Part I

Introduction to Trading
 ch 1
Trading in Bond Markets
Introduction to Financial Trading

This is the first in our series of ‘‘finance notes’’. Our aim in the present
chapter is threefold:
(i) Give a brief indication of what constitutes the financial system. The
best way of answering the question ‘‘What is the financial system?’’ is to go
straight to specific cases and analyse them, so we won’t spend too much time
with abstract preliminary discussions. All we do here is to introduce you to
the main players and their field of action.
(ii) Introduce our first main example of a financial instument, bonds. We
will study bonds quite extensively in the next few chapters, and when we
move on to other types of financial instruments (such as stocks) later in the
course, we will find that most of the general insights that we gained from
studying bonds carry over into the analysis of those other assets.
(iii) Most importantly, the present chapter explores in great detail what
it means to ‘‘trade’’ in financial instruments, and how an investor can build
up a trading positon, maintain it and relinquish it. Our discussion may seem
pedantic or overly technical on first reading, but a good understanding of the
principles of asset trading will be essential in all our future work and will
enable you to see the rationale behind the various pricing rules that will be
developed in this course.
The main purpose of this course is to enable you to make judgements on
financial matters that are based, not on belief or memorised formula, but on
knowledge and true understanding. The present handout begins to lay the
foundation for this endeavour.

Supplementary Reading The introductory chapters in Bodie/Merton, Luen-

berger and Bailey offer concise general introductions into the role of finance.
Chapter 2 in Sharpe gives a full account of the pracicalities of securities trad-
ing, inclusing short-selling. All of these texts have good chapters on the
specifics of bonds; another good introduction to bonds is in the early chapters
of Taggart.
1: Trading in Bond Markets 5

1 The Financial System

This part of the handout gives a rough preliminary sketch of the basic tasks
that need to be performed by the financial system. We keep this discussion
deliberately very brief, as most of the underlying issues are best understood
in the context of specific cases.

1.1 Actors, Objects, Actions When investigating an economic phenomenon,

we need to ask three basic questions: (1) Who are the economic actors in-
volved? (2) What objects do these actors face? (3) What kinds of actions do
these actors perform on these objects?
In finance, the answers to these questions are: investors (the actors) form
trading positions (the actions) on assets (the objects). We elucidate these
concepts in the next few sections, and we will find out much more about
various possible manifestations of these concepts as the course progresses.
Typical examples of investors include private households who desire to
build up savings for the future or who demand a loan to boost their current
spending power, commercial enterprises who are in need of external capital
funding for a new product line, or various specialist financial institutions like
investment banks, hedge funds, or insurance companies.
Investors interact with each other by issuing and exchanging financial
assets, that is, promises of current or future cash payments. Examples for
assets are current cash, bank deposits and bank loans, corporate bonds and
common stocks. Some of these assets (like a personal loan contract between
two business people) are tied to two specific individual parties and cannot
be transferred to other investors, but the most important types of asset can
be traded between investors once they have been issued. Such tradeable
assets are called securities. Many features of non-tradeable assets can best
be understood against the background of tradeable securities, and for the
moment we shall focus entirely on one class of such securities, bonds.
We also allow for so-called derivative assets, which are claims not on
cash but on other assets. The financial industry generates many forms of
derivatives (options, futures, warrants), but for the moment we need consider
only one very simple derivative, a borrowing contract on a bond.
By trading in assets, an investor builds up a trading position. The selling
of an asset results in a short position, while the buying of an asset yields a
long position. Investors can form very complex mixtures of long and short
positions, and much of our understanding of the financial system will depend
at its most basic level on understanding the rules that govern the formation
of trading positions.
1: Trading in Bond Markets 6

1.2 Time Profile of Cash Flows (Surplus and Deficit) We consider investors who
engage with each other by exchanging current and future cash commitments
(tradeable assets).
The key function of trading in an asset market is to enable individual
investors to tailor their cash-flow profiles over time, according to their par-
ticular individual needs.
Some investors are in need of receiving an extra inflow of current cash, and
in exchange they are prepared to commit to future cash outflows. These
investors are called deficit units or fund users.
Other investors are in need of securing extra cash inflows in the future, and
in exchange for receiving the promise of such a future cash inflow, they are
prepared to accept a current cash outflow. These are called surplus units or
fund providers.
Trading in assets makes it possible to match the surplus funds of the fund
providers with the deficit funds of the fund users. This matching is effected by
allowing the deficit units to issue promises of future payment (eg, bonds) and
sell these promises to the surplus units. These transactions transfer current
cash from the surplus units to the deficit units, followed by reverse cash flows
in the future.

