The economics of financial markets

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The Economics of Financial Markets Roy E Bailey    Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo Cambridge University Press The Edinburgh Building, Cambridge  , UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521848275 © R E Bailey 2005 This book is in copyright Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press First published in print format 2005 - - ---- eBook (EBL) --- eBook (EBL) - - ---- hardback --- hardback - - ---- paperback --- paperback Cambridge University Press has no responsibility for the persistence or accuracy of s for external or third-party internet websites referred to in this book, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate Contents List of figures Preface page xv xvii Asset markets and asset prices 1.1 Capital markets 1.2 Asset price determination: an introduction 1.3 The role of expectations 1.4 Performance risk, margins and short-selling 1.5 Arbitrage 1.6 The role of time 1.7 Asset market efficiency 1.8 Summary Appendix 1.1: Averages and indexes of stock prices Appendix 1.2: Real rates of return Appendix 1.3: Continuous compounding and the force of interest References 11 15 20 22 23 24 28 Asset market microstructure 2.1 Financial markets: functions and participants 2.2 Trading mechanisms 2.3 Industrial organization of financial markets 2.4 Trading and asset prices in a call market 2.5 Bid–ask spreads: inventory-based models 2.6 Bid–ask spreads: information-based models 2.7 Summary References 33 34 36 41 45 48 49 52 54 ix 29 32 x Contents Predictability of prices and market efficiency 3.1 Using the past to predict the future 3.2 Informational efficiency 3.3 Patterns of information 3.4 Asset market anomalies 3.5 Event studies 3.6 Summary Appendix 3.1: The law of iterated expectations and martingales References 56 57 64 70 72 75 77 79 81 Decision making under uncertainty 4.1 The state-preference approach 4.2 The expected utility hypothesis 4.3 Behavioural alternatives to the EUH 4.4 The mean-variance model 4.5 Summary Appendix 4.1: Useful notation Appendix 4.2: Derivation of the FVR Appendix 4.3: Implications of complete asset markets Appendix 4.4: Quadratic von Neumann–Morgenstern utility Appendix 4.5: The FVR in the mean-variance model References 83 85 90 98 101 105 107 108 109 110 111 112 Portfolio selection: the mean-variance model 5.1 Mean-variance analysis: concepts and notation 5.2 Portfolio frontier: two risky assets 5.3 Portfolio frontier: many risky assets and no risk-free asset 5.4 Portfolio frontier: many risky assets with a risk-free asset 5.5 Optimal portfolio selection in the mean-variance model 5.6 Summary Appendix 5.1: Numerical example: two risky assets Appendix 5.2: Variance minimization: risky assets only Appendix 5.3: Variance minimization with a risk-free asset Appendix 5.4: Derivation of P = jP P aj Appendix 5.5: The optimal portfolio with a single risky asset References 114 115 118 121 125 131 133 134 135 139 140 141 142 Contents xi The capital asset pricing model 6.1 Assumptions of the CAPM 6.2 Asset market equilibrium 6.3 The characteristic line and the market model 6.4 The security market line 6.5 Risk premia and diversification 6.6 Extensions 6.7 Summary Appendix 6.1: The CAPM in terms of asset prices Appendix 6.2: Linear dependence of j in the CAPM Appendix 6.3: The CAPM when all assets are risky References 143 144 145 149 151 154 157 159 160 162 162 165 Arbitrage 7.1 Arbitrage in theory and practice 7.2 Arbitrage in an uncertain world 7.3 State prices and the risk-neutral valuation relationship 7.4 Summary Appendix 7.1: Implications of the arbitrage principle References 166 166 168 173 176 177 182 Factor models and the arbitrage pricing theory 8.1 Factor models 8.2 APT 8.3 Predictions of the APT 8.4 Summary Appendix 8.1: The APT in a multifactor model Appendix 8.2: The APT in an exact single-factor model References 183 184 187 190 194 195 197 199 Empirical appraisal of the CAPM and APT 9.1 The CAPM 9.2 Tests of the CAPM: time series 9.3 Tests of the CAPM: cross-sections 9.4 Sharpe ratios and Roll’s criticism 9.5 Multiple-factor models and the APT 9.6 Summary Appendix 9.1: The Black CAPM in terms of excess returns References 200 201 202 206 214 215 219 220 221 10 Present value relationships and price variability 10.1 Net present value 10.2 Asset price volatility 222 223 228 xii Contents 10.3 Behavioural finance, noise trading and models of dividend growth 10.4 Extreme asset price fluctuations 10.5 Summary Appendix 10.1: Present values in continuous time Appendix 10.2: Infinitely lived assets: constant growth Appendix 10.3: The RNVR with multiple time periods References 235 237 243 245 246 246 248 Intertemporal choice and the equity premium puzzle 11.1 Consumption and investment in a two-period world with certainty 11.2 Uncertainty, multiple assets and long time horizons 11.3 Lifetime portfolio selection 11.4 The equity premium puzzle and the risk-free rate puzzle 11.5 Intertemporal capital asset pricing models 11.6 Summary Appendix 11.1: Intertemporal consumption and portfolio selection Appendix 11.2: Simplifying the FVR Appendix 11.3: The consumption CAPM References 250 12 Bond markets and fixed-interest securities 12.1 What defines a bond? 12.2 Zero-coupon bonds 12.3 Coupon-paying bonds 12.4 Bond valuation 12.5 Risks in bond portfolios 12.6 Immunization of bond portfolios 12.7 Summary Appendix 12.1: Some algebra of bond yields References 281 282 286 291 295 297 298 300 302 305 13 Term structure of interest rates 13.1 Yield curves 13.2 Index-linked bonds 13.3 Implicit forward rates 13.4 The expectations hypothesis of the term structure 13.5 Allowing for