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The Trade Lifecycle
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Table of Contents

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

About the Author

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

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