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Fund Management encompasses pension funds, insurance funds and collective investments such as mutual funds and unit trusts. Fund managers select what instruments to hold positions in for maximum return and minimum risks and manage these investments on a medium to long term basis. In addition to return objectives, fund managers have to operate within trustee requirements. Insurance and pension fund managers also need to structure their portfolios to meet the various claims on the fund, such as insurance or pension claims, a process called “portfolio dedication”.

Fund Manager Skills There are several analytical techniques that a fund manager can use to protect the return on his investments. The first is called switching. When the fund is not performing, the fund manager uses available market information and his skills to restructure his portfolio by selling some positions and replacing them (switching) with assets which have better prospects. In most cases, the amount of turnover in a fund is either restricted by regulation or by the tax implications of the fund. The second technique is called immunisation – and is typically used in fixed income portfolios, where for example, the fund manager sets the duration of a portfolio to equal the longest period over which he can predict events.

Attributes of Institutions

It is important to recognise the differences between institutions because the objectives of the institution will be a large factor in determining the goals and how they go about achieving them. Institutions can differ greatly, although the majority of financial institutions, such as Building Societies and Banks, have common attributes.

Revenues Institutions earn revenues and therefore can generate profits in a number of different ways: + Market makers make a profit through the “turn” – that is, the difference between their bid and ask prices on any instrument. + Traders make a profit though their skill in determining when and at what price to buy and sell. + Brokers earn their revenues by charging commission on trades they complete for their clients – the “fills”. + Fund managers earn fees, which in most cases are based on return or risk performance. + Investment banks earn fees for underwriting new issues.

Business Objectives All organisations or institutions develop and try to meet business objectives that steer the activities of the organisation towards the achievement of certain goals. Some common objectives are to: + satisfy customers and develop a good business relationship with them + increase earnings per share + increase market share + reduce costs + expand into new developments.

In order to meet these objectives, institutions must perform these activities: + trading + sales activities + cash flow management + asset management + risk management.

Trading Trading involves taking a position. A position is held when there is an imbalance between the sales and the purchases of an instrument. When there are more purchases than sales of an instrument the position is said to be long. When there are more sales than purchases the position is said to be short.

Sales Activities The sales role is the customer-facing one in most security houses. The role of sales is to drum up business with clients, private clients, corporate clients or fund management companies. In security houses that also perform proprietary trading or market-making, the security house must be careful not to off-load unattractive positions onto unsuspecting clients. The new tighter regulatory structure is intended to minimise this practice. Many institutions offer to buy or sell financial instruments on behalf of other institutions, for commission. An example is a bank which buys foreign currency such as Deutschmarks on behalf of a corporate treasurer. This activity will leave both institutions with a position in the market since the bank will be short on Deutschmarks and the corporate treasury will be long on Deutschmarks. The institution usually hedges this position.

Cash Flow Management Large organisations often have temporary cash surpluses or deficits in their domestic currency or foreign currency. These need to be managed by making deposits or loans. An example of where cash flow management may be required is pension or insurance claims in an investment management institution. If a company does not have sufficient funds to cover the cash requirement, it may arrange a loan to cover the shortfall.

Asset Management Asset allocation accounts for a significant number of the tasks of many players in the financial markets, especially portfolio and fund managers. The aim of asset allocation is to select the assets in which to invest, for a stipulated risk and return, subject to a variety of constraints, for example, “no more than x% of the fund must be invested in emerging markets” or “at least 20% of the fund must be cash” etc. Asset allocation is important, as the user will want to browse through and search for the available instruments that fall within the constraints and meet the objectives of the business.

Risk Management Most financial institutions hold positions in the financial markets, and are therefore exposed to a number of different types of risk. Risk is the probability that a loss may occur due to an unforeseen development in the market. Risk management is a term used to cover all the tools and strategies managers use to minimise risk and avoid a possible financial loss on a position. It is important to note that there are various types of risk, for example, market risk, counterparty, or settlement, risk. Hedging is a strategy used to manage market risk by using one position to offset another. Different types of instruments can be used to hedge, such as forwards, options and futures. These instruments allow the investor to limit market risk.

