Chapter 1
Trading

In this chapter we introduce the concept of trading which underpins the whole book and go on to look at factors influencing trading, market participants, how trading occurs and related topics.

1.1 How and why do people trade?

People engage in trade primarily for one or more of the following reasons:

• Require more or less of a product

  We go shopping because we need things. The same is true of financial products. One person buys something that another person has in surplus and is prepared to sell.

• To make profit

  If someone anticipates that he can buy for less than he can sell and has the ability to hold a product long enough to take advantage of the price differential, he trades.

• To remove risk

  Sometimes we need protection. We are worried that future events may cause our position to deteriorate and we therefore buy or sell to reduce our risk. The ship is safe, fully loaded in port today, but how will it fare exposed to the open sea tomorrow?

1.2 Factors affecting trade

In order to understand trading we will proceed to discuss the motivation behind why trading occurs.

Product appetite

Everybody wants to buy as cheaply as possible, but some people have a greater need for a product and will be willing to pay more for it. Our appetite for a product will determine the price at which we buy. Conversely, our desire to divest ourselves of a product will affect the price at which we are prepared to sell.

Risk appetite

Risk is not necessarily an undesirable concept. Different people and organisations have a different attitude to risk. Some people make money by owning and managing risk. They are prepared to service other people's desire to reduce risk. Many trades arise because some people will pay money to reduce risk and others will accept money for taking on risk.

Exposure

Whenever a trade occurs, both counterparts have each increased and reduced their exposure to something. For example, if Company A buys yen and sells euros to Company B, then A has increased its exposure to yen and decreased its exposure to euros and B has done the opposite (see Table 1.1).

Table 1.1 How a trade affects currency exposure

Item

Exposure for buyer (Company A)

Exposure for seller (Company B)

EUR JPY

Increased Decreased

Decreased Increased

The EUR-JPY foreign exchange transaction has resulted in the trading of one exposure for another.

Even when something is bought for money, the seller has increased his exposure to the currency of the money he receives. Someone living in New York and trading in dollars does not consider receiving more dollars as a risk because he is not exposed to changes in exchange rates. But in international commerce most market participants do worry about exposure to all currencies including their domestic currency which may attract less deposit interest than an alternative, making holding money in that currency less attractive.

1.3 Market participants

We use the example of a forward trade to illustrate various market participants. Other trades such as spot trades (immediate buy and sell) and options (rights to buy and sell in the future) have similar participation.

Producer

Imagine an apple grower owning a number of orchards. His product sells once a year and his entire income is dependent upon the size and price of his harvest. He can take steps to maximise his crop but he can do little to predict or control the price. He would rather have a fixed and known price for his produce than be subject to the vagaries of the market price at harvest time. How does he achieve a fixed price? He enters into a forward trade with a speculator obliging him to supply a fixed quantity of apples in return for a guaranteed price. He has now removed price uncertainty (or risk) and can concentrate on producing enough apples to meet his obligation.

Consumer

A cider manufacturer requires a certain supply of apples in six months' time. He is willing to pay more than the current market value to guarantee fresh stock is available when it is useful to him. His desire is to reduce his exposure to fluctuation of supply.

Speculator

A speculator takes a view on the likely direction of price change. If he sees a future shortage of apples, he will buy forward contracts now and hope to take advantage of his ability to supply later. He will take the opposite position and sell forward contracts if he forecasts a future glut. He is a risk taker, prepared to take advantage of other market participants' desire to reduce their level of risk.

Market maker

The market maker brings together buyers and sellers. He creates a market where it might be difficult for them to trade directly. He doesn't require the produce himself, nor does he have a view on the direction of price change; he is the middleman. He makes the market more efficient and helps to ensure prices reflect supply and demand.

1.4 Means by which trades are transacted

This section explains how trading actually takes place.

Brokers

Individuals and small financial entities cannot always get direct access to market makers. This may be due to their unknown credit worthiness, their small volume of trading or their specialised nature. They must rely on brokers to transact their trades. A broker, in return for a commission, will act on their behalf to execute a transaction at a given price or at the best possible price.

Sales departments of investment banks also have a broking function. Customers of the bank may request orders for financial instruments which the sales force transacts on their behalf either at their own bank or using their contacts with other banks.

Exchanges

An organised trading exchange is a safe and reliable place to trade. Prices are published, there is a plentiful supply of all products covered by the exchange and counterparty risk is virtually eliminated. There is a set of products traded, each one is well-defined, eliminating legal risk and liquidity is maintained by the guarantee of a market in each of the products.

Market participants buy or sell a product with the exchange taking the other side of the trade. Members of the exchange ensure that the exchange has sufficient funds to cover any transaction and the members themselves are vetted to ensure they behave according to the rules of the exchange. Examples of exchanges are:

• London Metal Exchange
• Chicago Mercantile Exchange
• New York Stock Exchange.

It is increasingly common for trading to be conducted electronically. Most exchanges have moved beyond open outcry, where participants shout out or visually indicate their requirements and prices. Electronic exchanges work by having participants sending in orders and setting prices across a network of computers connected to the main exchange which publishes all the information simultaneously to all subscribers. This creates a virtual market place: the traders can operate from their own locations without ever meeting their counterparts.

Breaches of security are a greater risk to electronic exchanges – it is essential that the participants are bona fide members of the exchange and that their details, prices and orders are kept secure. There is also communication risk where a computer or network fails in the central exchange or in one location, preventing some or all members from access to the market data.

Over-the-counter

Exchange trades are limited to:

• members of the exchange
• certain sets of defined products
• times when the exchange is open.

If trading is required without these restrictions, it has to be done directly between the counterparties. This is known as over-the-counter (OTC) trading. There is increased flexibility because the counterparties can agree to any trade at any time but the absence of an exchange carries greater risks. Nowadays, much OTC trading is covered by regulation to ensure, inter alia, that both counterparties are competent and knowledgeable enough to trade, and understand the risks entailed.

1.5 When is a trade live?

A trade is live between the time of execution and the time of maturity. Final delivery may sometimes occur after the maturity date, in which case although the trade has no value at maturity, it does still bear the risk of non-delivery. Even when a trade has matured it may still feature in trade processes, such as for compilation of trading statistics, lookback analysis, auditing or due to outstanding litigation.

1.6 Consequences of trading

Once a trade has been executed, there will be at least one exchange of cash or assets at some future time ranging from within a few hours or days for spot trades, to many years for trades such as swaps, to unlimited periods for perpetual bonds. (Assets here include cash.)

Apart from exchanging cash or assets, the trade itself has value while it is still live. So all processes and risk analysis must work with both the cash or asset exchanges and the intrinsic trade.

The buyer and seller are holding different sides...