TLFeBOOK 1 Head iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John Wiley & Sons, Inc. TLFeBOOK TLFeBOOK Financial Engineering Principles TLFeBOOK Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more. For a list of available titles, please visit our Web site at www.WileyFinance.com. TLFeBOOK 1 Head iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John Wiley & Sons, Inc. TLFeBOOK Copyright © 2004 by Perry H. Beaumont, Ph.D. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or oth- erwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. 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HG176.7.B42 2003 658.15’224—dc21 2003011338 Printed in the United States of America. 10987654321 TLFeBOOK For my wife, Alexandra, with love and devotion TLFeBOOK Currencies Bonds Equities TLFeBOOK 1 Head vii FOREWORD IX PREFACE XI INTRODUCTION XVII PART ONE Products, Cash Flows, and Credits 1 CHAPTER 1 Products 3 CHAPTER 2 Cash Flows 15 CHAPTER 3 Credit 73 PART TWO Financial Engineering, Risk Management, and Market Environment 111 CHAPTER 4 Financial Engineering 113 CHAPTER 5 Risk Management 171 CHAPTER 6 Market Environment 241 INDEX 271 Contents vii TLFeBOOK [...]... together to help weave the complex fabric of financial engineering The text and the entire Appendix for Chapter 4 are peppered with practical examples that give Financial Engineering Principles a “real world” flavor In this way, professionals and laypersons alike have access to a virtual Global Positioning System to safely and swiftly navigate the most challenging of financial straits, even as the market... drivers, but also on cash flow and credit interrelationships to develop a richer, more powerful approach to risk management Financial Engineering Principles combines the best of a well-crafted “practitioner’s guide” with an invaluable “reference work” to give readers a financial engineering tool that will undoubtedly become one of the most used tools in their investment management tool chest Gilbert... assist with creating new financial products in the world of fixed income Here my goal is to introduce a unifying theory among the various factors that make up the world of finance The three fundamental factors to this unified theory are products, cash flows, and credit With a solid grounding in these first principles, we will show how any financial security can be better understood by financial professionals,... in any financial product While primarily intended for professional portfolio managers, individual investors and students of the financial markets also will find the text to be of value Key financial terms are highlighted in italics throughout the book for easy reference and identification While one obvious benefit of specialized texts is that they offer an indepth view of particular classes of financial. .. of par? With the rapid pace of financial innovation, convenient labels simply do not apply, and this is especially the case today with credit derivatives Thus, by virtue of its focus on the dynamics of processes and interrelationships as opposed to more definitional and static concepts, this text provides a financial toolbox that is equipped to build or deconstruct any financial product that may evolve... text highlights the commonality among these three markets; I do not mean to understate the depth and breadth of other financial markets Indeed, Chapter 5 attempts to link the unified approach to these other markets The underlying principles for the big three are applicable to every type of financial product Why focus on equities, bonds, and currencies? They are well-established markets, they are very much... the sincerity of an issuer wanting to keep a promise, but rather the business realities affecting an issuer’s ability to make good on the financial promises it has made Ability, in turn, involves any number of factors, including financial fundamentals (as with key financial ratios), quality of company management, economic standing relative to peer group (other comparable companies if there are any),... honor its promise of paying a coupon at the appointed time generally is seen as suffering very serious financial problems In many instances the failure to make good on a coupon payment equates to an automatic distressed (company is in serious financial difficulty) or default (company is unable to honor its financial obligations) scenario whereby bondholders are immediately vested with rights to seize certain... Head xi Preface After nearly 20 years in the financial industry, and with assignments that have taken me to every corner of the globe, it is only now that I feel this book could be written In my first text, Fixed Income and Synthetic Assets, the idea was to trek from the front of the yield curve to the back and provide ideas for how a properly equipped financial toolbox could help identify trading... principles, we will show how any financial security can be better understood by financial professionals, students, or individual investors who desire to go beyond more basic financial concepts After having spent years teaching about the financial markets, I continue to find it disheartening that some students feel that global markets are far more disparate than they are similar and shy away from thinking . iii Financial Engineering Principles A Unified Theory for Financial Product Analysis and Valuation Perry H. Beaumont, PhD John Wiley & Sons, Inc. TLFeBOOK TLFeBOOK Financial Engineering Principles TLFeBOOK Founded. weave the complex fabric of financial engineering. The text and the entire Appendix for Chapter 4 are peppered with prac- tical examples that give Financial Engineering Principles a “real world”. risk management. Financial Engineering Principles combines the best of a well-crafted “practitioner’s guide” with an invaluable “reference work” to give readers a financial engineering tool that