How the Trading Floor Really Works
Book Discussion Questions
Chapter 1 Questions:
1.1 Q: For what reasons does a borrower choose a bond over a loan when he needs to borrow money?
A: For most individual borrowers and small and medium sized companies, they only really have access to the loan market because they are not large enough or well-known enough to borrow money from the bond market investors.
1.2 Q: What are the cashflows of a $100-million investment in a bond with a 5% annual coupon, a 5-year maturity and an initial price of 101%?
A: There is an initial investment of $101 million, then each year the investor receives a $5 million coupon for 5 years. At maturity, in 5 years, the investor receives the 5th coupon payment plus the principal repayment of $100 million.
1.3 Q: After the iPad was introduced, why would anyone sell their shares in Apple?
A: Investors buy and sell financial products for a variety of reasons. Because the share price of Apple rose after the iPad was introduced, some investors who already owned Apple shares may have sold because they had a return target for their investment which was reached. Some investors may have concluded that there was no more upside in owning Apple shares. Other investors may have had limits to the amount of technology shares they can own and decided to take profit by re-allocating their investment in Apple to other younger technology companies.
1.4 Q: Why don’t technology companies generally pay dividends?
A: Most technology companies are young growth companies. This means that they normally re-invest their earnings into research and development in order to continue growing. For the more mature and successful technology companies, like Apple, they are able to pay dividends because they have made so much profit.
1.5 Q: How do private equity companies make money?
A: Private equity can make money in two ways. The first is by investing in a new (called a start-up) company or in a young company which is still privately owned and growing rapidly but needs capital. The private equity company will often help to manage the company and over time hopes the company is large enough to issue public equity in the form of an IPO. Then, if that is successful, company can do a Secondary Offering where the private equity company can sell their shares. The second is by taking a company which is already public, but is underperforming, and buying all the public shares and making the company private again. The private equity company then hopes to manage the company better and eventually issue public equity in the form of an IPO.
Chapter 2 Questions:
2.1 Q: Why does a bank add value in an illiquid product?
A: A bank will put a price where it is prepared to buy or sell a product even if there are no other bids or offers in the market for that product. For clients who want to buy or sell these products, this is very valuable. For the bank, this is taking risk.
2.2 Q: How are exchanges different from banks?
A: An exchange is simply a broker of financial transactions. Market participants can submit bids or offers or can agree to sell at bids or buy at offers which are published on the exchange by other market participants. The trade only occurs when there are two market participants who agree to transact. A bank will buy or sell whenever the client wants to do that. Thus, the bank becomes the counterparty to the client regardless of what the client wants to do. The bank takes risk and doesn’t need another market participant to match up with the client’s request.
2.3 Q: Can clients access financial markets without speaking to a major bank?
A: Taken literally, yes, they can. Clients can trade many products via electronic trading platforms managed by banks which are only provided to their clients. Also, depending on the size of the client, some clients can trade directly with an exchange without going through a major bank. Finally, there are many broker firms which are not major banks but provide access to exchanges for smaller clients.
For products which are not exchange traded, there are new electronic trading platforms which are looking to intermediate between the clients and the major banks so that clients can see bids and offers from a variety of major banks. However, these clients still need to be an approved client of the major bank in order to transact in this format.
2.4 Q: How are hedge funds and asset managers different? How are they the same?
A: Hedge funds are a subset of the asset management industry. They are different because 1) they often target a handful of large investors rather than hundreds or thousands of investors like other asset managers, 2) they are more active investors which means that they may buy and sell something on the same day, 3) they don’t always bet that market prices will go up, they often bet that prices will go down and 4) they are generally paid more in management and performance fees than other asset managers. They are the same because they invest money on behalf of other investors and are paid fees to do that.
2.5 Q: Why do insurance companies have large pools of money to invest in financial products?
A: Insurance companies receive insurance premiums from their clients which they need to invest and grow in order to have the money available to make payouts to their clients when they claim on their insurance.
Chapter 3 Questions:
3.1 Q: Are there banks which only have retail businesses? Do they have a global financial markets business?
A: There are many banks which are primarily retail businesses. They are mostly smaller or regional banks which service the retail and small businesses in their region. In the most commonly used definition of “global financial markets”, these banks don’t have a global financial markets business. In other words, they primarily provide access to global financial markets to their clients by acting as a broker rather than a liquidity provider, if they provide access at all.
