March 26, 2008
Sales & Trading and Investment Banking
http://www.vault.com/nr/printable.jsp?ch_id=240&article_id=26747189&print=1 How is sales and trading different from investment banking? There are several ways to compare and contrast the differences between investment banking and sales and trading. The first is the actual work that they do and the time in which this work is done. Investment bankers primarily help to raise money for clients through stock or bond offerings or advise clients on mergers or acquisitions. The endless flow of pitchbooks (PowerPoint presentations to clients), the detailed financial modeling and around-the-clock client schmoozing are all focused on achieving one result: a deal that will generate substantial fee income for the investment bank. This fee is calculated as a percentage of the deal (for example, a percentage of the money raised by an initial public offering). Investment bankers work for months -- even years -- to generate one deal, schmoozing comany execs until the company is ready to raise money or acquire a company. But when the company is ready and hires the bank to ehlp them, the reward for the bank is substantial. Salespeople and traders also work on deals -- every trade is a deal -- and also entertain clients. Compared to investment banking, however, it takes much less time to consummate a transaction in S&T. Typical trades are consummated in seconds or minutes, and the average fee per trade is measured in cents per share traded rather than as a percentage of the deal's proceeds. Another big difference between S&T and I-banking is the lifestyle. Sales and trading professionals are the first-in-and-first-out in the investment bank. To get a jumpstart on the trading day, salespeople and traders normally take the earliest train into work. But they are the first ones out of the office, leaving shortly after the markets close. Salespeople and traders also never work weekends -- trading desks are completely abandoned on the weekends. In contrast, investment bankers are expected to be their desks during the weekdays and weekends, at all hours and throughout major holidays. If you ever want to see a sad sight, go to one of the major investment banks on Christmas Day or Easter. Around lunch time, you'll see investment banking analysts trickle down from their cramped bullpens to pick up their food orders from the delivery guy. Sales and trading is a sprint; investment banking is an endless marathon that rarely ever stops for anything. Why do investment banks have sales and trading departments? The most important function of a sales and trading department at an investment bank is, of course, to make money. An investment bank collects significant fees every time its sales and trading professionals execute a deal for clients. Traders and salespeople add incrementally to the bottom line through daily profit and loss and commissions, and raise the profile of the firm in the marketplace. But there are ancillary benefits to having a strong S&T department. Investment banks provide capital raising and mergers and acquisition advisory services. Salespeople and traders are needed to create and maintain an active secondary market in these new issues. (Investments that are simply bought and held, such as life insurance, do not have secondary markets. Secondary markets exist to allow investors to buy and sell investments such as stock even after an initial public offering.) Most large investment banks target their secondary market activities towards issues that will support the primary market activities and capital raising efforts of the investment bank (for example, a client company's IPO). Companies and other entities that raise money by issuing stock or bonds are primarily concerned with how much money they can raise and at what price, but they're also concerned with the ability of the investment bank to properly distribute shares of the new issue and the ability of the investment bank and its syndicate (other investment banks partnering in the deal) to actively trade the new issue. An investment bank's market share of the daily trading volume in the issuer's stock can often be a decisive factor in deciding which bank gets to bring the new issue to market. Of course, to do this properly, traders will also trade stocks that are important in the context of the overall marketplace.
Trading activities at Investment Banks
Lots of ways to trade at IBs. Here are some of the main ones I'm aware of: 1) Dealing. Basically facilitating customer order flow, i.e. market-making. Profit comes from bid-offer spread, having greater price-knowledge than customers, and knowing customer order flow & positions better than customers. Examples - FX trading; block trading of stocks; government bond trading. 2) "Arbitrage". There are very few true arbitrages, but many semi-arbs around in the market. Basically this involves calculating the true value of an asset as precisely as possible, then trying to acquire another version of the asset for a different price, and pocketing the difference. The necessity of using leverage to get a decent return in arbitrage is what prevents the vast majority of these trades from being risk free (in addition to the usual problems of execution failure and counterparty risk). Examples: options/volatility arbitrage; basis trading; cash/futures arbitrage; convertible arbitrage. Newer products like credit derivatives, swaps, exotic options etc often provide fertile ground for arbing. 3) Speculation. Basically punting on asset price changes. Examples: global macro bets; "risk arbitrage" (punting on takeovers); long/short equity investment; statistical "arbitrage"/pairs trading. Dealing usually requires having a serious institutional presence in the market, because most products dealt are not traded on exchanges. You need to be credible, and credit-worth enough for people to trust you to be able to handle large size orders and not default or play silly buggers. Arbitrage usually requires either a very efficient execution setup, or (more often) advanced quantitative modelling and valuation skills. Cargill can arb grain cash/futures much cheaper and faster than you. Goldman's team of quants can work out the implied value of an exotic FX swaption portfolio more accurately than some daytrader. With speculation, there is nothing stopping you or I from having better ideas than the prop desk at Goldman Sachs. It's one of the few level playing fields in terms of outright edge. However, they get large base salaries, and are paid a call on their performance. Whereas an independent trader takes 100% of his losses and gets no salary. On the flip side, an independent trader has no pressure from management, and has more fleibility than any IB trader The reason that nobody can put an exact finger on what proprietary groups within IBs do is because they are, well... proprietary. An example would be statistical arbitrage that was developed in-house at Morgan Stanley, which they used for many years and which eventually leaked out in due time (after they, I assume, made lots of money off of it). If you are looking for a precise answer as to the exact difference between a daytrader/prop trader at a firm like Schonfeld and an in-house Prop trader at a bulge bracket IB, you're not going to get one. It really comes down to scale - any idiot can scalp a stock with 100-200 shares, but how does one scale a short-term trading strategy up to the extent that it produces the types of profits to make it worthwhile to a huge bank like Goldman (after paying the trader a generous wage)? Anyone who knows how to use such scale (capital) to thier advantage is probably doing it themselves at those places. If you are asking this question to decide, which one you want to do... that's an easier question: Unless you know someone in prop trading at an IB, or if you are asian from an IVY with a math degree, you have no shot of getting one of those jobs. You'd be better served just buying your way in at a firm like Schonfeld and figuring out how you can make a living for yourself by pulling money out of the markets consistently. The third category is, of course, the sales trader at an IB, which is no more than a bookie and who often loses his ass when he tries his hand at prop trading because he lacks both internal discipline/emotional control and an understanding of directional price movements (yes, even though he is filling orders at, ideally, competitive prices). Take a look at Working the Street: What You Need to Know About Life on Wall Street by Erik Banks. It details the progression of a career on Wall Street.
