The IB Business of Trading Prime Brokerage
The IB Business of Trading Prime Brokerage
The IB Business of Trading Prime Brokerage
1 Market making
2 Arbitrage trading
3 Repo
4 Prime Brokerage
Index arbitrage
▫ An investment trading strategy that exploits
divergences between actual and theoretical
futures prices. This is done by simultaneously
buying (or selling) a stock index future while
selling (or buying) the stocks in that index
▫ The idea is that an index is made up of several
components that influence the index price in a
different manner
2. Arbitrage trading
Index arbitrage
There are sets of rules which index arbitrage
follows:
▫ If a futures contract is deemed high relative to the
cash price of the index (underlying stock basket),
the index future is sold and the stocks making up
the index are purchased
▫ If a futures contract is deemed low relative to the
cash price of the index, the index future is
purchased and the stocks making up the index
are sold
2. Arbitrage trading
Index arbitrage
In either of the scenarios, the arbitrageur is fully hedged against
upward or downward movement in the value of the index
Profits are made when the spread between the futures contract and
its spot price returns to its "normal" or expected value
Index arbitrage
Convertible arbitrage
▫ A trading strategy that typically involves taking a
long strategy in a convertible security and a short
position in the underlying common stock, in order
to capitalize on pricing inefficiencies between the
convertible and the stock. Convertible arbitrage is
a long-short strategy that is favored by hedge
funds and big traders
▫ The rationale behind a convertible arbitrage
strategy is that the long-short position enables
gains to be made with a relatively lower degree of
risk
2. Arbitrage trading
Convertible arbitrage
▫ If the stock declines, the arbitrage trader will
benefit from the short position in the stock, while
the convertible bond will have less downside
risk because it is a fixed-income instrument
▫ If the stock gains, the loss on the short stock
position would be capped because it would be
offset by the gain on the convertible
▫ If the stock trades sideways, the convertible bond
pays a steady coupon that may offset any costs of
holding the short stock position
2. Arbitrage trading
Convertible arbitrage
▫ Convertible securities are hybrid securities, usually issued as
bonds or preferred stocks, which offer investors an embedded
option – the ability to “convert” to a specified number of shares of
common stock
The global
convertible
market was
estimated at
$320 billion as of
June 30, 2012
(see Exhibit 1)
2. Arbitrage trading
Analysis of CB prices factors in three different sources of
value: investment value, conversion value, and option value
▫ The investment value is the theoretical value at which
the bond would trade if it were not convertible. This
represents the security’s floor value, or minimum price at
which it should trade as a nonconvertible bond
▫ The conversion value represents the value of the
common stock into which the bond can be converted. If,
for example, these shares are trading at $30 and the
bond can convert into 100 shares, the conversion value is
$3,000
▫ The option value represents the theoretical value of
having the right, but not the obligation, to convert the
bond into common shares
2. Arbitrage trading
Convertible arbitrage
CB = BOND + OPTION
2. Arbitrage trading
Convertible arbitrage
Key steps
▫ Identifying convertible securities
▫ Establishing and re-balancing the hedge ratios
▫ Managing the risks
2. Arbitrage trading
Convertible arbitrage
This strategy should do well whatever direction equity
markets move
▫ If the stock price falls, the hedge fund will benefit
from its short position; it is also likely that the CBs will
decline less than the stock, because they are
protected by their value as fixed-income instruments
▫ If the stock price rises, the hedge fund can convert
its CBs into stock and sell that stock at market value,
thereby benefiting from its long position, and ideally,
compensating for any losses on its short position
2. Arbitrage trading
Convertible arbitrage
Examples: CB matures in 1 year, trading at $1,050,
convertible into 100 shares, which is trading at $10 /
share
▫ => Premium $50
▫ The equivalent straight bond is trading at $920
▫ Assuming future stock price range: $7.5 or $12.5, thus
the conversion value is $750 or $1250
▫ Investor long 1 CB at $1050 short 60 shares at $10
2. Arbitrage trading
Convertible arbitrage
Examples
▫ Future price of share = $7.5
Long 1 bond: 920 – 1050 = -130
Short 60 shares: (10 – 7.5) x 60 = 150
Profit 20
Convertible arbitrage
2. Arbitrage trading
Convergence trading
▫ A trading strategy consisting of two positions:
buying one asset forward, i.e. and selling a similar
asset forward for a higher price, in the expectation
that by the time the assets must be delivered, the
prices will have become closer to equal (will have
converged), and thus one profits by the amount of
convergence
▫ Convergence trades involve two assets whose
prices must converge with time and, at maturity (if
there is a maturity), must be equal
2. Arbitrage trading
Convergence trading
▫ Investors studied the relationships between yields
and prices of numerous securities and their
respective futures contracts to see if they were out
of line
▫ The risk of a convergence trade is that the
expected convergence does not happen, or that it
takes too long, possibly diverging before
converging
2. Arbitrage trading
Convergence trading
▫ Example involved on-the-run and off-the-run U.S. Treasury
securities.
