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.
Implementation shortfall delay (Perold): apply the price drift between the decision time and order arrival to the shares actually executed; cancelled shares feed the missed-trade opportunity-cost term instead.
| Item | Amount | Why |
|---|---|---|
| Decision price | $47.95 | Prior close when Chen made the call |
| Arrival price | $48.15 | Bid–ask midpoint when order hit Park |
| Per-share delay | $0.20 | |
| Executed shares | 900,000 | Filled quantity (300,000 cancelled excluded) |
| **Delay cost** | **$180,000** | |
Applying the delay differential only to the 900,000 executed shares preserves additivity of the IS decomposition (delay + market impact + opportunity cost + fees = total IS) without double-counting the 300,000 cancelled shares already captured in the missed-trade term.
Implementation shortfall delay (Perold): apply the price drift between the decision time and order arrival to the shares actually executed; cancelled shares feed the missed-trade opportunity-cost term instead.
| Item | Amount | Why |
|---|---|---|
| Decision price | $47.95 | Prior close when Chen made the call |
| Arrival price | $48.15 | Bid–ask midpoint when order hit Park |
| Per-share delay | $0.20 | |
| Executed shares | 900,000 | Filled quantity (300,000 cancelled excluded) |
| **Delay cost** | **$180,000** | |
Applying the delay differential only to the 900,000 executed shares preserves additivity of the IS decomposition (delay + market impact + opportunity cost + fees = total IS) without double-counting the 300,000 cancelled shares already captured in the missed-trade term.
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.