Sales and Trading

Theoretically, a good trader should be able to trade anything and a good salesperson should be able to sell anything. Still, a lot of thought does go into the product you end up trading or selling. Wall Street is constantly dreaming up new products to meet the needs of its clients. This process eventually creates a need for these firms to support the active trading of these products in the secondary market. Many products fit into several broad categories.

Equity and Equity-Related Products

Equity markets provide a liquid market for the orderly trading of ownership interests (i.e., shares) in public companies. Shares are issued to investors who then have a stake in the company represented by a stock certificate. Listed or block trading involves all stocks traded on the New York Stock Exchange (NYSE), which prides itself on listing the biggest and best companies from around the world. The other major market for cash equities is the NASDAQ, which is home to both the best and the worst of the technology sector.

Fixed Income Securities

Governments, corporations, agencies, organizations, supra-nationals, and financial institutions issue bonds to fund their activities. Bond market financing doesn’t represent an ownership stake, but rather an IOU with interest. Within this vast over-the-counter market, computers, telephones, and the Internet facilitate trading activity. Institutional customers call dealers who trade order flow (dealers whose goal is to provide liquidity for customers rather than trade on proprietary accounts) based on the real-time information that is continuously updated on these broker-maintained monitors.

Fixed income instruments can be traded as either negotiable or nonnegotiable. Non-negotiable loans are private transactions between two counterparties. Since these are private transactions, there’s not much need for traders or salespeople to get involved, so just know that this market category exists. The other major market segment is comprised of negotiable debt instruments, which trade on secondary markets after they have been issued by the borrower. These instruments include bonds and notes, and structured securities such as asset-backed and mortgage-backed securities. Negotiable fixed income instruments also include a class of instruments called derivatives, which derive value from an underlying market variable such as LIBOR (London Inter-bank Offered Rate).

Another way of segmenting the bond market is to broadly divide the universe of fixed income products into two groups: government bonds and spread products. Government bonds are issued by the U.S. Treasury and are the risk-free standard backed by the full faith and credit of the United States government. Spread products are bonds issued by any other issuer-agencies, corporations, foreign governments, and supra-national organizations. Spread products have additional default risk, and are quoted as a “spread over comparable Treasuries” that is, the difference in yield when compared to a treasury board of the same term. For example, if a 10-year U.S. Treasury bond offers a 3% yield and a 10-year IBM bond offers a 3.5% yield, the spread is 0.5%.

Government Bonds

U.S. Treasuries are the benchmark against which all other fixed-income products are priced. If you enjoyed economics in college, this might be a great product area for you. Government bond desks are organized by maturity. “Treasury bills” are government bonds with a maturity of one year or less. The Treasury issues three-month, six-month, and one-year Treasury bills, which are discount securities that pay par at maturity. (The bills pay a set amount a bit above the original purchase price; this amount is called the par value of the security.) “Treasury notes” are securities that have a maturity exceeding one year, but not exceeding 10 years. “Treasury bonds” (10- and 30-year bonds) are the longest-dated maturity instruments issued by the Treasury. Notes and bonds are both conventional semi-annual coupon-paying securities. The Treasury also issues STRIPS (Separate Trading of Registered Interest and Principal of Securities), or zero-coupon bonds. These securities allow investors to hold and to trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities. Another Treasury product are TIPS (Treasury Inflation Protected Securities), which pay interest based on the level of inflation. They mature in five, 10, or 30 years.

The shortest maturity products are like trading with training wheels. It’s tough to screw up if you’re a three-month bill trader or repo trader. (Repo and reverse repo are the business of borrowing and lending securities.) The seasoned veterans are on the long end of the curve, trading 10- and 30-year bonds. These instruments have the most price volatility for a given change in yield. Long-dated zero coupons are the most price volatile instruments in the government bond market, since the full value of the bond is received as a bullet at maturity.

While U.S. government bonds do not have any default risk, do not mistake this for meaning that bonds are risk-free investments. Even with the full faith and credit of the U.S. Treasury, govies are interest-rate sensitive, and the principal can fluctuate dramatically in different interest rate environments. However, for buy-and-hold investors, there is no interest rate risk, since the principal is fully returned at maturity.

