Course Name: Investment and Merchant Banking

Chapter note
Prepared by SM Nahidul Islam
Dept. of Finance & Banking
Islamic University, Kushtia.

Chapter Trading

Questions at a glance:

1. Describe the basic approach of trading.

2. Describe Market Making and Day Trading
3. What do you mean by Arbitrage? Describe the different types of Arbitrage.
 SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
1. Describe the basic approach of trading.
Or
Define efficient market & state the types of efficient market
Or
Define technical analysis. State the assumptions of technical analysis.

Answer: There are following three basic approaches to trading.

1. Fundamental analysis: Fundamental analysis is really a logical and systematic approach to
estimating the future dividends and share price. It is based on the basic premise that share
price is determined by a number of fundamental factors relating to the economy, industry and
company.
The purpose of fundamental analysis is to evaluate the present and future earning capacity of
a share based on the economy, industry and company fundamentals and thereby assess the
intrinsic value of the share .The investor can compare the intrinsic value of the share with the
prevailing market price to arrive at an investment decision.
2. Market efficiency hypothesis: A market for securities in which every security's price equals
its investment value at all times, implying that a specified set of information is fully and
immediately reflected in market prices. Different forms of efficient market are given below:
a. Weak-form market efficiency: It states that any information contained in the past is
already included in the current price and that its future price cannot be predicted by
analyzing past prices. This is because many market participants have access to past price
information, and hence any free lunches would have been consumed.
b. Semi strong-Form Market Efficiency: A level of market efficiency in which all relevant
publicly available information is fully and immediately reflected in security prices.
Information available to the public includes past prices, trading volumes, economic
reports, brokerage recommendations, advisory newsletters, and other news articles.
c. Strong-form market efficiency: It implies that all relevant information, public or private,
is immediately and fully reflected in security prices. Thus this information cannot be used
to earn abnormal profits.
3. Technical analysis: Technical analysis attempts to use information on past price and volume
to predict future price movement. It also attempts to time the markets. For its purposes,
technical analysis is based on several key assumptions, including:
a. Demand and supply determine market price.
b. Securities prices tend to move in trends that persist for long periods.
c. Reversals of trends are caused by shifts in demand and supply, which can be detected in
charts.
d. Many chart patterns tend to repeat themselves.
Technicians have developed numerous techniques, which attempt to predict changes in demand
(bulls) and supply (bears).

Islamic University, Kushtia 2

 SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
2. Describe Market Making and Day Trading

Answer: Market making is an integral part of a dealers operation and is necessary for the
underwriting business. In addition, the information on market flow the dealer obtains through
market making is valuable. Dealers stand ready to buy at bid and sell at offer (asked). The bid-
asked spread is largely determined by the dealers perception of risks such as price uncertainty
and carry in making the market. During volatile periods market makers widen the spread to
protect themselves. If the trader is making a market but feels that the market is going against
him, he will hedge with other highly correlated securities.
In day trading, traders make money by buying securities or currencies and then selling them
again in a short period, hoping to gain a small fraction of a point on the sale. Day trading is not
investing, however. Day trading is a tough profession that is not for the faint of heart. It is a risk-
versus-reward scenario that may allow the astute and disciplined trader who studies the art and
science of day trading to make profits greater than what he or she would make at most other
professions.

3. What do you mean by Arbitrage? Describe the different types of Arbitrage.

Answer: Arbitrage is the simultaneous buying and selling of securities, currency, or

commodities in different markets or in derivative forms in order to take advantage of differing
prices for the same asset. Several types of arbitrage are given below
1. Index Arbitrage: An index arbitrage trades in the cash and futures markets when the
differences between the theoretical futures price and actual futures price are sufficiently
large to generate arbitrage profits. A trader can generate arbitrage profits by selling the
futures index if it is expensive and buying the underlying stocks, or by buying the futures
contract when it is cheap and selling short the underlying stocks.
2. Convertible Arbitrage: A convertible arbitrage involves the purchase of convertible
bonds or preferred stocks and then hedging that position by selling short the underlying
equity. The resulting position generates income from the accrued interest or preferred
dividends and interest earned on the short-sale proceeds.
3. Mergers and Acquisitions Risk Arbitrage: Risk arbitrage is an integral part of
proprietary trading. Arbitrageurs take a position in firms in a merger or a takeover. They
are interested in the deal, not in becoming shareholders. In order to commit funds, they
must have reasonable belief that the deal will go through. The standard strategy is to go
long on the target and short on the acquiring firm.
4. Structural Arbitrage: The objective is to identify opportunities through the recombination
and restructuring of securities. Historically, structural arbitrage has generated handsome
profits for pioneering investment banks. Many forms of structural arbitrage have been
implemented across the capital markets, but this activity is most prevalent in the global
fixed-income markets.
5. Convergence trading: It is a trading strategy consisting of two positions: buying one
asset forwardi.e., for delivery in future (going long the asset)and selling a similar asset
Islamic University, Kushtia 3
 SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
forward (going short the asset) for a higher price, in the expectation that by the time the
assets must be delivered, the prices will have become closer to equal (will have converged),
and thus one profits by the amount of convergence.
6. Yield Curve Arbitrage: A yield curve arbitrage involves trading bonds of different
maturities on the yield curve. A trader would long the cheap part of the curve and short the
rich. If the arbitrageur is successful, he will be able to unwind his positions at a profit
because the abnormal yield spread will have returned to the expected norm in one of
several ways:
The security shorted will have fallen in price and risen in yield.
The security purchased will have risen in price or fallen in yield.
A combination of the above two will have occurred.
7. Covered Interest Arbitrage: Covered interest arbitrage involves the short-term
investment in a foreign currency that is covered by a forward contract to sell that currency
when the investment matures.

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