Financial Assets

Debt Versus Equity Claims

The Price of a Financial Asset and Risk
Financial (Intangible) Assets versus Tangible Assets
Derivative Instruments
The Role of Financial Assets
The Role of Derivative Instruments
Properties of Financial Assets
Financial Markets
Role of Financial Markets
Role of Futures Markets
Types of Financial Markets
Market Participants
Financial Institutions
Role of Financial Intermediaries
Regulation of Financial Markets 18
Regulatory Reform 18
Financial Innovation 19
Summary 22

SECTION I

FINANCIAL INSTITUTIONS

CHAPTER 2 : DEPOSITORY INSTITUTIONS 27

Asset/Liability Problem of Depository Institutions 28

Funding Risk 29
Financial Innovations and Asset I Liability Management 30
Liquidity Concerns 32
Commercial Banks 33
Bank Services 36
Bank Funding 38
Regulation 41
Federal Deposit Insurance 48
Savings and Loan Associations 49
Assets 50
Funding 51
Regulation 51
The S&L Crisis 52
Savings Banks 54
Credit Unions 54
Summary 55

CHAPTER 3: INVESTMENT BANKING 59

Nature of the Business 62

Public Offering (Underwriting) of Securities 63
Trading of Securities 68
Private Placement of Securities 73
Securitization of Assets 76
Mergers and Acquisitions 76
Merchant Banking 77
Trading and Creation of Risk Control Instruments 78
Money Management 79
Fees 79
Current Industry Structure 80
Competition and Challenges for Investment Banking Firms 82
Competition 82
Reassessing the Business 84
Summary 84

CHAPTER 4: INSURANCE COMPANIES, PENSION FUNDS, AND INVESTMENT

COMPANIES 89

Overview of Asset/Liability Management for Financial Institutions 90

Nature of Liabilities 91
Liquidity Concerns 93
Regulations and Taxation 93
Life Insurance Companies 94
Nature of the Business 94
Types of Policies 96
Investments 98
Regulation 99
Property and Casualty Insurance Companies 100
Nature of the Business 101
Regulation 103
Pension Funds 103
Types of Pension Plans 104
Regulation 105
Investments 107
Participants in the Non-insured Pension Fund Business 107
Investment Companies 109
Types of Investment Companies 109
Structure of a Fund 111
Types of Funds by Investment Objective 112
Economic Motivation for Funds 113
Regulation 114

Summary 115

SECTION II

ASSET PRICING AND DERIVATIVE MARKETS

CHAPTER 5: RISK / RETURN AND ASSET PRICING MODELS 119
Portfolio Theory 121
Investment Return 121
Portfolio Risk 125
Diversification 130
The Risk of Individual Securities 136
Estimating Beta 140
The Capital Asset Pricing Model 142
Underlying Assumptions 144
Tests of the Capital Asset Pricing Model 145
The Multifactor CAPM 148
Arbitrage Pricing Theory Model 150
Illustration 151
Empirical Evidence 154
Summary 154

CHAPTER 6: INTRODUCTION TO FINANCIAL FUTURES MARKETS 159

Mechanics of Futures Trading 160

Liquidating a Position 161
The Role of the Clearinghouse 161
Margin Requirements 162
Market Structure 163
Daily Price Limits 164
Futures Versus Forward Contracts 165
Risk and Return Characteristics of Futures Contracts 165
Leveraging Aspect of Futures 166
Pricing of Futures Contracts 166
Theoretical Futures Price Based on Arbitrage Model 170
Price Convergence at the Delivery Date 173
A Closer Look at the Theoretical Futures Price 173
General Principles of Hedging with Futures 176
Hedging Illustrations 177
Cross Hedging Illustrations 180
The Role of Futures in Financial Markets 181
Effect of Futures on Volatility of Underlying Asset 182
Is Increased Asset Price Volatility Bad? 183
Summary 184

CHAPTER 7: INTRODUCTION TO OPTION MARKETS 187

Option Contract Defined 188
Exchange-Traded versus OTC Options 189
Differences Between Options and Futures Contracts 190
Risk and Return Characteristics of Options 190
Buying Call Options 191
Writing (Selling) Call Options 194
Buying Put Options 196
Writing (Selling) Put Options 199
Considering the Time Value of Money 199
Pricing of Options 200
Basic Components of the Option Price 201
Put-Call Parity Relationship 202
Factors that Influence the Option Price 204
Option Pricing Models 206
Deriving the Binomial Option Pricing Model 207
Economic Role of the Option Markets 215
Summary 218

SECTION III

THE EQUITY MARKET

CHAPTER 8: COMMON STOCK MARKET 223

Secondary Markets 226

Perfect Markets 226
Trading Locations 227
Trading Mechanics 230
The Role of the Dealer as Market Maker 235
The National Market System 239
Trading Arrangements for Institutional Investors 241
Block Trades 242
Program Trades 243
Transactions Costs 245
Stock Market Indicators 246
Pricing Efficiency and Implications for Portfolio Strategies 249
Empirical Tests of Pricing Efficiency 250
Implications for Investing in Common Stock 254
The Market Crash of 1987 256
Institutional Arrangements 257
 Overvaluation of Stock Prices prior to Black Monday 258
Overreaction to Economic News 259
Is There a Conclusion? 259
Summary 260

