An INtroduction to capital markets products strategies and participants

An Introduction to Capital Markets P roducts, Strat egies, P art icipants Andrew M Chisholm JO HN W IL E Y & S O N S, L T D An Introduction to Capital Markets Wiley Finance S eries Swaps and Other Derivatives R ichard Flavell S ecurities Operations: A Guide to Trade and Position Management Michael Simmons Monte Carlo Methods in Finance Peter Ja¨ ckel Modeling and M easuring Operational R isk: A Quantitative Approach Marcelo Cruz Building and Using Dynamic Interest R ate Models Ken Kortanek and Vladimir M edvedev S tructured Equity Derivatives: T he Definitive Guide to Ex otic Options and S tructured N otes Harry Kat A dvanced Modelling in Finance Using Ex cel and V BA Mary Jackson and Mike Staunton Operational R isk: Measurement and Modelling Jack King Ad v anced C redit R isk Analy sis: Financial Approaches and Mat hem at ical Models t o Assess, Price and Manage C redit R isk Didier Cossin and Hugues Pirotte Dictionary of Financial Engineering John F Marshall Pricing Financial D erivat ives: T he Finit e D ifference Met hod Domingo A Tavella and Curt R andall I nt erest R at e Modelling Jessica James and Nick Webber Handbook of Hy brid I nst rum ent s: C onvert ible B onds, P ref erred Shares, L y ons, E L K S , D E C S and Ot her Mandat ory C onvert ible N ot es Izzy Nelken (ed.) O pt ions on Foreign E x change, R evised E dit ion David F DeRosa T he Handbook of E quit y D erivat ives, R evised E dit ion Jack Francis, William Toy and J Gregg Whittaker V olatility and Correlation in the Pricing of Equity, FX and Interest-rate Options Riccardo Rebonato Risk Managem ent and Analy sis vol 1: Measuring and Modelling Financial R isk Carol Alexander (ed.) R isk Managem ent and Analy sis vol 2: New Mark et s and Product s Carol Alexander (ed.) I m plem ent ing Value at Risk Philip Best C redit D erivat ives: A Guide t o I nst rum ent s and A pplicat ions Janet Tavakoli I m plem ent ing D erivat ives Models Les Clewlow and Chris Strickland I nt erest -rat e O pt ion Models: U nderst anding, A naly sing and U sing Models f or E x ot ic I nt erest -rat e O pt ions (second edition) Riccardo Rebonato An Introduction to Capital Markets P roducts, Strat egies, P art icipants Andrew M Chisholm JO HN W IL E Y & S O N S, L T D Copyright © 2002 John Wiley & Sons, Ltd, Baffins Lane, Chichester, West Sussex PO19 1UD, UK National 01243 779777 International ( + 44) 1243 779777 e-mail (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on http://www.wiley.co.uk All R ights R eserved 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 otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency, 90 Tottenham Court R oad, London W1P 9HE, UK, without the permission in writing of the publisher Ot her Wiley E dit orial Offices John Wiley & Sons, Inc., 605 Third Avenue, New York, N Y 10158-0012, U SA WILEY-VCH Verlag GmbH, Pappelallee 3, D -69469 Weinheim, G ermany John Wiley & Sons Australia Ltd, 33 Park R oad, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons (Canada) Ltd, 22 Worcester R oad, R exdale, Ontario M9W 1L1, Canada British Library Cataloguing in Pub lication Data A catalogue record for this book is available from the British Library ISBN 471 49866 Typeset in 10/12pt Times from the author’s disks by D obbie Typesetting Limited, Tavistock, D evon Printed and bound in Great Britain by Biddles Ltd, Guildford and Kings Lynn This book is printed on acid-free paper responsibly manufactured from sustainable forestry, in which at least two trees are planted for each one used for paper production Contents Acknowledgements xv Introduction: The Market Context 1.1 F inancial Intermediation and Risk 1.2 The Euromarkets 1.3 M odern Investment Banking 1.4 About this Book The Money Markets 2.1 Chapter Overview 2.2 Domestic Money Markets 2.3 US Domestic Markets 2.4 Eurozone Markets 2.5 Sterling Money Markets 2.6 The Bank of Japan 2.7 Treasury Bills 2.8 Discounting Treasury Bills 2.9 US Commercial Paper 2.10 Credit R isk on USCP 2.11 Bankers’ Acceptances 2.12 The Eurocurrency Markets 2.13 Eurocurrency Loans and Deposits 2.14 Eurocurrency R ate Quotations 2.15 Eurocurrency Certificates of Deposit 2.16 CD Yield to Maturity 2.17 Euro-Commercial Paper 2.18 Repos and Reverses 2.19 R epo: Case Study 2.20 Other Features of Repos 2.21 Chapter Summary 11 11 11 12 14 15 15 16 17 19 20 21 22 22 24 25 26 27 27 28 28 30 The Foreign Exchange Market 3.1 