risk preferences in the term structure 13.6 Arbitrage and the term structure 13.7 Summary 306 307 310 313 317 322 326 328 11 251 254 258 262 269 273 274 276 278 280 Contents xiii Appendix 13.1: The expectations hypothesis with explicit uncertainty Appendix 13.2: Risk aversion and bond portfolios References 329 331 334 14 Futures markets I: fundamentals 14.1 Forward contracts and futures contracts 14.2 The operation of futures markets 14.3 Arbitrage between spot and forward prices 14.4 Arbitrage in foreign exchange markets 14.5 Repo markets 14.6 Summary and conclusion Appendix 14.1: Forward and futures prices Appendix 14.2: Revaluation of a forward contract References 336 337 342 349 354 355 357 359 360 362 15 Futures markets II: speculation and hedging 15.1 Speculation 15.2 Hedging strategies 15.3 Optimal hedging 15.4 Theories of futures prices 15.5 Manipulation of futures markets 15.6 Summary Appendix 15.1: Futures investment as portfolio selection Appendix 15.2: Derivation of h References 363 363 365 374 378 383 386 387 390 392 16 Futures markets III: applications 16.1 Weather futures 16.2 Financial futures contracts 16.3 Short-term interest rate futures 16.4 Long-term interest rate, or bond, futures 16.5 Stock index futures 16.6 The fall of Barings Bank 16.7 Summary References 393 393 397 400 404 406 412 414 416 17 Swap contracts and swap markets 17.1 Swap agreements: the fundamentals 17.2 Why swaps occur? 17.3 Risks associated with swaps 17.4 Valuation of swaps 417 417 423 429 429 xiv Contents 17.5 Metallgesellschaft: a case study 17.6 Summary References 431 435 437 Options markets I: fundamentals 18.1 Call options and put options 18.2 Varieties of options 18.3 Option-like assets 18.4 Upper and lower bounds for option prices 18.5 Put-call parity for European options 18.6 The Modigliani–Miller theorem 18.7 Summary Appendix 18.1: Lower bound for a European call option premium Appendix 18.2: Lower bound for a European put option premium Appendix 18.3: Put-call parity for European options Appendix 18.4: The Modigliani–Miller theorem: a proof References 438 439 446 448 449 454 457 459 461 462 463 466 19 Options markets II: price determination 19.1 The fundamentals of option price models 19.2 A two-state option-pricing model 19.3 The Black–Scholes model 19.4 Contingent claims analysis 19.5 Summary References 467 468 471 480 486 490 492 20 Options markets III: applications 20.1 Stock index options 20.2 Options on futures contracts 20.3 Interest rate options 20.4 Options and portfolio risks 20.5 Portfolio insurance 20.6 Combinations and spreads 20.7 Summary Appendix 20.1: Put-call parity for European options on futures References 494 495 496 500 504 507 512 514 18 460 515 518 Subject index 519 Author index 526 Figures 1.1 2.1 3.1 4.1 4.2 4.3 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 6.1 6.2 6.3 6.4 6.5 8.1 8.2 9.1 10.1 11.1 12.1 13.1 13.2 Market equilibrium for a single asset Flow demand and supply for a single asset A method for appraising asset market efficiency States in a two-period world The value function, z W , in prospect theory Indifference curves in P , P space The efficiency frontier with two assets The efficiency frontier with two assets and 12 = ±1 The efficiency frontier allowing for short-sales The efficiency frontier with three assets Efficient portfolios with a risk-free asset Efficient portfolios with different lending and borrowing rates The Sharpe ratio and risk-adjusted performance Optimal portfolio selection The portfolio frontier with risky assets The capital market line The characteristic line for asset j The security market line Disequilibrium in the CAPM Zero-beta portfolios A single-factor model The APT in a single-factor model A test of the CAPM Observed US stock prices, pt , and ex post rational prices, pt∗ Two-period consumption plans A zero-coupon bond’s price, p, as a function of its yield, y Yield curves Estimated yield curves xv 37 67 87 100 104 119 119 120 122 126 128 131 132 137 147 150 152 153 158 185 191 208 232 253 289 308 309 xvi 13.3 14.1 15.1 18.1 18.2 18.3 18.4 19.1 19.2 19.3 20.1 20.2 20.3 List of figures Estimated real yield curves Pay-offs from long and short futures positions The slope of the fitted line is an estimate of the pure hedge ratio, h∗ Pay-offs at exercise for call and put options: long positions Pay-offs at exercise for call and put options: short positions Absence of arbitrage opportunities (AoAO) regions for European options Bounds for American and European put option prices Call and put option prices as a function of the asset price, S The pattern of underlying asset prices: the two-period case Sample paths for asset prices in continuous time Interest rate caps and floors Portfolio insurance with a put option A long straddle 312 345 376 443 444 452 456 470 477 479 501 509 514 514 The economics of financial markets Pay-off ✻ X −p Put pay-off     ✠   Call pay-off ❅ ❅ ❘ ❅   ❅   ❅ ❅   ❅   ❅   ❅   ❅   ❅   ❅ ❅   ❅   ❅   ❅   ❅   ❅   ❅ ❅   ❅   ❅   ❅   ❅   ❅   ❅ ❅   ❅   ❅   ❅   ❅   ❅   ❅ ❅   ❅   ❅   ❅   ❅   ❅ X   ❅ ❅   ❅   ❅ ✲   ❅   ❅   ❅   ❅ ❅   ❅ S   ❅   −p ❅   ❅   ❅   ❅ ❅   ❅   −c ❅   ❅   ❅   ❅   ❅ ❅   −c − p ❅   ❅  Fig 20.3 A long straddle A put option with exercise price, X, has been purchased at a cost of p A call option on the same underlying asset, with the same exercise price and expiry date, has been purchased at a cost of c The dashed lines depict the payoffs (net of the premium paid for each option), at exercise, for the put and call, respectively The solid line depicts the payoff of the combination of the put and call (i.e a long straddle) as a function of the underlying asset price at the exercise date (While the figure is drawn with p < c, there is no