©Schwartz, Sipress, Weber Fall 2008 Slide 1 Topic 9

©Schwartz, Sipress, Weber Fall 2008 Slide 2 1.Beyond P&L 2.Risk measures in trading 3.Transactions cost analysis (TCA) Useful for How to trade-Where to trade- When to trade decisions Role of Alternative trading systems (ATS) Achieving Best Execution Performance Measurement in Trading

©Schwartz, Sipress, Weber Fall 2008 Slide 3 Measures 1.Profits (P&L) 2.Trading “surplus” vs. target price 3.Benchmarks (VWAP, TWAP, …)

©Schwartz, Sipress, Weber Fall 2008 Slide 4 Transaction Cost Analysis (TCA) See SFW text: Pages

©Schwartz, Sipress, Weber Fall 2008 Slide 5 Risk Management 1.Operational and Transfer Risk Technical and human failure 2.Counterparty Risk Who is your trading counterparty? A Central Counterparty (CCP) 3. Market Risk Volatility Pages 332 – 337

©Schwartz, Sipress, Weber Fall 2008 Slide 6 Best Execution Text: Pages

©Schwartz, Sipress, Weber Fall 2008 Slide 7 Performance Measures: P&L Unrealised mark-to-market (9:41-9:55 a.m.): Profit = 20,000  (Bid – 60.00) Partially realised … after position closing trade: Profit = 8,000  (0.10) + 12,000  (Bid – 60.00) Fully realised: Profit = 8,000  (0.10) + 12,000  (0.05) = $1,400 Do we need to risk-adjust our $1,400 ?? – YES! The principal-proprietary trader case

©Schwartz, Sipress, Weber Fall 2008 Slide 8 Institutional Trading Costs/TCA To a retail investor, stock exchanges look like vending machines Institutional-sized buy or sell interest overwhelms the exchange’s trading structures Results: –Institutions avoid active participation in price discovery –Latent demand, illiquidity, and higher trading costs How do large traders get needed liquidity? –Dealer/block trading desk capital –Place anonymous limit orders –Enter into a crossing/ matching network –“Shop” orders and negotiate –Use Not Held (NH) orders –Slice, dice, and shred (Algorithmic trading) –Don’t fully implement their ideas

©Schwartz, Sipress, Weber Fall 2008 Slide 9 Institutional Equities (U.S. Survey) Source: TABB Group Annual Growth Rate +19% +9% +10% +3% ─13%

©Schwartz, Sipress, Weber Fall 2008 Slide 10 Assuming no change in base price: Minimize liquidity impact by slicing- up order and spreading over time Assuming trader expects base price to rise over the next four hours: Pay for liquidity in market Expected shortfall (bps) How Fast to Execute?

©Schwartz, Sipress, Weber Fall 2008 Slide 11 Hyper-Continuous Market 5 minutes: 1 million shares traded in 1,170 trades averaging 682 shares, with a price range of (0.6%)

©Schwartz, Sipress, Weber Fall 2008 Slide 12 Achieving “ Best Execution ” – Difficulties The CFA Institute Trade Management Guidelines: “The Trading Process Most Likely to Maximize the Value of Client Portfolios.” Growing regulatory obligations to demonstrate best execution practices soft and bundled commissions paid by money manager are in investors interests Who’s accountable for trading costs? Bid-ask spread and market/liquidity impact are exchange and sell-side determined BUT delay and opportunity costs are the responsibility of the fund manager Poor selection of a broker …

©Schwartz, Sipress, Weber Fall 2008 Slide 13 Are Trading Commissions for Trading? 95% of US institutional brokers received trading commissions for research and investment-related services (SEC, 1998) 82% of US buy-side report paying “soft dollars” for third-party research and investment-related services (Greenwich Associates, 2004) The average US institutional broker kicks back $1 in products and services to buy-side client for every $1.60 it receives in trading commissions (Greenwich Associates, 2004)

©Schwartz, Sipress, Weber Fall 2008 Slide 14 Trading outcomes need to be assessed relative to risk Performance measurement is not complete without risk measurement Risk measures in trading will depend on: Trader’s role (prop trading, institutional order handling, market maker, …) Time horizon (intraday, daily, quarterly, …) Objective (P&L, minimize transactions cost, timing, …) Risk Measures in Trading

©Schwartz, Sipress, Weber Fall 2008 Slide 15 POSITION 0 TIME e.g., first half of day, short 200, second half long 600 => Average position = ( )/2 = 400 Position size is time-weighted by time it is held Market Maker Risk = Average Absolute Value of Position Position

©Schwartz, Sipress, Weber Fall 2008 Slide 16 POSITION pm TIME Buy-Side Trader Risk = Average Absolute Value of Gap Between Position and Pace 0 1,000 9:30 PACE Position

©Schwartz, Sipress, Weber Fall 2008 Slide 17 POSITION pm TIME Greater Buy-Side Trader Risk: Larger Average Gap Between Position & Pace 0 1,000 9:30 PACE Position

©Schwartz, Sipress, Weber Fall 2008 Slide 18 Trader 1 builds it gradually and has an average gap to the pace position of Trader 2 waits until the end of the day to sell the last 850 and has an average deviation of 248 more risk Traders 1 & 2 Are Trying To Build 1,000 Share Positions Long & Short

©Schwartz, Sipress, Weber Fall 2008 Slide 19 Fund manager gives an instruction to buy 1,000 by the end of the day 12:45 (halfway through the day) fund manager increases the order Target shares (2,000) to acquire by end of day Pace = Position if acquired evenly over the day Pace if original order for 1,000 was not amended Our Measure of Buy-Side Trader Risk: Gap Between Position & Pace

©Schwartz, Sipress, Weber Fall 2008 Slide 20 Risk is Controlled by Staying Within the Collars (Grey Lines) Risk reduced and points added for staying within the collars Risk increased and points lost when outside the collars

©Schwartz, Sipress, Weber Fall 2008 Slide 21 User Total Score = f(three components) = f(VWAP, P&L, Risk) TraderEx’s Composite Metric