Investment Banking

TRADING:
SPECULATION & ARBITRAGE
 Definition of Trading
Trading:
- Taking positions in financial instruments or commodities in
order to earn profits either from the change in price levels or
discrepancy in relative values.
Investment banks engage in trading activity in two ways-
Proprietary Trading: Trading done for the investment bank’s
own account

Institutional Trading: Trading done for the benefit of institutional

clients (on profit-sharing basis or management fee basis).

l.
 TRADING VS SALES

 Trading is distinct from sales.

 Trading and sales both involve buying and selling securities yet
these two are different activities.
– Sales include both broking and dealing activities.
– The difference between trading and sales is a matter of the underlying
intention/motive.
– The motive behind sales (broking/dealing) is to make the secondary
market and thereby enhance market liquidity. The business objective is to
generate return through the bid-ask spread from the transaction. The
objective is not to take a long term position.
– In contrast, the motive of trading is to take a position in a security (long
term if needed) and generate return from trading profits (price changes).
 TYPES OF TRADING
• Trading can be broadly classified in two types:
– 1. Speculation: Taking position in a security in an
anticipation of future change in price level so that a
gain can be made from the said price change.
– 2. Arbitrage: Taking simultaneous position in two
or more markets so as to take advantage of any
price differential that might exist in these markets
for a particular security.
 TYPES OF TRADING
Traders, particularly speculators, take risks—
often big risks. Dealers do not take risks as a part
of their “dealer” function.
 Speculation
Taking Position in anticipation of a change in price levels.
● Speculators are forecasters who act upon their forecasts. i.e A speculator
might forecast that a stock’s price will rise then he will buy that stock now.
- They take risks; e.g., risk of forecast not appearing true, exogenous shocks
True Speculators do not have enough power to change the price level
themselves. Price levels change due to market forces. Thus, Speculators are
not manipulators.
Speculative buying and selling are usually in response to information
acquisition and analysis, and any price changes that subsequently result
should represent movement toward market clearing. In the absence of
speculation, market prices would respond more slowly to changing market
conditions, and delays would mean less efficiency in resource reallocation.
 Speculation

Manipulators are those investors who use private power to bring about
a rise or fall in price. For example, investors doing “circular
trading” to increase price of a security are “manipulators”.
– It is illegal as it hinders efficient allocation of resources in the
market and defrauds naïve investors.
 Speculative Methods

1. Fundamental Analysis
2. Technical Analysis

Regardless of the method used, the objective is to identify

whether a security is undervalued or overvalued in the
market. The speculator will buy an undervalued
security and sell an overvalued security.
 Speculative Method 1: Fundamental
Analysis
 Fundamental Analysis – determine the intrinsic value
of a security by analysing the micro and macro level
information.

- Gather micro information like company production,

cost, employees, strategies, technology as well as
macro information like interest rate, demographic
trends, government policy, foreign trade patterns etc.
to estimate the intrinsic value of a security.
 Speculative Method 1: Fundamental
Analysis
• Fundamental Analysts usually take a long term view to investment and
are willing to wait for their price convergence to happen.

• Fundamental Analysis is considered an intuitively robust method.

• However, many believe it is very difficult to practice fundamental

analysis successfully because of its comprehensive nature. In other
words, it is difficult to consistently gather so much information and
analyse it.

• Thus, another method has been developed.

 Speculative Method 2: Technical
Analysis
 Technical Analysis – This refers to techniques used to
predict/forecast future price movements of a security
based on its transaction data. Transaction date means data
regarding past trading volume, transaction prices, Open
interest, short interests etc.

 Technicians examine huge amount of past data to identify

“patterns” or “formations” of price movement that have
repeatedly occurred in the past and assumes that such
pattern will occur in the future as well.