guarantee that this would be so; p could be greater or smaller than c, depending on the asset price when the options were purchased.) long straddle The construction of diagrams for the remaining cases is left as an exercise for the reader 20.7 Summary Stock index options are written and traded for bundles of shares, the values of which are equal to commonly quoted stock price indexes If a stock index option is exercised, settlement is in cash (not by the delivery of the bundle of securities underlying the stock index) Options on futures contracts are options to acquire short or long positions in the futures contracts (including, for example, futures on stock indexes) Options on futures are written to expire on or before the futures delivery date Normally, the options expiry date is shortly before the futures delivery date Interest rate options take a variety of forms (e.g options on interest rate futures contracts) This sort of option is convenient for creating interest rate caps or floors Options markets III: applications 515 Options can be used as hedge instruments in constructing hedge strategies The relationship between changes in the option’s price and the underlying asset’s price provides the crucial link that determines the hedge ratio Portfolio insurance strategies seek to place a floor under the value of a portfolio while, at the same time, guaranteeing that the value of the portfolio increases in line with increases in the market value of its component assets While trading in options can, in principle, achieve the objectives of portfolio insurance, the strategies normally involve the creation of synthetic options Synthetic options are created by trading in the underlying assets and risk-free bonds in such a way as to replicate option payoffs Combinations and spreads are bundles of options packaged together with a view to achieving specific objectives The components of the bundles differ according to the type of option (call or put), their exercise prices, their expiry dates and whether they are purchased or written (sold) As a consequence, it is possible to devise strategies that result in payoffs that are known functions of the underlying asset price realized at specific dates in the future Further reading Hull (2005, chaps 13–15 & 19) provides an excellent exposition of the material covered in this chapter but in greater depth For a more advanced treatment, Hull (2003, chaps 13–17) should be consulted Analyses of portfolio insurance include those by Leland (1980) and O’Brien (1988) The stock market crash of 1987 inspired much analysis, discussion and controversy about the role of portfolio insurance in the crash On this topic, Rubinstein (1988) and Miller (1991, especially chaps 3, & 6) provide thoughtful assessments Appendix 20.1: Put-call parity for European options on futures The put-call parity relationship for options on futures is a straightforward extension of the relationship for stock options, and is demonstrated here for completeness Recall that the parity relationship states that cf + X f = pf + Rt T Rt T The proof follows the familiar pattern of showing that, if the relationship does not hold and if markets are frictionless, there exists an arbitrage opportunity Given that the absence of arbitrage profits is a criterion for market equilibrium, the equality must hold Two analogous arguments are needed, one when ‘>’ replaces the equality, and the second for ‘ pf + f/R (where the arguments of R t T are omitted for convenience) For later reference, rearrange the inequality X − f − R pf − cf > (20.5) which follows because R > Consider the following strategy: buy one futures contract for f , buy one put for p, write one call for c and borrow B = p − c, so that the strategy requires zero initial outlay (fT denotes the futures settlement price at date T ).9 At expiry, T Buy one put option Write one call option Buy one futures contract Borrow Initial outlay fT > X fT X −pf +cf B X − fT fT − f −RB X − fT fT − f −RB X − f − RB X − f − RB The table shows that, if fT > X, the call option is exercised and the put option is allowed to die Conversely, if fT X, the put option is exercised and the call option is allowed to die The payoff is the same in either case From (20.5), X − f − RB = X − f − R pf − cf > Hence, the payoff is positive irrespective of whether fT is greater than, less than or equal to X Thus, if cf + X/R > pf + f/R, a portfolio with zero initial outlay yields a positive return whatever the price fT at date T This is an arbitrage portfolio with a positive payoff in both states From the arbitrage principle, it cannot be consistent with market equilibrium Suppose now that the put-call parity is violated with cf + X/R < pf + f/R Rearranging the inequality, it follows that f − X − R cf − pf > (20.6) Consider the following strategy: take a short position in one futures contract, write one put, buy one call and borrow B = cf − pf , so that the strategy requires Note that B could be positive or negative If B < 0, the strategy involves lending In a frictionless market, lending is just negative borrowing Options markets III: applications 517 zero initial outlay (Because B could be of either sign, remember that both cases are covered if negative borrowing is interpreted as lending.) At expiry, T Write one put option Buy one call option Sell one futures contract Borrow Initial outlay fT > X fT X +pf −cf +B fT − X f − fT −RB fT − X f − fT −RB f − X − RB f − X − RB Once again, the table shows that the payoff is the same whatever the outcome From (20.6), f − X − RB = f − X − R cf − pf > 0, by hypothesis Hence, the payoff is positive no matter whether fT is greater than, less than or equal to X Consequently, if cf + X/R < pf + f/R, a portfolio with zero initial outlay yields a positive return whatever the outcome; there is an arbitrage opportunity In conclusion, if the put-call parity relationship is violated with either inequality, arbitrage profits can be made in frictionless markets Hence, the put-call parity relationship must hold under the stated conditions References Hull, J C (2003), Options, Futures, and Other Derivatives, Englewood Cliffs, NJ: Prentice Hall, 5th edn (2005), Fundamentals of Futures and Options Markets, Englewood Cliffs, NJ: Prentice Hall, 5th edn Leland, H E (1980), ‘Who should buy portfolio insurance?’, Journal of Finance, 35(2), pp 581–96 Miller, M H (1991), Financial Innovations and Market Volatility, Cambridge, MA: Blackwell O’Brien, T J (1988), ‘The mechanics of portfolio insurance’, Journal of Portfolio Management, 14(3), pp 40–7 Rubinstein, M (1988), ‘Portfolio insurance and the market crash’, Financial Analysts Journal, 44(1), pp 38–47 518 Subject index 3Com and Palm, 167 absence of arbitrage opportunities, 169, 224, 471 agency markets, 37 alpha-coefficient, 153, 202, 220 annuity, 284 anomalies in asset prices, 72 anticipatory hedging, 367 arbitrage, 20, 66, 126, 166–77 arbitrage in forward markets, 337 arbitrage opportunity, 169, 178, 316, 319 arbitrage portfolio, 169 arbitrage principle, the, 169, 468 arbitrage profit, 169 foreign exchange (forex) markets, 354–5 forward and futures contracts, 349–52, 399 market equilibrium, 169 option contracts, 440 proposition I, 170, 180 proposition II, 173 proposition III, 174, 177, 179 role in option markets, 449–50 term structure of interest rates, 326–8 arbitrage pricing theory, (APT), 194, 215–19 APT and CAPM, 193 bond markets, 327 futures markets, 380 risk premia, 190 systematic risk, 187 unsystematic risk, 187 Arrow security, 110, 174, 264 ask price, 17, 36 asset price volatility, 228–35 auction markets, 37 backwardation, 381 Bank of England, 308, 357 Quarterly Bulletin, 356 Barings bank, 35 fall of, 412–14 Bayes’ Law, 51 BE / ME, book / market value of a firm’s equity, 212 bear spreads, 515 behavioural finance, 10, 65, 75, 98–101, 235–7, 261 beta-coefficient, 129, 148, 203, 270 bid price, 17, 36 bid–ask spread, 36, 48–52 Black CAPM, 143, 157, 162, 205, 220, 270 Black Wednesday, 16th September 1992, 310 Black–Scholes model, see options bonds annuity, 284 average period, 294 balloons, 284 bond covenant, 286 bond markets, bond rating agencies, 286 bond valuation, 295–7 bullets, 285 callable, 283, 448 clean price, 285 collateral, 286 consols, 284, 293 continuous compounding, 303–4 convertible, 283, 449, 487 convexity, 288, 295, 300 coupon, 224, 284–5 coupon-paying bonds, 291–5 coupons, 282 credit risk, 297 debentures, 286 default, 283, 285–6 definitions, 282–6 dirty price, 284 event risk, 297 exchange-rate risk, 298 face value (maturity value, principal), 282 flat (current) yield, 292 floating rate bonds, 285 forward markets, 316–7 holding-period yield, 287, 288, 314 immunization (neutral-hedge) strategies, 298–300 indenture, 283 index-linked bonds, 285 Macaulay duration, 293–5, 298, 303 519 520 Subject index bonds (cont.) maturity (redemption) date, 282–4 modified duration, 295 par yield, 292 perpetuities, 284, 292 purchasing power risk, 298 pure discount bonds, 285 reinvestment risk, 292, 297 risk aversion and bond portfolios, 331–3 risks in bond portfolios, 297–8 sinking funds, 284 spot yield, 287 stripped bonds, 285, 297 subordinated bonds, 286 timing risk, 297 unit time period, 282 yield to maturity, 291 zero-coupon bonds, 285–91, 307 nominal, 286–8 real, 288 bottom vertical combinations, 513 bounded rationality, 98 brokers, 35 bubbles, 237–42 bucket shop assumption, 339, 469 bull spreads, 513 buying on margin, 12, 346, 440 Committee on Banking and Financial Services, US House of Representatives, 489 Commodity Futures Trading Commission, 340 commodity markets, common knowledge, 71 complete asset markets, 22, 88, 97, 109–10, 264 composite assets, see mean-variance analysis conditional (ex ante) equity premium, 267–9 CONNECT trading platform, 343 Consolidated Fund Stock, 284 consols, 284 constant absolute risk aversion (CARA) utility function, 94, 103 constant relative risk aversion (CRRA) utility function, 94, 256, 263 consumption capital asset pricing model, (CCAPM), 269 contango, 381 contingent claims analysis, 468, 486–9 continuous compounding, 29, 245–6 convenience yield, 350, 378 conventional recommendation (portfolio selection), 258 conventional wisdom, 72 cornering the market (futures markets), 383 covered interest parity, 354 cylinder spreads, 513 calendar effects, 72 calendar spreads, 513 call market, 38 callable bonds, 448 capital asset pricing model (CAPM), 143–64, 201–15 capital market line, 146, 157, 214 consumption (CCAPM), 269 cross-section tests, 206–14 disequilibrium, 152, 153 futures markets, 380 intertemporal, 269–73 security market line (SML), 151, 206 time series tests, 202–6 capital market line (CML), see capital asset pricing model (CAPM) carrying-charge hedging, 367 cash (forward) markets, 338 chain letters, 242 characteristic line (in the CAPM), 149 charting, see security analysis Chicago Board of Trade (CBOT), 39, 42, 341, 342, 404, 406, 422 Chicago Board Options Exchange (CBOE), 440 Chicago Mercantile Exchange (CME), 342, 400, 406 Citigroup, 26 classical linear regression model, 203 clearing house, 34 clearing house (futures markets), 340 closed-end mutual fund paradox, 73 cognitive dissonance, 99 combinations and spreads, 512–14 COMEX, a division of NYMEX, 498 data mining, 218 data snooping, 218 dealer markets, 36 dealers, 35 debt / equity ratio, 212, 457 derivatives markets, Deutsche Börse, 45 discount factor, 31, 225, 252 disequilibrium