BANK3014

INVESTMENT AND PRIVATE BANKING

WEEK 5 TUTORIAL BASED ON WEEK 4 MATERIAL

Concept Review Questions

1. What functions do the Trading and Sales operations of investment banks

perform? Why is it important that investment banks perform these
services?
The Trading and sales operations perform the following functions:
(a) Work with the IB team in the origination and placement of primary
and secondary market offerings.
(b) Acts as the distribution channel for primary and secondary market
offerings.
(c) Provide aftermarket services as part of the underwriting of an
issue.
(d) Pitches deals to investors providing them with expanded
investment opportunities. This involves building relationship with
institutional and private banking clients of the IB.
(e) Market making activities provide liquidity in the markets (both
secondary and tertiary) thus enabling investors to alter their portfolio
and risk positions.
(f) These activities represent profitable operations for IB’s.
These activities are crucial because the key role of IB’s is to undertake
financial intermediation via markets. Trading activities in these markets
are therefore core activities in ensuring the viability of these markets as
a venue for borrowers and investors.

2. How do traders operate in both the primary and secondary markets?

Primary market transactions

-Work with the underwriting team from corporate finance, this activity
is subject to the imposition of strict controls around information related
to the issue (Chinese Walls)
-Purchase securities from a corporate or government issuer

Secondary market
-Making markets in previously issued securities on a lit exchange or OTC

3. What are the two main counterparties that prime brokers act as an
intermediary between for hedge funds? What risk does the prime broker
bear to provide this service?
 Institutional investors on one hand and commercial banks on the other.
Institutional investors supply securities to short and are the main
counterparty that facilitates the securities lending business. Commercial
banks provide margin financing, and are the main counterparty driving
the margin financing business.
Prime brokers bear counterparty credit risk and increased systemic risk,
as they become central nodes in leveraged trade.

4. Describe the operation of the following:

(a) Securities lending
(b) Margin lending
Your answer should consider:
(i) the counterparties that investment banks provide these
services to;
(ii) how they work;
(iii) the benefits that are delivered to the participants
(iv) how they are priced; and
(v) the functions performed by investment banks.
(a) Securities lending is a process where securities held by an investor
(the lender, who is usually a long-term investor such as an asset
manager) who does not intend to sell these shares soon lends them
to another counterparty (the borrower), often a hedge fund. The
investment bank acts as the intermediary to the transaction. As a
prime broker the IB can transfer ownership of the shares from the
lender through its settlement systems in so doing the ownership of
the shares is transferred to the borrower. This enables the borrower
to cover a short position in the shares.
The IB receives and holds cash collateral from the borrower which
is usually greater than the value of the shares lent. This is called
over-cover (usually between 102% and 105% of the shares current
market value) and is designed to cover any potential volatility
(increase) in the price of the shares. This is designed to protect the
lender from the potential default of the borrower during the life of the
transaction. The IB invests the collateral funds (usually at the
overnight cash rate) and pays this less a margin to the borrower.
This margin reflects the demand and supply factors for securities
lending in the particular share subject to the transaction. The margin
is shared between the IB and the lender. The amount paid to the
lender is termed the “rebate”.
(b) Margin lending is provided by an IB to customers who want to invest
in shares using leverage. Margin lending is provided to investors at
both the retail and wholesale/institutional level. The lender deposits
an agreed proportion (say 60%) of the value of the shares with the
IB. The amount lent, in our example 40%, and is termed the loan to
value ratio (LVR). The LVR is determined based on the volatility of
the shares and the creditworthiness of the borrower and is subject
to change at any time by the margin lender. In te case of retail
investors the LVR is usually applied at the level of the individual
share but for institutional investors the LVR is often applied across

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 a portfolio of shares. In the event that the value of the shares fall
and the LVR rises above the maximum agreed proportion the
borrower is required to increase the amount of the deposit or
margin, this is referred to as a margin call. In extreme cases the
borrower may be forced to sell the shares and realise the loss to
cover the margin call.
The IB purchases the shares and settles them to the borrowers
account and thus lends the difference between the proportion and
the full value of the shares (in our example 40%). The IB may lend
the funds itself or may source funding from a commercial bank. The
latter would be particularly the case if the IB operation was part of a
commercial banking operation (a universal bank, as discussed in
Week 1). The interest rate will be determined based on the
borrower’s risk and the size of the LVR. In the case of retail investors
the rate is often a fixed interest rate in the case of institutions the
rate is often a margin over the overnight cash rate.
The Margin lending transaction enables investors to make
leveraged investments thus increasing the investors return on their
investment.

5. Explain the operation of the two principal types of market making services
provided by investment banks. How does the investment bank’s risk
profile different in each of these activities? How can a market maker bank
manage the risks that arise from these activities?

Agency Trading encompasses receiving an order from a client, and

executing it on an exchange or crossing two clients against one
another.
Agency business is “no market risk” business, it’s essentially a
brokerage/execution service. The market maker acts as an
intermediary between the two counterparties thus eliminating market
risk. Note the market maker still has the risk that one of the
counterparties might default at settlement.

