Inflection Capital Case Scenario (Trade Strategy and Execution)

CFA Level III Portfolio Management
#1

This appears on the CFAI question bank.

Extract of question:

Morrison has been working on executing a sell order to liquidate shares in Acme Industrials (ACME). The closing price on Tuesday was $79.90. Morrison received the order from Wright before the market open on Wednesday morning to sell 50,000 ACME shares with a day limit of $80.00. No part of the order is filled on Wednesday, and the stock closes the day at $79.60. On Thursday morning, Morrison instructed a new day order to sell the 50,000 shares at $79.50; 30,000 shares were sold at $79.50 per share, with resulting commissions and fees for the trade of $0.02 per share. Shares for ACME closed the day Thursday at a price of $79.40 per share. No further attempts were made to sell the unfilled 20,000 shares, which were canceled.

Suggestion solution

The implementation shortfall for the ACME trade is closest to:

A. $8,600.
B. $12,600.
C. $20,600.

Solution

C is correct. The implementation shortfall (IS) is the combination of execution cost, opportunity cost, and fees. Mathematically, IS is calculated as follows:

IS = Paper return – Actual return

The paper return shows the hypothetical return that the fund would have received if the manager were able to transact all shares at the desired decision price and without any associated costs or fees (i.e., with no friction):

Paper return = (Pn−Pd)(S)=(S)(Pn)−(S)(Pd)

where:

S = the total order shares,

S > 0 = a buy order,

S < 0 = a sell order,

Pd = the price at the time of the investment decision, and

Pn = the current price.

The actual portfolio return is calculated as the difference between the current market price and actual transaction prices minus all fees (e.g., commissions):

Actual return = (∑sj)(Pn)−∑sjpj−Fees

where:

sj and pj = the number of shares executed and the transaction price of the jth trade, respectively,

∑sj∑sj = the total number of shares of the order that were executed in the market, and

“Fees” = all costs paid by the fund to complete the order.

IS=∑sjpj−∑sjpdExecution cost+(S−∑sj)(Pn−Pd)Opportunity cost+Fees.

Execution cost = (30,000 × 79.90) – (30,000 × $79.50)

= $2,397,000 – $2,385,000

= $12,000.

Opportunity cost = 50,000 – 30,000 = 20,000 × ($79.90 – $79.50) = $8,000.

Fees = $0.02 × 30,000 = $600.

Total cost = $12,000 + $8,000 + $600 = $20,600.

I could never get 20,600

Closing price (pn) should be 79.40 and Decision price (pd) 79.90

Execution cost = -30,000 x 79.50 - (-30,000 x 79.90) = 12,000

OC = -20,000 x (79.40 - 79.90) = 10,000

EC + OC + Fees = 12,000 + 10,000 + 600 = 22,600

Am I tired or am I just very tired?

#2

Their opportunity cost appears to be wrong; it should be $10,000, not $8,000.

2 Likes
#3

I needed that reassurance. Thanks again…

#4

My pleasure.

1 Like
#5

Why the decision price is 79.90 instead of 80.00?
The decision to sell the stock is made when the price is 80.00. and in the text the definition is “The decision price benchmark represents the security price at the time the portfolio manager made the decision to buy or sell the security”.

Any thoughts? Thank you very much!

#6

We don’t know what the market price was at that time. All we know is that the limit order price was 80.00.

The decision price has to be a market price, not some artificial price created by the person whose effectiveness we’re trying to measure.

#7

So the stock close at 79.90, and manager made the decision to sell the stock before market open.

We should use the market close price as the decision price.
If we have known the pre-market price or the market open price, we use have used that as the decision price?

Thank you S2000magician!

#8

Yes.

My pleasure.

Why do you discount me by 90%?

1 Like
#9

:slight_smile: just made the same mistake as CFAI – didn’t proofread!