The Trade Lifecycle. Baker Robert P.

receives EUR 1m from X, pays JPY 137.88m to X

      Y pays EUR 1m to Z and receives JPY 140m from Z

      Z receives EUR 1m and pays JPY 140m

      So instead of Y buying a new trade (the three-month future), he could simply have sold his side of the original (six-month future) trade with X to Z. The fair price of the sale would be the amount of yen that would result in a value of JPY 2.12 million (140 – 137.88) on 11th July.

      We see that through the life of a trade it has past, current and future cash or asset exchanges and it has intrinsic value. Concomitant with these exchanges come their associated risks and processes.

      In financial terms, a trade converts potential to actual profit and loss with every exchange of cash or assets.

      1.7 Trading in the financial services industry

      So far we have discussed some of the general issues of trading. Now we will focus on trading within the financial services industry. This includes investment banks, hedge funds, pension funds, brokers, exchanges and any other professional organisations engaged in financial trading. We exclude from this list retail banking services and private investments.

      Market makers in a financial institution are sometimes referred to as ‘front book’ traders and typically their ‘open’ positions are held for a maximum of three months – often very much less. In contrast, the risk takers or speculators are often called ‘back book’ traders or the ‘prop desk’ and they may hold positions to maturity of the transaction (though they can also be very short-term traders).

Two types of trading policy

      Where a trade is completed very soon after execution with a single exchange of cash or assets (a spot trade), there is no policy required for how to treat it. The only course of action is to accept the change in cash or assets caused by the trade. However, where the trade remains in existence for a period of time, there are two policies that can be adopted.

      One is to buy with a view to holding a trade to its maturity; the other to buy with the expectation of resale before maturity. Sometimes it is unknown at the time of purchase which policy will be adopted. At other times, changes in market conditions may force the purchaser to alter his course of action. Most trading participants in the financial services industry engage in buy and resell before maturity, whereas private individuals apply both policies. To a large extent the decision is dependent upon:

      ■ the reason for entering into the trade

      ■ the view on direction of market conditions which affect the value of the trade

      ■ the possibility of resale – is there a potential buyer willing to buy it before maturity?

Why does a financial entity trade?

      We divide our discussion into the principal types of financial entities.

Investment banks

      These institutions have a large customer base. Some of these customers are drawn from the retail banking arm usually connected to major banks. Due to their size they can offer a range of financial services and draw on expert advice in many different fields. They benefit from economies of scale and because they trade in large volumes, enjoy lower bid/offer spreads making their trading cheaper. They are sometimes referred to as the ‘sell side’ of the industry because they are supplying products for the market place. Investment banks are active in trading activities in order to:

      1. Service their clients

      The clients come to the bank with requirements that are satisfied by trading. The bank can either act as the middleman or broker to execute trades on behalf of the client who has no access to counterparties or it can trade directly with the client and either absorb the trade or deal an equal and opposite trade (known as back-to-back) in the market place, making a profit by enjoying lower trade costs.

      2. Proprietary trading

      Most investment banks have proprietary (or ‘prop’) desks with the aim of using the bank's resources to make profit. The financial knowledge and skills base within the bank should enable it to understand the complexities of trades and take a realistic view on the future direction of the market in order to generate revenue for the bank.

      3. Offset risks

      By engaging in a range of financial activities, the bank may have substantial holdings in various assets. These could expose the bank to risk if the market price moves against them. Therefore much of the trading of investment banks is to offset these risks.

      Examples:

      ■ too much holding in a risky foreign currency – trade into less risky or domicile currency

      ■ too much exposure to a particular corporate debt such as holding a large number of bonds – buy credit protection by way of credit default swaps.

      4. Broaden their client base

      Just as a shop selling sports equipment might decide to appeal to more customers or better service its existing customers by expanding into sports clothing, so an investment bank might trade in new areas or products to provide a better service to its clients. The bank will constantly review its current service in the light of:

      ■ what the competition is providing

      ■ what clients are requesting

      ■ what are likely profit-making ventures in the future.

      Some trades done by the bank do not make money or might even lose money, but are justified to attract new business or to service important clients.

      The image of a bank is very important. The product of banking is money, from which it cannot distinguish itself (it can't provide better banknotes than its competitor!) so the diversity and quality of its services are the means by which it seeks competitive advantage.

Hedge funds

      Hedge funds are established to make profits for their investors. In return, the fund managers usually get paid an annual fee plus a percentage of any profits made. The funds are generally constructed to adopt a particular trading strategy. All other risks and exposures that occur as a by-product of following that strategy are offset or hedged. Hedge funds are like the consumers in the financial industry and therefore known as being on the ‘buy side’. They engage in trading in order to pursue their strategy and manage their risks.

Pension funds and other asset managers

      Asset management is a generic group of financial companies of which pension funds are the most well known. They trade for very similar reasons to hedge funds. They want to maximise the return on the assets they hold for their clients or employees. They usually take a long-term view and are more risk-averse.

Brokers

      Brokers facilitate trades by bringing together buyers and sellers. They do not take upon themselves positions or trade risks. They do, however, require many of the trading processes described in the trade lifecycle section of this book with the additional complication of having two counterparties on every trade (one purchaser, one vendor).

      1.8 What do we mean by a trade?

      A trade can be a single transaction or a collection of transactions that are associated together for some reason. In this book, we use the former definition.

      A trade is an agreement between two counterparts to exchange something for something else. This book will concentrate on financial trades, which means those involving financial instruments.

      Examples of financial trades are:

      ■ 1000 barrels of West Texas intermediate crude oil for USD 6015

      ■ 1000 Royal Bank of Scotland ordinary shares for GBP 33.50

      ■ LIBOR floating rate for five years for 35 basis points per quarter

      ■ GBP 1 million for JPY 151 million in six months' time

      There are many reasons why a trader might transact such trades. To take advantage of expected price rises one would buy (or sell for expected falls). If a large change in price was expected (volatility) but the direction was unknown there are trading strategies (involving call and put options – see Chapter