The Trade Lifecycle. Baker Robert P.

lower operating costs

      ■ elimination of wastage

      ■ better overall awareness leading to more confidence in the trading process.

      I hope that this book might encourage all participants in the trade lifecycle to look again at their activities and those of their colleagues and see where improvements can be made to reduce risk and enhance the reputation of a battered industry.

      Gaining employment in the financial sector is becoming increasingly competitive. It is no longer sufficient to have the skills and experience in one business function. Applicants must demonstrate an understanding of where they fit into the organisation and have the ability to communicate with other business functions – every activity in the trade lifecycle being connected to others. This book is written with a view to helping this understanding.

      I have tried to make the book a readable progression through all the important activities and components of the trade lifecycle. Detailed explanations are given where necessary, but the book is intended as a comprehensive overview and therefore I have avoided too much detail where it might hinder the reader's ability to see the full picture.

      Any mistakes are mine. All views expressed are entirely my own.

      Foreword to the Second Edition

      Since the book was first published in 2010, many changes have been occurring to trading. The most significant is in the field of regulation. Investment banks and other financial institutions are now subject to more regulations which cut deep into the way they are allowed to operate. This is both on a macro level affecting the way they are structured and on a micro level in how individual trades are executed and processed. Thus a section of the second edition is devoted to regulation.

      Feedback from the first edition included a desire of the readership to know more about asset classes – this chapter has been expanded.

      A common confusion is the difference between asset classes and financial products. A chapter of the book seeks to remove this confusion and further the understanding of how products behave by ‘following the money’, that is examining the cashflows of several commonly traded products.

      Quantitative analysts play a vital role in finance but are little known and understood. A chapter is therefore devoted to shedding some light on this business function.

      In training courses based on the book, I have frequently been asked what working in capital markets and on trading floors is really like. This edition tries to give the reader a flavour of these experiences including real life case studies.

      Finally, I have in the course of my career come to the realisation that one of the greatest impediments to delivering successful IT projects is a phenomenon I refer to as ‘The IT divide’. This second edition describes the problem and some possible solutions.

      Preface

      This book is divided into five parts.

      Part I is entitled ‘Products and the background to trading’. It starts with a chapter on trading giving an overview of trading in general as well as that related to the financial services industry. The next chapter is a background to risk which is another important theme of the book. We then look into specific trades by examining the cashflows associated with each. Chapters follow on asset classes and derivative products. Part I concludes with a look at three important aspects of trading – liquidity, price and leverage.

      Part II is ‘The trade lifecycle’. It starts with an anatomy of the trade which is the core element of the lifecycle. Then the lifecycle is analysed in detail followed by a chapter on cashflows and asset holdings which are directly influenced by the lifecycle. We then move on to four methods of direct monitoring of trades throughout their lifetime: risk management, market risk control, counterparty risk control and accounting. There is a discussion of P&L attribution followed by a full description of the business functions in the lifecycle (i.e. the people). Then there is a chapter on regulation including Credit Value Adjustment (CVA) – a subject growing in importance.

      Part III ‘What really happens’ lifts the lid on the trading floor with chapters on insights into the real world of capital markets – here be dragons, case studies of real projects, the ‘IT divide’ and quants in capital markets.

      Part IV ‘Behind the scenes’ looks into processes, new products, testing, data, reports and calculations.

      Finally, in Part V, the Appendix summarises the risks arising from the trade lifecycle.

      Acknowledgements

      I would like to thank my colleague Geoff Chaplin (of Reoch Credit Partners LLP) for his inspiration and guidance that allowed this book to come into existence.

      I would also like to thank Meirion Morgan and Andrew Gates for giving up their time and sharing their considerable professional knowledge with me.

      Special thanks to my sister Mandy for her diligence in checking the whole book for grammar and readability.

      This book would not have been possible without the help of Thomas Hyrkiel, Jenny Kitchin and many more at the publishers John Wiley & Sons.

      Finally I thank my wife Nechama for her constant love and support, my children and grandchildren for reminding me what is important in life and my father for all his advice and guidance.

      About the Author

      Robert Baker (London, UK) works as a consultant in the development of financial software and in training. Robert has over 20 years of commercial programming experience of which the last 13 have been in the financial sector, primarily as a quantitative developer sitting between traders, quants and programmers. He has been involved in credit derivatives for 10 years, and has held positions at ABN Amro, Barclays Capital, UBS Warburg, Rabobank, Royal Bank of Scotland and at the hedge fund Solent Capital. Robert also has experience of project management across a wide range of asset classes and financial instruments from plain vanilla to complex exotics. He holds a degree in mathematics from the University of Oxford.

      The author can be contacted by e-mail at [email protected].

      Part One

      Products and the Background to Trading

      Chapter 1

      Trading

      In this chapter we introduce the concept of trading which underpins the whole book and go on to look at factors influencing trading, market participants, how trading occurs and related topics.

      1.1 How and why do people trade?

      People engage in trade primarily for one or more of the following reasons:

      ■ Require more or less of a product

      We go shopping because we need things. The same is true of financial products. One person buys something that another person has in surplus and is prepared to sell.

      ■ To make profit

      If someone anticipates that he can buy for less than he can sell and has the ability to hold a product long enough to take advantage of the price differential, he trades.

      ■ To remove risk

      Sometimes we need protection. We are worried that future events may cause our position to deteriorate and we therefore buy or sell to reduce our risk. The ship is safe, fully loaded in port today, but how will it fare exposed to the open sea tomorrow?

      1.2 Factors affecting trade

      In order to understand trading we will proceed to discuss the motivation behind why trading occurs.

Product appetite

      Everybody wants to buy as cheaply as possible, but some people have a greater need for a product and will be willing to pay more for it. Our appetite for a product will determine the price at which we buy. Conversely, our desire to divest ourselves of a product will affect the price at which we are prepared to sell.

Risk appetite

      Risk