Agency Bonds

Federal government agencies issue bonds to finance their activities. These agency bonds help support projects relevant to public policy, such as farming, small business, or loans to first-time home buyers. Agency bonds do not carry the full faith-and-credit guarantee of government-issued bonds, but they carry triple-A ratings due to the implicit guarantee that exists between the government and a government agency. This implicit guarantee allows the respective government agency to access low-cost capital to support objectives deemed to be consistent with the national interest. Federal agencies that issue bonds include:

• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corporation (Freddie Mac)
• Farm Credit
• Federal Agricultural Mortgage Corporation (Farmer Mac)
• Federal Home Loan Banks
• Small Business Administration
• Tennessee Valley Authority

Corporate Bonds

Corporate bonds are bonds issued by corporations to meet their short- and long-term working capital requirements. “Non-dollar corporate bonds” are issued in currencies other than the U.S. dollar. Secondary trading activities tend to be most robust at dealers that have strong deal flow and a reputable credit research department. These research departments are always analyzing prospective bond swaps and are searching for favorable relative value trades (e.g., swapping down in credit or within similarly rated paper for a pick-up in yield, or swapping up in credit for a minimal yield give-up).

Corporate bonds are typically divided into two markets: high grade and high yield. Whether a bond is high grade or high yield depends on credit ratings given to the company by credit rating agencies like Standard & Poor’s and Moody’s. The higher the credit rating, the lower the risk of default, and the lower the interest. High grade bonds are issued by companies with good credit ratings and offer a lower yield (interest) for investors. High yield bonds (also known as “junk bonds”) are any issues that trade below BBB from Standard & Poor’s and and Fitch Ratings and Baa from Moody’s. Sometimes, in anticipation of a credit downgrade, high grade bonds can trade with spreads equivalent to high yield bonds and vice versa. Junk bonds often offer higher levels of default, interest rate, economic, and liquidity risk than other types of bonds.

International Bonds

International bond markets are less regulated than domestic bond markets, and therefore carry greater default risk. Anytime an investor buys bonds outside of his local currency, he or she is also incurring foreign currency risk (the currency invested in can drop relative to the dollar), and in certain emerging markets, there is the added dimension of political risk (a coup will make bonds issued from that country lose their value quickly). There are four main types of international bonds issued by corporations, governments, sovereigns, and supranationals: foreign bonds, eurobonds, dragon bonds, and global bonds.

1. Foreign bonds are issued by foreign borrowers in a domestic market denominated in that market’s own currency. The domestic market authorities regulate the issuance of these bonds. An example of a foreign bond would be IBM (an American company) issuing bonds in the United Kingdom, or SAP (a German company) issuing bonds in the United States. IBM issuing bonds in the United Kingdom would be a Bulldog issue, and SAP issuing bonds in the United States would be a Yankee issue.

2. Eurobonds are instruments for unsecured debt issued by governments, banks, corporations, and supranationals that are outside the domestic market of the currency of denomination. Eurobonds are sold to an international group of investors who are beneficial owners of the currency of issue but not resident in the country of that currency. This last attribute means that Eurobonds enjoy a less restrictive regulatory environment, since they are not subject to national laws or regulations. A further advantage of Eurobonds is that they can be issued in any country and in any currency other than that of its country of issue, affording maximum flexibility to the issuer. The historical unofficial home of Eurobond trading is the United Kingdom.

3. Dragon bonds are issued in any currency and trade on at least two of the “Dragon” exchanges in Asia (except those in Japan)—including Hong Kong, Singapore, or Taiwan. They are relatively short-term (three to five years).

4. Global bonds are traded simultaneously in the Eurobond market and on one or more domestic markets. Global bond issuers are typically triple-A rated and are frequently accessing the capital markets.

Municipal Bonds

Municipal bonds are issued by local and state governments. Typically, these securities are tax-exempt, and therefore trade at lower yields. Investors need to consider their individual tax brackets to consider the relative attractiveness of municipal bonds relative to comparable taxable bonds. Municipal bonds are favored by wealthy investors in higher tax brackets. Municipal bonds (or "munis") are categorized as general obligation or revenue bonds. General obligation bonds are supported by the taxing power of the issuer, and revenue bonds are secured by revenues from tolls and rents for a range of projects and facilities.