 The technician then takes a position to take advantage of

this “predicted pattern”.
 Speculative Method 2: Technical
Analysis
 Ideally, such patterns/trends should not exist in an
efficient market. Nevertheless, they do because of some
factors:

1. Gradual Dissemination of Information

2. Slow swing in new direction (market psychology)
3. Herd Instinct (tendency to associate with others and
follow the group's behaviour)
4. Some participants have better access to information.
 Types of Speculation
1. Absolute Value trading
2. Relative Value Trading
3. Rating Forecasts
4. Complex Forecasts
 Types of Speculation
1. Absolute Value Trader:

A trader who believes that the price of an asset is

too high or too low (compared to its intrinsic
value) and who takes an outright (unhedged)
position.
- Based on fundamental / technical analysis.
i.e the price of a security is 40 tk. An investor
calculated the intrinsic value to be 45 tk. He
speculates that the price will rise in future. So,
he buys the security now.
 Types of Speculation
2. Relative Value Trader:
Identify the under-priced and over-priced
securities based on relationship with some
variables (e.g., term, duration etc.) and trade
securities.
 Speculation
Buy Bond A & B
Short Sell Bond H & G

Relative Value Trading

Yield Yield
∙ ∙ ∙ B
∙ ∙
∙ ∙ ∙ ∙ A
∙ ∙
∙ ∙ ∙ ∙∙ ∙
∙ ∙ ∙ ∙
∙ ∙ ∙G
∙ ∙ ∙ ∙ ∙
∙ ∙
∙ ∙ H

Maturity Duration

Yield Curve Interest Rate Sensitivity

 Types of Speculation
The bonds whose yields lie above the curve (A,B)
are undervalued and the bonds whose yields lie
below the curve (H,G) are overvalued relative to
one another. The values are relative values, not
absolute values.
 Speculation
3. Rating Forecasts:
Some traders trade bonds based on rating
forecasts:
For Example, the bond rating of X Leather
Industries is forecasted to be downgraded.
Action: Short Sell X Leather Bond.
But this short position is exposed to interest rate
risk. (Say, market interest rate may decline)
- To cope with this, the trader will hedge the
speculative position by buying treasury bond
future.
 Speculation
4. Complex Forecasts:
Simple Forecast: Market interest rate will rise
Action: Sell short bonds
Complex Forecast: Short term interest rate will rise relative
to intermediate term and long term bonds. Thus, yield
curve will flatten.
Action: Short sell only short term bonds.
Complex Forecast: Corporate bond yield will rise relative
to treasury yield
Action: Short sell corporate bond.
 Arbitrage
• Arbitrage is the simultaneous taking of positions in two or more
markets in order to exploit pricing aberration (anomaly) among
them.

• Successful implementation of arbitrage requires:

- complex strategies & sophisticated math
- Lightning Speed Execution is important.

Pure (Academic) Arbitrage: This is an arbitrage which satisfies two

conditions
1. does not involve arbitrager’s own fund
2. it is riskless
 Forms/Types of Arbitrage
1. Across space (Spatial Arbitrage)
2. Across time (Temporal Arbitrage)
3. Across instruments
4. Risk arbitrage
 Type of Arbitrage : Spatial Arbitrage
1.Spatial (Geographic) Arbitrage:
Arbitrager looks for pricing discrepancies across geographically
separate markets and takes advantage of it. In market slang, who
practice arbitrage are often called, arbs.
i.e : “Dealer X” in New York is willing to buy the share of ABC
Limited at $ 15.50. At the same time, another “dealer Y” in San
Fransisco is looking to sell some shares of ABC Limited at $15.30.

An alert Arbitrager will see this price discrepancy in the two

markets, borrow funds from somewhere and use it to purchase the
shares from “Dealer Y” and sell it to “Dealer X” thereby making a
gross arbitrage profit of $0.20 per share from himself. Suppose, the
transaction cost and cost of funding is $0.10 per share. Then, the
net arbitrage profit would be $0.10 per share/
 Type of Arbitrage : Spatial Arbitrage

• Spatial Arbitrage can be done for any kind of

asset – debt, equity, mortgaged backed security,
commodity or equity index.
- For securities, arbitrager can transfer ownership at
nearly zero cost.
- For commodity (physical goods like oil, wheat,
gold, silver etc.) it must be transported to make
deliveries. This results in a transportation cost.
Type of Arbitrage : Spatial Arbitrage

