Free CFA Level III: Portfolio Management Trade Strategy & Execution Practice Questions
Trade strategy and execution on CFA Level III tests execution algorithms (VWAP, TWAP, implementation shortfall), transaction cost analysis, market microstructure, and best execution policies.
Sample Questions
Question 1
Easy
Alpha decay refers to the concept that:
Solution
C is correct.
Alpha decay is the reduction in the expected alpha of a trade as time passes. Once a manager identifies a trading opportunity, the information advantage erodes as other market participants also discover and trade on the same or similar information. The longer the delay between the investment decision and trade execution, the less alpha remains to capture. This creates urgency to execute quickly, which must be balanced against market impact costs.
Alpha decay is the reduction in the expected alpha of a trade as time passes. Once a manager identifies a trading opportunity, the information advantage erodes as other market participants also discover and trade on the same or similar information. The longer the delay between the investment decision and trade execution, the less alpha remains to capture. This creates urgency to execute quickly, which must be balanced against market impact costs.
Question 2
Medium
Using the data in Exhibit 1, the delay (slippage) component of implementation shortfall on the NTI order, in dollars, is closest to:
Solution
A is correct. In the Perold implementation-shortfall decomposition, the delay (or slippage) cost captures the price drift between the moment Chen made the investment decision and the moment the order reached Park's desk, applied only to the shares that were ultimately executed (the unfilled balance is captured separately in the missed-trade opportunity-cost term). The decision-time price is the prior close of $47.95 and the arrival price is the bid–ask midpoint of $48.15, so the per-share delay is . Multiplying by the 900,000 shares actually filled gives Applying the delay differential to the executed quantity preserves the additivity of the IS decomposition (delay + market impact + opportunity cost + fees = total IS) without double-counting against the missed-trade term computed on the 300,000 cancelled shares.
Question 3
Hard
Considering the full IS decomposition implied by Exhibit 1 together with the algorithm menu in Exhibit 2, the component that contributed the most to total shortfall on the NTI order, and the algorithm change that would most directly address it, is:
Solution
B is correct. Component dollars: delay $180,000, market impact $180,000, missed trade $195,000, explicit $18,000. The missed-trade opportunity cost at $195,000 is the largest single contributor because NTI rallied from $47.95 at decision to $48.60 at close and 300,000 shares went unfilled. The fix targeted at that component is completion risk: a front-loaded IS algorithm accepts incrementally more market impact in exchange for higher fill probability before the price runs, which is exactly the trade-off appropriate when the PM's thesis has enough alpha to justify urgency.