3.2 Q: Are there banks which don’t give out loans?
A: There are few major banks which don’t have a loan business. The history of this stems primarily from the US where the commercial (lending) banks were separated from the investment banks. The two major banks remaining which don’t have a loan business are Morgan Stanley and Goldman Sachs. Others were Solomon, Bear, Lehman and Merrill Lynch.
3.3 Q: What are some examples of some high-profile front running cases?
A: Martha Stewart in 2001 reportedly sold shares ahead of a company announcement based on insider information from her broker; Merril Lynch prior to 2008 reportedly traded shares in equities ahead of large client trades; and Raj Rajaratnam reportedly bought bank shares ahead of Warren Buffet based on insider information in 2008 which he had as a board member of Goldman Sachs.
3.4 Q: Post the 2008–2009 credit crisis, the process for setting Libor was criticized. Why was that?
A: The criticism is based on the idea that some banks set Libor at a different rate than where Libor was actually trading in an effort either to 1) profit from a different market rate or 2) to show a lower borrowing rate for certain banks during the height of the crisis in order to calm market fears down.
3.5 Q: Why is the Chinese wall a key concept to understand for people who work in a bank?
A: The Chinese wall is the idea that someone who possesses information about a company which is not public but could move market prices for financial instruments in that company cannot trade in an effort to profit from that information. It is illegal. Because banks often have this type of information about their clients, the individuals who work within banks are often restricted from trading in those companies as a result.
Chapter 4 Questions:
4.1 Q: Why do clients often ask to see both the bid and the offer from the market makers?
A: For 2 reasons: 1) clients don’t want to risk the market maker front running their trade, and 2) clients want to understand where both sides of the market are before trading.
4.2 Q: Are clients always the market takers?
A: In most financial markets, clients are the market takers. The one exception is when a client decides to put in an order on an exchange and wait to be hit or lifted rather than immediately hit or lift a bid or offer.
4.3 Q: Why is it so important that trade execution is on a recorded medium (either phone or a form of electronic communication)?
A: This is primarily to have a record or the trade details in case of a dispute between the parties post execution. The record can be examined by the two parties or by an independent 3rd party in the case of a dispute.
4.4 Q: Why is clear communication in trade execution so important?
A: Ideally to prevent trade disputes from occurring. Repeating all the key details of the transaction either on a recorded line or in electronic communication is crucial at the point of execution.
Chapter 5 Questions:
5.1 Q: Why do we generally say that when equity prices go up bond prices go down?
A: When equity prices go up, this means the economy is strong. In order to prevent bubbles from occurring, the government in that economy will often push interest rates higher to slow the economy down. Higher interest rates means lower bond prices. And vice versa.
5.2 Q: Why is macroeconomics important to all asset classes?
A: Macroeconomics is simply the state of the economy, whether it is strong or weak in a certain region. In a strong economy, share and commodity prices should go up and bond prices should go down, while in a weak economy, share and commodity prices should go down and bond prices should go up. This is a general relationship which doesn’t always hold but is a good starting point for understanding financial market price moves. As mentioned in the book though, supply and demand ultimately determine the price for all financial products.
5.3 Q: What type of events might only affect one asset class?
A: These are primarily company specific events such as earnings statements which primarily affect the shares in one company. There are also some supply and demand events which impact one asset class. For example, oil supply can have an impact on commodity prices but not necessarily on other asset classes.
Chapter 6 Questions:
6.1 Q: When a bank loses money on a client trade, is it the fault of the trader or the sales person?
A: There is no right answer to this question although it is probably equally split between the trader and sales person or some combination of the two. Some examples are: the sales person was not aware that the client was going to do more of the same trade in size, the trader’s market view was not correct, the sales person pushed the trader to make a tighter market, the trader was unaware of other large interests in the market.
6.2 Q: Why is the bid–offer spread an indication of the profitability to the bank?
A: Theoretically, we say the profit to the bank is the difference in price from the bid or offer to the mid-market. So the wider the bid-offer spread, the more the theoretical profit. However, the wider the bid-offer spread, the less liquid the product and the more risk to the bank.
