VWAP vs. Implementation Short Fall Under what circumstances should we use these? Can someone who has this down care to provide any tips?
i don’t have these down pat but it helps to know that a major difference between them is that VWAP can be gamed where as ISF cannot, so that’s a reason you would use ISF over VWAP. Also, ISF breaks up the cost of trading into different components so it’s easier to analyze where your costs are coming from, allowing it to be a bigger part of the investment management process rather than simply a trading process. someone posted a youtube link on ISF, you should be able to find it if you do a search.
VWAP should not be used when your trade dominates the average volume so more suitable for small trades Implementation shortfall helps you analyze all those 4 cost components - explicit, opportunity … hence suitable to analyze the trade impact. Can be used when you want to mininimize these costs like opportunity cost in specific. Your trade will be filled earlier in the day ensuring execution.
The easiest way to see the difference is to compare it to IS, which shows ALL the costs of trading and can’t be gamed. IS will show you: 1. Explicit Costs 2. Realized Gain/Loss 3. Delay Costs 4. Opportunity Costs The actual results have to be compared to the ideal paper portfolio to calculate the above costs. VWAP doesn’t not address delay costs or opportunity costs which is part of what leads to gaming. Basically VWAP is what it says - Volume weighted Average Price. If your price is less (for a buy order) then supposedly you did your job as a trader, but it is flawed.
Here are a few other thoughts that I dug up: VWAP is unsuitable for trades with: 1) High Urgency 2) Large size of trade relative to volume of order 3) Large Bid-Ask spread Implementation Shortfall is unsuitable for: 1) Higher volumes towards the end of the day 2) Large Bid-Ask Spreads 3) Low Urgency
FastEd Wrote: ------------------------------------------------------- > Here are a few other thoughts that I dug up: > > VWAP is unsuitable for trades with: > > 1) High Urgency > 2) Large size of trade relative to volume of > order > 3) Large Bid-Ask spread > > Implementation Shortfall is unsuitable for: > > 1) Higher volumes towards the end of the day > 2) Large Bid-Ask Spreads > 3) Low Urgency You are talking VWAP and IS strategies here right, Ed?
you should just focus mainly on the fact that vwap focuses on PRICE and implementation shortfall focuses on getting the trade executed. for me it’s like the tradeoff between limit prices and market prices. depending on that you can tell how would use what strategy
mwvt9 - yes I am. This is directly out of the guideline answer for the 2008 morning exam.
VWAP executes orders when a security is trading below the VWAP. Most of the trades end up occurring later in the day because the VWAP is uncertain early on in a trading day. The potentially delayed trading makes this strategy unsuitable for strategies that need to be executed quickly. Also, the VWAP measure isn’t a good gauge of profitable trading when the trade is large because it dominates the VWAP measure. IS strategies trade quickly in order to minimize delay/opportunity costs of trading. The emphasis on quick execution makes this unsuitable for low-urgency trades. Also, if higher volume is present at the end of the day you don’t want to use IS because it will push the order through at times of illiquidity earlier in the trading day. Neither strategy is suitable for very illiquid securities, they should be traded using other strategies (ie via broker).
I thought with VWAP the trades occur relatively evenly throughout the day in an attempt to have execution equal VWAP.
With TWAP, trading is spread out evenly over the course of the day. VWAP is spread out over the course of a day, but not necessarily evenly (not necessarily late in the day, but later than an IS strategy). It uses spreads the order out in order to meet or outperform the VWAP. Early in the day, a model is used to predict trading volume later in the day. When it’s used to measure transaction costs, VWAP can be gamed by trading later in the day.
1 Like
When the VWAP vs Imp Shortfall question came up on the exam last year, I looked at the problem and said “I have no f-ing idea how to answer this at all.” I think I just guessed at the things you circle and hoped for the best. There was that, and one other problem in the AM (I think the one about portfolio insurance vs constant mix) where I was pretty clueless. Actually, on the portfolio insurance vs constant mix, I wasn’t completely clueless (as I was with the VWAP vs IS one), I was just too frazzled at the end of the test to remember the stuff correctly. Those two problems scared the cr*p out of me after the AM. I was so freaked out that I started having trouble with the simple cash-and-carry problem at the end.
This has been a helpful thread, thanks. I was unsure about the right algorithmic strategy with a large bid/ask spread, but what I’ve gathered here is that any algorithmic trading strategy is inappropriate with a large B/A spread, and other trading strategies should be used (i.e. broker, crossing network).
Ah, thanks McLeod.
bchadwick I felt exactly the same way. The CPPI one freaked me out too. I had no idea, and then the time pressure!!! Also, in the afternoon, the break even and the fx q did the same for me. Did you get it at all ?
bchadwick Wrote: ------------------------------------------------------- > When the VWAP vs Imp Shortfall question came up on > the exam last year, I looked at the problem and > said “I have no f-ing idea how to answer this at > all.” I think I just guessed at the things you > circle and hoped for the best. There was that, > and one other problem in the AM (I think the one > about portfolio insurance vs constant mix) where I > was pretty clueless. Actually, on the portfolio > insurance vs constant mix, I wasn’t completely > clueless (as I was with the VWAP vs IS one), I was > just too frazzled at the end of the test to > remember the stuff correctly. > > Those two problems scared the cr*p out of me after > the AM. I was so freaked out that I started > having trouble with the simple cash-and-carry > problem at the end. Funny to me you vets thought trading strategies were hard, but reverse cash and carry easy. That futures problem might as well be written in Greek for me.
derswap07 Wrote: ------------------------------------------------------- > bchadwick > > I felt exactly the same way. The CPPI one freaked > me out too. I had no idea, and then the time > pressure!!! > > Also, in the afternoon, the break even and the fx > q did the same for me. Did you get it at all ? I don’t remember much about the afternoon session, other than the socially responsible investing question and the fact that they snuck some FCFF/FCFE questions in there that I wasn’t expecting because I thought we were done with that at L2 (they worked it in by calling it “economics”). I don’t remember break even and fx… oh wait… yes, I do. I forget how the question was worded, but I do remember that I got it wrong because I forgot to take into account the RFR and I was kicking myself silly for making such a simple mistake. My main memories of the PM section last year are that 1) most of the questions were deceptively easy, especially after the complete mind frak that was the AM session, and 2) the ethics questions were way weirder than any I’d ever encountered on any practice exam, L1, or L2. I don’t remember what made them weird, but they definitely were.
Analyse in this order: Size of the trade (large principal/broker and small VWAP/IP) Urgency (high IS and low VWAP) Spread (high principal/brokerage and low VWAP/IP)
I know that this is late–but did you mean TWAP, not VWAP, gets trades made evenly during the day?