Arbitrage is the exploitation of markets moving at different rates. For example if 3 month £ cash rate moves but the spot, forward and $ cash rate does not then there may be an opportunity to make money by trading in the underlying markets.
The lowest price at which someone will sell an investment at a given moment.
A person who believes that prices will decline.
A person who believes that prices will rise.
A market characterised by declining prices.
The price that one is prepared to pay to buy at. The bid may be described as the buying side or ‘pay’ side.
Bonds are tradable instruments that are issued by a borrower to raise money. They pay either fixed or floating interest. Governments, banks or companies can issue bonds. The better the credit of the borrower the lower the rate of interest they would expect to pay. The interest paid is known as the ‘coupon’. Bonds are usually issued and redeemed at a price of 100. The yield of a bond is the effective rate of return of that bond. It is calculated from the current bond price, coupon and the maturity. As interest rates fall, bond prices rise and vice versa. For example a bond with a 10% coupon at a price of 100 will yield 10%. If interest rates fall to 9% the bond price will rise to reflect this, say to 110. One pays away 110, receives 10% interest on 100 and receives 100 back at maturity. Thus the real return is less than 10%. Examples of commonly traded bonds include UK Government bonds, known as Gilts and US Government bonds, known as Treasuries.
A market characterised by rising prices.
An old fashioned market term for £/$
The capital markets are more international then money markets and are usually tradable instruments of a longer maturity than money markets (over 1 year). Government bonds and Eurobonds are capital market products. Instruments such as Interest Rate Swaps are usually classed within capital markets.
Caps and Floors
A Cap is an instrument that protects the buyer against rising rates. A floor is an instrument that protects the buyer against falling rates. In the case of a cap if rates stay below the ‘strike’ rate, one enjoys the advantage of the low rate. If they are higher then one only pays interest at the strike rate. A capped mortgage is a good example of this. Caps and floors are priced and re-valued from market rates (such as futures and bonds) and perceived movement (called volatility).
A currency which can be freely exchanged for other currencies, or gold, without special authorisation from the appropriate central bank.
Credit is an important consideration when trading, both in the Inter-bank market (i.e. trades between banks) and between banks and their customers. Because large sums of money change hands it is essential to check that that the counterparties have ‘room’ for the trade. Once the price has been agreed the credit is checked. If the credit is ‘bad’ then no trade takes place. One can regard credit checking as a similar procedure to buying goods with a credit card.
Large banks and trading institutions will have agreements to net outstanding deals. They will either physically cancel matching deals or will calculate net exposure. These arrangements exist to maximise free credit and thus speed the dealing process by reducing the need to constantly re-check credit.
Refers to opening and closing the same position or positions within one day’s trading.
The borrowing and lending of cash. The rate that the money is borrowed/lent at is known as the deposit rate or ‘depo’ rate. There are also Certificates of Deposit (CD’S) which are a tradable instrument.
Derivatives are trades that are constructed or ‘derived’ from standard instruments. Derivatives can be both exchange and non-exchange traded (known as Over the Counter or OTC). OTC derivatives carry more credit risk as they are traded direct with the counterparty rather than an Exchange. Examples of derivative instruments include Options, Interest Rate Swaps, Forward Rate Agreements, Caps, Floors and Swaptions.
End Of Day or Mark to Market
Traders account for their positions in 2 ways: accrual or mark-to-market. An accrual system only shows a profit or loss when it is realised in that it only accounts for cash flows when they occur. Major banks or trading entities do not commonly use this method as bad positions can remain hidden until they impact on the book. (Note that the term ‘accrual’ is the opposite of the Accountancy usage of the word.) The mark-to-market method values the trader’s book at the end of each working day using the closing market rates or revaluation rates. Any profit or loss is ‘booked’ and the trader will start the next day with a net position.
This type of transaction pays an agreed interest rate for the term of the deal. Deposit deals usually have a fixed interest rate. Many bonds pay fixed interest. A fixed rate mortgage is a good example this type of deal.
FIXED EXCHANGE RATE
Official rate set by monetary authorities for one or more currencies. In practice, even fixed exchange rates are allowed to fluctuate between definite upper and lower bands, leading to intervention.
