rates fo training session ii markets 03112010

8/9/2019 Rates FO Training Session II Markets 03112010

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Copyright 2009 Sapient Corporation Copyright 2006 Sapient Corporation 1

Rates Front Office TrainingSession II: Financial Markets, Participants and Operations

Feb.

102010


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About the training

This training will cover

Products and markets What are interest rates, really ?

How are they set, and in which markets are they traded? (Session II, III)

What are the key products used for trading and hedging rates?

Processes

What is the front to back process used to trade rates?

What do FO, MO and BO do? What tools and techniques do they use?

What tools and techniques do they use in UBS?

We will emphasize FO concepts, and operations, but cover some MO and BO What role can, might I play in the process?

Mathematics underlying rates trading

Introduction to rates analytics/mathematics (A flavor!)

Valuation and risk management (forward curves, discount curves, and those pesky greeks!)

Typical IT projects, assignments, challenges in FO, and possible solutions (Optional)

So where will it get me?

You will not become an expert, but you will be

Able to talk to a trader, and understand his needs

Able to talk to a BA, and understand his needs

Able to talk rates FO - in weeks, and hopefully, start walking the walk a journey of years!

Where do you want to go?

Assumptions?

For 101 sessions, we dont assume much and start from the basics (time value of money)

For 201 sessions- we will use slightly advance maths not necessary, but very helpful


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Agenda

Overview of Capital Markets

Types of Markets

The Players

Types of Orders

The Process


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Regulatory Regime(The Fed, Regional feds, SEC, CFTC, OCC etc.)


StartupCompanies

EstablishedCompanies

Need Money

CorporateFinance

Sales

Syndicate Research

Trading

Raise Money Trade Money Have Money

PensionFund

Mutual/HedgeFunds

Trusts/Foundations

IndividualInvestors

PrivateEquity

IssuersAsset Managers(The BUY Side)

Investment Banks(The SELL Side)

Exchanges

ECNsOtherCompanies

OtherI-Banks

Secondary Markets

RaisingCapital

M&AClearing

Custodian

Trades

M&A


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StartupCompanies

EstablishedCompanies

Need Money

Issuers

Issuers - People who need money

Corporations need money for new products and to enternew market

Governments need money to cover deficit and fundpublic infrastructure

Startups go public when they first issue stock, in an IPO(initial public offering) or through private equity


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What is investment banking?

Is it investing? Is it banking?

Actually, it is neither

Investment banking, or I-Banking, as it isoften called, is the term used to describe thebusiness of raising capital for companies.

Investment Bank (I-Bank)

CorporateFinance

Sales

Syndicate Research

TradingPrivateEquity

Investment Banks(The SELLSide)

Raise Money Trade Money


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Corporate finance

Mergers and acquisitions advisory involves negotiating and structuring mergers

Underwriting involves shepherding the process of raising capital for a company

Syndicate

Syndicate exists to facilitate the placing of securities in a public offering

The investment bank forms a "syndicate" of other underwriters to "spread the risk" and "share thewealth" in the industry

Sales a person is sales performs one of the following roles: the classic retail broker, the institutionalsalesperson, the private client service representative

Trading Facilitate the buying and selling of stock, bonds, or other securities such as currencies, either

by carrying an inventory of securities for sale or by executing a given trade for a client

Research

Research analysts follow stocks and bonds and make recommendations on whether to buy, sell,or hold those securities

Idea generation think of it as an assembly line where the output is an investment or trading idea

The modern concept ofInvestment Bank

was created in the

Glass-Steagall Act (Banking Act of 1933)

Glass Steagall separated commercial banks, investment banks, and insurance companies after the crashof 1929

The Gramm-Leach-BlileyAct (GLBA) repealed part of the Glass-Steagall Act of 1933, allowinginstitution to act as any combination of an investment bank, a commercial bank, and/or an insurancecompany- often cited for creating financial institutions that are too-large-to-fail (e.g. merger of Citicorpwith Travelers to form the behemoth Citigroup)

I-Bank Functions


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UBS IB Structure

CorporateFinance

Sales

Syndicate Research

TradingPrivateEquity

Investment Bank

Inv

estmentBankingSpin-offs

Mergers &Acquisitions

LeveragedBuy-out Advice& Financings

Hostile

DefenseAdvisory

Restructurings

Divestitures

StrategicAdvisory

Privatizations

CapitalStructureAdvisory

FI/Rates

Fixed Income/Rates

EmergingMarkets

Debt CapitalMarkets

Govt Bonds

InvestmentGrade

High Yield

ResidentialMortgages

DistressedDebt

Credit/IRDerivatives

EnergyTrading

Asset Backed

Securities

IR

Deriv

ativ

es


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Asset Managers have the following roles: Trading