Limits Limits are net amounts which define the range within which an institution or trader can trade. These are set by the institutions management in order to manage risk. A trader who reaches his limit must get authorisation from his manager if he intends to exceed that limit. A trader’s limit increases as his experience and responsibilities increase.

The following table illustrates how the strategy used depends upon the type of risk to be managed:

Risk Type Management Strategies

Credit Risk/CounterParty Risk The exposure to counterparties defaulting on a payments due, such as a bank becoming insolvent. Set counter party limits.

Country Risk/Sovereign Risk The total exposure of investments in a particular country. Possible problems could include economic collapse, changes to local regulations or government seizing or freezing assets. Set country limits.

Currency Risk The potential losses due to adverse movements in exchange rates. Setting limits on traders and desks exposed to a particular currency, and hedging large positions with derivatives.

Inflation Risk Associated with the return on an investment being eroded by the loss of purchasing power. Investing in inflation-linked investments such as Gold or index-linked bonds.

Market Risk The risk associated with losses due to the reduced value of investments, reduced income or increased costs due to interest rate movements. Hedge, plus limits, plus capital adequacy constraints

Liquidity Risk The risk of not being able to purchase or sell an instrument at the times desired. Only participate in liquid markets.

Settlement Risk The risk of a counterparty not settling on time. If the counterparty settles late, this means you either have a long or short position until the deal is settled. Dealing with reputable market participants, and using efficient settlement procedures. Bilateral limits. Netting.

Roles within Markets

This section defines the roles in the markets and details the activities they are involved in and the type of information they require.

Traders

What do Traders do? Traders buy and sell in all areas of the financial market. They aim to buy low and sell high. Trading may take place at physical exchanges, for example, for commodities or futures, or over the counter (OTC), for example, in foreign exchange. A trader may specialise in a particular type of financial instrument and different types of traders have different roles and requirements depending on the instruments they trade in. A trader who has gained responsibility in his career for managing a group of traders may be classed as a chief trader. The chief trader sets the credit limit for each trader and ensures that at the end of the day, all his traders are not long or short, that is, their buy and sell deals balance.

What is Order Driven Trading? If a trader is buying or selling instruments to fulfil an order for a customer, it is said to be order-driven trading. To avoid potential confusion with another meaning of this term, it is best to refer to this type of trading as “customer-driven trading” to distinguish it from “proprietary trading. It is important to note that order-driven and quote-driven trading in the markets are also used to describe different types of trading markets. For example, the old Seaq Level II and also NASDAQ are quote-driven markets, in which market-makers quote firm two-way prices and sizes. The new UK equity market Sequent 6 and Reuters Dealing 2000-2 matching are both examples of order-driven markets.

What is a Proprietary Trader? If a trader takes positions on behalf of his institution, he is known as a proprietary trader. Proprietary traders tend to take decisions based on detailed technical and fundamental research, analytic calculations and time series forecasting. In most cases, the tools available to the proprietary traders are developed in-house and are jealously guarded.

What is Arbitrage Trading? Arbitrage trading involves the buying and selling of the same or similar instruments in different markets in order to take advantage of any misalignment in the relationships between these instruments. The arbitrageur makes a profit when the relationships are restored. For example, a currency options trader who believes that the put-call parity relationship between a call, a put, and the DEM underlying on the IMM may execute an arbitrage strategy whereby he will buy the call and sell the put, or vice-versa, depending on his view of the misalignment.

What information do they need? Traders require real time prices for the market in which they trade, plus any supporting technical analyses and related news. However, because of the relationships between various instruments, they may also look at information from markets that they do not directly trade. For example, an equities trader may look at foreign exchange rates, deposit rates, bond prices and yields.

Fund Managers

What do Fund Managers do? Fund managers may invest funds for themselves or on behalf of their customers. Fund managers deal within the FX and money, fixed income and equities markets. An individual fund manager may specialise in a given market, or country, or region, or currency. They generally manage medium to long term investments such as pension funds, insurance funds, investment trusts or unit trusts.

What information do they need? Fund Managers require information on markets in which they directly invest. However, they also look closely at interest rates, foreign exchange, bond and equity data for any trends that may affect their investment strategy.

