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The Trade Lifecycle: Behind the Scenes of the Trading Process

Book Description

Every person working in an investment bank or hedge fund has a large part of his work connected to the lifecycle of a trade. It is the glue by which all the departments are bound and the aggregated success or failure of each trade determines the survival and growth of the entire organization. Trading has evolved from a humble apple grower wanting a stable price for his produce come harvest time, to a complex and exciting industry comprising a significant share of the global economy, and more recently, taking a hand in saving it. It is the fundamental activity of investment banks, hedge funds, pension funds and many other financial companies. There is no better way to understanding the workings of a financial institution than to follow the progress of a trade through all of its various stages and all the activities performed upon it.

In the aftermath of the financial crisis, the financial world has changed, with less emphasis on trading and entrepreneurial activity and more on risk management, regulation and auditing. In this new world order, there will be a much greater analysis of every trade, and all market participants will need to have a much better understanding of the impact of their work on the whole trade cycle.

This book will dissect a trade into its component parts, track it from pre-conception to maturity and how the trade effects each business function of a financial institution. As well as illustrating each part of the trade process, it will highlight the legal, operational, liquidity, credit and market risks to which the trade is exposed. Readers will benefit from a full understanding of all parts of the trade process, including derivative and credit derivative trades, and will also see, with examples where appropriate, how the mismanagement of these risks led to today's financial crisis.

