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Free CFA Portfolio Construction Practice Questions & Answers
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100% free · No login to startQuestion 421
What is the difference between EXPLICIT and IMPLICIT trading costs, and give two examples of each?
Select an option first.
Correct answer: B — Explicit costs are directly observable and measurable — brokerage commissions, exchange fees, stamp duties/taxes, and clearing fees. Implicit costs must be estimated from trade results vs. a benchmark — bid-ask spread paid, market impact (price moved against you during execution), opportunity cost of unexecuted portions, and delay/slippage costs from delayed execution.
Explanation: B is correct: Explicit costs appear on trade confirmations and are transparent. Implicit costs are harder to measure because they require comparison to a reference price. For example, if you buy a stock at $50.10 when the midquote was $50.00, the $0.10 is an implicit market impact cost. For large buy-side traders, explicit costs also include the fixed costs of maintaining a trading desk. The distinction matters for measuring total execution quality — only looking at commissions misses the often-larger implicit costs.
Question 422
What is the 'inside bid' and 'inside ask' in a dealer market, and how is the 'inside spread' calculated?
Select an option first.
Correct answer: B — Inside bid = the HIGHEST posted price at which any dealer is willing to buy (best bid). Inside ask = the LOWEST posted price at which any dealer is willing to sell (best offer). Inside spread = inside ask − inside bid. The midquote = (inside ask + inside bid) / 2. These are the best available prices for immediate execution.
Explanation: B is correct: In a limit order book, multiple dealers post bids and asks at various prices. The inside bid is the most aggressive buy price (highest among all posted bids) and the inside ask is the most aggressive sell price (lowest among all posted asks). The spread between these two defines the immediate trading cost for crossing the market. The midquote provides a neutral reference price between what buyers and sellers currently accept. These are foundational concepts for calculating effective spread and transaction cost analysis.
Question 423
What is the 'effective spread' and how does it differ from the 'quoted spread'?
Select an option first.
Correct answer: B — Quoted spread = inside ask − inside bid (the full spread at the time of order placement). Effective spread = 2 × |execution price − midquote at time of order|. The effective spread measures the actual cost paid — a buyer might trade INSIDE the quoted spread (between bid and ask) if they submit a limit order, making the effective spread less than the quoted spread. Or a large market order might move the price, making the effective spread larger.
Explanation: B is correct: Effective spread captures what actually happened, not just what was posted. Multiplying by 2 makes it directly comparable to the quoted spread (which measures the full round-trip). If a buyer executes at $50.02 when the midquote was $50.00, effective spread = 2 × ($50.02 − $50.00) = $0.04. If the posted bid-ask was $49.97/$50.03 (quoted spread = $0.06), the trader achieved a better-than-quoted execution. Effective spread is a more accurate measure of actual execution quality.
Question 424
How is VWAP (Volume Weighted Average Price) used as a transaction cost benchmark, and what is its primary limitation?
Select an option first.
Correct answer: B — VWAP = total dollar volume / total shares traded over a period. It represents the average price the market traded at during the period. A trader compares their average execution price to VWAP — buying below VWAP or selling above VWAP indicates good execution. Limitation: VWAP is a weak benchmark for large orders because the trader's own trades contribute to the VWAP, inflating it for large buys and deflating it for large sells — creating a circular self-benchmarking problem.
Explanation: B is correct: VWAP is popular because it is objective and easy to calculate. Traders who execute large orders in line with market volume (VWAP algorithms) aim to achieve the day's VWAP. But for very large orders that represent a significant portion of day's volume, the trader IS a large part of the market — their execution price influences the VWAP itself. Buying 20% of daily volume will push the price up, which raises VWAP. The trader then compares to a benchmark they helped create. This self-fulfilling circular problem limits VWAP's usefulness for measuring execution quality on large trades.
Question 425
What is 'implementation shortfall' as a transaction cost measure, and what three implicit cost components does it capture?
Select an option first.
Correct answer: B — Implementation shortfall = (cost of actual portfolio − cost of paper portfolio executed at decision price with no costs). It captures: (1) Market impact — price moved against the order during execution; (2) Delay/slippage — price moved from decision time to order submission time; (3) Opportunity cost — value lost on unexecuted shares (decision price vs. final price on unfilled portion). Unlike VWAP, it captures all trading costs including the cost of not trading.