Portfolio Management

Research

Risk Management and Compliance

Client Service

Individual Investors

People who have money

And want to invest it

Asset Managers & Individuals People who havemoney

Have Money

PensionFund

MutualFunds

Trusts/Foundations

Asset Managers(The BUY Side)

Individual

Investors


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Types of Markets


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Types of Markets

Money Market

Short-term, high quality debt securities are traded here. These securities carrylittle or no default risk and have very little price risk due to their short maturities.

Capital Market

Capital Market Long-term securities trade in the capital markets. Thesesecurities are subject to significant price risk, default risk, purchasing power risk,etc. due to their longer maturities.

Primary markets are where securities are initially sold. In this market the issuerreceives the proceeds from the sale.

Once securities have been sold into the primary market, they begin trading in thesecondary markets. In the secondary markets the seller of the securities receives

the proceeds, not the issuer.


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Primary Markets

Debt Issuance

The most common process of issuing bonds is through underwriting. In underwriting, one or moresecurities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to endinvestors.

Government bonds are instead typically auctioned.

Primary issuance is arranged by bookrunners who arrange the bond issue, have the direct contactwith investors and act as advisors to the bond issuer in terms of timing and price of the bond issue.The bookrunners willingness to underwrite must be discussed prior to opening books on a bond

issue as there may be limited appetite to do so. Equity Issuance

Private placement : To wealthy individuals or institutions, facilitated by private equity firms

Public placement :

IPO process : First listing of a company on an exchange.

Underwriting: An investment bank typically performs the function of underwriting an issue.As in the bond world, it involves a transfer of risk from the issuer to the underwrite, forwhich the underwrite gets a premium on the issued stock. An underwriter typically unloads

the securities through the process of book-building, which is essentially an institutionalauction, and is obliged to purchase the unsubscribed portion.

The book building process also established the initial price

The issues is oblieged to offer a certain portion of the issue to the general public at large.

Seasoned Equity offering : fresh offering for an already listed stock


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Secondary Markets

Organized markets are those which have a physical location where all tradingtakes place. For example, the NYSE, CME, CBOT and regional exchangesare organized markets.

Over the Counter (OTC) markets do not have physical locations. Instead,they are characterized by networks of dealers who are connected bytelephone or computer networks. The Nasdaq was an OTC market.


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Exchanges

Exchanges are organized marketplaces which bring together buyers and sellers to trade standardizedsecurities under a transparent and well regulated regime

Examples: NYSE, AMEX, NASDAQ, CBOT, CME, ICE, LME, LSE, BSE

Key features

Standardization only pre-definedsecurities and contracts are traded. Forinstance Rates futures contracts tradedon an exchange (like CME) would specify

the underlying (3 month OIS futures with afixed notional), date of delivery, block size(i.e. the number of contracts) etc.

Counterparty risk is eliminated theexchange is the counterparty for eachtrade, and makes margin calls based onthe rise and fall of the value of contracts.

Margin calls all participants have to

place a collateral (cash or security)with the exchange against all opencontracts, to mitigate the risk that thethe exchanges counter party i.e. thetrader wont deliver on the contract.The contract is revalued daily, andchecked against the collateral. Anyshortfall has to be posted, else theexchange unwinds the contract to

recover the proceeds


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Over-the-counter (OTC) Markets

Constitutes anetwork of brokers and dealers

that trade stocks and bonds that are not listed on anExchange

Involves buying and selling securities outside the organized stock exchange

Brokers/Dealers negotiate most transactions by telephone, private leased lines and computer networks

Some reasons over-the-counter trading exists:

Non standard deals-customized to specific client requirements

unwillingness to abide by the information disclosure rules of an exchange

low volume

OTC market operates under the rules & procedures defined by their own governing authorities: ISDA, NASD


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Third Market and Fourth Markets

Third markets

Trading by non exchange-member brokers / dealers and institutional investors of exchange-listedstocks.

These markets exists to avoid making such big orders through markets, which may greatly impact theprices of securities

Fourth market (ECN, Crossing Networks)

The trading of exchange-listed securities between institutions on a private over-the-counter computernetwork, rather than over a recognized exchange such as the NYSE or NASDAQ.