1.3 Brokers Investors often hire the services of a ‘‘broker’’, an agent who
engages in the buying and selling of assets on behalf of his clients. Any profits
and losses associated with a trading transaction are with the client; the broker
merely receives a fixed service fee from the client. By contrast, if a trader
trades on his own account (rather than on behalf of a client), he is called a
‘‘dealer’’.

1.4 Specialist Investors Apart from the ‘‘public investors’’ who have external
reasons for issuing or buying bonds (deficit and surplus units), there is an im-
portant third group of investors who have no specific external funding needs
but who specialise in various aspects of financial trading as an aim in itself.
We shall refer to these investors as ‘‘specialist investors’’, in contradistinction
to the ‘‘public investors’’ or ‘‘ordinary investors’’. Examples of specialist
investors are investment banks, hedge funds, dealers, insurance companies,
pension funds. These institutions play many and vied roles. Some of the
activities of specialist investors involve the ‘‘speculative motive’’ and the
‘‘arbitrage motive’’. Speculators trade to exploit the fact that their own pre-
dictions of future prices differ from the rest of the market; arbitrageurs trade
to exploit a current mis-pricing of assets.
Most public investors do not engage in speculative trading or arbitrage
trading. However, even if you are an ordinary retail investor who simply
1: Trading in Bond Markets 7

wishes to deal with a particular external funding problem, the environmnent

in which you act will be shaped by specialist arbitrage investors, and it is
therefore important for you to understand what effects the activities of these
specialists will have on the market.

1.5 Assets: Bonds The primary concept in all of finance theory is the notion
of an asset. An asset is a current entitlement on the receipt of future payoffs
(cash payments). The asset’s future payoffs may be safe or risky. If the payoffs
are safe (no risk), we refer to the asset as a bond, or more generally as a
fixed-income security. We shall investigate bonds in greater detail further
below. Current cash represents the special case of an asset whose paysoff
occur immediately, at present.
Every bond embodies a relationship between two investors, namely, the
initial issuer and the current owner. The bond is created by an investor in
need of current cash (a deficit unit). To obtain current cash, the investor
issues the bond, a certificate entitling the owner of the certificate to certain
future cash payments. The issuer sells this certificate to an investor who has
a surplus of current cash (a surplus unit).
After having sold the bond, the issuer of the bond owes money to the
current owner of the bond — he has taken on debt and is a borrower. By
contrast, the purchaser of the bond is owed money by the issuer — he has
given a credit to the issuer and is a lender.
For many assets, the initial purchaser of the asset is entitled to re-sell
the asset to third parties; this is called secondary trading. Such a transaction
transfers all entitlements from the initial purchaser to the new owner. If
the bond initially represents a credit relationship between original issuer and
initial purchaser, after re-selling this old credit relationship has ceased and
has been replaced by a new credit relationship between the new owner and
the original issuer. Thus, under secondary trading, the borrower remains
unchanged (the original issuer of the bond) but the lender keeps changing
(the current owner of the bond).

1.6 Borrowing Contract on an Asset Consider two investors, investor L who

owns a unit of the bond but does not currrently want to trade in it, and
investor B who wishes to trade in the bond but does not currently own any
units of the bond.
A borrowing contract on a bond connects these two investors and enables
investor L to get into trading without having to purchase the bond. The
borrowing contract lets investor B temporarily borrow a unit of the bond from
its current owner L, against a small borrowing fee. If the contract period
extends over any of the bond’s payoff dates, then the certificate will also
specify the obligation of the borrower to pay those payoffs to the lender at
1: Trading in Bond Markets 8