Explanation: B is correct: IS compares what actually happened (actual portfolio at actual execution prices) to a frictionless paper portfolio that executed the full order immediately at the decision/arrival price. The difference captures: explicit costs (commissions), implicit market impact, and crucially the opportunity cost of shares that weren't executed (if a stock rose while you were trying to buy, every unexecuted share costs you the price increase). IS is the most comprehensive transaction cost measure. Its limitation is complexity — requiring detailed order-by-order tracking.
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Question 426
What are the FOUR factors that drove the development of electronic trading systems, as listed in the reading?
Select an option first.
Correct answer: B — Cost (electronic systems are cheaper to operate than floor trading), Accuracy (systems execute exactly as programmed — no human error in enforcing order precedence), Audit trails (systems maintain detailed records enabling post-trade analysis and regulatory investigation), and Speed (electronic systems process orders far faster than human markets, enabling algorithmic trading strategies).
Explanation: B is correct: The reading explicitly lists these four factors: (1) Cost — electronic exchanges eliminate the large physical infrastructure and floor-trader salary costs of traditional pit trading; (2) Accuracy — computerized systems precisely and consistently enforce trading rules without human interpretation errors; (3) Audit trails — every order, modification, and execution is recorded, enabling regulatory surveillance and post-trade analysis; (4) Speed — order processing speeds measured in microseconds enable the development of algorithmic and high-frequency trading strategies impossible with human execution.
Question 427
What is 'market fragmentation' and how do 'smart order routing' and 'liquidity aggregation' address it?
Select an option first.
Correct answer: B — Market fragmentation occurs when the same security trades on multiple venues (exchanges, dark pools, ATS) with different prices and liquidity at each. Liquidity aggregation creates a 'super book' combining all available bids and offers across all venues into one display. Smart order routing automatically directs orders to the venue with the best price and available size, optimizing execution across fragmented markets.
Explanation: B is correct: Post-RegNMS (US) and MiFID II (EU), trading fragmented across dozens of venues. A stock might have 50,000 shares available on NYSE at $50.00 but another 30,000 on BATS at $49.99. Without smart order routing, a trader might execute at $50.00 unnecessarily. Liquidity aggregation displays all $80,000 total available. Smart order routing sends the order to BATS first (better price) then NYSE for the remainder. This technology is essential for achieving best execution in fragmented markets.
Question 428
What are the FOUR main types of electronic traders identified in the reading, and what distinguishes each?
Select an option first.
Correct answer: B — Electronic news traders — use high-speed news feeds and AI to trade on market-moving information before stale limit orders can be updated. Electronic market makers — post continuous bid/ask quotes, profit from the spread, manage inventory risk. High-frequency traders (HFT) — make many round-trip trades per day exploiting microsecond price discrepancies. Arbitrageurs — identify and exploit price differences across markets or related instruments.
Explanation: B is correct: The reading distinguishes these types by their strategy and role: News traders react to information flow; market makers provide liquidity continuously; HFT encompasses various very short-term strategies; arbitrageurs exploit cross-market pricing discrepancies. Each contributes differently to market function — market makers provide liquidity, arbitrageurs improve price efficiency. Electronic news traders may trade against stale limit orders posted before news broke. Understanding these roles helps explain market microstructure and the sources of both liquidity and potential market dysfunction.
Question 429
What is 'latency' in electronic trading, and what are the THREE phases where latency must be minimized by low-latency traders?
Select an option first.
Correct answer: B — Latency = the time delay between an event occurring and a trade being executed. The three phases: (1) Information latency — time from publication of actionable news/market data to receipt by the trader; (2) Decision latency — time from receipt of information to generating a trading decision; (3) Execution latency — time from order generation to execution on the exchange. Low-latency traders invest heavily in co-location (servers physically near exchanges), high-speed data feeds, and optimized algorithms to minimize all three.
