Financial Market Analysis

DAVID BLAKE is Professor of Pension Economics and Director of the Pensions Institute at Cass Business School, London, and Chairman of Square Mile Consultants, a training and research consultancy. He was formerly Director of the Securities Industry Programme at City University Business School, Research Fellow at both the London Business School and the London School of Economics and Professor of Financial Economics at Birkbeck College, University of London. He is consultant to many organisations, including Merrill Lynch, Deutsche Bank, Union Bank of Switzerland, Paribas Capital Markets, McKinsey & Co., the Office of Fair Trading, the Office for National Statistics, the Government Actuary's Department, the National Audit Office, the Department for Work and Pensions, HM Treasury, the Bank of England, the Prime Minister's Policy Directorate and the World Bank. In June 1996, he established the Pensions Institute, which undertakes high-quality research on all pension-related issues and publishes details of its research activities on the internet.

Preface xix

Abbreviations xxi

I Introduction to Financial Markets 1

1 The Financial System 5

1.1 Participants 5

1.1.1 End-users of the financial system 5

1.1.2 General financial intermediaries 7

1.1.3 Specialist financial intermediaries 12

1.1.4 Market-makers 16

1.2 Securities 16

1.3 Markets 20

1.3.1 The classification of financial markets 20

1.3.2 Financial markets in the UK 25

1.4 Trading arrangements 38

1.4.1 Types of order 39

1.4.2 Types of account 39

1.4.3 Stock borrowing agreements 41

1.4.4 Clearing and settlement of trades 42

1.4.5 Official intervention in markets 43

1.5 Regulation 44

1.6 The financial system in a temporal context 51

1.6.1 The recent past: the Big Bang of October 1986 51

1.6.2 The near future 53

Appendix: The City Research Project 1991-95 69

2 The market determination of discount rates 79

2.1 The price of time and risk 79

2.2 The expected real interest rate 80

2.3 The expected inflation rate 82

2.4 The expected liquidity premium 83

2.5 The expected risk premium 84

2.6 Interest rates and discount rates 87

3 Financial arithmetic 89

3.1 Future values: single payments 89

3.1.1 Simple interest 89

3.1.2 Compound interest: annual compounding 90

3.1.3 Compound interest: more frequent compounding 90

3.1.4 Flat and effective rates of interest 92

3.2 Present values: single payments 92

3.2.1 Present value: annual discounting 92

3.2.2 Present values: more frequent discounting 93

3.3 Future values: multiple payments 93

3.3.1 Irregular payments 93

3.3.2 Regular payments: annual payments with annual compounding 94

3.3.3 Regular payments: annual payments with more frequent compounding 95

3.3.4 Regular payments: more frequent payments and compounding 96

3.4 Present values: multiple payments 96

3.4.1 Irregular payments 96

3.4.2 Regular payments: annual payments with annual discounting 97

3.4.3 Regular payments: annual payments with more frequent discounting 97

3.4.4 Regular payments: more frequent payments and discounting 98

3.4.5 Perpetuities 100

3.5 Rates of return 100

3.5.1 Single-period rale of return 100

3.5.2 Internal rate of return or money-weighted rate of return 101

3.5.3 Time-weighted rate of return or geometric mean rate of return 103

Appendix: A simple iterative method for calculating internal rates of return 104

II The Analysis and Valuation of Securities 107

4 Monty market securities 111

4.1 Securities quoted on a yield basis 112

4.1.1 Money market deposits 112

4.1.2 Negotiable certificates of deposit 113

4.2 Securities quoted on a discount basis 116

4.3 Recent innovations 120

5 Bonds 123

5.1 Types of bond 123

5.2 The fair pricing of bonds 127

5.3 Clean and dirty bond prices 128

5.4 Yield measures on bonds 129

5.4.1 Current yield 130

5-4.2 Simple yield to maturity 131

5.4.3 Yield to maturity 131

5.4.4 Holding-period yield 135

5.4.5 Yield to par 135

5.4.6 Yield to call and yield to put 135

5.4.7 Yield to average life and yield to equivalent life 136

5.4.8 Index-linked yields 138

5.5 Yield curves 141

5.5.1 The yield to maturity yield curve 142

5.5.2 The coupon yield curve 142

5.5.3 The par yield curve 142

5.5.4 The spot (or zero-coupon) yield curve 144

5.5.5 The forward yield curve 146

5.5.6 The annuity yield curve 150

5.5.7 Rolling yield curve 150

5.6 Theories of the yield curve 152

