Financial Markets Operations Management (4 page)

The Operations Department does not and cannot operate in isolation. It has to maintain relationships with many different types of organisation including:

• Clients – external;
  
• Clients – internal;
  
• Counterparties;
  
• Suppliers;
  
• The authorities.
  

There are other business functions that work outside of the direct Front Office/Middle Office/Back Office triangle but are nevertheless important elements in a well-run investment organisation. Again, the exact management of these functions depends on the size of the organisation and how it chooses to run its own business.

These functions include:

• Accounting
  
• Compliance
  
• Human Resources
  
• Information Technology/Systems
  
• Internal Audit
  
• Risk Management
  
• Treasury.
  

See
Table 1.5
for details.

An Operations Department is the “engine room” of an investment organisation and the conduit along which transactions that have been executed in the Front Office flow.

Operations have a processing role – ensuring that these transactions are completed (settled) in an accurate and timely manner.

Operations also have a supporting role – they help the Front Office by reducing costs and making sure that any profits are not reduced through late interest claims.

Operations have a safekeeping role – ensuring that assets are held in custody and are only released on properly authorised instructions.

Operations do not work alone – they provide information to other functions and require resources such as staff (Human Resources) and cash (e.g. Treasury). To do this effectively, Operations maintain many different types of relationship, both internally (e.g. with the Front Office) and externally (e.g. with counterparties, clients, custodians, etc.).

Financial instruments are negotiable (i.e. they can be traded) assets that can be divided into cash instruments and derivative instruments. Cash instruments are issued in response to a legal entity, a corporate or a government raising capital and are either securities or loans. We will concentrate on securities.

Derivative instruments derive their value from the value and characteristics of one or more underlying entities, for example, a security, an interest rate or a market index. Derivatives are not created by the issuers of the underlying entity; rather they are created either by a derivatives exchange (known as exchange-traded derivatives – ETDs) or by participants in the market (OTC derivatives – OTCDs).

Another way to look at these examples is to consider the differences between the money markets and the debt and equity markets (both collectively known as the capital markets). We can differentiate the money markets from the capital markets on the basis of maturity, the credit instruments and the purpose of the financing (see
Table 2.1
).

As we are going to see in this chapter, there is a great variety of financial instruments, each with a varying degree of complexity from an operational point of view. For what purpose, though, are these instruments issued?

Entities that issue financial instruments do so for one fundamental reason and that is to raise capital. If you take a look at a company's annual report and accounts, you will notice on the Balance Sheet that the company has assets that are matched by liabilities. Assets are what the company owns and liabilities reflect the ways that the assets have been financed. Depending on the individual circumstances, a company can finance its assets by issuing securities (equity, bonds, etc.), borrowing cash or a combination of both.

The type of securities issued depends on the purpose for which the cash is being raised and the time horizon for which the cash is needed.
Table 2.2
shows some examples.

A “soft” benefit of issuing securities is that the issuer gains a presence in a particular market; there is a certain cachet for a company that has its shares listed on a major stock market, such as Tokyo, New York or London.

One of the features of equity and bonds is that these are negotiable and the investor community is free to buy and sell these instruments under rules and regulations laid down in the markets where the instruments are issued. We refer to this as a
secondary market
.

Investing is an inherently risky business. The market price might move away from the investor, resulting in a loss if the investor decides to sell the asset. It is also risky in the sense that the
issuer might default, leaving the investor with a worthless asset, and risky in the sense that the benefits of ownership may either not be received or not be as high as expected.

By contrast, derivative financial instruments are issued by the market rather than the issuer of the underlying asset from which the derivative derives its value. The market issues and uses derivatives for a number of purposes, including:

• To hedge an existing position in a related underlying asset;
  
• To obtain exposure to an underlying asset;
  
• To create an option of doing something;
  
• To speculate and make a profit.
  

It is not the purpose of this book to teach you about the reasons why entities issue debt and equity securities; there are excellent books that fulfil this purpose. Rather, it is to illustrate that the ways in which we administer financial instruments are determined by some of the features of these instruments. The main learning objective is to know enough about any particular instrument to enable you to understand the main processes within a settlements or custody or asset servicing context.

By the end of this chapter you should be able to:

• Define the different types of financial instrument;
  
• Describe the operational features of these instruments;
  
• Calculate accrued interest on debt securities using the correct day-count conventions;
  
• Calculate the transaction amounts of a selection of financial instruments.
  

Together with the capital markets, the money markets form the financial markets. The main distinction between the two is that the money markets focus on short-term debt financing, whereas the capital markets focus on the longer term through the issuance and subsequent trading of equity, bonds and all the other types of securities.

In this section, we will look at the main money-market instruments including deposits, coupon securities (such as certificates of deposit) and discount securities (such as treasury bills and commercial paper). Due to the short-term nature of these instruments, interest can be paid to the lender in one of two ways:

• Instruments are issued at a discount to their face value and, on maturity, the repayment will be at par (i.e. the face value). We refer to these as
  discount instruments
  .
  
• Instruments are issued at their face value and mature at par together with interest. We refer to these as
  accrual instruments
  .
  