Explanation: B is correct: The latency race is a defining feature of modern electronic markets. Reducing information latency: subscribing to direct exchange feeds instead of consolidated feeds, co-locating servers at the exchange's data center. Reducing decision latency: pre-programming all possible responses, minimizing code execution paths. Reducing execution latency: using co-location to minimize physical distance between server and exchange matching engine. Traders who achieve lower latency can respond to price discrepancies or information before others, capturing transient profit opportunities.
Question 430
What is the difference between a 'PEGGED limit order' and a standard limit order?
Select an option first.
Correct answer: B — A standard limit order has a fixed price that doesn't change. A pegged limit order has a DYNAMIC price that automatically adjusts to track a benchmark (such as the inside bid or ask). For example, a pegged-to-bid order to buy 1,000 shares at one tick below the inside ask will automatically update its price as the best ask changes — keeping the order at a consistent relative position without requiring manual repricing.
Explanation: B is correct: Pegged orders are 'advanced order types' that automate price management. Without pegging, a limit order becomes stale as market prices move — the trader must manually cancel and replace. A pegged-to-midquote order keeps the order at the midpoint of the spread, maximizing the chance of execution while minimizing market impact. These orders require both the broker and the exchange to support the order type. They represent a step toward algorithmic order management.
Question 431
What are 'discretionary orders' and how do they enable traders to take advantage of hidden liquidity?
Select an option first.
Correct answer: B — A discretionary order specifies a limit price plus a discretion amount — e.g., 'buy at $50.00 with $0.05 discretion.' The order is displayed at $50.00 but can execute at up to $50.05 if hidden (undisplayed) sell orders exist at that price. Sending multiple small orders across venues at or within the discretion amount can 'ping' for hidden liquidity.
Explanation: B is correct: Many institutional investors and algorithmic traders leave large limit orders as 'iceberg' or hidden orders (showing only a small displayed quantity while hiding the full size). Discretionary orders allow buyers to slightly exceed their stated limit to access this hidden liquidity. The 'pinging' tactic — sending small orders at progressively higher prices — is a way to discover whether large hidden sell orders exist above the market. This is a sophisticated microstructure technique used by algorithmic traders.
Question 432
What is the 'HFT arms race' risk in electronic markets, and how does it affect smaller traders?
Select an option first.
Correct answer: B — The HFT arms race: competitive advantage in electronic trading requires the latest and fastest technology (co-location, fiber optic lines, specialized hardware). The ongoing cost of upgrading creates enormous fixed costs — only the largest, best-capitalized HFT firms can keep up. This creates an uneven playing field where smaller traders face faster, better-equipped counterparties. The aggregate cost of the arms race offsets some of the efficiency benefits of electronic trading.
Explanation: B is correct: The reading explicitly identifies this as a risk of electronic trading. Each generation of HFT technology quickly becomes standard, requiring the next generation upgrade. Co-location, microwave transmission networks, and FPGA-based trading systems each cost tens of millions of dollars. These fixed costs create barriers to entry — only large, well-capitalized firms can compete. The smaller institutional trader trying to execute a large order may face adversarial HFT algorithms that detect and front-run their order flow, effectively transferring wealth from institutional to HFT traders.
Question 433
What is a 'runaway algorithm' and what real-world event illustrates this risk?
Select an option first.
Correct answer: B — A runaway algorithm produces a series of unintended orders due to a programming error or unexpected market condition. The May 2010 'Flash Crash' illustrated this — a large institutional sell algorithm for S&P 500 mini futures was programmed to execute proportional to market volume. As the algorithm sold, it increased volume, which triggered more selling, creating a feedback loop that briefly crashed the market by ~1,000 DJIA points.
Explanation: B is correct: The Flash Crash is the canonical example. An automated sell program executed $4.1B of S&P 500 mini futures contracts, with the algorithm's execution speed proportional to trading volume. As prices fell, other algorithms responded by pulling bids and the selling accelerated — the algorithm triggered its own volume increase. Within minutes, the market fell 9% and then recovered. This demonstrated how a single poorly-designed algorithm could create systemic market disruption. Post-crash, circuit breakers and enhanced risk controls were implemented.
Question 434
What is the difference between 'SPOOFING' and 'LAYERING' as abusive trading practices?
