What can I read to really understand how financial instruments work in the market?

May 18, 2007 8:29 AM

I have become interested in finance. After lots of reading, I understand the mechanics of how most financial instruments work. Now I want to understand how they are used in the marketplace, specifically analysis or description of transactions and their outcomes. What should I read?

I feel I have a good theoretical base of information about how financial instruments work. Stocks, bonds, options, futures, swaps - I can understand how they work and what they do in theory. But I feel like I know all about the parts of a car and what they do without knowing what it is like to drive in a race.

What can I read that will give me specific insight into how all these things are used? I have read most of the books mentioned in this thread, and while they said "so-and-so lost millions shorting oil stocks", they weren't detailed enough for me. I wanted numbers that I could follow and maybe even put in a spreadsheet to understand. The closest I have come is Traders, Guns, and Money, which talks in some depth about a few different transactions, but left me wanting more.

I would love to read analyses of actual events - situations that detail where a hedge failed to work correctly and why; how someone engineered a short squeeze and how it worked out; how a transaction's risk model failed; things like that, but in enough detail to follow what happened pretty exactly, with numbers.

It seems likely that what I am looking for is outside what appears in the popular press, and is in finance texts and case studies. Any finance MBAs out there, or traders who know what might meet my criteria? I bet that lots of this is oral tradition, but I am hoping some things might have leaked out to the world somewhere.

posted by procrastination to work & money (12 comments total)

So, my library has a bunch of research guides available. You may not be able to access some of the materials, but you can mill up a good list of resources to look in to by clicking about.

You can attempt to track down Margin of Safety by Seth Klarman, but as you can see, it's out of print and copies are $1,000 plus. It is, hands down, the most popular book at HBS.
posted by robocop is bleeding at 8:40 AM on May 18, 2007

Oh, and give Harvard Business School Press a try. HBR articles and cases are available for download here.
posted by robocop is bleeding at 8:42 AM on May 18, 2007

I'd never heard of that book until you mentioned it robocop. You ain't kidding about the cost; copies on ebay are going for several hundred dollars a pop.

You'd have to wonder if this guy isn't making a killing by doing the short run with such popularity to drive up the price and sell off copies through intermediaries.
posted by dr_dank at 9:37 AM on May 18, 2007

Every day I come to work, I ask myself "Why am I not scanning Margin of Safety and selling the PDFs for 20 bucks each?"

Then the Ethics Monster smacks me in the back of the head and I get a cup of coffee.
posted by robocop is bleeding at 9:46 AM on May 18, 2007

Ok, if you really understand the academic principles of valuation, there are a couple of ways to take this to the next level.

If you can / or are working in a back office environment, you'll naturally see lots of real-world examples. Some traders may be reticent to talk openly about their strategies but this is really more about gaining their confidence than anything else. When I started out my career I learned a great deal by talking to traders about how and why they'd entered / exited the market in certain ways. This would be the most effective way to acquire the expertise you seek.

But if you can't get the real world examples I'd suggest that you paper trade, putting various strategies to work in order to deepen your insight.

Do you have access to a Bloomberg terminal? If not this will be very difficult for all but the simplest instruments and very basic derivatives. A Bloomberg terminal give you access to necessary data that is unobtainable via any other single mechanism.

Once you've got the market data you can take your view and build up positions; I noticed above you mentioned "transactions". Desks will almost NEVER assume a market position based on a single transaction. Positions, consisting of multiple transactions, will be built up over time, sometimes relatively long periods but often frighteningly short (e.g., Statistical Arbitrage, which is almost all computer driven trading). Each transaction will bring it's costs & weighting to the final position. Depending upon the market, transaction size, liquidity, etc, each transaction may or may not impact market price. This would have to be factored in as well.

Also, you're going to have to make assumptions about funding costs (desks constantly leverage their equity to assume larger and larger positions) and transactions costs.

