Introduction

When we think of the financial markets, the first thing that comes to mind is a frenzy of young guys in multi-coloured jackets shouting and waving hands simultaneously on the Exchange floor. That is a typical working day of any Stock Exchange worldwide that is still open to ‘Open Outcry’ trading. But this is just the ‘tip of an iceberg’ and much more ‘action’ takes place daily behind closed doors, using computer screens and over the phone.

In the following chapters we will get the chance to enter this mystical world and see how it really operates and the driving forces behind it.

This book is structured in five distinctive sections:

Part 1 – Structures

Part 2 – Money markets and capital markets instruments

Part 3 – Financial derivatives

Part 4 – Pricing and valuation tools

Part 5 – Risk management

PART 1 – STRUCTURES

This section covers the investment bank structure and the various departments it requires for smooth business operation. It will aid understanding of how it all fits together and serve as an excellent guide for job selection and planning career progress.

PART 2 – MONEY MARKETS AND CAPITAL MARKETS INSTRUMENTS

Standard short- and long-term financial instruments used for lending and borrowing funds are the subject of this section. To ease us into the world of strangely named products and strategies, we will first get familiar with the main cog of this giant machinery – money and its time value. We will learn the concepts of present value (PV), calculate interest on investments, compare values of different cashflows and lots more. This will come in useful in the following chapters where we delve deeper into each class of investment products (also known as securities or instruments). This is followed by the simplest type of instrument – money market instruments – short-term loans and deposits, transacted and fixed at the time of trading. Capital markets instruments, used for longer term financing, are covered next.

PART 3 – FINANCIAL DERIVATIVES

The fairly safe products covered in the previous section will be followed by a range of speculative and therefore much riskier instruments – derivatives, covered in this section. A chapter will be devoted to a brief overview of different product classes currently in the market, from the most popular and most widely transacted interest rate derivatives, to commodity derivatives and various exotic and hybrid securities. Subsequent chapters deal with specifics of each product class in more detail. Financial futures – exchange traded contracts for purchase/sale of an underlying product at some future date, and forward rate agreements (FRAs) – over the counter (OTC) products with similar characteristics, will be introduced first.

Swaps – contracts for exchange of cashflows of different origins between two counterparties over a period of time – are discussed next. The reasons behind various ‘flavours’ of such transactions with the advantages provided to both sides of the deal are presented.

The very popular topic of foreign exchange (FX) will follow, enabling the reader to calculate spot and future exchange rates for various currency pairs and providing insight into the range of FX products available for trading.

Then we finally come to more speculative products – options, which offer to the buyer a certain downside protection and potential unlimited profit, but at a price; and for the seller a huge ‘headache’ if his/her view of the market moves is proven to be wrong. To price options, two approaches are taken: analytical (typically a variation of the famous Black–Scholes model), and numerical (using binomial trees). Both approaches will be covered, together with their advantages and disadvantages.

Bond and equity derivatives – speculative instruments typically used to borrow and land funds without the investment bank as an intermediary – are covered next. Commodity and credit derivatives will get their well-deserved mention in the chapter that follows. But as their portion of the derivatives market is so small compared to interest rate products, only a brief overview of the product ranges will be given without any calculations. As the investment banking world is coming up with an ever increasing number of financial instruments, this book would not be complete without exotic products and hybrid securities. These are truly innovative strategies tailored specifically to the client’s requirements and transacted rarely, hence their pricing is extremely complex and uncertain.

PART 4 – PRICING AND VALUATION TOOLS

This section provides a selection of tools and techniques required for successful product valuation. Some basic concepts on probability are covered first, including types of distribution and binomial tree construction. To give the rationale for decisions on short- vs. long-term investment, the concept of yield curve – a current market view of how the economy and interest rates will evolve with time – will be introduced in the chapter that follows. Next, the role of the quantitative analytics department, mathematicians who write models used for pricing all financial instruments, is briefly addressed and the model classification with their brief overview is also given. This is followed by a summary of all pricing formulae and key points from the previous chapters.

PART 5 – RISK MANAGEMENT

This final section includes chapters on credit risk and market risk, aiding the understanding of the risks associated with trading derivatives, their identification, assessment, monitoring and management.

Finally, a graphical representation of various option strategies can be found in Appendix 1, whilst ISO (SWIFT) currency codes are listed in Appendix 2. A glossary of the terms used in the book and a list of references and sources are included at the end. Enjoy!