Chapter Overview 3.2 Market Structure 31 31 31 vi Contents 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 3.15 3.16 3.17 F X Dealers and Brokers Spot Foreign Exchange Deals Sterling and Euro Quotations F actors Affecting Spot F X Rates Spot F X Trading Spot Position Keeping F X R isk Control Cross-Currency R ates Outright F orward F X Deals F orward F X H edge: Case Study F orward F X F ormula F X or F orward Swaps F X Swap Quotations Interpreting F orward Points Chapter Summary 32 33 34 34 36 38 40 42 44 44 46 47 49 50 52 Bond Markets 4.1 Chapter Overview 4.2 Government Bond Markets 4.3 Sovereign Risk 4.4 US Government Bonds 4.5 US Treasury Quotations 4.6 US Treasury Strips 4.7 Bond Pricing 4.8 Pricing Coupon Bonds: Examples 4.9 Detailed Bond Valuation: U S Treasury 4.10 Bond Yield 4.11 Reinvestment Assumptions 4.12 Annual and Semi-Annual Bond Yields 4.13 UK Government Bonds 4.14 Corporate Bonds 4.15 Credit Derivatives 4.16 Credit Ratings 4.17 Other Corporate Bond Features 4.18 Securitization 4.19 Eurobonds 4.20 Pricing Eurobonds at Issue 4.21 Chapter Summary Appendix: Other M ajor Government Bond Markets 53 53 53 55 56 58 60 60 62 63 64 66 67 68 69 70 71 71 72 73 74 75 76 Bond Price Sensitivity 5.1 Chapter Overview 5.2 Bond M arket Laws 5.3 Other F actors Affecting Price Sensitivity 5.4 Macaulay’s Duration 5.5 Calculating Macaulay’s Duration 5.6 Duration of a Zero 79 79 79 80 81 82 83 Contents 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15 5.16 5.17 M odified Duration Price Value of a Basis Point Convexity Measuring Convexity Convexity Behaviour Portfolio Duration Dedication Immunization Duration-Based Hedges Convexity Effects on Duration Hedges Chapter Summary vii 84 86 86 87 88 89 90 92 94 95 96 The Yield Curve 6.1 Chapter Overview 6.2 Real and Nominal Interest Rates 6.3 Compounding Periods 6.4 The Yield Curve Defined 6.5 Theories of Yield Curves 6.6 Yield Curves and Credit Risk 6.7 Zero Coupon or Spot Rates 6.8 Bootstrapping 6.9 R elationship with the Par Curve 6.10 Pricing Models Using Spot Rates 6.11 Forward Rates 6.12 Discount Factors 6.13 Chapter Summary 97 97 97 98 99 100 102 103 105 106 107 108 110 111 Equity Markets 7.1 Chapter Overview 7.2 Debt and Equity 7.3 Additional Features of Equity 7.4 Hybrid Securities 7.5 Institutional Investors 7.6 Equity Investment Styles 7.7 Efficient Markets 7.8 Hedge Funds 7.9 Primary M arkets 7.10 Subsequent Issues 7.11 Rights Issue: Example 7.12 Other N ew Share Issues 7.13 The London Stock Exchange 7.14 Stock Exchange Trading System (SETS) 7.15 The New York Stock Exchange 7.16 Depository Receipts 7.17 Stock Lending 7.18 Portfolio Trading 113 113 113 114 115 116 116 117 119 120 122 122 123 123 125 126 126 127 128 434 An Introduction to Capital Markets Zero cost collar A collar strategy on which there is zero net premium to pay The premiums on the calls and puts cancel out Zero coupon bond A bond which does not pay a coupon and which trades at a discount to its par or face value At maturity the holder of the bond is repaid the face value Zero coupon rate (spot rate) The rate of interest that applies to a specific future date Specialists in fixed income markets use zero coupon rates to discount cash flows and price instruments because no reinvestment assumptions need be made Useful Internet Sites American Stock Exchange Bank for International Settlements Bank of Japan Barclays Capital Bloomberg Chicago Board of Trade Chicago Board Options Exchange Chicago Mercantile Exchange CIBC World M arkets Citigroup Credit Suisse F irst Boston Deutsche Bank (CIB) Deutsche Borse ¨ Dresdner Kleinwort Wasserstein Dun and Bradstreet EBR D Eurex Euromoney Publications Euronext European Central Bank Fannie Mae (F NMA) Financial Times Fitch Freddie M ac (F H LM C) Goldman Sachs HSBC International Monetary Fund ISMA JP Morgan Lehman Brothers LIFFE London Stock Exchange Merrill Lynch Moody’s Investor Services Morgan Stanley NASDAQ New York Stock Exchange Nomura Philadelphia Stock Exchange Reuters www.amex.com www.bis.org www.boj.or.jp/en www.barclayscapital.com www.bloomberg.com www.cbot.com www.cboe.com www.cme.com www.cibcwm.com www.citigroup.com www.csfb.com www.db.com www.deutsche-boerse.com www.drkw.com www.dnb.com www.edrd.com www.eurexchange.com www.euromoney.com www.euronext.com www.ecb.int www.fanniemae.com www.ft.com www.fitchibca.com www.freddiemac.com www.gs.com www.hsbc.com www.imf.org www.isma.org www.jpmorgan.com www.lehman.com