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1 Market making

2 Arbitrage trading

3 Repo

4 Prime Brokerage

Chapter 12 & Chapter 13

After finishing this part, you should be
able to
• Understand the structure of the sales and trading
business – brokers, traders, market makers,
• How traders make money – spreads, positions,
speculation, arbitrage
• Understand important aspects of the repo markets
• Know the prime brokerage activities in IB
What is Sales and Trading?
▫ The term refers to the various activities relating to the
buying and selling of securities or other financial
instruments. Typically an IB will perform these tasks
on behalf of itself and its clients
▫ Sales: refers to the IB's sales force, whose primary
job is to call on institutional and investors to suggest
trading ideas and take orders
▫ Trading: the 2 basic, different types are agency
trading and proprietary trading (prop trading)
 Agency traders act as a trading agent for clients. Their
job is to execute trades as skillfully as possible on behalf
of the firm’s clients
 In contrast, prop traders are in charge of trading the
financial firm’s own money
Trading approaches
▫ There are many markets, many instruments, and
many techniques. Each market has its own unique
characteristics and its own trading hours
▫ To excel in trading, people may look at hundreds
of systems, study with dozens of gurus, genuine
or fake, or spend money and time on reading
various books on trading
▫ Most people need to learn not to rely on these
systems and books. You cannot buy success. You
have to make it yourself
1. Market making
▫ A market maker or liquidity provider is
a company or an individual that quotes both a buy
and a sell price in a financial instrument or
commodity held in inventory, hoping to make a
profit on the bid – offer spread
▫ A market maker is a firm that stands ready to buy
and sell stock on a regular and continuous basis
▫ A market maker takes very high risks with each
transaction. There is a chance that the shares they
bought from us will lose value, making big losses
for them. This is why a market maker needs to
maintain a big spread on each stock
1. Market making
▫ Market making is an integral part of a dealer’s
operation and is necessary for the underwriting
▫ Market maker is normally tasked with providing
sufficient liquidity in order to reduce volatility in
prices and maintain a 'fair and orderly market' for
2. Arbitrage trading
▫ There are various types of arbitrage. The classical
riskless arbitrage opportunities are practically
nonexistent in many active markets. In developing
sectors of markets, however, riskless arbitrage
opportunities do occasionally present themselves.
▫ Several major types of arbitrage:
 Index arbitrage
 Convertible arbitrage
 M&A risk arbitrage
 Convergence trading
 Yield curve arbitrage
 Covered interest arbitrage
2. Arbitrage trading
▫ Arbitrage involves buying securities on one
market for immediate resale on another market in
order to profit from a price discrepancy
▫ In IB, arbitrage more commonly refers to the
simultaneous purchase and sale of two similar
securities whose prices, in the opinion of the
trader, are not in sync with what the trader
believes to be their “true value.”
2. Arbitrage trading
▫ Acting on the assumption that prices will revert to
true value over time, the trader will sell short the
overpriced security and buy the underpriced
security. Once prices revert to true value, the
trade can be liquidated at a profit
▫ Arbitrage could be a good investment option, but it
is best used by institutional investors who have
significant assets and are willing to accept the
2. Arbitrage trading

Index arbitrage
▫ An investment trading strategy that exploits
divergences between actual and theoretical
futures prices. This is done by simultaneously
buying (or selling) a stock index future while
selling (or buying) the stocks in that index
▫ The idea is that an index is made up of several
components that influence the index price in a
different manner
2. Arbitrage trading

Index arbitrage
There are sets of rules which index arbitrage
▫ If a futures contract is deemed high relative to the
cash price of the index (underlying stock basket),
the index future is sold and the stocks making up
the index are purchased
▫ If a futures contract is deemed low relative to the
cash price of the index, the index future is
purchased and the stocks making up the index
are sold
2. Arbitrage trading

Index arbitrage
In either of the scenarios, the arbitrageur is fully hedged against
upward or downward movement in the value of the index
Profits are made when the spread between the futures contract and
its spot price returns to its "normal" or expected value

The figure illustrates

arbitrage-bound band
around fair value.
Should the futures price
exceed the upper bound
or fall below the lower
bound, then an arbitrage
opportunity would
2. Arbitrage trading