5.6.1 The expectations hypothesis 152

5.6.2 The liquidity preference theory 153

5.6.3 The segmentation or preferred habitat theory 154

5.7 Fitting the yield curve 154

5.7.1 Polynomial curve fitting 154

5.7.2 Regression analysis 155

5.7.3 Matrix modelling 156

5.8 Interest rate risk 158

5.8.1 Duration 158

5.8.2 Convexity 164

5.8.3 Dispersion 166

5.9 Floating rate notes 166

5.10 Recent innovations: the gilt repurchase market 170

6 Shares 181

6.1 Types of share in the firm 181

6.2 The financial structure of the firm 183

6.2.1 The income statement and statement of retained earnings 183

6.2.2 Inflation accounting 184

6.2.3 Depreciation 184

6.2.4 Corporation tax and corporate capital gains tax 185

6.2.5 The effect of accounting conventions on reported earnings 188

6.2.6 The balance sheet 190

6.3 The fair pricing of shares 192

6.3.1 Valuation based on expected dividends 192

6.3.2 Valuation based on expected earnings 194

6.4 Dividend policy 196

6.5 Earnings analysis 198

6.5.1 Constant or normal growth models 198

6.5.2 Differential growth models 201

6.5.3 Forecasting earnings 205

6.6 The value of the firm: the effect of leverage 206

7 Foreign currency 215

7.1 The foreign exchange market 215

7.1.1 Spot foreign exchange transactions 216

7.1.2 Forward foreign exchange transactions 219

7.2 Exchange rate risk 222

7.3 Covering foreign exchange transactions 226

7.3.1 Covering forward transactions 226

7.3.2 Covering spot transactions 228

7.4 The fair pricing of foreign currency 230

7.4.1 Consistent cross exchange rates 230

7.4.2 Purchasing power parity 231

7.4.3 International Fisher effect 234

7.4.4 Covered interest rate parity 235

7.4.5 Uncovered interest rale parity 236

8 Forwards and futures 239

8.1 Forward and futures contracts 239

8.1.1 Forward contracts 239

8.1.2 Futures contracts 240

8.2 Financial futures contracts 244

8.2.1 Short-term interest rale futures 247

8.2.2 Long-term interest rate futures 250

8.2.3 Currency futures 257

8.2.4 Stock index futures 257

8.3 The fair pricing of forward and financial futures contracts 260

8.3.1 Fair pricing with no uncertainty 260

8.3.2 Futures prices and expected spot prices 262

8.3.3 Fair pricing of the short-term interest rate contract 263

8.3.4 Fair pricing of the long-term interest rate contract 264

8.3.5 Fair pricing of the currency contract 266

8.3.6 Fair pricing of the stock index contract 267

9 Options, warrants and convertibles 273

9.1 Option contracts 273

9.2 Option combinations 277

9.3 Financial options contracts 283

9.3.1 Equity options 288

9.3.2 Interest-rate options 291

9.3.3 Currency options 297

9.3.4 Stock index options 297

9.3.5 Restricted-life traded options 301

9.3.6 Traditional options 302

9.3.7 Over-the-counter options 302

9.4 The fair pricing of options contracts 303

9.4.1 Factors influencing the premium 303

9.4.2 Boundary conditions for options 304

9.4.3 The binomial model of the fair European call option price 309

9.4.4 The Black-Scholes model of die fair European call option price 312

9.4.5 Properties of the Black-Scholes model: the Greeks 316

9.4.6 Pricing a European put option 321

9.4.7 Modifications to the Black-Scholes model 322

9.5 Exotic options 327

9.6 Warrants and convertibles 334

9.6.1 Warrants 334

9.6.2 Convertibles 336

Appendix A: Accounting issues with options and futures contracts 338

Appendix B: Taxation issues with options and futures contracts 340

Appendix C: Standard normal distribution table 342

10 Synthetic securities 349

10.1 The basic building blocks of synthetic securities 349

10.2 Synthetic options and futures 352

10.3 Swaps 357

10.3.1 Interest rate swaps 358

10.3.2 Basis swaps 363

10.3.3 Currency swaps 363

10.3.4 Asset swaps 369

10.3.5 More esoteric swaps 370

10.3.6 The risks involved in swaps 371

10.3.7 The uses of swaps 372

10.4 Forward rate agreements 373

10.5 Caps, floors and collars 375

10.6 Bundled and unbundled securities 378

10.6.1 Bundled securities 378

10.6.2 Unbundled securities 380

III Portfolio Analysis, Management and Performance Measurement 385

11 Market efficiency: theory and evidence 389

11.1 Allocative operational and informational efficiency 389

11.2 The EMH the fair game model and random walk 390

11.3 The EMH and information 392

11.4 The EMH and an information-efficient equilibrium 393

11.5 Tests of the efficient markets hypothesis 394

