Using clear, worked examples of everything from basic equity and debt securities to complex instruments - like derivatives and mortgage-backed securities - the author outlines the structure and dynamics of the free-market system and explores the environment in which financial instruments are traded. This one-of-a-kind book also includes: - New discussions on interest rate derivatives, bonds with embedded options, mutual funds, ETFs, pension plans, financial macroeconomics, orders and exchanges, and Excel functions for finance - Supplementary materials to enhance the reader’s ability to apply the material contained within - A foundational exploration of interest rates and the time value of money
Fundamentals of Financial Instruments is the ideal resource for business school students at the undergraduate and graduate levels, as well as anyone studying financial management or the financial markets. It also belongs on the bookshelves of executive education students and finance professionals seeking a refresher on the fundamentals of their industry.
Table of Contents
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
