Acknowledgements xv
1 Introduction: The Market Context 1
1.1 Capital and the Capital Markets 1
1.2 The Euromarkets (International Capital Markets) 4
1.3 Modern Investment Banking 5
1.4 The Clients of Investment Banks 8
1.5 About this Book 11
2 The Money Markets 15
2.1 Chapter Overview 15
2.2 Domestic Money Markets 15
2.3 US Domestic Markets 16
2.4 The European Central Bank (ECB) 18
2.5 Sterling Money Markets 19
2.6 The Bank of Japan 20
2.7 Systemic Risks and Moral Hazards 20
2.8 Treasury Bills 21
2.9 Discounting Treasury Bills 21
2.10 US Commercial Paper 24
2.11 Credit Risk on USCP 25
2.12 Bankers' Acceptances 26
2.13 The Eurocurrency Markets 26
2.14 Eurocurrency Loans and Deposits 27
2.15 Eurocurrency Interest and Day-Count 29
2.16 Eurocurrency Certificates of Deposit 30
2.17 CD Yield-to-Maturity 31
2.18 Euro-Commercial Paper 31
2.19 Repos and Reverses 32
2.20 Repo: Case Study 33
2.21 Other Features of Repos 33
2.22 Chapter Summary 34
3 The Foreign Exchange Market 37
3.1 Chapter Overview 37
3.2 Market Structure 37
3.3 FX Dealers and Brokers 38
3.4 Spot Foreign Exchange Deals 39
3.5 Sterling and Euro Quotations 40
3.6 Factors Affecting Spot FX Rates 41
3.7 Spot FX Trading 44
3.8 Spot Position Keeping 45
3.9 FX Risk Control 47
3.10 Cross-Currency Rates 49
3.11 Outright Forward FX Rates 50
3.12 Outright Forward FX Hedge: Case Study 51
3.13 Forward FX Formula 52
3.14 FX or Forward Swaps 53
3.15 FX Swap Two-Way Quotations 55
3.16 Chapter Summary 56
4 Major Government Bond Markets 59
4.1 Chapter Overview 59
4.2 Introduction to Government Bonds 59
4.3 Sovereign Risk 60
4.4 US Government Notes and Bonds 62
4.5 US Treasury Quotations 64
4.6 US Treasury Strips 66
4.7 Bond Pricing 67
4.8 Pricing Coupon Bonds: Examples 68
4.9 Detailed Bond Valuation: US Treasury 69
4.10 Bond Yield 71
4.11 Reinvestment Assumptions 72
4.12 Annual and Semi-Annual Bond Yields 73
4.13 UK Government Bonds 74
4.14 Japanese Government Bonds (JGBs) 77
4.15 Eurozone Government Bonds 77
4.16 Chapter Summary 78
5 Bond Price Sensitivity 81
5.1 Chapter Overview 81
5.2 Bond Market Laws 81
5.3 Other Factors Affecting Price Sensitivity 83
5.4 Macaulay's Duration 83
5.5 Calculating Macaulay's Duration 84
5.6 Duration of a Zero 85
5.7 Modified Duration 86
5.8 Price Value of a Basis Point 87
5.9 Convexity 88
5.10 Measuring Convexity 88
5.11 Convexity Behaviour 90
5.12 Portfolio Duration 91
5.13 Dedication 92
5.14 Immunization 94
5.15 Duration-Based Hedges 96
5.16 Convexity Effects on Duration Hedges 97
5.17 Chapter Summary 98
6 The Yield Curve 99
6.1 Chapter Overview 99
6.2 Real and Nominal Interest Rates 99
6.3 Compounding Periods 100
6.4 The Yield Curve Defined 101
6.5 Theories of Yield Curves 102
6.6 Zero Coupon or Spot Rates 104
6.7 Bootstrapping 106
6.8 Spot Rates and the Par Curve 108
6.9 Pricing Models Using Spot Rates 108
6.10 Forward Rates 109
6.11 Discount Factors 110
6.12 Chapter Summary 112
7 Credit Spreads and Securitization 113
7.1 Chapter Overview 113
7.2 Basics of Credit Spreads 113
7.3 The Role of the Ratings Agencies 115
7.4 Credit Spreads and Default Probabilities 117
7.5 Credit Default Swaps 118
7.6 Index Credit Default Swaps 121
7.7 Basket Default Swaps 122
7.8 Credit-Linked Notes 123
7.9 Securitization and CDOs 124
7.10 Rationale for Securitization 126
7.11 Synthetic CDOs 126
7.12 Chapter Summary 128
8 Equity Markets and Equity Investment 129
8.1 Chapter Overview 129
