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Introduction to Financial Markets

Financial markets exist in many forms. For example, some commonly traded financial products are stocks, bonds, futures, and options. At a high level, financial markets trading three broad categories of assets. First, they trade real assets - assets that you can typically touch or feel. Second, they trade financial assets. Financial assets typically provide some type of right to a corporation’s earnings - stocks and bonds. Finally, traders can use contracts, called derivatives, which transfer wealth from one trader.

 

Portions of this discussion were adapted from the books, “Risk Management in Trading” by Davis W. Edwards, published by J. Wiley in 2014 and “Energy Trading and Investing”, published by McGraw-Hill in 2013.


What makes something tradable?

What kinds of things do people trade?

What are some unique features of Real Assets (Commodities)?

What are some unique features of Financial Assets?

What are some common types of Financial Assets?

What are some unique features of Derivatives?

What are some different types of Derivatives?

 

Coming soon: Bonds, Equities, Commodities


What makes something tradable?

Keeping in mind that trading involves short-term holdings (often less than a year), there are many types of assets that cannot be traded. Some common features of financial instruments:

                     Assignable. The asset has to be transferable to someone else and others traders have to be willing to both buy and sell.

                     Fungible. The asset typically must be interchangeable with similar assets.

                     Liquid. Buying and immediately reselling the product cannot involve a substantial loss in value. A difference of more than 10% between purchase and sale prices indicates a market where active trading is difficult.

Not all assets are tradable. One requirement for trading is that the underlying asset is assignable. Assignable means that it is legally possible to transfer the asset (or liability) from one party to someone else. For example, in the United States, it is possible to own rights to minerals and oils still underground and to sell those rights to someone else. However, in many other countries, mineral and oil deposits belong to the country’s government.

A second requirement for trading is comes from the need to get into and out of a position within a relatively short holding period. This means that it has to be possible to place an objective value on an asset and be able to sell it for that price within a reasonable timeframe. For example, the value of unique framed art or similar one-of-a-kind artifacts will vary by observer. This may make it difficult for a trader to sell the asset for its perceived value in a timely manner. Sometimes, the owner will not be willing to sell a unique asset at any price. Some other examples of unique assets are real estate and intellectual property like patents.

Because of this, trading typically requires the asset to be interchangeable with similar assets. This allows enough people willing to buy or sell at any given time to develop a marketplace. Traders use the term, fungible, to describe when an asset can be substituted, replaced, or interchanged with a similar asset. For example, shares of a company stock are interchangeable regardless of how they are acquired - share purchased through an initial public offering are the same as shared purchased on an exchange. This simplifies trading because it is easier to establish enough buyers and sellers to establish a common price for an asset.

This leads into the third requirement for trading - traders need the ability to buy and sell the asset in a relatively short timeframe without giving up a substantial amount of the asset’s value. Otherwise, any type of short term trading is doomed to being non-economical. Another way to state the same requirement is that tradable assets must be readily convertible into cash within a reasonably short time without taking a substantial loss. As a result, traders have developed terminology to describe how easy it is to turn an asset into cash (or pay money to remove a liability). This term is liquidity.

                     Liquid Market. A liquid market allows an asset to be easily converted into cash, or a liability to be removed by paying cash, without a significant loss of money. Typically, liquid markets have low transaction costs, low volatility, and it is easy to execute a trade at a reasonable price.

                     Illiquid Market. An illiquid market does not allow easy trading. Typically, an illiquid market requires the trader to spend a substantial amount of time finding a trading partner or to take an unfavorable price.

What kinds of things do people trade?

Tradable items include both physical items (real assets) and certain contracts (financial assets and derivatives). Real assets include physical commodities (like gold, oil, corn, or cattle), real estate, and legislatively created rights (like carbon emissions rights). Financial Assets are primarily composed of contracts that give an ownership interest in a company (stocks), borrowing (bonds), or currencies. Derivatives are financial contracts that derive their value from other financial instruments. For example, a derivative might be an agreement to buy a physical commodity at some point in the future (a futures contract) or a contract that gives its owner the right, but not the obligation, to purchase stock in a company (a stock option).

Financial instrument and security are general terms that typically refer to any type of tradable financial contract. Originally, securities referred to instruments that provided an ownership right like stocks and bonds. However, in many jurisdictions, the term security now encompasses financial instruments that derive their value from commodities and from other financial instruments (derivatives).

Some examples of tradable assets, and there categorization, can be found in Table 1 - Types of Tradable Assets.

Table 1 - Types of Tradable Assets

Category

Financial Instruments

Created by:

Real Assets

Physical Commodities

Real Estate

Emissions Rights

Patents

Mining, Oil Drilling, Farming

Builders

Governments

Inventors

Financial Assets

Stocks

Bonds

Currencies

Corporations

Borrowers

Governments

Derivatives

Futures

Forwards

Swaps

Options

Sellers

Sellers

Sellers

Sellers

 


What are some unique features of Real Assets (Commodities)?

