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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
A comprehensive resource for understanding how to minimize risk and increase profits In this accessible resource, Wall Street trader and quantitative analyst Davis W. Edwards offers a definitive guide for nonprofessionals which describes the techniques and strategies seasoned traders use when making decisions. Risk Management in Trading includes an introduction to hedge fund and proprietary trading desks and offers an in-depth exploration on the topic of risk avoidance and acceptance. Throughout the book Edwards explores the finer points of financial risk management, shows how to decipher the jargon of professional risk-managers, and reveals how non-quantitative managers avoid risk management pitfalls. Avoiding risk is a strategic decision and the author shows how to adopt a consistent framework for risk that compares one type of risk to another. Edwards also stresses the fact that any trading decision that isn't based on the goal of maximizing profits is a decision that should be strongly scrutinized. He also explains that being familiar with all the details of a transaction is vital for making the right investment decision. * Offers a comprehensive resource for understanding financial risk management * Includes an overview of the techniques and tools professionals use to control risk * Shows how to transfer risk to maximize results * Written by Davis W. Edwards, a senior manager in Deloitte's Energy Derivatives Pricing Center Risk Management in Trading gives investors a hands-on guide to the strategies and techniques professionals rely on to minimize risk and maximize profits.
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Veröffentlichungsjahr: 2014
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Risk Management in Trading
Techniques to Drive Profitability of Hedge Funds and Trading Desks
DAVIS W. EDWARDS
Cover image: ©iStockphoto.com/Jan_Neville Cover design: Wiley
Copyright © 2014 by Davis W. Edwards. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Edwards, Davis W. Risk management in trading : techniques to drive profitability of hedge funds and trading desks / Davis Edwards. pages cm. — (Wiley finance) Includes index. ISBN 978-1-118-76858-7 (hardback) — ISBN 978-1-118-77285-0 (ePDF) — ISBN 978-1-118-77284-3 (ePub) 1. Risk management. 2. Investment banking. 3. Hedge funds. I. Title. HD61.E374 2014 332.64′524—dc23
2014005542
This book is dedicated my wife, Angela, and my children, Spencer and Brianna.
I would also like to thank everyone who acted as a pre-reader to the book. All of the mistakes are mine, and I am fortunate that they caught as many as they could.
Angela Edwards
William Fellows
Colin Edwards
Matt Davis
Barbara Sapienza
Haseeb Khawaja
Dan Gustafson
Andrew Coleman
Clint Carlin
Alexander Abraham
John Vickers
Varun Chavali
Andrew Dunn
Kirat Dhillon
Ken Parrish
Iordanis Karagiannidis
Contents
Preface
CHAPTER 1 Trading and Hedge Funds
Overview of Book
Trading Desks
Hedge Funds
Hedge Funds Today
Strategies
Fund of Funds
Risk Management
Risk and Trading Decisions
Trading
Making a Trade
Trades
Markets
Market and Limit Orders
Order Lifespan
Trading Positions
Prices
Managing Trading Risk
What is Risk?
Risk and Reward
Monitoring Risk
Managing Risk
Test Your Knowledge
CHAPTER 2 Financial Markets
Financial Instruments
Real Assets
Financial Assets
Derivatives
Commodity Spot Market
Equities (Stocks)
Bonds (Fixed Income, Debt)
Currencies (Foreign Exchange)
Forwards and Commodity Swaps
Futures
Interest Rate Swaps
Options
Test Your Knowledge
CHAPTER 3 Financial Mathematics
Overview
Variables and Functions
Random Numbers
Statistics
Mean, Median, and Mode
Variance and Volatility
Skew and Kurtosis
Random Walks (Stochastic Processes)
Mean Reversion
Correlation
Diversification
Normal Distributions
Log-Normal Distributions
Calculus
Functions
First Derivative
Calculus Integration
Calculus Derivatives
Calculus Taylor Series
Time Value of Money
Test Your Knowledge
CHAPTER 4 Backtesting and Trade Forensics
Systematic Trading
Data Validation
Strategy Testing
Transaction Costs and Slippage
Monte Carlo Testing
Model Risk
Comparing Strategies
Combining Strategies
Trade Surveillance
Test Your Knowledge
CHAPTER 5 Mark to Market
Profits and Losses
Market Price
Market Liquidity and Mark to Market
MTM and Market Crashes
MTM Accounting
Highest and Best Use
Fair Value Hierarchy
Efficient Markets
Dominant Traders
Test Your Knowledge
CHAPTER 6 Value-at-Risk
Position Limits
What is Value-At-Risk?
Trading Limits
Percent Returns
Parametric VAR
Estimating Volatility for Parametric VAR
Calculating Portfolio VAR
Variance/Covariance Matrix
Non-Parametric VAR
VAR Limits in Practice
The Misuse of VAR
Test Your Knowledge
CHAPTER 7 Hedging
Hedging
How is Hedging Used?