8.2 Comparing Corporate Debt and Equity 129
8.3 Additional Features of Common Stock 130
8.4 Hybrid Securities 131
8.5 Equity Investment Styles 132
8.6 Efficient Markets 133
8.7 Modern Portfolio Theory (MPT) 135
8.8 Primary Markets for Common Stock 138
8.9 Subsequent Common Stock Issues 140
8.10 Secondary Markets: Major Stock Markets 142
8.11 Depository Receipts 145
8.12 Stock Lending 146
8.13 Portfolio (Basket) Trading 148
8.14 Chapter Summary 148
9 Equity Fundamental Analysis 151
9.1 Chapter Overview 151
9.2 Principles of Common Stock Valuation 151
9.3 The Balance Sheet Equation 152
9.4 The Income Statement 154
9.5 Earnings Per Share (EPS) 156
9.6 Dividend Per Share (DPS) 157
9.7 Ratio Analysis 158
9.8 Liquidity Ratios 159
9.9 Profitability Ratios 159
9.10 Leverage Ratios 161
9.11 Investor Ratios and Valuation 162
9.12 Applying Valuation Multiples 163
9.13 Firm or Enterprise Value Multiples 165
9.14 Chapter Summary 166
10 Cash Flow Models in Equity Valuation 169
10.1 Chapter Overview 169
10.2 The Basic Dividend Discount Model 169
10.3 Constant Dividend Growth Models 170
10.4 The Implied Return on a Share 172
10.5 Dividend Yield and Dividend Growth 172
10.6 Price/Earnings Ratio 173
10.7 Stage Dividend Discount Models 175
10.8 Two-Stage Model: Example 175
10.9 The Capital Asset Pricing Model (CAPM) 176
10.10 Beta 177
10.11 Estimating the Market Risk Premium 178
10.12 The Equity Risk Premium Controversy 178
10.13 CAPM and Portfolio Theory 180
10.14 Free Cash Flow Valuation 183
10.15 Forecasting Free Cash Flows 184
10.16 Weighted Average Cost of Capital (WACC) 185
10.17 Residual Value 186
10.18 WACC and Leverage 187
10.19 Assets Beta Method 189
10.20 Company Value and Leverage 190
10.21 Chapter Summary 191
11 Interest Rate Forwards and Futures 193
11.1 Chapter Overview 193
11.2 Forward Rate Agreements (FRAs) 193
11.3 FRA Application: Case Study 194
11.4 Borrowing Costs with an FRA Hedge 196
11.5 FRA Market Quotations 197
11.6 The Forward Interest Rate 199
11.7 Financial Futures 201
11.8 CME Eurodollar Futures 203
11.9 Eurodollar Futures Quotations 203
11.10 Futures Margining 204
11.11 Margining Example: EURIBOR Futures on Eurex 205
11.12 Hedging with Interest Rate Futures: Case Study 208
11.13 Futures Strips 209
11.14 Chapter Summary 211
Appendix: Statistics on Derivative Markets 211
12 Bond Futures 213
12.1 Chapter Overview 213
12.2 Definitions 213
12.3 The CBOT 30-Year US Treasury Bonds Futures 213
12.4 Invoice Amount and Conversion Factors 214
12.5 Long Gilt and Euro-Bund Futures 216
12.6 Forward Bond Price 217
12.7 Carry Cost 218
12.8 The Implied Repo Rate 218
12.9 The Cheapest to Deliver (CTD) Bond 219
12.10 CTD Behaviour 221
12.11 Hedging with Bond Futures 222
12.12 Basis Risk 223
12.13 Hedging Non-CTD Bonds 224
12.14 Using Futures in Portfolio Management 225
12.15 Chapter Summary 226
13 Interest Rate Swaps 227
13.1 Chapter Overview 227
13.2 Swap Definitions 227
13.3 The Basic Interest Rate Swap Illustrated 228
13.4 Typical Swap Applications 230
13.5 Interest Rate Swap: Detailed Case Study 231
13.6 Interest Rate Swap Terms 233
13.7 Comparative Advantage 234
13.8 Swap Quotations and Spreads 236
13.9 Determinants of Swap Spreads 237
13.10 Hedging Swaps with Treasuries 238
13.11 Cross-Currency Swaps: Case Study 239
13.12 Cross-Currency Swap Revaluation 241
13.13 Chapter Summary 242
Appendix: Swap Variants 242
14 Interest Rate Swap Valuation 245