their due date. Throughout the lending period, ownership of the underlying
bond remains with the lender.
Lender L keeps the borrowing contract as a security and to him (the
lender), this certificate is itself an asset, namely a claim to be given back
the bond by the borrower, and hence an indirect claim on the payoffs that are
promised by the bond itself. Borrowing certificates on primary assets are of
special importance in the design of short-selling strategies.
In practice, the borrower typically has to put down a ‘‘margin payment’’
with a third party (broker) that provides the lender with some collateral se-
curity. Here we shall ignore margin requirments.
Note that the lender never loses any payoffs from the bond; he merely
loses the ability to sell the bond during the lending period. Thus, the borrow-
ing fee has to compensate the lender only for the inconvenience of not being
able to sell, but not for any direct reduction in bond payoffs. For this reason,
borrowing fees are typically fairly small, and here we will often ignore them.
A borrowing certificate on a primary bond such as a bond is a special (and
very simple) type of a derivative asset, or simply a derivative. Derivatives are
claims on claims on cash, and as such they are themselves claims on cash,
albeit indirect ones.

1.7 Markets Bonds are issued and held by investors. Investors may trade
assets in markets. Trade is a transaction between two parties, a buyer and
a seller. Markets where an agreement to trade is immediately followed by
the actual trading transaction are called spot markets. By contrast, markets
where the agreement precedes the actual transaction are called forward mar-
kets. For the moment, we shall confine our attention to spot markets.
In a trading transaction, the seller gives up ownership of the asset in
return for the receipt of a cash payment, while the buyer parts with cash in
return for receiving ownership of the asset. The agreed cash payment that the
buyer makes to the seller is called the asset’s price. Prices in spot markets are
called spot prices, as opposed to forward prices. Once the trading transaction
has taken place, all the asset’s entitlements to future cash payments have
been transferred from the seller (the previous owner) to the buyer (the new
owner of the asset).

1.8 Market Price and Market View If we find an asset traded at a particular
market price p, this price tells us a great deal about ‘‘how the market views’’
the asset. Notice that there are always two parties to every trading transac-
tion; the buyer can only buy the asset if there is a seller who is willing to part
with it, at the agreed price. Actually, in truth there are four parties here, not
just two. In addition to the actual buyer and the actual seller, there are also
two hidden additional parties, namely the potential buyer who doesn’t buy at
1: Trading in Bond Markets 9

this price and the potential seller who doesn’t sell at this price. Thus, if the
price is p, we know that:
The buyer puts a value of at least p on the asset (otherwise he would not have
purchased it for this price);
the seller puts a value of at most p on the asset (otherwise he would not have
parted with it at this price);
investors who did not purchase the asset put a value of less than p on the
asset (otherwise they would have purchased it);
investors who own the asset without selling it put a value of more than p on
the asset (otherwise they would have sold it).

In this sense, the market price p reflects the ‘‘market view’’ of the value of
the asset; the price is not too high to make everyone sell, it is not too low
to make everyone buy, and it is just right to make some investors exchange
ownership at that price.
Much of finance theory is concerned with determining the implications
of an existing set of benchmark asset prices on the remaining asset prices.
We do not try to judge whether the benchmark prices are correct, but we try
to find out whether the prices of the other assets are consistent with those
benchmark prices. This will be a common theme throughout the course.

1.9 Primary and Secondary Markets Very often the initial sale of a newly issued
bond takes place in specialist markets (‘‘primary markets’’) that are restricted
to certain specialist intermediaries acting on behalf of the general public;
these bonds are then passed on to ‘‘secondary markets’’ where the general
public can purchase them.

1.10 Long and Short Positions An investor may trade in any number of assets.
We refer to the investor’s policy of buying and selling various assets as a
trading strategy and the resulting entitlements and obligations are called the
investor’s trading positions. The investor’s overall trading position is also
called his portfolio.
If the investor has bought a certain number of the asset and holds the
asset, the investor has an entitlement on future payoffs from the bond. We
then say that the investor has a long position in the asset.
Conversely, if the investor has issued a certain number of units of the
bond, he owes the bond’s future payoffs of the bond to the bond’s current
owners; we then say that the investor has a short position in the bond.
A short position involves an obligation and reflects future cash outflows;
a long position involves and entitlement and reflects future cash inflows.
You acquire a long position by buying the asset; you acquire a short position
by issuing the asset. Alternatively, investors who are unable to issue their
1: Trading in Bond Markets 10

own bonds can form a short position in an existing bond by borrowing and
then selling the bond. The process of borrowing an asset and then selling the
borrowed asset is known as short-selling. We explore short-selling in greater
detail in the Parts 3–4 of this handout.

