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S&T Interview Guide

Terms in this set (120)

What is the difference between a broker, fund manager and a sell-side trader?
A broker is an agent that matches buyers and sellers. A broker does not execute a trade unless he has both sides of the trade lined up, sort of a matchmaker. Therefore, brokers do not take any risks, they never hold any positions. A fund manager, or portfolio manager controls a certain amount of money and invests it according to a strategy for other people. A sell-side trader, also known as a market maker, facilitates customer orders by always being willing to buy or sell at a certain price, acting in a dealer capacity.
Why would a bank willingly take on a trade from a client, knowing in advance it will make a loss on that trade?
This is actually fairly common in the equities space. A lot of times, a client will want to sell X shares, where X is a multiple of the daily volume of the stock. The bank will make him a price, knowing that chances are the price they will be able to get out of that position will be worse than they offered the client. However, the client pays commission for the trade, and most likely prime brokerage fees to the bank. The key is that the commissions and prime brokerage fees cover any losses facilitating their trades.
What is the bid-ask spread?
The bid is the price the market maker is willing to buy and the ask is the price at which he is willing to sell. The more illiquid the security, the higher the bid ask spread.
What is a market maker?
They are the dealers who maintain inventory of securities and are willing to buy and sell at any time, thereby acting as liquidity providers in the market. They are usually stuck with positions that nobody else wants, with a size that is too big to get rid of. If a market maker wants to get rid of a position quickly, he will also probably have to become a market taker and hit someone else's bid. The skill here is to obtain an inventory that will have near term demand.
You are a market maker, and post a price of 98-100. Someone lifts you at 100. Explain why you can't simply earn an immediate profit by buying at 98.
If you sell at 100, in order to be able to buy at 98, the stock either has to go down in price, or you need another customer to come in and want to sell shares to you. If you don't get a customer who wants to take that other side, you have to act as a market taker and ask another maker maker for a price. If he has the same prices (98-100), in order to cover your short, you need to lift him at 100, and therefore you have not made any profit.
Explain why market makers tend to make more money in calm periods and lose money in volatile periods.
In calm periods, it's easier and less risky to earn a spread. Let's say a stock gets hot, and everyone demands it. Customers keep calling the market maker for a price, and they keep buying, making the market maker short. As the stock rises the market maker keeps increasing his prices, but the average sell price is below the current price as he has been selling all the way up. Therefore at the peak, the market maker has suffered a huge build up of a short position at a loss.
What is the difference between an agency and risk trade?
An equities market maker at an investment bank can take two types of trades. An agency trade, where all he does is simply execute the trade for the client in the marketplace, therefore neither the trader nor the bank takes any risk on the position. On the other hand, the client may ask for a risk trade, which means immediate execution as the trader takes the position in his book. Risk trades are done if the client needs to move a certain size and he doesn't want to wait for it to be executed in pieces in the market.
Explain how a market maker is also a market taker.
A market taker is also a market participant, and if he needs to unload or needs to take on a certain product and can't wait until an order comes to him, he will have to act as a market taker.
"Make me a market on the area of the U.S. in square miles"
Let's assume the state of Florida is 500 miles long, and we can fit around 5x the length on the east coast, and the U.S. is twice as wide as it is tall. So that would be (500*5)^2 = 6.25 square miles. So I'll make you a market of 6-6.5 million.
"Mine at 6.5. Make me another market."
The key here is you need to buy for less than this price to make a profit. So after the trader buys for 6.5, move the price up to a bid that is less than the average price you sold for. For example, 6.25 - 6.75 million. Now if he sells to you, you buy back at 6.25 and make a .25 profit from covering the 6.5 short at a price of 6.25. Now you have sold 2 at an average price of 2.625 (6.5+6.75/2), therefore your next bid needs to be below this number, and so on.
What is a derivative security?
A security whose value is based on an underlying asset.
How are derivatives used?
They can be used for portfolio hedging, and as levers to express a particular view of the underlying.
What's the difference between a future and a forward?
Both are obligations to buy the underlying at a set price at a future date. There difference is that a futures are traded on exchanges that are standardized and is marked to market, while a forward is an OTC product traded in the secondary market.
What does marked to market mean?
An investor has to put up margin when they buy the product, and if the product drops in value, they might have to put up more margin as collateral.
Underlying is at 100, 1 yr. interest rate is 10%, what is the 1 yr. forward?
F = S * e^(r+c-d)t

e = ln
r = rate
c = cost
d = benefit (dividend)
t = time

F = 100 * e^0.1 = 110.52
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