Index arbitrage

“Lý giải động thái bán mạnh của nhóm tự doanh

khiến thị trường "bay" chục điểm: Khi các tay chơi
"arbitrage" vào cuộc”
Cafef, 27/11/2019
2. Arbitrage trading

Convertible arbitrage
▫ A trading strategy that typically involves taking a
long strategy in a convertible security and a short
position in the underlying common stock, in order
to capitalize on pricing inefficiencies between the
convertible and the stock. Convertible arbitrage is
a long-short strategy that is favored by hedge
funds and big traders
▫ The rationale behind a convertible arbitrage
strategy is that the long-short position enables
gains to be made with a relatively lower degree of
2. Arbitrage trading

Convertible arbitrage
▫ If the stock declines, the arbitrage trader will
benefit from the short position in the stock, while
the convertible bond will have less downside
risk because it is a fixed-income instrument
▫ If the stock gains, the loss on the short stock
position would be capped because it would be
offset by the gain on the convertible
▫ If the stock trades sideways, the convertible bond
pays a steady coupon that may offset any costs of
holding the short stock position
2. Arbitrage trading

Convertible arbitrage
▫ Convertible securities are hybrid securities, usually issued as
bonds or preferred stocks, which offer investors an embedded
option – the ability to “convert” to a specified number of shares of
common stock

The global
market was
estimated at
$320 billion as of
June 30, 2012
(see Exhibit 1)
2. Arbitrage trading
Analysis of CB prices factors in three different sources of
value: investment value, conversion value, and option value
▫ The investment value is the theoretical value at which
the bond would trade if it were not convertible. This
represents the security’s floor value, or minimum price at
which it should trade as a nonconvertible bond
▫ The conversion value represents the value of the
common stock into which the bond can be converted. If,
for example, these shares are trading at $30 and the
bond can convert into 100 shares, the conversion value is
▫ The option value represents the theoretical value of
having the right, but not the obligation, to convert the
bond into common shares
2. Arbitrage trading

Convertible arbitrage
2. Arbitrage trading

Convertible arbitrage
Key steps
▫ Identifying convertible securities
▫ Establishing and re-balancing the hedge ratios
▫ Managing the risks
2. Arbitrage trading
Convertible arbitrage
This strategy should do well whatever direction equity
markets move
▫ If the stock price falls, the hedge fund will benefit
from its short position; it is also likely that the CBs will
decline less than the stock, because they are
protected by their value as fixed-income instruments
▫ If the stock price rises, the hedge fund can convert
its CBs into stock and sell that stock at market value,
thereby benefiting from its long position, and ideally,
compensating for any losses on its short position
2. Arbitrage trading

Convertible arbitrage
Examples: CB matures in 1 year, trading at $1,050,
convertible into 100 shares, which is trading at $10 /
▫ => Premium $50
▫ The equivalent straight bond is trading at $920
▫ Assuming future stock price range: $7.5 or $12.5, thus
the conversion value is $750 or $1250
▫ Investor long 1 CB at $1050 short 60 shares at $10
2. Arbitrage trading

Convertible arbitrage
▫ Future price of share = $7.5
 Long 1 bond: 920 – 1050 = -130
 Short 60 shares: (10 – 7.5) x 60 = 150
 Profit 20

▫ Future price of share = $12.5

 Long 1 bond: 1250 – 1050 = 200
 Short 60 shares: (10 – 12.5) x 60 = -150
 Profit 50
2. Arbitrage trading

Convertible arbitrage
2. Arbitrage trading

M&A risk arbitrage

▫ Risk arbitrage (Merger arbitrage) is a strategy that
speculates on the successful completion of M&A.
It is an investment strategy to profit from the
narrowing of a gap of the trading price of a target's
stock and the acquirer's valuation of that stock in
an intended takeover deal. Risk arbitrage involves
buying the shares of the target and selling short
the shares of the acquirer
▫ This investment strategy will be profitable if the
deal is consummated; if it is not, the investor will
lose money
2. Arbitrage trading

