Chapter 5 – Trading
Q1. When might an investment bank decline participation in an underwriting and why?
A. When the perceived risks of participation outweigh the expected underwriting
fees. One possible risk is if the trader believes demand for new securities from
the issuer is lower than the contemplated issuance size. Alternatively, the
Q2. How do professionals in sales, trading and research work together?
A. Research provides investment ideas to sales, who contacts the bank’s investing
clients with speci”c trade ideas based on research’s recommendations. Should
Q3. Describe what Prime Brokerage is, including four principal products in this area and
the generic name of the “nancial institutions that are targeted for this business.
A. Prime Brokerage is a Trading Division business area that focuses on hedge funds
and provides the following products: lending and clearing securities; margin
Q4. Explain traders’ market-making function.
A. The trader provides bid and offer prices to the bank’s investing clients that want
to sell or buy a speci”c security that the bank covers. This provides clients with
Q5. Why would a prospective issuer prefer to hire as underwriter an investment bank
that has traders already active in its security?
A. By already being active in a security, the bank may have a be2er understanding
of who the potential investors are and may have already developed a relationship
Q6. FICC is one of the main Divisions in an Investment Bank. What does FICC stand for?
Other than during 2007 and 2008, how does this division typically rank from a
pro”tability point of view, compared to other Divisions? What happened during
these two years and which part of the FICC Division was most responsible for this
outcome?
A. Fixed Income, Currencies and Commodities. FICC is typically the most pro”table
Division. However, during 2007 and 2008, there were huge losses in this Division
Q7. Why might a high short interest ratio be potentially misleading with respect to the
opinions of market participants regarding a particular stock?
A. A large portion of the short interest reported for some companies is due to
hedge funds taking short positions in order to hedge share price risk on shares
Q8. An investor lends 10,000 shares of ABC for two months when the stock is at $50 and
requires 102% cash collateral. The market interest on cash collateral is 4.0%. The
rebate rate on ABC shares is 2.5%. Calculate the combined pro”t for the stock lender
and investment bank.
A. 10,000 x $50 x 102% = $510,000 cash collateral. $510,000 x (4% / 6) = $3,400
Q9. What risks do investors take on when buying on margin?
A. If the value of the investor’s collateral drops, the investor must deposit additional
cash, or other collateral. In the case of a precipitous drop in the value of the
Q10. How were senior tranches of a CDO able to obtain investment grade credit ratings
when some of the underlying assets were non-investment grade?
A. Rating agencies, issuers and investors believed that risk can be decreased
through the diversi”cation of the assets underlying the CDO and that by slicing
Q11. A domestic airline based in the U.S. has placed a large $10 billion order for new
airplanes with French aircraF manufacturer Airbus. Delivery is scheduled in four
years. Payments are staggered based on a percentage of completion rate. The U.S.
airline believes the Euro will appreciate against the Dollar during this time frame.
How can the U.S. airline hedge currency risk related to this purchase with an
investment bank?
A. The airline can work with the currencies desk and enter into forward FX
Q12. What does VaR stand for? What is its de”nition and why is it important to
investment banks? What are some of the criticisms of VaR?
A. Value-at-Risk. Potential loss of value from trading positions due to adverse
market movements over a one-day period based on a set con”dence level
