Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

ISBN-13: 9781119816614 / Angielski / Twarda / 2022 / 560 str.

Sunil K. Parameswaran

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Preface xxiiiPreface to the First Edition xxivAcknowledgments xxvAbout the Author xxviChapter 1 An Introduction to Financial Institutions, Instruments, and Markets 1The Role of an Economic System 1A Command Economy 2AMarket Economy 2Classification of Economic Units 4An Economy's Relationship with the ExternalWorld 6The Balance of Trade 8The Current Account Balance 8Financial Assets 9Money 10Money as a Unit of Account or a Standard of Value 10Money as a Medium of Exchange 11Money as a Store of Value 11Money Is Perfectly Liquid 11Equity Shares 12Debt Securities 12Preferred Shares 14Foreign Exchange 14Derivatives 14Forward and Futures Contracts 15Options Contracts 16Swaps 18Mortgages and Mortgage-backed Securities 19Hybrid Securities 19Primary Markets and Secondary Markets 19Exchanges and Over-the-Counter (OTC) Markets 21Brokers and Dealers 22The Need for Brokers and Dealers 23Trading Positions 24The Buy-side and the Sell-side 25Investment Bankers 25Direct and Indirect Markets 26Mutual Funds 27Money and Capital Markets 30The Eurocurrency Market 31The International Bond Market 32Globalization of Equity Markets 34Dual Listing 35Fungibility 37Arbitrage 37Arbitrage with ADRs 38GDRs 39Risk 39After the Trade - Clearing and Settlement 41Dematerialization and the Role of a Depository 42Custodial Services 43Globalization - The New Mantra 43Chapter 2 Mathematics of Finance 46Interest Rates 46The Real Rate of Interest 46The Fisher Equation 48Simple Interest & Compound Interest 49Variables and Corresponding Symbols 50Simple Interest 50Compound Interest 51Properties 53Effective Versus Nominal Rates of Interest 55A Symbolic Derivation 56Principle of Equivalency 56Continuous Compounding 57Future Value 58Present Value 59The Mechanics of Present Value Calculation 59Handling a Series of Cash Flows 60The Internal Rate of Return 61Evaluating an Investment 63The Future Value Approach 63The Present Value Approach 63The Rate of Return Approach 63Annuities: An Introduction 64Present Value 64Future Value 65Annuity Due 66Present Value 66Future Value 67Perpetuities 67The Amortization Method 68Amortization with a Balloon Payment 70The Equal Principal Repayment Approach 71Types of Interest Computation 71The Simple Interest Approach 72The Add-on Rate Approach 72The Discount Technique 73Loans with a Compensating Balance 73Time Value of Money-related Functions in Excel 73The Future Value (FV) Function in Excel 74The Present Value Function in Excel 75Computing the Present and Future Values of Annuities and Annuities Due in Excel 75Amortization Schedules and Excel 76Chapter 3 Equity Shares, Preferred Shares, and Stock Market Indices 78Introduction 78Par Value Versus Book Value 79Accounting for a Stock Issue 80Voting Rights 80Statutory Versus Cumulative Voting 81Proxies 81Dividends 82Dividend Yield 83Dividend Reinvestment Plans 84Stock Dividends 85Treasury Stock 86Accounting for Treasury Stock 86Splits and Reverse Splits 87Costs Associated with Splits and Stock Dividends 89Preemptive Rights 89Interpreting Stated Ratios 91Handling Fractions 91Physical Certificates Versus Book Entry 92Tracking Stock 92Report Cards 93Types of Stocks 93Interest-sensitive Stocks 93Risk and Return and the Concept of Diversification 94Preferred Shares 96Callable Preferred Stock 97Convertible Preferred Shares 97Cumulative Preferred Shares 98Adjustable-Rate Preferred Shares 100Participating Preferred Shares 100Dividend Discount Models 100A General Valuation Model 101The Constant Growth Model 102The Two-Stage Model 102The Three-Stage Model 103The H Model 105Stock Market Indices 105Price-weighted Indices 105Changing the Divisor 107The Importance of Price 109Value-weighted Indices 110Changing the Divisor 111Changing the Base Period Capitalization 113EquallyWeighted Indices 113Tracking Portfolios 114Rebalancing a Tracking Portfolio 114EquallyWeighted Portfolios 114Price-weighted Portfolios 116Rights Issues 117Value-weighted Portfolios 117Handling a Rights Issue 119The Free-floating Methodology 120Well-known Global Indices 121Margin Trading and Short-selling 121Terminology 121Case A: The Market Rises 124Case B: The Market Declines 