Real assets include both tangible and intangible assets, not all of which are tradable. Tangible assets are physical assets like physical commodities, buildings, equipment, and land. Intangible assets don’t have physical form but still have value. Some examples of intangible real assets are inventions, works of art, and advertising trademarks.

Traded real assets are typically called commodities. These include petroleum products, metals, and agricultural produce. At its simplest, the market for many commodities is a type of spot market where physical commodities are exchanged for cash on the spot. It should be noted that due to the complexity of storing and delivering physical products, a large portion commodity trading is actually done in the derivatives markets (discussed below) where contracts to purchase and sell commodities are arranged ahead of time. This substantially simplifies trading since storage and transportation can be worked out ahead of time.

Compared to most financial instruments, commodities have several unique features. First, commodities have to be at the right place at the right time. A warehouse of cotton located in Egypt can’t be immediately delivered to a factory in United States. As well as having different levels of supply and demand, different locations might also have different regulations (like taxes) that give commodities a strong location-based component to their prices. Second, the units of trading are very important for commodities. For example, crude oil can be traded in units of volume (barrels) or weight (metric tonnes). If a trader is quoting a price for a commodity, understanding the units in which the price is being quoted is important. Third, most commodities have to meet specific standards for purity and quality called the commodity grade. Finally, consumers will often destroy commodities in the process of using them. For example, gasoline might be consumed while driving a car, corn would be consumed for food, and so on.

Some features of commodities that are different from other financial instruments:

                     Location. Commodities have a physical location. This is important since commodities are often expensive to transport and different locations can have variations in supply and demand that lead to different prices.

                     Units. Commodities can trade in different units. For example, oil can trade in units of volume (barrels or gallons) or weight (metric tonnes). This can cause traders some difficulty since different types of crude oil have different densities. As a result, one batch might have 7.2 barrels per metric tonne and a second batch of crude oil 6.9 barrels per metric tonne, making a simple rule to convert between the volume and weight very difficult.

                     Grade. Most commodities will need to meet certain quality specifications to be tradable. The grade of a commodity describes which quality standard is met by the commodity.

                     Consumed. Many commodities are consumed and need to be replenished through the growing crops, mining, or similar activities.


What are some unique features of Financial Assets?

Financial Assets represent ownership of real assets or cash flows created by real assets. Financial assets differ from real assets because issuers create financial assets. For example, a corporation could create a financial asset by issuing either stock or bonds or a government could create a financial asset by issuing currency. Financial assets typically exist in perpetuity.

The process of issuing new assets is the major unique feature of financial assets. The terms primary market and secondary market describe trading in various parts of the financial asset lifecycle. The primary market for financial assets involves the issuance of the financial assets and the initial sale to investors. An initial public offering is the issuance of new shares of stock. The secondary market for financial assets involves the subsequent trading of already issued assets. For example, buying shares of a stock from an exchange is a secondary market transaction.

The two markets for financial assets are:

                     Primary Market. A marketplace for issuing new financial assets like a bond offering or an initial public offering for a stock.

                     Secondary Market. A marketplace for trading existing financial assets like a stock exchange

While companies can directly issue assets to buyers, the process of issuing assets is commonly facilitated by an underwriter. An underwriter is financial institution, or a group of financial institutions organized into a syndicate, which helps find buyers for an issuance. Typically, the underwriters of an issue will agree to purchase the financial assets if buyers cannot be found. In some cases, the underwriter will act only as a broker, without guaranteeing a sale, in a best-efforts offering. There are few limits on how many financial assets can be issued as long as there are a sufficient number of buyers.


What are some common types of Financial Assets?

Financial assets come in a number of forms. The most common types are stocks, bonds, and currencies.

·         Stocks (Equities). Stocks (also called Equities) are a type of financial asset issued by corporations that give an ownership share of the corporation.

·         Bonds (Fixed Income, Debt). Bonds are a type of debt instruments created when investors loan money to a corporation, nation, or other legal entity. Typically, the initial offering is in the form of an auction.

·         Currency (Foreign Exchange). Currencies are financial assets issued by countries. Most commonly, currencies derive value by the ability of the country levy taxes on a (hopefully) growing economic base located in the country.


What are some unique features of Derivatives?

A derivative contract is a financial contract whose value is based on the value of some other asset. The asset that determines that value of the derivative is called an underlying asset. Some common examples of derivatives are futures, forwards, swaps, and option contracts. However, derivatives don’t necessarily need to be stand-alone contracts. Derivatives can also exist embedded inside larger contracts.

Some factors common to most derivatives include:

·         The underlying asset is tradable or readily convertible to cash

·         Created by transactions that transfer wealth between buyer and seller

·         Have a limited lifespan

·         Depend on future prices of the underlying asset

·         A fixed quantity of the underlying asset is traded

To be considered a derivative, the underlying asset has to be tradable. A trader needs to be able to both buy and sell this asset for cash at approximately the same price in a reasonable amount of time. In other words, the underlying asset has to be readily convertible into cash (RCC). In the case of an embedded derivative, the exposure created by that portion of the contract designated as a derivative needs to have the ability to be settled in cash or offset through trading.