M&A risk arbitrage

There are two main types of corporate mergers: cash
and stock mergers (and a combination of both)
▫ When a corporation announces its intent to acquire
another corporation, the acquiring company's stock
price typically declines, while the target company's
stock price generally rises
▫ However, the target company's stock price typically
remains below the announced acquisition price.
This discount reflects the uncertainty of the deal
2. Arbitrage trading
M&A risk arbitrage
▫ In an all-cash merger, investors generally take a long
position in the target firm
▫ In a stock-for-stock merger, a merger arbitrageur
typically buys shares of the target company's stock
while shorting shares of the acquiring company's stock
▫ If all goes as planned, the target company's stock price
should eventually rise, and the acquirer's price should
fall. The wider the gap, or spread, between the current
trading prices and their prices valued by the acquisition
terms, the better the arbitrageur's potential returns
2. Arbitrage trading

M&A risk arbitrage

▫ An acquirer is offering to buy the target’s stock at
a price of $60/share while it is trading at
$50/share => 20% premium
▫ After the announcement, the stock price rises to
$56/share. An arbitrageur buys the target at $56
 He will realize a profit of $4 if the acquisition takes
place at $60
 He will lose $6 if the deal does not go through and
the target’s stock declines back
2. Arbitrage trading
M&A risk arbitrage
▫ An acquirer is offering to exchange 1 share of it for 1
share of the target. The acquirer stock is trading at a
price of $60/share while the target is trading at
$50/share => 20% premium
▫ After the announcement, the target’s stock price rises
to $56/share. An arbitrageur buys the target at $56
 He will realize a profit of $4 if the acquisition takes
place and the acquirer’s share still trades at $60
 He will lose $6 if the deal does not go through, the
acquirer’s stock declines to $50
2. Arbitrage trading
M&A risk arbitrage
Arbitrage strategies
▫ Identify existing M&A opportunities with a focus on large
percentage spreads between the proposed purchase
price and the target stock price
▫ Analyze potential reasons for the spread between the
two, including the possibility that the merger will fall
through and be unsuccessful
▫ Purchase stock in the target company (and short stock in
the acquirer)
▫ Monitor the trade over time for any changes that could
impact the odds of success and adjust the trade
2. Arbitrage trading

Convergence trading
▫ A trading strategy consisting of two positions:
buying one asset forward, i.e. and selling a similar
asset forward for a higher price, in the expectation
that by the time the assets must be delivered, the
prices will have become closer to equal (will have
converged), and thus one profits by the amount of
▫ Convergence trades involve two assets whose
prices must converge with time and, at maturity (if
there is a maturity), must be equal
2. Arbitrage trading

Convergence trading
▫ Investors studied the relationships between yields
and prices of numerous securities and their
respective futures contracts to see if they were out
of line
▫ The risk of a convergence trade is that the
expected convergence does not happen, or that it
takes too long, possibly diverging before
2. Arbitrage trading
Convergence trading
▫ Example involved on-the-run and off-the-run U.S. Treasury
 Price discrepancies occur because on-the-run securities are newly
issued and have relatively more active markets than off-the-run
 Because of the relatively higher demand, the price of a newly issued
Treasury bond with a 30-year maturity might be high compared to an
off-the-run bond that was issued six months ago (i.e., with 29.5 years
to maturity)
 Investors would purchase the relatively low-priced, off-the-run security
and simultaneously sell short the high-priced, on-the-run security
 Then, the on-the-run securities would become seasoned and their
prices would converge to the already seasoned securities, thereby
earning a profit
2. Arbitrage trading
Convergence trading
▫ In fixed income markets, an expensive bond would be
shorted, while a cheap bond would be purchased
▫ Examples of John Meriwether’s convergence trading
 In late 1988, worries about mortgage market had driven
MBS decline relative to Treasury, widening the spread
to 1.5% from 1%
 Arbitrageur believed MBS would regain their historical
value => purchased MBS and sold short Treasury.
When the spread narrowed, the value of MBS would
rise more or fall less than that of Treasury
2. Arbitrage trading
Convergence trading
▫ Examples of John Meriwether’s convergence trading
 Purchased $5 billion worth of MBS yielding 10.5% and sold
short $5 billion worth of treasuries at 9.0%. To hedge
against prepayments, they also purchased interest rate
options costing 0.5% of the value of the MBS, or $25 million
 Every year for 3 years, the MBS earned $75 million more in
interest than Salomon had to pay on the treasuries. But the
prepayment hedge cost $25 million. Over the 3 year period,
the positive carry amounted to $150 million
 When the spread narrowed to 1.0%, covered the short
position and sold mortgage securities. Each $1,000 bond
had risen $25 more than Treasuries, for a $125 million gain.
Total profit for the trading strategy: $275 million
2. Arbitrage trading
Yield curve arbitrage
▫ Involves trading bonds of different maturities on the
yield curve. A trader would long the cheap part of
the curve and short the rich. The trader would be
successful if
 The security shorted will have fallen in price or risen in
 The security purchased will have risen in price or
fallen in yield
 A combination of the above
▫ Consists of the discovery and exploitation of
inefficiencies in the pricing of bonds
2. Arbitrage trading