124Case A: The Market Rises 125Case B: The Market Declines 125Interest and Commissions 125Case A: The Market Rises 126Case B: The Market Declines 126Maintenance Margin 126Short-selling 127Maintenance of a Short Position 130Shorting Against the Box 131The Risk Factor 131The Economic Role of Short Sales 132The Uptick Rule 132Chapter 4 Bonds 134Introduction 134Terms Used in the Bond Market 136Face Value 136Term to Maturity 136Coupon 136Yield to Maturity 137Valuation of a Bond 137Par, Premium, and Discount Bonds 138Evolution of the Price 139Zero-coupon Bonds 140Valuing a Bond in Between Coupon Dates 141Day-Count Conventions 142Actual-Actual 142The Treasury's Approach 143Corporate Bonds 144Accrued Interest 144Negative Accrued Interest 145Yields 146The Current Yield 147Simple Yield to Maturity 148Yield to Maturity 148Approximate Yield to Maturity 149Zero-coupon Bonds and the YTM 150Analyzing the YTM 150The Realized Compound Yield 152Reinvestment and Zero-Coupon Bonds 152The Holding Period Yield 153Taxable Equivalent Yield 153Credit Risk 154Bond Insurance 156Equivalence with Zero-coupon Bonds 156Spot Rates 156The Coupon Effect 157Bootstrapping 158Forward Rates 158The Yield Curve and The Term Structure 159Shapes of the Term Structure 159Theories of the Term Structure 160The Pure or Unbiased Expectations Hypothesis 160The Liquidity Premium Hypothesis 160The Money Substitute Hypothesis 161The Market Segmentation Hypothesis 161The Preferred Habitat Theory 161The Short Rate 162Floating Rate Bonds 163Simple Margin 165Bonds with Embedded Options 165Callable Bonds 165Yield to Call 166Putable Bonds 167Convertible Bonds 168Using Short Rates to Value Bonds 168Price Volatility 170A Concise Formula 171Duration and Price Volatility 171Properties of Duration 172Dollar Duration 172Convexity 172A Concise Formula 174Dollar Convexity 175Properties of Convexity 175Immunization 175Analysis 176Treasury Auctions 177When Issued Trading 179Price Quotes 179STRIPS 179Inflation Indexed Bonds 180Computing Price Given Yield and Vice Versa in Excel 182Computing Duration in Excel 185Chapter 5 Money Markets 187Introduction 187Market Supervision 190The Federal Reserve System 190Key Dates in the Case of Cash Market Instruments 191The Modified Following Business Day Convention 192The End/End Rule 192The Interbank Market 193Types of Loans 193LIBOR 194LIBID 194SONIA 194Transitioning from LIBOR 195Interest Computation Methods 195Term Money Market Deposits 197Money Market Forward Rates 197Federal Funds 198Federal Funds Versus Clearinghouse Funds 199Correspondent Banks: Nostro and Vostro Accounts 200Treasury Bills 200Reopenings 201Yields on Discount Securities 202Notation 202Discount Rates and T-bill Prices 202The Bond Equivalent Yield (BEY) 203Case A: TmThe Money Market Yield 205Case B: Tm > 182 days 205Holding Period Return 207Value of an 01 208Concept of Carry 208Concept of a Tail 208T-Bill Related Functions in Excel 209TBILLPRICE 209TBILLYIELD 210TBILLEQ 210DISC 210Treasury Auctions 211Types of Auctions 211Results of an Auction 212Primary Dealers and Open Market Operations 213Repurchase Agreements 213Reverse Repos 214General Collateral Versus Special Repos 215Margins 215Sale and Buyback 217Collateral 217Repos and Open Market Operations 217Negotiable CDs 218Notation 218Cost of a CD for the Issuing Bank 221Term CDs 221CDs Versus Money Market Time Deposits 224Commercial Paper 224Letters of Credit and Bank Guarantees 225Yankee Paper 226Credit Rating 227Moody's Rating Scale 227S&P's Rating Scale 227Fitch's Rating Scale 228Bills of Exchange 228Documents Against Payment (DAP) Versus Documents Against Acceptance (DAA) Transactions 230Eligible and Noneligible Bank Bills 230Buying and Selling Bills 230Bankers' Acceptance 231Acceptance Credits 232Eurocurrency Deposits 232Appendix 234Chapter 6 Forward and Futures Contracts 235Introduction 235Marking to Market for a Trader in Practice 242Delivery Options 242Profit Diagrams 242Value at Risk 244The Expected Shortfall 245Spot-Futures Equivalence 246Products and Exchanges 247Cash-and-carry Arbitrage 247Reverse Cash-and-carry Arbitrage 247Repo and Reverse Repo Rates 248Synthetic Securities 248Valuation 248The Case of Assets Making Payouts 249Physical Assets 250Net Carry 252Backwardation and Contango 252The Case of Multiple Deliverable Grades 253Risk Arbitrage 255The