6.3 Q: Do banks deserve the bid–offer spread that they charge?
A: Banks need to protect themselves against the risk they take when they take positions due to providing liquidity to clients. In a transparent competitive market, the bid-offer spread should be a fair one for both the bank and the client but in an illiquid market, sometimes it benefits the client and sometimes it benefits the bank.
6.4 Q: Why do market makers always have to have a view?
A: When a market maker takes a position from a client, the market maker needs to have a view on whether market prices are going up or down in order to best determine his close out or hedge strategy.
Chapter 7 Questions:
7.1 Q: What might be the concern of shareholders in banks who have large proprietary trading businesses?
A: The issue most often cited is that of volatility of earnings. The reason is that a proprietary trading desk is taking large positions based on a view of an individual which may or may not turn out to make money. Thus, while prop desks haven’t all had very volatile earnings, they have to potential to have volatile earnings and if this makes up a large portion of the earnings of a bank, the shareholders will possibly have volatile share prices.
7.2 Q: Why is proprietary trading similar to trading for a hedge fund?
A: Proprietary trading is about individuals taking positions based upon their micro or macro views on the financial markets. From this perspective it is the same as working for a hedge fund.
7.3 Q: Do traders want to be proprietary traders or hedge fund traders?
A: In general, working for a hedge fund is considered a more “sexy” role than working for a bank despite the day to day activity being similar.
7.4 Q: Why are market makers forced to trade with clients?
A: The role of a market maker is to make markets for clients. So while they are not forced to do anything, the job description is clear.
Chapter 8 Questions:
8.1 Q: Is the relationship management or the risk taking more important to a bank?
A: They should be equally important. There is no risk taking without client trades and if a bank is not considered stable, in other words, is too risky, then there are no clients in theory.
8.2 Q: Why aren’t sales points real money?
A: Sales points are a portion of the theoretical profit of each client trade which are assigned to the sales person irrespective of whether or not the trade is hedged or closed out. Thus, the hedge or close out could actually be a loss to the bank but the bank still would have assigned some sales points to the sales person.
8.3 Q: Why do traders and sales people often have difficult relationships?
A: If they don’t consider themselves to be working on the team and have medium to long term horizons, they could find themselves working at cross purposes. The sales person could be focused on winning the client trade and the trader could be focused on making as much money as possible from the client trade.
Chapter 9 Questions:
9.1 Q: Why are research teams sometimes called cost centers? Is this a fair description?
A: Research teams are a resource for both the clients as well as the bank itself, but it is not a revenue center as banks rarely charge for the use of their research. So, strictly speaking, they are cost centers even though in practice they are crucial to the overall business of the bank.
9.2 Q: Is research valuable if it doesn’t have a trade recommendation associated with it?
A: It is rare to see financial research which doesn’t have an associated trade recommendation. Sometimes macroeconomic research isn’t accompanied by trade recommendations and is merely an analysis of what an upcoming number might be. This is still useful information and at the end of the day, it is important for a trader or investor to make their own trading decision.
9.3 Q: Why do banks produce trade strategy research reports?
A: Trade strategy research is a relatively recent development in the world of research analysts over the last 10 to 15 years. It has come about as a result of development in the derivative markets. The derivative products have become more technical and thus it is valuable to have strategy research reports discussing different uses of different derivative products.
9.4 Q: What investors in particular benefit from research reports?
A: The answer is in the question. All investors benefit from research reports while companies who only really use the financial markets for risk management purposes aren’t particularly influenced by research reports.
Chapter 10 Questions:
10.1 Q: Is trading derivatives harder than trading cash products?
A: Very generally, when cash products are standardized and liquid, the answer is yes because there is little if any residual risk when buying one cash product and selling it on while there is a lot of residual risk when trading derivatives and hedging them even if the derivative is standardized and liquid.
10.2 Q: Why don’t cash products have significant counterparty credit risk?
A: The answer has to do with the time to settlement. For cash products it is a matter of days to settle a cash product at which point there is no further exposure to the counterparty while derivatives can have exposure to a counterparty for years.
