It should be said that managing risk is distinct from being risk-averse. There are many reasons why a trading desk might take on market risk and manage it successfully. Similarly an institution may decide on a more risky course of action because the likely benefits outweigh the possible losses. As long as the potential risks are understood and estimated, it can be said that risk is being managed.
2.6 Problems of unforeseen risk
No stakeholders in a business – investors, managers, employees and customers – want unforeseen risk. Due to its sudden effect, the organisation is ill-equipped to deal with it and its consequences are unknown. One of the major causes of the recent credit crunch was the failure of many organisations to take into account a particular risk: that so many American sub prime mortgage borrowers would be unable to repay their debt. Unforeseen risk points to poor management and supervision and reduces confidence in the financial entity. If risk is present, it should be identified and then sensible decisions can be taken about how to manage it.
2.7 Summary
A financial entity must accept that risks are an unavoidable part of the trading process. When an adverse scenario arises, it will fare better and be able to keep costs down if it is proactive in uncovering them, estimating their probability and effect and deciding best how to deal with them. Controlling risks does not necessarily mean being cautious in business – aggressive trading can reap big rewards. But recognising risk in all its manifestations is a fundamental part of managing the trading process.
Chapter 3
Understanding Traded Products – Follow the Money
To gain an understanding of financial trading one must distinguish between the concept of an asset class and that of a financial product. These terms are often confused. The aim of this chapter is to define a set of common financial products. In the following chapter we discuss asset classes. A financial product (or ‘product’) is a contract between two parties which determines an exchange of money or assets. There are many specific products tailored for the needs of one or both parties, but here we will discuss a set of common products existing in the financial world with a well-defined structure.
To help remove the confusion between products and asset classes, let us consider the everyday case of buying a sack of potatoes and the less frequent purchase of a washing machine. Essentially the process of acquisition of potatoes and washing machines is the same: you spend money and receive goods. However, since the type of vendor, the layout of the store, the delivery mechanism and various other factors are different, we normally view these two acquisitions in different ways. We may say that potatoes are in the asset class of perishable food and washing machines are in the asset class of domestic appliances. So the underlying process is the same but the asset classes are different.
The same is true for financial products. Buying shares is intrinsically the same as buying aluminium, sovereign bonds or purchasing dollars in exchange for euros. However, since the people and trading environments of each of these trades are very different, we generally group them into different asset classes. (The examples above corresponding to equities, commodity, fixed income and foreign exchange (FX)). The processes for dealing with each of these trades will normally depend on the asset class rather than the product itself.
As we have seen, some products exist in more than one asset class. Every asset class has a suite of possible products. A financial institution organises its traders, sales staff, middle office and controllers around each asset class rather than around each product.
A trade is an actual instance of a product. There are two parties to any trade, often referred to as counterparties or counterparts. Many products make reference to other parties or events. For example, UBS might buy Ford Motor Company shares from BNP Paribas. The two parties to the trade are UBS and BNP Paribas. Once purchased, UBS will have to claim dividends from Ford and not from BNP Paribas, so UBS will have to make Ford aware of its acquisition.
Some products make reference to events or entities. A swap trade (described below) needs at least one reference entity for its float leg (or two for a float-float swap). The reference will state the date, time and nature of the entity to be taken into consideration. An analogy might be to betting on a horse. The customer purchases the bet from the seller (the bookkeeper) but any winnings are dependent on the reference entity in the bet (the horse and the race). The horse itself knows nothing of the trade.
As mentioned, financial products are contracts. We can analyse the product by looking at the terms and conditions of the contract, but it is often easier to examine the cash or asset flows. The product is uniquely defined by the following:
■ date
■ value
■ direction
■ type of cashflow (cash or physical).
The cashflows are the mechanics of how the trade works from start to finish. The value of the trade is something different. Value is a function of the expected worth of future cashflows. Note the keywords expected and future – these involve a view of how the underlying market forces will change over time. So do not confuse cashflows, which are determined at the start of the trade by the type of product being traded, with value which varies over the lifetime of the trade.
For a consistent approach, let us consider each product from our point of view as a trader who is buying something. We shall use the following graphical notation:
■ A down arrow indicates something we are contractually obliged to part with.
■ An up arrow indicates something we are contractually expecting to receive.
■ A grey arrow indicates money (cash) in our own currency.
■ A black arrow indicates something other than money or cash in a foreign currency.
■ A straight line indicates a fixed amount.
■ A dotted line indicates an unknown amount.
3.1 Spot trades
A spot trade is the purchase of an asset for cash. It is the simplest financial product and is often referred to as an outright because, once the cash and assets are exchanged, there is no residual obligation on either party – the trade is settled outright.
In Figure 3.1, we are buying a fixed quantity of something in exchange for cash.
Figure 3.1 Cashflows on spot trade
Notice that the actual exchange does not necessarily take place when the trade is agreed. There is a gap known as the settlement period, which could be anything from a few hours to three days after transaction. However, everything is committed at the time of transaction and the size of payment and assets is fully determined and cannot be changed.
Examples of spot trades in various asset classes are:
■ Commodity: We buy 1m troy ounces of Gold from Commerzbank at USD 1000 per troy ounce.
■ Equity: We buy 10,000 Ford Motor Company shares from BNP Paribas at USD 17.32 per share.
■ FX: We buy 10m Swiss Francs from RBS at exchange rate of 1.118142 francs per US dollar.
■ Fixed income: We buy 5m IBM Bonds from Chase Manhattan at 92.88 cents per bond.
Note that when purchasing an equity or a bond, we have settled outright with the counterparty (BNP Paribas or Chase Manhattan in the examples above) so they have no further financial responsibility or liability,