Financial engineering principles phần 10 ppt

Again, readers should think about howother product types might be placed here, not just as an academic exercise,but as a practical matter of how portfolios are constructed and managed.Wi

to respond with opinions about where they were best ranked relative to theissuer’s capital structure At the same time, they also issued explicit guide-lines regarding how much of this product type they felt a given entity shouldissue.

Table 6.8, reprinted with permission from the Bank of InternationalSettlements, summarizes various credit-related statutes as practiced withinthe United States

In closing, investment rules and regulations—both those that are untarily imposed and those that are mandated by formal decree—willalways be a key consideration for investors

vol-CHAPTER SUMMARY

The very existence of various market rules and regulations (inclusive of taxes)may serve to create pockets of price dislocation in the marketplace From apure classical economic viewpoint, this not very surprising When economicagents act more in response to how someone else wants them to behave than

to how they themselves might want to behave, distortions can well arise.When such distortions are a necessary side-effect of commonly accepted prin-ciples of sound behavior (as with protecting the risks that banks or insur-ance companies might take to the detriment of consumers who rely on theirsound business practices), such rules and regulations typically are embraced

as necessary and reasonable What particular rules, regulations, and tax cies are helpful or not, and how best to create and enforce them, is a topic

poli-of considerable debate and review as long as there are markets

Figure 6.2 offers a three-dimensional viewpoint to help reinforce the relationships presented in this chapter Again, readers should think about howother product types might be placed here, not just as an academic exercise,but as a practical matter of how portfolios are constructed and managed.With reference to the above mapping process, investors can view a vari-ety of investment choices in the context of legal, regulatory, and tax envi-ronments, then make strategic choices according to their preferences andoutlook regarding each category of potential risk and reward

inter-To bridge the first four chapters, Table 6.9 links products, cash flows,credit, and legal and regulatory matters

While they are often thought of as a rather unexciting aspect of cial markets, tax, legal, and regulatory considerations are quite important,fluid, and deserving of very careful consideration

finan-264 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT

[Table not available in this electronic edition.]

[Table not available in this electronic edition.]

The usual legal protections

are enhanced with special

language pertaining to

missed dividend payments

and how the firm would be

expected to respond to

prespecified events

Regulatory restrictions prohibit bank purchases of convertible preferreds, and this affects supply and demand fundamentals as would any similar restriction

at opposite points of a horizontal continuum Indeed, as has been referencedearlier in the text, the Achilles’ heel of equities is the right conveyed to share-holders to vote on matters pertaining to the company, and the Achilles’ heel

of bonds is the presence of a maturity date

In sum, while it remains popular in financial circles today to emphasizehow different bonds are from equities, and how different these are from cur-rencies, and so on, it is this author’s view that financial products of all stripeshave much more in common than not; there is much more to be gained ped-agogically by emphasizing commonality as opposed to rifts When aninvestor considers any financial product, there ought to be at least some cur-sory consideration of market risk, credit risk, and regulatory and tax issues,

268 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT

Second preferred stock Mezzanine debt

Senior debt Common stock

First

preferred

stock

Junior debt

Common stock (CS) – Voting rights = Preferred stock (PS)

PS + Maturity date = Mezzanine debt (MD)

MD – Equity allocation + Maturity date (optional) = Junior debt (JD)

JD + Secured status + Maturity date = Senior debt

FIGURE 6.3 The debt/equity continuum as semicircular.

particularly since every financial product is affected by each of these ments And for securities in the form of spot, a forward or future, or anoption, these structures certainly share much in common across each andevery type of financial instrument that they embody.

ele-Perhaps the real conclusion here is that there is no conclusion, that ers are now in possession of a new toolbox filled with fresh perspectives ofthe marketplace, and as such are fully equipped to better understand exist-ing products as well as engineer a financial innovation or two of their own.Good luck to you!

A tranches, 141

Absolute return

fund, 150investing, 150–153

ABSs See Asset-backed securities

Accept delivery, 46

Add-on, usage, 260

Adjustable-rate mortgages

(ARMs), 164–165Agency bonds, 245

taxable status See U.S federal

agency bondstax-adjusted totalreturns, 145tAgency securities, tax-adjusted

total returns, 244tAggressive growth, 150

servicer, 91Asset-backed securities (ABSs),types, 262

Asset-liability management, 156Asset-liability portfolio

management, 156Assets

market value, 202stream, 156volatility, 202Asymmetrical information, 203At-the-money

10–non-call-2, pricevolatility, 144call option, 215option, 63fn, 210, 213put, 208

strike prices, 127Available for sale, 259Average life, 139prepayment rate,contrast, 139fsensitivity test, 262tests, 262

Bear market environment, 102

Benchmark See Market

Binomial option model, tree, 59

BIS See Bank for International

Settlements

Black-Scholes application, 72f

Black-Scholes assumption See

Log-normalityBlack-Scholes option pricingformula, 70

Blue chip stocks, 30Bond-equivalent basis, 173Bond-equivalent yield, 25,174–175

Bonds See Shorter-maturity

bondsbasis, 122fbasket, 121fncheapness/richness, 27fncoupon value, accruing, 37credit quality, 96f

futures, 45–47CTD, 123price, 46–47indices, investment-gradeportion, 169

market, callablestructures, 129portfolio construction, 234price

risk, 172–182sensitivity, 189products, optionalityvariations, 134–150statistical methods, 205summary, 64

total returns, 232uncertainty, layers, 25fn

yield curve See U.S Treasury

Bonex bonds/securities, 86–87

Brady bonds, 159fn

credit benefits, 149Bullet bond, 70, 208

Call option, 133, 203f, 256 See

also At-the-money; Credit;

