Although an overall aim of the book is to highlight the unifying aspect of my approach to these important financial markets, the chapters can be quite instructive on a stand-alone basis. To this end, it is worth emphasizing that when I refer to a unifying theory of financial markets, I am referring both to a unifying aspect within each market segment and across them.
Preface
After nearly twenty years in the financial industry, and with assignments that have taken me to all corners of the world, it is only now that I feel that this book could be written. The significance of this is twofold: it emphasizes the interconnected nature of the markets, and it indicates that credit is an extremely important aspect of the market as a whole.
Acknowledgments
Another dimension of this book is that during its writing I was fortunate enough to live and work on two continents and with global responsibilities. I would also like to thank the anonymous reviewers of this text, although I fully accept any errors as my own.
Introduction
In an important paper written in 1958 entitled "Cost of Capital, Corporate Finance, and the Theory of Investment", Franco Modigliani and Merton Miller first proposed, among other proposals, 1Franco Modigliani and Merton Miller, "Cost of Capital, Corporate Finance, and the Theory of Investment", American Economic Review; December 1958, p.
ONE PART
If the issuer is no longer able to repay the investor (as in bankruptcy), the bond investor is generally protected by law to have a priority position over an equity investor in the same company. Unlike a bond, a stock gives an investor the right to vote on various matters affecting the issuer.
PROMISES AND PRIORITIES
While the value of a stock or bond is generally expressed in units of a currency (eg, a share of IBM stock costs $57 or a share of Société Generale stock costs 23), one way to value a currency in a certain time is to - sure how much a good or service can buy. An exchange rate is simply defined as a measure of the value of one currency relative to another.
INTEREST RATE PARITY
Two of the more well-known theories used for exchange rate pricing include the interest rate parity theory and the purchasing power parity theory. Indeed, the theory of interest rate parity essentially states that on a fully hedged basis, any difference that exists between two countries' interest rates will be offset by the difference in exchange rates between those two countries.
PURCHASING POWER PARITY
So why is it that neither interest rate parity nor purchasing power parity works perfectly. An interest rate as defined by the Fischer relation is equal to a real interest rate plus expected inflation (as with a measure of the CPI or consumer price index).
CHAPTER SUMMARY
Reinvested at a yield equal to the yield of the underlying security when originally purchased. It is assumed that all reinvestments are made for the remaining life of the bond and at the yield prevailing at the time of purchase of the bond.
SPOT PRICING FOR BONDS
In some cases, even a yield on a coupon bond priced at par can be said to have a spot yield.4 In fact, for a coupon bond priced at par, the yield- Its i is sometimes called the nominal bond yield. .For all types of quoted yields, annualized according to the U.S. If today's spread value was 82 bps, then we can say that the non-standard security is at the cheaper (wider) end of the range it has been trading.
SPOT SUMMARY
Suppose we want to buy 10 ounces of gold at $400 per ounce, but we don't want to receive physical delivery of the gold for a year. Regardless, the difference is between the total spot price of the gold and the opportunity cost of not having the total spot value over the course of a year.
FUTURES
We already know that the first six-month T-bill yields 4.75 percent and that the forward rate on the second six-month T-bill is 5.25 percent. However, a forward spread for the treasury can be calculated as the difference between the forward interest rate of two government bonds.
BOND FUTURES
That is, when a bond futures contract reaches its expiration month, investors shorting the contract face a number of choices. Investors who short the future or the future receive cash and deliver (transfer ownership) of the asset. If the par bond curve is flat, or if T=0 (settlement is immediate), then the forward curve is.
CASH-SETTLED EQUITY FUTURES
Since the investment will be fully hedged, it's safe to say that three-month Canadian Treasury bills will win. In this case, the fully hedged return would have to exceed the three-month Eurodollar rate. However, when the quarterly Canadian Treasury bill is combined with a futures contract, another credit risk emerges.
OPPORTUNITIES WITH CURRENCY FUTURES
Given a choice between a three-month Canadian T-bill fully hedged to US dollars earning 5.670 percent and a three-month U.S. T-bill earning 5.520 percent, the fully hedged Canadian T-bill appears to be the better investment. Investors who buy a Canadian Treasury note accept sovereign credit risk, that is, the risk that the Government of Canada may default on its debt.
SUMMARY ON FORWARDS AND FUTURES
Investors therefore buy call options when they believe that the value of the underlying spot will increase. Investors therefore buy put options when they believe that the value of the underlying spot will decrease. The idea that an option is undervalued or overvalued relative to futures or forward contracts or the money; that, in the eyes of a particular investor, there is a material difference between the market value of the futures transaction and its actual value.