Corporate Treasurers

What do Corporate Treasurers do? Corporate Treasurers work within the FX and money markets, as part of a treasury department within an institution. Their main functions are to manage the institution’s day to day cash, invest cash surpluses, and borrow funds at minimum costs to the institution.

What information do they need? Corporate Treasurers require information on interest rates, foreign exchange, bond and equity data as well as forward and deposit rates. They also require the cash flow status of the institution they work for.

Brokers

What do Brokers do? Brokers mediate between buyers and sellers which means, in practice, customers and traders. Brokers also mediate between dealers or market makers – in which case they are referred to as inter-dealer brokers. They operate in the foreign exchange, bond and equity markets and usually work for independent brokerage companies. The main means of communication between brokers and clients is the phone. Most brokers have a constant live telephone connection with a number of dealers to increase the chance of obtaining best deal for their clients in terms of price and speed. Brokers earn commission on the deals they arrange. Brokers are agents. They are not principals and as such they do not normally manage a position, namely own equities, currency or other instruments, in the market in which they trade. Brokers have to be in touch with the market and be aware of developments so they can talk knowledgeably to customers when they ring.

Agency Broker Agency brokers buy or sell instruments on behalf of their customers on the buy side of the market. As brokers, they earn their living by charging a commission or brokerage fee for this service.

Inter-Dealer Broker Inter-Dealer Brokers match buys and sellers on the sell side of the market. They ensure that traders can trade with each other anonymously.

Brokers also need to create interest in the relevant instruments to persuade their customers to do business with them and to attract new business. By virtue of the fact that brokers are in constant touch with the market, they have access to the latest dealable prices. A number of the bigger brokers assemble these prices into a price service for their clients. For example, money brokers such as Tradition, Tullett and Tokyo, Harlow Butler all have price services distributed by various vendors on their behalf.

What information do they need? Brokers require the same type of information as traders. a money broker requires foreign exchange rates, bank deposit rates, bond data, graphical analysis and news information, as does a money trader.

Sales

What do Sales staff do? Sales staff take orders from customers to buy and sell instruments and act as an intermediary between customers and traders. Sales staff function in all markets. In equity and commodity markets, sales staff may also be known as brokers. Their customers are often institutional investors and they work for investment banks and agency brokerage houses. However, sales staff differ from traditional brokerage in that their institutions can hold a position in the market.

What information do they need? The sales function exists in all markets. In equity and commodity markets, sales staff may also be known as brokers. Sales staff may use the same information as brokers, depending on the instruments they specialise in. This includes foreign exchange rates, bond and equity data, other market prices, graphical analysis and news information. They use any information they can to build relationships with customers.

Decision Management

What is Decision Management? The term decision management describes the function performed by: + economists + analysts + researchers.

These groups of people forecast economic performance and market movements to provide guidance to traders and sales staff. They may also publish their forecasts, for a fee, to a wider market audience.

What information do they need? Decision management exists in all markets and financial institutions. Those engaged in decision management require price information, access to large quantities of historical data, spreadsheet and graphical analysis and notification of impending financial events and announcements.

General Management

What is General Management? The term general management describes the function performed by the following groups of people: + those from dealing room manager upwards, who may be active in the day-to-day trading operation + those in corporate finance, mergers and acquisitions + managers in a variety of roles in non-financial companies who are users of limited financial information and news information.

What information do they need? Managers may require historic and current information about companies in their sector or areas of interest. They also require basic foreign exchange information for the countries in which they operate.

Trader Support

What is Trader Support? Trader support can be split into two distinct roles: + position keeping, assisting traders in the dealing room + order entry, a book-keeping role in the back office of financial institutions.

What information do they need? Those who work in trader support roles require well developed operation skills and the patience to deal with traders in a hurry. They also need to have a general view of the financial marketplace.

Back Office Support

What is the Back Office? The back office is where the administrative tasks connected with dealing are performed. The back office staff are responsible for clearing, settlement, consolidation, integration with accounting, and so on. They also perform credit control and statutory and management accounting.