2 Bond Specifics
Finance is best done by looking at specifics and trying to understand the
general principles that are at work in those specifics. The aim of this part
of the chapter is to give slightly fuller details on the specifics of one financial
instrument, bonds. This will be useful later in this chapter and in subsequent
parts of the course.

2.1 Time Time passes in periods or ‘‘years’’. Year 1 starts at date 0 (the present)
and ends at date 1; year 2 starts at date 1 and ends at date 2, and so on. All
financial assets are traded in a spot market at date 0, and investors expect
there to be further such spot markets at each future date. Investors have a
time horizon of T years. A typical future date will be indexed by ‘‘t’’, 1 ≤ t ≤
T.

2.2 Payoffs We consider assets that promise a series of fixed payoffs dt over
a series of T future dates t = 1, 2, . . . T:

d1 , d2 , d3 , . . . dT . (1)

Such instruments are called fixed-income instruments. Typical examples

of fixed-income instruments are high-grade corporate or government bonds,
loans, or mortgage contracts. For simplicity of terminology, we refer to all
such assets as ‘‘bonds’’. The current price of a bond (at date 0) is denoted by
p.
For the moment, we assume that all cash promises are secure (no default
risk). Bonds for which this is true are called high-grade bonds.

2.3 Coupon Bonds Typically, the time horizon of a bond’s payoff profile will
be finite, with final payoff date T. We refer to the bond’s final payoff date T
as the bond’s maturity date or term. Payoffs dt at dates prior to maturity
(t < T) are called coupon payments. Bonds that offer at least one such coupon
payment are called coupon-paying bonds or simply coupon bonds.

2.4 Coupon Rate In practical applications, bond payoffs often have a very
special structure, with constant small coupon payments C at all dates up to
(and including) maturity plus one large extra lump-sum at maturity. The final
lump-sum is called the bond’s face value of par value.
1: Trading in Bond Markets 11

The relationship between face value and coupon payments is often ex-
pressed in terms of the bond’s coupon rate c that determines the bond’s annual
coupon payments as a proportion of the face value, giving annual coupon
payments of C = cF. Payoffs then are restricted by the condition:

cF for t = 1, 2, 3, . . . , T − 1
dt = (1)
F + cF for t = T
This is a somewhat specialist payoff structure that does not cover all the
relevant cases of fixed-income pricing. However, arrangements of type (1)
are common enough in practice to warrant our attention in cases where this
restriction enables us to make relevant predictions that would not be possible
for the unrestricted case.
We note that for given coupon payments C and given face value F, coupon
rate c can be computed as
C
c= . (2)
F

2.5 Par Bonds, Discount Bonds, Premium Bonds A bond’s face value F is also
called its par value. Bonds whose price p is exactly equal to F are said to trade
at par and are called par bonds:

p=F at par. (1)

Bonds that trade below par (p < F) are called discount bonds, since their price
is discounted compared with their face value. By contrast, bonds that trade
above par (p > F) are called premium bonds, since they can only be purchased
at a premium relative to their face value.

2.6 Zero-Coupon Bonds Bonds that pay nothing prior to maturity are called
zero-coupon bonds, zero bonds or simply zeros. We consider an entire series
of such zero-coupon bonds, one for each future date, Z1 , Z2 , . . . , ZT . By
convention, we assume that such zero bonds have a one-pound payoff at
maturity. For example, zero bond Zh has a payoff of 1 pound at date h, and
payoffs of zero pounds at all other dates:

1 for t = h

dt = (1)
0 for all t 6= h

The price of the year-h zero Zh is denoted by qh . Thus, investing qh pounds

into Zh at date 0 yields a one-pound payoff at date h:

qh at date 0 −→ 1 at date h.

Zero bonds and their prices are of fundamental importance in the analysis
of bond markets. In our theoretical discussions, we often assume that zero
1: Trading in Bond Markets 12

bonds exist for all relevant dates and that their prices are known to the in-
vestor. In practice, this assumption will not normally be correct and some
zeros might not be traded or their prices might not be observable to the in-
vestor.
In terms of coupon rates, zero bonds are bonds with a coupon rate of
c = 0%. In the absence of any coupon payments prior to maturity, the price
of a zero bond is heavily discounted relative to its face value of one pound
(qt < 1); hence zero bonds are sometimes called pure discount bonds.

