A Trader's Guide To ... The Series:
Read Me 1^{st}
(please) PART I
and PART II
Table of Contents
PART
I & PART II Available at the ARTShop
(798
colour
pages, soft cover, +software)
PART
I Only Available at the ARTShop
(312
colour
pages, soft cover)
See the entire TG2
Series
0 Foreword & How to Use the "TG2" Series Most Profitably i
0.1 Why the TG2 Series of Books? ii
0.2 What is, and is not, important, and who is this for anyway? iii
0.2.1 Who is this (book/Series) for? iv
0.2.2 Pedagogical issues v
0.2.3 Notation, Grammar, Spelling vi
0.2.4 About Accompanying (free) software, and Commercial Software. vii
0.2.5 About these books and relationship to ARTSchool viii
0.3 Future direction & Road Map for the Series. ix
0.4 About the Authors x
0.4.1 Invitation for Contribution x 1 Introduction to the "TG2… Read Me First" book 1
1.1 Feeds, Screens, and Calculators 2
1.2 What we do for a living 3 PART I: Market Basics 2 Market Basics  Overview 5
2.1 Basics of Finance, Trading, and Business (in the Real World) 5
2.1.1 Business Mandate, and Overview of Strategies & Tools for Profit & Risk 6
2.1.2 Cash is King  "show me the money" 9
2.1.3 Supply/Demand, and Prices 11
2.1.4 The Participants & (Economic) Needs 15
2.1.5 Tradingfloor/Tradingoperation layout 35
2.1.6 Forecasting vs. Arbitrage & (Forward) Fair Value 41
2.1.7 Spot/Forward Arbitrage Example: 3MForward Ferraris 49
2.1.8 CrossMarket Arbitrage Example: Interest Rate Parity 53
2.1.9 Risk and Return 56
2.1.10 The Efficient Frontier and CAPM/APT 65
2.1.11 Holding Period Risk/Return and (Optimal) PaR 69
2.1.12 Reality Impact 76
2.1.13 What Role Does Economics Have in Trading? 78
2.1.14 What Role Does Mathematical Modelling Have in Trading? 81
2.1.15 Market Basics: Overview Summary  The Story so Far 83 3 Market Basics  The Trading Cycle, Trading Discipline, and Management 87
3.1 What/How/Why we trade: Transactions Basics 88
3.1.1 Asset Classes: Equities, IR/FX, and Commodities 88
3.1.2 Description of a few important types of contracts and "payouts" 91
3.1.3 Transaction Basics and (some) Terminology 103
3.2 The Business of Trading 107
3.2.1 The Trading Cycle 108
3.2.2 How and why we trade: The basics of strategies and discipline 115
3.2.3 Examples of where/how money is made in trading/investment banking 130
3.2.4 Funding, Costs, and Capital  this is real money 157
3.2.5 Position Reporting & Accounting 166
3.2.6 Position Reporting vs. Performance Measurement 171
3.2.7 Managing Trading, Traders, and Compensation 178 4 Market Basics  Risk Management & Position Keeping  Part 1 187
4.1 What is Risk & Types of Risk 188
4.1.1 Types of Risk 188
4.1.2 Traditional Measures of (primarily market) Risk 190
4.2 Holding Period vs. Instantaneous Risk Methods, and PaR 202
4.2.1 Holding Period Risk Management  Parameterisation Selection 202
4.2.2 Holding Period Risk Management  Strategy Selection 204
4.2.3 Holding Period Risk Management  Strategy Switching 206
4.3 Position Keeping vs. Risk Management 208
4.3.1 Does the Risk Management Department Exist Purely for "Show"? 208
4.3.2 (Qualitative) Examples of Position Keeping 212
4.4 Proactive Approaches ( … heaven forbid) 213
4.4.1 Heuristic and Informal Proactive Processes 214
4.4.2 Forecastfree Proactive Methods: Surfaces, Scenarios, etc 216
4.4.3 Holding Period Proactive Methods: PaR 221
4.5 Valuation and Risk Reporting 222
4.5.1 Typical Risk Reports 222
4.5.2 Extended Risk Reports, and (other) Complications 225
4.5.3 Operational Issues Trade Booking and Risk Reporting/Management 227
4.5.4 Revisiting P&L, RiskAdjusted Reporting, and Bonuses 228
4.6 The Management of Risk vs. Risk Management: the Story so Far 229
4.6.1 The Risk Management Big Picture 229
4.6.2 Risk Management Operational Matters 230
4.6.3 Other (Risk) Managerial Matters 231
4.6.4 Management, Risk Management, and Compensation 231 5 Market Basics  A Few Easy but Important (mini) Cases 235
5.1 A Few Notable (mini) Cases 235
5.1.1 Know Your Contract 235
5.1.2 Did you really do the trade? 236