Table of Contents

  1. Dedication
  2. Title Page
  3. Copyright Page
  4. Preface
    1. WHY THIS BOOK?
  5. Author’s Note
  6. Acknowledgements
  7. Part I - Products and the Background to Trading
    1. Chapter 1 - Trading
      1. 1.1 HOW AND WHY DO PEOPLE TRADE?
      2. 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?
      6. 1.6 CONSEQUENCES OF TRADING
      7. 1.7 TRADING IN THE FINANCIAL SERVICES INDUSTRY
      8. 1.8 WHAT DO WE MEAN BY A TRADE?
      9. 1.9 WHO WORKS ON THE TRADE AND WHEN?
      10. 1.10 SUMMARY
    2. Chapter 2 - Risk
      1. 2.1 INTRODUCTION
      2. 2.2 RISK IS INEVITABLE
      3. 2.3 QUANTIFYING RISK
      4. 2.4 METHODS OF DEALING WITH RISK
      5. 2.5 MANAGING RISK
      6. 2.6 PROBLEMS OF UNFORESEEN RISK
      7. 2.7 SUMMARY
    3. Chapter 3 - Asset Classes
      1. 3.1 INTEREST RATES
      2. 3.2 FOREIGN EXCHANGE (FX)
      3. 3.3 EQUITY
      4. 3.4 BONDS AND CREDIT
      5. 3.5 COMMODITIES
      6. 3.6 TRADING ACROSS ASSET CLASSES
      7. 3.7 SUMMARY
    4. Chapter 4 - Derivatives, Structures and Hybrids
      1. 4.1 WHAT IS A DERIVATIVE?
      2. 4.2 LINEAR
      3. 4.3 NONLINEAR
      4. 4.4 SOME OPTION TERMINOLOGY
      5. 4.5 OPTION VALUATION
      6. 4.6 EXOTIC OPTIONS
      7. 4.7 STRUCTURES AND HYBRIDS
      8. 4.8 IMPORTANCE OF SIMPLER PRODUCTS
      9. 4.9 TRADE MATRIX
      10. 4.10 SUMMARY
    5. Chapter 5 - Credit Derivatives
      1. 5.1 INTRODUCTION
      2. 5.2 CDS
      3. 5.3 CLN
      4. 5.4 CDO
      5. 5.5 DATA RELATING TO CDOs
      6. 5.6 PRACTICAL ASPECTS OF CDO MANAGEMENT
      7. 5.7 PRACTICAL ASPECTS OF CDO VALUATION
      8. 5.8 WHY ARE CREDIT DERIVATIVES DIFFERENT?
      9. 5.9 SUMMARY
    6. Chapter 6 - Liquidity, Price and Leverage
      1. 6.1 LIQUIDITY
      2. 6.2 PRICE
      3. 6.3 LEVERAGE
  8. Part II - The Trade Lifecycle
    1. Chapter 7 - Anatomy of a Trade
      1. 7.1 THE UNDERLYING
      2. 7.2 GENERAL
      3. 7.3 ECONOMIC
      4. 7.4 SALES
      5. 7.5 LEGAL
      6. 7.6 BOOKING
      7. 7.7 COUNTERPARTY
      8. 7.8 TIMELINE
    2. Chapter 8 - Lifecycle
      1. 8.1 PRE EXECUTION
      2. 8.2 EXECUTION AND BOOKING
      3. 8.3 CONFIRMATION
      4. 8.4 POST BOOKING
      5. 8.5 SETTLEMENT
      6. 8.6 OVERNIGHT
      7. 8.7 CHANGES DURING LIFETIME
      8. 8.8 REPORTING DURING LIFETIME
      9. 8.9 EXERCISE
      10. 8.10 MATURITY
      11. 8.11 EXAMPLE TRADE
      12. 8.12 SUMMARY
    3. Chapter 9 - Cashflows and Asset Holdings
      1. 9.1 INTRODUCTION
      2. 9.2 HOLDINGS
      3. 9.3 VALUE OF HOLDING
      4. 9.4 RECONCILIATION
      5. 9.5 CONSOLIDATED REPORTING
      6. 9.6 REALISED AND UNREALISED P&L
      7. 9.7 DIVERSIFICATION
      8. 9.8 BANK WITHIN A BANK
      9. 9.9 CUSTODY OF SECURITIES
      10. 9.10 RISKS
      11. 9.11 SUMMARY
    4. Chapter 10 - Risk Management
      1. 10.1 TRADERS
      2. 10.2 RISK CONTROL
      3. 10.3 TRADING MANAGEMENT
      4. 10.4 SENIOR MANAGEMENT
      5. 10.5 HOW DO RISKS ARISE?
      6. 10.6 DIFFERENT REASONS FOR TRADES
      7. 10.7 HEDGING
      8. 10.8 WHAT HAPPENS WHEN THE TRADER IS NOT AROUND?
      9. 10.9 TYPES OF RISK
      10. 10.10 TRADING STRATEGIES
      11. 10.11 HEDGING STRATEGIES
      12. 10.12 SUMMARY
    5. Chapter 11 - Market Risk Control
      1. 11.1 VARIOUS METHODOLOGIES
      2. 11.2 NEED FOR RISK
      3. 11.3 ALLOCATION OF RISK
      4. 11.4 MONITORING OF MARKET RISK
      5. 11.5 CONTROLLING THE RISK
      6. 11.6 RESPONSIBILITIES OF THE MARKET RISK CONTROL DEPARTMENT
      7. 11.7 LIMITATIONS OF MARKET RISK DEPARTMENTS
      8. 11.8 REGULATORY REQUIREMENTS
      9. 11.9 SUMMARY
    6. Chapter 12 - Counterparty Risk Control
      1. 12.1 REASONS FOR NON FULFILMENT OF OBLIGATIONS
      2. 12.2 CONSEQUENCES OF COUNTERPARTY DEFAULT
      3. 12.3 COUNTERPARTY RISK OVER TIME
      4. 12.4 HOW TO MEASURE THE RISK
      5. 12.5 IMPOSING LIMITS
      6. 12.6 WHO IS THE COUNTERPARTY?
      7. 12.7 COLLATERAL
      8. 12.8 ACTIVITIES OF THE COUNTERPARTY RISK CONTROL DEPARTMENT
      9. 12.9 WHAT ARE THE RISKS INVOLVED IN ANALYSING CREDIT RISK?
      10. 12.10 PAYMENT SYSTEMS
      11. 12.11 SUMMARY
    7. Chapter 13 - Accounting
      1. 13.1 BALANCE SHEET
      2. 13.2 PROFIT AND LOSS ACCOUNT
      3. 13.3 FINANCIAL REPORTS FOR HEDGE FUNDS AND ASSET MANAGERS
    8. Chapter 14 - P&L Attribution