14.1 Chapter Overview 245
14.2 Valuing a Swap at Inception 245
14.3 Valuing the Swap Components 246
14.4 Swap Revaluation 247
14.5 Revaluation Between Payment Dates 248
14.6 The Forward Rate Method 249
14.7 Forward Rate Method on a Spreadsheet 251
14.8 Swap Rates and LIBOR Rates 251
14.9 Pricing a Swap from Futures 252
14.10 Hedging Interest Rate Risk on Swaps 256
14.11 Chapter Summary 257
15 Equity Index Futures and Swaps 259
15.1 Chapter Overview 259
15.2 Index Futures 259
15.3 Margining Procedures 260
15.4 Final Settlement and Spread Trades 262
15.5 Hedging with Index Futures: Case Study 263
15.6 Hedge Efficiency 264
15.7 Other Uses of Index Futures 265
15.8 Pricing an Equity Forward Contract 266
15.9 Index Futures Fair Value 267
15.10 The Basis 268
15.11 Index Arbitrage Trade 269
15.12 Running an Arbitrage Desk 270
15.13 Features of Index Futures 271
15.14 Equity Swaps 272
15.15 Managing the Risks on Equity Swaps 273
15.16 Structuring Equity Swaps 274
15.17 Benefits and Applications of Equity Swaps 275
15.18 Chapter Summary 276
16 Fundamentals of Options 277
16.1 Chapter Overview 277
16.2 Definitions 277
16.3 Basic Option Trading Strategies 278
16.4 Long Call: Expiry Payoff Profile 279
16.5 Short Call: Expiry Payoff Profile 281
16.6 Long Put: Expiry Payoff Profile 282
16.7 Short Put: Expiry Payoff Profile 284
16.8 Summary: Intrinsic and Time Value 284
16.9 CBOE Stock Options 285
16.10 CME S&P 500 Index Options 286
16.11 Stock Options on LIFFE 287
16.12 FT-SE 100 Index Options 288
16.13 Chapter Summary 289
Appendix: Exotic Options 289
17 Option Valuation Models 293
17.1 Chapter Overview 293
17.2 Fundamental Principles: European Options 293
17.3 Synthetic Forwards and Futures 295
17.4 American Options and Early Exercise 296
17.5 Binomial Trees 297
17.6 Expanding the Tree 300
17.7 Black-Scholes Model 302
17.8 Black-Scholes Assumptions 305
17.9 Chapter Summary 305
Appendix: Measuring Historic Volatility 306
18 Option Pricing and Risks 309
18.1 Chapter Overview 309
18.2 Intrinsic and Time Value Behaviour 309
18.3 Volatility Assumption and Option Pricing 311
18.4 Delta (¿ or ¿) 312
18.5 Delta Behaviour 313
18.6 Gamma (¿ or ¿ ) 314
18.7 Readjusting the Delta Hedge 315
18.8 Gamma Behaviour 316
18.9 Theta (¿) 318
18.10 Vega 319
18.11 Rho (p) and Summary of Greeks 319
18.12 Chapter Summary 321
Appendix: Delta and Gamma Hedging 322
19 Option Strategies 325
19.1 Chapter Overview 325
19.2 Hedging with Put Options 325
19.3 Covered Call Writing 329
19.4 Collars 330
19.5 Bull and Bear Spreads 332
19.6 Other Spread Trades 334
19.7 Volatility Revisited 336
19.8 Volatility Trading: Straddles and Strangles 338
19.9 Current Payoff Profiles 339
19.10 Profits and Risks on Straddles 341
19.11 Chapter Summary 343
20 Additional Option Applications 345
20.1 Chapter Overview 345
20.2 OTC and Exchange-traded Currency Options 345
20.3 Hedging FX Exposures with Options: Case Study 346
20.4 Pricing Currency Options 348
20.5 Interest Rate Options 349
20.6 Exchange-Traded Interest Rate Options 350
20.7 Caps, Floors, and Collars 352
20.8 Interest Rate Cap: Case Study 353
20.9 Pricing Caps and Floors: Black Model 355
20.10 Swaptions 357
20.11 Interest Rate Strategies 359
20.12 Convertible Bonds 360
20.13 CB Measures of Value 361
20.14 Conversion Premium and Parity 363
20.15 Convertible Arbitrage 364
20.16 Chapter Summary 366
Glossary of Financial Terms 369
Index 415