The former isn't that tough; look at LIBOR and assume a small spread. Note that spread can be either positive or negative; yes, some firms can finance positions at below market costs depending on lots of other factors that aren't germane to what you're trying to accomplish here. Look at the CDS markets to arrive at what a benchmark funding rate would be for institutions of various credit worthiness; document your assumptions as they will be key to determining if your trading strategy will be profitable. Don't be surprised if there is extreme sensitivity to funding as costs of capital are integral to trading.

Transaction costs will be a little tougher to back into, but most institutions will have very cheap costs here, relative to the size of the positions funded / assumed.

Use these assumptions to reverse engineer stuff you read about in FT or The Wall Street Journal. Same thing goes for any financial product that you see being offered to the public. Example: many institutions here in the UK offer guaranteed return products, tied to the performance of a equity benchmark. Try to understand how they'd engineer product this to guarantee gains to the retail investors, while not only protecting themselves from loss but also insuring they break even in the worst case. Estimate their cost structure and look at opportunity costs as well. Experiment with various offering sizes and market scenarios. Look back at significant market events (e.g., 1987 in the US, Black Wednesday in the UK, the 1997 Asian Crisis, etc), see how your product performed under each and when & how it became unprofitable.

You're correct in that much of this information just isn't shared, but that doesn't mean you can't take your self-education to the next level.

And who knows? You might be able to land yourself a job on a desk someplace, once you know how these things work at more than the most basic level.
posted by Mutant at 10:48 AM on May 18, 2007 [2 favorites]

Good luck getting a Bloomberg terminal unless you want to drop some serious dime. That's really a resource you only get a hold of if you're working in the industry, or if you've got super deep pockets. You have to pay a monthly subscription fee, and it's pretty outrageous.

And also, sure, pretty much any information about any financial offering is at your fingertips, but it's not really going to mean anything to you.

Honestly, do you have a brokerage account? Because regardless of whether or not you're actually trading them, that's going to be the best place for you to get data on stocks, options, futures, bonds, etc. You can watch them quote, and paper trade them, and that's going to probably be your best bet.
posted by mckenney at 11:01 AM on May 18, 2007

Thanks for the answers so far. The business school cases look very promising. I will get a few and see if they are what I am looking for.

I should mention that I am a computer science academic who is interested in this because I am a geek and got curious about things trying to learn to hedge my own small portfolio. Paper trading is exactly what I have in mind for the time being, but I figured I could learn much faster from reading about others mistakes than I could waiting for mine to become obvious.

I do have a great library on campus. We'll see if they come through with the copy of Margin of Safety I requested. There also seems to be access to Bloomberg in the business school; I will see if they will share it with me.
posted by procrastination at 11:15 AM on May 18, 2007

"That's really a resource you only get a hold of if you're working in the industry, or if you've got super deep pockets. "

Not really. I teach part time at a University in London and the library has a couple of Bloombergs which are available to the anyone on campus.
posted by Mutant at 11:18 AM on May 18, 2007

I go to a business school (but am not in finance); we have three Bloomberg terminals for anyone's use. See if your school has any affiliations with area schools that do have Bloomberg terminals. (Although quite frankly, I just use Google Finance; anything more advanced is over my head anyway.)

Some of it might be beneath you, but Morningstar has courses online, and they're quite plentiful.
posted by fogster at 11:30 AM on May 18, 2007

The (Mis) Behavior of Markets: A Fractal View of Risk, Ruin And Reward (Paperback)
by Benoit B. Mandelbrot (Author), Richard L. Hudson (

http://www.amazon.com/Mis-Behavior-Markets-Fractal-Reward
posted by yoyo_nyc at 2:54 PM on May 18, 2007

A few books you may enjoy which give all the gory details, and which seem to be accurate are when genius failed, liars poker and market wizards. I do this for a living and I make sure I read the last three pages of the second section of the financial times every day.
posted by shothotbot at 1:45 PM on May 19, 2007

Seconding When Genius Failed and Liar's Poker, but I'd read Liar's Poker first, and When Genius Failed second, due to the overlap and common players between the two. Both are great reads.
posted by CipherSwarm at 1:26 PM on May 26, 2007