BANK3014

INVESTMENT AND PRIVATE BANKING

WEEK 6 TUTORIAL SUGGESTED SOLUTIONS WEEK 5

MATERIAL
Concept Review Questions

1. What distinguishes proprietary trading from market making?

Proprietary trading:
-Trading the banks money for profit
-No client flow necessary to establish positions
-building a positive selection driven long short portfolio
Market Making:
-Showing two sided quotes
-Client focused business
-Managing a negative selection portfolio to maximize proportion of
commissions earned.

2. Outline and describe technical and fundamental analysis. Critically

assess the differences between the two and their uses in trading.

Fundamental Analysis:
-Is evaluating a security or a market to determine intrinsic value to
determine its intrinsic value along the axes of macro, micro,
quantitative, and qualitative factors. Anticipating how the drivers
may lead to value change in the future.
-Time horizon is generally out to ~18 months in an IB setting,
maybe longer in a hedge fund.
-The shortcomings of FA are that fair value may never prevail.
-Timing is critical so being correct is not a guarantee of being
profitable.
-Bubbles especially diverge so far from fair value that you can
bankrupt yourself waiting for sanity to prevail.

Technical Analysis
-Statistical and visual analysis of charts and historical price data
aiming to find patterns that repeat themselves through time.
-Technical analysis can be a way of examining collective biases
from a behavioural finance perspective.
-The assumption is that all publicly known data, and all sentiment
about the future prospects of a security is impounded in the price,
thus price is the only decision tool a trader needs.
 -Generally, the time horizon is short but is a function of the time
horizon of the data being examined. For example, chart resolutions
from 1 minute up to a week may display similar patterns, which will
play out at that timescale.
-The shortcomings of technical analysis are that most of it is not
objective or objectively verifiable.
- The patterns identified may be the result of randomness not
indicative of any underlying market structure.
-Patterns may be unstable through time for no reason other than
randomness.
-Human beings are pattern recognition machines, and may be
doing nothing more than seeing dogs in clouds.
In practise the majority of portfolio managers will use both
fundamentals to determine where to look long term market
movements such as moving toward a new equilibrium, and
technical analysis to time entries and exits or to exploit perceived
short term even intraday trading opportunities. Fundamental
analysis is also critical in markets such as the bond and FX markets
where fundamental factors are core in driving long term trends.

3. How does a market maker in fixed income manage the risk of the
negative selection portfolio they are assigned by fulfilling client flow?
The market maker has broadly three strategies that it can
employ:
– Hold the position because the MM believes the market will move
in their favour, this in effect becomes a quasi-proprietary trading
position;
– Seek out parties to take the position from the MM. This could in
turn take
two courses of action:
• The sales desk actively identifies clients who might wish to take
the
position from the MM. In this case the MM expects that the position
can be laid off at a favourable yield and hence generate a profit
on the trade
• Request a two way quote from another market maker and lay the
position of with them by accepting their bid or offer. This will involve
the MM having to cross the spread; or
– Hedge the risk using derivatives until the position can be laid off.

Extension Questions
1. Suppose that the risk-free interest rate is 10% per annum continuously
compounded, the dividend yield on a stock index is 4% per annum. E-
mini S&P 500 futures with 4-month expiry are at 405 and the index is at
400.

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 Recall the theoretical futures price is 𝐹𝐹0 = 𝑆𝑆0 𝑒𝑒 (𝑟𝑟−𝑞𝑞)𝑇𝑇
Where: F0 is the theoretical futures price
S0 is the current price of the underlying stock index
r is the risk free rate of return
q is the dividend yield on the underlying stock index.
T is the time to expiry of the futures
e is exponential

(a) What is the theoretical futures price?

𝐹𝐹0 = 400𝑒𝑒 (𝑟𝑟−𝑞𝑞)𝑇𝑇
𝐹𝐹0 = 400𝑒𝑒 (0.10−0.04) 𝑥𝑥 4/12
𝐹𝐹0 = 408.8

(b) What arbitrage opportunities (this will involve either buying the
futures and then selling the index or vice versa) if any does this
market environment create?

The basket is overpriced relative to the futures; hence the correct

strategy to lock this arbitrage in is to:
1.Long futures
2. Short the basket of stocks comprising the index.

