Fundamentals of Financial Instruments

SUNIL PARAMESWARAN, PhD, is Director and CEO of Tarheel Consultancy Services, a corporate training and management consulting firm. His professional expertise includes securities markets, financial derivatives, fixed income securities, and international finance. He obtained his doctorate from the Fuqua School of Business at Duke University in North Carolina, USA.

Preface xxiii

Preface to the First Edition xxiv

Acknowledgments xxv

About the Author xxvi

Chapter 1 An Introduction to Financial Institutions, Instruments, and Markets 1

The Role of an Economic System 1

A Command Economy 2

AMarket Economy 2

Classification of Economic Units 4

An Economy’s Relationship with the ExternalWorld 6

The Balance of Trade 8

The Current Account Balance 8

Financial Assets 9

Money 10

Money as a Unit of Account or a Standard of Value 10

Money as a Medium of Exchange 11

Money as a Store of Value 11

Money Is Perfectly Liquid 11

Equity Shares 12

Debt Securities 12

Preferred Shares 14

Foreign Exchange 14

Derivatives 14

Forward and Futures Contracts 15

Options Contracts 16

Swaps 18

Mortgages and Mortgage-backed Securities 19

Hybrid Securities 19

Primary Markets and Secondary Markets 19

Exchanges and Over-the-Counter (OTC) Markets 21

Brokers and Dealers 22

The Need for Brokers and Dealers 23

Trading Positions 24

The Buy-side and the Sell-side 25

Investment Bankers 25

Direct and Indirect Markets 26

Mutual Funds 27

Money and Capital Markets 30

The Eurocurrency Market 31

The International Bond Market 32

Globalization of Equity Markets 34

Dual Listing 35

Fungibility 37

Arbitrage 37

Arbitrage with ADRs 38

GDRs 39

Risk 39

After the Trade – Clearing and Settlement 41

Dematerialization and the Role of a Depository 42

Custodial Services 43

Globalization – The New Mantra 43

Chapter 2 Mathematics of Finance 46

Interest Rates 46

The Real Rate of Interest 46

The Fisher Equation 48

Simple Interest & Compound Interest 49

Variables and Corresponding Symbols 50

Simple Interest 50

Compound Interest 51

Properties 53

Effective Versus Nominal Rates of Interest 55

A Symbolic Derivation 56

Principle of Equivalency 56

Continuous Compounding 57

Future Value 58

Present Value 59

The Mechanics of Present Value Calculation 59

Handling a Series of Cash Flows 60

The Internal Rate of Return 61

Evaluating an Investment 63

The Future Value Approach 63

The Present Value Approach 63

The Rate of Return Approach 63

Annuities: An Introduction 64

Present Value 64

Future Value 65

Annuity Due 66

Present Value 66

Future Value 67

Perpetuities 67

The Amortization Method 68

Amortization with a Balloon Payment 70

The Equal Principal Repayment Approach 71

Types of Interest Computation 71

The Simple Interest Approach 72

The Add-on Rate Approach 72

The Discount Technique 73

Loans with a Compensating Balance 73

Time Value of Money–related Functions in Excel 73

The Future Value (FV) Function in Excel 74

The Present Value Function in Excel 75

Computing the Present and Future Values of Annuities and Annuities Due in Excel 75