10.3 Q: Why does a bank take more risk in an illiquid market?
A: An illiquid product is harder to hedge or closeout whether it is cash or derivative. Thus, the price could move before the bank has closed out or hedged it’s position.
10.4 Q: Why is the size of the bid–offer spread an indication of an illiquid market? What else can it be an indication of?
A: Because it is riskier to make markets in illiquid products, the market maker needs to widen the bid-offer spread in order to compensate him for the risk of the market moving before he has hedged or closed out the trade. It can also be an indication of a large size transaction compared to the normal daily volume in a financial product.
Chapter 11 Questions:
11.1 Q: Do structurers need to be technical?
A: Yes, structurers need to be able to broadly understand both the pricing models that the traders use as well as how the structuring models work. The don’t necessarily need to be able to build the models themselves, but they need to understand the ramifications of changes to model parameters.
11.2 Q: Is structuring a role which is conducive to creating complex products for the sake of it?
A: This question has been asked a lot post the 2008-2009 credit crisis. Generally speaking the answer is no. While structurers need to understand and appreciate structural complexity, it is generally employed for a purpose. Complexity hasn’t historically been a goal.
11.3 Q: Are structurers more like sales people or more like traders?
A: The answer entirely depends on the individual. There are some structurers who are more technical and tend to be more like traders and others who are more like sales people and thus less technical.
11.4 Q: Are structured products dangerous?
A: This has been the claim post the 2008-2009 credit crisis. Any product which is not fully understood by the investor can be dangerous. Structured products are more complex than most and as a result are more susceptible to being misunderstood.
Chapter 12 Questions:
12.1 Q: Why don’t quants run financial markets?
A: The answer is that there is no single group of individuals who run financial markets. They are too large, too global and too complex for that to ever really be the case.
12.2 Q: Are models too complex?
A: Some are, but as the book states, all models are wrong and some are useful. Thus, using any model is a mater of understanding the assumptions and the limitations of it.
12.3 Q: Why are there derivatives traders who don’t know how the model works?
A: The skillset of a good trader is being able to make a good market and manage the risk while still earning a profit. Thus it is not necessary to know in detail how to model some of the more complex models. It is important though, to understand the sensitivities of the model results to the assumptions being used.
12.4 Q: Why aren’t quants traders?
A: Similar to the answer above, the skillset of a quant isn’t to be a good market maker or manage risk, it is to understand how to model the behavior of a financial product.
Chapter 13 Questions:
13.1 Q: Is the US government more credit risky than McDonald’s?
A: Both the US government and McDonald’s trade in the credit derivative markets. Sometimes, the US government credit spread which is the measure of riskiness is higher than McDonald’s credit spread. This is a market price at a point in time and has as much to do with supply and demand as it does to do with fundamentals. In general and since the inception of McDonald’s, the answer has been no.
13.2 Q: Is market risk more important than credit risk to a bank?
A: This depends on the activities of a bank. Generally a bank which focuses mostly on lending to it’s clients will be more focused on credit risk and a bank which has a larger trading floor business than lending business will be focused on market risk. However today, it is clear that both the lending business and the trading floor business needs to focus on both market and credit risk equally.
13.3 Q: Do banks care about reputational risk today?
A: They certainly say they do, but actions speak louder than words.
13.4 Q: Is operational risk significant in banks?
A: Yes it is. The fact is that even in the best risk managed bank in the world, mistakes and even fraud can happen.
Chapter 14 Questions:
14.1 Q: Do banks add value to the financial markets?
A: Yes they do. They are the ultimate liquidity providers to financial markets but they need to take risk to do that which is where the problems crop up…
14.2 Q: Should they be allowed to take risk?
A: Banks can’t provide liquidity without taking risk. So the question is whether we want a different financial system to be in place entirely.
14.3 Q: Should there be more regulation?
A: In my experience, the more regulation, the more unintended consequences and the more routes around regulation. So, my answer is no but I am aware that the answer to this question could possibly take another book – namely one on how banks should be regulated.
14.4 Q: How should traders be paid?
A: Traders should be paid for managing risk, not for taking risk. Many traders are paid simply as a function of the profits they generate rather than for prudent decision making. This is a culture shift on the trading floors rather than a formula shift in the bonus calculations.