Case of Multiplicative Adjustment 255The Case of Additive Adjustment 256Trading Volume and Open Interest 259Delivery 261Cash Settlement 262Hedging and Speculation 262Rolling a Hedge 264Tailing a Hedge 264The Minimum Variance Hedge Ratio 265Estimation of the Hedge Ratio and the Hedging Effectiveness 266Cross-hedging 266Speculation 266Leverage 268Contract Value 269Forward Versus Futures Prices 270Hedging the Rate of Return on a Stock Portfolio 271Changing the Beta 272Program Trading 273Stock Picking 275Portfolio Insurance 277Importance of Futures 279Chapter 7 Options Contracts 280Introduction 280Notation 282Exercising Options 282Moneyness 285Exchange-Traded Options 286Option Class and Option Series 287FLEX Options 287Contract Assignment 288Adjusting for Corporate Actions 288Nonnegative Option Premia 289Intrinsic Value and Time Value 289Time Value of American Options 290Time Value at Expiration 291Put-Call Parity 291Implications for the Time Value 294Put-Call Parity with Dividends 295Implications for the Time Value 296A Very Important Property for American Calls 297Early Exercise of Options: An Analysis 298Profit Profiles 299Speculation with Options 301Hedging with Options 303Using Call Options to Protect a Short Position 303Using Put Options to Protect a Long Spot Position 304Valuation 305The Binomial Option Pricing Model 307The Two-period Model 309Valuation of European Put Options 310Valuing American Options 311Implementing the Binomial Model in Practice 312The Black-Scholes Model 313Put-Call Parity 314Interpretation of the Black-Scholes Formula 314The Greeks 315Option Strategies 316Bull Spreads 316Bear Spreads 318Butterfly Spread 320The Convexity Property 321A Straddle 323A Strangle 324Futures Options 326Put-Call Parity 327The Black Model 327Chapter 8 Foreign Exchange 329Introduction 329Currency Codes 330Base and Variable Currencies 330Direct and Indirect Quotes 331European Terms and American Terms 331Bid and Ask Quotes 331Appreciating and Depreciating Currencies 332Converting Direct Quotes to Indirect Quotes 333Points 333Rates of Return 334The Impact of Spreads on Returns 335Arbitrage in Spot Markets 336One-Point Arbitrage 336Two-Point Arbitrage 336Triangular Arbitrage 337Cross Rates 338Market Rates and Exchange Margins 339Value Dates 340The Forward Market 340Outright Forward Rates 341Swap Points 341Broken-Dated Contracts 343Covered Interest Arbitrage 344A Perfect Market 345Foreign Exchange Swaps 346The Cost 347The Motive 348Interpretation of the Swap Points 349A Clarification 350Short-Date Contracts 350Option Forwards 353Nondeliverable Forwards 356Range Forwards 357Futures Markets 357Hedging Using Currency Futures 357A Selling Hedge 357A Buying Hedge 358Exchange-Traded Foreign Currency Options 359Speculating with FOREX Options 359The Garman-Kohlhagen Model 360Put-Call Parity 361The Binomial Model 361Exchange Rates and Competitiveness 363Chapter 9 Mortgages and Mortgage-backed Securities 364Introduction 364Market Participants 364Mortgage Origination 364Income for the Originator 365Mortgage Servicing 365Escrow Accounts 365Income for the Servicer 365Mortgage Insurance 366Government Insurance and PMI 366Secondary Sales 366Risks in Mortgage Lending 367Default Risk 367Liquidity Risk 367Interest Rate Risk 367Prepayment Risk 368Other Mortgage Structures 369Adjustable-Rate Mortgage (ARM) 369Option to Change the Maturity 371Rate Caps 371Carryovers 372Payment Caps 372Negative Amortization 374Graduated Payment Mortgage 376Growing Equity Mortgages (GEM) 378WAC and WAM 379Calculation ofWAC andWAM 379Pass-Through Securities 379Cash Flows for a Pass-Through 381Prepayment Conventions 381Single Month Mortality Rate 382Average Life 388Cash Flow Yield 389ANote 390Conditional Prepayment Rate 390PSA Prepayment Benchmark 391Illustration of 100 PSA 392Analysis 393Illustration of 200 PSA 393Collateralized Mortgage Obligations 394Sequential Pay CMO 394Analysis - Tranche A 395Analysis - Tranche B 398Analysis - Tranche C 398Analysis - Tranche D 398Extension Risk and Contraction Risk 399Accrual Bonds 399Analysis 399Floating Rate Tranches 403Notional Interest-only Tranche 404Interest-only and Principal-only Strips 405PAC Bonds 405Chapter 10 Swaps 411Introduction 411Market Terminology 415Key Dates 415Inherent Risk 416The Swap Rate 416Illustrative Swap Rates 417Determining the Swap