Fundamentals of Financial Instruments

Preface xxiii Preface to the First Edition xxiv Acknowledgments xxv About the Author xxvi Chapter 1 An Introduction to Financial Institutions, Instruments, and Markets 1 The Role of an Economic System 1 A Command Economy 2 AMarket Economy 2 Classification of Economic Units 4 An Economy's Relationship with the ExternalWorld 6 The Balance of Trade 8 The Current Account Balance 8 Financial Assets 9 Money 10 Money as a Unit of Account or a Standard of Value 10 Money as a Medium of Exchange 11 Money as a Store of Value 11 Money Is Perfectly Liquid 11 Equity Shares 12 Debt Securities 12 Preferred Shares 14 Foreign Exchange 14 Derivatives 14 Forward and Futures Contracts 15 Options Contracts 16 Swaps 18 Mortgages and Mortgage-backed Securities 19 Hybrid Securities 19 Primary Markets and Secondary Markets 19 Exchanges and Over-the-Counter (OTC) Markets 21 Brokers and Dealers 22 The Need for Brokers and Dealers 23 Trading Positions 24 The Buy-side and the Sell-side 25 Investment Bankers 25 Direct and Indirect Markets 26 Mutual Funds 27 Money and Capital Markets 30 The Eurocurrency Market 31 The International Bond Market 32 Globalization of Equity Markets 34 Dual Listing 35 Fungibility 37 Arbitrage 37 Arbitrage with ADRs 38 GDRs 39 Risk 39 After the Trade - Clearing and Settlement 41 Dematerialization and the Role of a Depository 42 Custodial Services 43 Globalization - The New Mantra 43 Chapter 2 Mathematics of Finance 46 Interest Rates 46 The Real Rate of Interest 46 The Fisher Equation 48 Simple Interest & Compound Interest 49 Variables and Corresponding Symbols 50 Simple Interest 50 Compound Interest 51 Properties 53 Effective Versus Nominal Rates of Interest 55 A Symbolic Derivation 56 Principle of Equivalency 56 Continuous Compounding 57 Future Value 58 Present Value 59 The Mechanics of Present Value Calculation 59 Handling a Series of Cash Flows 60 The Internal Rate of Return 61 Evaluating an Investment 63 The Future Value Approach 63 The Present Value Approach 63 The Rate of Return Approach 63 Annuities: An Introduction 64 Present Value 64 Future Value 65 Annuity Due 66 Present Value 66 Future Value 67 Perpetuities 67 The Amortization Method 68 Amortization with a Balloon Payment 70 The Equal Principal Repayment Approach 71 Types of Interest Computation 71 The Simple Interest Approach 72 The Add-on Rate Approach 72 The Discount Technique 73 Loans with a Compensating Balance 73 Time Value of Money-related Functions in Excel 73 The Future Value (FV) Function in Excel 74 The Present Value Function in Excel 75 Computing the Present and Future Values of Annuities and Annuities Due in Excel 75 Amortization Schedules and Excel 76 Chapter 3 Equity Shares, Preferred Shares, and Stock Market Indices 78 Introduction 78 Par Value Versus Book Value 79 Accounting for a Stock Issue 80 Voting Rights 80 Statutory Versus Cumulative Voting 81 Proxies 81 Dividends 82 Dividend Yield 83 Dividend Reinvestment Plans 84 Stock Dividends 85 Treasury Stock 86 Accounting for Treasury Stock 86 Splits and Reverse Splits 87 Costs Associated with Splits and Stock Dividends 89 Preemptive Rights 89 Interpreting Stated Ratios 91 Handling Fractions 91 Physical Certificates Versus Book Entry 92 Tracking Stock 92 Report Cards 93 Types of Stocks 93 Interest-sensitive Stocks 93 Risk and Return and the Concept of Diversification 94 Preferred Shares 96 Callable Preferred Stock 97 Convertible Preferred Shares 97 Cumulative Preferred Shares 98 Adjustable-Rate Preferred Shares 100 Participating Preferred Shares 100 Dividend Discount Models 100 A