Asset-Backed Securities

Asset-backed securities include any products that are secured by some type of asset. These products include securities collateralized by mortgages (mortgage-backed securities), credit cards, aircraft loans, and so on.

Mortgage Securities

Mortgage securities represent an ownership interest in mortgage loans made by financial institutions to finance the borrower’s purchase of a home or other real estate. Mortgage securities are created when these loans are pooled by issuers or servicers for sale to investors. Two particular types of mortgage securities are worth knowing about.

Pass-Throughs or Participation Certificate

The issuer or servicer of pass-through securities collects the monthly mortgage payment from homeowners whose loans are in a given pool (a pool brings together loans of the same maturity and same coupon rate) and “passes through” the cash flow to investors in monthly payments. Most pass-through securities are backed by fixed-rate mortgages, but adjustable-rate mortgages are also pooled to create pass-through securities. ARMS typically have caps and floors. These option-like characteristics require a higher yield on the ARM-backed pass-through security.

Real Estate Mortgage Investment Conduit (REMIC)/Collateralized Mortgage Obligation

Mortgage-backed-securities collateralized by mortgage pass-through securities. REMICs allow cash flows to be directed so that different classes of securities with different maturities and coupons can be created.

Convertible Securities

Convertible Bond Basics

Convertibles combine the equity upside with the income characteristics of bonds. Convertible bond desks offer a nice work environment for people with an analytical bent who want something a little more exciting than bonds.

Here’s a basic example of how a convertible bond might be structured: convertible bonds of Company X can be converted into five shares of Company X stock if its stock price rises above a pre-specified threshold. There are three determinants of value in a convertible bond: investment value, conversion value, and option value. Investment value refers to the value of the convertible bond if it were a straight bond. This is the value below which a convertible can never trade. The conversion value is the value of the bond if it were to be converted into stock of Company X. In this case, if Company X stock currently trades at $20/share, and converting one bond for five bonds produces a conversion value of $100. If the conversion value exceeds the investment value, then conversion value takes precedence. Note that conversion value can only be positive since it is a right and not an obligation available to convertible bond investors. This option normally translates into a convertible bond price that exceeds the investment and conversion value. The present value of this premium represents the option value of the convert.

Convertible Arbitrage Trade Example

This transaction type consists of matching a long position in a convertible security (owning the security) with an offsetting short position (owning the right to sell at a certain price) in the underlying stock. The main driver of profitability in convertible arbitrage transactions is the current income generated by combining the yield of the convertible security with the interest income on the proceeds from the short positions, less any dividends on the shares sold short.

Additional profit is generated through delta hedging. First, the setup: suppose the price of a convertible bond is $1,000, and that the company’s current stock price is $75 with a 33% conversion premium, so the value of the stock conversion premium is $100. Option delta is the change in the price of the option for a 1% increase in the stock option. Assuming an option delta of 0.5, then the amount of shares to sell short is given by the following formula:

Hedge ratio = (Convertible bond price/Conversion premium) * Option delta = ($1000/$100) * 0.5 = 5 shares

The hedge ratio indicates that for every one convertible bond owned, five shares should be sold short. For small changes in the price of the stock, this delta hedge creates a market-neutral position where the profit from this convertible arbitrage trade is the income from the short and the coupon on the bond. In volatile markets, this hedge breaks down and a large decrease in the value of the stock will create an additional profit, since the stock will lose more in value than the convertible. Similarly, if the price of the stock increases substantially, the convertible will gain more than the short stock position, again earning a profit for the convertible arbitrage trader. Typically, the bond side of the trade needs to be hedged, since if the yield curve shifts significantly, the trader could end up reaping an additional windfall gain or loss, which is not part of the game for most convertible arb trades.

Derivatives

A derivative is an agreement between two parties in which each agrees to transfer an asset or amount of money on or before a specified future date at a specified price. A derivative’s value is derived from one or more underlying variables. Originally, derivatives trading involved commodities as a way for farmers to hedge away the financial risk of their business, but today derivatives are tied to everything from currencies and interest rates to the weather.