Hedging Costs Money
Minimum Variance Hedge Ratio
Mismatched Cash Flows
Hedge Effectiveness Testing
Hedge-Accounting Memo
Regression Tests
Logarithmic Returns
Test Your Knowledge
CHAPTER 8 Options, Greeks, and Non-Linear Risks
Options
Greeks
The Value of Options
Black Scholes Formula
Delta
Gamma
Relationship Between Put/Call Parity and Gamma
Theta
Vega
Rho and Phi
Test Your Knowledge
CHAPTER 9 Credit Value Adjustments (CVA)
Trading is a Social Activity
Credit Risk
Exposure at Default (EAD)
Loss Given Default (LGD)
Probability of Default (PD)
Correlation Between PD and LGD
Credit Limits and Counterparty Exposure
Current Exposure and Potential Future Exposure
Calculating a Credit Value Adjustment
Multi-Period CVA Calculation
Settlement Risk
Test Your Knowledge
Afterword
Answer Key
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Chapter 7
Chapter 8
Chapter 9
About the Author
Index
End User License Agreement
List of Tables
Chapter 1
TABLE 1.1
TABLE 1.2
TABLE 1.3
TABLE 1.4
Chapter 2
Table 2.1
Chapter 4
TABLE 4.1
TABLE 4.2
Chapter 5
TABLE 5.1
TABLE 5.2
Chapter 6
TABLE 6.1
TABLE 6.2
Chapter 8
TABLE 8.1
TABLE 8.2
Chapter 9
TABLE 9.1
List of Illustrations
Chapter 1
FIGURE 1.1
Trading Desk Strategies
FIGURE 1.2
Discrete Risks
FIGURE 1.3
Continuous Risks
Chapter 2
FIGURE 2.1
Natural Gas Basis
FIGURE 2.2
U.S. Standards for Wheat
FIGURE 2.3
A Corporation
FIGURE 2.4
Bond Prices and Interest Rates
FIGURE 2.5
A Commodity Swap Contract
FIGURE 2.6
Forwards versus Futures
FIGURE 2.7
Interest Rate Swap
FIGURE 2.8
Option Payoff Diagrams
FIGURE 2.9
Put/Call Parity
Chapter 3
FIGURE 3.1
Prices as a Function
FIGURE 3.2
Discrete and Continuous Distributions
FIGURE 3.3
Probability Density Function
FIGURE 3.4
Cumulative Density Function
FIGURE 3.5
Mean, Median, and Mode
FIGURE 3.6
Dispersion
FIGURE 3.7
Skew
FIGURE 3.8
Kurtosis
FIGURE 3.9
Dispersion in a Random Series
FIGURE 3.10
Positive and Negative Correlation
FIGURE 3.11
Asset Allocation
FIGURE 3.12
Risk/Return
FIGURE 3.13
Normal Distribution
FIGURE 3.14
Log-Normal Distribution
FIGURE 3.15
Calculating Discrete Probability
FIGURE 3.16
Calculating Continuous Probability
FIGURE 3.17
Calculus Derivatives
FIGURE 3.18
Interest Rates
Chapter 4
FIGURE 4.1
Bid/Ask Spread
FIGURE 4.2
Risk Associated with Waiting for Execution
FIGURE 4.3
Crossing Bid/Ask Spread for Immediate Execution
FIGURE 4.4
Option Strategy Payoffs
FIGURE 4.5
Trade Surveillance
Chapter 6
FIGURE 6.1
Normal Distribution
FIGURE 6.2
Understanding VAR
FIGURE 6.3
Normal Distributions with Different Standard Deviations
FIGURE 6.4
Types of Volatility Estimates
FIGURE 6.5
S&P 500 Historical Volatility
FIGURE 6.6
Exponential Decay Speeds
FIGURE 6.7
Implied Volatility
FIGURE 6.8
S&P 500 Frequency Distribution
FIGURE 6.9
VAR Backtest
FIGURE 6.10
Daily P&L for Two Strategies
FIGURE 6.11
Expected Shortfall
Chapter 7
FIGURE 7.1
Correlation and Hedge Effectiveness
FIGURE 7.2
An Improved Hedge
FIGURE 7.3
Types of Relationships
FIGURE 7.4
Regression Plot
FIGURE 7.5
Regression Output
Chapter 8
FIGURE 8.1
Option Payoffs
FIGURE 8.2
Option Prices Changing over Time
FIGURE 8.3
Linear Approximations of Option Value
FIGURE 8.4
Delta Approximations
FIGURE 8.5
Delta Values
FIGURE 8.6
Gamma Measures Curvature
FIGURE 8.7
Gamma Always Benefits Option Buyers
FIGURE 8.8
Gamma Compared to Price
FIGURE 8.9
Out-of-the-Money Delta/Gamma Approximation
FIGURE 8.10
At-the-Money Delta/Gamma Approximation
FIGURE 8.11
Put/Call Parity
FIGURE 8.12
At-the-Money Option Prices as Time Passes
FIGURE 8.13
Option Prices at Expiration
FIGURE 8.14
Theta Values
FIGURE 8.15
Vega Compared to Underlying Price
FIGURE 8.16
Rho Compared to the Price of the Underlying Asset
FIGURE 8.17
Phi Compared to the Price of the Underlying Asset
Chapter 9
FIGURE 9.1
Unexpected Loss
FIGURE 9.2
Forward Prices
FIGURE 9.3
Bankruptcy Priority
FIGURE 9.4
Annual Average Sr. Unsecured Recovery Rates, 1982–2005
FIGURE 9.5
Bond Ratings
FIGURE 9.6
Average One-Year Corporate Whole Letter Rating Migration Rates, 1970–2005
FIGURE 9.7
Bootstrapping a PD Curve
FIGURE 9.8
Correlation between Defaults and Recoveries, 1983–2005
Guide
Cover
Table of Contents
Preface
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Preface
I started learning about trading strategies and managing trading risk while working on statistical arbitrage trading desks at two investment banks—first at JP Morgan and later Bear Stearns. The core of the job was converting some type of analysis into an action. In other words, I had to use data to make a decision and think through the effects of those decisions. Over time, that most risk management is focused on analysis rather than making decisions. In most risk management texts, there is very little discussion on what decisions are made as the result of analysis.