HEDGEing vs. SPECULATEing
A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already been advertised in an upcoming catalog with specific prices. But what if the price of silver goes up over the next six months? Because the prices of the earrings and bracelets are already set, the extra cost of the silver can’t be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. How?
The silversmith would enter the futures market and purchase a silver contract for settlement in six months time (let’s say June) at a price of $5 per ounce. At the end of the six months, the price of silver in the cash market is actually $6 per ounce, so the silversmith benefits from the futures contract and escapes the higher price. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract.
So that’s basically what hedging is: the attempt to minimize risk as much as possible by locking in prices for future purchases and sales. Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract’s expiration the equity price has risen, the investor’s contract can be closed out at the higher price. The opposite could happen as well: a hedger could go short in a contract today to hedge against declining stock prices in the future.
A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee beanery could hedge against rising coffee bean prices next year.
Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against. Hedgers want to minimize their risk no matter what they’re investing in, while speculators want to increase their risk and therefore maximize their profits.
Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity.
http://en.wikipedia.org/wiki/Hedge_(finance)
Hedge fund terms…
Statistical arbitrage (stat arb)
Market Neutral Trading Strategy
Relative Value Strategy
Event driven Trading Strategy
all of these & much more in this link:
http://www.riskglossary.com/link/market_neutral_strategy.htm
Alpha and Beta
Alpha is a common measure of assessing active manager’s performance as it is the return in excess of a benchmark index (like S&P 500) or “risk-free” investment.
Beta – The measure of how volatile an investment (or an investment manager’s track record) is compared to the entire market is called beta.
* A beta of 1 means that the investment manager’s performance has been just as volatile as the market
* a beta of 0.5 means that the manager’s performance has been half as volatile
* a beta of 1.5 means that performance has been 50 percent more volatile.
Investors ought to judge a manager’s performance by both alpha and beta. If the manager has had a high alpha, but also a high beta, investors might not find that acceptable, because of the chance they might have to withdraw their money when the investment is doing poorly.
Front, Middle & Back office
The terms of front office, middle office, and back office refer to three separate but key functions of most large or sophisticated investment or commercial banks, especially in regards to open market activities like buying and selling bonds, options, or other securities.
Front office is the actual trading floor. Here is where the buying and selling takes place and is usually considered a profit center. Traders actively engage in either making trades that hedge a position or making money on a security.
Middle office usually consists of highly adept traders, analysts, and managers who are knowledgeable of trading activities but usually don’t engage in market activities themselves. Instead, they evaluate positions, manage risk, and calculate profit and loss and act as knowledgeable ‘consultants’ to both front office and back office staff.
Back office is a much more general, administrative, and supportive role. Staff in back office handle day-to-day transaction overhead, data-entry, settlement, clearance, records, compliance, and accounting.
Proprietary traders and Flow traders
There are two fundamental types of trader: proprietary traders and flow traders. Most traders are flow traders, who buy and sell financial products on behalf of an investment bank’s clients. Salespeople tell flow traders what their clients want to buy and sell. In turn, flow traders tell salespeople whether a particular trade is possible at a particular price. Flow traders can also help guide salespeople by keeping them informed of trading strategies and the direction a market is headed in.
Once a client agrees to buy an instrument, flow traders are obliged to make the trade at the price the client has agreed to. If they don’t act quickly and the price rises, they will have to sell the products to the client at a loss. On the other hand, if traders buy at a price lower than what was quoted to the client, the firm makes a profit.
A group of elite traders work on behalf of the bank. These are the proprietary traders. They can make huge profits – or considerable losses. It takes a stout heart and considerable self-confidence to be a successful proprietary trader, but if you’re a good one the rewards can be substantial.