2.7 Annuities & Perpetuities A bond that pays a fixed annual payment C over
T years is called an annuity:

d1 = C, d2 = C, . . . , dT = C. (1)

We may think of an annuity as a regular coupon-paying bond whose final face

value is withheld. An annuity that never matures is called a perpetuity or a
console:
d1 = C, d2 = C, d3 = C, . . . (up to infinity). (2)

We may think of a perpetuity as a regular coupon-paying bond whose maturity

date T is indefinitely delayed. Conversely, we may think of a T-year annuity
as a perpetuity whose payoffs are truncated at date T. Perpetuities are a useful
benchmark case for the study of bonds with very long terms to maturity.

3 Trading Strategies
In this part of the chapter, we discuss in some detail the mechanics of how
an asset is created and traded and how trade gives rise to various trading
positions. We explore these issues by giving a full discussion of a simple
example.

3.1 Asset-Liability Balances We explore the impact of all trading transactions

on the asset-liability balances of the participating investors. In particular,
we consider (i) an investor’s current cash balance; (ii) an investor’s current
long positions in the primary asset (a bond A); (iii) an investor’s current short
positions in bond A; (iv) an investor’s long positions in a borrowing certificate
B[A] on the bond; (v) an investor’s short positions in borrowing certificate
B[A].

3.2 Initial Issue of the Bond The initial sale of a newly issued bond (in the pri-
mary market) creates a credit relationship between the issuer and the initial
buyer. The issuer has received current cash (the intitial price of the asset) in
return for handing over the bond certificate; he is now in debt to the owner
1: Trading in Bond Markets 13

of the certificate, and he will have to repay his debt by honoring the future
cash commitments specified in the certificate.
The buyer of bond A has reduced his current cash balance (by the initial
price p of the bond), and he now owns the bond instead; he has given up
current cash, but has gained an entitlement on future cash payments. Thus,
the owner of the bond has exchanged one type of asset (cash) against another
(bond).
On the other side of the trade, the issuer has increased his current cash bal-
ance (by the initial price p of the asset), but in return he now owes the future
cash payments that are promised by bond A. Thus the issuer has increased
his asset base (in current cash), but at the same time he has also increased his
liabilities or obligations, namely his commitment to honour the promised
future cash payments of A.

3.3 Example of a Bond We consider a safe bond A that promises payoffs of

d1 = 100 pounds on 2 Oct 2008 and d2 = 1, 100 pounds on 2 Oct 2009. The
bond is to be issued on 3 Oct 2007. Thus, in October 2006 the bond is a 2-year
coupon bond with a face value of 1,000 pounds and a coupon rate of 10 per
cent.

3.4 Example of an Initial Issue Suppose that on 3 Oct 2007, investor ABC
(a deficit unit) issues one unit of bond A. Investor XYZ (a surplus unit) pur-
chases the bond from the issuer, at an initial market price of p = 1, 000 pounds.
(At this market price, the bond is traded as a par bond.)
Here are the asset-liability balances of the two investors on the day before
the initial sale, 2 Oct 2007:
ABC owns no cash and no assets. He has no liabilities.
XYZ owns 1,000 pounds cash and no assets. He has no liabilities.

ABC then issues the bond and sells it to XYC during the day. Suppose The
market price of bond A on 3 Oct is 1,000. Here are the asset-liability balances
of the two investors immediately after the initial sale, on 3 Oct 2007:
ABC now owns 1,000 cash and no assets. At the same time, he needs to back
his bond and thus he now has liabilities in the shape of bond A’s future payoff
promises.
XYZ owns no more cash but now he owns the bond purchased from ABC,
entitling him to receive A’s future payoffs. XYZ still has no liabilities.

3.5 Acquiring Long And Short Positions In our example, on 3 Oct 2007, investor
ABC has acquired a short position; he did that by issuing the bond. The
acquisition of a short position is associated with a current cash inflow (by
amount p) combined with liabilities (future cash payments d1 and d2 )
1: Trading in Bond Markets 14

Conversely, investor XYZ has acquired a long position; he did that by

buying the bond. The acquisition of a long position is associated with a
current cash outflow (by amount p) combined with entitlements on future
payoffs d1 and d2 .

