Execution risk

Most IRD strategies in the workbook have more than one leg: buy the bond and sell the future, sell one month and buy the next, buy one bond future and sell another. On paper the legs happen together. In a real market they are separate orders, and execution risk is what can go wrong in between.

The workbook uses the idea in three places.

1. Arbitrage. Even if systems are seamless and both legs are liquid, there is a possibility of some gap between the executions of both the orders. If either leg is illiquid, the risk is huge: only one leg may get executed, leaving the arbitrager with a naked exposure.
2. Spreads. Entering a calendar spread as two orders carries the risk that the price moves between placing both the orders, i.e., execution risk, plus a higher margin until the second order fills. Spread order facilities provided by exchanges avoid it.
3. The investor's risk disclosure. The buy or sell order may not get executed at the desired price due to higher price volatility or due to the type of order placed. This may result in slippages.

Where it comes from and what reduces it.

How the spread order book removes the gap. A spread contract such as 6.10% GOI 2031 OCT21NOV21 trades the difference between the far and near month. Orders are matched on price-time priority, where price is that difference. Once matched, the first leg trades at the reference price (the first leg's last traded price) and the second leg at the reference price plus the price difference. Both legs execute together, so the spread you agreed is the spread you get.

Frictions are separate. The workbook adds that its strategy examples ignore brokerage, stamp duty, margin cost and impact cost, which must be counted before entering a trade.

Execution versus settlement. In Chapter 7 the workbook lists among the benefits of clearing interoperability that execution risk can be decoupled from settlement risk, since there can be an arm's length relationship between the exchange and its clearing corporation.

The workbook's calendar spread. A trader expects the near-month to mid-month spread to widen. He sells September 6.10% GOI 2031 futures at 99.00 and buys October at 99.05: spread 0.05. Ten days later September is at 98.80 and October at 98.95: spread 0.15. Gain = (0.15 − 0.05) × 2,000 = Rs 200 per contract.

The same trade with execution slippage (illustrative). He places the September sell first. By the time his October buy fills, October has moved to 99.08.

Gain = 0.07 × 2,000 = Rs 140 per contract, instead of Rs 200. The view was right; Rs 60 per contract was lost in the gap between two orders. On 50 contracts that is Rs 3,000.

Had the October order not filled at all, he would have held a lone short September future: a naked position exposed to every move in the bond, which is the arbitrager's worst case in section 5.5.

Chapter 5 (Strategies using Interest Rate Derivatives) raises execution risk at the end of the arbitrage examples in section 5.5 and names it in the calendar spread example in section 5.6. Chapter 6 (Trading Mechanism) explains the spread order book in section 6.2.5; Chapter 7 mentions it under interoperability; Chapter 10 includes it in the risk disclosures for ETIRD. Expect a question on what execution risk is and which exchange facility reduces it for spread trades.

• Execution risk is not credit risk. The clearing corporation's guarantee does not protect a leg that never traded.
• The fix for two-order spreads is the spread order facility, not a lower margin.
• An illiquid leg is the biggest danger: one leg fills and leaves a naked exposure.
• Slippage is the workbook's word for execution away from the desired price in the client risk disclosures.
• In the spread order book the second leg trades at reference price + the entered difference; the reference price is the first leg's last traded price.
• Transaction and impact costs are separate frictions that the strategy examples ignore.