Introduction

Every trade has its own life cycle. The entire Life Cycle of a trade can be broken down into pre-trade and
post-trade events. Before going into the details of the trading events, let me explain how a trading deal is
being struck between two entities.

We know that one of the primary usages of derivative contract is to hedge the risk. Let us consider that a
company has got a floating rate liability in LIBOR (London Inter Bank Offered Rate) and it wants to
convert its liability into a fixed rate. The feasible option would be to enter into an Interest Rate Swap. The
company would strike a deal with a bank and enter into a swap where it would pay fixed rate to the bank
and receive floating rate. The company and the bank would enter into a trade and the trade passes
through various stages. The various trade events can be categorized into Front Office, Middle Office and
Back Office activities which are explained below: -

Front Office: The FO forms the stage where the trade gets initiated. Here, the order gets placed and the
entity will price the instrument and give the quote to the counterparty. If the counterparty agrees to the
details of the trade and is willing to enter into the deal, the trade gets executed. The trade is then
captured in the trading desk usually using a deal capture system. The deal capture system validates all
the necessary trade economics before assigning a trade reference number. Subsequent trade events like
amendment, cancellation would refer to the trade with the help of the identifier. An acknowledgement is
being sent to the counterparty with the trade details who confirms it back.

Middle Office: The important function that MO performs is to do the Limits and Risk Management. The
Limits are being calculated at a business hierarchy level. The usual hierarchy would be at a Portfolio level
and subsequently aggregating to a Trader Level, a Desk Level, an Entity Level, and finally to a Group
Level. Validations are being done on the trade captured, and in case of any discrepancy, an exception is
being raised.

The MO plays a vital role in the exception management. The trade gets enriched by static data like the
standard settlement instructions of the counterparty, Custodian details, City holidays, etc.

Such static data details are important for the completion and settlement of the trade. The allocation of the
trade is done in the MO and finally the trade is being pushed to the BO and the trade goes live.

Back Office: The BO is the back bone of the entire life cycle of the trade. The BO mostly deals with the
operational activities like record keeping, confirmation, settlement and regulatory reporting. In most cases,
BO activities are being outsourced to cheaper sources to cut down on costs for the company.

The Life Cycle of such a trade can be categorized into pre-trade events and post-trade events which are
discussed below: -
Pre-Trade Events
Setting up a Master Agreement: It is a standardized contract between the counterparties and should be
there in place before the two parties enter into a deal. For derivative contracts, the Master Agreement is
drafted according to ISDA protocols.
Define Product Characteristics: Every Deal has to be defined by some primary characteristics called
the primary economics of the trade. In case of a Plain Vanilla Interest Rate Swap, the economics of trade
would be as follows: -

Pre-Trade Negotiation: In this stage the client tries to reach a preliminary agreement with the bank. This
stage may include documentation, indication of the interest rate and defines the criteria for executing a
trade which may include the credit support and the bank policies which the counterparty has to abide by.

Request for Quote: The client will ask for a quote to the bank, say the fixed rate against LIBOR.
Provide Quote: The bank will provide the quote which may be through their traditional channels like
phone, fax and email, or through standardized channel as provided by Swaps wire.

Request Trade Pricing Inputs: The Client will ask inputs which will help to price the product. It may
relate to volatility of the underlying in some cases. The trade is priced after matching every detail of the
trade. For an IRS, both the parties will agree to the rates when the Net Present Value of the swap is zero.