• A forward contract is a transaction in which the buyer and seller agree upon the delivery of a specified quality and quantity of asset at a specified future date. A price is normally specified in advance or at the time of delivery.
• A futures contract is a legally binding obligation for the holder of the contract to buy or sell a particular commodity at a specific price and location at a specific date in the future. The appeal of an exchange-traded future is that the contracts can be standardized, so that everyone in the market is trading the same contract.
• An option gives the buyer the right, but not the obligation, to buy (call) or sell (put) the underlying asset at a specified price (called the “strike price”) up to or on a specific future date (expiration date). The buyer of the option pays the seller of the option a premium for this right.
• A swap is the simultaneous buying and selling of a similar asset or obligation of equivalent capital amount. This exchange of financial arrangements provides both parties with more favorable conditions than they would otherwise expect. For example, a payer of fixed-rate debt may desire paying floating-rate debt, and a payer of floating-rate debt may want to pay fixed-rate debt. If the two sides can agree on a notional amount upon which to compute coupon payments, then they can swap fixed for floating and floating for fixed. The notional amount never changes hands, and interest payments are netted.

Derivatives and Risk Management

The main reason for using derivatives is to manage risk. The derivatives market offers hedgers like the chief financial officer of a large industrial company a way to hedge away his firm’s financial risk, and it provides speculators (who are hopelessly addicted to leverage) an opportunity to profit from a particular market view. Arbitrageurs keep the market efficient by exploiting any price discrepancies between different markets or between the derivative and the underlying asset. Derivatives can trade in three ways, explained in the following sections.

Fixed Income Derivatives

Fixed income derivatives are any derivatives instruments which derive value from a fixed-income security. Typically, these instruments are structured by Wall Street firms as a way to reallocate risks from corporations (who are seeking to mitigate business or financial risk) to speculators (who are seeking risk exposure in the expectation of profiting from a particular market view). Dealers will create a derivative instrument, and to support the development of this market will subsequently engage in creating and maintaining an active secondary market. As the market becomes more developed, spreads that the dealers pocket decrease dramatically. When interest rate swaps were popularized by Bankers Trust, it was able to extort exorbitant fees from relatively unsophisticated corporate treasurers. One word of caution for the neophyte fixed income derivative enthusiast: Warren Buffet has characterized derivatives as “financial weapons of mass destruction.” While Wall Street has peddled derivatives as an efficient manner of reallocating risk, as the Long Term Capital Management debacle demonstrated, there are tremendous amounts of counter-party risk, since risk ends up being concentrated in relatively few hands, and one default in the derivatives market can trigger multiple defaults throughout the system, threatening the integrity of the entire worldwide financial market.

Equity Derivatives

Equity derivatives trade listed and OTC equity options. OTC options are contracts structured by the firm to meet the needs of specific institutional customers. Listed options are exchange-listed products that are completely standardized and more liquid. Call holders have the right (but not the obligation) to purchase shares of the underlying company at a pre-specified price. Put holders have the right to sell shares of the underlying company at a pre-specified price. Dealers are typically sellers of options, and the vast majority of options expire worthless (out-of-the-money). Being short options is equivalent to being short volatility (some options desks now call themselves “volatility trading desks”). Options give the right to buy or sell an underlying stock: the higher the volatility, the greater the price of the option; the lower the volatility, the lower the price of the option. When a desk is net short options, it is short volatility, and will profit if volatility does not exceed the implied volatility at which the options were sold at. Think of options desks as insurers who are constantly collecting small premiums, but must, every once in a while, make a large payout related to a natural or manmade disaster.

Over-the-Counter (OTC) Derivatives

Dealers structure and trade just about anything that can generate a fee, but typically these structured products compete with standardized exchange-traded products. These products include currency and commodity derivatives, as well as interest rate swaps. Structured products like interest rate swaps will typically trade over-the-counter, whereas more standardized products are traded on exchanges such as the Chicago Board of Trade (which is now a designated contract market of the CME Group) and ICE Futures Europe (which was formerly known as the London International Financial Futures and Options Exchange).

By now you should understand that the OTC equity market, the OTC bond market, and the OTC derivatives market are all inter-dealer markets connected by telephone and computer network. There is no centralized exchange floor.