      1. 14.1 BENEFITS
      2. 14.2 THE PROCESS
      3. 14.3 EXAMPLE
      4. 14.4 SUMMARY
  9. Part III - Systems and Procedures
    1. Chapter 15 - People
      1. 15.1 TRADERS
      2. 15.2 TRADING ASSISTANTS
      3. 15.3 STRUCTURERS
      4. 15.4 SALES
      5. 15.5 RESEARCHERS
      6. 15.6 MIDDLE OFFICE (PRODUCT CONTROL)
      7. 15.7 BACK OFFICE (OPERATIONS)
      8. 15.8 QUANTITATIVE ANALYST
      9. 15.9 INFORMATION TECHNOLOGY
      10. 15.10 LEGAL
      11. 15.11 MODEL VALIDATION
      12. 15.12 MARKET RISK CONTROL DEPARTMENT
      13. 15.13 COUNTERPARTY RISK CONTROL DEPARTMENT
      14. 15.14 FINANCE
      15. 15.15 INTERNAL AUDIT
      16. 15.16 COMPLIANCE
      17. 15.17 TRADING MANAGER
      18. 15.18 MANAGEMENT
      19. 15.19 HUMAN RISKS
      20. 15.20 SUMMARY
    2. Chapter 16 - Developing Processes for New Products (and Improving Processes ...
      1. 16.1 WHAT IS A PROCESS?
      2. 16.2 THE STATUS QUO
      3. 16.3 HOW PROCESSES EVOLVE
      4. 16.4 INVENTORY OF CURRENT SYSTEMS
      5. 16.5 COPING WITH CHANGE
      6. 16.6 IMPROVING THE SITUATION
      7. 16.7 INERTIA
      8. 16.8 SUMMARY
    3. Chapter 17 - New Products
      1. 17.1 ORIGIN OF NEW PRODUCTS
      2. 17.2 TRIAL BASIS
      3. 17.3 NEW TRADE CHECKLIST
      4. 17.4 NEW PRODUCT EVOLUTION
      5. 17.5 RISKS
      6. 17.6 SUMMARY
    4. Chapter 18 - Systems
      1. 18.1 WHAT MAKES A GOOD SYSTEM?
      2. 18.2 IT PROCUREMENT
      3. 18.3 SYSTEM STAKEHOLDERS
      4. 18.4 THE IT TEAM
      5. 18.5 TIMELINE OF A PROJECT
      6. 18.6 PROJECT MANAGEMENT
      7. 18.7 THE IT DIVIDE
      8. 18.8 TECHNIQUES AND ISSUES RELATED TO IT
      9. 18.9 SYSTEMS ARCHITECTURE
      10. 18.10 DIFFERENT TYPES OF DEVELOPMENT
      11. 18.11 BUY VERSUS BUILD
      12. 18.12 SOFTWARE VENDORS
      13. 18.13 PERFORMANCE
      14. 18.14 PROJECT ESTIMATION
      15. 18.15 GENERAL THOUGHTS ON IT
      16. 18.16 SUMMARY
    5. Chapter 19 - Testing
      1. 19.1 WHAT IS TESTING?
      2. 19.2 WHY IS TESTING IMPORTANT?
      3. 19.3 WHO DOES TESTING?
      4. 19.4 WHEN SHOULD TESTING BE DONE?
      5. 19.5 WHAT ARE THE TYPES OF TESTING?
      6. 19.6 FAULT LOGGING
      7. 19.7 RISKS
      8. 19.8 SUMMARY
    6. Chapter 20 - Data
      1. 20.1 COMMON CHARACTERISTICS
      2. 20.2 DATABASE
      3. 20.3 TYPES OF DATA
      4. 20.4 BID/OFFER SPREAD
      5. 20.5 CURVES AND SURFACES
      6. 20.6 SETS OF MARKET DATA
      7. 20.7 BACK TESTING
      8. 20.8 HOW CAN DATA GO WRONG?
      9. 20.9 TYPICAL DATA SOURCES
      10. 20.10 HOW TO COPE WITH CORRECTIONS TO DATA
      11. 20.11 DATA INTEGRITY
      12. 20.12 THE BUSINESS RISKS OF DATA
      13. 20.13 SUMMARY
    7. Chapter 21 - Reports
      1. 21.1 INTRODUCTION
      2. 21.2 WHAT MAKES A GOOD REPORT?
      3. 21.3 REPORTING REQUIREMENTS
      4. 21.4 WHEN THINGS GO WRONG
      5. 21.5 REDUNDANCY
      6. 21.6 CONTROL
      7. 21.7 ENHANCEMENT
      8. 21.8 SECURITY
      9. 21.9 RISKS
      10. 21.10 SUMMARY
    8. Chapter 22 - Calculation
      1. 22.1 WHAT DOES THE CALCULATION PROCESS ACTUALLY DO?
      2. 22.2 THE CALCULATION ITSELF
      3. 22.3 SENSITIVITY ANALYSIS
      4. 22.4 BOOTSTRAPPING
      5. 22.5 CALCULATION OF DATES
      6. 22.6 CALIBRATION TO MARKET
      7. 22.7 TESTING
      8. 22.8 INTEGRATING A MODEL WITHIN A FULL SYSTEM
      9. 22.9 RISKS ASSOCIATED WITH THE VALUATION PROCESS
      10. 22.10 SUMMARY
    9. Chapter 23 - Mathematical Model and Systems Validation
      1. 23.1 TESTING PROCEDURES
      2. 23.2 IMPLEMENTATION AND DOCUMENTATION
      3. 23.3 SUMMARY
    10. Chapter 24 - Regulatory, Legal and Compliance
      1. 24.1 REGULATORY REQUIREMENTS
      2. 24.2 LEGAL
      3. 24.3 COMPLIANCE
      4. 24.4 RISKS
      5. 24.5 SUMMARY
    11. Chapter 25 - Business Continuity Planning
      1. 25.1 WHAT IS BUSINESS CONTINUITY PLANNING?
      2. 25.2 WHY IS IT IMPORTANT?
      3. 25.3 TYPES OF DISASTER
      4. 25.4 HOW DOES IT WORK?
      5. 25.5 RISKS ASSOCIATED WITH BCP
      6. 25.6 SUMMARY
  10. Part IV - What Can Go Wrong, the Credit Crisis
    1. Chapter 26 - Credit Derivatives and the Crisis of 2007
      1. 26.1 BACKGROUND
      2. 26.2 THE EVENTS OF MID-2007
      3. 26.3 ISSUES TO BE ADDRESSED
      4. 26.4 SUMMARY
  11. Appendix - Summary of Risks
  12. Recommended Reading
  13. Index