?callytomarketsinwhichtransactionsarelargelyeffectedthroughasearch-brokeragemechanismawayfrompublicmarkets.8Typically,thesemarketsareimportantincountrieswheretheunderlyingpublicmarkets(e.g.,stockexchanges)arerelativelysmallorwhereitisdif?cultto?ndliquidityinsize.Consequently,brokeredmarketsaremostlyusedforblocktransactions.Brokerscanhelplocatenaturalcounterpartiestoadif?cultorder—forexample,ablockorder.Ablockorderisanordertosellorbuyinaquantitythatislargerelativetotheliquidityordinarilyavailablefromdealersinthesecurityorinothermarkets.Thetradermightusetheservicesofabrokertocarefullytrytouncovertheothersideofthetradeinreturnforacommission;thebrokermightoccasionallypositionaportionoftheblock.(Topositionatradeistotaketheothersideofit,actingasaprincipalwithcapitalatrisk.)Brokerscanalsoprovideareputationalscreentoprotectuninformedorliquidity-motivatedtraders.Forexample,thebrokermight‘‘shoptheblock’’onlytothosepotentialcounterpartiesthatthebrokerbelievesareunlikelytofront-runthetrade(tradeaheadoftheinitiator,exploitingprivilegedinformationabouttheinitiator’stradingintentions).Theseattributesofbrokeragemarketsfacilitatetradingandhenceaddvalueforallpartiestothetransaction.7Forfurtherreadingonthissubject,seeWagner(2004).8IntheUnitedStates,brokeredequitymarketsweretraditionallyreferredtoasupstairsmarkets.Thereferenceistotradesexecutednotonthe?oorofanexchange(‘‘downstairs’’)butviacommunications‘‘upstairs’’inbrokerage?rms’of?ces. Chapter10ExecutionofPortfolioDecisions649EXAMPLE10-2MarketClassi?cationsAreSimpli?cationsAlthoughitisconvenienttoequatethedealerfunctionwiththeactivitiesofprofessionalmarketmakers,manypartiescananddoperformpartsofthedealerfunction.Asdiscussed,brokerage?rms’‘‘upstair