- Spatial arbitrage may require conversion of the

asset to meet the standard of another market. For
example: Gold with 95% purity in one market and
gold with 99% purity in another market. This
results in yet another cost.
Arbitrager must capture sufficient price differential
between two markets to capture a profit after
incurring all transportation cost, transaction cost
and conversion costs. Otherwise, an arbitrage
strategy could backfire.
Type of Arbitrage : Spatial Arbitrage
• An arbitrager has identified a price differential $3 per
barrel of crude oil between the Venezuelan market and the
Mexican market. The cost of transportation and funding
cost is $ 2 per barrel. The cost of conversion/processing
needed to make the Venezuelan oil conform to Mexican
market requirements is $1.25. Should the Arb go for
executing his arbitrage strategy? Recommend.

• Answer- No. A loss of $0.25 (3-2-1.25) will arise.

 Types of Arbitrage: Temporal Arbitrage
2. Temporal Arbitrage (Arbitrage across time):

Involves buying an asset for immediate delivery and

selling it for later delivery in order to exploit a price
discrepancy between the cash price and forward price.
The forward transaction is usually done through a futures
contract.

- Vice versa, temporal arbitrage might also involve selling

asset short for immediate delivery and buy the future
contract.
Types of Arbitrage: Temporal Arbitrage

• Temporal Arbitrage can be conducted using

2 strategies:
– 1. Program Trading
– 2. Cash & Carry Synthetic Transaction
 Program Trading
Program trading involves exploiting pricing discrepancies between
current cash stock prices (spot price) and stock index future
prices. (Also called cash/index arbitrage)

- In program trading, the investment bank will use sophisticated

softwares to identify a basket of stocks that closely correlates with
an index futures contract. If any price discrepancy exists between
these two than program trading can be done.

- Involves a futures contract.

- Sometimes used to include a number of mechanical trading.
- The cost of carrying must be considered
 Program Trading
Program trading is difficult to conduct because of multiple reasons.

1. No actual tradable thing (like S&P stock index). So, a Proxy

portfolio is created which mimic/replicates the S&P 500 index.
2. Search for the pricing discrepancy is very difficult. Expensive
and highly sophisticated software is needed to identify such
discrepancies.
3. Transactions must be executed instantly to capture the pricing
discrepancy as the discrepancy might exist only for a short time.
Once again, speedy execution requires sophisticated technology.
 Feasibility of Program Trading
Whether a program trading (temporal arbitrage) opportunity is
feasible or not depends on whether the price discrepancy between
the fair futures price and the actual futures price is sufficiently large
enough to cover all the costs.

Steps in assessing feasibility of program trading:

1. Determine the fair futures price by adjusting the spot price of the
security for cost of carry
2. Compare with actual futures price
3. If discrepancy exists, determine whether it is large enough to cover
the transaction costs.
4. Recommend strategy based on result of step 3
 Program Trading Example
The Actual price of 3 month S&P Futures contract is
$482.50. A proxy portfolio which highly correlates the
S&P 500 index is currently priced at $480.20. An
arbitrager is contemplating temporal arbitrage. The
purchase of the proxy portfolio can be financed from the
repo market at an annual rate of 7.2%. If bought, the proxy
portfolio will entitle the investor to annual dividend yield
of 6%. Additional transaction costs are 0.10% of the spot
price of the proxy portfolio.

Is there any arbitrage opportunity? If so, what should the

strategy be? What will be the profit?
 Solution
Given,

Spot price/S = 480.20

Dividend yield /d = 6% annually or 0.50% monthly
Interest expense / r = 7.2% annually or 0.60% monthly
Actual price of 3 month S&P Futures contract = 482.50

Step 1: Determine fair futures price

Fair future price= S (1 + r –d) r = interest; d = div.
= 480.2 [1+ 3(0.006) – 3(.005)] = 481.6406

Step 2: Difference with actual futures price

Difference = 482.50 – 481.6406 = 0.8594

Step 3: Is discrepancy large enough to cover transaction cost

Transaction cost = 0.10% of spot price = 0.4802
Discrepancy > Transaction cost, so arbitrage opportunity exists
Arbitrage strategy
Buy proxy portfolio and short index future contract