CHAPTER 9 : STOCK OPTIONS MARKET 265

Exchange-Traded Options 266

Stock Option Pricing Models 268
Black- Scholes Option Pricing Model 268
Assumptions Underlying the Black- Scholes Model and Extensions 272
Option Strategies 276
Naked Strategies 276
Covered (Hedge) Strategies 277
Is There a Superior Options Strategy? 281
Pricing Efficiency of the Stock Options Market 284
Tests Not Based on an Option Pricing Model 285
Tests Based on Option Pricing Models 286
Related Products 288
Warrants 288
Primes and Scores 289
Summary 291

CHAPTER 1 0 : STOCK INDEX OPTIONS AND FUTURES MARKETS 295

Stock Index Options 296

Basic Features of Stock Index Options 296
Pricing Efficiency of the Stock Index Options Markets 298
Portfolio Strategies with Stock Index Options 300
Stock Index Futures Market 301
Basic Features of Stock Index Futures 301
Illustration of Margin Requirements 303
Pricing of Stock Index Futures 305
Pricing Efficiency of the Stock Index Futures Market 307
Portfolio Strategies with Stock Index Futures 309
Stock Index Contracts, Stock Price Volatility, and Black Monday 320
Are Derivative Index Markets Beneficial to the Financial Markets? 320
What Has Been the Effect on Stock Price Volatility? 326
Did Stock Index Contracts Cause Black Monday? 327
Summary 330
SECTION IV
INTEREST RATE DETERMINATION

CHAPTER 1 1 : THEORY OF INTEREST RATE DETERMINATION AND BOND

VALUATION: I 333

Theory of Interest Rate Determination 334

Description of Preferences between Current and Future Consumption 335
Loan Market 337
Carryover Through Investment 340
Market Equilibrium 348
Efficiency Properties of Markets 352
Real and Nominal Interest Rates: Fisher's Law 353
Basic Principles of Bond Valuation 355
Return from a Bond: Yield to Maturity Measure 358
Reasons Why a Bond's Price Will Change 360
What Determines the Premium-Par Yield 360
Reinvestment of Cash Flow and Yield 361
Summary 362

CHAPTER 1 2 : THEORY OF INTEREST RATE DETERMINATION AND BOND

VALUATION: I I 367

The Term Structure of Interest Rates 368

Yield on Zero-Coupon Bonds: Spot Rates 369
Derivation of Spot Rates from Coupon Bonds 374
Implicit Forward Rates 377
Determinants of the Shape of the Term Structure 380
The Pure Expectations Theory 382
The Liquidity Theory 386
The Preferred Habitat Theory 387
Market Segmentation Theory 388
Bond Price Volatility 389
Review of Price/Yield Relationship 389
Price Volatility Properties 389
Characteristics of a Bond that Affect Price Volatility 392
Measure of Price Volatility: Duration 393
Curvature and Convexity 398
Use of Duration in Institutional Investment Strategies 402
Summary 404
SECTION V

THE DEBT MARKETS

CHAPTER 1 3 : MONEY MARKET INSTRUMENTS 411

Treasury Bills 411

Bid and Offer Quotes on Treasury Bills 413
The Primary Market for Treasury Bills 415
Commercial Paper 422
Issuers of Commercial Paper 424
Directly Placed versus Dealer-Placed Paper 425
The Secondary Market 426
Yields on Commercial Paper 426
Bankers Acceptances 426
Illustration of the Creation of a Bankers Acceptance 427
Accepting Banks 428
Dealers 430
Large-Denomination Negotiable CDs 430
CD Issuers 432
Yields on CDs 432
Repurchase Agreements 433
Credit Risks 436
Participants in the Market 437
Determinants of the Repo Rate 438
Federal Funds 439
Summary 440

CHAPTER 1 4 : TREASURY AND AGENCY SECURITIES MARKETS 445

Treasury Securities 446

The Primary Market 448
The Secondary Market 452
Stripped Treasury Securities 457
Federal Agency Securities 461
Federally Sponsored Agency Securities 462
Future Regulation of Federally Sponsored Agencies 465
Summary 466
CHAPTER 1 5 : CORPORATE SENIOR SECURITIES MARKET 471

Corporate Bonds 472

Classification of Corporate Bonds 473
Terms of a Corporate Bond Issue 473
Credit Ratings 479
Risks Associated with Investing in Corporate Bonds 480
Term Structure of Credit Spreads 484
Bonds with Special Features 487
Secondary Market 490
High-Yield Sector of the Corporate Bond Market 491
The Role of High-Yield Bonds in Corporate Finance 492
Historical Performance of High-Yield Bonds 494
High-Yield Bond Structures 497
Investors in High-Yield Bonds 499
Medium-Term Notes 500
Preferred Stock 503
Types of Preferred Stock 506
Summary 507