in the CAPM, see capital asset pricing model (CAPM) dividend growth models, 227, 236, 267 dividends, 224 role in option pricing, 450, 453 Dow Jones Industrial Average (DJIA), 25, 406 dynamic replication, 511 earnings / price (E/ P) ratio, 73, 212 Economist, The, 489 efficient markets hypothesis (EMH), see market efficiency efficient portfolios, set of, see mean-variance analysis electronic communications networks (ECNs), 35 envelope theorem, 137, 275 equity premium puzzle, 262–9 conditional equity premium, 267 unconditional equity premium, 267 equivalent martingale measure, 174 errors in variables, 209 Euler condition, 255 Euribor, 422 Euronext, 42 Euronext.liffe, see LIFFE European Banking Federation (FBE), 422 Subject index European Exchange Rate Mechanism (ERM), 310 event studies, 75–7 ex ante (conditional) equity premium, 267–9 ex post (unconditional) equity premium, 267–9 ex post rational asset price, 229 expectations, expected utility hypothesis (EUH), 90, 254 factor analysis, 218 factor loading, 184 factor models, 215, 183–219, 327 Fama–MacBeth regressions, 210 Federal Reserve Board, 489 Ferruzzi corporation (soybean manipulation), 386 financial innovations, 2, 33, 36, 42 Financial Services Authority (FSA), 43 Fisher hypothesis, force of interest, 21, 29, 245 foreign exchange (FOREX) markets, 4, 16 arbitrage, 354–5 forward and futures prices, equality of, 351–2, 359–60 forward contracts, 337–8 revaluation of, 352–4, 360–1 swap agreements, 418–22 forward markets, 313 arbitrage, 337 bonds, 316–17 hedging, 337 repo agreements, 356 speculation, 337 free float, 27 frictionless markets, see market frictions FT-Actuaries All-Share index, 150, 202 FT-SE 100 index, 27, 495 futures contract, 343, 346, 406, 409–12 spread betting, 397 functions of financial systems, fundamental valuation relationship (FVR), 95–8, 159, 175, 250, 254 bond portfolios, 331 mean-variance model, 111 with futures contracts, 387 futures contracts, 339–40, 432, 440 bond futures accrued interest, 405 bond futures price (conversion) factor, 405 cash settlement, 346 closing price, 344 contract grades, 346 contract month, 341 contract size, 343 equality of forward and futures prices, 351–2, 359–60 exchange delivery settlement price (EDSP), 401, 405, 406, 422 FT-SE 100 index, 406 futures on swaps, 422–3 long gilt contract, 346 long-term interest rate (bond) futures, 404–6 margin accounts, 341, 354 521 marking to market, 341, 354, 369, 375, 399, 405 offsetting trades, 344 options on futures, 446, 496–500 put-call parity relationship, 515 portfolio selection, 387–90 settlement price, 344 short sterling contracts, 401 short-term interest rate futures, 400–4 straddles (spreads), 348 strips (calendar strips), 348, 422, 434 synthetic futures contracts, 499 tick size, 343 treasury bills, 400 weather futures, 393–6 futures markets alternative delivery procedure (ADP), 346 arbitrage, 363 arbitrage with stock index futures, 407–8 convenience yield, 350, 378 cornering the market, 383 delivery, 345 disposing of the corpse, 384 exchange of futures for physicals (EFP), 345, 384 floor traders and brokers, 343 hedging, 363, 365–78, 381, 400 weather futures, 395 long-term interest rate hedge, 405–6 manipulation, 383–6 margin accounts, 346–8 market efficiency, 379 member firms, 343 normal backwardation, 380–3 operation, 342–8 price limits, 344 short-term interest rate hedge, 403–4 speculation, 363–5, 367, 381, 400 spread betting, 397–8 stock index futures, 406–12 stock index futures hedge, 408–12 storage (carrying) costs, 350, 378 the basis, 373–4, 378 theories of futures prices, 378–83 trading mechanisms, 343–4 warehouse receipt, 346 Gale’s theorem for linear equalities, 196 gambling, 57 gearing, 457 General Theory, The, see Keynes, J M (Author index) geometric Brownian motion, (gBm), 60, 478, 480 gilt-edged securities (British government debt), 3, 38, 308, 311, 346, 355, 404 long gilt futures contract, 404 Global Minerals (copper manipulation), 385 GLOBEX trading platform, 343 good-faith deposits, see margin accounts Goschen conversion, 284 gross interest rate, 349 Grossman–Stiglitz paradox, 71 522 Subject index Hansen–Jagannathan lower bound, 277 hedge funds, 365, 489 hedging futures markets, 365–78 hedge instrument (asset), 366 hedge ratio, 371, 433 hedging in practice, 367–8 hedging in principle, 365–7 long hedges, 371 non-linear (dynamic) hedging, 376 optimal hedge ratio, 377 optimal hedging, 374–8 perfect hedge strategies, 368–71 portfolio choice, 377–8 pure hedge ratio, 375 risky (imperfect) hedging, 371–3 roll-over risk, 433 speculative hedge, 377 stack-and-roll hedge, 433 strip hedge, 434 tailing the hedge, 369 homogeneous (unanimous) beliefs (in the CAPM), 144 horizontal spreads, 513 hour-of-the-day effect, 73 human capital, 261 Hunt silver case, 384 idiosyncratic risk, 155 imperfect capital markets, see perfect capital markets incomplete asset markets, 88 indexation lag, 311 indifference curve, see mean-variance analysis industrial organization of financial markets, 41–5 inflation rate, 290 informational efficiency, see market efficiency informed investors, 45 ING banking group, 412 initial public offerings (IPOs), 74 IntercontinentalExchange, 42 interest factor, 31, 349 interest rate cap, 501 interest rate floor, 503 interest rate options, 500–4 internal rate of return, 225, 291 International Petroleum Exchange (IPE), 42, 342 International Swaps and Derivatives Association (ISDA), 423 intertemporal capital asset pricing model, 269–73 intertemporal marginal rate of substitution, 256 IPE, see International Petroleum Exchange, (IPE) irrational exuberance, 240 iso-elastic utility function, 94, 256, 263 iterated expectations, law of, see law of iterated expectations