The practical guide to wall street (2009)

The Practical Guide to Wall Street Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com The Practical Guide to Wall Street Equities and Derivatives MATTHEW TAGLIANI John Wiley & Sons, Inc Copyright C 2009 by Matthew Tagliani All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data: Tagliani, Matthew, 1974– The practical guide to Wall Street : equities and derivatives / Matthew Tagliani p cm – (Wiley finance series) Includes index ISBN 978-0-470-38372-8 (cloth) Stocks Derivative securities I Title HG4661.T34 2009 332.63 220973–dc22 2008039517 Printed in the United States of America 10 To Nati, Sof´ıa, and Cosmo Contents Preface xiii A Comment on the Events of 2008 xxiii Acknowledgments xxv PART ONE What Is a Stock? CHAPTER Equity Fundamentals (Part 1): Introduction to Financial Statements Introduction Equity and Corporation Introduction to Financial Statements The Balance Sheet The Income Statement Statement of Cash Flows Summary CHAPTER Equity Fundamentals (Part 2): Financial Ratios, Valuation, and Corporate Actions Introduction Financial Ratios Growth and Value Bloomberg Valuation Technical Analysis Corporate Actions Summary 3 15 20 24 27 27 28 38 39 40 51 54 64 vii viii CONTENTS PART TWO Products and Services CHAPTER Cash Market Introduction How a Stock Exchange Functions Exchange Structure Order Types How the Cash Trading Business Works Communication Purchasing a Stock in a Foreign Currency Summary CHAPTER Equity Indices Introduction Index Construction What an Index Doesn’t Tell Us Valuation and Calculation Replicating Portfolio Trading an Index Portfolio Index Changes Index Dividend Points Total Return Index Calculation Multicurrency Indices Equity Indices in Practice International Indices Summary CHAPTER Program Trading Introduction Explanation of a Sample Trade When Is Program Trading More Beneficial? Portfolio Analytics Transition Management Principal Trades Summary 67 69 69 69 76 81 102 112 115 121 123 123 125 129 131 134 136 139 142 144 145 147 156 165 167 167 173 182 184 189 191 201 Contents CHAPTER Exchange-Traded Funds (ETFs) Introduction Trading Mechanics Net Asset Value (NAV) Popularity Trading versus Holding ETFs in Practice Summary CHAPTER Forwards and Futures Introduction Calculation of Fair Value Futures Index Arbitrage The Futures Roll Exchange for Physical (EFP) Basis Trades Futures Contracts in Practice Technical Comment on the Accuracy of Approximations Summary CHAPTER Swaps Introduction Motivation for a Swap A Long Equity Swap Example The Swap in Detail: Definitions and Terminology Calculation of Payments Short Swap Back-to-Back Swaps Swaps as a Trading Tool A Comment on Hedging Swap Valuation: Accrual versus NPV Currency Exposure ISDA Risks and Other Considerations Summary ix 203 203 205 207 208 212 214 214 217 217 219 223 233 240 245 254 259 263 264 267 267 267 269 272 277 279 280 281 286 287 289 293 294 296 x CONTENTS CHAPTER Options (Part 1) Introduction Definitions and Terminology Payoff Structure Option Values Prior to Maturity Quantitative Considerations The Black-Scholes Derivation Types of Volatility Summary CHAPTER 10 Options (Part 2) Volatility Trading Option Sensitivities: The “Greeks” Implied Volatility Revisited OTC and Exotic Options Summary CHAPTER 11 The Trading Floor Introduction Organization of the Sales and Trading Businesses Other Groups Summary 299 299 300 301 311 323 326 337 341 343 343 354 374 377 383 385 385 386 390 404 PART THREE Economics CHAPTER 12 Macroeconomics for Trading and Sales Introduction Capital Asset Pricing Model (CAPM) Overview of Macroeconomics The Fed Moving beyond the Big Three: Other Macroeconomic Concepts Other Variables 405 407 407 408 408 417 424 426 515 Notes In the Black-Scholes framework, where hedging is continuous, the option’s time value can be viewed as the expected value of the trading-related gains from delta-hedging This conversion of a level of implied volatility into an estimate of the average daily percent movement in the underlying stock price is intended only as a guideline The realities of delta-hedging are much more complex and the impact of factors such as intraday movements which revert (e.g., the stock rallies until midday and then sells