Yield curve arbitrage

▫ The yield curve is a graph
showing the bond yields
of various maturities
ranging from 3-month T-
bills to 30-year T-bonds
▫ The graph is plotted with
interest rates on the y-
axis, the increasing time
durations on the x-axis
2. Arbitrage trading

Yield curve arbitrage

▫ Since short-term bonds typically have lower yields
than longer term bonds, the curve slopes upwards
from the bottom left to the right. This is a normal
or positive yield curve.
▫ Sometimes, the yield curve may be inverted or
negative, meaning that short-term Treasury yields
are higher than long-term yields
▫ When there is little or no difference between the
short-term and long-term yields, a flat curve
2. Arbitrage trading

A yield curve spread is the yield differential between two different

maturities of a bond issuer
2. Arbitrage trading

Yield curve arbitrage

▫ Bull Flattener is observed when long-term rates
are decreasing faster than short-term rates
▫ Bear Flattener is a yield-rate environment in which
short-term interest rates are increasing at a faster
rate than long-term interest rates
2. Arbitrage trading

Yield curve arbitrage

▫ Bull Steepener when short term interest rates fall
faster than long term interest rates
▫ Bear Steepener when long term interest rates rise
faster than short term interest rates
2. Arbitrage trading

Yield curve arbitrage

▫ Flattening Yield Curve: when traders expect the
yield curve to flatten, they will go short short-term
bonds and long long-term bonds
▫ As the difference between short and long term
interest rates converge, trader should earn more
from the short-term bonds they sold short, than
they lose on the long-term bonds they went long
2. Arbitrage trading
Yield curve arbitrage
▫ Steepening Yield Curve: When traders expect
the yield curve to steepen they will go long short-
term bonds and short long-term bonds
▫ As the difference between short and long term
interest rates widens, the trader should earn more
on the short-term bonds they bought than he
loses on the long-term bonds they sold short
2. Arbitrage trading

Covered interest arbitrage

▫ Involves trading of an instrument denominated in
one currency with one in another currency. A trader
is looking to exploit discrepancies between the spot
rate and the futures or forwards rate of two
currencies. This allows the trader to borrow or lend
at below market or above market rates respectively
▫ If speculator relies on his expectations regarding
the future spot rate, he engages in an uncovered
interest arbitrage. When speculator has a forward
contract with a predetermined forward rate, he
engages in covered interest arbitrage
2. Arbitrage trading

Covered interest arbitrage

▫ Why Are Spot and Forward Prices Different?
Forwards trade at either a premium or a discount
to the spot rate
▫ It’s often thought that this must be because the
market is “pricing in” assumptions about the future
▫ Future or forward does include a discount or
premium that is reflected in the underlying market
or in interest rates, IF NOT can arbitrage against
that and make a profit
2. Arbitrage trading

Covered interest arbitrage

▫ Assume currency X and currency Y are trading at parity in
the spot market X = Y, the one-year interest rate for X is
2% and for Y is 4%
▫ The one-year forward rate for this pair is therefore X =
1.0196 Y (without getting into the exact math, F is
calculated as spot rate x (1.04 / 1.02)
▫ The difference between the forward rate and spot rate is
known as “swap points”, which is 196 (1.0196 – 1.0000)
▫ Let’s assume that the one-year forward rate for X and Y is
X = 1.0125 Y
2. Arbitrage trading

