Chapter 4
INTRODUCTION TO TRADING AND HEDGING
In this chapter we introduce the basics of trading and hedging as employed by a bank asset–liability management (ALM) desk. The instruments and techniques used form the fundamental building blocks of ALM, so the reader can imagine that a full and comprehensive treatment of this subject would require a book in its own right.1 Our purpose here is to acquaint the newcomer to the market with the essentials, with further recommended reading suggested in the Bibliography.
The ALM and money market desk has a vital function in a bank, funding all the business lines in the bank. In some banks and securities houses it will be placed within the Treasury or money market areas, whereas other firms will organize it as an entirely separate function. Wherever it is organized, the need for clear and constant communication between the ALM desk and the other operating areas of the bank is paramount. We present an overview of ALM, liquidity and interest rate strategy in the next chapter; here we look at specific uses of money market products like deposits and repo in the context of yield enhancement and market-making.
TRADING APPROACH
The yield curve and interest rate expectations
When the yield curve is positively sloped, the conventional approach is to fund the book at the short end of the curve and lend at the long end. In essence, therefore, if the yield curve resembled that shown in Figure 4.1 a bank would borrow, say, 1-week funds while simultaneously ...