Amortization Schedules and Excel 76

Chapter 3 Equity Shares, Preferred Shares, and Stock Market Indices 78

Introduction 78

Par Value Versus Book Value 79

Accounting for a Stock Issue 80

Voting Rights 80

Statutory Versus Cumulative Voting 81

Proxies 81

Dividends 82

Dividend Yield 83

Dividend Reinvestment Plans 84

Stock Dividends 85

Treasury Stock 86

Accounting for Treasury Stock 86

Splits and Reverse Splits 87

Costs Associated with Splits and Stock Dividends 89

Preemptive Rights 89

Interpreting Stated Ratios 91

Handling Fractions 91

Physical Certificates Versus Book Entry 92

Tracking Stock 92

Report Cards 93

Types of Stocks 93

Interest-sensitive Stocks 93

Risk and Return and the Concept of Diversification 94

Preferred Shares 96

Callable Preferred Stock 97

Convertible Preferred Shares 97

Cumulative Preferred Shares 98

Adjustable-Rate Preferred Shares 100

Participating Preferred Shares 100

Dividend Discount Models 100

A General Valuation Model 101

The Constant Growth Model 102

The Two-Stage Model 102

The Three-Stage Model 103

The H Model 105

Stock Market Indices 105

Price-weighted Indices 105

Changing the Divisor 107

The Importance of Price 109

Value-weighted Indices 110

Changing the Divisor 111

Changing the Base Period Capitalization 113

EquallyWeighted Indices 113

Tracking Portfolios 114

Rebalancing a Tracking Portfolio 114

EquallyWeighted Portfolios 114

Price-weighted Portfolios 116

Rights Issues 117

Value-weighted Portfolios 117

Handling a Rights Issue 119

The Free-floating Methodology 120

Well-known Global Indices 121

Margin Trading and Short-selling 121

Terminology 121

Case A: The Market Rises 124

Case B: The Market Declines 124

Case A: The Market Rises 125

Case B: The Market Declines 125

Interest and Commissions 125

Case A: The Market Rises 126

Case B: The Market Declines 126

Maintenance Margin 126

Short-selling 127

Maintenance of a Short Position 130

Shorting Against the Box 131

The Risk Factor 131

The Economic Role of Short Sales 132

The Uptick Rule 132

Chapter 4 Bonds 134

Introduction 134

Terms Used in the Bond Market 136

Face Value 136

Term to Maturity 136

Coupon 136

Yield to Maturity 137

Valuation of a Bond 137

Par, Premium, and Discount Bonds 138

Evolution of the Price 139

Zero-coupon Bonds 140

Valuing a Bond in Between Coupon Dates 141

Day-Count Conventions 142

Actual-Actual 142

The Treasury’s Approach 143

Corporate Bonds 144

Accrued Interest 144

Negative Accrued Interest 145

Yields 146

The Current Yield 147

Simple Yield to Maturity 148

Yield to Maturity 148

Approximate Yield to Maturity 149

Zero-coupon Bonds and the YTM 150

Analyzing the YTM 150

The Realized Compound Yield 152

Reinvestment and Zero-Coupon Bonds 152

The Holding Period Yield 153

Taxable Equivalent Yield 153

Credit Risk 154

Bond Insurance 156

Equivalence with Zero-coupon Bonds 156

Spot Rates 156

The Coupon Effect 157

Bootstrapping 158

Forward Rates 158

The Yield Curve and The Term Structure 159

Shapes of the Term Structure 159

Theories of the Term Structure 160

The Pure or Unbiased Expectations Hypothesis 160

The Liquidity Premium Hypothesis 160

The Money Substitute Hypothesis 161

The Market Segmentation Hypothesis 161

The Preferred Habitat Theory 161

The Short Rate 162

Floating Rate Bonds 163

Simple Margin 165

Bonds with Embedded Options 165

Callable Bonds 165

Yield to Call 166

Putable Bonds 167

Convertible Bonds 168

Using Short Rates to Value Bonds 168

Price Volatility 170

A Concise Formula 171

Duration and Price Volatility 171

Properties of Duration 172

Dollar Duration 172

Convexity 172

A Concise Formula 174

Dollar Convexity 175

Properties of Convexity 175

Immunization 175

Analysis 176

Treasury Auctions 177

When Issued Trading 179

Price Quotes 179

STRIPS 179

Inflation Indexed Bonds 180

Computing Price Given Yield and Vice Versa in Excel 182

Computing Duration in Excel 185

Chapter 5 Money Markets 187

Introduction 187

Market Supervision 190

The Federal Reserve System 190

Key Dates in the Case of Cash Market Instruments 191

The Modified Following Business Day Convention 192

The End/End Rule 192

The Interbank Market 193

Types of Loans 193

LIBOR 194

LIBID 194

SONIA 194

Transitioning from LIBOR 195

Interest Computation Methods 195

Term Money Market Deposits 197

Money Market Forward Rates 197

Federal Funds 198

Federal Funds Versus Clearinghouse Funds 199

Correspondent Banks: Nostro and Vostro Accounts 200

Treasury Bills 200

Reopenings 201

Yields on Discount Securities 202

Notation 202

Discount Rates and T-bill Prices 202

The Bond Equivalent Yield (BEY) 203

Case A: Tm < 182 days 203

The Money Market Yield 205

Case B: Tm > 182 days 205

Holding Period Return 207

Value of an 01 208

Concept of Carry 208

Concept of a Tail 208

T-Bill Related Functions in Excel 209

TBILLPRICE 209

TBILLYIELD 210

TBILLEQ 210

DISC 210

Treasury Auctions 211

Types of Auctions 211

Results of an Auction 212

Primary Dealers and Open Market Operations 213

Repurchase Agreements 213

Reverse Repos 214

General Collateral Versus Special Repos 215

Margins 215

Sale and Buyback 217

Collateral 217

Repos and Open Market Operations 217

Negotiable CDs 218

Notation 218

Cost of a CD for the Issuing Bank 221

Term CDs 221

CDs Versus Money Market Time Deposits 224

Commercial Paper 224

Letters of Credit and Bank Guarantees 225

Yankee Paper 226

Credit Rating 227

Moody’s Rating Scale 227

S&P’s Rating Scale 227

Fitch’s Rating Scale 228

Bills of Exchange 228

Documents Against Payment (DAP) Versus Documents Against Acceptance (DAA) Transactions 230