My first exposure to risk management came when I worked as a programmer on JP Morgan’s proprietary trading desk in the early 1990s. Just before I’d taken that job, I’d left my job at a computer game company and needed a short-term job to pay the bills. At the time, I intended it to be temporary and lasting long enough for me to raise enough capital to start my own company. My life would have taken a different turn had I ever managed to get that IPO completed. Instead, I was sucked into the world of trading and risk management. I started off as a junior programmer focused on implementing a new approach to managing risk on a trading desk called “value at risk”.
The goal of that first job was to give the CEO of JP Morgan, Douglas (Sandy) Warner III, a summary that told him “how much money does the firm have on the table” within 15 minutes after the close of trading. This report was to be short—something that could be conveyed in a minute. It should be something that could be compared to the previous day’s report to indicate whether risk was rising or falling. But, mostly it had to concisely give information to business leaders to make trading decisions.
When I was later managing a trading desk at Bear Stearns, and even later as a consultant, the intuition behind that first report—a concise summary designed to help managers make specific decisions—is contrasted against the analysis that I often observe being used—lengthy analysis not linked to any action steps. In one extreme case, I reviewed a daily risk management report that was more than 200 pages long. The last 150 pages of the report were filled with #N/A results instead of numbers. The report had failed 17 months previously, and despite being distributed to more than 100 readers, no one had caught the fact that the report wasn’t running properly. Clearly, no one was using the report as an input into their daily decision making process.
A goal of this book is to help improve the use of risk management by linking risk analysis to a set of actions that a trader might take based on that analysis. There are a wide range of activities that can cause trading losses or diminished opportunity for profit. Describing those risks is often very complicated. However, there are only a couple of trading decisions related to risk management that can actually be made. As a result, one common way to manage risk more effectively is to think about the decisions that can be made from the analysis.
The four main categories of risk management decisions are:
Avoidance
. The best way for traders to avoid losses is to make better trading decisions. This includes elimination of risk and/or withdrawal from activities that might lead to that risk.
Control
. Traders can reduce risks through the use of organizational safeguards to reduce the likelihood of problems. One common way to do this is to calculate profits and losses on a daily basis (daily mark to market) and to limit the size of trading positions.
Transfer
. Transferring risk involves offloading risk to a third party (or a different group in the organization) by trading, purchasing insurance, outsourcing, or contract modification. It is done when a trader can’t avoid the source of the risk and wants to limit the size of the risk.
Acceptance
. Acceptance involves taking on risks and establishing a budget that will cover potential losses.
This book focuses on techniques that professional traders use to assist in making decisions. The first three chapters establish the building blocks that are used in the rest of the text. The first chapter introduces trading and two major types of professional traders (hedge funds and proprietary trading desks). The second chapter discusses the major financial markets, and the third describes some of the terminology used by professional traders. The final six chapters of the book describe decisions that are made by traders.
Risk avoidance and acceptance are discussed in Chapter 4: Backtesting and Trade Forensics. Avoiding risk is a strategic decision that involves determining the markets where a trader has the biggest advantage relative to other traders. It is difficult to do all things well, and successful traders often have to choose some opportunities to avoid. Specializing allows traders to concentrate on the opportunities that are the most promising.
Techniques to control risk are discussed in Chapters 5, 6, 8, and 9: Mark to Market; Value at Risk; Options, Greeks, and Non-Linear Risks; and Credit Value Adjustments. In a nutshell, the primary way to control risks is to set limits on how much risk will be allowed and then develop ways to quantify those risks on a daily basis. Adopting a consistent framework for risk allows different types of risks to be compared to each other.
Transferring risk is primarily discussed in Chapters 7 and 9: Hedging and Credit Value Adjustments. For a cost, traders can selectively pay to remove risks from their trading portfolios. However, since there is a cost associated with removing risk, this can remove the possibility for profits too.
There are a couple of themes that run throughout the book. First, risk management can be risky. It is always worthwhile to think through the implications of a risk management policy before committing to a course of action. Massive trading losses can come from trades intended to manage risks as easily as they come from speculative trading. Even worse, trades for risk management purposes are much less likely to be scrutinized or second-guessed by management.
A second theme running through the book is that details are important. Risk management simplifies details to make decisions easier. However, this simplification can lead to problems since critical details are in danger of being lost. There isn’t always a set of rules to indicate how much abstraction is best. There is no substitute for somebody who knows what is actually going on being involved in decisions.
Finally, risk isn’t always bad. Risk is largely a description of an investment’s size and not a measure of whether an investment is good or bad. Assuming an identical investment mix, a large retirement account is riskier than a small retirement account. This is because the large account can lose more money on any given day than the small account. As a practical example, this means that billionaires can completely eliminate financial risk by giving away all of their money. That doesn’t make giving away money a good business decision.
Effective risk management is as much an art as it is a science. I hope you find that the practical focus of the chapters helps bridge the gap between theoretical risk management and successful trading.
Davis W. Edwards
Houston, 2014
CHAPTER 1Trading and Hedge Funds
This chapter introduces how trading organizations, such as hedge funds or the proprietary trading desks of investment banks, apply risk management concepts to operate their businesses. Risk is uncertainty or a potential for loss. Risk isn’t necessarily bad. Risky activities often provide higher profits than safe investments. Techniques developed to manage risk are used by trading desks to drive profitability by balancing risk and reward. Some of these techniques include choosing the most profitable investments, allocating a limited amount of money between multiple investments, eliminating risks through hedging, and assigning size limits to various investment strategies.
