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

• 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 http://ask.metafilter.com/44670/Grab-that-cash-with-both-hands-and-make-a-stash, 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 http://www.amazon.com/exec/obidos/ASIN/0273704745/metafilter-20/ref=nosim/, 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.

• Answer:

  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.