www.liffe.com www.londonstockexchange.com www.ml.com www.moodys.com www.morganstanley.com www.nasdaq.com www.nyse.com www.nomura.com www.phlx.com www.reuters.com 436 An Introduction to Capital Markets Risk Metrics Group Securities & Exchange Commission Securities & Futures Authority Standard and Poor’s Telerate The Bank of England The Economist The Royal Bank of Scotland UBS Warburg UK Treasury US Federal Reserve US Treasury Wall Street Journal World Bank www.riskmetrics.com www.sec.gov www.fsa.gov.uk/sfa www.standardandpoors.com www.telerate.com www.bankofengland.co.uk www.economist.com www.royalbankscot.co.uk www.ubswarburg.com www.hm-treasury.gov.uk www.federalreserve.gov www.treas.gov www.info.wsj.com www.worldbank.com Further Reading Many books and articles have been written on the capital markets The following are a few select titles that cover topics raised in the current volume in more detail Arditti F D Derivatives Harvard Business School Press 1996 Berstein P.L A gainst the Gods: The Remarkable Story of Risk John Wiley & Sons 1996 Bickerstaffe G ed Mastering Finance FT Pitman 1998 Brearley R A and M yers S.C Principles of Corporate Finance McGraw-Hill 1991 Choudhry M T he Bond & M oney M arkets Butterworth-Heinemann 2001 Cornwell B T he Equity R isk Premium John Wiley & Sons 1999 Damodaran A Investment V aluation John Wiley & Sons 1996 F abozzi F J Fix ed Income Mathematics M cG raw-Hill 1997 Hull J.C Options, Futures and Other Derivatives F ourth edition Prentice-Hall 2000 Jarrow R and Turnbull S Derivative Securities South-Western College Publishing 1996 Natenberg S Option V olatility & Pricing Probus 1994 R oth P M astering Foreign Ex change & Money Markets F T Pitman 1996 Smithson C.W., Smith C.W and Sykes Wilford D Managing Financial R isk Irwin 1995 Walmsley J N ew Financial Instruments John Wiley & Sons 1998 Walmsley J T he Foreign Ex change and Money Markets Guide Second edition John Wiley & Sons 2000 For a highly readable overview of the City of London’s recent history try Philip Augar’s T he Death of Gentlemanly Capitalism published by Penguin in 2001 The full story is told in David Kynaston’s magnificent series T he City of L ondon published by Chatto and Windus in four volumes Volume IV published in 2001 covers the years 1945–2000 Index Accepting Houses Committee, accounting ratios, 143 accreting swap, 233 accruals accounting, 136 accrued interest, 58–60, 64, 75, 240 active and passive management, 116 actual basis, 265 adjusted earnings per share, 142 alpha, 166 American depository receipts, 127 American options, and binomial trees, 313 defined, 280 early exercise, 289–90, 293, 304 euribor options, 373 intrinsic and time value, 288–9, 281, 302 maximum and minimum values, 302–3 and put-call parity, 307 amortizing swap, 233 annual equivalent rate/yield, 67–8, 98–9 annualized volatility, 319, 325 arbitrage, 182–3, 265–7 Armstrong World Industries, 21 Asian options, 296 asset allocation, 117, 211–12, 260–1 asset beta, 171–2 asset management, asset swap, 219–20 asset turnover, 146 asset-backed commercial paper, 21 asset-liability management, 220 associated economic exposure, 259 at-the-money option, defined, 281–2 average deal rate, 40 average price options, 296 balance sheet, defined, 134 equation, 134–6 fixed and current assets, 134–5 liabilities and equity, 135, 139 for Tesco and Sainsbury, 138–40 bank discount method, 17 bank disintermediation, Bank for International Settlements (BIS), 31 Bank of England, 4, 15, 22 Bank of Japan, 15–16 Bankers’ acceptances, 21–2 Bankers Trust, Barclays Bank, 2, barrier options, 296 base and counter-currency, 33 basis, 209–10, 259, 264–5 basis points, defined, 12 basis risk, 209–10, 259, 268, 275 basis swap, 216, 233 bear spread, 351–2 bearer securities, 25, 73 Bermudan options, 280, 297 beta, and alpha, 166 asset beta, 171–2 calculation of, 165–6 defined, 161–2 proxy, 168 used in an index futures hedge, 257–60 Big Bang, 124 big figure, 33 binary options, 297 binomial trees, 307–13 Black model for interest rate options, 376–81 Black–Scholes model, 302, 313–16, 322–4, 337, 369–70 blended equity swap, 275 block trades, 125 Bloomberg service, 54 blotter, 38 Bobls, 77 bond futures, in asset allocation, 211–12 basis risk, 209–10 bund futures, 201–2 the CTD, 204–7 hedging with bond futures, 207–11 U K gilt futures, 200–1 US long-bond futures, 198–200 bond pricing, annual coupon bond, 61–2 duration-based hedges, 94–6 price sensitivity, 80–9 