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Fundamentals of financial instruments : an introduction to stocks, bonds, foreign exchange, and derivatives / Sunil K. Parameswaran.

By: Parameswaran, Sunil K, 1964- [author.]

Contributor(s): John Wiley & Sons [publisher.]

Language: English Series: Wiley financePublisher: [Hoboken, New Jersey] : Wiley, [2022]Copyright date: ©2022Edition: Second editionDescription: 1 online resourceContent type: text Media type: computer Carrier type: online resourceISBN: 9781119816614; 9781119816621 ; 9781119816638; 9781119816645Subject(s): Financial instruments | Securities | Foreign exchangeGenre/Form: Electronic books.DDC classification: 332.6 LOC classification: HG4521Online resources: Full text is available at Wiley Online Library Click here to view

Contents:

TABLE OF CONTENTS 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

Summary: In the newly revised Second Edition of Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives, renowned finance trainer Sunil Parameswaran delivers a comprehensive introduction to the full range of financial products commonly offered in the financial markets. Using clear, worked examples of everything from basic equity and debt securities to complex instruments—like derivatives and mortgage-backed securities – the author outlines the structure and dynamics of the free-market system and explores the environment in which financial instruments are traded. This one-of-a-kind book also includes: New discussions on interest rate derivatives, bonds with embedded options, mutual funds, ETFs, pension plans, financial macroeconomics, orders and exchanges, and Excel functions for finance Supplementary materials to enhance the reader’s ability to apply the material contained within A foundational exploration of interest rates and the time value of money Fundamentals of Financial Instruments is the ideal resource for business school students at the undergraduate and graduate levels, as well as anyone studying financial management or the financial markets. It also belongs on the bookshelves of executive education students and finance professionals seeking a refresher on the fundamentals of their industry.

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ABOUT THE AUTHOR
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.

Includes bibliographical references and index.

TABLE OF CONTENTS
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

In the newly revised Second Edition of Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives, renowned finance trainer Sunil Parameswaran delivers a comprehensive introduction to the full range of financial products commonly offered in the financial markets.

Using clear, worked examples of everything from basic equity and debt securities to complex instruments—like derivatives and mortgage-backed securities – the author outlines the structure and dynamics of the free-market system and explores the environment in which financial instruments are traded. This one-of-a-kind book also includes:

New discussions on interest rate derivatives, bonds with embedded options, mutual funds, ETFs, pension plans, financial macroeconomics, orders and exchanges, and Excel functions for finance
Supplementary materials to enhance the reader’s ability to apply the material contained within
A foundational exploration of interest rates and the time value of money
Fundamentals of Financial Instruments is the ideal resource for business school students at the undergraduate and graduate levels, as well as anyone studying financial management or the financial markets. It also belongs on the bookshelves of executive education students and finance professionals seeking a refresher on the fundamentals of their industry.

Description based on print version record and CIP data provided by publisher; resource not viewed.

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