off back to its original level by the close) or discontinuous jumps (e.g., overnight newsflow causing large moves in the stock price at the market opening) can have significant impact on the profits or losses from deltahedging that are not captured in the simplistic “divide by 16” estimate If the borrow costs are known then an adjustment can be made to the interest rate to account for them, which would allow the true level of implied volatility to be known Vega is not actually a Greek letter and is sometimes replaced by kappa (κ) Delta, gamma, and vega are only strictly additive for a single underlier, while theta and rho can be summed across multiple underliers to produce a picture of the aggregate exposure to the passage of time or rates Notwithstanding, it is common to aggregate delta, gamma, and vega across different underliers (with, perhaps, an adjustment for individual stock betas) to produce an estimate of the aggregate market exposure of the whole desk We are effectively taking the partial derivatives of the implied volatility with respect to maturity and strike Given the extremely conservative investor protection laws in the United States, I still find it refreshing and somewhat amusing to see the relaxed way in which highly complex, long-dated exotic derivatives are embedded into capitalprotected structures that are then sold to retail investors at local bank branch offices (and even post offices) across Europe Another type of exotic option that has a similar look-back feature (but is not path-dependent) is a chooser option, which allows the holder to decide at maturity whether the option was a call or a put Chapter 11 The Trading Floor By lowering the strike price to zero, the option is always deep in-the-money and has zero probability of ending out-of-the-money (the option to buy something for nothing is always worth something) It therefore has no curvature or volatility sensitivity and is a pure one-delta product The large stock positions held by passively indexed ETFs, mutual, and pension funds, whose managers not choose the stocks based on their particular fundamentals but simply to replicate the performance of a benchmark index, are an immensely useful pool of long positions that can be sourced by stock lending desks to provide short access to more dynamic traders For the index fund manager, the pick-up from lending stock is a welcome source of additional revenue, which improves their performance versus the benchmark 516 NOTES The assumption is that the broker is not aware that the uncovered short was deliberate, in which case the position would be bought-in immediately Depository Trust & Clearing Corporation data (www.dtcc.com) At current levels, this is approximately 120 years of U.S GDP Chapter 12 and Sales Macroeconomics for Trading This is not strictly correct Beta measures the sensitivity to the excess return over the risk-free rate However, over short periods, the difference is minimal and is generally ignored within the trading floor environment Our discussion of macroeconomics will be from a U.S.-centric viewpoint, though the general concepts can be applied to any country We will also allow the occasional imprecise use of “American” as the adjective for things pertaining to the United States, with apologies to our neighbors to the north and south for the linguistic arrogance Bureau of Economic Analysis data (www.bea.gov) as of July 31, 2008 “Investment,” in the computation of GDP, has nothing to with financial investments (purchases of stocks or bonds) as these not represent actual production of goods or services To be specific, the graph shows the rolling eight-quarter moving average of the annualized rate of real GDP growth based on seasonally adjusted data in constant, year 2000 dollars (Is anyone surprised I decided to hide this lovely bit of detail in a footnote?) The graph starts in 1949 because quarterly data were not available before then In economics literature this is often replaced by the Latin ceteris paribus The Federal Reserve Act of 1913 This formula comes from the same infinite series we used in Chapter on Valuation and Chapter on Futures These concepts are central to one of the key scenes in the holiday classic film It’s a Wonderful