price/yield relationship, 79–81 semi-annual bond, 62–3 using spot rates, 107 U S Treasury, 63–4 bond yield, 64–5 annual and semi-annual bonds, 67 440 Index bond yield (cont.) annual equivalent yield, 67–8 current yield, 65 price/yield relationship, 79–81 reinvestment assumptions, 66 yield to maturity, 65–6 bonus issues, 123 bookbuilding, 121 bootstrapping, 105–6, 237–8 BOTs, 77 bottom-up fund management, 117 Bowie bonds, 73 British Bankers’ Association (BBA), 23, 217, 221 BTANs, 77 BTF s, 77 BTPs, 77 bulge bracket firms, bull spread, 349–51 Bund Issue Auction Group, 77 bunds, 76–7 calendar spread, 354–5 callable bonds, 71 callable swap, 234 call options, bull spread, 349–51 calendar spread, 354–5 caps, floors and collars, 373–8 collars, 347–9 covered call writing, 345–7 currency call options, 366–70 defined, 280 expiry payof f profiles, 282–4 index options, 291–5 interest rate calls, 370–2 stock options, 289–91 swaptions, 379–81 volatility trades, 356–62 Capital Asset Pricing Model (CAPM), and beta, 162 and the dividend discount model, 156 formula, 161–2 and portfolio theory, 164–5 and the risk premium, 163–4 and WACC, 168–9 capital flows, capital markets defined, 1–2, 5–8 caplet, 374, 376–7, 381 caps, floors and collars, 373–6, 378, 381 cash equity markets, cash settlement, 185, 254 cash-and-carry pricing, 202–3, 262–4 central banks and foreign exchange, 32 central counterparty, 126, 216–17 certificates of deposit, 25–7 cheapest to deliver bond, 204–7 Chicago Board of Trade (CBOT), 54, 184–5, 197–200, 204 Chicago Board Options Exchange (CBOE), 279, 289–91 Chicago Mercantile Exchange (CME), 184–6, 188, 191, 253–4, 293–4, 371–2 Chinese walls, 117 chooser options, 297 Citigroup, 5, 23, 31 clean price, 58–60, 64 Clearstream, 74 cliquet options, 298 coefficient of determination, 166 collars, 347–9 collateral, 22, 28, 128 collateralized mortgage obligations, 73 commercial banking, 2–3, 12 commercial paper, credit risk, 20–1 Eurocommercial paper, 27 foreign issuers, 20 maturities, 20 quotations, 20 spread over Treasuries, 20 US commercial paper origins, 19 common stock, 113 comparative advantage and swaps, 223–7 compound interest, 60–1 compound options, 297 compounding periods, 98–9 concavity, 251 concentration risk, 176 continuous compounding, 99, 312–13 conversion factors, 198–201, 204–12 convertible bonds, 72, 116 convertible preference shares/stock, 115 convexity, 80, 86–90, 95, 251, 329 corporate actions and options, 291 corporate bonds, call and put features, 71 credit ratings, 72 credit risk, 70–1 debenture bonds, 70 issuers, 6, 69 non-straight bonds, 72 sinking fund, 70 subordinated bonds, 70 corporate finance/advisory, cost of carry, 44, 202–3, 263–5, 369 counterparty risk, 180, 185, 215, 226–7, 273, 280 coupon cycle, 59 coupon rate, 25, 58, 80–1 coupon stripping, 104–6 coupons, 53 Index covenants, 70, 114 covered call writing, 345–7 covering foreign investments, 52 Cox, Ross and Rubenstein, 311 credit default swap, 70–1 credit derivatives, 6, 70–1 credit event, 71 credit ratings, 21, 71–2 credit risk, and bonds, 70–2 and commercial paper, 20 and lending, and swaps, 225, 228, 233 and yield curves, 102–3 credit spread, 70, 103, 228–9 Credit Suisse, cross-currency F X rates, 42–44 cross-currency swaps, 216, 231–3 crosses, 129 cum-dividend, 115 cumulative preference shares/stock, 115 currency options, definitions and quotations, 365–6 hedging with, 366–9 pricing, 369–70 current assets, 135, 139 current liabilities, 135, 139 current ratio, 143–4 current yield, 65 curve risk, 96, 107–8 day-count conventions, actual/360, 18, 24–5 actual/365, 18, 24–5 actual/actual, 58–9 30/360, 75 DAX 30 index, 254 deal blotter, 38 dealer’s spread, 33 dealing limits, 176 debenture bonds, 70 debt capital markets, Debt Management Office, 19, 68 debt markets, dedication, 90–2 deferred swap, 234 delta, behaviour, 327–8 and bull spreads, 351 and currency options, 370 definition, 307–8, 326–8 delta and gamma hedging, 336–9 and gamma, 329–2 sign, 326–7 and volatility trades, 357–62 delta neutrality/hedging, 308–9, 316, 328, 336–9 441 depository receipts, ADRs, 127 defined, 126 GDRs, 127 market statistics, 127 depreciation defined, 134 derivatives market statistics, 196 Deutsche Bank, 5, 23, 31 Deutsche Bo¨rse, 131 digital options, 297 diluted earnings per share, 141 dirty price, 28, 58–60, 62, 64, 240 discount factors, defined, 110 deriving from spot rates, 110 and forward rates, 110–111 and swap valuation, 