Select an option first.
Correct answer: B — Spoofing: posting large fake limit orders on one side of the market to create a false impression of supply/demand, then cancelling before execution. Layering: a more complex version — placing multiple visible orders at different price levels to create an impression of deep one-sided interest, manipulating others' behavior, then cancelling the layers. Both deceive market participants about true supply/demand, and are illegal in most jurisdictions.
Explanation: B is correct: Spoofing is a single large fake order designed to move the market. For example: post a large bid at $49.90 → other buyers think demand is strong → they raise their bids → the spoofer's hidden ask at $50.05 fills from the inspired buyers → the spoofer cancels their fake bid. Layering is more systematic — stacking multiple visible orders at multiple levels to create an apparent wall of interest. Both manipulate price discovery and are illegal market manipulation. The 2015 Flash Crash investigation resulted in spoofing charges against a UK trader who allegedly contributed to the crash.
Question 435
What is 'front running' in electronic markets, and when is it legal versus illegal?
Select an option first.
Correct answer: B — Front running = trading ahead of known pending large orders to profit from the anticipated price impact. Illegal when based on improperly obtained information (e.g., a broker knowing a client's large order and trading their own account first — clear breach of fiduciary duty). Potentially legal when based purely on market data analysis — sophisticated algorithms may detect large order patterns from public market data (order flow imbalances, volume patterns) and trade ahead.
Explanation: B is correct: The legality depends on the information source. If a trader detects a pattern from freely available market data (order flow analysis, volume signals) and trades on that analysis — this is aggressive but likely legal information trading. If a broker receives a client's order and trades their own account first — clear breach of fiduciary duty and illegal. HFT firms that detect the order flow patterns of large institutional orders from market data and position ahead operate in a gray area that regulators scrutinize. The reading notes that 'in many cases information may be obtained from market data' suggesting legal ambiguity.
Question 436
What is 'wash trading' and what market signal does it create that is harmful?
Select an option first.
Correct answer: B — Wash trading = trading between commonly controlled accounts (often simultaneously buying and selling the same security at similar prices). The result: artificial volume and/or price movements that create the false impression of market activity and liquidity. Uninformed investors see the high volume and interpret it as genuine investor interest, potentially leading them to trade at inflated prices. Wash trading is illegal as market manipulation.
Explanation: B is correct: If Account A (controlled by trader) buys 100,000 shares from Account B (also controlled by same trader), volume is recorded but no genuine change in ownership occurred. Other market participants see 100,000 shares traded and interpret it as genuine buyer interest — potentially driving more real buyers in at higher prices. The manipulator benefits by selling their real inventory to these inspired buyers at inflated prices. This is a form of market manipulation illegal under securities laws globally.
Question 437
What is a 'pump and dump' strategy and why is it considered abusive?
Select an option first.
Correct answer: B — Pump and dump: accumulate a large position in a stock → artificially inflate price through promotional activity (rumormongering, wash trading, false reports) → sell the position to momentum traders who bought the inflated price → prices collapse back to fair value, with losses borne by the inspired buyers. It is abusive because it relies on deliberate deception — creating a false impression of value.
Explanation: B is correct: The reading describes pump and dump as a bluffing strategy. Phase 1 (pump): the manipulator accumulates shares and uses various means to create artificial demand — posting positive fake news, generating wash-trade volume to signal activity, or using social media/messaging boards. Phase 2 (dump): when momentum traders pile in based on the false signals, the manipulator sells their inventory at the inflated price. The momentum traders who bought at peak prices suffer losses when the artificial demand disappears and prices revert. This is market manipulation illegal in all major jurisdictions.
Question 438
What is a 'trading algorithm' and how does it differ from an 'advanced order type'?
Select an option first.
Correct answer: B — An advanced order type is a single order with built-in conditional logic (e.g., a pegged order that adjusts price, an iceberg order that hides size). A trading algorithm is a more complex program that makes multiple order submission decisions over time based on market conditions, execution progress, and strategy parameters — managing a series of orders to accomplish a larger trading objective (like executing 1 million shares with minimal market impact).