Life (1946) While George Bailey (played by Jimmy Stewart) never actually uses the term “fractional reserve banking,” when a mob of customers storm into his family-owned building and loan (a type of savings bank that specializes in mortgages) demanding their money, he desperately tries to explain it to them: “No, but you you you’re thinking of this place all wrong! As if I had the money back in a safe The money’s not here Your money’s in Joe’s house right next to yours and in the Kennedy house, and Mrs Macklin’s house, and a hundred others! Why, you’re lending them the money to build, and then they’re going to pay it back to you as best they can Now what are you going to do? Foreclose on them?” (Quote transcribed by the author) 517 Notes This sort of panicked withdrawal of deposits was, until very recently thought of as a depression-era phenomenon However, since the onset of the credit crisis in August of 2007, it has recurred numerous times around the world, triggering a wave of bankruptcies, capital injections, bail-outs, and, in some cases, nationalizations of what were previously considered perfectly sound banks 10 For simplicity, percentages are expressed of GDP excluding net trade, which, in the case of the United States, is actually a negative contribution 11 We will make the simplifying assumption that all foreign companies are kind enough to allow U.S consumers to pay in USD While this is not generally true— with the notable exception of oil and other commodities that trade in dollars globally—it greatly simplifies the explanation 12 U.S Treasury Department data (www.treas.gov) as of July 31, 2008 Chapter 13 Economic Data Releases The Institute for Supply Management was formerly known as the National Association of Purchasing Managers and the Survey of Manufacturing is still occasionally referred to as the NAPM survey According to its website (www.ism.ws), ISM defines supply management as “the identification, acquisition, access, positioning and management of resources and related capabilities the organization needs or potentially needs in the attainment of its strategic objectives.” This definition is effectively a generalized and more formal version of the intuitive notion of a purchasing manager as “the guy in charge of buying all the stuff.” Between March 2000 and October 2002, the SPX dropped nearly 49 percent and the NDX more than 83 percent The months of September and October of 2008 were arguably the most tumultuous to the global economic system since the Great Depression In the span of fewer than eight weeks, the two largest mortgage lenders in the United States, Fannie Mae and Freddie Mac, were nationalized; Lehman Brothers declared bankruptcy; Merrill Lynch was acquired by Bank of America; American Insurance Group (AIG) received a $150 billion bailout from the Treasury; Morgan Stanley and Goldman Sachs became bank holding companies; Washington Mutual Bank was seized by the FDIC; Fortis Bank was partially nationalized by the Benelux governments; Iceland nationalized all the major banks and suspended trading in the Icelandic krona; the Treasury made equity investments worth $125 billion in nine major banks; short-selling was partially or completely suspended in more than a dozen countries and trading in many emerging markets was halted as global equity markets dropped an average of between 30 and 40 percent from what were already depressed levels These were truly unbelievable days to be working in the financial services industry, the consequences of which will not be fully understood for many years Durable goods are generally defined as items with a life expectancy of at least three years 518 NOTES U.S International Trade in Goods and Services—Annual Revision for 2007, June 10, 2008 (www.census.gov) From the perspective of a given industry, each employer “consumes” (hires) only a single type of employee and there is, in general, little potential for substitution A hospital can’t fire a highly trained anesthesiologist and replace her with the local Starbucks barista just because he requires a lower wage Companies such as ExxonMobil, Royal Dutch-Shell, Total and British Petroleum that are involved in all aspects of the exploration, extraction, refinement, and