238–9, 241–3, 247–50 discount rate US Federal Reserve, 16 discount window, 14 diversifiable risk, 165 diversification, 268 dividends, dividend cover, 142 dividend per share, 142 dividend yield, 148–9, 157 on gilts, 68 on ordinary shares, 142–3 payout ratio, 142 policy, 142–3 dividend discount models, basic model, 153–4 constant growth model, 155–6 and dividend yield, 157–8 extended model, 154 implied return, 156–7 and price/earnings ratio, 158–9 stage models, 159–61 DJ STOXX index, 268 domestic markets, 11 downside risk, 283, 341 dual capacity, 124 duration, applications, 90–6 and convexity, 86–9 Macaulay’s duration, 81–4 modified duration, 84–5 portfolio duration, 89–90 price value of a basis point, 86, 94–5, 210–11, 251 early exercise and American options, 293, 304 earnings, defined, 140–1 earnings per share, 141–2, 149–50 EBITDA, 151, 167, 169 EBR D , economic indicators, 35–6 442 Index EDSP, 256–7, 292–3 efficient markets, defined, 117–18 implications and research, 118–19 and share price movements, 118 electronic communications networks, 130 electronic deal capture, 40 eligible bills, 22 enterprise value, 151, 167–8 equilibrium value, 261 equity, features of, 114–15, 135, 139 forward pricing, 261–3 new issues, 6, 120–3 risk premium, 163–4 shareholders’ funds, 135, 139–40 Eurex, 54, 188–9, 201–2, 254, 280, 373 euribor, 24, 189 euribor futures, 189–91 euribor options, 373 euro, 3, 34 Eurobonds, 4, 73–5 euro-bund futures, 201–2 Euroclear, 74 Eurodollars and Eurocurrencies, background, 3–4, 11, 22 certificates of deposit, 25–7 commercial paper, 27 dollar deposits, 24–5, 186 Eurobonds, 4, 73–5 Eurodollar futures, 185–8, 191–4, 372 Eurodollar options, 371–2 loans and deposits, 22–4, 26, 84 euro–LIBOR , 23 European Banking F ederation, 24 European options, Black–Scholes valuation, 313–16 defined, 280 intrinsic and time value, 288–9 minimum and maximum values, 302–4 and put-call parity, 305–6 European System of Central Banks, regulation, 14–15 role of NCBs, 14 structure and goals, 14 equity capital markets, 6, 120–3 equity index futures, in asset allocation, 130, 212, 260–1 defined, 253–4 and equity swaps compared, 275–6 features of, 268 hedging with, 257–60 index arbitrage trades, 265–7 margining, 254–7 equity swaps, basic structure, 269–1 hedging, 273–4 managing risks, 271–3 structuring and benefits, 274–6 equilibrium value, futures, 261 eurozone government bonds, 767 exchange options, 297 exchange rate mechanism, 119 exchangeable bonds, 72 ex-dividend, 69, 115, 291 exotic options, 296–9 extendable swap, 234 extraordinary items, 140 fair value, 261 Fama, E.F , 118 fat tail problem, 316 Federal funds, 13–14, 24 financial distress, 114 financial futures, bund futures, 201–2 comparison with F R As, 195 definition, 185 equity index futures, 253–68 euribor futures, 189–90 Eurodollar futures, 186–8 gilt futures, 200–1 hedging with, 191–2 margining, 188–91 origins, 184–5 single stock futures, 268–9 strips and strip hedges, 192–3 synthetic futures, 306 US Treasury bond futures, 198–200 financial institutions, 12 financial intermediation, firm value, 151, 167 fiscal policy, 36 Fitch, 55 fixed assets, 134, 138–9 flat yield curve, 100 flight to quality, 21 floating principal equity swap, 275 floating rate note, 72, 236–40 floor brokers, 126 floorlet, 378 flow derivative products, flow trading, 125 foreign exchange, cross-currency rates, 42–4 cross-currency swaps, 216, 231–3 currency options, 365–70 F X swaps, 47–52 market structure, 31–3 outright forward deals, 44–7 spot market, 33–42 forward points, 49–52 Index forward price/rate, bonds, 202–4 currency, 46–7, 49–52 equity index, 264 interest rates, 108–10, 181–4, 240–4, 376–81 shares, 261–3 forward rate agreement (F R A), applications, 176–8 comparison with futures, 195 compensation formula, 178 defined, 175–6 the forward rate, 181–4 and interest rate caps, 373 and interest rate options, 370–1 and interest rate swaps, 240–6 market and counterparty risk, 180 quotations, 179–80 shading rates, 181 forward start options, 298 forward start swap, 234 F R ABBA terms, 176 free cash flow, 167–8 F T-SE 100, 165 F T-SE 100 index futures, 254, 261, 264–7 F T-SE 100 index options, 291–3 funding risk, 273 futures strips, 192–3, 251 G10, 56 gamma, behaviour, 331–2 and bull spreads, 351 definition, 329 and delta, 329–30 delta and gamma hedging, 336–9 and volatility trades, 360–2 Garman–K ohlhagen model, 369–70 gearing and company value, 170–2 gearing/leverage, 114 