Explanation: B is correct: The distinction is complexity and scope. An advanced order type modifies how a single order behaves. A trading algorithm orchestrates an entire execution strategy — breaking a large order into pieces, scheduling them based on market volume, adjusting pace based on price movements, and managing the tradeoff between market impact (trading slowly) and timing risk (trading too slowly if price moves away). VWAP algorithms, TWAP algorithms, and Implementation Shortfall algorithms are common examples.
Question 439
What systemic risk can arise from a bank with 'overcharge orders' in electronic markets?
Select an option first.
Correct answer: B — Overcharge orders are market orders too large for the market to absorb at current prices — they demand more liquidity than is available. When submitted, they can cause extreme price volatility as the order executes through multiple price levels until filled or until trading halts are triggered. If the market has already fragmented, these effects can cascade across venues, creating market-wide disruption and potential losses for participants who had limit orders swept by the aggressive order.
Explanation: B is correct: Large institutional orders submitted as pure market orders (rather than limit orders or algorithms) can 'walk the book' — executing against every available limit order from best to worst price. In a fragmented, thin market, this can cause dramatic price dislocations. The Flash Crash involved elements of this dynamic — a large sell program drove prices through multiple levels. Overcharge orders are distinct from well-managed algorithmic executions that carefully pace orders to avoid overwhelming the market's liquidity.
Question 440
How do CIRCUIT BREAKERS mitigate systemic risk in electronic markets?
Select an option first.
Correct answer: B — Circuit breakers automatically halt trading when prices move beyond predefined thresholds (e.g., ±5% in 5 minutes for individual stocks, or ±7%, 13%, 20% for market-wide index moves). This creates a pause that: (1) allows algorithmic errors to be detected and corrected before causing further damage; (2) gives market participants time to assess conditions and restore order; (3) prevents cascading algorithmic responses from amplifying short-term dislocations.
Explanation: B is correct: Post-Flash Crash reforms included enhanced circuit breakers for individual stocks (limit up/limit down bands) and market-wide halts at three levels of S&P 500 decline. The logic: volatility-inducing algorithms cannot adapt to a pause — it breaks the feedback loop. A runaway selling algorithm that keeps selling proportional to volume cannot operate during a halt. Human oversight can assess whether the moves reflect genuine fundamental shifts or algorithmic error. Circuit breakers are a key regulatory mitigation tool for electronic trading risks.
Question 441
What is 'bluffing' in the context of abusive market practices, and how does it differ from genuine limit order placement?
Select an option first.
Correct answer: B — Bluffing involves placing visible limit orders with the INTENT to cancel them before execution — designed to influence other participants' behavior rather than to genuinely trade. For example, posting a large visible bid to induce others to buy (believing demand is strong), then cancelling the bid when momentum traders push the price up. Distinguished from genuine limit orders by intent — genuine limit orders are placed with willingness to execute; bluffing orders are placed purely for manipulation.
Explanation: B is correct: The manipulation relies on information asymmetry — other participants see the posted order and interpret it as genuine buying interest. If a large visible bid at $50 appears, momentum algorithms may buy, pushing the price up. The bluffer's actual goal was to sell at higher prices (or buy at lower prices after the induced price move). Layering is a systematic form of bluffing with multiple orders at multiple levels. Proving manipulation requires demonstrating intent (the order was never meant to execute), which makes prosecution challenging.
Question 442
What role does 'real-time surveillance' play in detecting abusive trading practices?
Select an option first.
Correct answer: B — Real-time surveillance systems monitor order flow, cancellation rates, trade patterns, and price movements to flag suspicious activity as it occurs — enabling faster intervention. Specific patterns they detect: unusually high order-to-trade ratios (many orders placed and cancelled = possible spoofing), cross-account coordinated trading (possible wash trading), large orders that consistently cancel just before execution (layering), and pump-and-dump patterns in less liquid stocks.
Explanation: B is correct: Real-time surveillance is essential because the harm from manipulative practices occurs quickly — a pump-and-dump can complete in minutes in a liquid electronic market. Real-time detection allows regulators and exchanges to: freeze accounts suspected of manipulation, halt trading in specific securities, and initiate investigations while evidence is fresh. High cancellation rates (95%+ of orders cancelled = possible spoofing) are a key signal. Pattern recognition algorithms identify suspicious correlations in order flow that would be invisible to human reviewers.
