How the Trading Floor Really Works

A detailed look at what really happens in the front office of an investment bank and why

Trading floors have always fascinated people, but few understand the role they play in the world of finance today. Though markets rise and fall every day, the drivers of those are rarely explored. Those who understand the dynamics of trading floors will better understand the dynamics of global financial markets. This book reveals the key players on the floor, their roles and responsibilities, how they serve their clients, and how it all impacts the markets. It also explains important terminology, explains the world of trading both cash and derivatives, and much more.

Includes a foreword by Gillian Tett, author of Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe.

Terri Duhon (www.terriduhon.co) is a financial market expert who in 2004 founded B&B Structured Finance Ltd, which provides expert consulting and financial markets training . Her time on the trading floor has been documented in the book Fool's Gold as well as by PBS's Frontline.

Foreword by Gillian Tett xi

Preface xv

Why I Wrote this Book xv

What this Book Does and Does Not Do xvi

Who this Book Is For xvi

Finally, Some Key People in the Process of Writing this Book xvii

All Feedback Welcome! xvii

Women on the Trading Floor . . . Really? xix

Chapter 1 What Are Financial Markets? 1

Debt Markets 4

Equity Markets 11

Other Asset Classes 21

Derivative Markets 22

Conclusion 26

Discussion Questions 27

Chapter 2 What Role Do Banks Play in Financial Markets? 29

What It Means to Provide Liquidity 31

Central Market Platforms 37

Who Are the Clients and What Are They Doing? 45

Conclusion 54

Discussion Questions 56

Chapter 3 Which Part of the Bank Are We Talking About? 57

Corporate Finance 60

Global Financial Markets 63

Where Are these Trading Floors? 73

The Trading Floor’s Relationship with Clients 75

The Loan Portfolio and the Funding Department 76

Conclusion 80

Discussion Questions 81

Chapter 4 What Does It Mean to Trade? 83

PACAM Treasury Trade 85

Supermart Interest Rate Swap Trade 94

A Structured Equity Product 108

Conclusion 118

Discussion Questions 119

Chapter 5 What Is the Market and Why Does It Move? 121

What Is the Market? 123

Price Fundamentals: Macroeconomics 128

Price Fundamentals: Company Specific News 135

Supply and Demand 140

Conclusion 142

Discussion Questions 143

Chapter 6 How Do Traders Make a Market? 145

PACAM Treasury Trade 148

Supermart Interest Rate Swap Trade 158

Equity Structured Product Trade 163

A Typical Trader Day 166

Conclusion 168

Discussion Questions 169

Chapter 7 How Is Proprietary Trading Different from Market Making? 171

Proprietary Trading Desk Overview 173

Proprietary Desk Liquidity 176

How Market Makers Are Similar to Proprietary Traders 180

Trading Book Accounting 186

Trader Capital Allocation 187

Conclusion 188

Discussion Questions 189

Chapter 8 What Is the Relationship Between Sales and Trading? 191

A Day in the Life 195

Know Your Client 199

Managing the Client Relationship 201

Sales Person Stereotypes 209

Conclusion 211

Discussion Questions 211

Chapter 9 What Role Does the Research Analyst Play? 213

The Role of a Credit or Equity Analyst 215

Conflict of Interest 221

The Economists and Strategists 222

Desk Analysts 225

Conclusion 226

Discussion Questions 227

Chapter 10 What’s So Special About Trading Derivatives? 229

Bond Intermediation 231

Derivative Intermediation 234

Counterparty Credit Risk 241

Illiquid Derivatives Intermediation 246

Conclusion 248

Discussion Questions 249

Chapter 11 Where Does Structuring Fit? 251

The Deal Origination 252

Deal Negotiation 255

Deal Closing 260

Conclusion 263

Discussion Questions 264

Chapter 12 Where Are the Quants? 265

Pricing Models and What They Do 266

Risk Management Models and What They Do 271

Financial Market Evolution 274

Quants’ Relationship with the Trading Floor 275

Conclusion 277

Discussion Questions 278

Chapter 13 What Are the Risks? 279

Market Risk 281

Credit Risk 287

Other Risk 292

Conclusion 295

Discussion Questions 296

Chapter 14 How Do We Manage These Risks? 297

New Product Approval Process 299

Market Risk Limits 304

Credit Risk Limits 307

Learn from Experience 309

Conclusion 312

Discussion Questions 313

Epilogue 315

Glossary 317

Index 341