gearing/leverage ratios, 147–8 general cash offers, 122 General Electric, 20 gilts and gilt futures, 15, 68–9, 200–1 Glass–Steagall Act, 2–3 global depository receipts, 127 global trading, 41 GLOBEX, 185 Goldman Sachs, government bond markets, background, 53 brokers, 54 eurozone government bonds, 76–7 Japanese government bonds, 76 market sizes, 54 price and yield, 60–8 sovereign default risk, 55–6 443 trading methods, 54 UK gilts, 68–9 US government bonds, 56–60 greenshoe option, 121 grey market, 121 gross gearing, 147 growth investment, 116 haircut, 29, 128 Hammersmith & Fulham, 229 hedge funds, 119–20 hedge ratio, 94–5, 191–2, 208–11, 258 hedging bond portfolios, 94–6, 207–11 hedging currency risk, 44–6, 366–9 Herstatt risk, 41–42 historic volatility, 317–19, 324–6, 355 horizon yield, 66 humped yield curve, 100 hybrid securities, 115–116 immunization, 92–3 implied forward interest rates, 103, 108–10, 240–3 implied repo rate, 203–4 implied volatility, 316, 325–6, 337, 355–6 index arbitrage, 265–7 index-linked bonds, 69 index options, F T-SE 100 contracts, 291–3, 315 S&P futures options, 293–5 inflation rate, 97–8 inflation-linked notes, 57 initial margin, 188, 197, 254, 256 initial net present value (INPV), 239 initial prospectus, 121 initial public offerings (IPOs), defined, 120 issuance methods, 120 private placements, 121 stages, 120–1 insider dealing, 118 instrike, 296 intangible assets, 134–5, 138–9 interdealer brokers, 54 interest cover, 148 interest rate futures, contracts, 186–1 and F R AS compared, 195 hedging swaps with, 250–1 hedging with, 191–4 and interest rate options, 371–3 and swap rates, 240–50 interest rate options, caps, floors and collars, 373–6 Eurodollar options, 371–3 Euribor options, 373 444 Index interest rate options (cont.) exchange-traded options, 371 hedging with, 370–1 OTC options, 370–1 pricing, 376–81 swaptions, 379–81 interest rate strategies, 381 interest rate swaps, approximate revaluation methods, 244–5 basic structure, 216–18 and caps compared, 374–6 comparative advantage, 223–7 and convexity, 251 credit risk, 225–6, 228–9, 233 cross-currency swaps, 216, 231–33 definition, 215–16 and F R As/futures, 245–50 hedging with interest rate futures, 250–1 hedging with Treasuries, 230 and LIBOR rates, 243–4 non-standard, 233–4 quotations, 227–8 revaluation, 239–43 standard terms, 223 typical applications, 218–20 valuation at inception, 235–9 intermarket spread, 257 internal rate of return, 65 international bonds (Eurobonds), 73–4 International Monetary Fund (IM F ), 56 intrinsic value, 281–2, 288–9, 307–8, 321–2 investment banking, 2, 5–6, 12 investment management, hedge funds, 119–20 investment styles, 116–19 investor ratios, 148 ISD A, 218 ISMA, 74 James Capel, Japanese government bonds, 76 JP Morgan Chase, 2, 5, 31 kappa, 334 Kleinwort Benson, knock-in and knock-out options, 296 ladder options, 298 lead manager (bookrunner), 74, 120–1 Lehman Brothers, 60 lender of last resort, 16 lending margin, liabilities, 135 LIBOR defined, 21, 23–4 LIBOR -in-arrears swap, 234 LIF F E contracts, 200, 254, 289, 373 LIF F E-Connect, 185, 254, 290 limited liability, 114 liquidity, 75, 102, 125, 130, 259, 268 liquidity preference theory, 101–2 liquidity premium, 102 liquidity ratios, 143–4 Lloyds of London, London as a financial centre, London Clearing H ouse (LCH ), 126, 188, 216, 254–5 London Stock Exchange, Big Bang, 124 market statistics, 131 origins, 123–4 trading methods, 124–6 long gilt futures, 200–1 long-only funds, 116 long-term liabilities, 135, 139 lookback options, 298 LTCM, 119 Macaulay’s duration, 81–4 macro fund, 119 maintenance margins, 257 manufactured dividends, 128 market capitalization, 114–15, 151–2 market expectations theory, 100–2, 107, 109 market makers, 124–5 market risk, 41, 180 market risk premium, 161–4, 170 Markowitz, Harry, 164 mark-to-market, 39–40, 188, 190, 201, 239 merchant banks, Mercury Asset M anagement, mergers and acquisitions, Merrill Lynch, 2, 4, 5, 8, 60 minority interests, 139–40 modified duration, 84–9 Monetary Policy Committee, 15 money dealers, 23 money markets, bankers’ acceptances, 21–2 defined, 11 domestic, 11–12 eurozone markets, 14–15 repos and reverses, 27–30 sterling market, 15 Treasury bills, 16–19 US commercial paper, 19–21 US markets, 12–14 money supply, 35 M oody’s Investors Services, 20–1, 55, 71–2 moral hazard, 16 Morgan Grenfell, Morgan Stanley, 2, multi-asset options, 299 mutual funds, 116 Index naked option