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How do bank trading desks actually work?

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8/16/14
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I am working at a start up hedge fund building quantitative strategies.

We are looking to dabble into getting some tailor-made forward contracts to hedge specific risks.

1.) Who should I be looking to get into contact with?

2.) How do banks hedge their risk after delivering a custom forward contract (are there certain trades they wont make?)

3.) How much should I expect to pay in transaction fees?
 
I am working at a start up hedge fund building quantitative strategies.

We are looking to dabble into getting some tailor-made forward contracts to hedge specific risks.

1.) Who should I be looking to get into contact with?

2.) How do banks hedge their risk after delivering a custom forward contract (are there certain trades they wont make?)

3.) How much should I expect to pay in transaction fees?
Yo, what's my "consultancy fee" for answering this?

1) A Broker Dealer
2) It depends but it shouldn't matter to you, should it?
3) It also depends
 
1. some bank dealing desks do handle customers like you, if you don't want to go through a broker dealer.
2. they find a counter party, or deal with other branch desks to minimize the risk, or trade in similar contracts.
3. fees varies by transaction volumes. no fees in FX trades.
 
Are we talking about FX forward contracts? If so, what sorts of currencies and how long-dated?
 
I am looking for a 1 day expiration contract (so as to mirror the spot price movement) on lets say USD to EUR
 
Right, okay. I'll break this all down.

Mechanics.
So EURUSD spot settles t+2 business days. You are looking for a t+3 settlement, I'm guessing, meaning 1 day beyond spot settlement. That's also called spot-next in the market, and if you are looking at quotes for EURUSD forward points in the very front end, you will see things like O/N (overnight, settles one business day from today), T/N (tom-next, this is the cost in USD pips to move a EUR balance forward from settling tomorrow to settling the day after tomorrow, i.e. to settle spot), S/N (spot-next, this is the cost in USD pips to move a EUR balance forward from settling spot to settling one day beyond spot). It looks like the current mid for S/N is +.15. That means if EURUSD spot is 1.1340, you should expect to deal a 3 day outright forward at 1.134015. You could also do the EURUSD spot trade, then roll it out to the next day by doing a S/N FX swap. The mechanics are you sell 1mio EURUSD spot at 1.1340, then you buy/sell the swap at +.15 pips, meaning you simultaneously buy 1mio EURUSD spot at 1.1340 and sell 1mio EURUSD forward to t+3 at 1.134015. The two spot trades net out with each other and you are left with the same net result as just dealing the FX forward. Obviously if you were just doing this once you would do the outright forward, but I'm assuming you are going to be continually rolling residual balances forward, so for that you do the FX swap every day as the 3 day balance becomes a spot balance and needs to be pushed back out to the new spot-next settlement date. Note for you: if you are doing 3 day forwards because your firm's system can't see spot FX risk/pnl, you actually want to be doing t+4 settlements rather than t+3. This is because when you do t+3 settlement, the next day when it becomes spot and you have to roll it out, you (1) won't see the FX risk from the balance that has now become spot, and (2) won't see the pnl due to the difference between where you closed spot in your system the day before and where the spot rate was on the front leg of the new FX swap you did to roll the balance back out a day. If you continually roll the balances as they become t+3 back out to t+4 every day, you see all your risk and pnl every day all the time, and 4 day forwards mimic spot just as well as 3 day forwards. Frankly you could be rolling these out every month or so and see just about the same result to make your life easier and make the FX swap rolling a monthly routine rather than a daily exercise.

Who to get in contact with.
If you have a Bloomberg terminal, talk to them about getting you set up with their FX dealing platform. That's the easiest way. You can deal with banks you have dealing lines with through Bloomberg's platform. Also if you have Bloomberg, you would look up all these forward points and outright levels for your reference at EURUSD Curncy FRD. If you don't have a Bloomberg terminal, contact an investment bank of your choosing and ask to get set up with their FX dealing platform. DB's Autobahn and Barclay's BARX are a couple good ones. You really only need one of these for your purposes. In general, given the small size of the trade, anyone you contact will ask you to deal electronically with them. There's no real exchange for this stuff, so expect to deal OTC, but it's so liquid that it doesn't matter.

