CHAPTER 20 Approaches to Trading and Hedging

The term trading covers a wide range of activities. Market makers who are quoting two-way prices to market participants may be tasked with providing a customer service, building up retail and institutional volume, or with purely running the book at a profit and trying to maximise return on capital. The nature of the market that is traded will also have an impact on their approach. In a highly transparent and liquid market such as the U.S. Treasury or the UK gilt market the price spreads are fairly narrow, although increased demand has reduced this somewhat in both markets. However, this means that opportunities for profitable trading as a result of mispricing of individual securities, while not completely extinct, are rare. It is much more common for traders in such markets to take a view on relative-value trades, such as the yield spreads between individual securities or the expected future shape of the yield curve. This is also called spread trading. A large volume of trading on derivatives exchanges is done for hedging purposes, but speculative trading is also prominent. Very often, bond and interest-rate traders will punt using futures or options contracts, based on their view of market direction. Ironically, market makers who have a low level of customer business—perhaps because they are newcomers to the market, or for historical reasons or because they do not have the appetite for risk that is required to service high-quality ...

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