positions, 284 NASDAQ, 125, 131, 268 National Westminster Bank, 2, negative earnings and valuation, 150–2 negative yield curve, 100, 107 net gearing, 147 net profit margin, 144–6 N ew York Stock Exchange, 126, 131 nominal interest rates, 97–8 normal distribution, 314, 316 nostro accounts, 42 OATs, 77 on-the-run bond, 57 open- and closed-ended funds, 116 open market operations, 12–15 open-ended investment companies, 116 operating profit, 140, 145 operational failure, 41 opportunity loss, 342 options, basic trading strategies, 281–8 bear spread, 351–2 Black–Scholes pricing model, 313–16 bull spread, 349–51 calendar spread, 354–5 collars, 347–9 and corporate actions, 291 covered call writing, 345–7 currency options, 365–70 defined, 279–80 Greek letters, 326–9 index options, 291–5 interest rate options, 370–81 pricing with binomial trees, 307–13 protective put strategy, 341–5 put-call parity, 305–7 put ratio spread, 352–4 stock options, 289–91 time value behaviour, 322–4 valuation principles, 301–4 versus futures hedge, 341–2 and volatility, 317–19, 324–6 volatility trades, 356–62 Options Clearing Corporation (OCC), 366 order-driven market, 125–31 ordinary shares, ex-dividend and cum-dividend, 115 features, 113–15, 133–4 and limited liability, 114 partly-paid shares, 115 and retained earnings, 135 and shareholders’ funds, 139–40 valuation principles, 133–4 voting rights, 114 outright forward foreign exchange, 44–7 445 outright risk, 107–8 outstrike, 296 overnight risk, 41 over-the-counter market defined, 32 pairs trades, 125 Pakistan government debt, 55 par swap, 239, 243 par yield curve, 103 partly-paid shares, 115 passive fund management, 116 pass-through securities, 72–3 payer swaption, 379, 381 petro-dollars, Philadelphia Stock Exchange, 365–7 physical delivery, 185 placements, 12 portfolio duration and convexity, 89–90 portfolio theory, 164–5 portfolio trading, defined, 128 implementation, 129 market trends, 129–30 principal and agency deals, 129 position keeping, 38–40 positive and negative carry, 203, 264 positive yield curve, 100, 107, 109 preference shares/stock, 115 preferred habitat theory, 102 premium, on options defined, 279–80 present value formulae, 26, 60–1 price relatives, 317 price stability and central banks, 14 price value of a basis point (PVBP), 86, 94–5, 210–11, 251 price/book ratio, 151–2 price/earnings ratio, applications, 150 defined, 148 and the dividend discount model, 158–9 and relative value, 150 for Tesco and Sainsbury, 149–50 price/sales ratio, 151 primary market, 2, 73–4, 120 private banking, private equity, private placements, 120–1 privatization, profit & loss account, and accruals accounting, 136 defined, 134 and earnings, 140–1 for Tesco and Sainsbury, 140–1 profit before interest and tax, 140 profitability ratios, 144–7 proprietary trading, 125 446 Index protection seller, 70 protective put, 341–5 provisions, 139 put ratio spread, 352–4 putable bonds, 71 putable swap, 234 put-call parity and options, 305–7 put options, bear spread, 351–2 bull spread, 351 caps, floors and collars, 373–8 collars, 347–9 currency put options, 366–70 defined, 280 expiry payof f profiles, 284–8 interest rate puts, 370–3 protective put strategy, 341–5 put ratio spread, 352–4 swaptions, 379–81 quanto equity swap, 275 quanto options, 299 Quantum fund, 119 quick ratio, 143–4 quote-driven market, 124 r squared, 166 random walk, 118, 316 rate-capped swap, 234 real interest rates, 97–8 receiver swaption, 379, 381 red herring, 121 redemption date, 53 reinvestment risk, 66, 91–2 replacement risk, 41 replacement value of assets, 152 repos and reverses, 13, 27–30 reserves, 14 residual value, 169–70 retained earnings, 135, 141 return on capital (R OCE), 144–7 return on equity (R OE), 144–6 return on total assets, 144–7 return on total capital, 147 R euters, 32 revaluation, 39–40, 239–40 rho, 335–6 Ricardo, D avid, 124 rights issues, defined, 122 and general cash offers, 122 procedures, 122–3 risk capital, equity as, 135 risk management, risk premium, 161 risk-free rate, 19–20, 161, 163 risk-neutral valuation, 310 Robert Fleming, rollercoaster swap, 233 rollover risk, 260, 268 Royal Bank of Scotland, Russell 2000 index, 268 S&P 500 index, futures, 253–4 options, 293–5 sale & repurchase agreement (repo), 27–30 Salomon Brothers, 5, 57, 60 Sainsbury plc, balance sheet, 138–9 company background, 137 gearing ratios, 147–8 investor ratios, 148–51 liquidity ratios, 143–4 profit & loss account, 