Transaction fees.
There are no fees per se in FX, but you pay transaction cost in that you don't deal at mid. You have to deal at either the bid or offer rate, so the transaction cost is built into the rate at which you deal. Happily for you, you are dealing basically the most liquid thing ever in FX, in the most liquid currency, and in a size that no one will care to think about. On 1mio EUR of a spot-next swap (or t+3 to t+4 swap, or 1 month to 1 month plus one day), I'd expect you to be paying about $10, if even, from mid / fair value. The two-way price on the S/N swap above I think is +.135/+.165 (that's where the mid of +.15 came from), so you would have to deal at .015 pips from mid on either side of that price. On 1mio EURUSD, thats .0000015*1mio EUR = $1.50. EURUSD spot is at most 2 pips wide in 1mio EUR, so that's 1 pip from mid, which is $100, meaning all-in for the 3 day forward $101.50 of spread cross. We're talking 1bp or less for initial trade, and then much less to roll it forward in subsequent days. So bid/offer spread is really minimal. I'm sure your prime broker will charge you something for booking each trade, but that's up to you to negotiate. Actually, I should mention that if you do have a prime broker, using that bank for your FX dealing will probably be your cheapest option as they'll likely charge you less (or not charge at all) for booking trades facing their own investment bank rather than facing another bank. If you don't have a prime broker, then there will be some sort of margin requirement, which again is up to you to negotiate.

How banks hedge forward risk.
Forward points are determined by the interest rate differential between the two currencies. You can construct a no-arbitrage argument around this. Say planned on buying EURUSD spot at the prevailing spot rate, then selling EURUSD 1y forward against it, what forward rate allows for no arbitrage? To buy these Euros, you've borrowed Dollars and are paying the USD interest rate on those. Once you'd bought the Euros, you can invest them at the EUR interest rate. Because you will pay more interest on the USD leg than you earn on the EUR leg (because EUR rates are currently lower than USD rates), you should expect to be able to sell the 1y EURUSD forward above where you bought the spot, at exactly the right premium to compensate you for your loss on the current interest rate differential. In practice, the way banks will see this risk on their books from any given forward is in 4 places: (1) spot risk, (2) ccy1 DV01 risk, (3) ccy2 DV01 risk, (4) basis swap risk between ccy1 and ccy2. Because DV01 is normally hedged via interest rate swaps, the difference in payment rules and schedules between the two legs would need to be netted out with a basis swap to flatten the whole position out between the hedging components and the FX forward. A bank's FX forward portfolio would look at these risks on net and hedge them as they see fit, either by entering into offsetting transactions with other customers, by trading offsetting transactions with other banks, or by hedging out the components. Not every custom date needs to be hedged, because as spot balances become tom balances, instead of taking settlement and having to invest in various government bonds, FX desks will do tom-next rolls to turn t+1 balances into spot, and will pay or receive T/N forward points to do so. In this way, a bank can realize the carry it gives to a customer on, say, a 1 week forward by realizing 1/5 of the cumulative carry every business day on the tom-next roll, so that by the end of the week, the rolls add up to about the same as the points given to the custom trade. This is why having a few days' offset of balances isn't a big deal to a bank, and why they won't mind quoting you pretty much anything you want in the front end quite liquidly, so long as the settlement date isn't a weekend or holiday.

I think I've touched on probably more than you ever wanted to know about FX swaps, but let me know if there's anything else that needs clearing up.
 
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That makes sense to me as far as the next steps to take place in terms of hedging our currency risk. We do have bloomberg so I will have to see what they can do for me.

However, it seems like what you have said applies only to FX.

In terms of getting other OTC products made, such as index forwards that expire in 1 day based on the SPY,R2000 indices, I would appreciate what you could share on getting those products in terms of: where to go, execution costs etc.

A swap wouldn't be a bad idea seeing that I would plan to continuously roll these every day, but some days I will want to take the other side of the trade as well.
 
I'm not sure about 1 day forwards in equities, but I assume you can try the same avenues if you need bespoke 1 day maturity: first Bloomberg, then your prime broker, then a bank of your choosing if the first two paths fail. I would just use the first futures traded on the exchange, though, and roll to the next earliest maturity whenever they settle. It won't be t+1 but it will be reasonably short dated and very liquid. Transaction costs should be transparent on the exchange, but this is some of the most liquid stuff out there. As for hedging, it works just about the same as in FX, except instead of EURUSD, it's units of stock per USD. You borrow dollars to buy the stock, so you owe interest on USD rates, and then you forgo receiving dividends on the stock. The forward price against spot will therefore depend on the differential between the expected dividend yield and the interest rate, rather than the differential between two interest rates.
 
The reason behind 1 day maturity is that I am basically trying to hedge against moves in the spot price. There is not an etf product out there unfortunately based on changes in the spot, only futures prices.

With a perfect hedge I can get a daily return over risk of .2112, but with having to settle for an imperfect hedge it drops to like .1223
 
Check with the banks. I don't know if that's a commonly traded product. If not be ready to expect high t costs.
 
The reason behind 1 day maturity is that I am basically trying to hedge against moves in the spot price. There is not an etf product out there unfortunately based on changes in the spot, only futures prices.

With a perfect hedge I can get a daily return over risk of .2112, but with having to settle for an imperfect hedge it drops to like .1223
You can create synthetic forwards through loans.
 
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