distribution of crude oil and distillates Note that the average is computed using the actual overnight rates as reported by the New York Fed, not the target rate, though outside of times of significant stress in the markets, of which there was much in 2008, these will usually not differ significantly Greece did not adopt the euro until January 1, 2001 10 In recent years, more countries have joined the European Union, bringing current membership to 27 countries Three of these, Cyprus, Malta, and Slovenia have adopted the euro as their official currency However, by convention, the Eurozone is still used to refer only to the 11 countries (plus Greece) that adopted the euro at inception 11 Due to the large size and global diversification of many U.K companies, the significance of the Bank of England is somewhat greater than these statistics would suggest Weighing each country by stock market capitalization, the Bank of England oversees 28 percent of the European market cap while the ECB oversees 56 percent 12 The three largest economies in Euroland, responsible for approximately 65 percent of the Eurozone GDP 13 Belgium, Finland, Portugal, and Luxembourg are not included However, the included countries account for more than 92 percent of the Eurozone GDP Appendix: Mathematical Review The number e is irrational—a nonterminating, nonrepeating decimal, and therefore can never be written precisely as a decimal or fraction It is also a transcendental number (cannot be expressed as the solution to a polynomial equation), which sounds even cooler About the Author atthew Tagliani, CFA, has more than 10 years trading and risk management experience in delta-one products including equity swaps, ETFs, futures, and program trading He has worked at Morgan Stanley, Goldman Sachs, Credit Suisse, and Banco Santander in New York, London, and Madrid Prior to his professional career, he received a master’s degree in Applied Mathematics from the University of Massachusetts at Amherst He lives in London with his wife and two children M 519 Index 2007–2008, events of, xxiii, 170–171, 368, 372, 419, 439–441, 468, 517 Accounts, receivable/payable, 10–11 Accounting identity, 7, 12, 15, 22 Algorithmic execution, See Electronic trading American depositary receipt (ADR), 120–121 American option(s), 301, 334 put trading below intrinsic value, 334–335 Analysis: fundamental, 51 technical, 51–54 Arbitrage, 59, 62, 168–170, 233, 310–311 Asia ex-Japan, 163–165, 469–471 Ask, See Offer Assets, 6–7, 10 “At the touch,” 73 Authorized participant, 204 Average daily volume (ADV), 110, 176 Average price account, See Wash account Back office, 399–400 Balance sheet, 5, 6–14, 295 Baltic Dry Index (BDI), 428 Bank of England (BoE), 461, 462 Bank of Japan (BoJ), 467 Base effects, 435 Basis, 218 Basis trade, 254–259, 264 Bellweather companies, 478 Best execution guidelines, 82, 100 Beta, 196, 251, 408 Bid, 71–72 Bid-offer spread, 72, 187, 199, 238 Bid sheet, 193, 195–197 Black-Scholes formula, 326–333 Blind risk bid, 193–201 Bloomberg, 39–40 AQR (Average Quote Recap), 88 BBAM (British Banking Association), 270 BBO (Best Bid and Offer), 73 BQ (Block Quote), 76 CACS (Corporate Actions), 55 CALL (Calls), 341 CDR (Calendar), 220 CN (Corporate News), 40 COMP (Comparison), 54 CT (Contract Table), 261 DES (Description), 40, 510 DVD (Dividends), 57 ECO (Economics), 432 ECOS (Economist Estimates), 432 EQ (Equity Quote), 76 ERN (Earnings), 40 FA (Financial Analysis), 40 FFIP (Fed Funds Implied Probability), 456 FVD (Fair Value Detail), 237 G (Graph), 54 GIP (Graph of Intraday Price), 54 GMOV (Group Movers), 155 GP (Graph Price), 54 GPC (Candlestick Graph), 54 GPO (Hi-Lo Graph), 54 GRPS (Groups), 155 HCP (Historical Change in Price), 54 HDS (Holders), 509 HIVG (Historical Implied Volatility Graph), 341 HP (Historical Price), 54 HVG (Historical Volatility Graph), 338 IGPO (Intraday Hi-Lo Graph), 88 IMAP (Index Map), 155 MEMB (Members), 134, 510 MOV (Movers), 154 PUT (Puts), 341 OMON (Options Monitor), 340 OSA (Option Scenario Analysis), 377 521 522 Bloomberg (continued) OV (Option Valuation), 337 Q (Quote), 73 QR (Quote Recap), 76 QRM (Quote Recap & Market), 76 REQ (Related Equities), 40 RV (Relative Value), 40 SKEW (Skew), 377 TRA (Total Return