5.1.3 Correlation vs. Efficiency: liquidity in hedging and replication 237
5.1.4 There is no Arb without liquidity  1: Foreign restricted equity arbitrage. 238
5.1.5 There is no Arb without liquidity  2: Convertible bond arbitrage 239
5.1.6 There is no Arb without liquidity  3: Portfolio Insurance & Oct 1987. 241
5.1.7 There is no Arb without liquidity  4: GBP swaptions arbitrage. 242
5.1.8 Front Office vs. Back Office: marktomarket prices 243
5.1.9 Front Office vs. Back Office: systems & valuation models 244
5.1.10 Barings, Sumitomo, Daiwa, & Kidder Peabody: the "Rogue Trader" Syndrome 246
5.1.11 The "birth" of Credit Derivatives: Risk, Supply Push, and "Hype" 249
5.1.12 KYC: Bankers Trust vs. Procter & Gamble 252 PART I: Summary 253 PART II: Valuation and Risk Management Basics 6 Valuation and Risk Modelling Basics 259
6.1 Why are mathematical methods required? 259
6.2 Type of maths required  Model vs. Solution 260
6.2.1 Mathematical modelling  rate of return vs. bank balance 260
6.2.2 Mathematical Solutions  Closed form vs. Numerical 262
6.2.3 Numerical methods 262 7 Valuation and Risk Under Certainty 265
7.1 A Short Review of Present Value Theory 266
7.2 Review of usual discounting measures 266
7.2.1 Discount Factors 267
7.2.2 (Spot) Interest Rates 268
7.2.3 Frequency Conversion 271
7.2.4 Forward Rates 272
7.3 IR Curves and discounting multiple cash flows 275
7.3.1 The Internal Rate of Return 276
7.3.2 A few sundry items 279
7.4 IR Curves in Practice 282
7.4.1 Curves: The Zerocoupon and IRR curve 282
7.4.2 Government, LIBOR, Corporate, etc  Curves 283
7.5 Present Value Theory for the Real World 286 8 Valuation and Risk Under Uncertainty  Part 1 289
8.1 Overview of the underlying issues 291
8.1.1 Mathematical modelling of securities prices 291
8.1.2 Some Simplifying Assumptions for Economics and Finance 292
8.2 Modelling the Price/Returns processes  The Basic Idea 294
8.2.1 The "Goal" 294
8.2.2 A First Qualitative Model of Price Dynamics: Trends and Wobbles. 295
8.3 Developing a First Model for Valuation Under Uncertainty 302
8.3.1 Down to earth explanation of the terminology 303
8.3.2 Expectations 304
8.3.3 Recoupling and Decoupling Drift 312
8.3.4 Expectations and Distributions Summary 312
8.3.5 Making a Bet or Pricing an Option?  1st (Crude) Valuations under Uncertainty 314
8.3.6 A First Quasi Forecasting Model of Uncertainty 322
8.3.7 Forecasting Prices vs. Forecasting Returns Revisited 323
8.4 Developing an Extended & Working First Model of Uncertainty 327
8.4.1 A First "Good" Shape of Uncertainty 328
8.4.2 A First Calibration of the Uncertainty 334
8.4.3 A First Model for the Time Evolution of Uncertainty 337
8.4.4 Formalising the First (proper) Model of Uncertainty 342
8.4.5 Calibration of Uncertainty and Annulisation 359
8.5 Putting it all together: A First "Complete" Model for Valuation Under Uncertainty 360
8.5.1 First Valuation of Digital Options 361
8.6 Other Models for Valuation Under Uncertainty 369
8.7 Summary: A First "Complete" Model for Valuation Under Uncertainty 371 9 Risk Management & Position Keeping  Part 2 375
9.1 Introduction to Sensitivity Based Risk Reporting & Hedging 377
9.1.1 Sensitivity Matching and Hedging  The Basic Idea 377
9.1.2 Position Sensitivity Measures 380
9.1.3 Sensitivity of Sensitivity 394
9.1.4 MultiDimensional Sensitivities 399
9.1.5 Basic Sensitivity Hedge: Bond/Bond and Bond/Futures 403
9.1.6 Basic Sensitivity Hedge: Options Delta & Delta/Gamma/Rho (Pyramid) Hedging 409
9.1.7 Scenarios of Sensitivities and Risk 423
9.1.8 (Almost) Everything has TermStructure and Curves 428
9.1.9 Sensitivities and "Greeks" Summary 434
9.2 Introduction to Profile Matching 438
9.2.1 Pension Fund Cash Flow Matching & Immunisation 439
9.2.2 Position keeping with "Singularities" and Model "Mismatch" 444
9.3 Introduction to VaR Based Risk Reporting (and Hedging?) 449
9.3.1 Illustration of the Basic VaR Idea 450
9.3.2 Introduction to Types of VaR Measurement 456
9.3.3 Historical methods: HVaR 458
9.3.4 Covariance VaR Methods: CVaR 465
9.3.5 Monte Carlo methods: MCVaR 471