Eligible and Noneligible Bank Bills 230

Buying and Selling Bills 230

Bankers’ Acceptance 231

Acceptance Credits 232

Eurocurrency Deposits 232

Appendix 234

Chapter 6 Forward and Futures Contracts 235

Introduction 235

Marking to Market for a Trader in Practice 242

Delivery Options 242

Profit Diagrams 242

Value at Risk 244

The Expected Shortfall 245

Spot-Futures Equivalence 246

Products and Exchanges 247

Cash-and-carry Arbitrage 247

Reverse Cash-and-carry Arbitrage 247

Repo and Reverse Repo Rates 248

Synthetic Securities 248

Valuation 248

The Case of Assets Making Payouts 249

Physical Assets 250

Net Carry 252

Backwardation and Contango 252

The Case of Multiple Deliverable Grades 253

Risk Arbitrage 255

The Case of Multiplicative Adjustment 255

The Case of Additive Adjustment 256

Trading Volume and Open Interest 259

Delivery 261

Cash Settlement 262

Hedging and Speculation 262

Rolling a Hedge 264

Tailing a Hedge 264

The Minimum Variance Hedge Ratio 265

Estimation of the Hedge Ratio and the Hedging Effectiveness 266

Cross-hedging 266

Speculation 266

Leverage 268

Contract Value 269

Forward Versus Futures Prices 270

Hedging the Rate of Return on a Stock Portfolio 271

Changing the Beta 272

Program Trading 273

Stock Picking 275

Portfolio Insurance 277

Importance of Futures 279

Chapter 7 Options Contracts 280

Introduction 280

Notation 282

Exercising Options 282

Moneyness 285

Exchange-Traded Options 286

Option Class and Option Series 287

FLEX Options 287

Contract Assignment 288

Adjusting for Corporate Actions 288

Nonnegative Option Premia 289

Intrinsic Value and Time Value 289

Time Value of American Options 290

Time Value at Expiration 291

Put-Call Parity 291

Implications for the Time Value 294

Put-Call Parity with Dividends 295

Implications for the Time Value 296

A Very Important Property for American Calls 297

Early Exercise of Options: An Analysis 298

Profit Profiles 299

Speculation with Options 301

Hedging with Options 303

Using Call Options to Protect a Short Position 303

Using Put Options to Protect a Long Spot Position 304

Valuation 305

The Binomial Option Pricing Model 307

The Two-period Model 309

Valuation of European Put Options 310

Valuing American Options 311

Implementing the Binomial Model in Practice 312

The Black-Scholes Model 313

Put-Call Parity 314

Interpretation of the Black-Scholes Formula 314

The Greeks 315

Option Strategies 316

Bull Spreads 316

Bear Spreads 318

Butterfly Spread 320

The Convexity Property 321

A Straddle 323

A Strangle 324

Futures Options 326

Put-Call Parity 327

The Black Model 327

Chapter 8 Foreign Exchange 329

Introduction 329

Currency Codes 330

Base and Variable Currencies 330

Direct and Indirect Quotes 331

European Terms and American Terms 331

Bid and Ask Quotes 331

Appreciating and Depreciating Currencies 332

Converting Direct Quotes to Indirect Quotes 333

Points 333

Rates of Return 334

The Impact of Spreads on Returns 335

Arbitrage in Spot Markets 336

One-Point Arbitrage 336

Two-Point Arbitrage 336

Triangular Arbitrage 337

Cross Rates 338

Market Rates and Exchange Margins 339

Value Dates 340

The Forward Market 340

Outright Forward Rates 341

Swap Points 341

Broken-Dated Contracts 343

Covered Interest Arbitrage 344