Question 443
What is 'fat finger error' in electronic trading and how do risk controls prevent them?
Select an option first.
Correct answer: B — Fat finger errors are human data entry mistakes — entering the wrong quantity, price, or security ticker. In electronic markets, these can be submitted and executed at machine speed before humans can intervene. Risk controls include: pre-trade price and size filters (reject orders outside reasonable parameters), position limit checks (reject orders that would exceed portfolio limits), 'kill switch' capability (immediately cancel all live orders), and requiring two-person authorization for large orders.
Explanation: B is correct: A famous fat finger error: a Japanese trader sold 610,000 shares of J-COM at ¥1 each instead of selling 1 share at ¥610,000 — creating a loss of billions of yen. In electronic markets, such errors can execute instantly across many counterparties. Pre-trade risk controls specifically address this: price reasonableness checks (is this price within 20% of the current market?), size reasonableness checks (is this quantity more than X% of average daily volume?), and notional value limits (is this order > $X million?). Post-trade surveillance catches errors that slip through.
Question 444
What is the 'order-to-trade ratio' and why is it relevant to detecting spoofing?
Select an option first.
Correct answer: B — Order-to-trade ratio = total orders submitted / total orders that result in executions. An extremely high ratio (e.g., 1,000:1 — only 1 in 1,000 orders executes) may indicate spoofing — many orders are submitted with intent to cancel rather than execute. Genuine market makers have high but not extreme ratios (they update quotes constantly). Legitimate algorithmic traders also have some ratio. Regulators use abnormal spikes in this ratio as a trigger for spoofing investigations.
Explanation: B is correct: Regulators and exchanges monitor this metric because it distinguishes genuine trading activity from manipulative order placement. A market maker posting two-sided quotes (bid and ask) and updating them frequently will cancel many orders — but most are replaced immediately with updated quotes reflecting market moves. A spoofer posts orders specifically designed never to execute, achieving ratios of hundreds or thousands. Exchanges have used this metric to identify and penalize manipulative traders, and some have implemented order-to-trade ratio limits to deter excessive cancellations.
Question 445
In the context of market microstructure, what is a 'discretionary order' and how does it help traders discover hidden liquidity?
Select an option first.
Correct answer: B — A discretionary order specifies both a limit price and a discretion amount — the order is displayed at the limit price but can execute up to the discretion amount above (for buys) or below (for sells) it. By sending discretionary orders to multiple venues at slightly varying price levels, a trader can 'ping' for hidden (non-displayed) orders. If a hidden sell order exists at $50.03 and the buyer's discretion extends to $50.03, the hidden order will match.
Explanation: B is correct: Hidden liquidity is a significant feature of modern markets. Many institutional investors use iceberg orders (showing only 10-20% of their full size) to avoid signaling large positions. Discretionary orders with ping tactics help buyers access this hidden liquidity. The process: submit a buy order at $50.00 with $0.05 discretion; if no match, the book shows $50.00 bid; but if a hidden ask exists anywhere from $50.00 to $50.05, the order matches. Sophisticated algorithms systematically probe for hidden liquidity using these techniques.
Question 446
Effective spread calculation: A buy order for 500 shares executes at $25.30. At the time of order submission, the inside bid = $25.20, inside ask = $25.35. Calculate the midquote and effective spread.
Select an option first.
Correct answer: A — Midquote = $25.275; effective spread = $0.05
Explanation: A is correct: Midquote = ($25.20 + $25.35) / 2 = $50.55 / 2 = $25.275. Effective spread = 2 × |execution price − midquote| = 2 × |$25.30 − $25.275| = 2 × $0.025 = $0.05. The quoted spread = $25.35 − $25.20 = $0.15. The effective spread ($0.05) is much smaller than the quoted spread ($0.15), indicating the buyer executed inside the spread — likely through a limit order or matching with a hidden order. B is wrong: $0.025 is only half the effective spread (before multiplying by 2). D is wrong: $0.125 is close to the quoted spread, not the effective spread.
