The Trade Lifecycle Behind the Scenes of the Trading Process

Drive profit and manage risk with expert guidance on trade processing

The Trade Lifecycle catalogues and details the various types of trades, including the inherent cashflows and risk exposures of each. Now in its second edition, this comprehensive guide includes major new coverage of traded products, credit valuation adjustment, regulation, and the role of information technology. By reading this, you’ll dissect a trade into its component parts, track it from preconception to maturity, and learn how it affects each business function of a financial institution.  You will become familiar with the full extent of legal, operational, liquidity, credit, and market risks to which it is exposed. Case studies of real projects cover topics like FX exotics, commodity counterparty risk, equity settlement, bond management, and global derivatives initiatives, while the companion website features additional video training on specific topics to help you build a strong background in this fundamental aspect of finance.

Trade processing and settlement combined with control of risk has been thrust into the limelight with the recent near collapse of the global financial market. This book provides thorough, practical guidance toward processing the trade, and the risks and rewards it entails.

• Gain deep insight into emerging subject areas
• Understand each step of the trade process
• Examine the individual components of a trade
• Learn how each trade affects everything it touches

Every person working in a bank is highly connected to the lifecycle of a trade. It is the glue by which all departments are bound, and the aggregated success or failure of each trade determines the entire organization's survival. The Trade Lifecycle explains the fundamentals of trade processing and gives you the knowledge you need to further your success in the market.

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 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. The author can be contacted by email at robert.baker@elmcroft.net