CHAPTER 1 6 : MUNICIPAL SECURITIES MARKET 511

Investors in Municipal Securities 512

Households (Retail Investors) 512
Commercial Banks 513
Property and Casualty Insurance Companies 514
Types and Features of Municipal Securities 515
General Obligation Bonds 515
Revenue Bonds 515
Hybrid and Special Bond Securities 517
Municipal Notes 519
Redemption Features 519
Special Investment Features 520
Credit Ratings 520
Risks Associated with Investing in Municipal Securities 523
The Primary Market 523
The Secondary Market 524
Yields on Municipal Bonds 524
Regulation of the Municipal Securities Market 526

Summary 527

CHAPTER 1 7 : THE MORTGAGE MARKET 529

What Is a Mortgage? 530

Mortgage Origination 531
The Mortgage Origination Process 533
The Risks Associated with Mortgage Origination 536
The Traditional Mortgage 537
Some Historical Background 537
Characteristics of the Fixed-Rate, Level-Payment, Fully Amortized
Mortgage 538
Investment Risks 541
The Level-Payment Fixed-Rate Mortgage Before the 1970s 543
The Mismatch Problem and the Creation of Variable-Rate Mortgages 546
Nature of the "Mismatch" Problem 546
Characteristics of the Adjustable-Rate Mortgage 547
Hybrid Mortgages 550
Assessment of Variable-Rate Mortgages 550
The Tilt Problem and the Creation of Other Mortgage Instruments 551
Nature of the Tilt Problem 551
The Graduated-Payment Mortgage 553
The Price-Level-Adjusted Mortgage (PLAM) 554
The Dual-Rate Mortgage (DRM) 560
Summary 564

CHAPTER 1 8 : THE MARKET FOR MORTGAGE POOLS AND OTHER

SECURITIZED ASSETS 567

Development of the Secondary Mortgage Market 570

Mortgage Pass-Through Securities 571
Cash Flow Characteristics 572
Grantor Trust Structure 572
Issuers of Mortgage Pass-Through Securities 573
Agency Pass-Through Securities 573
Conventional Pass-Through Securities 576
Measuring Yields on Pass-Through Securities 577
Secondary Market 580
 Prepayment Risks Associated with Pass-Through Securities 581
Yield Spread to Treasuries 583
Collateralized Mortgage Obligations 584
Considerations in Constructing a CMO 586
Credit Risk and Yield Spreads 587
Other CMO Structures 587
CMO Residuals 591
Stripped Mortgage-Backed Securities 592
Asset-Backed Securities 595
Asset-Backed Securities Backed by Automobile Loans 596
Asset-Backed Securities Backed by Credit Card Receivables 597
Benefits of Securitization and Implications for Financial Markets 598
Benefits to Issuers 598
Benefits to Investors 600
Benefits to Borrowers 600
Implications of Securitization for Financial Markets 601
Summary 602

CHAPTER 19: INTEREST RATE FUTURES AND OPTIONS 607

Interest Rate Futures Contracts 609

Features of Actively Traded Contracts 609
Pricing of Interest Rate Futures Contracts 615
Pricing Efficiency of Interest Rate Futures 617
Portfolio Strategies with Interest Rate Futures 618
Forward Rate Agreement 623
Interest Rate Options 624
Over-the-Counter Options on Treasury and Mortgage-Backed Securities 624
Exchange-Traded Futures Options 625
Portfolio Strategies with Interest Rate Options 627
Option-Pricing Models 629
Pricing Efficiency of the Options Markets 631
Summary 632

CHAPTER 20: CUSTOMIZED INTEREST RATE CONTROL CONTRACTS 635

Interest Rate Swaps 636

Risk/Return Characteristics of a Swap 637
Comparison of Interest Rate Swaps to Futures/Forward Contracts 638
 Applications 639
Development of the Interest Rate Swap Market 645
Terminology, Conventions, and Market Quotes 650
Secondary Market for Swaps 652
Beyond the "Plain Vanilla" Swap 653
Options on Swaps 655
Interest Rate Agreements 656
Risk/Return Characteristics 657
Applications 657
Compound or Split-Fee Options 658
Summary 659

SECTION VI
FOREIGN EXCHANGE AND GLOBAL FINANCIAL
MARKETS

CHAPTER 2 1 : FOREIGN EXCHANGE MARKETS 663

Foreign Exchange Rates 664

Foreign Exchange Risk 667
Spot Market 667
Cross Rates 668
Dealers 669
The European Currency Unit 670
Instruments For Hedging Foreign Exchange Risk 671
Currency Forward Contracts 671
Currency Futures Contracts 677
Currency Option Contracts 678
Currency Swaps 680
Summary 684

CHAPTER 2 2 : GLOBAL FINANCIAL MARKETS 689

Factors Leading to the Globalization of Financial Markets 691

Deregulation 691
Technological Advances 692
Institutionalization of Financial Markets 693
Global Bond Markets 693
Securities Issued in the Eurobond Market 695
Major Non-U.S. Bond Markets 697
Clearing Systems 703
Global Equity Markets 704
National Market Structures 707
Trading Procedures 708
Stock Market Indexes 709
Stock Index and Interest Rate Derivative Contracts 709
Japanese Stock Index Futures and Options 710
Japanese Interest Rate Futures and Options 711
Summary 711

Index 717