11.5.1 Evidence favouring the efficient markets hypothesis 394

11.5.2 Evidence against the efficient markets hypothesis 398

11.5.3 Are the financial markets efficient? 405

12 Speculation and arbitrage 415

12.1 Speculation 415

12.1.1 The process of speculation 415

12.1.2 Trading strategies with futures 417

12.1.3 Trading strategies with options 426

12.2 Arbitrage 434

12.2.1 The process of arbitrage 434

12.2.2 Arbitrage strategies with futures 435

12.2.3 Arbitrage strategies with options 439

Appendix A: The collapse of Barings Bank 441

Appendix B: Technical analysis 444

13 Portfolio analysis and asset pricing 461

13.1 Portfolio analysis 461

13.1.1 Choice under uncertainty: the consumption of risk and return 461

13.1.2 Portfolios under uncertainty: the production of risk and return 465

13.1.3 Diversification 468

13.1.4 The minimum standard deviation portfolio opportunity set and the efficient set 474

13.1.5 The efficient set when there is a riskless security 476

13.1.6 Market equilibrium, portfolio optimally and the pricing of efficient portfolios 477

13.1.7 Pricing inefficient portfolios and the decomposition of total risk 482

13.2 Asset pricing 489

13.2.1 The capital asset pricing model 489

13.2.2 The multi-factor model 501

13.2.3 The arbitrage pricing model 501

14 Portfolio management 511

14.1 The functions of portfolio management 511

14.2 Assessing the investing client’s utility function 514

14.3 Passive portfolio management 519

14.3.1 Passive portfolio management for an expected utility-maximizing client 519

14.3.2 Passive portfolio management for a safety-first client 521

14.4 Active portfolio management and adjustment 528

14.4.1 Active share portfolio management and adjustment 528

14.4.2 Active treasury portfolio management 537

14.4.3 Active bond portfolio management and adjustment 538

14.5 Mixed active-passive portfolio management 542

14.6 Investment management styles 544

14.6.1 Traditional investment management 545

14.6.2 Quantitative investment management 547

14.7 Recent innovations: hedge funds and bear funds 548

Appendix: Investment-Objectives Questionnaire 550

15 Portfolio performance measurement 559

15.1 The components of portfolio performance measurement 559

15.1.1 Ex post returns 559

15.1.2 Adjusting for risk 562

15.1.3 Benchmarks of comparison 562

15.2 Measures of portfolio performance 564

15.2.1 Performance measures based on risk-adjusted excess returns 564

15.2.2 Performance measures based on alpha values 567

15.3 The decomposition of total return 570

15.4 Treasury performance measurement 574

15.5 Asset-liability managed portfolios 574

15.6 Portfolios containing financial futures and options contracts 578

15.6.1 Individual treatment of futures 578

15.6.2 Individual treatment of options 579

15.6.3 A worked example 580

15.7 Performance measurement with multiple fund managers 586

15.8 The Roll critique of performance measurement 588

15.9 Evidence on the performance of fund managers 588

Appendix: A note on the different uses of the geometric mean and the arithmetic mean 590

16 Hedging and efficient portfolio management 597

16.1 The objective of hedging 597

16.2 Money market hedges 599

16.3 Hedging using futures 601

16.3.1 Hedging with short-term interest rate futures contracts 601

16.3.2 Hedging with stock index futures contracts 604

16.3.3 Hedging with long-term interest rate futures contracts 613

16.3.4 Hedging with currency futures contracts 617

16.4 Hedging using options 620

16.4.1 Hedging with individual stock options contracts 621

16.4.2 Hedging with stock index options contracts 627

16.4.3 Hedging with short-term interest rale options contracts 630

16.4.4 Hedging with long-term interest rate options contracts 631

16.4.5 Hedging with currency options contracts 632

16.5 Hedging with swaps and swaptions 633

16.6 Hedging with FRAs 637

16.7 Hedging with caps, floors and collars 637

16.8 Portfolio insurance 638

16.9 Efficient portfolio management 643

IV Postscript 655

17 The failure of financial markets 659

17.1 The anatomy of the crash 659

17.2 The consequences of the crash 661

17.3 The causes of the crash 663

17.4 Conclusion 669

18 Recent developments in financial market analysis 673

18.1 Value-at-risk analysis 673

18.2 Speculative bubbles 676

18.3 Volatility effects in financial markets 678

18.4 Chaos 682

18.5 Neural networks 693