An Introduction to International Capital Markets: Products, Strategies, Participants, 2nd Edition

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 (Δ or δ) 312

18.5 Delta Behaviour 313

18.6 Gamma (Γ or γ ) 314

18.7 Readjusting the Delta Hedge 315

18.8 Gamma Behaviour 316

18.9 Theta (Θ) 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