Covered interest arbitrage

2. Arbitrage trading

Covered interest arbitrage

 Borrow 500,000 of currency X @ 2% per annum,
total loan repayment obligation after a year would be
510,000 X
 Convert the 500,000 X into Y (because it offers a
higher one-year interest rate) at the spot rate of 1.00
2. Arbitrage trading

Covered interest arbitrage

 Take the 4% rate on the deposit amount of 500,000
Y, and simultaneously enter a forward contract that
converts the full maturity amount of the deposit
(which is 520,000 Y) into currency X at the one-year
forward rate of X = 1.0125 Y
 After one year, settle the forward contract at the
contracted rate of 1.0125, which would give the
investor 513,580 X
 Repay the loan amount of 510,000 X and pocket the
difference of 3,580 X
3. Repo
▫ Repo – Repurchase Agreement: when an institution
lends money to a dealer by way of purchasing the
collateral and agreeing to resell the same collateral
back, the transaction is called a repo
▫ When an institution borrows funds from a dealer by
selling the collateral and agreeing to repurchase the
same, the transaction is called a reverse repo
3. Repo
▫ Securities market participants enter into repo
transactions because they have cash and want a short
term investment or because they have securities and
need funding
▫ Classified as a money market instrument, a repo
functions in effect as a short-term, collateral-
backed, interest-bearing loan. The buyer acts as a
short-term lender, the seller acts as a short-term
borrower, and the securities being sold are the
3. Repo
3. Repo
▫ The interest rate for such a loan is called a repo rate,
which is determined by many factors such as term of
the repo, type of the collateral, credit quality of the
borrower and market conditions
▫ Coupon pass through - The coupon interest on the
collateral is passed through from the buyer back to the
3. Repo

▫ The seller: you are borrowing on a collateralised basis
 a cheaper source of financing than bank borrowing
 allows investor to get leverage – the seller retains the
economic interest in the bond, and can use the bond as
collateral to raise cash to buy more of the security
3. Repo

▫ The buyer: for the buyer (who repos in the security,
for whom the transaction is a reverse repo), this is
collateralised lending
 secure home for cash, at better rates than bank deposits
 the buyer can sell the security, buying it back at the term
to return it to the original owner, so benefitting from any
fall in the price of the security => the reverse repo
therefore facilitates short sales
3. Repo
▫ Based on tenor
 Overnight repos – one day transactions
 Term repos – longer maturities
Repos may be arranged on an open basis and terminated when
either party chosen to do so
3. Repo
▫ Based on differences in settlement
 Bilateral repo - each counterparty’s custodian bank is
responsible for the clearing and settlement of the trade
 Triparty repo - involves a third party, which is a clearing
In U.S., triparty repo services are currently offered by Bank
of New York Mellon Corp. and JPMorgan
3. Repo
▫ Bilateral repo
3. Repo
▫ Triparty repo
3. Repo
▫ Collateral
3. Repo

Haircuts and margin calls

▫ The haircut is designed to ensure that buyer is
protected if dealer fails, even if the value of collateral
has declined - but market is competitive so cannot
demand a large haircut
▫ The size of haircuts/initial margins should be a
function of market liquidity risk, operational risk, legal
risk, default risk
▫ If value of collateral declines, the dealer would be
required to post more collateral - This is a margin call
▫ If default occurs, collateral is sold, the debt is repaid,
and any balance returned to dealer
3. Repo
▫ Dealer buys $10m FV of 10 year T-bond, with coupon
of 4%, which is trading at par
▫ Dealer enters into an overnight repo with a bank,
selling the bond out, and receiving cash
▫ The haircut is 1% - the bank will not lend the full $10m
because if rates rise and dealer defaults it will lose
money – so bank lends only $9.9m
▫ The REPO rate is 1.6%
3. Repo
• On day t
- Dealer delivers $10m T-bond to bank
- Bank lends dealer $9.9m cash
• On day t+1
- Dealer pays bank $9.9m + interest
- Bank returns collateral to dealer
3. Repo
▫ Interest for d day = Loan amount x repo rate x d/360
Use 360 day convention