Trades between institutions will often be made in large blocks and without a broker, allowing theinstitutions to avoid brokerage fees.

Example

When a mutual fund and a pension fund enter into a large block trade with each other, this wouldgenerally occur in the fourth market and usually over an electronic communication network(ECN). By executing the transaction this way, both parties avoid brokerage and exchange transactionfees. They also avoid the possibility of distorting the market price or the volume traded on anexchange.

Biggest ECNs in the Nasdaq Instinet, owned by Reuters, Island.

Other major ECNs include Archipelago, REDI-Book, Bloomberg, and Brut.

Crossing Networks quotes not displayed


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The Players


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Brokers/Dealers Prime Brokers

Market Makers

Specialists

Traders

Custodians

Regulators

Securities Exchange Commission (SEC) Federal Reserve

The Players


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Broker is an individual/firm who facilitates trades between clients

They charge a commission for executing buy and sell orders submitted by an investor Broker is under a legal obligation to make sure that you get the best execution for your order

Dealers is a person/firm which buys and sells forhis or her own inventory of securities and for others

Broker/dealers must register with the SEC

Types of Brokers

Direct-Access Broker- concentrates on speed and order execution, allows clients to define orderrouting

Full-Service Broker- provides a large variety of services to its clients, including research andadvice, retirement planning, tax tips, and much more

Discount Broker- who carries out buy and sell orders at a reduced commission, compared to afull-service broker, but provides no investment advice

Floor Broker- an employee of a member firm who executes trades on the exchange floor onbehalf of the firm's clients

The Players Brokers/Dealers


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Act as a wholesalerfor the shares in which it is registered to trade as a principal (major party to afinancial transaction)

Are firms that typically maintain an inventory, and quote bid and offer prices in a given security

On an exchange the market maker will offer firm bid and ask quotes, i.e. Market makerHAS TOGIVEYOU A PRICE to enable market to run smoothly on exchanges. Of course on the OTC markets, there isno such obligation

Market Makers must be compensated for the risk they take. The market makermaintains a spread oneach stock he covers

Example: Market Makerbuys 100 IBM @ $100 each (ask price)

Then offer to sell them to a buyer @ $100.05 (bid price)

The difference between the ask and bid price is only $0.05, but by trading millions of shares a day,he's managed to pocket a significant chunk of change to offset his risk.

Specialist

Special type of market maker-only applicable to exchanges. They operate from exchanges wherethey buy seat

Important roles of a specialist: to ensure that all bids and asks are reported in an accurate and timely manner

Specialist must also set the opening price for the stock every morning

Role of the specialist is to find the correct market price based on supply and demand

The Players Market Makers and Specialists


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Traderis a securities professional or firm, who buys and sells securities, such as stocks and bonds

Trader Types

Day Traders

Buying and selling of securities within a single trading day

Scalpers

make tiny profits from each trade exploiting the bid-ask spread

Momentum Traders

Keeps a watch on stocks that are making significant moves in one direction, tries to ride this roller

coaster Technical Traders

Obsessed with charts, graphs and historical trends from prices

Fundamental Traders

Keeps a watch on companys financial health, market news

Swing Traders

kind of fundamental trading in which positions are held for longer than a single day

The Players Traders


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Custodian, refers to a bank, agent, or other organization responsible forsafeguarding a firm's orindividual's financial assets

Banks are the major players in this domain

A custody relationship is contractual, and services performed for a customer may vary

Banks that are not major custodians may provide custody services for their customers through anarrangement with a large custodian bank

Services

To hold in safekeeping assets such as equities and bonds

Arrange settlement of any purchases and sales of such securities

Collect information on and income from such assets (dividends in the case of equities and interestin the case of bonds)

Provide information on the underlying companies and their annual general meetings

Manage cash transactions

Perform foreign exchange transactions where required

Provide regular reporting on all their activities to their clients

The Players Custodians


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Players Clearing Firms and Settlement Agencies

Clearing ensuring that the trade details match for both the counterparties

Millions of transactions happen each trading day, initiated through brokerage firms. About 250 of thosefirms are self-clearing, which means they compare the details of their transactions themselves. The non-clearing firms also known as correspondent firms forward their orders to a clearing firm that handlecomparison for other firms.