Rate 417The Market Method 419Valuation of a Swap During Its Life 419Terminating a Swap 420The Role of Banks in the Swap Market 421Motivation for the Swap 421Speculation 421Hedging 422Comparative Advantage and Credit Arbitrage 422Swap Quotations 423Matched Payments 424Amortizing Swaps 425Extendable and Cancelable Swaps 425Swaptions 425Currency Swaps 426Cross-Currency Swaps 427Valuation 427Currency Risks 429Hedging with Currency Swaps 429Chapter 11 Mutual Funds, ETFs, and Pension Funds 430Introduction 430Pros and Cons of Investing in a Fund 430Shares and Units 431Open-end Versus Closed-end Funds 432Premium/Discount of a Closed-End Fund 433Unit Trusts 433Calculating the NAV 433Costs 436Sales Charges 436Price Quotes 440Annual Operating Expenses 440Switching Fees 441Dividend Options 441Types of Mutual Funds 443Categorization by Nature of Investments 444Categorization by Investment Objectives 444Categorization by Risk Profile 444Money Market Funds 444Gilt Funds 445Debt Funds 445Diversified Debt Funds 445Focused Debt Funds 445High Yield Debt Funds 446Debt Funds and Bond Duration 446Equity Funds 446Aggressive Growth Funds 446Growth Funds 447Specialty Funds 447Sector Funds 447Offshore Funds 447Small Cap Equity Funds 447Option Income Funds 448Fund of Funds 448Equity Index Funds 448Value Funds 448Equity Income Funds 448Balanced Funds 449Asset-Allocation Funds 449Commodity Funds 449Real Estate Funds 449Tax-exempt Funds 449Risk Categories 450Low Level Risk Funds 450Moderate Level Risks 450High Level Risks 450The Prospectus 450Structure of a Mutual Fund 450Services 451Automatic Reinvestment Plan 451Contractual Accumulation Plan 451Voluntary Accumulation Plan 451CheckWriting 452Switching Within a Family of Funds 452VoluntaryWithdrawal Plans 452Investment Techniques 452Dollar-cost Averaging 452Value Averaging 453The Combined Method 454The Total Return 455Computation of Returns 456Analysis 457Taxation Issues 458Alternatives to Mutual Funds 459Exchange-Traded Funds (ETFs) 460Potential Asset Classes 461Segregated (Separately Managed) Accounts 461Pension Plans 462Types of Plans 462Defined Benefit Plans 462Defined Contribution Plans 463IRAs 464Cash Balance Plans 464Chapter 12 Orders and Exchanges 465Important Acronyms 467Market Orders and Limit Orders 467The Limit Price 468The Limit Order Books 468Illustration of a Limit Order Book 468Limit Orders Versus Market Orders 469Marketable Limit Orders 470Trade Pricing Rules 471Stop-Loss and Stop-Limit Orders 472Trailing Stop-Loss Orders 473Market to Limit Orders 474Equivalence with Options 474Validity Conditions 475Good Till Canceled (GTC) Orders 475Good Till Days Orders 475Orders with Quantity Restrictions 476A Point on Order Specification 476Open-Outcry Trading Systems 477Electronic Markets Versus Open-Outcry Markets 478Call Markets 479Chapter 13 The Macroeconomics of Financial Markets 481Economic Growth 481Gross Domestic Product 481Consumption 482Real Estate 482Capital Expenditure 483Government Spending 483Inventories 483Foreign Trade 483GDP Versus GNP 484Inflation Adjustment 485Transnational Comparisons 485The Big Mac Index 485Inflation 485Types of Inflation 486Interest Rates 488The Federal Budget Deficit 488Measures of Budget Deficits 489The Primary Deficit 490Fiscal Policy 490Budget Deficits and the Capital Market 490The Role of the Central Bank 490Budget Deficits and Monetary Policy 491Cross Border Borrowing 491Central Banks and Foreign Exchange Markets 492Sterilized and Unsterilized Interventions 493Exchange Rates 493Issues with a Reserve Currency 494Cross-border Implications of Central Bank Actions 494Quantitative Easing 495Quantitative Easing Versus Open-market Operations 496Chapter 14 Interest Rate Derivatives 497Forward Rate Agreements (FRAs) 497Settling an FRA 499Determining Bounds for the FRA Rate 499Eurodollar Futures 500Calculating Profits and Losses on ED Futures 501Locking in a Borrowing Rate 502Locking in a Lending Rate 503The No-Arbitrage Pricing Equation 505Creating a Fixed-rate Loan 50630-year T-bond Futures Contracts 507Conversion Factors 507Interest Rate Options 510State Prices 510Callable and Putable Bonds 511Caps, Floors, and Collars 512Captions and Floortions 513Sources and References 515Index 521

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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.