Trade execution methodologies and strategies
This is the first in a series of blogs which will look more closely into some successful approaches to designing effective derivative and FX trade execution strategies for clients. “Effective’, in my definition is a fair outcome for both sides of the transaction which also minimises any chance of offending regulatory and legal requirements.
For example, pre-hedging is one strategy that I have found very useful (when managed correctly) to reduce risks and achieve positive outcomes for clients. It is particularly effective in managing large trades and/or illiquid markets to avoid adverse price movements.
We have written previously on the topic of ‘pre-hedging’ and how this challenging matter can present both buy and sell-side market participants with real decisions.
This blog looks at identifying a preferred outcome, developing a series of potential strategies and deciding on the appropriate strategy to follow. Future blogs will look at examples of alternative strategies, how to you may choose to implement these strategies and managing counterparties.
Identifying the preferred outcome(s)
The first step is to identify and internally agree the preferred outcomes. Basically, if you do not know and agree how you want this to end, it is hard to make plans that support that end.
Some outcomes could include:
Is there a specific price or level that is important to hit?
In some cases, there is a price point that delivers an outcome which is required for cashflow, target price, accounting simplicity etc.
Do you have any counterparties you have to include?
Sometimes relationships and/or other dependencies on a counterparty may mean they need to be part of any trade.
Are there any other counterparties you would like to include?
Is there a balance between best price and relationship?
Are there any internal parties that need to be included in decisions?
For large transactions, the board may need to be informed, and they may have some specific requirements.
Prioritise the preferred outcome(s)
The next step is to prioritise the preferred outcomes.
If you have more than one preferred outcome, then they will need to be prioritised.
In most cases, you will need to compromise on lower priority outcomes if you need to meet the highest priorities.
Look at alternative strategies to achieve the preferred outcomes
There are many ways to achieve the outcomes, but a strategy suited to the market liquidity conditions, counterparties and preferences will greatly improve the probability of a favorable outcome.
Some of the strategies include:
Single counterparty only for the trade
Running a tender involving several potential counterparties
Using a syndicate of banks who all get some of the trade
Using a single bank to execute the hedge before novating the hedges to a syndicate of banks
Single bank to arrange a pre-hedge the trade before novating to a syndicate of banks
Etc.
And note, each strategy has merits and challenges!
Deciding which strategy to adopt for this transaction
It is important to match the strategy to the preferred outcome.
Not all strategies will be effective for all outcomes
So, a decision will need to be made as to the best strategy in this situation.
Summary
The better approaches spend time and effort on making sure the outcomes are well understood (and agreed) before proceeding to the strategy to get the best chance of achieved that outcome.
Not all situations are the same so matching the strategy to the conditions is also important.
The next blog will look at examples of the strategies above. I will look more closely at the merits and better uses of each strategy and the ways they may be used to get an effective outcome.
