style="font-size:15px;"> ■ certain sets of defined products
■ times when the exchange is open.
If trading is required without these restrictions, it has to be done directly between the counterparties. This is known as over-the-counter (OTC) trading. There is increased flexibility because the counterparties can agree to any trade at any time but the absence of an exchange carries greater risks. Nowadays, much OTC trading is covered by regulation to ensure, inter alia, that both counterparties are competent and knowledgeable enough to trade, and understand the risks entailed.
1.5 When is a trade live?
A trade is live between the time of execution and the time of maturity. Final delivery may sometimes occur after the maturity date, in which case although the trade has no value at maturity, it does still bear the risk of non-delivery. Even when a trade has matured it may still feature in trade processes, such as for compilation of trading statistics, lookback analysis, auditing or due to outstanding litigation.
1.6 Consequences of trading
Once a trade has been executed, there will be at least one exchange of cash or assets at some future time ranging from within a few hours or days for spot trades, to many years for trades such as swaps, to unlimited periods for perpetual bonds. (Assets here include cash.)
Apart from exchanging cash or assets, the trade itself has value while it is still live. So all processes and risk analysis must work with both the cash or asset exchanges and the intrinsic trade.
The buyer and seller are holding different sides of the same trade. Although at execution the price they agreed was the same for both, the value of each side of the trade may vary over time.
Here is an example that shows how a trade has two independent sides that result in intrinsic value and exchange of cash.
On 11th January X buys a future contract from Y in EUR/JPY where he will in six months pay one million EUR and receive 137.88 million JPY (that is a 6m future at 137.88).
On 11th April, the three-month future price is 140. X holds but Y buys a three-month future from Z.
On 11th July, both futures settle.
X pays EUR 1m and receives JPY 137.88m
Y 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).
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?
We divide our discussion into the principal types of financial entities.
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
