The Front Office Manual: The Definitive Guide to Trading, Structuring and Sales

315 Pages·2013·2.916 MB·English

by  Andrew Sutherland, Jason Court (auth.)

THE
FRONT
OFFICE
MANUAL
The Definitive Guide to Trading,
Structuring and Sales
ANDREW SUTHERLAND
JASON COURT
GLOBAL FINANCIAL MARKETS
The Front Offi ce Manual
Global Financial Markets series
Global Financial Markets is a series of practical guides to the latest financial market
tools, techniques and strategies. Written for practitioners across a range of disciplines
it provides comprehensive but practical coverage of key topics in finance covering
strategy, markets, financial products, tools and techniques and their implementation.
This series will appeal to a broad readership, from new entrants to experienced prac-
titioners across the financial services industry, including areas such as institutional
investment; financial derivatives; investment strategy; private banking; risk manage-
ment; corporate finance and M&A; financial accounting and governance; and many
more.
Titles include:
Daniel Capocci
THE COMPLETE GUIDE TO HEDGE FUNDS AND HEDGE FUND
STRATEGIES
Guy Fraser-Sampson
INTELLIGENT INVESTING
A Guide to the Practical and Behavioural Aspects of Investment Strategy
Michael Hünseler
CREDIT PORTFOLIO MANAGEMENT
A Practitioner’s Guide to the Active Management of Credit Risks
Gianluca Oricchio
PRIVATE COMPANY VALUATION
How Credit Risk Reshaped Equity Markets and Corporate Finance Valuation Tools
Andrew Sutherland and Jason Court
THE FRONT OFFICE MANUAL
The Definitive Guide to Trading, Structuring and Sales
Michael C. S. Wong and Wilson F. C. Chan (e ditors )
INVESTING IN ASIAN OFFSHORE CURRENCY MARKETS
The Shift from Dollars to Renminbi
Global Financial Markets series
Series Standing Order ISBN: 978–1–137–32734–5
You can receive future titles in this series as they are published by placing a standing order. Please
contact your bookseller or, in case of difficulty, write to us at the address below with your name
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Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke,
Hampshire RG21 6XS, England
The Front Offi ce Manual
The Defi nitive Guide to Trading, Structuring
and Sales
Andrew Sutherland
and
Jason Court
© Andrew Sutherland and Jason Court 2013
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
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may be liable to criminal prosecution and civil claims for damages.
The authors have asserted their rights to be identified as the authors of this work
in accordance with the Copyright, Designs and Patents Act 1988.
First published 2013 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries
ISBN 978-1-349-44055-9 ISBN 978-1-137-03069-6 (eBook)
DOI 10.1057/9781137030696
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin.
A catalogue record for this book is available from the British Library.
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Contents
List of Figures xi
List of Tables xiii
Preface x v
Acknowledgements x vii
1 T he Structure of an Investment Bank 1
1 .1 Introduction 1
1 .2 Front office versus back office 4
1 .3 The basic front to back process 5
1 .4 The generation of trades 5
1 .5 Structure versus flow 6
1 .6 Vanilla versus exotic trades 7
1 .7 Over-the-counter versus securitized trades 7
1 .8 New products 8
1 .9 Trading and profit in a bank – the role of the trader 8
1 .10 Different types of trading activity 10
1 .11 Risk management and valuation 13
1 .12 Explaining P&L 14
1 .13 The role of Product Control 15
1 .14 Sales and distribution 1 6
1 .15 Structuring 18
1 .16 Quantative analysts 18
1 .17 Support functions around the trading desk 1 9
1 .18 Research 2 0
1 .19 General control processes 20
1 .20 Risk management 23
1 .21 Trading and market risk management 23
1 .22 Credit Risk Management 24
1 .23 CVA 2 5
1 .24 Back-office functions: settlement and mitigation of
settlement risk 25
1 .25 Client Services and Client Valuations 2 7
1 .26 Finance and regulatory reporting 2 8
1 .27 Collateral Management 29
2 I nterest Rate Swaps 3 1
2.1 An overview of the product 3 1
v
vi Contents
2.2 Technical aspects of the swap 3 3
2 .3 How much is a swap worth? 34
2 .4 Counting the days 35
2 .5 Adjusting the days 3 7
2 .6 Holidays 38
2 .7 Special features – stubs 3 8
2 .8 Special features – IMM Dates 3 9
2 .9 Special features – amortization 39
2 .10 Special features – compounding 40
2 .11 Special features – accruals in arrears 4 1
2 .12 Basis swaps 4 1
2 .13 Non-deliverable swaps 4 2
2 .14 Overnight-index swap 42
2 .15 Using swaps for hedging exposures 4 3
2 .16 Management of the swap lifecycle 4 6
2 .17 Operations 46
2 .18 Product control and the profit and loss process 4 8
2 .19 Risk management 48
2 .20 Changes to swap clearing 49
2 .21 Tri-Optima 5 0
3 A n Introduction to the Interest Rate Yield Curve 51
3 .1 What is a yield curve? 5 1
3 .2 LIBOR and the interest rate curve 5 2
3 .3 An introduction to discounting 54
3 .4 Using deposit rates to build a very simple yield
curve model 55
3 .5 The zero coupon curve 58
3 .6 Issues with the classic yield curve 6 0