In this case
▫ Interest for 1 day = $9,900,000 x 1.6% x 1/360 = $440
▫ So on day t + 1 dealer pays $9,900,440 to bank
3. Repo

▫ Carry is the difference between the interest earned on
a position and the cost of financing it
▫ In our case, interest accrues at the rate of 4% on the
▫ Carry = ($10.0m x 4%)/365 – ($9.9m x 1.6%)/360
= $655.89

This is roughly 2.4% annualised

3. Repo

▫ The gain or loss on the position is the carry plus the
capital gain on the bond
▫ Suppose modified duration of bond is 9 years
▫ If 10 year yields fall by 2bp overnight => Bond price
rises by 0.18%
P&L = 0.0018 x $10m + $655.89 = $18,655.89
▫ If yields rise by 1 bp overnight => Bond price falls by
P&L = -0.0009 x $10m + $655.89 = -$8,344.11
This is a fall of 8.3% relative to the $100,000 equity the
dealer has in the position
3. Repo

Short selling
You believe bond A is overvalued relative to bond B
▫ If you own A, sell it, and buy B
▫ If you don’t own it, you could do a reverse repo
 Repo in bond A, and sell it
 Buy bond B and repo it out
▫ Capital needed for haircuts only
▫ When bond A has gone down relative to bond B, buy
back A, sell B and liquidate both repos, and realise
3. Repo

Short selling
If A and B both go up, face a margin call on A but
hopefully can get margin from counterparty on B (and
conversely if they both go down)
But if A becomes more overvalued relative to B, will face
a net demand for margin
▫ With limited capital, may need to liquidate at a loss
▫ Also vulnerable if lender of A terminates the repo
4. Prime Brokerage
▫ The generic name for a bundled package of services
offered by IBs and securities firms to clients (mostly
hedge funds) which need the ability to borrow
securities and cash
▫ The services provided under prime brokering include
securities lending, leveraged trade executions and
cash management, among other things
▫ Prime brokerage services are provided by most of
the largest financial services firms, including
Goldman Sachs, UBS and Morgan Stanley, with the
inception of units offering such services tracing back
to the 1980s
4. Prime Brokerage
▫ Bundled package of services
4. Prime Brokerage

▫ Global custody (including clearing, custody, and
asset servicing)
▫ Securities lending
▫ Financing (to facilitate leverage of client assets)
▫ Customized technology (provide hedge
fund managers with portfolio reporting needed to
effectively manage money)
▫ Operational support (prime brokers act as a
hedge fund's primary operations contact with all
other broker dealers)
4. Prime Brokerage

▫ Global custody
4. Prime Brokerage

▫ Securities lending & financing
4. Prime Brokerage

▫ Securities lending & financing
 A financial institute may desire to go short but
realizes it does not own security. In such instances,
a prime brokerage serves to create efficiency in the
market by lending security to its client
 Repo vs securities lending: most repo is for general
collateral and is therefore motivated by the need to
borrow and lend cash, whereas securities lending is
typically driven by the need to borrow securities. The
repo market overwhelmingly uses fixed-income
instruments as collateral
4. Prime Brokerage

In addition, certain prime brokers provide additional

services, which may include some or all of the
▫ Capital Introduction – prime broker attempts to
clients to qualified hedge fund investors who have
an interest in exploring new opportunities to make
hedge fund investments
▫ Office Space Leasing and Servicing – typically
called a "hedge fund hotel”
4. Prime Brokerage

In addition, certain prime brokers provide additional

services, which may include some or all of the
▫ Risk Management Advisory Services – The
provision of risk analytic technology, sometimes
supplemented by consulting
▫ Consulting Services – A range of consulting /
advisory services, typically provided to "start-up"
hedge funds, and focused on issues associated
with regulatory establishment requirements
4. Prime Brokerage
4. Prime Brokerage

▫ Prime brokers do not charge a fee for the bundled
package of services they provide. Rather,
revenues are typically derived from three sources:
spreads on financing (including stock loan),
trading commissions and fees for the settlement
of transactions done away from the prime broker