3.6 Secondary Trading The investor who initially purchased the bond from
the issuer is not required to keep this bond; he is free to re-sell the bond to
other investors, who in turn are free to sell it on to yet other investors. This
is called secondary trading. Investors who purchase a bond may do so either
because they wish to receive the actual cash payments promised by the title
or because they wish to re-sell the title at a later date prior to the bond’s
maturity.

3.7 Example of Secondary Trading Continuing our earlier example. On 3 Oct

2007, investor XYZ owns the bond issued by ABC. Suppose that on 4 Oct
2007, XYZ needs to sell his bond to another investor UVW, perhaps because
he urgently needs to raise cash for other purposes. Suppose that for reasons of
reduced overall demand the market price of A on 4 Oct has dropped to p = 980
pounds.
Here are the asset-liability balances of the three investors immediately
before this secondary sale, on 3 Oct 2007:
ABC owns 1,000 cash and no assets. He has bond A as a liability. These
liabilities are due to initial purchaser of the bond, XYZ.
XYZ owns no cash but he owns bond A purchased from ABC. XYZ has no
liabilities.
UVW owns 980 cash but no other assets. He has no liabilities.
Here are the asset-liability balances of the three investors immediately after
the secondary sale, on 4 Oct 2007:
ABC is unchanged; he owns 1,000 cash and has liability A. After the transfer
of the bond from XYZ to UVW, these liabilities are now due to be paid to
UVW, not XYZ.
XYZ owns 980 cash but no other assets; in particular, he has no further credit
relationship with ABC. He has no liabilities.
UVW owns no more cash but now he owns bond A issued by ABC, entitling
him to receive A’s future payoffs. He has no liabilities.
Any number of further secondary trades may take place until the bond ex-
pires.

3.8 Liquidating a Long Position In our example, on 4 Oct 2007, investor

XYZ has cancelled or liquidated his short position, by re-selling the bond
to another investor, UVW. The liquidation of a long position is associated
1: Trading in Bond Markets 15

with a current cash inflow (the current market price p), combined with a loss
of future entitlements.
Conversely, investor UVW has acquired a long position, by purchasing
the bond from XYZ. This results in a current cash flow (by amount p) com-
bined with future entitlements of d1 and d2 . This situation is in exact parallel
to XYZ’s initial acvquisition of his long position on 3 Oct, except that the
price has changed.

3.9 Liquidating a Short Position Since 3 Oct 2007, investor ABC as the initial
issuer of bond A has a short position in this bond. How could ABC cancel this
short position? Answer: by buying back the bond from its current owner.
This is called liquidating a short position.
Since 4 Oct 2007, the bond belongs to investor UVW. If shortly after-
wards, say on 5 Oct 2007, ABC were to offer UVW the right price, say p = 990,
then UVW would happily return his bond to issuer ABC. This would cancel
all credit relations between the two parties; ABC would have reduced his cash
balance by amount p = 990 but would have removed all liabilities from bond
A, whereas UVW would have lost his entitlements on A’s future payoffs, but
would have increased his cash balances by p = 990.

3.10 Maintaining a Short Position If the initial issuer does not liquidate his
short position, he needs to honour all of the bond’s payoff promises at their
due date. In our example, if investor UVW decides to keep bond A after the
purchase on 4 Oct 2007, then on 2 Oct 2008 he has a claim on receiving d1 =
100 from issuer ABC, and on 2 Oct 2009 he has another claim on receiving
d2 = 1, 100 from ABC.
The only way for investor ABC to get out of these obliations is to buy
back the bond (liquidate the short position), which requires payment of the
bond’s current market price. If ABC does not buy back the bond, we say that
he maintains his short position. We can then see that in order to maintain
a short position, an investor needs to make the promised cash payments of
the bond (cash outflows). The owner of the bond, in contrast, needs to do
nothing in order to maintain his long position; he merely needs to abstain
from re-selling his bond.

