FINC6015 Week 3:

Topic: Large traders and market impact costs

Question 1

One year ago, Jack finished his Bachelor of Commerce degree and started working for
Platinum Asset Management as a buy-side analyst. After the first six months, it was
exciting analysing companies to add or remove for one of the active funds “Black
Panther” that Platinum Asset Management was managing. Lately, Jack’s portfolio
manager is not happy with Jack’s performance. So, Jack is actively looking to change
careers ….

The thoughts that are currently running through Jack’s head are …. “How hard could it
be to create my own fund? … I know the basics …. and I’m a pretty smart guy …”

Jack wants to be the boss and run his own fund. How would Jack go about setting up:

- A hedge fund; or
- A mutual fund

When advising Jack, provide him with realistic advice as to how successful he would be
in setting up these funds? In your advice give some factors that he should consider when
going out on his own.

Question 2

You are a broker at Bell Potter Securities Limited. Your client (Reuben) has asked you to
purchase 110,000 shares in Rio Tinto (RIO). The current bid and ask prices are 85.71
and 85.74 respectively. The buy and sell schedules for RIO are as follows:
 Bids Offers
Volume Price Price Volume
26,000 85.71 85.74 38,700
42,500 85.70 85.76 33,500
32,300 85.68 85.77 29,200
10,700 85.65 85.78 21,700
3,600 85.64 85.81 11,300

a. What will be the average traded price if you decide to trade the entire order
immediately?
b. How does this compare with the current market price (i.e. mid-point price)?
c. What will the market price (i.e. mid-point price) be following this trade?
d. What alternative strategies may the trader employ in order to attempt to minimise
this market impact?

Question 3

What additional transaction costs may be incurred by institutional investors as compared

to retail investors? Is there any way to mitigate or reduce these?

Question 4

How does market impact costs relate to:

a) Order size and imbalances

b) Volatility
c) Trading style
d) Market conditions (i.e., liquidity)

Question 5

Why are benchmarks important when trading? Answer with examples of benchmarks we
have used in this course.

Question 6
You have received an order to buy stock in BHP. Over the next two minutes the following
series of trades takes place:

Time Price Quantity

11:15:00 54.40 4,000
11:15:47 54.39 3,200 *
11:16:03 54.40 900
11:16:21 54.40 600
11:16:33 54.40 8,800 *
11:16:39 54.41 2,400
11:16:53 54.42 3,600 *

Your buy trades are marked with “*”.

a. What is the VWAP of your buy transactions for that interval?

b. How do your buy transactions compare with prices traded for BHP during that
interval?
c. Calculate the running VWAP at each point you execute a trade assuming the interval
during which you are assessed begins at 11:15:00.

(Note – it would be recommended to use excel for this)

Question 6

What is the implementation shortfall and how is it calculated?

Question 7

Suppose an investment decision to buy 500 shares on a given security traded. The
implementation details are the following:

X = 500
x1=200 and x2=200
P0 = 20
PT = 22
P1 = 21 and P2 = 21.5
EC = (spread, market impact, operational and market timing opportunity costs)
amount together to $500 or $1 per share.

Based on the information below, calculate the implementation shortfall (IS)?

The mathematical notations for measuring the implementation shortfall for a given trade
in a particular security can be presented as follows.
X = total quantity to execute (total trade size)
xi = number of shares executed at price i
X, xi > 0 for a buy; X, xi < 0 for a sell
P0 = quotation midpoint at the time of the investment decision
PT = quotation midpoint at the end of trading
Pi = execution price of ith trade
EC = all the explicit costs associated with the trade
Question 8

A broker offers the following execution options:

A) They will buy you 15000 shares at $5.55

B) They will aim for VWAP, conditional on:

- They will achieve between 1% better and 1% worse
- They will guarantee to fill between 85-100% of your order

What are the range of IS options given this VWAP and price evolution?

Assuming an even distribution, should you sell for $5.55, or take your chances with
VWAP? Hint – use excel to find calculate these answers

Time Quantity Price

10:00 100 5.60

10:30 400 5.40

11:00 1100 5.50

11:30 3760 5.45

12:00 1240 5.45

12:30 100 5.57

1:00 400 5.47

1:30 400 5.42

2:00 3100 5.52

2:30 3000 5.54

3:00 7000 5.55

3:30 2000 5.56

4:00 18000 5.70