A Perfect Market 345

Foreign Exchange Swaps 346

The Cost 347

The Motive 348

Interpretation of the Swap Points 349

A Clarification 350

Short-Date Contracts 350

Option Forwards 353

Nondeliverable Forwards 356

Range Forwards 357

Futures Markets 357

Hedging Using Currency Futures 357

A Selling Hedge 357

A Buying Hedge 358

Exchange-Traded Foreign Currency Options 359

Speculating with FOREX Options 359

The Garman-Kohlhagen Model 360

Put-Call Parity 361

The Binomial Model 361

Exchange Rates and Competitiveness 363

Chapter 9 Mortgages and Mortgage-backed Securities 364

Introduction 364

Market Participants 364

Mortgage Origination 364

Income for the Originator 365

Mortgage Servicing 365

Escrow Accounts 365

Income for the Servicer 365

Mortgage Insurance 366

Government Insurance and PMI 366

Secondary Sales 366

Risks in Mortgage Lending 367

Default Risk 367

Liquidity Risk 367

Interest Rate Risk 367

Prepayment Risk 368

Other Mortgage Structures 369

Adjustable-Rate Mortgage (ARM) 369

Option to Change the Maturity 371

Rate Caps 371

Carryovers 372

Payment Caps 372

Negative Amortization 374

Graduated Payment Mortgage 376

Growing Equity Mortgages (GEM) 378

WAC and WAM 379

Calculation ofWAC andWAM 379

Pass-Through Securities 379

Cash Flows for a Pass-Through 381

Prepayment Conventions 381

Single Month Mortality Rate 382

Average Life 388

Cash Flow Yield 389

ANote 390

Conditional Prepayment Rate 390

PSA Prepayment Benchmark 391

Illustration of 100 PSA 392

Analysis 393

Illustration of 200 PSA 393

Collateralized Mortgage Obligations 394

Sequential Pay CMO 394

Analysis – Tranche A 395

Analysis – Tranche B 398

Analysis – Tranche C 398

Analysis – Tranche D 398

Extension Risk and Contraction Risk 399

Accrual Bonds 399

Analysis 399

Floating Rate Tranches 403

Notional Interest-only Tranche 404

Interest-only and Principal-only Strips 405

PAC Bonds 405

Chapter 10 Swaps 411

Introduction 411

Market Terminology 415

Key Dates 415

Inherent Risk 416

The Swap Rate 416

Illustrative Swap Rates 417

Determining the Swap Rate 417

The Market Method 419

Valuation of a Swap During Its Life 419

Terminating a Swap 420

The Role of Banks in the Swap Market 421

Motivation for the Swap 421

Speculation 421

Hedging 422

Comparative Advantage and Credit Arbitrage 422

Swap Quotations 423

Matched Payments 424

Amortizing Swaps 425

Extendable and Cancelable Swaps 425

Swaptions 425

Currency Swaps 426

Cross-Currency Swaps 427

Valuation 427

Currency Risks 429

Hedging with Currency Swaps 429

Chapter 11 Mutual Funds, ETFs, and Pension Funds 430

Introduction 430

Pros and Cons of Investing in a Fund 430

Shares and Units 431

Open-end Versus Closed-end Funds 432

Premium/Discount of a Closed-End Fund 433

Unit Trusts 433

Calculating the NAV 433

Costs 436

Sales Charges 436

Price Quotes 440

Annual Operating Expenses 440

Switching Fees 441

Dividend Options 441

Types of Mutual Funds 443

Categorization by Nature of Investments 444

Categorization by Investment Objectives 444

Categorization by Risk Profile 444

Money Market Funds 444

Gilt Funds 445

Debt Funds 445

Diversified Debt Funds 445

Focused Debt Funds 445

High Yield Debt Funds 446

Debt Funds and Bond Duration 446

Equity Funds 446

Aggressive Growth Funds 446