Analysis), 145 WEI (World Equity Indices), 160 WGT (Weight), 134, 510 VAP (Volume at Price), 88 Book value, 10 “Bottom line,” 15, 19, 20 Brady Commission report, 168–169 Breakeven level, 312 BRIC countries, 158, 163, 164 Business cycle, 411–414 Buy-in, 392 Buy-side, 509 Calendar spread, See Roll, futures Call option(s), 300 overwriting, 377 Capital, 14 total, 14 weighted average cost of (WACC), 35–36, 44 working, 14 Capital introduction, 396 Capital Asset Pricing Model (CAPM), 408 Carry costs, 242 Cash, and marketable securities, 10 Cash drag, 211 Cash market, 69 Cash settlement, 400 Charting, 52 Chinese wall, 105, 509 Circuit breakers, 171 Commodity prices, 428, 479 Compliance, 396–397 Conference Board, The, 449–450, 451 Confirmation, long-form, 272 Controllers, 403 Conversion, 308 Corporate actions, 54–64 Correlation, 291, 381, 501–504 Corruption Perception Index (CPI), 469 Cost of goods sold (COGS), 16, 507 INDEX Cover, program trading risk bid, 197–198 Creation and redemption process, 204–205 Credit risk, 296, 404 Cross, 94 Cumulative distribution function, 333, 504 Currency, 115–120, 274, 289–292, 381 Current, definition of, 9, 14 Customer facilitation, 93 Customized baskets, 284 Cyclical, defensives versus, 478 Daily Program Trading Report (DPTR), 172–173 Day count, 219, 276 Days: in accounts payable, 30 in accounts receivable, 30 in inventory, 29–30 Dealer (buy-side trader), 104, 105–107 Debt, long term, 11 Deferred-month futures contract, 241 Delta, 356–360 adjustment of option prices, 345, 515 adjustment in EFP, 246–247 equivalent share position, 321 hedge, 331 neutral option trade, 345 neutral portfolio, 330–331, 343 of an option, 319–323 Depository Trust and Clearing Corporation (DTCC), 400 Depository Trust Company (DTC), 400 Depreciation, and amortization, 17, 21 Derivative, 217 Diffusion index, 435–436 Direct market access (DMA), 83 Discount rate, 418 Discount window, 419 Dividend yield, 37 Dividends, 56–58, 204, 220, 230–231, 239, 294 index points of, 142–143 preferred, 19 Divisor, index, 132, 133, 140–141 DK (“Don’t know”), 400 Double-entry bookkeeping, 7–9 Dual-listed securities, 121 DuPont Model, 33–34 Durable goods, 442, 518 Index Early termination, mutual right of, 277 Earnings: before interest and taxes (EBIT), 18, 20 before interest, taxes, depreciation and amortization (EBITDA), 18, 20 per share (EPS), 19 retained, 13 yield, 49 Economic statistics, 431–471 coincident, leading and lagging, 433 Europe: CPI, German states and preliminary national, 465 Euroland M3, 466 Euroland Purchasing Managers Index, 464–465 Flash GDP Estimates, 463–464 German unemployment report, 466 Harmonized Index of Consumer Prices (HICP), 462, 465–466 IFO Business Survey, 464 ZEW Financial Market Report, 464 Japan: Consumer Price Index (CPI), 468 Corporate Goods Price Survey (CGPS), 468 TANKAN survey, 468–469 Tertiary Industry Activity Index (TIAI), 469 United States: advance retail sales, 437, 474–475 consumer confidence survey, 449–450 Consumer Price Index (CPI), 444–446 continuing claims, 449 crude oil and distillate inventory data, 452–453 durable goods orders, 442 Employment Costs Index (ECI), 444, 447–448 Employment Report, 448–449 GDP Price Deflator, 444, 446–447 advance GDP estimate, 437 housing starts, 439 Index of Leading Economic Indicators, 451 industrial production report, 442 initial jobless claims, 449 ISM Report on Business, 438 National Income and Product Accounts (NIPA), 410, 432, 437 523 non-farm payrolls, 448 non-farm productivity, 448 Producer Price Index (PPI), 444, 446 Productivity and Costs Report, 444, 448 trade balance, 443 unit labor costs (ULC), 448 University of Michigan Consumer Sentiment Survey, 451, 475 Economic value added (EVA), 35–36 Effective date, 274 Electronic trading, 101–102 Emerging market access, 285–286 Employment, 414–415, 448–449 Enterprise value, 50 Equity: cost of, 43, 44 finance, 389 indices, global listing of, 147–165 risk premium, 43 total, 14 Error account, 82 Exchange-traded fund (ETF), 203–216 most popular, 215 popularity of, 208–210 trading, 205–207, 388 Europe, 159–163, 458, 510 European Central Bank (ECB), 458, 461–462 European exercise, 301 European Political and Monetary Union, 458 Eurostat, 459 Eurozone, 458 Exchange for