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 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.
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 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 5) to profit from such a situation. Some trading is motivated by the expected shape of future prices known as the term structure or curve of an asset such as WTI crude oil.
In addition trades are often transacted as hedges to limit exposure to changes in market conditions caused by other trades. We examine hedging in Chapter 10.
The trading parties must agree:
■ what each side is committed to supplying
■ when the agreement takes effect
■ how the transfer is to be arranged
■ under what legal jurisdiction the trade is being conducted.
A trade is in essence a legally binding agreement creating an obligation on both sides. It is important to consider that from the point of agreement, the trade exists. If one side reneges on the trade and nothing is actually transacted, the other side will have legal recourse to compensation.
Trading has benefits and risks. It is an everyday activity we sometimes take for granted, but a transacted trade requires processes to be undertaken from conception to expiry. We will examine the journey of a trade and its components and in doing so will explore the activities of a financial entity engaged in trading.
Trading encompasses many types of trades. Some are standardised with very few differences from a regular template. They are traded in high volumes and require little formal documentation. For example, buying a share in an exchange-listed security would require only the security name, deal date and time, settlement date, quantity and price.
Other trades are far more specialised. They may have hundreds of pages of documentation and take months to put together. They will be traded individually and no two trades will be alike. Even these more complicated trades however are usually made up of components built from simpler, standard trades.
1.9 Who works on the trade and when?
In Chapter 15 we will discuss the various business functions. Table 1.2 shows a summary of the most general activities of each business function and at what point they are performed.
Table 1.2 Business Functions at points in trade lifecycle
1.10 Summary
There are many reasons why people might trade. Financial trading is undertaken by a broad range of companies specialising in various areas and strategies. A trade has both common and specific properties and can be transacted in many different ways. The various business functions within a financial entity will perform their activities at different stages in the trade lifecycle.
Chapter 2
Risk
Risk is a major part of trading. Not only do most traders need to actively manage risks that arise from their trading (market risk) but the actual processes in the trade lifecycle carry various types of risk. Here we present an introduction to the concept of risk in general.
2.1 The concept of risk
The German sociologist, Niklas Luhmann, defined risk as ‘the threat or probability that an action or event will adversely or beneficially affect an organisation's ability to achieve its objectives’.
In the financial services industry, the term risk often denotes the market risk of holding trading positions. Risk management is then the action taken by traders to control this risk. This is an important type of risk and one to which we will devote a chapter of this book (Chapter 10), but it is by no means the only source of risk to an organisation engaged in trading. Whenever we use the unqualified term risk, we mean the wider connotation of risk as in Luhmann's definition.
2.2 Risk is inevitable
Imagine you own £10,000 in cash and decide to store it in the proverbial shoebox under the bed. You are now certain that you have protected your money – there are no risks attached. Correct? Unfortunately, things are not quite as safe as you think. Firstly, it could get stolen or there could be fire or flood. Secondly, if you leave the cash there long enough, the denomination of bank notes could cease to be legal tender and banks and shops refuse to accept them. Thirdly, inflation