What information do they need? In addition to deal ticket flow, the information they require is mostly internal – credit limits, ledgers, etc.

International Considerations

Although the financial markets are becoming increasingly global, each country has its own currency and laws, taxation and other nuances such as number of currency days per year, bond yield calculation conventions, and so on. Considerations for internationalisation of software products, in addition to language issues, should be given during the design and development of products.

Since the FX market is an international market, all the standards, rules and regulations are in place to ensure smooth running of the market. All businesses, regardless of size, must register within the appropriate bodies before they can trade in the market. By registering, the business must agree to adhere to any guidelines laid down by the regulatory authorities.

Chapter 4

Foreign Exchange Traders

What Does a Foreign Exchange Trader Do?

The Foreign Exchange Trader’s Role

A foreign exchange (FX) trader, or dealer, buys and sells currencies in the foreign exchange markets. He may specialise in one of the major currency pairs, for example dollar/mark or dollar/yen, or trade several of the less active ones.

Size of the FX Market The Foreign exchange market is one of the largest markets in terms of turnover. It is essentially a 24-hour global market which never really closes. Typically, $1 trillion a day is traded in this market. In this market, $5m dollars is a small deal since deals can be as large as $100m or more. Traders in major currencies may perform up to 1000 deals per day. Individual traders have been known to make their banks 10 million in one day.

What motivates traders? Traders are motivated purely by profit which they earn from their bid/ask spread. They buy (that is, take long positions in) currencies that they think will rise in value and sell (that is, take short positions in) currencies they think will fall in value. Foreign exchange traders look for mispriced currencies in the market so that they can benefit from long positions in undervalued currencies and short positions in overvalued ones. They assess a currency’s prospects using a number of sources. These include currency rate trends from inter-day and intra-day charts, interest rate policy, news of major political developments, economic announcements and the outlook of its domicile country. They also keep a look out for relevant developments in related markets such as the debt markets, equities and commodities, as these might also affect exchange rates.

How much can a trader risk? Unless appropriate controls are put in place, an FX trader can expose the bank to quite large currency or counterparty risks. The dealing room manager sets a daylight limit on the size of the position, or quantity of currency, that a trader can hold. Traders cannot ordinarily trade beyond their limits and must notify the dealing room manager if they make a loss in excess of the loss reporting limit that has been set.

Specialisms Within the Foreign Exchange Market

Different types of foreign exchange transaction exist; traders tend to specialise in one particular type of transaction. Traders may however trade a number of currency pairs.

Spot trader A spot trader conducts spot deals. A spot deal is an agreement to exchange one currency for another, settled over a standard period of trade (spot), usually two business days. By convention, one of the currencies in a spot deal is the US dollar. When this is not the case the deal is a cross rate deal, although settlement is still spot. A spot deal always involves a single outright exchange of principal and in the majority of cases leads to transfers through the payments system of the countries in which the currencies are issued.

As all the spot trader’s deals are settled spot, delivery dates do not have to be matched and as a result turnover and liquidity are high and the markets can be volatile. In April 1992, about 47% of the foreign exchange market was in spot activity.

Forward trader A forward trader conducts two types of forward deals: outright and swap. In April 1992, forward deals amounted to 46% of foreign exchange turnover. A forward outright deal is similar to a spot deal, but is settled on a date other than spot. Outright deals represent somewhat less that 15% of the total forwards market and about 7% of total foreign exchange turnover. An outright rate is quoted in the same way as spot. A forward swap consists of two separate parts. Two counterparties agree to exchange two currencies at a particular rate on one date called the near date, and to reverse the transaction, generally at a different rate, at a future date called the far date. For most swaps, the near date is normally spot but a number of forward/forward transactions exist, where the near date is not spot. Forward swaps make up somewhat more than 85% of the forwards market, which represents about 39% of the foreign exchange turnover, and are heavily concentrated on the US dollar. A forward swap is quoted as a margin. This is the difference between the exchange rates for the near date and far date and there are conventions governing how the subtraction is done using the two bid/ask exchange rates. Nearly two thirds of all forward transactions have a maturity of seven days or less. Only around 1% of forward deals have maturities greater than 1 year.