There are a limited number of decisions that can be made by trading desks to manage risk. Profitability starts when traders do a good job identifying investment opportunities. After that point, common decisions are: how to allocate capital between investment opportunities, limiting how much money is allocated to any single investment, and reducing the size of investments by liquidating or placing protective trades.
OVERVIEW OF BOOK
This book describes how risk management techniques are used by professional traders to reduce risk and maximize profits. The focus of the book is how traders working at hedge funds or on investment bank proprietary trading desks use risk management techniques to improve their profitability and keep themselves in business. However, these techniques can be applied to almost any trading or investment group.
This book focuses on six major activities that are part of managing trading businesses.
Backtesting and Trade Forensics
. Backtesting is a disciplined approach to testing trading ideas before making bets with actual money. Trade forensics is a post-mortem analysis that identifies how well a trade is tracking pre-trade predictions and if markets have changed since the trade was initiated.
Calculating Profits and Losses
. Once a trade has been made, traders have to calculate the daily profits and losses. For some financial instruments, this is as simple as checking the last traded price from an exchange feed. For other investments, calculating the fair value of the trade is challenging.
Setting Position Limits
. The size of investments that traders can make are typically limited by the volatility of their expected daily profits and losses. In other words, risk can be a way to measure size. As a result, the goal of hedge fund traders is to maximize the profits relative to a fixed amount of risk.
Hedging
. Hedging is a trading strategy designed to limit profits and losses in one investment by taking an offsetting position in another asset. For example, a hedge fund might want to lock in profits associated with a physical asset like an oil well that they can’t sell right away. They can agree to sell oil at a fixed price and remove the risk of price fluctuations.
Managing Option Risk.
Certain types of financial instruments, particularly options, present much more complicated risk management challenges for traders. Risk managers have developed a variety of techniques to model this risk and fit options risk with other position limits.
Managing Credit Risk.
Trading can’t be done in isolation. Every time someone wants to buy an asset, someone else needs to sell. Not all trades settle right away—trading often involves obligations that are taken on in the future. As a result, traders depend on their trading partners meeting their trading obligations, and are exposed to the risk that their trading partners will default on their obligations.
TRADING DESKS
Professional traders often work on teams called trading desks. A trading desk is a group whose members are traditionally seated side-by-side at a series of long desks (usually filled with computer equipment) that is responsible for buying and selling financial products for an organization. Trading desks will typically specialize in one or two types of financial products. Some trading desks will specialize in stocks, others in bonds, and so on.
Many types of companies will maintain trading desks. Some of these desks will focus on supporting the company’s other lines of business—buying fuel for a trucking company or financial products on behalf of investors, for example. However, a couple types of trading desks are operated as their own line of business. The most prominent of these are mutual funds, hedge funds, and proprietary trading desks at banks.
Some organizations whose focus is on trading for profit are:
Mutual Funds
. Mutual funds are a pooled-investment fund where the leadership of the fund manages investments on behalf of investors. These funds are restricted from many investment strategies deemed too speculative or risky for uninformed investors.
Proprietary Trading Desks
. A trading desk found in many investment banks that operates like an internal hedge fund to invest the firm’s capital.
Hedge Funds
. Hedge funds are pooled investment funds similar to mutual funds. They differ in that they do not cater to the general public—only to accredited investors. Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling, and using other speculative investment practices that mutual funds are restricted from using.
One of the largest differences between hedge funds and proprietary trading desks compared to mutual funds or individual investors is that they will often make trades designed to make profits when prices decline. This is called shorting the market and allows profitability in both rising and falling markets. Shorting is not exclusive to hedge funds and trading desks—it can be done by individual investors. For example, shorting is commonly practiced in various commodity markets.
Shorting involves agreeing to sell something that the trader does not currently own. For example, a soybean farmer might agree to sell his crop (which hasn’t been grown yet) for a fixed price per bushel when the crop is harvested. If prices fall after that point, the sales contract will acquire value to the farmer. If the contract allows him to sell 10,000 bushels of soybeans at $20 per bushel and prices fall to $10 per bushel, the contract is worth $10 per bushel (or $100,000) to the farmer. The contract is an asset to the farmer, and if a trading market exists for those contracts, could be sold to another trader.
HEDGE FUNDS
Hedge funds are a prototypical trading organization. They have few restrictions on their activities and typically have no source of income other than their skill at trading. In this book, hedge funds are used as an example of firms that use risk management techniques to help them compete more effectively.
KEY CONCEPT: LEVERAGE AND SHORTING
Two activities differentiate professional trading groups from most other types of investors. First, professional traders often finance trading positions through borrowed money. Second, professional traders have the ability to make trades that benefit from both rising and falling markets.
Leverage
is any activity (like borrowing money) that increases the size of the investment without increasing the capital that needs to be contributed by investors. This is sometimes called
gearing
.
Shorting
is entering into a trade that makes money when prices decline.
Hedge funds are private partnerships that invest in the financial markets. Like mutual funds, hedge funds pool money from investors and invest the money in an effort to make a profit. Their organizational structure varies from other investment structures because the investors in the fund are typically limited partners rather than clients. This allows hedge funds an extremely high level of flexibility in their operations and allows them to trade in markets deemed too risky for typical investors.
Hedge funds require that their investors meet certain qualifications before they are allowed to invest in the fund. By catering only to qualified investors, hedge funds can avoid many limitations designed to protect the average investor. The reasoning behind government rules to protect investors is that not all investors are sufficiently qualified to understand the risks associated with exotic or risky investments. In other words, the government limits investors from focusing only on an investment’s profit potential without regard for the associated risks.