January effect, 72 Jensen’s inequality, 330 Kobe earthquake, January 1995, 413 kurtosis, 102 Laspeyres index weighting, 27 law of iterated expectations, 59, 79, 150, 184, 247, 254 law of large numbers, 156, 188 law of one price (LoOP), 16, 74, 167, 172 Law, J., see Mississippi bubble, 238 leverage, 457 LIBID (London interbank bid rate), 420 LIBOR (London interbank offered rate), 419, 420 lifetime portfolio selection, 258–62 LIFFE (London International Financial Futures Exchage – Euronext.liffe), 42, 342, 346, 401, 404, 406, 422, 440, 446, 495, 496 limit order book, 38 limit orders, 38 linear pricing rule, 173 liquidity, 39 futures markets, 358 liquidity premium, 350 LME, see London Metal Exchange (LME) London Clearing House, (LCH), 343 London gold fixing, 38 London International Financial Futures Exchange, see LIFFE London Metal Exchange (LME), 42, 342, 385 London Stock Exchange (LSE), 27, 36, 38, 42, 406, 408 long horizon returns, 62 Long Term Capital Management (LTCM), 365, 489 LSE, see London Stock Exchange (LSE) Macaulay duration, see bonds Manchester Guardian (newspaper), 338 margin accounts, 12, 338, 341, 429, 440–1 futures markets, 346–8, 388, 389, 399 market efficiency, 22, 64–8 abnormal profits, 69 allocative efficiency, 22 asymmetric information, 70 beating the market, 69 efficient markets hypothesis (EMH), 10, 23, 65, 379 futures markets, 379 informational efficiency, 23, 64 intertemporal optimization model, 267 operational efficiency, 22 portfolio efficiency, 23 random walk model, 70 relative efficiency, 68 semi-strong form efficiency, 48, 51, 70 strong form efficiency, 71 weak form efficiency, 70 market equilibrium, 6, 169 market frictions, 17, 115, 144, 168, 173, 264, 297, 350, 449, 470, 497 market model, 151 market orders, 38 market portfolio, 146, 150, 157, 202, 271 market risk, 155 market makers, 35, 45 Subject index martingale hypothesis, 51, 57, 79, 379 martingale probabilities, 174, 228 martingale valuation relationship, 174 mean reversion, 62, 63, 259 mean-variance analysis, 101–5, 114–33 composite assets, 121 efficient portfolios, set of, 121, 125 indifference curves, 103, 115, 132 minimum risk portfolio (MRP), 121 optimal portfolio selection, 131 portfolio frontier 115, 117–31 measuring portfolio volatility, 506 Merton–Black–Scholes analysis, 468 Metallgesellschaft (case study), 431–5 Mississippi bubble, 238 Modigliani–Miller theorem, 77, 457–8, 463–5 Monday blues, 73 monetary policy, 288 money markets, money pump, see arbitrage mutual fund theorems, 123, 127 mutual ownership of financial exchanges, 41 NASDAQ (National Association of Securities Dealers Automated Quotations), 36, 42, 44, 240 net present value (NPV), 31, 174, 223–8, 349 New Palgrave Dictionary of Money and Finance, The, 24, 64, 69, 72, 75, 79, 107, 160, 177, 178, 181, 195, 234, 244, 286, 297, 329, 383, 406, 457, 459 New Palgrave, The: A Dictionary of Economics, 137 New York Mercantile Exchange see NYMEX New York Stock Exchange, see NYSE Nikkei 225 stock index futures contracts, 412 Nobel Memorial Prize in economics, 101, 143, 322, 325, 468, 483 noise, 10 noise traders, 45, 65, 235–7 normal backwardation, 324, 380–3 Normal distribution, 60, 102 NYMEX (New York Mercantile Exchange), 342, 344, 369, 373, 422, 496, 498 NYSE (New York Stock Exchange), 38, 42, 44, 207 OMgroup, 41 open interest, 339 open outcry, 39 option contracts American-style, 439, 495 as-you-like-it (chooser) options, 446 Asian options, 448 asset-or-nothing options, 448 barrier options, 448 Bermudan options, 447 binary options, 448 call options, 283, 439–41, 510 cash-or-nothing options, 448 combinations and spreads, 512–14 compound options, 447 covered call options, 441 delta, 505 523 down-and-out call options, 448 equity (stock) options, 446 European-style, 439, 470, 495 exchange options, 447 exchange-traded, 440 exercise, 441 exotic options, 446 foreign currency options, 446 forward start options, 447 Greek letters: delta, gamma, kappa, theta, rho, 507 hedged position, 469 hedging with options, 505 in and out of the money, 445–6 interest rate cap, 501 interest rate floor, 503 interest rate options, 446, 500–4 intrinsic (parity) value, 445 look-back options, 447 naked options, 441 option-like assets, 448–9 options on futures, 446, 496–500 put-call parity relationship, 515 options on gold futures, 498 options on oil futures, 497 options on three-month sterling, 501 options on weather futures, 498 payoffs, 442–5 portfolio risks, 504–7 put options, 439–40, 508 rainbow (basket) options, 447 replicating portfolio, 469, 473 shout options, 448 stock index options, 446, 495 synthetic put options, 510–12 termination, 441 varieties, 446–8 vega, 507 option markets arbitrage, role of, 449–50 binomial model, 471, 476–9 Black–Scholes model, 468, 480–6, 500, 505, 511 dividends, impact of, 485 implicit volatility, 485 option conversion relationship, 454 option prices, 467–90 put-call parity relationship, 454–57, 462–63, 499 two-state model, 471–9 upper and lower bounds on option prices, 449–53, 460–1 order-driven markets, 39, 343 ordinary least squares (OLS), 203, 375 organization of financial markets, 41, 41–5 orthogonality condition, 230 orthogonality tests, 61, 230 over-the-counter, (OTC), contracts, 341, 422 overpriced asset, 152 Oxford English Dictionary, The, 39, 242 Paasche index weighting, 27 Palgrave’s Dictionary of Political Economy, 284 524 Subject index Pareto efficiency, 22 payoff array (matrix), 87 perfect capital markets, 18, 428 performance risk, 11, 316, 338 perpetuity, 227, 284, 292 Philadelphia Stock Exchange, 440 Poisson distribution, 478 Ponzi schemes, 242–3 portfolio diversification, 155, 507 portfolio frontier, see mean-variance analysis portfolio insurance, 507–12 