Derivatives trading Derivatives trading is relatively new, with 6% of turnover in April 1992, yet is the fastest growing sector of foreign exchange. FX derivatives include futures and options. Strictly speaking, a currency forward or swap is also a derivative, as its value depends on time to maturity, spot and deposit rates. Currency Futures are contracts which specify delivery of a particular currency at a given rate on a date more than two days hence. They differ from forwards in that they are standardised contracts tradable through an exchange clearing house.

Currency Options give the purchaser the right, but not the obligation, to buy or sell a certain amount of currency in the future at a predetermined rate. They are traded on an exchange or over the counter (OTC). Around 80% of currency activity is OTC where a whole range of customised products (exotic options) have evolve

Currencies Traded

The US dollar is the predominant counter-currency in foreign exchange trading and it appears in over 80% of all transactions. Other major currencies, for which there is an active cross-market, are the German mark representing 38%, and the Japanese yen representing 24% of all transactions.

Europe In Europe in general, and London in particular, the most heavily traded currency is the dollar against the mark ($/DM). Other heavily traded currencies include: + sterling against the dollar ( /$) and mark ( /DM) + dollar against Swiss franc ($/CHF) and yen ($/ ) + mark against yen (DM/ ) + all European Monetary System (EMS) currencies.

Asia In Asia, and Tokyo in particular, the most heavily traded currency is the dollar against the yen ($/ ). Other important currencies are: + Australian dollar (A$) + New Zealand dollar (NZ$) + Hong Kong dollar (HK$)

+ Singapore dollar (SG$) + Thai Baht (THB).

Americas In the Americas the vast majority of foreign exchange trading is performed in the USA and Canada, and the majority of that in New York.

The emphasis is on the major currencies: + mark (DM) + sterling( ) + Swiss franc (CHF) + yen ( ) + Canadian dollar (CA$). Periods when the New York markets trade are especially important. This is because the release of US economic indicators is carefully tracked and the US Federal Reserve (the “Fed”) is the most influential central bank. What the Chairman of the Fed says about the state of the financial market has the power to move all markets

Typical Employers

Most foreign exchange traders are employed by international banks such as Barclays or Citibank.

Locations London has the largest share of foreign exchange dealing, about 27% of trading activity. All the world’s large banks have branches or subsidiaries there. Dealing is carried out in any convertible currency.

Other major dealing centres are the United States (mainly New York) with 17% of turnover, and Japan (Tokyo) with 11%. Singapore, Switzerland and Hong Kong are also important centres, and dealing takes place in many other cities worldwide. Modern technology even allows dealing to be performed from home. A trader in London may phone his or her New York or Tokyo branch in the late evening to take, or get out of, a currency position.

Characteristics of Foreign Exchange Traders

Demographics

As of 1995, there were approximately 15,000 foreign exchange traders worldwide. London is the largest centre, employing about 3,800 traders. However this number has declined slightly in recent years partly as a result of new trading methods and company mergers and acquisitions.

In London, the majority of traders are in their mid 20s to mid. Very few are over the age of 50. There are few female traders working in London.

Educational background Although some banks currently recruit graduates only, approximately half the FX traders in London dealing rooms are estimated to have a degree. Often the degree is not in a financial subject.

Typical skills Traders have to be quick-thinking and able to prioritise information. They need to be able to assimilate new market information and relate this to their current or potential position. Information arrives from all sides in many different forms. Experienced traders can pick up what is most relevant to them and what represents potential trading opportunities.

Work experience Some traders work their way up from the bottom. A school leaver could begin in the Back Office checking deal details, then move to the trading floor to assist traders as a position keeper or dealer’s assistant. The aspiring trader might then be allowed to deal small amounts in quiet currencies and gradually take on more responsibility and risk. A graduate might begin working in the dealing room as a dealer’s assistant and progress from there.

Work performance targets Many traders are required to achieve appropriate profit targets. This is the main mechanism for determining salary. Traders need to sustain consistently high performance to retain their jobs and to progress within their company.

High staff turnover Employers tend to be unsympathetic to traders who do not achieve required levels of performance.



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