Hedge funds offer investors, traders, and hedge fund managers the possibility of making a lot of money. However, the hedge fund industry is also a competitive and stressful environment where the most successful traders win big and unsuccessful ones go broke. Hedge funds use risk management to successfully run a complex and risky business.
KEY CONCEPT: ACCREDITED INVESTOR
An investor with substantial assets or sufficient financial expertise that they can voluntarily exempt themselves from rules designed to protect the average investor.
Hedge funds are usually arranged as limited partnerships. A limited partnership is composed of two tiers of investors. The first tier of investors, called the general partners, has management authority and is personally liable for any debts incurred by the firm. These general partners take on the most risk, but have a tremendous ability to make money. The second tier of investors, the limited partners, have no management authority and are only liable up to the amount of their investments.
Hedge funds often charge very high investment fees. For example, a standard annual fee for hedge funds is to charge 1 to 2 percent of the limited partners’ investments in addition to 20 percent of net profits every year. For example, if an investor were to make a million-dollar investment, the annual fees might be $20,000 (2 percent of the investment). In addition, if the hedge fund were to make a 10 percent return ($100,000 profit), the hedge fund would keep another $20,000, and the investor would make a $60,000 profit.
Organizationally, a hedge fund will be managed by one or more general partners (the hedge fund managers) who manage a staff of employees (the traders, risk managers, information technology team, and so on). The fixed management fee will typically cover the salaries and fixed expenses of the hedge fund. The variable fees will be paid in bonuses to the general partners and the traders. For example, in a fund with a 20 percent of net profit payout, the payout might be split 50/50 between the general partner and the trader (an employee) who managed each strategy.
HEDGE FUNDS TODAY
Hedge funds have very few operating restrictions. They can make investments that benefit from both rising and falling markets. In addition, hedge funds can use various strategies and financial products to increase their financial leverage. Leverage is a term that describes the ability of a trader to make larger bets—increasing both the potential for profit and loss—for the same amount of initial investment.
Hedge funds have this flexibility because the investors in hedge funds have decided to opt out of some regulations designed to protect investors. The mechanism for opting out of these regulations is to become designated as an accredited investor. In the United States, the Securities Act of 1933, Regulation D, describes the conditions that allow investors to qualify as accredited investors.
Some of the requirements pertaining to individuals who may be considered accredited investors:
A director, executive officer, or general partner of the company selling the securities
A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person
A natural person with income exceeding $200,000 in each of the two most recent years, or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year
A trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes
Source: U.S. Securities Act of 1933, Regulation D
Hedge funds are often in the news since they can have an immense impact on financial markets. Since the first hedge fund was started by Alfred Winslow Jones in 1949, hedge funds have experienced exponential growth. By 2013, the assets managed by hedge funds was estimated to be approximately $2 trillion. This large size, combined with hedge funds’ heavy use of leverage and use of rapid-fire trading strategies, makes hedge funds some of the most active traders in many financial markets.
STRATEGIES
Trading desks and hedge funds commonly specialize in a specific market or trading style. They don’t try to be the best at everything. Instead, they try to pick and choose situations where they have an advantage. As a result, hedge funds will often have a standard approach to investing. Then, groups of traders will be organized into trading desks that are further specialized. Finally, the trading desk itself will be broken into strategies. A strategy is typically a systematic approach to trading managed by one or more traders who will focus on a very narrow style of trading. Traders often manage several strategies and their pay will be personally linked to the success of their strategies. (See Figure 1.1, Trading Desk Strategies.)
FIGURE 1.1 Trading Desk Strategies
Both trading desks and hedge funds can vary substantially in composition. Some are based on a single strategy, while others may be focused on a market sector (like healthcare or energy) or geography (like a Brazil-focused fund). Some of the more common types of hedge fund styles are Global Macro, Relative Value, and Event-driven styles.
Global Macro
Global Macro strategies make big-picture bets based on the economy as a whole. For these strategies, investment decisions are commonly based on interest rates, Gross Domestic Product, unemployment rates, or similar economic data. When executed, trades are commonly made in stock indices, government bonds, and currency markets.
Global Macro trades are often directional—they speculate on the rise or fall of the overall market. For example, a hedge fund might buy broad based market indices when the market is expected to rise. It would sell or short these same indices when the market is expected to fall. By taking advantage of markets that allow short selling, these strategies can make profits in both rising and falling markets.
Many global macro strategies are based on an analysis of economic trends. In particular, traders study when trends are likely to persist and when they are likely to reverse. Through modeling, or intuition, the traders will rebalance their trading portfolios in an attempt to properly time the market.
Relative Value
Relative Value strategies make bets based on spreads between assets. Typically, these are long/short strategies where traders simultaneously buy one asset while shorting another. Shorting is making a trade that benefits the trader when the price of an asset falls. This can be done by borrowing an asset from another trader and selling it (called short selling) or by entering into a derivative contract (like an agreement to sell an asset expected to be owned in the future at a fixed price).
Relative value strategies are often market neutral. By taking offsetting positions in related assets, the impact of the broader market move is mostly eliminated. For example, a trader might identify two bank stocks. By buying one stock and short selling the other, the trader will benefit if the long stock position (the stock that has been purchased) outperforms the short position (the stock that has been sold short). However, if the entire market goes up or down, both assets should change in value with offsetting profit or loss.
Event-Driven
Event-driven strategies analyze the tendencies of market participants around the time of certain events. In many cases, events like an upcoming economic announcement will make traders change their normal trading habits. This can create an inconsistency in how the market values assets immediately before and after the event.
