)WILEY A John Wiley and Sons, Ltd., Publication

Transcription

1 The Trade Lifecycle Behind the Scenes of the Trading Process Robert Baker )WILEY A John Wiley and Sons, Ltd., Publication

2 Preface. xxiii Author's Note Acknowledgements xxv xxvii PARTI PRODUCTS AND THE BACKGROUND TO TRADING 1 Trading How and why do people trade? Factors affecting trade Market participants Producer Consumer Speculator Market maker Means by which trades are transacted Brokers Exchanges Over-the-counter When is a trade live? Consequences of trading Trading in the financial services industry Two types of trading policy Why does a financial entity trade? What do we mean by a trade? Who works on the trade and when? Summary Risk Introduction Risk is inevitable Quantifying risk

3 viii Contents Methods of dealing with risk Ignore Minimise Avoid Remove Managing risk Problems of unforeseen risk Summary v Asset Classes 3.1 Interest rates Foreign Equity Bonds; Deposit Future Swap Tradeflow issues ; exchange (FX) Spot Futures and forwards Swaps Baskets Tradeflow issues Synthetic equities (index) Lifecycle issues pertinent to equity trades md credit Commodities Bonds Other credit risk bearing instruments What are commodities? Agricultural commodities Examples of animal products Energy Precious metals Industrial metals OTC commodities Localised nature of production Time lag Utility of commodities Precious metals as a currency Physical settlement Other tradeflow issues 3.6 Trading across asset classes Summary 30 Derivatives, Structures and Hybrids What is a derivative? Linear

4 ix 4.3 Nonlinear Trade process issues relating to options Exercise Optionality Leverage Some option terminology Option valuation Exotic options Issues with exotics Structures and hybrids Importance of simpler products Trade matrix Summary 39 5 Credit Derivatives Introduction CDS CLN \ CDO CDO reference pool Static and managed CDOs CDO pricing methodology Other terminology Data relating to CDOs Reference pool data Tranche data CDO deal details Practical aspects of CDO management What is happening? What has happened? What is likely to happen and what is the worst that can happen? What opportunities do I have? Reporting Limits Alerts Practical aspects of CDO valuation Why are credit derivatives different? Summary 56 6 Liquidity, Price and Leverage Liquidity Two types of trading What is liquidity? Asset liquidity Measuring liquidity Risks associated with liquidity 58

5 6.2 Pnce Price Over-the-counter price Exchange price Broker price What can we infer from price? Cost of unwind Volumes Leverage Advantages of leverage Disadvantages of leverage Measurement of leverage Current market position Time Asset class Monitoring of leverage Summary PART II THE TRADE LIFECYCLE 63 7 Anatomy of a Trade The underlying General Economic Sales Legal, Booking ', Counterparty Timeline Dates relating to a trade Fixed cash or asset exchange dates Unknown cash or asset exchange dates Example 67 8 Lifecycle Pre Execution Provisional trades Orders Execution and booking Execution Booking Confirmation Matching Confirmation Post booking Trade scrutiny Enrichment 75

6 Cashflows Fees and duties Error reporting Settlement The importance of settlement Settlement instructions Custodian Cash or physical Cash Documentation Physical commodity Cash settlement of commodities Nostro accounts Risks Advantage of quick settlement Multiple settlement dates \ Breaks 8.6 Overnight Individual trade and aggregation with other trades Date and time Internal and external trade dates Deciding time for end of day End of day roll Overnight processes Pre overnight checks Amalgamation between systems Stale data Changes during lifetime Dividends Coupons Other corporate actions Changes as a result of market data Counterparty changes Collateral Changes to the trade Management of changes Risks 86 Reporting during lifetime Exercise Exercise date When to exercise Cash or physical Exercise as a process Fugit Risks associated with exercise 8.10 Maturity Final settlement date

7 8.11 Example trade The trade lifecycle v Summary ' 91 Cashflows and Asset Holdings Introduction 93 ' 9.2 Holdings Value of holding Reconciliation Consolidated reporting Realised and unrealised P&L Diversification Bank within a bank Custody of securities \ Registered securities \ Bearer securities Use of custodians Risks Summary 10 Risk Management Traders Desirable exposure Undesirable exposure Risk control Trading management Senior management How do risks arise? Spot trades Futures and forwards Options Exposures to fixed or float income streams Exposure to debt Exposure to group of products Different reasons for trades Hedging r What happens when the trader is not around? Availability of other traders Stop and limit orders Types of risk Delta Gamma Vega (sometimes known as kappa) Rho Theta Additional risks for credit products Default risk (or jump to default)

8 Recovery rate Correlation risk Risks in general 106 v Dreaming ahead Trading strategies Front book Back book Hedging strategies Delta hedging Stop-loss hedging Summary Market Risk Control Various methodologies Scenario analysis Value at Risk (VaR) \ Instantaneous measures of risk (sensitivity analysis) Need for risk Allocation of risk Monitoring of market risk Controlling the risk Responsibilities of the market risk control department Limitations of market risk departments Everything correlated The tails The human factor Balanced approach Regulatory requirements Basel II Capital Adequacy Ratio (CAR) Summary Counterparty Risk Control Reasons for non fulfilment of obligations Consequences of counterparty default Counterparty risk over time How to measure the risk Expected loss Credit exposure Potential future exposure (PFE) Netting Back-to-back Imposing limits Who is the counterparty? Collateral Example of a collateral agreement Advantages of collateral in general 124