Flat (or Square)
To be flat or square is to be neither long nor short. A trader would have a flat book if he has no positions or if all the positions cancel each other out.
Floating Rate Interest
The interest rate on this type of deal will fluctuate as market rates move. A standard mortgage is a good example of this type of deal.
The deal will commence at an agreed date in the future. Thus 3 Month Â£/$ will commence 3 months from the deal date. Forward trades in FX are usually expressed as a margin above or below the spot rate. To obtain the actual forward FX price one adds the margin to the spot rate. The rate will reflect what the FX rate has to be at the forward date so that if funds were re-exchanged at that rate there would be no profit or loss (i.e. a neutral trade). The rate is calculated from the relevant deposit rates in the 2 underlying currencies and the spot FX rate.
Forward Rate Agreements (FRA’s)
FRA’s are transactions that allow one to trade interest rates for future value. For example 3 month’s deposit starting in 3 month’s time (known as 3/6′s). FRA’s are calculated from the relevant futures market prices. FRA’s are an Off Balance Sheet product.
Front and Back Office
The ‘front office’ is usually the trading room. The ‘back office’ is where settlement of trades takes place. Traders do not settle their own trades as this is frowned upon by the regulatory authorities (i.e. Barings).
Futures are a way of trading financial instruments, currencies or commodities for forward value dates. They can be used to both protect and to speculate against the future value of the underlying product. Futures transacted through an Exchange are traded in standardised units or ‘lots’. The market will have agreed future settlement dates.
FX or Foreign Exchange
The buying and selling of foreign currency. Most FX is quoted against US$. If another currency is involved (e.g. Â£/CHF) this is known as a cross rate.
GTC – Good Till Cancelled
An order left with a Dealer to buy or sell at a fixed price. The order remains in place until it is cancelled by the client.
Usually the highest traded price and the lowest traded price for the underlying instrument for the current trading day.
Indicated and Firm Prices
An ‘indicated’ price or ‘level’ is one that is not a ‘firm’ price or ‘dealer’. An indicated price is for information purposes and would need to be ‘firmed up’ in order to transact a deal.
Interest Rate Swaps (IRS)
An IRS is a transaction where 2 counterparties exchange fixed and floating interest with each other. They can be regarded as 2 parallel loans; one fixed the other floating. In a single currency IRS no principal changes hands, only interest, thus it is known as ‘notional principal’. The floating side of the transaction is typically set against LIBOR. The difference between the 2 rates is paid in the appropriate direction on each rollover. Traders talk about IRS in terms of the fixed side of the deal. The ‘borrower’ of fixed is called the ‘Payer’; the ‘lender’ is called the ‘receiver’.
The International Swaps and Derivatives Association is the body that sets terms and conditions for derivative trades. Many banks will use the ISDA document as a basis for a ‘master document’ for transactions with other banks.
This stands for London Interbank Offer Rate. It is currently used as a reference point for setting or fixing the floating side of derivative deals on the reset dates. Until now it has been the reference point for most trades around the world. IRS and FRA’s are types of transaction that use LIBOR in their pricing.
The London International Financial Futures Exchange. Liffe is currently transferring trading away from ‘open-outcry’ trading towards screen based trading.
This is an order to sell at an agreed price. Traders may utilise a limit order to take a profit. For example an item may have been bought at 100 and the trader may wish to sell if the price rises to 110. He will leave a limit order to sell if the price rises to 110.
Liquid and illiquid Markets
A market is described as ‘liquid’ if it is easy to obtain a ‘close’ or ‘tight’ dealing price (the ‘spread’ between the bid and the offer). Another measure of liquidity is the number of institutions trading in the market. The more players involved the more likely one is to obtain a tight price. Illiquid markets have few players and consequently have wide dealing spreads. Obviously it is important, when trading, to obtain the finest price so as to minimise profits wasted on the bid/offer spread when reversing the transaction. Liquid markets are sometimes described as ‘mature’ markets.
To go ‘long’ is to buy an instrument. If a trader is ‘long $’ that means he owns $.