A large number of event-driven strategies focus on corporate actions like mergers, acquisitions, and spin offs. For example, if two companies are merging, the value of the two companies’ stocks and bonds will be linked. If prices did not move to reflect the new information, there would be a trading opportunity. Alternately, a previously announced takeover might be rumored to be falling apart. In that case, the trader might bet that the prices will become decoupled.
FUND OF FUNDS
One of the major factors behind the growth of the hedge fund industry is the development of funds of funds. A fund of funds will allocate investors’ money into a variety of different hedge funds. These funds simplify the job of investing in hedge funds since the fund-of-funds manager has the responsibility for monitoring hedge funds and allocating capital to them. This can make diversification easier and allow investors to invest in more than one hedge fund.
For this service, a fund of funds will typically charge its own fees. This creates a double fee structure where the fund-of-funds costs are charged in addition to the fees paid to the underlying hedge funds. For example, a fund of funds might charge an additional 1 percent of assets and 10 percent of net profits on top of the hedge fund’s fees. These fees can easily cut into the benefits of holding a fund of funds.
Whether a hedge fund relies on fund of funds to acquire capital will have a big effect on the structure of the hedge fund. Funds of funds will typically want to handle their own diversification. As a result, they will typically want to invest in single strategy hedge funds. Funds of funds will also want to regularly modify the investments that are made in each hedge fund. This can be problematic for hedge funds, since they have to balance inconsistent funding with the needs to pay ongoing expenses like salaries and office space.
RISK MANAGEMENT
Risk measures uncertainty and potential for loss. Although this sounds like a bad thing, there is a strong relationship between risk and reward. In other words, risky activities typically offer a high potential for profit. Because of that, risk is largely a measure of an investment’s size rather than a way to measure whether an investment is good or bad. For example, given the choice between investing $50,000 in the market and keeping cash, many people would choose the investment because of the higher profit potential.
Risk management is a systematic, logical approach to limiting or mitigating risk. It is called “management” because its purpose is not focused strictly on eliminating risk. In most cases, eliminating risk will eliminate the possibility for profit. At its core, trading risk management has two focuses. The first aspect of trading risk management is concerned with putting in place processes to minimize or prevent unwanted risks. The second focus is is to help decision makers better understand the tradeoffs between risk and reward.
Risk management is complicated by the fact that each group in an organization may understand risk differently. Even using common terminology, each stakeholder in the risk management process may have their own preconceptions and spin about what type of data is being provided by risk management analysis. This problem is exacerbated by the busy schedule of many senior decision makers. Quite often, decision makers don’t want to understand risk management—they just want someone else to take care of it for them. This creates a danger that analysis prepared for one purpose will be used for other purposes without anyone taking the time to ensure that the data is used properly.
Some of the common uses for risk management:
Decision making tools
. In a trading organization like a hedge fund or trading desk, risk management is often used to help make decisions. For example, a trading desk might have a choice of investing in two strategies and wants to maximize their profits for a given level of risk.
Regulatory Compliance
. In heavily regulated industries such as banking, risk management is often used to demonstrate compliance with regulations. An example of risk management being used for compliance is the calculation of the regulatory capital that banks need to keep on hand to meet government requirements.
Worst-Case Scenarios
. Senior managers at many firms often want to limit the amount of damage that could be caused by riskier parts of their businesses. As a result, there is a substantial interest in calculating worst-case scenarios for investments.
Process and Controls
. Risk management is often used to contribute to processes that limit the size of trader investments, make sure that trades are working as expected, and that each trade is allowed under the firm’s policies.
RISK AND TRADING DECISIONS
For many hedge funds, risk management isn’t just a theoretical exercise. There are a variety of practical applications to risk management that are used to make sound trading decisions in a very competitive industry. These processes have developed over time, because hedge fund managers—for all the potential profits that might be possible—have very little margin for error.
Backtesting and Trade Forensics
Professional traders such as hedge funds and investment banks’ proprietary trading desks often follow a disciplined approach of testing investment strategies before placing any money at risk. The typical approach is to start with historical tests in a process called backtesting. Once that is finished, the historical tests are followed up with live simulations called paper trading. Then, once real money is at risk, the strategy is constantly monitored using tools called trading forensics.
Calculating Profits and Losses
Financial investments have to be valued every day. Unlike other assets, where the profit isn’t known until the asset is resold, financial investments get marked-to-market every day. Typically, this process calculates the fair value of the assets based on recent transactions. This creates a substantial risk to traders in markets without heavy trading volume. Many protective measures, like risk limits and forced liquidations, are triggered by price movements. This creates risks because prices can be set by a small transaction that does not provide the opportunity for all of the traders affected by the transaction the opportunity to transact at that price.
Hedging
Many trading companies want to lock in profits or protect an investment that can’t be easily liquidated. Hedging is the term that describes an investment strategy designed to limit profits and losses in another investment. Hedging is a way for traders to pay money to transfer the possible risks (and rewards) of holding an asset to another investor. For example, an airline might limit its exposure to uncertain jet fuel prices by entering into a long-term purchase agreement.
Setting Position Limits
A fundamental way to control risks is to limit the size of investments. This is relatively easy when trading is limited to a single asset. However, a coherent approach to position limits that combines different types of assets in a highly leveraged environment becomes much more difficult. To handle this complexity, hedge funds and trading desks use risk management techniques to compare the sizes of various assets and liabilities consistently across asset types.
Managing Option Risk
Certain types of financial instruments, particularly options, present much more complicated risk management challenges for traders. As a result, the terminology associated with valuing and managing option risk is now inseparable from options trading. Formulas like the Black-Scholes formula have been developed to value options and calculus techniques are used to fit options into a value-at-risk framework.