9.3.6 Backtesting and Verification of VaR 472
9.3.7 Credit VaR based methods 473
9.3.8 Reality Impact and Future Considerations 474
9.3.9 Basic VaR Summary 478 10 Trading with ArbitrageFree/Risk Neutral Methods  Part 1 481
10.1 Risk Neutral Valuation  The Coffee Table Edition 483
10.1.1 The Risk Neutral Valuation  The (easy) Math Edition 485
10.1.2 Risk Neutral vs. Risk Preference Forecasting Models 495
10.1.3 An Application of Risk Neutral Valuation: BlackScholes Options Pricing 497
10.2 Trading with RiskNeutral Valuation Under Uncertainty 505
10.2.1 Synthetic Replication Delta Hedging Example 1 506
10.2.2 Synthetic Replication Delta Hedging Example 2 515
10.2.3 Synthetic Replication Gamma Hedging Example 518
10.2.4 Provisioning  The Opposite of Dynamic Replication 522
10.3 Risk Neutral Valuation Summary 524 11 Volatility Basics 527
11.1 Statistical (or Empirical, or Historical) Volatility 528
11.1.1 Characterising (empirical) Volatility 528
11.1.2 Sampling length, Frequency, and Calendar Effects 532
11.1.3 Correlation/Covariance 539
11.1.4 Price vs. Returns (and Absolute vs. Relative) 541
11.1.5 Histories of "Historicals" 544
11.1.6 Relationship to Distributions and Calibration 547
11.2 Model (and Implied) Volatility 548
11.2.1 Implied Volatility(s) 549
11.2.2 Implied vs. Historical (Model) Volatility 551
11.2.3 Exotic and Structured (Model) Volatility 554
11.2.4 TermStructure Model Volatility 561
11.3 Representations of Quoted/Traded Volatility 564
11.3.1 Term structure of (Market & Model) Volatility as Curves & Surfaces 565
11.3.2 Volatility Skew 572
11.3.3 Mean Reverting Volatility and Other Effects 575
11.3.4 HJM: volatility isn't everything, it's the only thing 577
11.4 "Trading" Volatility 578
11.5 "P&L" Volatility 581
11.6 Advanced Volatility Concepts 583
11.7 Volatility Basics Summary 591 12 PaR: P&L Based Valuation, Risk Management, and Validation 595
12.1 Introduction to the PaR Methodology 599
12.1.1 Trading, Hedging, Selling, Managing, and Real World P&L 599
12.1.2 Trading, Hedging, Selling, Managing, and Simulated P&L 600
12.2 Comments on Software and Programming Issues 602
12.3 Forward Testing vs. Back Testing 604
12.3.1 Generating Forward Market Scenarios 605
12.3.2 Back Testing with Historical Market Data 607
12.4 Embedding a Dealing System in a Scenario Generator 610
12.5 Embedding Strategies: Prop Trading & Position Keeping Rules 612
12.6 Accounting & Reporting: Cash Flow vs. P&L, Interperiod Risk(s), and Much More 614
12.7 Riskadjusted Performance Calculations 616
12.8 "Optimal" Holding Period RiskAdjusted Returns PaR via Efficient Frontiers 617
12.9 What a PaR Calculator Might "Look Like" 619
12.9.1 A Spreadsheet Example (Suitable for simple positions) 619
12.9.2 A "full blown" Example (Suitable for almost anything) 622
12.10 Mathematically Optimal vs. Holding Period P&L Optimal Trading & Hedging 627
12.11 A Simple Forward/Backward PaR Example: Bonds/Bond Futures 629
12.11.1 Forward Testing (with a 1factor Model) 629
12.11.2 Back Testing the Hedging Strategy and the (1factor) model 632
12.12 PaR Summary: Theory vs. Reality 635 PART II: Summary 637 Appendices 1
Appendix A: Notation/Abbreviations 2
Abbreviations 2
Currencies 4
Greek Letters 5
Alphanumeric Letters 5
Mathematical Operators 5
Appendix B: ARTicles 1
B1: ARTicles: An Efficient Frontier Primer 1
B2: ARTicles: Optimisation and P&L  Part 1 1
B3: ARTicles: How much to pay a trader? 1
B4: ARTicles: Chaos and Predictability in Finance  Part 1: Are Markets Random? 1
B5: ARTicles: Chaos and Predictability in Finance  Part 2: Periodicity and Aperiodicity 1
B6: ARTicles: Chaos and Predictability in Finance  Part 3: Fractals and Options Trading 1
B7: ARTicles: TermStructure Calibration: Nonsense & Reality 1
B8: ARTicles: A Principal Components and Term Structure Models Quickie 1
References i
Subject Index i
PART
I & PART II Available at the ARTShop
(798
colour
pages, soft cover, +software)
PART
I Only Available at the ARTShop
(312
colour
pages, soft cover)
See the entire TG2
Series