Profit

0.8594-0.4802 = 0.3792 per futures contract

 • Practice Math

The Actual price of 2 month S&P Futures contract is $480. A

proxy portfolio which highly correlates the S&P 500 index is
currently priced at $478. An arbitrager is contemplating
temporal arbitrage. The purchase of the proxy portfolio can
be financed from the repo market at an annual rate of 6%. If
bought, the proxy portfolio will entitle the investor to annual
dividend yield of 6%. Additional transaction costs are 0.25%
of the spot price of the proxy portfolio.

Is there any arbitrage opportunity? If so, what should the

strategy be? What will be the profit?

Answer: Yes, Buy the proxy portfolio and sell the futures, 0.805
 Cash & Carry Synthetic Arbitrage
Cash-and-Carry Transaction:
- Involves purchase of an instrument and
simultaneous sale of a future contract (or other
derivative) to create a synthetic short-term
instrument.
- Such synthetic short term instruments are
created in order to earn low risk short term rates.
- Program trading is an example of Cash-and-
Carry synthetic transaction.
 Cash & Carry Synthetic
Arbitrage
Example: Cash-and-carry-synthetic with a bond

A 20.5 year bond is currently priced at $93.50. It has a coupon rate of 8%

with semi annual payment. The YTM of the bond is 8.684%. A six month
forward T-bond futures contract is available with $100,000 of T-bond to be
delivered on per futures contract. The futures contracts price is $93.0625.
What is the return to an investor who buys the bond and sells the futures?
 Cash & Carry Synthetic
Arbitrage
Buy 20.5-year 8% T-Bond at $93.50 (outflow)
6-month forward 20-year T-bond future sells at $93.0625 (inflow)
Interest $4 earned from the bond in six month (inflow)

(93.0625  4) - 93.50 12
Return  ( 6 )  0.0762
93.50
 Cash & Carry Synthetic
Arbitrage
• In this strategy, the investor used two securities.
– Long term T-Bond
– Short term T-bond Futures contract

As a result, he was able to create a synthetic instrument that

gave him short term low risk return of 7.62% which is
slightly less than the YTM that COULD HAVE BEEN
EARNT by investing in the long term T-bond solely but
is higher than the return that COULD HAVE BEEN
EARNT by solely investing in a short term T-bill.
 Risk Arbitrage
Risk Arbitrage:
Risk Arbitrage is associated with mergers and
corporate restructurings. It involves buying the
stocks of a target firm in a takeover and short
selling the shares of the acquiring firm.
 Risk Arbitrage Example
Example, Bank Asia announces that it will acquire Bank Scotia by exchanging shares.
(Asia offers two shares for each share of Scotia)

Bank Scotia’s share is traded at Taka 320

Bank Asia’s share is traded at Taka 200.

So, 2 shares of bank Asia is worth 400 tk (200*2). But it’s equivalent share (1 share of
Bank Scotia) is worth 320 tk. So, a price differential exists. Arbitrager will take
advantage of this by buying the cheaper stock and short selling the expensive
stock.

So, risk arb will buy 1 Bank scotia shares and short sell 2 Bank Asia share. He will get
400 tk by short selling the bank Asia shares and will spend 320 tk for the 1 bank
scotia share. Once the merger is complete, he will exchange the 1 Bank Scotia shares
for 2 Bank Asia share and use it to close out his short sale position. This will generate
tk 80 profit for him.
 Risk Arbitrage
Risk Arbitrage (Contd)
Investment banks spots situations of risk arbitrage
through their relationships and research
departments.
Conflict of interest arises when investment bank
is advising a company on takeover or defensive
measures, and it may get involved in arbitrage.
- This may go against the interest of clients.
Usually, when investment banks engage in
advising the clients, they instruct their arb dept to
be off-limits.
 Risk Arbitrage
Risk Arbitrage (Contd)
Many investment banks make a deal that they
will not be involved in risk arb until the
takeover effort has been announced. These
are called announced deals.