3.11 Maturity Once the bond has reached his final payoff date and the final
payments have been made, the bond has matured or is expired and there are
no further contractual relations between the issuer and the last owner.
1: Trading in Bond Markets 16

4 Short Selling
Sometimes it is convenient for an investor to be able to acquire a short posi-
tion in an asset that has been issued by another investor. As indicated above,
this can be effected by short-selling the asset, which means that one borrows
the asset from a third party and then sells it on to the buyer.
Short-selling is critically important for the deployment of arbitrage
strategies. It’s not difficult to grasp, but some of the more subtle aspects
of the technique can easily be misunderstood, and for this reason we dedicate
an entire Part of this handout to a full account of short-selling.

4.1 Example In our example from Part 3, consider the situation on 3 Oct
2007, after the bond has been issued by investor ABC and sold to investor
XYZ. Suppose there are two other investors in the market, investor MNO
who wishes to buy a unit of bond A at the current market price of p = 1, 000,
and investor KLM possesses special knowledge that makes him aware that
the market price of A is soon going to drop to 980. If KLM owned bond A
himself, he could sell A to MNO now for p = 1, 000, and buy it back a day
later for the lower price of p = 980, leaving him were he was before in terms
of A but increasing his cash balance by 2 pounds, the price difference between
his sale for 1,000 and his subsequent puchase for only 980. But what if KLM
does not own any units of bond A? In that case, he first needs to borrow some
units of bond A from one of the current owners.

4.2 Short-selling: Acquisition of Short Position Example from previous section

continued. On 3 Oct 2007, investor XYZ has just bought one unit of bond A
and has no intention of selling it. The first payoffs of the bond are due only
in a year’s time, on 2 Oct 2008, and in the meantime XYZ has no immediate
use for the bond cerificate.
In this situation, investor KLM can approach XYZ and offer him a bor-
rowing contract B[A] on bond A, specifying that KLM has the right to use
XYZ’s unit of bond A for the next few days, against a small borrowing fee (say
of 1 pound per day), payable by KLM to XYZ when the bond is returned. The
certificate obliges KLM to return one unit of A to XYZ by 8 Oct 2007, say,
and it may also specify all sorts of collateral securities and other safeguards
against default of this obligation.
If XYZ accepts this offer, KLM and XYZ can exchange the bond against
the borrowing certificate; KLM now has a long position in bond A, but he also
has a short position in the borrowing certificate B[A]. XYZ in turn no longer
possesses his unit of A, but he has a claim on receiving it back from KLM
by 8 Oct 2006 at the latest, as evidenced by his long position in borrowing
certificate B[A].
1: Trading in Bond Markets 17

Having obtained one unit of bond A from investor XYZ, investor KLM can
now sell this bond to investor MNO, at the current market price of p = 1, 000.
By doing this, KLM loses his long position in A but increases his cash balance
by 1,000. He still is short in B[A], which obliges him to return one unit of
bond A by 8 Oct.
Through this two-stage procedure, investor KLM is now in a situation
that is very similar to having issued one unit of bond A himself; he owes
the bond (and hence the bond’s payoff promises) to another investor, and he
has received a current cash inflow in exchange for this future obligation. We
refer to a short-position acquired through short-selling as a secondary short
position, in contradistinction to a primary position that is acquired through
the direct issuing of a new bond.

4.3 Short-selling: Liquidation of Short Position In our example, by 4 Oct 2007,

the bond price has dropped to p = 980.
This is the moment KLM has been waiting for. He can now re-purchase
one unit of A on the open market, say from investor MNO (or from any other
owner of A). This reduces KLM’s cash balance by 980 pounds and gives him
ownership of one unit of bond A. What is the resulting overall position of
KLM? Answer: long in cash, long in A short in B[A]. To be specific: KLM
now has a positive cash balance of 20 pounds (the 1,000 pounds earned when
selling A to MNO, minus the 980 pound lost when re-purchasing A from
MNO); he has a long position in A (by purchasing one unit of A from MNO);
and he has a short position in B[AS] (his original borrowing contract with
XYZ).
Having re-puchased A, he can return the bond to the lender XYZ, along
with the agreed borrowing fee (say 1 pound for the one day of borrowing).
By doing so, he loses ownership of A but he also fulfils his obligation from
B[A], and once the transaction is completed there is no further contractual
relationship between XYZ and KLM.
In sum, short-seller KLM liquidates his short position by re-purchasing
the bond and returning it to the lender, in exchange for a cancellation of
the borrowing contract. The net effect is an increase of his cash balance by
the current market price (minus borrowing fee), combined with a complete
cancellation of all positions in A or B[A].