2.3.1 Euro-Currency Deposits

Any currency that is traded outside the country of the currency is referred to as a
Euro-currency
trade. For example, if you are a dealer based in Tokyo wishing to borrow US dollars, you would be borrowing Euro-dollars.

Euro-currency deposits are non-negotiable and there is no secondary market as such. Title to a deposit cannot be assigned or transferred without the approval of the lender and borrower. This makes it a rather complex situation if either party wishes to liquidate the deposit; the normal practice if one party wishes to “cancel” the deposit is to enter into an equal-and-opposite transaction for the same maturity.

Euro-currency rates are quoted on a percentage per annum basis based on inter-bank offered rates and bid rates. Traditionally, the key benchmark rate has been the London Interbank Offered Rate (LIBOR – the rate which the market charges to lend money) and the London Interbank Bid Rate (LIBID – the rate which the market pays for taking money).

LIBOR and LIBID rates for the major currencies (see
Table 2.3
) are fixed every day in London by groups of banks known as
panel banks
(see
Table 2.4
) across a range of maturities (see
Table 2.5
).

AUD	Australian Dollar	GBP	Sterling
CAD	Canadian Dollar	JPY	Japanese Yen
EUR	Euro	NZD	New Zealand Dollar
CHF	Swiss Franc	SEK	Swedish Krona
DKK	Danish Krone	USD	US Dollar

Source:
www.bbalibor.com
.

Euro Panel Banks	Last Reviewed May 2012
Abbey National plc	Deutsche Bank AG	Rabobank
Bank of Tokyo-Mitsubishi UFJ Ltd	HSBC	Royal Bank of Canada
Barclays Bank plc	JP Morgan Chase	Société Générale
Citibank NA	Lloyds Banking Group	The Royal Bank of Scotland Group
Credit Suisse	Mizuho Corporate Bank	UBS AG

Source:
www.bbalibor.com
.

Overnight (O/N)	Starting today and maturing tomorrow
Tom–Next (T/N)	Starting tomorrow and maturing the next day
Spot–Next (S/N)	Starting on the spot date
1 w	Starting on the value date, maturing 1 week later
1 m	Starting on the value date, maturing 1 month later
2 m	Starting on the value date, maturing 2 months later
3 m	Starting on the value date, maturing 3 months later
6 m	Starting on the value date, maturing 6 months later
12 m	Starting on the value date, maturing 12 months later

Fixing, Value and Maturity Dates

When a deposit is transacted, there will be a difference between the dates on which the transaction is executed (the fixing date), the start date of the deposit (the value date) and the finish date of the deposit (the maturity date).

In general, there are two business days between the fixing date and the value date. The maturity date will be the number of days/months after the value date, as noted in the transaction (e.g. three months). In the BBA's LIBOR guidance notes, the period between the fixing and the value date for the ten currencies is as noted in
Table 2.6
.

Currency	Period between Fixing and Value Dates
All currencies except EUR and GBP	Two London business days after fixing
EUR	Two TARGET2 business * days after fixing
GBP	The fixing date and value date are the same

Source
: bbalibor (online). Available from
www.bbalibor.com/technical-aspects/fixing-value-and-maturity
. [Accessed Monday, 2 December 2013]

^*
A TARGET2 business day is when the Eurozone payment system is open in all participating countries. It is closed on 1 January, Good Friday, Easter Monday, 1 May and Christmas (25 and 26 December).

Calculations

There are two calculations to be aware of:

• Simple interest (Equation (
  2.1
  ))
  
• Repayment (Equation (
  2.2
  )).
  

Simple Interest Calculation

Interest is calculated on a simple interest basis based on the actual number of days in the deposit period divided by 360 days (365 days for GBP):

(2.1)

Repayment Calculation

(2.2)

Where:

• FV
  = Face value of deposit
  
• d
  = number of days from value date to maturity date
  
• r
  = interest rate per annum ÷ 100 (i.e. 5.00% is stated as 0.05).
  

The following two exercises will check your understanding of:

• Fixing dates, value dates and maturities;
  
• Interest and repayment calculations.
  

2.3.2 Certificates of Deposit

A
certificate of deposit
(CD) is a type of time deposit where a bank issues a receipt certifying that a deposit has been made. Unlike the time deposit that we saw previously with a Euro-currency deposit, a CD can be sold prior to the final maturity. Therefore, instead of waiting until maturity, depositors may sell them in the market for cash. The holder of a CD receives interest at a fixed or floating rate.

CDs are quoted on a discount-to-yield basis and, on maturity, the holder receives the face value plus interest (either at a fixed rate or a floating rate). Interest on a CD is calculated in the same way as for a Euro-currency deposit, as the example in
Table 2.11
illustrates.

Issuer	Nycredit Bank
Face value	EUR 1,000,000
Interest rate	0.16%
Tenor	180 days

On maturity, the holder will receive EUR 1,000,800.00 (i.e. the face value EUR 1,000,000.00 plus interest of EUR 800.00):

(2.3)

Let us assume that the holder sells the CD at a yield of 0.15% with 90 days remaining until maturity. The maturity amount is discounted by the yield for the remaining period:

(2.4)