Once a trade is confirmed, securities and money need to exchange hands (dvp). This process is calledsettlement

In North America most clearing and settlement is handled through the National Securities ClearingCorporation (NSCC) and the Depository Trust Company (DTC), subsidiaries of the Depository Trust &Clearing Corporation (DTCC). DTCC is owned by the clearing firms and markets that depend on it tohandle the exchange of securities and money that must occur to complete a trade

Netting and Matching

NSCC (National Securities Clearing Corporation) nets down, or reduces, the number of tradingobligations that require financial settlement to just 3% of the total by matching, or offsetting,transactions in each individual security reported by each firm.

Dealing with dollars

Money movement after settlement is the last phase of transaction

Actual payment for settlement of the net balance, or amount that must be exchanged, is sent toDTCC (Depository Trust & Clearing Corp.)

On Payment receipt the ownership of securities is transferred by DTCC

Settling accounts

If after settlement NSCC (National Securities Clearing Corp.) owes money to a firm it is moved andvice versa


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Prime Broker

Manager trades with multiple brokers

These brokers settles these trades with PB

Manager reports all the trades to its PB

PB reconciles trades between the client and otherbrokers and reports back to clients.

Prime Brokers

A broker which provides special group ofservices to special clients

Some of the major prime brokers are: UBS,Goldman Sachs, Morgan Stanley, JP Morgan

Clients for prime brokers are mainly Moneymanagers, Hedge funds, Market makers,

Arbitrageurs, Specialists, Other professionalinvestors

Services provided by prime brokers are: Clearing (Domestic/International)

Settlement (Domestic/International)

Securities lending

Provides custody for client assets

Leverage facility

Cash management

Daily/monthly reporting facility, including multi-currency reports for international trades

Technology Services to support all the above


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The Federal Reserve System was created in 1913 by the Federal Reserve Act It is a system ofeight to twelve regional reserve banks, owned by its commercial member banks and

supervised by the Federal Reserve Board

Fed is the gatekeeperof the U.S. economy

Regulates banks

Helps defining countrys economic policies

The bank of the U.S. government

All taxes collected come here

All government expenses go from here

Issues coins and paper currency

The main tasks of the Federal Reserve are:

Supervise and regulate banks

Sets the Discount Rates - the interest rate that banks pay on short-term loans from a Federal ReserveBank

Regulates federal funds rate - the rate at which banks borrow reserves from each other

Manage and Conduct monetary policy in the economy by managing the supply of money

The Players Regulators - Fed


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The Securities and Exchange Commission (SEC) was created by section 4 of the Securities ExchangeAct of 1934 following the market crash of 1929

The SEC is a United States government agency having primary responsibility forenforcing the Federalsecurities laws and regulating the securities industry

The mission of the U.S. Securities and Exchange Commission is:

Protect investors Maintain fair, orderly, and efficient markets

The SEC oversees the key participants in the securities world including:

Securities exchanges

Securities brokers and dealers

Investment advisors

Mutual/hedge/pension funds

The SEC is concerned primarily with promoting the disclosure of important market-related information,maintaining fair dealing, and protecting against fraud

Other regulators

CFTC Commodities

FINRA-Equities

The Players Other Regulators


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The Process


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The Process


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Type ofOrders

Limit - client is willing to buy (or sell) at a particular price

Buy 100 IBM @ 100

Market is at higher price

When market touches the order price trade is executed

Market - client is willing to buy (or sell) at current market price

Buy @ Market Price

Used to allow immediate execution of the trade

Stop Limit - is an order to buy or sell a stock at the market price once the price reaches or passesthrough a specified point, called the "stop price

Buy 100 IBM 105 with stop loss @ 95

Used to avoid sudden losses

Day - day order automatically expires if it is not executed during the trading session it was entered

Open - open order will remain in effect until filled, canceled, or until the contract expires

Market on Open- This order is executed as soon as possible following the opening of a market

Buy 100 IBM at market on open

Market on Close - This order is executed within the last minute of trading during the trading session theorder is placed

Sell 100 IBM at market on close

One cancels Another- This instruction is used together with two orders, so that upon the execution ofone order, the other order is automatically cancelled


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Useful Links

http://www.bloomberg.com/ Latest news from financial markets around the

world

http://online.wsj.com/home-page Wall Street Journal

http://www.nyse.com New York Stock Exchange

http://www.nasdaq.com/ NASDAQ website

http://www.sec.gov/ US Securities and Exchange Commission (SEC)

http://www.sifma.org/ Securities Industry and Financial Markets Association

http://www.sifma.org/services/techops/stp/html/process_flows.shtmlProcess flows for various financial markets/products

http://www.isda.org International Swaps and Derivatives Association (ISDA)


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