140–1 profitability ratios, 144–7 Schroders, scrip dividends, 123 SEAQ, 124 secondary markets, 2, 73–4, 123 Securities and Exchange Commission, 19 securitization, 2, 72–3 sell/buy-back agreements, 30 sellers’ options, on bond futures, 206–7 semi-annual bonds, 62–3, 67–8 SETS, 125–6 settlement risk, 41–2 shading F X quotes, 37–8 shareholder democracy, 114 Sharpe, William, 161 shout options, 299 simple interest, 25 single stock equity swaps, 275 single stock futures, 268–9 sinking fund, 70 Soros, George, 119 sovereign risk, 55–6 specialists, 126 specific risk, 165 split maturity date bonds, 69 spot (zero coupon) rates, 103–11, 238 spread over Treasuries, 74 Standard and Poor’s, 20–1, 55, 71–2, 229, 254 standard deviation, 165, 318, 325 standby credit line, 20 sterling and euro F X quotations, 34 sterling money markets, 15 stock lending, collateral, 128 defined, 127 Index dividends, 128 market participants, 127–8 termination, 128 stock market crash 1987, 125 stock options, 289–91, 313–16 stock splits, 123 stop-loss order, 41 straddles, 357–62 straight bonds defined, 53 strangles, 361–2 strips, bonds, 60, 69 strips, futures, 192–4 structured derivatives, stub period, 246 subordinated bonds, 70 SwapClear, 216 swaptions, 234, 379–81 SWIF T payments, 33 syndicated loans and LIBOR , 24 syndication, 74, 121 synthetic call option, 344 synthetic futures, 306 systematic risk, 165 systemic risk, 16 tangible assets, 134, 138–9 technical analysis, 118 Telerate, 32 tender issues, 120 tenor, 216, 379 terminal value, 169–70 Tesco plc, balance sheet, 138–40 company background, 137 dividend per share, 142 earnings per share, 141 gearing ratios, 147–8 investor ratios, 148–51 liquidity ratios, 143–4 profit & loss account, 140–1 profitability ratios, 145–7 theoretical basis, 265 theta, behaviour, 332–3 and bull spreads, 351 and calendar spread trades, 354–5 definition, 332 and volatility trades, 361–2 time decay on options, 333 time deposits, 23 time value on options, 282, 288–9, 321–4 Tobin, James, 152 top-down fund management, 117 tracking and tracking error, 116, 259, 276 trade balance, 35 trade creditors, 133 447 tranche, 73 transaction costs on index futures, 268 Treasury bills, discount formula, 17–18 discounting method, 17 eurozone bills, 77 Japanese bills, 76 open market operations, 13, 15 UK bills, 18–19 U S bills, 16–18, 56 when issued bills, 17 yield, 18, 20, 27 ultra vires, 229, 276 undated bonds, 68, 155 underwriting, 2, 74, 121 Union Bank of Switzerland, 23 unsystematic risk, 165 U S F ederal R eserve, and Eurodollars, 4, 22 F ederal Open Market Committee (F OMC), 12–13 and LTCM, 119 R eserve Bank of New York, 13 reserves and federal funds, 13–14, 24 System, 12 US government bonds, futures, 198–200 issuance procedures, 56 market size, 54 pricing, 60–4 quotations, 58 strips, 60 types, 56 when-issued and secondary market, 56 value date, 23, 33 value investment, 116–17 variance, 318 variation margins, 188–91, 255–6, 266, 268, 276 vega, behaviour, 334–5 and bull spreads, 351 definition, 334 and delta/gamma hedge, 339 and volatility trades, 361–2 voice brokers, 32 volatility, 310–11, 316–19, 324–6, 334, 355–62 volatility smile and surface, 356 volatility trades, 355–62 volume weighted average price (VWAP), 129–30 vostro accounts, 42 weighted average cost of capital, 168–72 Wedd Durlacher, 448 Index when-issued market, 17, 57 withholding tax, 73, 276 World Bank, yield, 18, 26–7, 57, 64–8, 79–81, 88 yield conversions, 68 yield curves, and credit risk, 102–3 defined, 96, 99–100 and liquidity, 102 non-parallel shifts, 96 shapes, 99–100 and spot rates, 103–7 and swap rates, 222 theories of, 100–2 zero cost collar, 348–9 zero coupon bond and duration, 83–4, 88–9 zero coupon (spot) rates, deriving, 103–6 pricing bonds with, 107 relationship with par yields, 106–7 and swap valuation, 238–9, 241–3, 247–50 zero coupon swap, 234 ... risk management specialists and auditors and middle-office staff who monitor and measure risks and exposures and profits; f information technology professionals who develop and manage the bank’s... issuers and the investors, and the role of the banks in bringing issues to the market and in trading bonds Investors and traders in bonds have to understand how the securities are priced and how.. .An Introduction to Capital Markets P roducts, Strat egies, P art icipants Andrew M Chisholm JO HN W IL E Y & S O N S, L T D An Introduction to Capital Markets Wiley Finance S eries Swaps and