Growth Funds 447

Specialty Funds 447

Sector Funds 447

Offshore Funds 447

Small Cap Equity Funds 447

Option Income Funds 448

Fund of Funds 448

Equity Index Funds 448

Value Funds 448

Equity Income Funds 448

Balanced Funds 449

Asset-Allocation Funds 449

Commodity Funds 449

Real Estate Funds 449

Tax-exempt Funds 449

Risk Categories 450

Low Level Risk Funds 450

Moderate Level Risks 450

High Level Risks 450

The Prospectus 450

Structure of a Mutual Fund 450

Services 451

Automatic Reinvestment Plan 451

Contractual Accumulation Plan 451

Voluntary Accumulation Plan 451

CheckWriting 452

Switching Within a Family of Funds 452

VoluntaryWithdrawal Plans 452

Investment Techniques 452

Dollar-cost Averaging 452

Value Averaging 453

The Combined Method 454

The Total Return 455

Computation of Returns 456

Analysis 457

Taxation Issues 458

Alternatives to Mutual Funds 459

Exchange-Traded Funds (ETFs) 460

Potential Asset Classes 461

Segregated (Separately Managed) Accounts 461

Pension Plans 462

Types of Plans 462

Defined Benefit Plans 462

Defined Contribution Plans 463

IRAs 464

Cash Balance Plans 464

Chapter 12 Orders and Exchanges 465

Important Acronyms 467

Market Orders and Limit Orders 467

The Limit Price 468

The Limit Order Books 468

Illustration of a Limit Order Book 468

Limit Orders Versus Market Orders 469

Marketable Limit Orders 470

Trade Pricing Rules 471

Stop-Loss and Stop-Limit Orders 472

Trailing Stop-Loss Orders 473

Market to Limit Orders 474

Equivalence with Options 474

Validity Conditions 475

Good Till Canceled (GTC) Orders 475

Good Till Days Orders 475

Orders with Quantity Restrictions 476

A Point on Order Specification 476

Open-Outcry Trading Systems 477

Electronic Markets Versus Open-Outcry Markets 478

Call Markets 479

Chapter 13 The Macroeconomics of Financial Markets 481

Economic Growth 481

Gross Domestic Product 481

Consumption 482

Real Estate 482

Capital Expenditure 483

Government Spending 483

Inventories 483

Foreign Trade 483

GDP Versus GNP 484

Inflation Adjustment 485

Transnational Comparisons 485

The Big Mac Index 485

Inflation 485

Types of Inflation 486

Interest Rates 488

The Federal Budget Deficit 488

Measures of Budget Deficits 489

The Primary Deficit 490

Fiscal Policy 490

Budget Deficits and the Capital Market 490

The Role of the Central Bank 490

Budget Deficits and Monetary Policy 491

Cross Border Borrowing 491

Central Banks and Foreign Exchange Markets 492

Sterilized and Unsterilized Interventions 493

Exchange Rates 493

Issues with a Reserve Currency 494

Cross-border Implications of Central Bank Actions 494

Quantitative Easing 495

Quantitative Easing Versus Open-market Operations 496

Chapter 14 Interest Rate Derivatives 497

Forward Rate Agreements (FRAs) 497

Settling an FRA 499

Determining Bounds for the FRA Rate 499

Eurodollar Futures 500

Calculating Profits and Losses on ED Futures 501

Locking in a Borrowing Rate 502

Locking in a Lending Rate 503

The No-Arbitrage Pricing Equation 505

Creating a Fixed-rate Loan 506

30-year T-bond Futures Contracts 507

Conversion Factors 507

Interest Rate Options 510

State Prices 510

Callable and Putable Bonds 511

Caps, Floors, and Collars 512

Captions and Floortions 513

Sources and References 515

Index 521