General Valuation Model 101 The Constant Growth Model 102 The Two-Stage Model 102 The Three-Stage Model 103 The H Model 105 Stock Market Indices 105 Price-weighted Indices 105 Changing the Divisor 107 The Importance of Price 109 Value-weighted Indices 110 Changing the Divisor 111 Changing the Base Period Capitalization 113 EquallyWeighted Indices 113 Tracking Portfolios 114 Rebalancing a Tracking Portfolio 114 EquallyWeighted Portfolios 114 Price-weighted Portfolios 116 Rights Issues 117 Value-weighted Portfolios 117 Handling a Rights Issue 119 The Free-floating Methodology 120 Well-known Global Indices 121 Margin Trading and Short-selling 121 Terminology 121 Case A: The Market Rises 124 Case B: The Market Declines 124 Case A: The Market Rises 125 Case B: The Market Declines 125 Interest and Commissions 125 Case A: The Market Rises 126 Case B: The Market Declines 126 Maintenance Margin 126 Short-selling 127 Maintenance of a Short Position 130 Shorting Against the Box 131 The Risk Factor 131 The Economic Role of Short Sales 132 The Uptick Rule 132 Chapter 4 Bonds 134 Introduction 134 Terms Used in the Bond Market 136 Face Value 136 Term to Maturity 136 Coupon 136 Yield to Maturity 137 Valuation of a Bond 137 Par, Premium, and Discount Bonds 138 Evolution of the Price 139 Zero-coupon Bonds 140 Valuing a Bond in Between Coupon Dates 141 Day-Count Conventions 142 Actual-Actual 142 The Treasury's Approach 143 Corporate Bonds 144 Accrued Interest 144 Negative Accrued Interest 145 Yields 146 The Current Yield 147 Simple Yield to Maturity 148 Yield to Maturity 148 Approximate Yield to Maturity 149 Zero-coupon Bonds and the YTM 150 Analyzing the YTM 150 The Realized Compound Yield 152 Reinvestment and Zero-Coupon Bonds 152 The Holding Period Yield 153 Taxable Equivalent Yield 153 Credit Risk 154 Bond Insurance 156 Equivalence with Zero-coupon Bonds 156 Spot Rates 156 The Coupon Effect 157 Bootstrapping 158 Forward Rates 158 The Yield Curve and The Term Structure 159 Shapes of the Term Structure 159 Theories of the Term Structure 160 The Pure or Unbiased Expectations Hypothesis 160 The Liquidity Premium Hypothesis 160 The Money Substitute Hypothesis 161 The Market Segmentation Hypothesis 161 The Preferred Habitat Theory 161 The Short Rate 162 Floating Rate Bonds 163 Simple Margin 165 Bonds with Embedded Options 165 Callable Bonds 165 Yield to Call 166 Putable Bonds 167 Convertible Bonds 168 Using Short Rates to Value Bonds 168 Price Volatility 170 A Concise Formula 171 Duration and Price Volatility 171 Properties of Duration 172 Dollar Duration 172 Convexity 172 A Concise Formula 174 Dollar Convexity 175 Properties of Convexity 175 Immunization 175 Analysis 176 Treasury Auctions 177 When Issued Trading 179 Price Quotes 179 STRIPS 179 Inflation Indexed Bonds 180 Computing Price Given Yield and Vice Versa in Excel 182 Computing Duration in Excel 185 Chapter 5 Money Markets 187 Introduction 187 Market Supervision 190 The Federal Reserve System 190 Key Dates in the Case of Cash Market Instruments 191 The Modified Following Business Day Convention 192 The End/End Rule 192 The Interbank Market 193 Types of Loans 193 LIBOR 194 LIBID 194 SONIA 194 Transitioning from LIBOR 195 Interest Computation Methods 195 Term Money Market Deposits 197 Money Market Forward Rates 197 Federal Funds 198 Federal Funds Versus Clearinghouse Funds 199 Correspondent Banks: Nostro and Vostro Accounts 200 Treasury Bills 200 Reopenings 201 Yields on Discount Securities 202 Notation 202 Discount Rates and T-bill Prices 202 The Bond Equivalent Yield (BEY) 203 Case A: Tm < 182 days 203 