Lecture 6: Sales & Trading

Question 1

Who are the three key participants in client trading?

Answer 1

Three key participants in client trading:

1) Traders
2) Sales Professionals
3) Research Analysts

Question 2

What are the role of traders, sales professionals and research analysts?

Answer 2

Traders: Participate in transactions in both the primary market (working with the IBD in the CMG) and also in the secondary market (working with sales professional in trading division)
Responsible for: buying securities from institutional and individual investors and then re-selling these securities in the future to investing clients for a higher price

Sales professionals:
Covers individual and institutional investing clients, bringing to clients value adding ideas.
Deliver proving from traders
Dual objective of maximising profits for clients and traders

Research analyst: Traders conduct research to gain insight into securities traded- may focus on a specific industry’s product or regulatory topics

Question 3

How do traders operate in both the primary and secondary market?

Answer 3

Primary market transactions: work with the IBD underwriting team in CMG - purchase securities driectly from a corporate or government issuer, reselling those securities at a profit, and standing ready to repurchase securities at any time
Secondary market: Buying and selling previously issued securities on an exchange or OTC market at a profit

Question 4

How are traders market makers?

Answer 4

They quote both bid and offer prices for the securities that the bank covers - there this provides the investor with liquidity - can be securities underwritten by the bank or just securities the bank chose to cover

Question 5

What is the commitment committee?

Answer 5

Before an underwriting commitment, IB will assemble a ‘commitment committee’ to determine the risk profile of underwriting and whether to proceed with an underwriting
- Involves bringing traders ‘over the wall’

Question 6

What potential COI does a traders involvement in a commitment committee post?

Answer 6

They will be exposed to nonpublic information regarding an upcoming financing - therefore they must “wall” themselves from trading outstanding securities on the basis of this information before coming public

Question 7

What is the traders role in a commitment committee?

Answer 7

• They are a key voice
• Should they see potential loss in an underwriting transaction, they will likely opposed
• When company asks IB in a bought deal - over the wall traders help making risk decisions based on timing pricing, size and structure of the bought deal

Question 8

What is prime brokerage?

Answer 8

Where the prime broker services as a central broker for hedge funds in coordinating extensive and complex trading in a variety of financial insturments

Question 9

What are the two forms of prime brokerage services?

Answer 9

1) Custodial and financial services: intermediary between hedge funds and institutional investors and commercial banks
2) Trade clearing and settlements

Question 10

In the prime brokers custodial and financial service duties, who are the two institution’s it services as an intermediary for? What do they provide to the hedge fund?

Answer 10

Institutional investors: Service as the source of securities to facilitate short selling (Securities lending)
Commercial banks: service as the sources of fund available to make large loans on margin (margin financing)

Question 11

What are the 4 additional prime brokerage services?

Answer 11

Risk and performance analysts, cash & asset management, research and operational support

Question 12

Where it the prime brokerage department housed? How do they earn fees? What is the typical profitability of this department?

Answer 12

• Trading division
• Profits from charging fees - such as spread or premium on a loan
• High profitability
• Largest source of client related within the trading division at may large IBs

Question 13

What is short selling? Rationale and risks of short? What are the two most common ways hedge funds short sell?

Answer 13

Selling a borrowed security, with the obligation to return it after repurchasing it in the market in the future

Rationale: Shorting is used to create downside security price protection, or potential gain based on a speculation in price form

Instruments used by hedge funds:

• Securities lending
• Margin financing

Question 14

What is securities lending?

Answer 14

Involves investors lending their shares to investment banks, who re-lend to other parties for a fee - and the fee is split between the lenders and the I Bank

Question 15

What do lenders receive in compensation for lending their shares?
What is the rebate?

Answer 15

A cash collateral - usually 2-5% greater than the value of the shares
Lender will pay interest BASED ON THE DEMAND OF HIS STOCKS (rebate) - higher demand for stocks = lower rebate

Question 16

How do IB’s earn a fee in security lending?

Answer 16

The borrower will pay a cash collateral in addition to an IB fee to the bank for borrowing

Question 17

What happens when dividends are paid on borrowed shares?

Answer 17

Must be paid back from the lender to the issue of the shares

Question 18

What is margin financing?

Answer 18

Where an investor borrows money to buy securities, and uses these securities as collateral for the loan

Question 19

What is the formula for calculating the current margin?

Answer 19

(Current value of then asset - loan amount)/ current value of asset

Question 20

What does margin financing require in relation to margin payments?

Answer 20

Value of the collateral is held market to market:
- Investors must maintenance the predetermined maintenance margin - minimum amount of equity that must be maintained in a margin account

Question 21

How do we calculate the additional margin payment required

Answer 21

Additional payment=
(A) First determine required equity amount = (margin % * investment value)
(B) Then calculate actual equity = Current value of collateral - loan amount
Additional repayment = (A) - (B)

Question 22

What does FICC stand for? How does it compare in terms of profitability?

Answer 22

Fixed income, commodities and currencies. Typically the most profitable division, however GFC saw significant losses from the division

Question 23

What is proprietary trading?

Answer 23

Non-client related traders who trade soley for the benefit of the firm

Question 24

How is proprietary trading different from client trading. What are the potential conflicts of interest between proprietary trading and client trading

Answer 24

Different as they are non-client related traders who trade solely benefit of their firm
- They have no responsibility to balance their profitability interests with those of the clients of the firm - could be considered competitors
- IBs are key figures in M&A, and although prohibited, it is possible for them to use insider information to engage in merger arbitrage
- Considered competitors of these clients
- also conflict arises where I bank itself has investment in a security and the bank also trades this on behalf of clients
Conflict; where the proprietary firm gains non public confidential from other departments and trades on the basis of this information
Resolution of conflicts: seperate the proprietary divisions from other divisions

Question 25

How do traders profit from market making? What is the underlying risk?

Answer 25

By acquiring securities for a discount to their market value, and selling them to investors at a higher price.
- Underlying risk: where securities held to be sold - risk of downward movement in market prices

Question 26

Why are OTC exchanges more risk?

Answer 26

Because there is no exchange for these trades and they do not need to be reported, and also weaker regulation on these kinds of trades

Question 27

Why may an IB decline to participate in an underwriting

Answer 27

• Not enough demand perceived in market
• IB may have several potential underwriting commitments at once
• Reputational concerns or other issues found at due diligence

Question 28

How do professionals in sales, trading and research work together?

Answer 28

Research provides investment ideas to sales, who contacts the bank’s investing
clients with specific trade ideas based on research’s recommendations.
Should the client decide to go ahead with the trade, sales works with traders
to execute the trade

Question 29

Describe a margin loan. Provide a numerical example on a margin loan.

Answer 29

Hedge funds frequently borrow (creating “leverage”) in order to increase the
size of their investment portfolio and to increase returns (if asset values
increase). For example, if a hedge fund received $100 million from investors,
the fund might purchase securities worth $400 million by borrowing $300
million from banks, using the $400 million of purchased securities as
collateral against the $300 million loan.