Terri Duhon is a financial market expert with almost 18 years of experience in financial markets. She graduated from MIT in Math in 1994 and immediately joined JPMorgan as a derivatives trader on Wall Street. While at JPMorgan, she was instrumental in developing the credit derivative market globally. Her time on the trading floor has been documented in the book Fool's Gold as well as by PBS's Frontline. In 2004, after 10 years on the trading floor in New York and London, Terri founded B&B Structured Finance Ltd, which provides expert consulting and financial markets training. She has led expert witness teams for financial litigation in both NY and London, assisted asset managers in assessing financial market risks as well as given hundreds of training programs globally for thousands of participants. She is also retained by a major financial regulator as an expert consultant on financial markets. Terri gives university lectures, speaks at conferences and is often quoted in the financial press. She sits on the board of two charities and lives with her family in Oxford, England.

"How the Trading Floor Really Works is an invaluable resource for current MBAs, recent graduates and experienced financial market participants alike. For the novice about to join the trading floor ranks, it provides a base framework for understanding the world they are entering. For the investment banker, investor, portfolio manager or other financial expert who doesn't work on the trading floor, it demystifies the "black box" of the trading floor in an entertaining yet informative way."
—Dr. Susan S. Fleming, Senior Lecturer, Johnson Graduate School of Management/School of Hotel Administration, Cornell University/Former Partner, Capital Z Partners, L.P.

"Written in a lively and digestible style, this clear and cogent book covers much more than the title suggests. In fact the book lays out much of the banking industry's critical role in financial markets; the basic differences between various classes of financial instruments; and how trading businesses interact with other parts of a large complex financial institution. Not only for students and post-grads interested in financial markets, this book would be a great primer for anyone entering or working in a related field, such as clients, journalists, regulators, consultants and policy-makers. The vignettes and examples the author uses bring relevance and humour to this technical subject, as well as capturing the trading floor environment."
—Betsy Gile, Board Member, Deutsche Bank Trust Corporation/Board Member, Keycorp

"An easy and enjoyable read – even for somebody who has been on a trading floor for over 20 years. I learnt a lot reading it. It has the balance of expertise written in an easy style with real examples – a valuable book for market professionals and also participants"
—Addy Loudiadis

Is the trading floor really the Wild West? Do banks’ trading floors have a purpose or are they relics of the past in the brave new world of finance post crisis? Trading floors have always fascinated people, but few understand the role they play in the world of finance today. The dynamics of the trading floor are a microcosm of the global markets. Understand these dynamics and better understand the dynamics of global financial markets.

The book is the perfect starting place for anyone who wants to understand financial markets. It clearly explains how the financial markets work and what the purpose of the bank and the bank trading floor is, using clear examples. The book puts the bank’s role in the financial markets in context, explains what really happens on the fabled trading floor and helps to interpret the conversations and the roles and responsibilities of the key players. It is also the ideal companion for any financial market professional not sat on the trading floor, with chapters detailing the roles of quants, risk managers and clients and going into the details of prop trading, market making and derivative trading.

How The Trading Floor Really Works covers what most academic books don’t by focusing on key individuals on the trading floor and walking through some common financial markets transactions. It also clarifies the role of the trading floor itself and sheds light on the opaque terminology. In this book, Terri Duhon uses her personal experience of the trading floor to decipher and translate the world of financial markets.

Important questions this book answers include:

• Who are the key players on the trading floor and what are their roles and responsibilities?
• Who are the clients and do they really need the services the trading floor provides?
• How does the client understand their risk and know when the price is right?
• How does all this impact global financial markets?