The Money Market Yield 205 Case B: Tm > 182 days 205 Holding Period Return 207 Value of an 01 208 Concept of Carry 208 Concept of a Tail 208 T-Bill Related Functions in Excel 209 TBILLPRICE 209 TBILLYIELD 210 TBILLEQ 210 DISC 210 Treasury Auctions 211 Types of Auctions 211 Results of an Auction 212 Primary Dealers and Open Market Operations 213 Repurchase Agreements 213 Reverse Repos 214 General Collateral Versus Special Repos 215 Margins 215 Sale and Buyback 217 Collateral 217 Repos and Open Market Operations 217 Negotiable CDs 218 Notation 218 Cost of a CD for the Issuing Bank 221 Term CDs 221 CDs Versus Money Market Time Deposits 224 Commercial Paper 224 Letters of Credit and Bank Guarantees 225 Yankee Paper 226 Credit Rating 227 Moody's Rating Scale 227 S&P's Rating Scale 227 Fitch's Rating Scale 228 Bills of Exchange 228 Documents Against Payment (DAP) Versus Documents Against Acceptance (DAA) Transactions 230 Eligible and Noneligible Bank Bills 230 Buying and Selling Bills 230 Bankers' Acceptance 231 Acceptance Credits 232 Eurocurrency Deposits 232 Appendix 234 Chapter 6 Forward and Futures Contracts 235 Introduction 235 Marking to Market for a Trader in Practice 242 Delivery Options 242 Profit Diagrams 242 Value at Risk 244 The Expected Shortfall 245 Spot-Futures Equivalence 246 Products and Exchanges 247 Cash-and-carry Arbitrage 247 Reverse Cash-and-carry Arbitrage 247 Repo and Reverse Repo Rates 248 Synthetic Securities 248 Valuation 248 The Case of Assets Making Payouts 249 Physical Assets 250 Net Carry 252 Backwardation and Contango 252 The Case of Multiple Deliverable Grades 253 Risk Arbitrage 255 The Case of Multiplicative Adjustment 255 The Case of Additive Adjustment 256 Trading Volume and Open Interest 259 Delivery 261 Cash Settlement 262 Hedging and Speculation 262 Rolling a Hedge 264 Tailing a Hedge 264 The Minimum Variance Hedge Ratio 265 Estimation of the Hedge Ratio and the Hedging Effectiveness 266 Cross-hedging 266 Speculation 266 Leverage 268 Contract Value 269 Forward Versus Futures Prices 270 Hedging the Rate of Return on a Stock Portfolio 271 Changing the Beta 272 Program Trading 273 Stock Picking 275 Portfolio Insurance 277 Importance of Futures 279 Chapter 7 Options Contracts 280 Introduction 280 Notation 282 Exercising Options 282 Moneyness 285 Exchange-Traded Options 286 Option Class and Option Series 287 FLEX Options 287 Contract Assignment 288 Adjusting for Corporate Actions 288 Nonnegative Option Premia 289 Intrinsic Value and Time Value 289 Time Value of American Options 290 Time Value at Expiration 291 Put-Call Parity 291 Implications for the Time Value 294 Put-Call Parity with Dividends 295 Implications for the Time Value 296 A Very Important Property for American Calls 297 Early Exercise of Options: An Analysis 298 Profit Profiles 299 Speculation with Options 301 Hedging with Options 303 Using Call Options to Protect a Short Position 303 Using Put Options to Protect a Long Spot Position 304 Valuation 305 The Binomial Option Pricing Model 307 The Two-period Model 309 Valuation of European Put Options 310 Valuing American Options 311 Implementing the Binomial Model in Practice 312 The Black-Scholes Model 313 Put-Call Parity 314 Interpretation of the Black-Scholes Formula 314 The Greeks 315 Option Strategies 316 Bull Spreads 316 Bear Spreads 318 Butterfly Spread 320 The Convexity Property 321 A Straddle 323 A Strangle 324 Futures Options 326 Put-Call Parity 327 The Black Model 327 Chapter 8 Foreign Exchange 329 Introduction 329 Currency Codes 330 Base and Variable Currencies 330 Direct and Indirect Quotes 