3 .7 Where do we go from here? 6 1
3 .8 Credit effects 6 5
4 T he Mechanics of Simple Yield Curve Construction 67
4 .1 The yield curve model 67
4 .2 The classic single-curve 6 8
4 .3 The basic discounting curve 70
4 .4 The forward rate curve 7 2
4 .5 A note on rates 73
4 .6 Building the classic single-curve 7 3
4 .7 Introducing the ZCR table 75
4 .8 Populating the ZCR table from deposits 76
4 .9 Deposit basis, spot days and holidays 7 8
4 .10 Extending the ZCR table with futures 78
4 .11 Extending the ZCR table with FRAs 81
Contents vii
4 .12 Introduction to swaps in the yield curve 8 2
4 .13 E xtending the ZCR table with swaps the
simple way 8 4
4 .14 Swap basis, frequency for major currencies 85
4 .15 Extending the ZCR table with swaps:
Newton–Raphson 87
4 .16 Methods of interpolation 8 9
4 .17 Other second-order corrections: futures convexity,
turn-of-year and swap adjustments 9 3
4 .18 Summary 95
5 D iscount and Forward Interest Rate Curves 97
5 .1 The overnight index swap and discounting 97
5 .2 Building the basic discounting curve 99
5 .3 Which curve to use? 1 03
5 .4 What curves are being used in practice? 104
5 .5 Building a reasonable LIBOR-based curve 1 04
5 .6 Two curves at once 1 05
5 .7 What difference does using OIS make? 106
5 .8 Other considerations: what the
curves mean 107
5 .9 Using the yield curve to estimate risk 109
5 .10 Delta and gamma in yield curve risk 1 10
5 .11 Another approach to interest rate risk – forward
rate sensitivity 1 11
5 .12 Converting from forward rate delta to swap delta 113
5 .13 O ther simple risk measures from the yield curve:
carry and theta 1 14
6 Foreign Exchange 116
6 .1 Buying and selling currencies 1 16
6 .2 Quoting conventions for FX 117
6 .3 Trading FX and FX positions 119
6 .4 Margin 121
6 .5 Cross rates 1 23
6 .6 Spot days 1 24
6 .7 Forward trades 125
6 .8 FX swaps and managing positions 125
6 .9 Forward points 1 27
6 .10 Deliverable or not? 1 28
6 .11 A note on the carry trade 130
6 .12 Bid/ask spreads, and skew 1 31
6 .13 Measuring risk in FX trading 1 31
viii Contents
7 C ross-Currency Trades in the Future: Forward FX and
Cross-Currency Basis Swaps 134
7 .1 Computation of forward FX in the collateralized world 1 34
7 .2 Why are forward points not exactly right? 1 35
7 .3 The question of present value 1 37
7 .4 Choice of collateral 1 39
7 .5 How did the market get skewed away from interest rates? 1 40
7 .6 Help, I’m trading basis swaps! 1 43
7 .7 Basis adjustment using basis swap spreads 145
7 .8 Getting the present value of a basis swap 1 46
7 .9 The FX components of an arbitrary investment 1 47
8 B asic Equity Trades 1 50
8 .1 Stock prices 150
8 .2 Lending 151
8 .3 Equity swaps 153
8 .4 Notional amounts 154
8 .5 Forward prices 1 54
8 .6 Valuation 1 57
8 .7 Equity dividends 157
9 G overnment Bonds 161
9 .1 Basic features of bonds 161
9 .2 Accrued interest 1 63
9 .3 Holidays 166
9 .4 Yield 1 66
9 .5 Yield from price 1 68
9 .6 Short-term debt instruments 169
9 .7 Funding and government securities: repo 1 70
9 .8 The repo and the reverse 1 73
9 .9 General and special 173
9 .10 Using the repo rate to get future prices 174
9 .11 Bonds and yield curves 1 75
9 .12 More on repo: RONIA, Eurepo and other indices 177
9 .13 Finding the price of illiquid bonds 1 77
9 .14 Futures markets 180
9 .15 Gross basis, net basis and implied repo 1 82
9 .16 Trading against benchmarks and futures 1 84
9 .17 Fixed-income portfolios and bond risk 1 84
10 C orporate Bonds, Credit Spreads and Credit
Default Swaps 1 87
1 0.1 Modelling corporate bonds 187
1 0.2 The credit spread 1 88
Contents ix
10.3 Spread-to-yield-curve 189
10.4 More complex corporate bonds: embedded options 1 92
10.5 Asset swaps 1 93
10.6 Other ways of looking at credit: credit default swaps 194
10.7 Pro-rata fee on credit events 1 96
10.8 Credit events and restructurings 1 97
10.9 Auctions and settlements 197
10.10 Succession events 198
10.11 Probability of default: another way of looking at
the credit spread 199
10.12 Recovery 2 01
10.13 Probability analysis to value CDS 201
10.14 Up-front fee versus conventional spread 202
10.15 The standard pricing model 203
10.16 Uses of the standard model 205
11 V anilla Options 206
11.1 A brief overview of calls and puts 206
11.2 An idiosyncratic introduction to option pricing 2 08
11.3 Volatility and price returns 209
11.4 Random numbers 2 11
11.5 Dynamic hedging 213
11.6 Direct integration 2 16
11.7 Black–Scholes 2 16
11.8 Put-call parity 217
11.9 Black–Scholes and delta 217
11.10 American options 218
11.11 An introduction to volatility 2 19
11.12 Quoting in delta terms 222
11.13 Sticky strike versus sticky delta 2 24
11.14 Interpolating volatilities 2 25
11.15 Smoothing the volatility surface 2 26
11.16 Interpolating in the time dimension 228
11.17 Problems with volatility surfaces 229
11.18 Forward volatility – the standard approach 2 29
11.19 More exotic options and the volatility surface 2 30
11.20 Pricing American options 232
11.21 Trinomial trees 2 35
12 M ore Vanilla Options 237
1 2.1 Notional units 237
1 2.2 An introduction to FX options 2 38
1 2.3 Delta in FX transactions 240