portfolio selection, 85 conventional recommendation, 258 present discounted value, 223 price discovery, 34, 44, 358, 367 price risk, 11, 338 pricing kernel, 256 primary markets, principal components analysis, 218 Proctor & Gamble, 26 programme trading, 511 prospect theory, 99 public investors, 35 put-call parity relationship, see option markets pyramid schemes, 242 quote-driven markets, 37 random walk hypothesis, 59 rate of return, 87 definition, excess (over risk-free rate), 95 gross, 7, 87 portfolio, 95 real, 28 risk-free (r0 ), 95 rate of time preference, 252 rational expectations, 10 futures markets, 365 regret theory, 99 regulation of financial markets, 43 relative risk aversion, index of, 94 repo markets, 308, 355–7 restrictions on trades, 17 retail price index (RPI), 311 Reuters, 422, 423 rights issue, 449 risk, 115 attitude to, 94 risk aversion, 97, 322 risk neutrality, 97, 149, 175, 228, 322, 379 risk tolerance, 104, 133 risk-adjusted performance (RAP), 130, 131 risk-avoidance hedging, 367 risk-free (riskless) asset, 88, 95, 117, 125, 154, 170, 190, 225 risk-free rate puzzle, 262–9 risk-neutral valuation relationship (RNVR), 174, 179, 197, 246, 326, 474 risk premium, 143, 154, 190, 228, 380 Roll’s criticism (of CAPMtests), 214 S & P 500, see Standard and poor’s 500 index Samuelson’s dictum, 236 saving, 251 SEAQ (Stock Exchange Automated Quotations), 36 seasoned equity offerings (SEOs), 74 secondary markets, Securities and Exchange Commission (SEC), 43 securitization of loans, 286 security analysis, 63 security market line (SML), see capital asset pricing model (CAPM) selective hedging, 367 senior debt, 286 September effect, 72 SETS (Stock exchange Electronic Trading Service), 38 settlement (function of markets), 34 shareholder ownership of financial exchanges, 41 Sharpe ratio, 130, 147, 214, 277 Sharpe–Lintner model, 143, 201 short-sales, 13, 96, 120, 126, 225, 374 availability of stocks, and, 351 side payment (forward contract), 337 silver market, manipulation of, 384 SIMEX, 412 sinking funds, 284 skewness, 102 small firm effect, 73 South Sea Bubble, 238 spot contract, 337 spread betting, 397–8, 496 Standard and Poor’s 500 index, 27, 150, 202, 406 state prices, 173 state-preference approach (portfolio selection), 85–90 states of the world, 85 Stiemke’s theorem, 178 stochastic discount factor, 250, 256, 264, 331, 389 stock index options, 495–6 stock market, stock market bubble of 1999–2000, 240 stock market crash of 1987, 239 stock price indexes, 24, 150 stock splits, 25, 76, 450 two-for-one splits, 26 Stockholm Stock Exchange, 41 stop-loss selling and buying, 508 storage (carrying) costs, 350, 378 storage, theories of, 351 straddles, 513 strangles, 513 strips, 513 style investing, 236 subjective discount factor, 252 Sumitomo (copper manipulation), 385 survivorship bias, 27 swap agreements basis rate swaps, 420 cash-out options, 434 Subject index commodity swaps, 421, 431 comparative advantage, 424 credit default swaps, 421 credit risk, 429 currency (foreign exchange) swaps, 418–19, 426–8 forward rate swaps, 420 funding risks, 429, 433 futures on swaps, 422–3 intermediary, 419 market risk (basis risk), 429 notional principal, 418 plain vanilla interest rate swaps, 419, 424–6, 431 risks, 429 roller-coaster swaps, 420 side payments, 419 swaptions, 423 total return swaps, 421 valuation, 429–31 zero-coupon swaps, 420 swap futures, see swap agreements Swapnote (Euronext.liffe), 422 swaptions, see swap agreements synthetic futures contracts, 499 synthetic put options, 510–12 tailing the hedge, 369 target wealth objective, 260 tâtonnement process, 37 taxes, neutrality of, 145 technical analysis, see security analysis term structure of interest rates arbitrage, 326–8 expectations hypothesis, 317–22, 329–30 hedging pressure theory, 325–6 implicit forward rates, 313–17, 320 index-linked (IL), bonds, 310–13 liquidity preference theory, 322–5 local expectations hypothesis, 319 preferred habitat theory, 325–6, 333 return to maturity (expecations hypothesis), 319 segmented markets hypothesis, 325 unbiased expectations hypothesis, 320 yield curve, 307–13 yield to maturity (expectations hypothesis), 320 terminal wealth, 85 theorems of the alternative, 177 time decision period, 21 horizon, 21 role of, 20 Toronto Stock Exchange, 38 trading mechanism, 34 trading pit, 39 transaction costs, 17, 261 transaction price, 36 transparency, 39 Travelers Property Casuality (TPC), 26 treasury bills, 4, 38, 285 futures contracts on, 400 Treasury Bond Futures contract, 404 tulipmania, 238 turn-of-the-year effect, 72 unconditional (ex post) equity premium, 267–9 uncovered interest parity, 355 underpriced asset, 152 uninformed investors, 45 US treasury bills and bonds, 38 utility function, 86, 89 Value and Capital, see Hicks, Sir John R (Author Index) Value Line Composite Index, 28 value at risk (VaR), 506 variance bounds, 230 vertical spreads, 513 virt-x, 45 volatility in rate of return, 468 volatility of asset prices, 228–35 von Neumann–Morgenstern utility function, 92 iso-elastic, 94, 256 quadratic, 110 Wall Street Crash, 1929, 239 warrants, 448, 469 Wealth of Nations, see Smith, A (Author index) weather and stock markets, 73 weather futures, 393–6 CME degree day index, 393 cooling degree day (CDD) index, 394 heating degree day (HDD) index, 394 week-of-the-month effect, 73 World Bank, 282 yield, 8, 287, 291 yield curve, see term structure of interest rates zero-beta portfolios, 157, 205, 207, 270 525 Author index Duchin, R., 102 Duffie, J D., 359, 374, 382, 387, 436 Dunbar, N., 491 Abken, P A., 436 Akerlof, G., 52 Alexander, G J., 24, 69, 133, 160, 195, 244 Anderson, N., 308, 311 Arrow, K J., 107, 109, 322 Eatwell, J., 24, 64, 69, 72, 75, 79, 107, 