4.4 Maintaining the Short Position In practice, if an investor acquires a short

position by a primary issuing of a bond, this position is likely to be maintained
for a lengthy period, very often up to the maturity date of the bond. In
contrast, if an investor acquires a short position by short-selling the bond, the
investor is likely to liquidate that position in a fairly short time span. This is
1: Trading in Bond Markets 18

due to a variety of reasons, inclusing the fact that even small borrowing fees
will add up to substantial sums if the borrowing continues for longer periods.
However, in principle it is quite conceivable (and it may well happen in
practice) that an investor short-sells the bond and then maintains the result-
ing short position for longer periods. If this happens, the investor will have
to make intermittent payments to the lender, namely occasional payments
of accumulated borrowing fees, plus the payment of any of the bond’s own
coupon payments whenever these are due.
In our example, if KLM were to maintain his short position in A for more
than one year (perhaps because XYZ charges a very low borrowing fee and has
no interest in retireving his bond from KLM), then on 2 Oct 2008 he would
have to pay to XYZ the sum of 100 pounds, precisely the sum promised by the
unit of bond A that was lent to KLM by XYZ and that is now in the hands of
MNO. To ABC, the 100 pounds that he receives appear to come from the bond
issuer, ABC, but in reality they come from the bond borrower, KLM. In 2008,
the bond issuer (ABC) will pay nothing to XYZ — the coupon payments that
ABC makes go directly to the investor who bought the borrowed bond from
KLM, investor MNO in our example. There is no longer any real relationship
between ABC and XYZ, even though XYZ has merely lent, not sold, his unit
of bond A. Only when borrower KLM actually returns the borrowed unit of
A to XYZ will there be a new credit relationship between ABC and XYZ.

4.5 Summary of Trading Activities Here’s a summary of the various actions

associated with trading positions. We cnsider three types of activities: ac-
quire, maintain and liquidate a position. We apply these three activities to
three types of position: long positions, primary short positions (from issuing a
new bond) and secondary short positions (from short-selling an existing bond).
Table 1 summarises the resulting possible nine cases; we consider a bond A
with price p and coupon payoffs dt , and allow for the borrowing of A with
borrowing fee f.
The table shows that in terms of the ultimate cash flows, primary and
secondary short positions are almost identical to the investor who acquires,
maintains and liquidates them. The only difference is the additional borrow-
ing contract required for secondary short positions, which complicates the
acquision and liquidation procedures and leads to an additional fee element.
Apart from these complications, an investor who short-sells a bond really acts
in exact analogy to an investor who issues the bond. For this reason, we will
often simply refer to the ‘‘selling’’ of a bond or a ‘‘short position’’ in a bond,
without specifying whether we are dealing with a primary or secondary short
position.
1: Trading in Bond Markets 19

Table 1 Long Position Primary Short Secondary Short

borrow A (—)
Acquire buy A (out p) issue A (in p)
then sell (in p)

claim coupons service coupons service coupons

Maintain
(in dt ) (out dt ) (out dt )

buy back A buy back A (out p)

Liquidate sell A (in p)
(out p) then return (out f)

5 Conclusion
This handout has shown how investors can tailor their cash flows across time
by exchanging entitlements for future cash payments (assets) with each other.
As a reflection of such exchanges, investors form trading positions in assets.
Long positions require current outflows in return for the entitlement to future
inflows; short positions provide current inflows in return for the obligation of
future cash outflows. Long and short positions come hand in hand; for every
entitlement there is a corresponding obligation. A short position makes you
a debtor, a long position makes you a creditor. The most natural way of going
short in an asset is to issue a new certificate. However, an investor can also
go short in an asset that he hasn’t issued himself. The way to go short in an
asset that has been issued by another investor is to short-sell the asset; this
means borrowing the asset from a third party and selling it on to the buyer.
The management of a trading strategy involves the acquisition, maintenance
and liquidation of short and long positions, and this happens through the
issuing, buying, selling, short-selling and honouring of assets. Throughout
the lifetime of an asset, such activities bring about a multitude of contractual
payment obligations between investors. Once the asset has expired (because
it has reached maturity or because it has been bought back by the issuer), all
such obligations cease.