9 xiv Contents 12.8 Activities of the counterparty risk control department Set policies for estimating exposure Assign limits based on credit worthiness Measure exposure v Deal with breaches Policies for new trade types Maintain legal data Managing margin payments and receipts Interface with management What are the risks involved in analysing credit risk? Correlation between counterparties Added complication of credit risk Insufficient consideration of counterparty risk Sudden counterparty changes Payment systems Summary 13 Accounting 13.1 Balance sheet Fixed assets Investments Cash Debtors Creditors Capital Profit and loss Events that affect balance sheet items Profit and loss account Introduction Realised Unrealised Accrued Incidental Worked example Individual trades Who is responsible for producing P&L? Risks associated with reporting P&L Financial reports for hedge funds and asset managers Overview Fees Reports P&L Attribution Benefits Catches mistakes ' Reconciliation Better understanding of the trades and the market

10 14.2 The process Market movements Theta Unexplained Example Summary 143 PART III SYSTEMS AND PROCEDURES People Traders Trading assistants Structurers Sales Researchers Middle office (product control) \ Trade Data Implementing trade changes Reporting Valuation Responsibility Liaison Processes Security End of day End of month Summary Back office (operations) Quantitative analyst Short-term pricing Long-term model development Tools of the trade Role of quantitative analysts Information technology Front-line support Infrastructure Architects Programmers Project managers IT operators Testers Legal Model validation Market risk control department Counterparty risk control department Finance

11 15.15 Internal audit Routine checks Thorough audit of one area Compliance Due diligence External regulation v --' Staff training Trading manager Management Balance Board of directors Human risks Too much knowledge in one person Not enough knowledge The wrong people Not enough investment in people Incentive Short-term thinking, Conflicts and tensions x Communication Summary Developing Processes for New Products (and Improving Processes for Existing Products) What is a process? The status quo How processes evolve Inventory of current systems Coping with change Improving the situation What would the ideal set of processes be? Understanding the current processes Inertia Summary New Products Origin of new products Trial basis Why trial? Features of the trial Advantages of the trial New trade checklist Management approval Legal and regulatory approval Trading limits Risk control limits 178

12 xvii Models Trade lifecycle processes Middle office can book and mark the products 178 New product evolution Risks Summary Systems What makes a good system? IT procurement System stakeholders The IT team Timeline of a project Project management The IT divide Techniques and issues related to IT Systems architecture User interface Business logic Data repository Example Different types of development Rapid application development (RAD) Dedicated IT team for a business function or area Independent IT division General comments Buy versus build Software vendors Performance Hardware constraints Grid computing Project estimation General thoughts on IT Summary 19 Testing What is testing? Why is testing important? Who does testing? When should testing be done? What are the types of testing? Stages of testing Testing types Fault logging Types of fault Workaround 205

13 xviii Contents Priority Area Fault description Risks Summary Data Common characteristics Database Types of data Why does type of data matter? Bid/offer spread Curves and surfaces Sets of market data ' Business usage of market data sets Back testing \ How can data go wrong? \ Techniques for dealing with bad data When to fix bad data Typical data sources How to cope with corrections to data Data integrity Importance of data integrity The business risks of data Putting too much faith in data Not reacting to data Coping when data not there Ensuring authentic data Summary Reports Introduction What makes a good report? Reporting requirements Readership Content Presentation External readership Habit Distribution Timing Accuracy Raw reporting Configuration Dynamic Frame of reference The problem of multiple dimensions 228

14 21.4 When things go wrong 21.5 Redundancy 21.6 Control 21.7 Enhancement 21.8 Security 21.9 Risks Summary 22 Calculation 22.1 What does the calculation process actually do? Example from outside the financial world Valuation of one trade Why not use mark-to-market? Other reasons why having a calculation engine is useful Why not rely solely on calculation engines? Compromise The model 22.2 The calculation itself Conversion to reporting currency Unknown cashflows Other dependencies Monte Carlo 22.3 Sensitivity analysis 22.4 Bootstrapping 22.5 Calculation of dates 22.6 Calibration to market 22.7 Testing 22.8 Integrating a model within a full system 22.9 Risks associated with the valuation process Summary 23 Mathematical Model and Systems Validation Geoff Chaplin 23.1 Testing procedures 23.2 Implementation and documentation 23.3 Summary 24 Regulatory, Legal and Compliance 24.1 Regulatory requirements Registration Reporting Inspections Personal registration 24.2 Legal 24.3 Compliance Money laundering Insider trading

15 xx Contents Risks Closure Penalties and prosecution Litigation Costs Reputational risk Advisory risk Summary Business Continuity Planning What is business continuity planning? Why is it important? Types of disaster How does it work? Risks associated with BCP Summary 257 PART IV WHAT CAN GO WRONG, THE CREDIT CRISIS N Credit Derivatives and the Crisis of Robert Reoch 26.1 Background SIVs Market liquidity The events of mid Subprime mortgages Investor impact Bank impact The failure of Lehman Brothers and the bailout of AIG Issues to be addressed A different rating agency process Standardised nomenclature for credit ratings Keeping a percentage of originated risk on balance sheet Undrawn credit facility capital charge The future of CDOs Mitigating the negative impact of mark-to-market Summary 269 Appendix: Summary of Risks 271 General comment - unforeseen risk 271 Operational risk (in the trade lifecycle) 271 Human risks 273 Market risk control 274 Counterparty risk control 275 Cashflow 275 Data 276 Reporting 276

16 New products 277 Legal and regulatory 277 Testing 277 Business continuity planning (BCP) 278 Valuation and model approval 278 Management 278 Documentation 279 Front office 279 Research 279 IT and systems 279 Effective control and support 280 Recommended Reading 281 Index 283