331 European Terms and American Terms 331 Bid and Ask Quotes 331 Appreciating and Depreciating Currencies 332 Converting Direct Quotes to Indirect Quotes 333 Points 333 Rates of Return 334 The Impact of Spreads on Returns 335 Arbitrage in Spot Markets 336 One-Point Arbitrage 336 Two-Point Arbitrage 336 Triangular Arbitrage 337 Cross Rates 338 Market Rates and Exchange Margins 339 Value Dates 340 The Forward Market 340 Outright Forward Rates 341 Swap Points 341 Broken-Dated Contracts 343 Covered Interest Arbitrage 344 A Perfect Market 345 Foreign Exchange Swaps 346 The Cost 347 The Motive 348 Interpretation of the Swap Points 349 A Clarification 350 Short-Date Contracts 350 Option Forwards 353 Nondeliverable Forwards 356 Range Forwards 357 Futures Markets 357 Hedging Using Currency Futures 357 A Selling Hedge 357 A Buying Hedge 358 Exchange-Traded Foreign Currency Options 359 Speculating with FOREX Options 359 The Garman-Kohlhagen Model 360 Put-Call Parity 361 The Binomial Model 361 Exchange Rates and Competitiveness 363 Chapter 9 Mortgages and Mortgage-backed Securities 364 Introduction 364 Market Participants 364 Mortgage Origination 364 Income for the Originator 365 Mortgage Servicing 365 Escrow Accounts 365 Income for the Servicer 365 Mortgage Insurance 366 Government Insurance and PMI 366 Secondary Sales 366 Risks in Mortgage Lending 367 Default Risk 367 Liquidity Risk 367 Interest Rate Risk 367 Prepayment Risk 368 Other Mortgage Structures 369 Adjustable-Rate Mortgage (ARM) 369 Option to Change the Maturity 371 Rate Caps 371 Carryovers 372 Payment Caps 372 Negative Amortization 374 Graduated Payment Mortgage 376 Growing Equity Mortgages (GEM) 378 WAC and WAM 379 Calculation ofWAC andWAM 379 Pass-Through Securities 379 Cash Flows for a Pass-Through 381 Prepayment Conventions 381 Single Month Mortality Rate 382 Average Life 388 Cash Flow Yield 389 ANote 390 Conditional Prepayment Rate 390 PSA Prepayment Benchmark 391 Illustration of 100 PSA 392 Analysis 393 Illustration of 200 PSA 393 Collateralized Mortgage Obligations 394 Sequential Pay CMO 394 Analysis - Tranche A 395 Analysis - Tranche B 398 Analysis - Tranche C 398 Analysis - Tranche D 398 Extension Risk and Contraction Risk 399 Accrual Bonds 399 Analysis 399 Floating Rate Tranches 403 Notional Interest-only Tranche 404 Interest-only and Principal-only Strips 405 PAC Bonds 405 Chapter 10 Swaps 411 Introduction 411 Market Terminology 415 Key Dates 415 Inherent Risk 416 The Swap Rate 416 Illustrative Swap Rates 417 Determining the Swap Rate 417 The Market Method 419 Valuation of a Swap During Its Life 419 Terminating a Swap 420 The Role of Banks in the Swap Market 421 Motivation for the Swap 421 Speculation 421 Hedging 422 Comparative Advantage and Credit Arbitrage 422 Swap Quotations 423 Matched Payments 424 Amortizing Swaps 425 Extendable and Cancelable Swaps 425 Swaptions 425 Currency Swaps 426 Cross-Currency Swaps 427 Valuation 427 Currency Risks 429 Hedging with Currency Swaps 429 Chapter 11 Mutual Funds, ETFs, and Pension Funds 430 Introduction 430 Pros and Cons of Investing in a Fund 430 Shares and Units 431 Open-end Versus Closed-end Funds 432 Premium/Discount of a Closed-End Fund 433 Unit Trusts 433 Calculating the NAV 433 Costs 436 Sales Charges 436 Price Quotes 440 Annual Operating Expenses 440 Switching Fees 441 Dividend Options 441 Types of Mutual Funds 443 Categorization by Nature of Investments 444 Categorization by Investment Objectives 444 Categorization by Risk Profile 444 Money Market Funds 444 Gilt Funds 445 Debt Funds 445 Diversified Debt Funds 445 Focused Debt