physical (EFP), 245–254 Exchange, stock: structure, 76–81, 91–93 centralization of orders, 70–71 role as counterparty, 70 Expenses, 15 financing, 18 operating, 16 prepaid, 10 selling, general and administrative (SG&A), 17 Expiration (also Expiry), 219, 239–240, 261–262 Extraordinary items, 18–19 “Fair and orderly market,” 78 Fair value, futures, 218–221, 234–240, 511 Fed Funds Overnight Rate, 270, 418 524 Federal Depositary Insurance Company (FDIC), 420 Federal Open Market Committee (FOMC), 418, 453–454 Federal Reserve Board, 282, 442 Federal Reserve System ("The Fed"), 400, 417–424 Financial Industry Regulatory Authority (FINRA), 398 Financial Information Exchange (FIX), 174 Financing activities, 20, 23 Fixed assets, See Long-term assets “Flight to quality,” 480 “Flow begets flow,” 190, 200 Flow product, 282 Force majeure, 195 Foreign ownership limits (FOL), 285 Forward contract, 217–222 limitations of, 222–223 Fractional reserve banking, 419–420 Free cash flow, 23–24 to equity (FCFE), 44–45 to the firm (FCFF), 44–45 yield, 51 Free float, 127 Front month, 224, 241, 261 Front-running, 100 Futures contracts, 223–264 Fed Funds, 455–456 hedging versus speculation, 226–228 most popular, 261 symbology, 259–261 trading, 262–263, 389 Gamma, 360–363 relationship to theta, 364–370 Gap risk, 352 Gearing, 30 Generally accepted accounting principles (GAAP), 5, 6, 11, 16, 17 Global Industry Classification System (GICS), 154 Goodwill, 10 Greeks, 354–374, 515 Gross Domestic Product (GDP), 410, 411, 432, 437, 446–447 components of: consumer purchases, 410, 424 fixed investment, 410, 425 INDEX government expenditure, 410, 425 net exports, 410–411, 425–426 Gross profit, 17, 20 Growth stock, 38 Housing, 439–441 Humphrey-Hawkins, 423–424 Implementation shortfall, 187–189 Income: statement, 5, 15–20 net, 19, 21 net from continued operations, 18, 19 non-operating, 18, 21 operating, 15, 20 Index: calculation of multicurrency, 145–147 changes, 139–141 composition updates of, 124 implied level from portfolio execution, 137–139, 186–187 level, calculation of, 131–133 loss of information in, 129–130 options, 390 replication via ETFs, 211, 212–214 replication via swaps, 282–283 replication, risks of, 295 scope of coverage, 125–126 selection criteria, 126–127 shares, 131, 133 weighting schemes, 127–129 Infinite sums, 45–46, 263 Inflation, 415–417, 444 hawkish versus dovish, 453 In-kind crossing, 190 In-kind transfers, 205 Inside quote, 72 Institute for Supply Management (ISM), 438, 517 Intangible assets, 10 Inter-dealer brokers (IDB), 254 Interest rate(s), 295, 427 risk-free, 218, 220, 331 International Swaps and Derivatives Association (ISDA), 293 Intrinsic value, 305 Inventory, 10, 16–17 Investing activities, 20, 23 Investments, long term, 10 Ito’s Lemma, 330 525 Index Japan, 163, 467 MSCI Barra, 156–158 Multiplier, 223, 300 Kappa, 515 Labor force, 414 Legacy portfolio, 190 Legal department, 396–397 Levels, support and resistance, 52 Leverage, 8, 31, 282 Liabilities, 6–7, 11 Limit price, 71 Liquidation value, 10 Liquidity, 72, 238 of a company, 21 of a portfolio, 196 Listed lookalike, 378 Lognormal distribution, 328 London Interbank Offer Rate (LIBOR), 269–270 Long position: option, 300 stock, 71 Long Term Capital Management, 233, 421 Long-term, definition of, Loss ratio, 94, 195 “Making a market,” 77 Margin, 204, 231–233 as measure of profitability, 31–32 gross profit, 31 net profit, 32 operating profit, 32 Market: access, 268 capitalization, 55, 477 depth, 73 impact, 109–110 makers, 76–77 risk, 108–109 Mark-to-market accounting, 90 Maturity date, 219, 274, 300 Mergers and acquisitions, 59–64 Middle office, 401 Minority interest, 12, 14 Monetary aggregates, 427 Monetary policy, 418, 421–423 Money multiplier effect, 419–420 Money supply, 427 Moneyness, 304–305, 315,–316 Moral suasion, 421 NAHB/Wells Fargo Housing Market Index, 441 NASDAQ, 149–150 National investor number (NIN), 285 National Securities Clearing Corporation (NSCC), 400 Net asset value (NAV), 203, 204, 207–208 Net present value (NPV), 229, 287–289 Normal distribution, 333, 500 Notional, 274 Offer, 71, 72 Open interest, 224 Operating activities, 20, 21 Option(s): contract, 300 exotic, 379–383, 390 pricing of a trade, 344–345 Options Clearing