137, 160, 177, 178, 181, 195, 196, 234, 244, 286, 297, 329, 406, 457, 459 Ederington, L H., 375 Edwards, F R., 359, 387, 415, 436, 459, 489 Elton, E J., 24, 78, 106, 133, 160, 195, 219, 301, 415, 459 Engle, R F., 102, 483 Epstein, L., 107 Etheridge, A., 491 Evans, M D D., 313 Bachelier, L., 78 Bailey, J V., 24, 69, 133, 160, 195, 244 Barberis, N., 236 Barsky, R B., 235 Bernstein, P L., 106, 468 Black, F., 10, 39, 73, 143, 207, 244, 359, 380, 468, 490 Bodie, Z., Brooks, C., 203, 220 Brown, S J., 24, 78, 106, 133, 160, 195, 219, 301, 415, 459 Cairns, A J G., 329 Campbell, J Y., 61, 78, 79, 160, 213, 217, 220, 235, 244, 274, 302, 329 Canter, M S., 436 Carlton, D W., 359 Cass, D., 134 Chamberlain, G., 102 Chapman, D A., 329 Christie, W G., 44 Cochrane, J H., 210, 220, 274 Constantinides, G M., 273 Cootner, P H., 78 Cox, J C., 322, 326, 333, 459, 471, 490 Crane, D B., 24 Culbertson, J M., 326 Culp, C L., 436 Cvitani´c, J., 24, 106, 301 Dai, Q., 329 de La Grandville, O., 301, 329 De Long, J B., 235 Debreu, G., 22, 86 DiNardo, J., 209 Dixit, A K., 459 Dorfman, R., 177 Fama, E F., 66, 76, 78, 79, 160, 210, 212, 216, 217, 219, 220, 273 Fay, S., 415 Feller, W., 156, 189 Fisher, L., 79 French, K R., 212, 217, 220, 273 Fridson, M S., 491 Gale, D., 177, 178, 196 Garber, P M., 238, 244 Geanakoplos, J., 71 Gilbert, C L., 387 Glosten, L R., 51 Godek, P E., 45 Goetzmann, W N., 24, 78, 106, 133, 160, 195, 219, 301, 415, 459 Golub, S S., 24 Goschen, G J., 284 Greenspan, A., 240, 489 Grimmett, G., 79 Grinblatt, M., 133, 160, 195 Grossman, S J., 72 Gruber, M J., 24, 78, 106, 133, 160, 195, 219, 301, 415, 459 Hamanaka, Y., 385 Hammond, P J., 245 526 Author index Hansen, L P., 277 Harris, J H., 44 Harris, L., 53 Hayashi, F., 203, 209, 232 Heinrich, K., 415 Hicks, Sir John R., 294, 317, 322, 324, 364, 380, 381 Higginbotham, H., 359 Hirshleifer, D., 73 Houthakker, H S., 359, 383 Huang, C.- F., 126, 133 Hull, J C., 359, 387, 415, 436, 459, 490, 515 Hunt, L., 415 Ingersoll, J E., Jr., 322, 326, 333 Jónsson, J G., 491 Jagannathan, R., 213, 220, 273, 277 Jarrow, R A., 301, 329 Jensen, M C., 79, 207 Johnston, J., 209 Jung, J., 236 Kahneman, D., 107 Kapner, K R., 436 Keynes, J M., 11, 18, 40, 63, 84, 337, 338, 350, 380, 382 Khanna, A., 76 Kindleberger, C P., 244 Klemperer, P., 53 Knight, F H., 83 Kocherlakota, N R., 265, 273 Kohn, M., 24 Kothari, S P., 213 Kritzman, M., 261 Kumar, P., 387 Kyle, A S., 45 Lamont, O., 167, 177 Lee, C M.C., 79 Leeson, N., 412, 415 Leland, H E., 515 Lengwiler, Y., 106, 273 LeRoy, S F., 229, 244 Levy, H., 102, 270 Liew, J., 489 Litzenberger, R H., 126, 133 Lo, A W., 53, 61, 78, 79, 160, 217, 220, 244, 274, 302, 329 Loomes, G., 107 Loughran, T., 73 Lowenstein, R., 491 Luenberger, D G., 301, 329, 359 Lutz, F A., 317 Ma, C W., 359, 387, 415, 459 Macaulay, F R., 293 MacBeth, J., 210 MacKinlay, A C., 61, 78, 79, 160, 217, 220, 244, 274, 302, 329 Malkiel, B G., 79 Mandelbrot, B B., 78 527 Mangasarian, O L., 177, 178, 196 Maor, E., 30 Markowitz, H M., 101, 273 Marschak, J., 91, 107 Marshall, J F., 436 McGrattan, E R., 273 McKay, C., 244 Mehra, R., 262, 263, 273 Merton, R C., 2, 134, 339, 459, 468, 469, 482, 489–491 Meyer, J., 102 Milgate, M., 24, 64, 69, 72, 75, 79, 107, 137, 160, 177, 178, 181, 195, 196, 234, 244, 286, 297, 329, 406, 457, 459 Milgrom, P R., 51 Miller, M H., 436, 457, 459, 515 Modigliani, F., 325, 457 Morgenstern, O., 93 Newman, P., 24, 64, 69, 72, 75, 79, 107, 137, 160, 177, 178, 181, 195, 196, 234, 244, 286, 297, 329, 406, 457, 459 O’Brien, T J., 515 O’Hara, M., 48, 51–53 Ohlsen, R A., 107 Pearson, N D., 329 Pindyck, R S., 459 Pirrong, S C., 53, 386, 387, 436 Pollard, D., 491 Porter, R D., 229 Prescott, E C., 262, 273 Pringle, J J., 436 Radner, R., 91, 107 Ramachandran, V S., 74 Rawnsley, J., 415 Rich, D., 261 Roll, R., 49, 79, 214 Ross, S A., 195, 301, 322, 326, 327, 329, 333, 471, 490 Ross, S M., 61, 491 Rubinstein, M., 459, 471, 490, 515 Russell, B., 65 Samuelson, P A., 62, 137, 177, 236, 245, 270, 273, 482, 490 Saunders, E M., 73 Savage, L J., 91 Scherbina, A., 273 Scholes, M S., 207, 468, 489–491 Schultz, P H., 44, 73 Schwartz, R J., 436 Seppi, D J., 387 Shanken, J., 213 Sharpe, W F., 24, 69, 130, 133, 143, 160, 195, 244 Shiller, R J., 65, 78, 79, 85, 107, 229, 233, 235, 236, 237, 240, 244, 325 Shleifer, A., 65, 67, 79, 167, 177, 236, 244 Shumway, T., 73 528 Author index Siegel, J J., 72, 273 Singleton, K J., 329 Sinn, H W., 102 Skidelsky, R., 64 Sleath, J., 308, 311 Sloan, R G., 213 Smith, Adam, 44 Smith, C W., Jr., 436 Solow, R M., 177 Spencer, P D., 53 Spulber, D F., 53 Starmer, C., 107 Stigler, G J., 18 Stiglitz, J E., 72, 134, 333 Stirzaker, D., 79 Stoll, H R., 459 Sugden, R., 107 Summers, L H., 244 Sutch, R R., 325 Sydsæter, K., 245 Titman, S., 133, 160, 195 Tobin, J., 24 Tversky, A., 107 Telser, L G., 359, 387 Thaler, R H., 79, 167, 177, 273 Zapatero, F., 24, 106, 301 Zhang, P G., 415 Varian, H R., 22, 86, 106, 177, 459 Viceira, L M., 274 Vishny, R W., 177 von Neumann, J., 93 Vuolteenaho, T., 213, 236 Wall, L D., 436 Wang, Z., 213, 220 Whitley, E., 415 Williams, J., 359, 384, 387 Working, H., 359, 367 Yan, H., 329 ... confusion The economics of financial markets 1.1 Capital markets Financial innovations are to the financial system what technological advances are to the economy as a whole They embrace changes in the. .. words: the rate of return is the proportional rate of change of the asset’s market price Slightly more generally, the rate of return is measured by the proportional rate of change of the asset’s... asset markets there are detailed, and often quite complicated, rules that determine the minimum size of margins In other markets the provision of good-faith deposits is at the discretion of the