Principal trading involves using the trader’s own inventory or balance

sheet limits to take the other side of a client trade. They can either then
hedge themselves or hold onto the position with the expectation of
making more money.
The risk in principal trading is the market risk of a negative selection
portfolio, they are assigned a position that will often be contrary to the
prevailing trend. When clients are selling, market makers are buying,
and vice versa. A negative selection portfolio is managed to minimise
the potential loss of the position acquired as a result of facilitating the
client trade. The market maker may also hedge the risk in the
derivatives markets such as futures swaps.

6. Algorithmic trading
(a) Explain the difference between Algo Trading and Algo Execution
Trading models.

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Algorithmic (Algo) trading models generate buy and sell signals for
positions in markets. Algo trading models can be fully automated
whereby the opening and closing of the position can be undertaken by
the computer model without human intervention. High Frequency
Trading is a form of Algo Trading in which trades are entered into to
open and close positions over very short time intervals.
Algo execution trading refers to trade execution strategies that are
typically used by fund managers or investment bank market makers to
buy or sell large amounts of assets. They aim to minimise the cost of
these transactions under certain risk and timing constraints. Such
systems follow preset rules in determining how to execute each order.
(b) Briefly explain the operation of the two most common types of
Algo Execution Trading models.
(i) Volume driven models including:
Volume Weighted Average Price
-algorithms are designed to achieve the VWAP of order book
traded volume.
-an example would be to buy 100K Valeant, allocating portions of
the order according to the expected volume profile, aiming to be
passive but crossing the spread to maintain the schedule with
respect to historical volume patterns.
-VWAP over the traded time period is the benchmark.
-It’s important to not that VWAP doesn’t perform well when
unexpected volume is combined with price moves that diverge
from the historical distribution.
-VWAP can be gamed by traders who wait for the price to be more
attractive.

Time Weighted Average Price

-algorithms are designed to execute equal amounts of the order
over a defined time period.
-Buy 100K Valeant and spread the order evenly over the required
trading period.
-TWAP will pay the spread to keep up with the trading schedule.
-The main disadvantage of TWAP; predictability, can be mitigated
by inserting randomness into the orders and flexibility into the
schedule.
-Trading illiquid issues may also have disproportionate market
impact.
(ii) Price driven models
Implementation Shortfall
-algorithms are designed to minimize the spread between the
execution price and the arrival price.
-buy 150,000 shares targeting the arrival price subject to an
aggressive trading style. Try to complete be order below a price.
-IS cannot be gamed.
-Allows investors to see the tradeoff between immediacy and
market impact.
-the main drawbacks are around how much data needs to be
collected, maintained and evaluated to run this type of algorithm.

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 (c) How have these changed the face of the trading function in
investment banks?

The proportion of working as traders has reduced significant since the

implementation of Algo execution trading. The management of large
client orders are to a large extent no longer managed by experience
traders but are managed by expert systems. It should be noted that
traders and managers now oversee the operation of these models and,
in particular, determine and advise on the appropriate parameters to be
used to execute particular trades. The rise of Algo execution trading has
seen a rise in the size and significance of the Technology teams in
Trading and Sales businesses. These Algo execution models have,
however, enabled the Trading and Sales operations of IB’s to offer value
added services. These models require sophisticated programming skills
and access to data. IB’s can utilise economies of scale to deliver these
services efficiently to their customers and distinguish their operations
from those of competitors.

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 Extension Question

1. Recalling our example from the lecture of Fahmi Q looking to get short
100,000 shares of Valeant, our market maker quoting Valeant at
$260/$262 with a 10bps commission, and Bill Hackman looking to get
long 100,000 shares of Valeant.
a. As an agency trade assume a trader receives Bill’s order and fills
it at the current mid-price (which we will assume is VWAP).
What’s the P&L if the order is crossed at a venue?
b. What’s the P&L if the trader crosses Bill and Fahmi at the mid?
c. If the trader chooses to go on risk to Bill, and fills his order at the
initial quoted ask-price, what is the directional position of the
market maker?
d. If the trader closes the position at a venue at a price of $262.10
what is their total P&L?
e. If we assume this trade is a good representation of this trader’s
median performance what is their retention ratio? What does the
retention ratio measure?

Answers to a and b see table below.

Crossed at venue

- To execute this on exchange the trader would then feed these instructions
into a VWAP algorithm and oversee execution of the order.
- P&L at VWAP is commission
=price x size x commission
=$261x100,000 x 0.0010
= $26,100.

External counterparty

– If another client, Fahmi, is looking to sell 100,000 shares of Valeant at or

better than VWAP the trader can act as a counterparty to both, and earn
the spread and commission.
– P&L is spread, and commission on both sides
= spread + commission(from buyer and seller)
= [$2 x 100,000] + [0.0010 x(262 x 100,000)] +
[0.0010 x (260 x 100,000)]
= $200,000 + 26,200 +26,000
=$252,200

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c. The trader is now short 100,000 shares of Valeant at $262, and needs to
buy that back in the market to offset that risk.
If the average price they cover their short is higher than $262 they lose money,
below $262 they make money.

d. Total P&L is sum of commission earned and money closing out the risk.
If the trader covers the short at $262.10 they lose $0.10 on 100,000 shares
P&L = -$10,000 + $26,200 commission.
Net P&L = $16,200

e. Retention Ratio= $Net P&L/$Commission

Retention Ratio = $16,200/$26,200)x 100%.
Retention Ratio = 61.8%
The retention ratio is a measure of how good a trader is at not losing
money.

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