2. The table below sets out the yield curve for government bonds.
Assume all bonds pay annual coupons and are currently at PAR.
Recall the formula to calculate a bond’s price is:

(1 − (1 + 𝑖𝑖)−𝑁𝑁 𝐹𝐹𝐹𝐹
𝑃𝑃 = 𝑐𝑐 ∗ 𝐹𝐹𝐹𝐹 � �+� �
𝑖𝑖 (1 + 𝑖𝑖)𝑁𝑁

Where: P is the bond’s price

c is the coupon rate
FV is the bond’s face value
i is the market yield
N is the number of compounding periods

Maturity Yield
1 0.50%
2 1.00%
3 1.50%
4 2.00%
5 2.50%
6 3.00%
7 3.50%
8 4.00%
9 4.50%
10 5.00%

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(a) What is the total return achieved by buying a 10Y bond and selling
it after one year, given the following yield curve and assuming it
remains unchanged over the one year period?

First we calculate the price of the 10Y bond at a 10Y maturity.

(1 − (1 + 𝑖𝑖)−𝑁𝑁 𝐹𝐹𝐹𝐹
𝑃𝑃 = 𝑐𝑐 ∗ 𝐹𝐹𝐹𝐹 � �+� �
𝑖𝑖 (1 + 𝑖𝑖)𝑁𝑁
(1 − (1 + 0.05)−10 1000
= 0.05 ∗ 1000 � �+� � = $1000
0.05 (1 + 0.05)10

Second we calculate the price of the 10Y bond when it’s yielding 4.5%
and has a 9Y maturity having paid one coupon, at the 9Y yield.
(1 − (1 + 𝑖𝑖)−𝑁𝑁 𝐹𝐹𝐹𝐹
𝑃𝑃 = 𝑐𝑐 ∗ 𝐹𝐹𝐹𝐹 � �+� �
𝑖𝑖 (1 + 𝑖𝑖)𝑁𝑁
(1 − (1 + 0.045)−9 1000
= 0.05 ∗ 1000 � �+� � = $1036.34
0.045 (1 + 0.045)9

We add in the coupon we received to our rolldown yield

𝑇𝑇𝑇𝑇 = (0.05 ∗ 1000) + ($1036.34 − $1000)
= $50 + $36.34
= $86.34
= 8.634%

(b) What is the yield that could be earnt over the one year period by
investing in the one year bond and holding it to maturity?

The investor would generate a return of 0.50% by investing in the

one year asset.

(c) Compare the return from the two strategies. What are the risks
associated with the strategy in (a) compared to that in (b)?

The return from the roll-down trade at 8.634%pa is much higher

than the return of 0.5%pa from simply investing in the one-year
asset and holding it to maturity.

This strategy however exposes the investor to significant risks

because the return is heavily influenced by the interest rates that
prevail in 1-years’ time. If interest rates increase from the current
levels, particularly for 9 year interest rates the return over the
holding period will be reduced. Importantly the investor has a long
position in 10 year bonds. These have a significant level of price
volatility because of their long duration. Thus a superior return
relative to a one-year hold to maturity investment is subject to
significant market risk.

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3. Your economics team hands down an analysis which suggests that the
economy is likely to perform better than expected. You’re asked to
recommend a strategy to capitalise on this analysis.

(a) What would you expect to be the change in credit spreads between
high yield corporate bonds and government bonds if the analysis is
correct? Give reasons for your view.

Higher levels of economic growth lead to the perception of

reduced risks within the economy, and in particular credit risks.
The higher growth is also likely to increase the amount of
investable funds and investors are likely to “chase” assets in
order to generate returns. Thus investors will “bid” for securities
including high risk securities and this is likely to lead to a
reduction in credit spreads (the difference between the return on
a risky corporate asset and a “risk free” government bond.

(b) Using the two bond exchange traded funds (ETF’s) HYB (which
comprises high yield corporate bonds) and GBS (which contains
government bonds), how would you structure a spread trade that
expresses this view?

You should enter into a long HYB and short GBS position. If the
spread between high yield bonds and government bonds
narrows as risk appetite increases, this trade would generate
positive net returns. Irrespective of what happens to the
absolute level of interest rates (rise or fall) this position will
generate positive gains because the long and short position
create a form of hedge to absolute interest rate movements and
the trader benefits from the narrowing of the spread. These
types of positions are commonly employed by hedge funds.
Note if the economist is wrong and spreads increase (blow-out)
then the trade will suffer significant losses. This was the case
with the hedge fund LTCM in 1998.

(c) If you only have the ability to manage your corporate bond inventory vs
your government bond inventory (i.e. either increase the holdings of
one (being overweight) vs the other (being underweight)), which one(s)
would you choose to be under/overweight?

You should overweight corporates in the portfolio and

underweight government bonds. Before customer flow pushes
us in the opposite direction. By reducing our inventory of
government bonds as much as possible and increasing our
inventory of corporate bonds we position ourselves to profit if
spreads narrow when the market reprices if the economic data
is in line with our leading indicator’s prediction.

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