Foreword from the First Edition xvii

Foreword to the Second Edition xix

Preface xxi

Acknowledgements xxiii

About the Author xxv

PART ONE Products and the Background to Trading

CHAPTER 1 Trading 3

1.1 How and why do people trade? 3

1.2 Factors affecting trade 3

1.3 Market participants 4

1.4 Means by which trades are transacted 5

1.5 When is a trade live? 7

1.6 Consequences of trading 7

1.7 Trading in the financial services industry 8

1.8 What do we mean by a trade? 10

1.9 Who works on the trade and when? 11

1.10 Summary 12

CHAPTER 2 Risk 13

2.1 The concept of risk 13

2.2 Risk is inevitable 13

2.3 Quantifying risk 14

2.4 Methods of dealing with risk 15

2.5 Managing risk 15

2.6 Problems of unforeseen risk 16

2.7 Summary 16

CHAPTER 3 Understanding Traded Products – Follow the Money 17

3.1 Spot trades 18

3.2 Future (forward) 20

3.3 Loan 21

3.4 Deposit 23

3.5 Swap 23

3.6 Foreign exchange swap 25

3.7 Equity spot 26

3.8 Bond spot 27

3.9 Option 27

3.10 Credit default swap 30

3.11 Summary 31

CHAPTER 4 Asset Classes 33

4.1 Interest rates 33

4.2 Foreign exchange (Forex or FX) 40

4.3 Equity 44

4.4 Bonds and credit 46

4.5 Commodities 53

4.6 Trading across asset classes 58

4.7 Summary 59

CHAPTER 5 Derivatives, Structures and Hybrids 61

5.1 Linear 61

5.2 Nonlinear 62

5.3 Some option terminology 66

5.4 Option valuation 67

5.5 Exotic options 67

5.6 Structures and hybrids 69

5.7 Importance of simpler products 70

5.8 Trade matrix 71

5.9 Summary 72

CHAPTER 6 Liquidity, Price and Leverage 73

6.1 Liquidity 73

6.2 Price 75

6.3 Leverage 76

6.4 Summary 79

PART TWO The Trade Lifecycle

CHAPTER 7 Anatomy of a Trade 83

7.1 The underlying 83

7.2 General 83

7.3 Economic 84

7.4 Sales 84

7.5 Legal 84

7.6 Booking 85

7.7 Counterparty 85

7.8 Timeline 86

7.9 Summary 87

CHAPTER 8 Trade Lifecycle 89

8.1 Pre execution 89

8.2 Execution and booking 91

8.3 Confirmation 94

8.4 Post booking 96

8.5 Settlement 97

8.6 What happens overnight 101

8.7 Changes during lifetime 105

8.8 Reporting during lifetime 110

8.9 Exercise 110

8.10 Maturity 112

8.11 Example trade 113

8.12 Summary 115

CHAPTER 9 Cashflows and Asset Holdings 117

9.1 Holdings 119

9.2 Value of holding 120

9.3 Reconciliation 121

9.4 Consolidated reporting 122

9.5 Realised and unrealised P&L 122

9.6 Diversification 122

9.7 Bank within a bank 123

9.8 Custody of securities 123

9.9 Risks 124

9.10 Summary 124

CHAPTER 10 Risk Management 125

10.1 Traders 125

10.2 Risk control 126

10.3 Trading management 126

10.4 Senior management 126

10.5 How do risks arise? 126

10.6 Different reasons for trades 128

10.7 Hedging 128

10.8 What happens when the trader is not around? 128

10.9 Types of risk 130

10.10 Trading strategies 132

10.11 Hedging strategies 133

10.12 Summary 134

CHAPTER 11 Market Risk Control 135

11.1 Various methodologies 135

11.2 Need for risk 139

11.3 Allocation of risk 139

11.4 Monitoring of market risk 140

11.5 Controlling the risk 140

11.6 Responsibilities of the market risk control department 141

11.7 Limitations of market risk departments 142

11.8 Regulatory requirements 143

11.9 Summary 145

CHAPTER 12 Counterparty Risk Control 147

12.1 Reasons for non-fulfilment of obligations 147

12.2 Consequences of counterparty default 148

12.3 Counterparty risk over time 148

12.4 How to measure the risk 149

12.5 Imposing limits 152

12.6 Who is the counterparty? 153

12.7 Collateral 153

12.8 Activities of the counterparty risk control department 154

12.9 What are the risks involved in analysing credit risk? 157

12.10 Payment systems 158

12.11 Summary 160

CHAPTER 13 Accounting 161

13.1 Balance sheet 161

13.2 Profit and loss account 164

13.3 Financial reports for hedge funds and asset managers 168

13.4 Summary 169

CHAPTER 14 P&L Attribution 171

14.1 Benefits 171

14.2 The process 172

14.3 Example 173

14.4 Summary 176

CHAPTER 15 People 177

15.1 Revenue generation 177

15.2 Activities that support revenue generation 179

15.3 Control 189

15.4 Summary 200

CHAPTER 16 Regulation 201

16.1 Purpose of regulation 201

16.2 What regulators require 202

16.3 The problems 204

16.4 Risk-weighted assets 205

16.5 Credit valuation adjustment (CVA) 207

16.6 Summary 213

PART THREE What Really Happens

CHAPTER 17 Insights into the Real World of Capital Markets – Here be Dragons! 217

17.1 How it used to be 217

17.2 Clash of cultures 219

17.3 The equality of money 219

17.4 The politics of money 220

17.5 The good 222

17.6 The bad 222

17.7 The ugly 223

17.8 Where are we heading? 223

17.9 Summary 224

CHAPTER 18 Case Studies 225

18.1 Case study 1 – Bonds 225

18.2 Case study 2 – Front office foreign exchange 235

18.3 Case study 3 – Equity confirmations project 247

18.4 Summary 252

CHAPTER 19 The IT Divide 253

19.1 What is the IT divide? 253

19.2 What problems does it cause? 255

19.3 IT in the middle 255

19.4 Improper use of IT 256

19.5 Organisational blockers 257

19.6 IT blockers 258

19.7 How to bridge the gap 259

19.8 Keeping up with change 260

19.9 What does the business want from IT? 261

19.10 What IT wants from the business 263

19.11 Particular challenges of the financial sector 264

19.12 Example of a good project 265

19.13 Example of a bad project 266

19.14 Summary 266

CHAPTER 20 The Role of the Quantitative Analyst 267

20.1 What is a quant? 267

20.2 Where do quants work? 267

20.3 Tools of the trade 269

20.4 Place in organisation 270

20.5 Where should quants sit? 270

20.6 The boundaries of Quantland 271

20.7 What does IT think of quants? 273

20.8 Different types of quants 274

20.9 Getting the job done 275

20.10 Summary 275

PART FOUR Behind the Scenes

CHAPTER 21 Developing Processes for New Products (and Improving Processes for Existing Products) 279

21.1 What is a process? 279

21.2 The status quo 279

21.3 How processes evolve 280

21.4 Inventory of current systems 282

21.5 Coping with change 284

21.6 Improving the situation 284

21.7 Inertia 287

21.8 Summary 288

CHAPTER 22 New Products 289

22.1 Origin of new products 289

22.2 Trial basis 290

22.3 New trade checklist 292

22.4 New product evolution 294

22.5 Risks 294

22.6 Summary 295

CHAPTER 23 Testing 297

23.1 What is testing? 297

23.2 Why is testing important? 298

23.3 Who does testing? 298

23.4 When should testing be done? 299

23.5 What are the types of testing? 300

23.6 Fault logging 302

23.7 Risks 304

23.8 Summary 305

CHAPTER 24 Data 307

24.1 Common characteristics 307

24.2 Database 308

24.3 Data 308

24.4 Bid/offer spread 310

24.5 Curves and surfaces 310

24.6 Market data 313

24.7 Back testing 317

24.8 How can data go wrong? 317

24.9 Typical data sources 320

24.10 How to cope with corrections to data 321

24.11 Data integrity 322

24.12 The business risks of data 324

24.13 Summary 325

CHAPTER 25 Reports 327

25.1 What makes a good report? 327

25.2 Reporting requirements 328

25.3 When things go wrong 333

25.4 Redundancy 334

25.5 Control 335

25.6 Enhancement 335

25.7 Security 335

25.8 Risks 335

25.9 Summary 336

CHAPTER 26 Calculation 337

26.1 What does the calculation process actually do? 337

26.2 The calculation itself 343

26.3 Sensitivity analysis 347

26.4 Bootstrapping 348

26.5 Calculation of dates 349

26.6 Calibration to market 351

26.7 Testing 351

26.8 Integrating a model within a full system 352

26.9 Risks associated with the valuation process 352

26.10 Summary 352

PART FIVE Summary of Risks

APPENDIX A Operational Risks 355

APPENDIX B Human Risks 359

APPENDIX C Control Risks 363

APPENDIX D Processing Risks 367

APPENDIX E Organisational Risks 373

Recommended Reading 377

Index 379

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