Managing Credit Risk
Trading is not done in isolation. Every time someone wants to buy an asset, someone else needs to sell for a transaction to occur. Not all trades settle right away—trading often involves obligations that are taken on in the future. As a result, traders depend on their trading partners meeting their trading obligations, and are exposed to the risk that their trading partners will default on their obligations.
TRADING
Hedge funds use the money given to them by their investors, called capital, to make investments. Commonly, the hedge fund will actively manage these investments, buying and selling assets as needed to improve profitability and reduce risk. The term trading is used to describe the activity of buying and selling financial assets.
The difference between a professional investor who works at a hedge fund and an individual investor is often a matter of scale and seriousness. Successful hedge funds take trading seriously. As much as possible, they eliminate emotion and follow a disciplined, analytical approach to making trades. A key part of disciplined trading is to consider both potential profits and the uncertainty associated with those profits.
Risk management is a specialized portion of active management that focuses on monitoring and controlling risks that might affect an organization. For a hedge fund, this commonly means the risks associated with trading. However, on a broader level, risk management techniques can be applied to anything that might cause a loss or a diminished opportunity for gain.
MAKING A TRADE
Individual investors will have to handle all aspects of trading by themselves. However, many hedge funds are large enough that they can support specialists in every aspect of the trading process. In these hedge funds, there will be a wide variety of people involved in making trades and managing the risk of those trades. Commonly these groups are divided into a couple of major categories: front office, middle office, back office, and various support groups. (See Table 1.1, Groups Involved with Trading.)
TABLE 1.1 Groups Involved with Trading
Front Office
Support and Control
Back Office
Sales Deal Structuring Scheduling Trading
Middle Office Risk Management Financial Control
Reconciliation (Clearing) Margining Documentation
Front Office
In a trading organization, the front office consists of various teams whose goal is to make trades on behalf of the organization. The front office is also referred to as the commercial group. This team is responsible for identifying trading opportunities, making trades, and managing any ongoing investments.
Sales and Origination
. The sales team is responsible for identifying potential trading partners and clients who need trading assistance. In cases where clients are likely to have complex needs, the sales team may be called the
origination team
.
Deal Structuring.
In many cases, determining a price for an asset requires substantial mathematical analysis. The deal-structuring team on a trading desk will be responsible for calculating fair prices and valuing complex (
structured
) transactions. These are typically quantitative, math-heavy groups found in front offices that trade derivatives or other complex products.
Scheduling
. Trading physical assets like commodities often involves a substantial amount of operational complexity. When trading desks trade products that are complicated to deliver (or accept delivery on), a dedicated team focuses on making sure that process goes smoothly. Scheduling teams need to understand minute details of the markets for which they are responsible.
Trading.
The trading desk is responsible for executing transactions and the market-focused follow up of monitoring and managing existing positions. In some firms, there are a variety of trading desks specializing in different areas. Different trading teams will usually have descriptive names like
foreign exchange trading
or
natural gas trading
. If the trading is done on behalf of the firm, this may be called
proprietary trading
to distinguish the trading desk from one supporting clients.
Support and Control
The trading desk is supported by several teams that provide operational controls over trading activity. Even though these groups generally sit close to the trading desk, they typically report to a different management team—one that is not directly in the trading chain of command.
Middle Office
. The middle office is responsible for ensuring the trading desk works smoothly. The middle office ensures that trades are properly entered into tracking systems, that existing positions are valued on a daily basis, and that all of the paperwork is completed properly.
Trading Desk Risk Management
. Risk managers assigned to trading desks ensure that traders are not taking on too much risk and keep management informed of ongoing risks associated with the current trading positions.
Financial Control
. The financial control team is responsible for accounting and profit and loss (P&L) reporting. The trades done by the trading desk ultimately need to be reflected in the firm’s books and records and reported to the limited partners (shareholders if it is a public corporation) and the government. The financial control team is responsible for putting together those reports.
Processing (Back Office)
The back office provides post-trade processing, settlement, and clearing functions to the trading desk. These functions are commonly performed in a location that is remote from the trading desk.
Reconciliation (Clearing)
. The reconciliation team ensures that the counterparty’s back office agrees on the terms of every trade. If the two parties to the trade can’t mutually agree on the terms, this team might need to pull phone records (trader’s phone lines are typically recorded), instant messages, or emails where the traders agreed to the terms of the trade.
Margining
. Trading desks often require trading partners to post collateral when owed a large amount of money. The margin group is responsible for posting and receiving collateral. A request for additional collateral is called a
margin call
. This can usually be done by either trading organization.
Documentation
. The documentation team is responsible for finalizing all the paperwork necessary for trading. Just like the paperwork on any other legal agreement, a substantial amount of work goes into ensuring paperwork is correct for trades.
TRADES
A trade is a special type of transaction where the asset being traded can be resold at approximately the same price that it was purchased. This makes a trade different from many other transactions. For example, buying stock in a company is a trade. The stock can be resold at a later date. The price of the stock may have gone up or down, but it remains valuable. However, buying a cheeseburger is not a trade since the cheeseburger probably cannot be resold.
Another key element that allows assets (or liabilities) to be traded is the ability to substitute identical products for one another. For example, it is very difficult to set up trading based on unique works of art. The negotiation between buyer and seller is too specific, and the worth of the piece too subjective, for prices to be fully generalized. However, it is possible to trade interchangeable products and use those transactions to determine a fair price. The ability to substitute equivalent products is called fungibility. For example, shares of common stock in a company are interchangeable. It is possible to buy shares of the same stock from two different people and the shares will be identical in all respects.
