Introduction Until recently, most of financial research focused on the investment decisions. There was a missing part of investment cycle — execution of investment decisions. More over, many investment optimization models assume zero execution cost. But in reality it is not true. Ignoring this fact may lead to significant mistake in estimating investment returns.
Stock exchange mechanism
Overview of stock exchanges The main stock exchanges in the world include: America –American Stock Exchange –NASDAQ –New York Stock Exchange –São Paulo Stock Exchange Europe –Euronext –Frankfurt Stock Exchange –London Stock Exchange –Madrid Stock Exchange –Milan Stock Exchange –Zurich Stock Exchange –Stockholm Stock Exchange
Listing requirements LSE — main market has requirements for a minimum market capitalization of £700,000, three years of audited financial statements, minimum public float of 25 % and sufficient working capital for at least 12 months from the date of listing NASDAQ — to be listed a company must have issued at least 1.25 million shares of stock worth at least $70 million and must have earned more than $11 million over the last three years NYSE — a company must have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last three years
Participants Broker — an individual or firm which operates between a buyer and a seller and usually charge a commission. For most products a licence is required. Dealer — an individual or firm which buys and sells for its own account. Broker/dealer — an individual or firm buying and selling for itself and others. A registration is required. Principal — a role of broker/dealer when buying or selling securities for its own account. Market maker — a brokerage or bank that maintains a firm bid and ask price in a given security by standing ready, willing, and able to buy or sell at publicly quoted prices (called making a market). These firms display bid and offer prices for specific numbers of specific securities, and if these prices are met, they will immediately buy for or sell from their own accounts. Specialist — a stock exchange member who makes a market for certain exchange-traded securities, maintaining an inventory of those securities and standing ready to buy and sell shares as necessary to maintain an orderly market for those shares. Can be an individual, partnership, corporation or group of firms.
Prototypical trading systems Call (periodic) auction — selling stocks by bid at intervals throughout the day. The orders are stored for execution at a single market clearing price. Continuous auction — buyers enter competitive bids and sellers place competitive offers simultaneously. Continuous, since orders are executed upon arrival. Dealership market — trading occur between principals buying and selling to their own accounts. Firm price quotations are available prior to order submission. Auction markets are concentrated and order-driven Dealership markets are fragmented and quote-driven
Examples NYSE — opens with a periodic auction market and then switches to a continuous auction. Same for Tokyo Stock Exchange. NASDAQ and International Stock Exchange (London) are quote-driven systems (continuous dealership market).
Examples Euronext Paris — the market is segmented into a number of different groups of stocks based on size and liquidity. The trading mechanisms vary depending on the segment. Euronext 100, Next 150,CAC40 indices and stocks which have more than 2,500 order book transactions per year — continuous auction. Other stocks — call auction twice a day.
Order types Market order — immediate execution at the best price available when the order reaches the marketplace Limit order — to execute a transaction only at a specified price (the limit) or better Stop order Good till cancelled Fill-or-kill All or None Day order
Limit order book A register for limit buy orders and a registry for limit sell orders. Limit orders are queued for execution against incoming market orders using price then time priority rules. Transparency: how much top orders can be viewed More transparent order book allows to see what is happening in the market and make more accurate forecasts
Limit order book
Cumulative Order Book
Example Euronext Paris — high transparency market: Brokers observe the full limit book at all times Other investors can observe the volume of orders available at the five best prices
Placing orders: How does it work? Exchange Electronic Communications Network Market Maker Firm Internalizes Order Internet order Phone order
Electronic Communication Network ECN is a computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. In order to trade with an ECN, one must be a subscriber. ECN subscribers can enter limit orders into the ECN, usually via a custom computer terminal or a direct dial-up. The ECN will post those orders on the system for other subscribers to view. The ECN will then match contra-side orders for execution. Generally, the buyer and seller are anonymous, with the trade execution reports listing the ECN as the party.
Principal bid A transaction where a broker/dealer provide an investor with guaranteed execution of the trade list at the market prices at a specific point in time. All timing risk is transferred to broker/dealers. Investors are charged a premium for this. Blind bid — investor provides only trade list statistics. Than broker/dealer defines the price.
The spread between Principal and Agency
Models for trade Scheduling 1. Background
Trading cost iceberg
Traders dilemma Market impact is a decreasing function with time and volume. Timing risk is an increasing function with time and volume. So, trading too aggressively will cause investors to incur high market impact cost and low timing risk. Trading too passively means having low market impact cost but high timing risk.
Potential execution strategies Min cost in presence of risk Balance trade off between cost and risk Max probability of price improvement
Market impact Market impact is primarily caused by: Supply-demand imbalance (liquidity needs) Information leakage Market impact could be Temporary — occurs when the order is released but does not alter market’s long-term outlook caused by liquidity demand and immediacy requirements. Permanent — long-term change in price caused by an order.
Market impact bubble Time Price
Temporary market impact Time Price
Permanent market impact Time Price
Long-lived Temporary MI Time Price
Timing risk. Opportunity risk. Timing risk grows from the uncertainty surrounding trading cost estimates. It includes price volatility and instability in volume profiles during a day. Opportunity risk is of not being able to implement investment decision in full. It is caused by insufficient stock liquidity or unfavourable price movement.
Models for trade Scheduling 2. Basic models
Bertsimas and Lo Fixed blocks of shares s=[s 1,…,s n ]’ Fixed finite number of periods T Set of price dynamics: Price = “no-impact” price + linear impact function Find optimal sequence of trade to minimize expected transaction cost
Further improvements Almgren and Chriss (2000) — permanent and temporary impact, efficient frontier of execution. Almgren (2003) — non-linear impact function. Malamut (2002) — instantaneous market impact: pre- calculated aggregate impact value to each period.
Further improvements Kissel and Glantz(2003) — ETF used to define best trading strategies. Concept of a capital trade line (CTL) for mixed trading strategies (agency versus principal bid). Obizhaeva and Wang (2005) — adding supply/demand dynamics. Model includes discrete and continuous trading. Engle and Ferstenberg (2006) — integration of portfolio decision and the execution decision. Hedging the trading risk.
References Almgren, R. and N. Chriss, 2000, Optimal Execution of Portfolio Transactions. Journal of Risk 3, 5-39 Almgren, R., 2003, Optimal Execution with Nonlinear Impact Functions and Trading-enhanced Risk. Applied Mathematical Finance 10, 1-18 Bertsimas, D. and A. W. Lo, 1998, Optimal Control of Execution Costs. J. Financial Markets 1, 1-50. Malamut R., 2002, Multi-Period Optimization Techniques for trade Scheduling, QWAFAFEW presentation Obizhaeva, A. and J. Wang, 2005, Optimal Trading Strategy and Supply/Demand dynamics, NBER working paper Engle, R., and R. Ferstenberg, 2006, Execution Risk, NBER working paper
References Kissel, R. and M. Glantz, 2003, Optimal Trading Strategies. Amacom Bennouri, M., 2005, Auction versus Dealership Markets Madhavan, A., 1992, trading Mechanisms in Securities Markets. The Journal of Finance, vol. XLVII, 2 Comerton-Forde, C. and A. Frino, 2004,The Impact of Limit Order Anonymity on Market Liquidity. SIRCA Working Paper