The Practical Guide to Wall Street

The Practical Guide to Wall Street is an indispensable resource for anyone who aspires to a front-office sales or trading position on Wall Street and an essential desk reference for market practitioners and those who interact with this exciting but widely misunderstood industry. Written by an experienced trader in a clear, conversational style and assuming no previous background in finance, The Practical Guide to Wall Street provides a thorough schooling in the core curriculum of the equity and equity derivatives sales and trading business - exactly what you would learn from sitting beside the traders at a tier-one Wall Street investment bank (except that in practice, traders rarely have time to provide such detailed explanations!) Topics covered include:

• Clear, detailed and intuitive explanations of all major products, their function, pricing and risks (several of which are unavailable anywhere else despite producing billions of dollars in annual revenue for Wall St.)
• The layout of the trading floor, the roles and responsibilities of the different sales and trading groups and how they interact to service the client business
• An overview of the structure of the macro-economy and the trader’s perspective on the significance of economic data releases and their impact on the financial markets
• A review of those concepts from fundamental valuation and financial statement analysis of greatest relevance on the trading floor (as opposed to abstract valuation models)
• Practical details of the structure and functioning of the equity and derivative markets including translations of trader jargon, Bloomberg tips, market conventions, liquidity and risk considerations and much more…

This book provides the first comprehensive explanation of all aspects of the functioning of the equities division, with information, details and insights previously only available to those who already worked on a trading floor. The availability of this material in a format accessible to non-professionals fundamentally changes the level of industry knowledge employers in the financial services industry can expect of new hires.

Preface xiii

A Comment on the Events of 2008 xxiii

Acknowledgments xxv

Part One What Is a Stock? 1

Chapter 1 Equity Fundamentals (Part 1): Introduction to Financial Statements 3

Introduction 3

Equity and Corporation 4

Introduction to Financial Statements 5

The Balance Sheet 6

The Income Statement 15

Statement of Cash Flows 20

Summary 24

Chapter 2 Equity Fundamentals (Part 2): Financial Ratios, Valuation, and Corporate Actions 27