Another feature of derivatives is that they require both a buyer and a seller. Derivatives are created when a buyer and a seller agree to a transaction. As a result, there are always an equal number of people holding positions on either side of the market. In other words, there is zero net supply of derivatives. For example, if prices go up in a stock market, every stockholder can benefit. However, with a derivative, because there is always the same number of buyers and sellers, wealth is only transferred between the buyer and seller.

In almost all cases, derivatives are contracts that have a limited lifespan. In other words, they expire after a certain amount of time (on the expiration date or expiry). On the expiration date, the transacting parties need to fulfill their obligations to one another. This might involve a physical transfer of the underlying asset or settlement in cash.

The value of the obligations that have to be fulfilled to settle a derivative typically depends on price movements that occur between the initiation of the transaction and the expiration date. One implication of this is that many derivatives don’t cost any money to transact. Another implication is that derivative transactions typically do not include payments for already existing value or past events. Their value typically depends only on things that might occur in the future.

Next, derivatives usually specify the quantity of the underlying asset (the notional) or dollar amount of the exposure (the notional value). Movements in the price of the underlying asset along with the fixed notional determine the magnitude of the obligations that need to be settled between the buyer and seller. For example, the change in a derivative’s value might be calculated by multiplying the price change in the underlying by the notional (a volume) to calculate a change in value.

Finally, derivatives require some way to settle the obligations of the buyer and seller. Depending on the needs of the buyer and seller, some derivatives might require the delivery of a physical product (barrels of oil, bushels of corn, tons of steel). Other derivatives might allow the obligations to be settled in cash. From a risk perspective, net settlement in cash is typically much less risky than exchange of a physical commodity for cash.

Derivatives may be settled in several different ways:

·         Physical Settlement. A physical settlement involves a delivery of a physical asset (like live cattle, gold, or oil) that is exchanged for cash. For example, a trader might have to pay $50 million to receive 500,000 barrels of oil. Physical settlement involves substantial operational risk due to the need to transfer ownership of physical assets. As with other financial instruments, there is a risk/reward relationship—many profitable trading opportunities only exist in the physical settled market.

·         Financial (Cash) Settlement. A financial settlement involves an exchange of cash flows, typically on a net basis. Financial settlement reduces many of the operational risks associated with physical delivery. In addition, the size of the settlement is much smaller. For example, a trader might agree to receive the difference between $50 million in cash and the value of 500,000 barrels of oil.

What are some different types of Derivatives?

There are many different types of derivatives. Some of the more common types include:

·         Interest Rate Swap Contracts. A swap is an exchange of two sets of cash flows. Swaps are typically cash settled. In the bond markets, fixed rate and floating rate cash flows are often swapped. In the commodity markets, the term swap commonly refers to financially settled commodity contracts. Because swaps are an exchange of cash, the terms buyer and seller commonly are often replaced with more descriptive terms.

 

·         Forward Contracts. In a forward contract, the buyer agrees to purchase a physically delivered asset from the seller at a fixed price (the strike price). Delivery is arranged at a specific point in the future. These contracts typically specify the grade, or quality, of the asset to be delivered, the location for delivery, and the price that will be paid by the buyer. Forwards typically involve no up-front payments to either party. The value of a forward at expiration is based on the difference between the strike price and the value of the physical asset at the delivery date.

 

·         Futures Contracts. Futures contracts are exchange-traded versions of forward contracts. The primary difference between a forward and a future is daily margining. Daily margining works by resetting the strike price of the contract and requiring a cash settlement each day. This is similar to selling and rebuying the contract every day. Buying or selling futures typically requires a good faith deposit, called margin, which is returned when the trade is exited.

 

·         Option Contracts. An option buyer has the right to take some action, but is not required to take that action if it is unprofitable. Options are a way to transfer risk from a buyer to a seller. The option seller has all the risk in these contracts. A substantial amount of mathematical finance is dedicated to the problem of calculating how much money (usually quite a bit) needs to be paid to the option seller to have them take this risk. The two main types of rights are the right to buy at a fixed price (a call option) and the right to sell at a fixed price (a put option). Options are also often characterized by when the option buyer can make a decision to take delivery. A European option can only be exercised at expiry while American options can be exercised at any time.

 

·         Embedded Derivatives. Contracts that are not considered derivatives may contain clauses that are considered derivatives for accounting purposes. These embedded derivatives might act like forwards, options, or any other type of derivative. For example, a contract between two firms might specify that a minimum quantity of a standardized product is purchased at a certain price.

 

·         Credit Default Swaps (CDS). Credit default swaps are derivatives whose value is based on corporate bonds issued by some corporation. In the event that the issuer of the bond defaults, the CDS issuer will take possession of the corporate bond and give a payoff to the CDS buyer. In compensation for taking on this risk, the CDS seller will receive a series of payments from the CDS buyer. The issuer of the bond (the reference entity or reference obligor) is not a party to the transaction.