Corporation, 400 Order book, 73, 75 Order(s): agency, 82–93 communication of, 112–115 matching on the exchange, 73–76 principal, 93–99 submitting to the exchange, 72 instruction buy-minus, 169 sell-plus, 169 beat the close, 97–98, 192 block trade, 95–96 course of day (COD), 88 descriptive, 86 good ‘til cancelled (GTC), 89–90 guaranteed VWAP, 96, 192 held, 84 in line, 85 limit (LMT), 84 limit-price stop, 98 market (MKT), 75, 84 market-on-close (MOC), 90–91 market-on-open (MOO), 91 not held (NH), 84 percentage of volume (POV), 84 risk price (bid or offer), 93 stop, 89 time-weighted average price (TWAP), 88 526 INDEX Order(s): (continued) volume-weighted average price (VWAP), 86–88 work, 85 would, 85 Output gap, 442 Over-the-counter (OTC), 222, 377–379, 512 Owner’s Equivalent Rent (OER), 445, 466 Put-call combo, 306–308 Put-call parity, 308–311 Paid-in capital, 13 “Painting the tape,” 95 Participation rate, 414 Path dependence, 379–380, 471 Payments, calculation of swap, 277–279 Payoff structure of options, 301–304 Pension obligation, deferred, 12 Percentage weight of an index constituent, 133 Pin risk, 359 Plant, property and equipment, 10 Poison pill, 61 Portfolio execution, analysis of, 184–189 Portfolio manager (PM), 104, 105 Portfolio: construction of an index replicating, 134–136 rebalance of an index replicating, 141–142 Preferred stock, 13, 19 Premium, option, 300 buyers versus sellers, 366–368 Pre-trade analysis, 176–178 Price: action, 100 multiples, 49–51 return, 143, 275–276 Prime brokerage, 394–396 Productivity, 448 Profit: net operating, after taxes (NOPAT), 36 pretax operating, See Earnings before interest and taxes (EBIT) Profitability: measures of, 19–20 non-GAAP measures of, 35–37 Program trading, 167–202, 388 order management system, 174–176, 178 benefits of, 172, 183–184 quality of execution, 180–181 Proprietary trade, 99–101 Put, 300, 313 Rate reset, 275 Ratio: acid test, See quick ratio activity, 29–30 cash, 29 current, 28 debt-to-equity, 30 dividend, 37–38 enterprise value to EBITDA, 50 interest coverage, 31 payout, 37 PEG, 50 price-to-book (PB), 50–51 price-to-cash-flow (PCF), 51 price-to-earnings (PE), 49–50, 508 price-to-sales (PS), 51 profitability, 31–37 quick, 28–29 retention, 37 risk/leverage, 30–31 times interest earned, 31 liquidity, 28–29 Reaction function, 431, 471 Real return, 416 Regulation, financial services industry, 397–399 Regulation SHO, 170, 394 Regulation T, 282, 512 Rule 10a-1, 170 Rule 80A, 169 Rule 80-B, 171 Reserve requirement, 419 Reset, 274–275 Return, 31 on investment, cash flow (CFROI), 36–37 measures of, 32–35 on assets (ROA), 33, 34 on capital employed (ROCE), 34–35 on (common) equity (ROE), 33, 34 on invested capital (ROIC), 35–36 on investment (ROI), 32, 64 Quant funds, 367–368 Quantitative and derivative strategies group, 390–391 Quanto, 261, 290 Quote, 72 527 Index Revenue, 15 Reverse conversion (reversal), 308 Rho, 372–373 Rights offering, 59 Risk: arbitrage, 62 EFP, 253–254 management, 401–404 Roll, futures, 240–245 Russell, 150–152 Rebalance, 151–152 Sales, 103–105, 388 net, 15, 19 Sales-trading, 105–107, 387 Seasonal adjustments, 434 Secondary offering, 59 Sectors, 154–156, 176, 188, 197, 478–479 Securities and Exchange Commission (SEC), 398 Securities lending, See Stock loan Self-regulatory organizations (SRO), 398 Sell-side, 509 Settlement: cash versus physical, 224–226, 301 of trade, 57, 509 Shareholders’ equity, 7, 12–13 Short: option position, 300 sale, 71, 394 covering, 71 -term financing, 11 Solvency ratios, See Liquidity ratios Special situations, 60 Specialist system, 77–78 Spin-off, 58–59 Spot, 217 convergence of futures to, 221–222 Standard and Poors, 148–149 Statement of cash flows, 5, 20–24 Statement of shareholders’ equity, 13 Stochastic process, 327 Stock loan, 239, 268, 294, 391–394 Stock split, 55–56 STOXX, 159–160 Strategic Petroleum Reserve, 452 “Street-side,” 82, 399 Strike price: of a portfolio, 187 option, 300 Style, 478 Subject, declaration of an order as, 93 Swap, equity: back-to-back, 280–281 bullet, 274 hedging of, 286–287 legs of, 274 long, 269 (pre)definition, 268, 272 short, 279–280 trading, 389 Synthetic stock, 287, 306 Tailing futures, 248–252, 263 Tape, printing to, 74 Target portfolio, 