Price discrepancies occur because on-the-run securities are newly
issued and have relatively more active markets than off-the-run
securities
Because of the relatively higher demand, the price of a newly issued
Treasury bond with a 30-year maturity might be high compared to an
off-the-run bond that was issued six months ago (i.e., with 29.5 years
to maturity)
Investors would purchase the relatively low-priced, off-the-run security
and simultaneously sell short the high-priced, on-the-run security
Then, the on-the-run securities would become seasoned and their
prices would converge to the already seasoned securities, thereby
earning a profit
2. Arbitrage trading
Convergence trading
▫ In fixed income markets, an expensive bond would be
shorted, while a cheap bond would be purchased
▫ Examples of John Meriwether’s convergence trading
In late 1988, worries about mortgage market had driven
MBS decline relative to Treasury, widening the spread
to 1.5% from 1%
Arbitrageur believed MBS would regain their historical
value => purchased MBS and sold short Treasury.
When the spread narrowed, the value of MBS would
rise more or fall less than that of Treasury
2. Arbitrage trading
Convergence trading
▫ Examples of John Meriwether’s convergence trading
Purchased $5 billion worth of MBS yielding 10.5% and sold
short $5 billion worth of treasuries at 9.0%. To hedge
against prepayments, they also purchased interest rate
options costing 0.5% of the value of the MBS, or $25 million
Every year for 3 years, the MBS earned $75 million more in
interest than Salomon had to pay on the treasuries. But the
prepayment hedge cost $25 million. Over the 3 year period,
the positive carry amounted to $150 million
When the spread narrowed to 1.0%, covered the short
position and sold mortgage securities. Each $1,000 bond
had risen $25 more than Treasuries, for a $125 million gain.
