In addition trades are often transacted as hedges to limit exposure to changes in market conditions caused by other trades. We examine hedging in Chapter 10.
The trading parties must agree:
■ what each side is committed to supplying
■ when the agreement takes effect
■ how the transfer is to be arranged
■ under what legal jurisdiction the trade is being conducted.
A trade is in essence a legally binding agreement creating an obligation on both sides. It is important to consider that from the point of agreement, the trade exists. If one side reneges on the trade and nothing is actually transacted, the other side will have legal recourse to compensation.
Trading has benefits and risks. It is an everyday activity we sometimes take for granted, but a transacted trade requires processes to be undertaken from conception to expiry. We will examine the journey of a trade and its components and in doing so will explore the activities of a financial entity engaged in trading.
Trading encompasses many types of trades. Some are standardised with very few differences from a regular template. They are traded in high volumes and require little formal documentation. For example, buying a share in an exchange-listed security would require only the security name, deal date and time, settlement date, quantity and price.
Other trades are far more specialised. They may have hundreds of pages of documentation and take months to put together. They will be traded individually and no two trades will be alike. Even these more complicated trades however are usually made up of components built from simpler, standard trades.
1.9 Who works on the trade and when?
In Chapter 15 we will discuss the various business functions. Table 1.2 shows a summary of the most general activities of each business function and at what point they are performed.
Table 1.2 Business Functions at points in trade lifecycle
1.10 Summary
There are many reasons why people might trade. Financial trading is undertaken by a broad range of companies specialising in various areas and strategies. A trade has both common and specific properties and can be transacted in many different ways. The various business functions within a financial entity will perform their activities at different stages in the trade lifecycle.
Chapter 2
Risk
Risk is a major part of trading. Not only do most traders need to actively manage risks that arise from their trading (market risk) but the actual processes in the trade lifecycle carry various types of risk. Here we present an introduction to the concept of risk in general.
2.1 The concept of risk
The German sociologist, Niklas Luhmann, defined risk as ‘the threat or probability that an action or event will adversely or beneficially affect an organisation's ability to achieve its objectives’.
In the financial services industry, the term risk often denotes the market risk of holding trading positions. Risk management is then the action taken by traders to control this risk. This is an important type of risk and one to which we will devote a chapter of this book (Chapter 10), but it is by no means the only source of risk to an organisation engaged in trading. Whenever we use the unqualified term risk, we mean the wider connotation of risk as in Luhmann's definition.
2.2 Risk is inevitable
Imagine you own £10,000 in cash and decide to store it in the proverbial shoebox under the bed. You are now certain that you have protected your money – there are no risks attached. Correct? Unfortunately, things are not quite as safe as you think. Firstly, it could get stolen or there could be fire or flood. Secondly, if you leave the cash there long enough, the denomination of bank notes could cease to be legal tender and banks and shops refuse to accept them. Thirdly, inflation of prices might reduce the real value. In addition to these risks of losing all or part of your money, you are also foregoing the ability to invest your money for profit.
In reality there is no such thing as being of free of risk. All activities incur some sort of risk. Trading and its associated processes have many risks; the important thing is to be aware of risks and choose how to deal with them.
2.3 Quantifying risk
In order to quantify and manage risk, one must define:
■ the event upon which the risk is to be measured
■ the probability of the event occurring
■ the loss entailed if it occurs
■ the means by which some or all of the risk can be mitigated
■ the cost of mitigating risk.
Both probability and loss calculations are very important in order to have an appreciation of the risk. A catastrophic event that occurs with a remote probability may require greater protective action than an everyday event that causes a small loss.
In practice, it may be difficult to quantify either the probability or the amount of loss entailed or both. With finite resources, an organisation will need to spread the amount it spends on protection against risk according to priorities. However, even an estimation of risk should aid the process of assigning priority. Also, in deciding a future course of action, the organisation should weigh the benefits against the risks in order to arrive at a fair decision as to how to proceed.
In Table 2.1, we give three examples of risk events, a rough estimate of the probability of occurrence, the amount of loss should the event happen, the selected remedial action and the estimated cost of such action.
Table 2.1 Examples of risk events
2.4 Methods of dealing with risk
There are four main ways to deal with risk:
■ Ignore
An event carrying risk may be considered of negligible impact and so can be totally ignored. Alternatively, it may be more expensive to protect against the risk than to let the event occur – sometimes an organisation just has to take the hit.
For example, the loss to a hedge fund of being without electricity is negligible compared to the cost of installing its own generator.
■ Minimise
If it is impossible or too costly to remove the risk altogether, steps can be taken to either lessen its impact or reduce the probability of it occurring.
The skydiver may carry two parachutes in case one malfunctions. (He would rather not think about the probability of both not working!)
■ Avoid
Again, if it is too difficult to protect against a risky event or the benefits are not sufficient to justify the possible damage entailed, the risk can be totally avoided.
For example, the market risk department might rule that a trade is so risky it cannot be transacted despite the potential profit.
■ Remove
Removal of risk is certainly desirable, but often difficult to achieve.
An example of risk removal is house insurance. One transfers the risks associated with owning a house to an insurance company. (Obviously there is still a residual risk that the insurance company will default on its obligations, but legislation and regulation generally make this probability negligible.)
2.5 Managing risk
A successful organisation relies on good management. One