190 Tax liability, deferred income, 11 Tender offer, 60 Term borrow, 392 Term sheet, 272–277 Termination date, 274 Theta, 363–370 Tick, 74 Time decay, 364 Time to maturity, 315, 317–319 Time value, 313–315 “Top line,” 15, 19, 20 Total return, 143, 144–145, 275 Tracking, 196, 199, 295 Trade date, 274 Trader, 107–112, 386–387 Trading floor, 385–390 Trading halt, 78 Transaction costs, 238, 268, 507 Transition management, 189–191 Transparency International, 469 Treasury stock, 13 Triple-witch, 262 Turnover: asset, 33 inventory, 29–30 payables, 30 receivables, 30 Two-pillar strategy, 462 Two-way market, 93 Underground economies, 414 Underlier, 300 Unemployment rate, 414, 449 528 University of Michigan Survey Research Center, 451 Unwind price, 276 Upstairs, 93 Valuation, 40–51 discounted cash flow, 41–48 dividend discount model, 43–44 Gordon growth model, 46–47 relative, 41, 48–51 Valuation date, 274 Value stock, 39 Value-at-Risk (VaR), 402 Variance swaps, 382–383 Vega, 370–372, 515 Volatility, 196, 199, 291, 315, 316–317 calculation of, 323–324 Index (VIX), 479 scaling with square root of time, 324–325, 329 INDEX skew, 375–377 smile, 375 surface, 374 swaps, 382–383 term structure of, 374–375 trader, 343–344, 353–354 volatility of, 380 historical, 338 implied, 338–341, 345–346 versus realized, 346–352 Volume smile, 508 Wash account, 75, 82 Wealth effect, 422 Whisper number, 473 White knight, 61 Writer, option, 300 Zero interest rate policy (ZIRP), 467–468 Praise for The Practical Guide to Wall Street “An extraordinary accomplishment This clear, well-written, and insightful book is an indispensable resource for any new entrant to the business and an enormously useful reference for more experienced practitioners as well Books on finance come and go, this one will stay the course.” —Sam Kellie-Smith, Managing Director, Global Head of Equity and Equity Derivative Trading, Morgan Stanley “The Practical Guide to Wall Street is an excellent introduction to the wide range of products traded in an equities business today I’d enthusiastically recommend it to any new hire in the sales or trading business.” — Simon Yates, Managing Director, Global Head of Equity Derivatives and Co-Head of European Securities, Credit Suisse “Since 2002 I have been teaching MBA courses on equity markets and equity derivatives Prior to that, I worked for eighteen years at Goldman Sachs in equity derivatives Until now, I have never found a textbook that combines practical wisdom with academic rigor Matthew Tagliani’s book, The Practical Guide to Wall Street, provides that unique combination I hope to use it in the classroom immediately.” — Mark Zurack, Professor and Visiting Lecturer, Columbia Business School and Johnson School of Management, Cornell University “Mr Tagliani has done what few have managed to before—demystify the machinery of the financial industry in plain and accessible language A hands-on introduction to what happens on the Street—if you are entering or thinking of joining the financial industry; or even if you simply want to understand what your next door neighbor does, this book is a must.” — Nikunj Kapadia, Associate Professor, Isenberg School of Management, University of Massachusetts Amherst “This book will provide a great head start for anyone considering joining an equities trading floor It contains a wealth of detail and covers the issues that traders, salespeople, and their customers deal with on a day-to-day basis It spares the reader unnecessary technicalities and focuses on the points that matter to finance professionals.” — Sandy Rattray, Portfolio Manager, GLG Partners wileyfinance.com ... entries to the balance sheet—one to record the change in assets, the other to record how it was paid for—or alternatively, to whom it belongs (the owners of the company or the creditors) Of the four... Mathematical Review The Appendix provides a brief review of the mathematical concepts necessary to understand the material in the book and relate intelligently to others on the trading floor There... (credit), then the offsetting adjustment to the addition of $600 to the equipment line on the left-hand side would be an increase in the liabilities of the company (the borrowed funds) on the right-hand