Total profit for the trading strategy: $275 million
2. Arbitrage trading
Yield curve arbitrage
▫ Involves trading bonds of different maturities on the
yield curve. A trader would long the cheap part of
the curve and short the rich. The trader would be
successful if
The security shorted will have fallen in price or risen in
yield
The security purchased will have risen in price or
fallen in yield
A combination of the above
▫ Consists of the discovery and exploitation of
inefficiencies in the pricing of bonds
2. Arbitrage trading
Motivation
▫ The seller: you are borrowing on a collateralised basis
a cheaper source of financing than bank borrowing
allows investor to get leverage – the seller retains the
economic interest in the bond, and can use the bond as
collateral to raise cash to buy more of the security
3. Repo
Motivation
▫ The buyer: for the buyer (who repos in the security,
for whom the transaction is a reverse repo), this is
collateralised lending
secure home for cash, at better rates than bank deposits
the buyer can sell the security, buying it back at the term
to return it to the original owner, so benefitting from any
fall in the price of the security => the reverse repo
therefore facilitates short sales
3. Repo
▫ Based on tenor
Overnight repos – one day transactions
Term repos – longer maturities
Repos may be arranged on an open basis and terminated when
either party chosen to do so
3. Repo
▫ Based on differences in settlement
Bilateral repo - each counterparty’s custodian bank is
responsible for the clearing and settlement of the trade
Triparty repo - involves a third party, which is a clearing
bank
In U.S., triparty repo services are currently offered by Bank
of New York Mellon Corp. and JPMorgan
3. Repo
▫ Bilateral repo
3. Repo
▫ Triparty repo
3. Repo
▫ Collateral
3. Repo
In this case
▫ Interest for 1 day = $9,900,000 x 1.6% x 1/360 = $440
▫ So on day t + 1 dealer pays $9,900,440 to bank
3. Repo
Carry
▫ Carry is the difference between the interest earned on
a position and the cost of financing it
▫ In our case, interest accrues at the rate of 4% on the
bond
▫ Carry = ($10.0m x 4%)/365 – ($9.9m x 1.6%)/360
= $655.89
P&L
▫ The gain or loss on the position is the carry plus the
capital gain on the bond
▫ Suppose modified duration of bond is 9 years
▫ If 10 year yields fall by 2bp overnight => Bond price
rises by 0.18%
P&L = 0.0018 x $10m + $655.89 = $18,655.89
▫ If yields rise by 1 bp overnight => Bond price falls by
0.09%
P&L = -0.0009 x $10m + $655.89 = -$8,344.11
This is a fall of 8.3% relative to the $100,000 equity the
dealer has in the position
3. Repo
Short selling
You believe bond A is overvalued relative to bond B
▫ If you own A, sell it, and buy B
▫ If you don’t own it, you could do a reverse repo
Repo in bond A, and sell it
Buy bond B and repo it out
▫ Capital needed for haircuts only
▫ When bond A has gone down relative to bond B, buy
back A, sell B and liquidate both repos, and realise
profit
3. Repo
Short selling
If A and B both go up, face a margin call on A but
hopefully can get margin from counterparty on B (and
conversely if they both go down)
But if A becomes more overvalued relative to B, will face
a net demand for margin
▫ With limited capital, may need to liquidate at a loss
▫ Also vulnerable if lender of A terminates the repo
4. Prime Brokerage
▫ The generic name for a bundled package of services
offered by IBs and securities firms to clients (mostly
hedge funds) which need the ability to borrow
securities and cash
▫ The services provided under prime brokering include
securities lending, leveraged trade executions and
cash management, among other things
▫ Prime brokerage services are provided by most of
the largest financial services firms, including
Goldman Sachs, UBS and Morgan Stanley, with the
inception of units offering such services tracing back
to the 1980s
4. Prime Brokerage
▫ Bundled package of services
4. Prime Brokerage
Services
▫ Global custody (including clearing, custody, and
asset servicing)
▫ Securities lending
▫ Financing (to facilitate leverage of client assets)
▫ Customized technology (provide hedge
fund managers with portfolio reporting needed to
effectively manage money)
▫ Operational support (prime brokers act as a
hedge fund's primary operations contact with all
other broker dealers)
4. Prime Brokerage
Services
▫ Global custody
4. Prime Brokerage
Services
▫ Securities lending & financing
4. Prime Brokerage
Services
▫ Securities lending & financing
A financial institute may desire to go short but
realizes it does not own security. In such instances,
a prime brokerage serves to create efficiency in the
market by lending security to its client
Repo vs securities lending: most repo is for general
collateral and is therefore motivated by the need to
borrow and lend cash, whereas securities lending is
typically driven by the need to borrow securities. The
repo market overwhelmingly uses fixed-income
instruments as collateral
4. Prime Brokerage
Fees
▫ Prime brokers do not charge a fee for the bundled
package of services they provide. Rather,
revenues are typically derived from three sources:
spreads on financing (including stock loan),
trading commissions and fees for the settlement
of transactions done away from the prime broker