Funds 445 High Yield Debt Funds 446 Debt Funds and Bond Duration 446 Equity Funds 446 Aggressive Growth Funds 446 Growth Funds 447 Specialty Funds 447 Sector Funds 447 Offshore Funds 447 Small Cap Equity Funds 447 Option Income Funds 448 Fund of Funds 448 Equity Index Funds 448 Value Funds 448 Equity Income Funds 448 Balanced Funds 449 Asset-Allocation Funds 449 Commodity Funds 449 Real Estate Funds 449 Tax-exempt Funds 449 Risk Categories 450 Low Level Risk Funds 450 Moderate Level Risks 450 High Level Risks 450 The Prospectus 450 Structure of a Mutual Fund 450 Services 451 Automatic Reinvestment Plan 451 Contractual Accumulation Plan 451 Voluntary Accumulation Plan 451 CheckWriting 452 Switching Within a Family of Funds 452 VoluntaryWithdrawal Plans 452 Investment Techniques 452 Dollar-cost Averaging 452 Value Averaging 453 The Combined Method 454 The Total Return 455 Computation of Returns 456 Analysis 457 Taxation Issues 458 Alternatives to Mutual Funds 459 Exchange-Traded Funds (ETFs) 460 Potential Asset Classes 461 Segregated (Separately Managed) Accounts 461 Pension Plans 462 Types of Plans 462 Defined Benefit Plans 462 Defined Contribution Plans 463 IRAs 464 Cash Balance Plans 464 Chapter 12 Orders and Exchanges 465 Important Acronyms 467 Market Orders and Limit Orders 467 The Limit Price 468 The Limit Order Books 468 Illustration of a Limit Order Book 468 Limit Orders Versus Market Orders 469 Marketable Limit Orders 470 Trade Pricing Rules 471 Stop-Loss and Stop-Limit Orders 472 Trailing Stop-Loss Orders 473 Market to Limit Orders 474 Equivalence with Options 474 Validity Conditions 475 Good Till Canceled (GTC) Orders 475 Good Till Days Orders 475 Orders with Quantity Restrictions 476 A Point on Order Specification 476 Open-Outcry Trading Systems 477 Electronic Markets Versus Open-Outcry Markets 478 Call Markets 479 Chapter 13 The Macroeconomics of Financial Markets 481 Economic Growth 481 Gross Domestic Product 481 Consumption 482 Real Estate 482 Capital Expenditure 483 Government Spending 483 Inventories 483 Foreign Trade 483 GDP Versus GNP 484 Inflation Adjustment 485 Transnational Comparisons 485 The Big Mac Index 485 Inflation 485 Types of Inflation 486 Interest Rates 488 The Federal Budget Deficit 488 Measures of Budget Deficits 489 The Primary Deficit 490 Fiscal Policy 490 Budget Deficits and the Capital Market 490 The Role of the Central Bank 490 Budget Deficits and Monetary Policy 491 Cross Border Borrowing 491 Central Banks and Foreign Exchange Markets 492 Sterilized and Unsterilized Interventions 493 Exchange Rates 493 Issues with a Reserve Currency 494 Cross-border Implications of Central Bank Actions 494 Quantitative Easing 495 Quantitative Easing Versus Open-market Operations 496 Chapter 14 Interest Rate Derivatives 497 Forward Rate Agreements (FRAs) 497 Settling an FRA 499 Determining Bounds for the FRA Rate 499 Eurodollar Futures 500 Calculating Profits and Losses on ED Futures 501 Locking in a Borrowing Rate 502 Locking in a Lending Rate 503 The No-Arbitrage Pricing Equation 505 Creating a Fixed-rate Loan 506 30-year T-bond Futures Contracts 507 Conversion Factors 507 Interest Rate Options 510 State Prices 510 Callable and Putable Bonds 511 Caps, Floors, and Collars 512 Captions and Floortions 513 Sources and References 515 Index 521

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Stock basics; options basics; bonds basics; equities basics; equity basics; financial instrument basics; intro to finance; intro to financial instruments; time value of money; interest rate basics; macroeconomics; mutual fund basics