A FINAL WORD
The option price is not the price that would be paid for the spot; the option price (if it is a call option) is F K V, and for a par16 option, FKVis usually much less than S17. The presence of F within the option pricing formula means that no exchange of cash for goods will take place until the option expires. In the case of a futures option where the option trades on an underlying futures contract as opposed to the spot, there is an additional delay from the time the option expires to the time cash is exchanged for the spot security.
SUMMARY ON BONDS, EQUITIES, AND CURRENCIES
The fact that the forward does not require an upfront payment and that the option costs a fraction of the upfront spot price is what contributes to the reference of forwards and options. Denotes the actual payment or receipt of cash for a cash flow value known at the time of the initial transaction (as with a purchase price or a coupon or principal payment) Indicates a reference to payment or receipt amount known at the time of the initial transaction, but without the exchange of cash. Indicates that the value of the cash flow cannot be known at the time of the initial trade and that an exchange of cash may or may not occur.
APPENDIX
It is "implied" because it comes directly from the price quoted in the market and embodies the market's view of the total value of the option. Here it is important to note that there is no kurtosis variable in the formula for an option's fair market value. When an implied volatility value is calculated, it may well contain more value than would be expected for an underlying price series that is normally distributed; it may contain some kurtosis value.
WHEN STANDARD DEVIATION IS ZERO
Ultimately, the investor may not actually create these products synthetically in the market, if only because of the extra time and effort required to do so (unless, of course, it offers particularly attractive arbitrage opportunities). Thus, in the extreme case where there is zero market volatility (or equivalently, where the future value of the underlying asset is known with certainty), the value of the call is primarily driven by the forward price of the underlying asset. In the extreme case where there is zero market volatility and no time value (or equivalently we want today's value of the underlying asset), then the value of the call is primarily driven by the spot price of the underlying asset.
THE ELUSIVE NATURE OF CREDIT RISK
For most of the world's developed countries, a local currency rating and a foreign currency rating are the same. Sometimes the perception of the credit risk in a particular geographic region (or collection of countries) can have an impact (positive or negative) on a country's rating. In the case of the United States, it is clearly a triple-A that ranks first among oddballs.
COLLATERALIZATION AND CAPITAL
On the basis that the bondholder has a superior claim to the entity's assets relative to the shareholder in the event of the entity's default, the bondholder is much closer to the issuer's collateral. Some leeway is allowed for loan defaults without undue impact on the overall creditworthiness of the securitized site. For example, an insurer may simply require the issuer to set aside a capital allocation that it promises not to touch during the life of the guaranteed security.
CREDIT DERIVATIVES
The above-mentioned type of interest rate swap (Constant Maturity Treasury swap or CMT swap) is a small part of the total swaps market. When the SPV sells the credit-linked bonds, the proceeds from the sale are not returned to the bank, but are invested in low-risk securities (ie instruments with a triple A rating). The bank pays a credit default swap insurance premium to the SPV under the swap arrangement.
TWO PART
The overall value of the base trade depends largely on the relative values of RandYc, as shown in Table 4.1. However, if the delivery options assume intrinsic value (such as via the quality option), then the option can be exercised before the expiration of the underlying trade. N = the notional amount of the exchange (in dollars or another currency) per unit of volatility.
VARIATIONS IN OPTIONALITY AMONG BOND PRODUCTS
In short, different patterns can and will emerge with the nature of the cash flows. A convertible that trades increasingly in the money (above its conversion value) and is immediately exercisable (American style) will increasingly reflect the price behavior of the underlying stock's spot price. A convertible that is trading increasingly out of the money (below its conversion value) is increasingly likely to mirror the price behavior of a debt instrument of the underlying issuer (and as such is termed a broken convertible).
ABSOLUTE RETURN INVESTING
These funds invest equally in long and short equity positions, and generally in the same sectors of the market. These funds invest in event-driven situations such as mergers, hostile takeovers, reorganizations or leveraged buyouts. These funds invest in securities that are believed to be selling at large discounts to their intrinsic or potential value.
RELATIVE RETURN INVESTING
Is it a question of where the security sits in the capital structure of the company's balance sheet? Portfolio managers can own any of the 30 stocks in the Dow, but with weightings that differ from the Dow. For example, half of an option's remaining decay time will be eroded in the last quarter of the option's life.
BOND PRICE RISK: DURATION AND CONVEXITY
There is only a subtle difference between the duration formula and the price/yield formula. In particular, the numerator of the duration formula is the same as the price/return formula, except that cash flows are a product of time (t). The denominator of the duration formula is exactly the same as the price/yield formula.