Introduction 27

Financial Ratios 28

Growth and Value 38

Bloomberg 39

Valuation 40

Technical Analysis 51

Corporate Actions 54

Summary 64

Part Two Products and Services 67

Chapter 3 Cash Market 69

Introduction 69

How a Stock Exchange Functions 69

Exchange Structure 76

Order Types 81

How the Cash Trading Business Works 102

Communication 112

Purchasing a Stock in a Foreign Currency 115

Summary 121

Chapter 4 Equity Indices 123

Introduction 123

Index Construction 125

What an Index Doesn’t Tell Us 129

Valuation and Calculation 131

Replicating Portfolio 134

Trading an Index Portfolio 136

Index Changes 139

Index Dividend Points 142

Total Return Index Calculation 144

Multicurrency Indices 145

Equity Indices in Practice 147

International Indices 156

Summary 165

Chapter 5 Program Trading 167

Introduction 167

Explanation of a Sample Trade 173

When Is Program Trading More Beneficial? 182

Portfolio Analytics 184

Transition Management 189

Principal Trades 191

Summary 201

Chapter 6 Exchange-Traded Funds (ETFs) 203

Introduction 203

Trading Mechanics 205

Net Asset Value (NAV) 207

Popularity 208

Trading versus Holding 212

ETFs in Practice 214

Summary 214

Chapter 7 Forwards and Futures 217

Introduction 217

Calculation of Fair Value 219

Futures 223

Index Arbitrage 233

The Futures Roll 240

Exchange for Physical (EFP) 245

Basis Trades 254

Futures Contracts in Practice 259

Technical Comment on the Accuracy of Approximations 263

Summary 264

Chapter 8 Swaps 267

Introduction 267

Motivation for a Swap 267

A Long Equity Swap Example 269

The Swap in Detail: Definitions and Terminology 272

Calculation of Payments 277

Short Swap 279

Back-to-Back Swaps 280

Swaps as a Trading Tool 281

A Comment on Hedging 286

Swap Valuation: Accrual versus NPV 287

Currency Exposure 289

ISDA 293

Risks and Other Considerations 294

Summary 296

Chapter 9 Options (Part 1) 299

Introduction 299

Definitions and Terminology 300

Payoff Structure 301

Option Values Prior to Maturity 311

Quantitative Considerations 323

The Black-Scholes Derivation 326

Types of Volatility 337

Summary 341

Chapter 10 Options (Part 2) 343

Volatility Trading 343

Option Sensitivities: The “Greeks” 354

Implied Volatility Revisited 374

OTC and Exotic Options 377

Summary 383

Chapter 11 The Trading Floor 385

Introduction 385

Organization of the Sales and Trading Businesses 386

Other Groups 390

Summary 404

Part Three Economics 405

Chapter 12 Macroeconomics for Trading and Sales 407

Introduction 407

Capital Asset Pricing Model (CAPM) 408

Overview of Macroeconomics 408

The Fed 417

Moving beyond the Big Three: Other Macroeconomic Concepts 424

Other Variables 426

A Final Observation 428

Summary 429

Chapter 13 Economic Data Releases 431

Introduction 431

Preliminary Definitions 433

Principal U.S. Economic Indicators 436

Rest of the World Economics 456

Europe 457

European Economic Statistics 462

Asia 466

The Market’s Reaction Function 471

What the Market Tells Us about the Economy 476

Summary 480

Appendix Mathematical Review 481

Introduction 481

Functions 482

Compound Interest and Exponential Growth 483

Calculus 487

Random Variables, Probability, and Statistics 494

Summary 505

Notes 507

About the Author 519

Index 521

Matthew Tagliani, CFA, has more than ten years of trading and risk management experience in equity swaps, ETFs, futures, and program trading. He has worked at Morgan Stanley, Goldman Sachs, and Credit Suisse and holds a master's degree in applied mathematics from the University of Massachusetts Amherst.

Your guide to the institutional equity and equity derivatives business

Despite countless financial books on many different specialties and methods, no one has taken a comprehensive look at the professional trading floor. The Practical Guide to Wall Street fills this gap, serving both as an essential go-to for new hires and as a helpful reference for more experienced traders and salespeople.

Written by a seasoned practitioner in a clear, conversational style and assuming no previous background in finance, The Practical Guide to Wall Street provides a thorough schooling in the core curriculum of the equity and equity derivatives sales and trading business. Starting with the basics, it gives you exactly what you would learn from traders at a tier-one investment bank.

In this guide, you'll find:

• Clear, detailed, and intuitive explanations of all major products, their structure, pricing, and risks—many of which are unavailable elsewhere

• The layout of the trading floor, the roles and responsibilities of the different sales and trading groups, and how they interact to service the client business

• An overview of the structure of the macroeconomy with explanations of economic data releases as seen from Wall Street's perspective

• A review of the concepts, from fundamental valuation and financial statement analysis, with the greatest applicability and rele-vance on the trading floor

• Practical details of the structure and functioning of the equity and deriva-tive markets, including translations of trader jargon, Bloomberg tips, mar-ket conventions, liquidity and risk considerations, and much more. . .

The first comprehensive explanation of how an equity division functions, The Practical Guide to Wall Street is packed with detailed information previously available only to those already working on the trading floor. This invaluable resource is your key to a successful career in finance.

Praise for The Practical Guide to Wall Street

"An extraordinary accomplishment. This clear, well-written, and insightful book is an indispensable resource for any new entrant to the business and an enormously useful reference for more experienced practitioners as well. Books on finance come and go, this one will stay the course."
—Sam Kellie-Smith, Managing Director, Global Head of Equity and Equity Derivative Trading, Morgan Stanley

"The Practical Guide to Wall Street is an excellent introduction to the wide range of products traded in an equities business today. I'd enthusiastically recommend it to any new hire in the sales or trading business."
—Simon Yates, Managing Director, Global Head of Equity Derivatives and Co-Head of European Securities, Credit Suisse

"Since 2002 I have been teaching MBA courses on equity markets and equity derivatives. Prior to that, I worked for eighteen years at Goldman Sachs in equity derivatives. Until now, I have never found a textbook that combines practical wisdom with academic rigor. Matthew Tagliani's book, The Practical Guide to Wall Street, provides that unique combination. I hope to use it in the classroom immediately."
—Mark Zurack, Professor and Visiting Lecturer, Columbia Business School and Johnson School of Management, Cornell University

"Mr. Tagliani has done what few have managed to do before—demystify the machinery of the financial industry in plain and accessible language. A hands-on introduction to what happens on the Street—if you are entering or thinking of joining the financial industry; or even if you simply want to understand what your next door neighbor does, this book is a must."
—Nikunj Kapadia, Associate Professor, Isenberg School of Management, University of Massachusetts Amherst

"This book will provide a great head start for?anyone considering joining an equities trading floor. It contains a wealth of detail and covers the issues that traders, salespeople, and their customers deal with on a day-to-day basis.? It spares the reader unnecessary technicalities and focuses on the points that matter to finance professionals."
—Sandy Rattray, Portfolio Manager, GLG Partners