Bank’s customers or those trading with an Exchange will have to lodge an agreed sum of money to allow them to trade. This is to ensure that they have enough money to cover any potential losses that may occur. It will be monitored in conjunction with a stop order. For example, a customer has 10 units of credit (equity) to use as margin and he buys an item at 100. If the price of the item falls to 90 he will be forced to sell as his margin will have been used up. A margin can be viewed as a form of credit. Once it is used up the trade has to be closed out.
‘Mine’ and ‘Yours’
To announce that a trader wants to buy he may say or type ‘Mine’. This would also be known as ‘taking the offer’. To sell he will use ‘Yours’. This would be known as ‘hitting the bid’.
A dealer who supplies prices to create or ‘support’ a market. They will supply an offer and a bid (a ‘two-way’ price). A market maker would run a trading ‘book’.
The term ‘Money Markets’ usually covers products that are related to short-term (i.e. under one year) trading. Examples include Deposits, Certificates of Deposit, Repurchase Agreements, Overnight Index Swaps and Commercial Paper.
Off Balance Sheet
Products such as Interest Rate Swaps and Forward Rate Agreements are called ‘off balance sheet products’. Because no capital changes hands, only interest, institutions are not required to show them directly on their balance sheets. However many will include a provision for the figures so that the balance sheet is an accurate representation of the trading and risk position.
The price, or rate, that one is prepared to sell at. (It is not to be confused with an ‘offer’ on a house, which is really a ‘bid’!). Traders may also describe an offer as the selling side, or ‘give at’.
ONE CANCELS OTHER ORDER
Where the execution of one order automatically cancels a previous order.
It is easiest to consider options from the point of view of the buyer. Buying an option gives one the right but not the obligation to perform a transaction. There are two main types of option; calls and puts. A Call is the right (but not the obligation) to buy the underlying instrument. A Put is the right (but not the obligation) to sell. Option buyers have limited liability in that they only stand to lose the option premium (purchase price). Selling or ‘writing’ an option is much more risky as it has unlimited risk. Option buying can be likened to buying insurance in that if one insures a car, the premium is the only payment made, however in the event of a crash the Insurance company could have liability running to Â£ millions! Options are priced and valued from market rates and perceived movement (called volatility).
An order is an instruction to trade. An order can be firm or subject to something else. It can be ‘good until filled’ or ‘until close of business’
PIP or POINTS
Depending on context, normally one basis point. ie 0.0001
A position is a trading view expressed by buying or selling. It can refer to a single trade or the whole book.
Realised and unrealised profit and loss
A smaller trader will effectively account for their position(s) on an accrual type accounting system. For example if one buys shares at 100 and the price rises to 110, there is a profit. If one keeps the shares it is only a ‘paper’ or unrealised profit. If one sells the shares then the profit is real i.e. cash. Individuals or relatively small traders may run a trading account that allows them to hold realised profits on account to use as margin. There may be a facility to take into account any unrealised profits. Unrealised losses can be considered in exactly the same way.
Re-purchase or Repo
This type of trade involves the sale and later re-purchase of an instrument. It is a form of lending where the instrument sold and re-purchased is used as security.
When a trader runs an end-of-day to establish profit and loss for the day the revaluation rates are the market rates used to establish those figures. It is important that there is an independent secondary input, say in the back office, to ensure that the rates used are accurate. This is often a compliance regulation set by the authorities.
To go ‘short’ is to have sold an instrument without actually owning it. If a trader is ‘short’ of $ he would need to buy them.
Usually this means value 2 days forward. For example in a spot foreign exchange deal, funds will change hands 2 days after it is struck.
This is an order to buy at an agreed price. They are also called ‘stop loss’ orders. For example if the price of the item bought at 100 were to fall 90 the trader may wish to (or have to) sell. He could do this by pre-arranging a stop order.
Swaps are used to exchange one currency for another and then back again for a fixed period. This type of deal is used if one holds one currency but have commitments in the other. They can be exchanged for a period of time. The calculation of the swap rate reflects the interest rate differential between the two underlying currencies and can thus be used for speculative purposes to exploit anticipated movement in the interest rates.
A table and/or graph that shows a trade by trade history of the underlying instrument. Traders like to use graphs because they show direction of market movement in an easy to understand format. Traders will use ticker graphs for day trading and will use historic graphs for long-term analysis and position taking.
Warrants are a form of traded option. They are the right to buy shares or bonds issued by a company.