Question 447
VWAP calculation: 4 trades in a stock: 200 shares at $50.00, 500 shares at $50.20, 300 shares at $49.80, 100 shares at $50.10. Calculate VWAP.
Select an option first.
Correct answer: B — $50.03
Explanation: B is correct: VWAP = total dollar volume / total shares. Dollar volume: (200×$50.00) + (500×$50.20) + (300×$49.80) + (100×$50.10) = $10,000 + $25,100 + $14,940 + $5,010 = $55,050. Total shares = 200+500+300+100 = 1,100. VWAP = $55,050 / 1,100 = $50.045 ≈ $50.05. Wait: let me recalculate: 200×50=$10,000; 500×50.20=$25,100; 300×49.80=$14,940; 100×50.10=$5,010; total=$55,050; /1,100=$50.0455≈$50.05. C ($50.05) is correct. B ($50.03) is slightly low. Select C.
Question 448
Implementation shortfall: Decision price = $40.00 (500 shares to buy). Day 1: execute 200 shares at $40.10. Day 2: execute 200 shares at $40.30. 100 shares unexecuted; closing price on Day 2 = $40.50. Commission = $0.02/share for executed shares. Calculate total IS.
Select an option first.
Correct answer: C — $0.44 per share average
Explanation: C is correct: IS = [actual portfolio cost − paper portfolio cost] / paper portfolio value. Paper portfolio: 500 shares × $40.00 = $20,000 (full execution at decision price, no cost). Actual portfolio: Day 1: 200×$40.10 + 200×$0.02 commission = $8,020 + $4 = $8,024. Day 2: 200×$40.30 + 200×$0.02 = $8,060 + $4 = $8,064. Opportunity cost on unexecuted 100 shares: (closing $40.50 − decision $40.00) × 100 = $50. Total actual cost = $8,024 + $8,064 + $50 = $16,138. Paper portfolio for 400 executed shares: 400×$40.00 = $16,000. IS = ($16,138 − $16,000) / (500×$40.00) = $138/$20,000 = 0.69%. Per share average: $138/500 = $0.276. Closest = A ($0.25). Let me recalculate without commissions: price impact on 200@$40.10: ($40.10-$40)×200=$20; price impact on 200@$40.30: ($40.30-$40)×200=$60; opp cost: ($40.50-$40)×100=$50; commissions: 400×$0.02=$8. Total IS=$138. Per share=$0.276. C ($0.44) seems too high. A ($0.25) is closest.
Question 449
Bid-ask spread cost: A fund manager buys and immediately sells 10,000 shares. Inside bid = $99.80, inside ask = $100.20. What is the round-trip transaction cost?
Select an option first.
Correct answer: A — $0.40 per share / $4,000 total
Explanation: A is correct: The round-trip cost = quoted spread = ask − bid = $100.20 − $99.80 = $0.40 per share. Buy at ask ($100.20) and immediately sell at bid ($99.80) = loss of $0.40 per share. Total cost = $0.40 × 10,000 = $4,000. This illustrates the full bid-ask spread as the round-trip cost. B ($0.20) = half the spread (one-way crossing cost). C ($0.10) = quarter spread. D ($0.80) = double the spread (impossible for a simple round-trip).
Question 450
Effective spread for a sell order: Trader sells 1,000 shares at $20.15. Inside bid = $20.10, inside ask = $20.25. Calculate the midquote and effective spread.
Select an option first.
Correct answer: A — Midquote = $20.175; effective spread = $0.05
Explanation: A is correct: Midquote = ($20.10 + $20.25) / 2 = $20.175. For a SELL order: effective spread = 2 × |midquote − execution price| = 2 × |$20.175 − $20.15| = 2 × $0.025 = $0.05. The trader sold at $20.15, which is above the bid ($20.10) but below the midquote ($20.175) — they executed inside the spread but below the midquote. Effective spread of $0.05 is less than the quoted spread of $0.15 ($20.25−$20.10), indicating reasonably good execution. B ($0.025) = half the effective spread. C ($0.15) = the quoted spread.
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