Like any type of transaction, trading requires two parties—typically a buyer and a seller. From the perspective of a trader (or a firm employing a trader), the other party in the transaction is called the counterparty. Typically, the price at which the asset (or liability) is transferred is based on voluntary negotiation between the two parties.
There are three major transaction types:
Buy
.
Buying
is associated with paying money to acquire an asset.
Sell
.
Selling
is associated with receiving money as compensation for transferring an asset to the buyer.
Short Sell
.
Short selling
is the practice of agreeing to sell something that isn’t currently owned but is expected to be owned in the future.
Buying and selling are sometimes confusing terms when cash is not being exchanged. It is possible to swap non-cash assets for each other. In those cases, another descriptive term might be substituted for the terms buyer and seller to clarify the obligations of each party in the transaction. In this book, the terminology of buyer and seller will be used since it is the most commonly used terminology.
Because it involves both a buyer and a seller, trading is impossible in isolation. Trading is a group activity. Some markets, like exchanges, obscure the buyer/seller relationship. However, even in those markets, buyers and sellers are matched up and work together to create prices. Markets where buyers and seller can easily find one another are called liquid markets. Markets where it is difficult for a buyer and a seller to meet are called illiquid markets. Regardless of how much an asset might be worth to the right buyer, unless that buyer is willing to buy it right then, there is no way to convert an asset into cash. This is called liquidity risk.
KEY CONCEPT: REQUIREMENTS FOR TRADING
Trading requires:
A buyer or a seller willing to take the other side of the transaction
The ability to both buy and sell without a substantial loss of value. A substantial loss of value might be defined as 10 percent.
The ability to define standard products which can be interchanged with one another (these are called
fungible
products)
Another complexity to trading is that, in many cases, it is not necessary to own an asset to sell it. This has its own term—the practice of selling assets that are not currently owned is called short selling or shorting. For example, a farmer can arrange to sell corn to a buyer through a forward contract before the corn is grown. After agreeing to the sale, the farmer could decide to grow soybeans. He is not required to grow corn. The farmer’s obligation is to acquire corn before the delivery and not necessarily to grow it himself. Other markets also allow short selling. In the stock market, short selling is made possible by borrowing shares and agreeing to repay them at some point in the future.
If done for purely speculative purposes, short selling is a way of betting that prices will decline over time. However, short selling can be used for a variety of other purposes. For example, a broker might short a stock to allow a customer to make an immediate transaction. The broker would then have to purchase in a later transaction. This can help small investors who want a one-stop solution for trading.
MARKETS
Trades can occur in a variety of venues. While this can be as simple as finding a trading partner and signing a contract, the customized nature of many contracts prevents them from being traded (transferred to another trader for a cash payment). As a result, it is common for traders to use resources that can help them find trading partners and sign standardized trading contracts. (See Table 1.2, Types of Trading Venues.)
KEY CONCEPT: REGULATIONS AROUND SHORT SELLING
Many countries and markets have restrictions on short selling. In those markets, specific actions, those designated as “short selling,” might have regulatory and compliance implications. Depending on how the regulations are written, there may be little relationship between “short selling” as a trading concept and “short selling” as a regulatory concept.
TABLE 1.2 Types of Trading Venues
Bilateral
Broker
Dealer
Exchange
Traders directly find one another.
Traders are introduced to each other through use of a broker.
Traders transact directly with a dealer
Traders are matched up on an exchange. The exchange simultaneously transacts with both traders.
Some common types of trading venues:
Bilateral Trading. The trader is responsible for finding a trading partner and signing a contract directly with that partner. Commodity markets where a limited number of producers and consumers interact regularly are often bilateral markets.
Broker. A broker introduces customers to one another for bilateral trading. In some cases, the broker has the ability to trade on behalf of the customer. This is a common way for traders with limited trading connections to get access to trading markets. Brokers typically get paid a commission for arranging trades.
Dealer. A dealer executes customer trades against the dealer’s own account. In other words, the dealer is the counterparty for a trade. In many cases, the dealer is a broker/dealer, with the capabilities of both a broker and a dealer. Like the broker market, traders with limited trading connections often use broker/dealers to get access to trading markets. Dealers will make a profit by offering slightly different prices to buyers and sellers—a bid price that indicates where they are willing to buy and an ask price where they are willing to sell.
Exchange. An exchange is a centralized location for trading standardized products. It is necessary to be a member of an exchange to trade on it. The exchange interposes itself between buyers and sellers and requires its members to post a refundable good faith deposit, called margin, when they transact. This margin payment will be held as collateral to ensure buyers and sellers meet their trading obligations.
MARKET AND LIMIT ORDERS
When traders are working with brokers and exchanges, they typically have to provide instructions for how they would like to trade. This is different from a bilateral contract (like a forward) where terms can be individually negotiated. Brokers and exchanges allow a limited number of instructions, and the terminology for those instructions is reasonably standardized.
Market Orders
In many cases, traders want a fast execution at the prevailing market price. These are called market orders. Market orders are executed by the broker or exchange as soon as possible. These trades should receive the best price available at the time of execution. A market order specifies only the name of the security and the action to be taken (either buy or sell).
Market orders are the most common type of order.
Market orders are executed as soon as possible.
Limit Orders (Limit Buy, Limit Sell)
In other cases, traders might want to accept a trade only under certain conditions. In these cases, traders can use a limit order to specify the price at which a customer is willing to transact. For example, a buy limit order will specify the highest price that the trader is willing to pay. A sell limit order will specify the lowest price that a trader is willing to accept.
Limit orders do not guarantee an execution.
