Financial institutions do a huge volume of trading in a wide range of different financial instruments. There are a number of reasons for this. Some trades are designed to satisfy the needs of their clients, some are to manage their own risks, some are to exploit arbitrage opportunities, and some are to reflect their own views on the direction in which market prices will move. (The Volcker rule in the Dodd–Frank Act, which will be discussed in Chapter 16, prevents U.S. banks from trading for the last two reasons.)
We will discuss the approaches a financial institution uses to manage its trading risks in later chapters. The purpose of this chapter is to set the scene by describing the instruments that trade, how they trade, and the ways they are used.
5.1 THE MARKETS
There are two markets for trading financial instruments. These are the exchange-traded market and the over-the-counter market (or OTC market).
Exchanges have been used to trade financial products for many years. Some exchanges such as the New York Stock Exchange (NYSE; www.nyse.com) focus on the trading of stocks. Others such as the Chicago Board Options Exchange (CBOE; www.cboe.com) and CME Group (CME; www.cmegroup.com) are concerned with the trading of derivatives such as futures and options.
The role of the exchange is to define the contracts that trade and organize trading so that market participants can be sure that the trades they agree to will ...