UPDATE 3-Morgan Stanley beats estimates on higher trading revenue

* Adjusted profit $1.25/shr above $1.11/shr expected

Large strategic deals and cross-border activity drive M&A

* Trading revenue up 18 pct to $3.8 billion (Adds details on investment banking, CEO comments on Fed stress tests)

By Aparajita Saxena and Matt Scuffham

July 18 (Reuters) - Morgan Stanley reported a better-than-expected quarterly profit on Wednesday, driven by higher revenues in equities and fixed income trading as well as investment banking.

Banks are benefiting from increased market volatility due in part to escalating trade tensions causing investors to buy and sell assets to protect their portfolios and take advantage of opportunities. Morgan Stanley highlighted its equity financing business and a stronger performance in commodities and credit products.

Large strategic deals and cross-border activity helped drive M&A in the quarter, Chief Financial Officer Jonathan Pruzan said on a call to discuss results. But the bank is watching for signs the trade and geopolitical concerns could dampen future underwriting revenue.

Shares were up 3.4 percent to $50.86 in early trading.

Morgan Stanley's net revenue rose 12 percent to $10.6 billion, with institutional securities accounting for 54 percent of the gains. Institutional securities comprises the bank's investment banking and trading units.

Chief Executive James Gorman called the quarter's performance straightforward and focused some of his prepared comments on the Federal Reserve's methodology for its stress tests, noting that the U.S. regulator's extreme scenarios this year exceeded even what the bank experienced during the 2007-2009 financial crisis.

"We will not get ahead of ourselves in predicting what the Fed will do next year, but 2018 appears to be a transition year. Going forward, we expect to be able to continue to invest in our business and offer our shareholders an attractive capital return while maintaining a prudent capital base," he said.

The Fed said last month it would not let Morgan Stanley boost overall capital returns to shareholders after its leverage ratio fell below the minimum allowed in the annual stress test. A failure to meet the requirement would normally result in an outright failure.

Morgan Stanley said net income rose 39 percent to $2.4 billion, or $1.30 per share, from $1.8 billion, or 87 cents per share, in the year-ago period.

Adjusted for special items, its profit was $1.25 per share, topping the $1.11 per share analysts expected, on average, according to Thomson Reuters I/B/E/S.

Net revenue from the bank's sales and trading business rose 18 percent to $3.8 billion, with fixed income and equity trading businesses recording gains of 12 percent and 15 percent.

Rival Goldman Sachs said on Tuesday its trading revenue rose 17 percent, with bond trading showing a 45 percent jump from a notably weak year-ago period and equity revenue remaining flat.

Morgan Stanley said net revenue at its wealth management business rose to $4.3 billion from $4.2 billion a year ago.

JPMorgan Chase & Co, Bank of America Corp, Goldman Sachs Group Inc, Morgan Stanley and Citigroup Inc have all reported second-quarter earnings which beat expectations, with only Wells Fargo & Co missing estimates.

(Writing by Meredith Mazzilli Editing by Nick Zieminski)