Short call option; Syntheticcall option

calculation, 59tvalue, 53Call payoff profile, 208f

Call value, 54–55

Callable bonds, 133, 149

conceptual presentation, 130fcreation, 129f

issuing, 130payoff profile, 209price, definition, 199

Callable structures See Bonds

Callables, 200 See also Discrete

callablesprice, 133Called away, 200

Canadian Treasury bills, 50–51Capital, 91–97

adequacy, supervisoryreview, 259

allocation See Risk

amount, availabililty, 217base, 155

exposure, 159flight, 85

gains See Long-term capital

gainsguidelines/restrictions, 217

See also Risk-based

capital guidelines

impact See Collateralization

preservation, 155fund, 154representation, 218requirements, 259

return See Return on

risk-adjusted capital;Risk-adjusted return onrisk-adjusted capitalstructure, 92, 202value, 205

Capital Asset Pricing Model(CAPM), 219

Capital-adjusted variables,219–220

Carry (cost of carry), 35, 212

See also Negative carry;

Positive carrycomponent, 189duration, relationship, 190foptions, 119

Carry (cost of carry) (continued)

Certificate of deposit (CD),

6, 157

CFA See Communauté

Financière AfricaineCheapest-to-deliver (CTD),

115–118, 120fn See also

Bondsbeneficial change, 121

Cheapness/richness See Bonds

Chicago Board of Trade(CBOT), 7710–year Treasury bondfuture, 115bond futures contract, 115delivery process, 115Chicago MercantileExchange, 35Class A/B/C securities, 140Clean prices, 37

calculation See Forward clean

price calculationCleanup tranche, 141

CLO See Collateralized loan

obligationClose out, usage, 212

CMOs See Collateralized

Collateralization, 89–91, 107.

See also

Overcollaterali-zationcapital, impact, 89–97Collateralized bond obligation

(CBO), 105Collateralized debt obligation

(CDO), 105–107 See also

Nonsynthetic CDO;

Synthetic CDOCollateralized loan obligation

(CLO), 105–106 See also

Synthetic CLOsCollateralized MBS, 135

Collateralized mortgage

obligations (CMOs),164–165, 261College savings accounts (529

plans), 242Communauté Financière

Africaine (CFA), 257Companies, geographical

diversification, 87Compounding frequency, 19

Constant Maturity Treasury

(CMT) swap, 102–103Constant Prepayment Rate

(CPR), 138Consumer Price Index (CPI), 12

Contract-eligible bond, 46

Conversion factor, 45

Convertible bond,

transformationscenarios, 146fConvertible preferred stock,

145–146

Convertible-equity conversionprice, 145–146

Convertibles, creation, 145fConvexity, 172–182

calculation, 180trisk, 197

strategies, 169, 193fCorporate securities, tax-adjustedtotal returns, 244t, 245tCorporate settlement, 33Correlation coefficient, 183–186decrease, 187

generation, 182fn

Cost of carry See Carry

Counterparty risk, 77, 80Country-level default scenario, 88Coupon cash flow, reinvestment,

22, 223, 229fnCoupon payments, 19, 173date, 131

Coupon reinvestmentrisk, 224

uncertainty, 25Coupon-bearing bonds, 25,

96, 117form, 90price, 26fnspot purchase, 227Coupon-bearing security, 18, 22Coupon-bearing Treasury, 21,

36, 1765–year, price cone, 230f12–month, 229

bond, 42cash flows, 18fn

Coupon-bearing Treasury

(continued)

reinvestment patterns,

requirements,21fn, 22fnone-year, 230

Covenants, 250–253

types, 251t

CPI See Consumer Price Index

CPR See Constant Prepayment

instrument See Spot

valuation, 99Credit risks, 25, 75–89, 165, 190allocation methodology,216–217

comparison, 225decrease, 226double-A, 78

protection See Downside

credit risk protectionquantification, 203security types, conceptuallinking, 94f

Credit-enhanced bond, creation,147f, 148f

Credit-enhancing strategies, 267fCredit-free securities, 79

Credit-linked note, 101, 105schematic, 101f

Credit-related appreciation, 149Credit-related events, 99

Credit-related risks, layering, 93fCredit-sensitive bond, 100

Credit-sensitive instrument See

Nonderivative sensitive instrumentCredit-sensitive products,demand, 103

credit-Credit-sensitive securities, 103Creditworthiness, evaluation, 76Crossover credits, 166

CTD See Cheapest-to-deliver

Cumulative preferred convertible

stock, mappingprocess, 267fCumulative protection, 82

Currencies See National

currency; Nonnationalcurrency; Planet currency

acceptance See Local

currency; Sponsor currencycontrols, 87

free flow, 85futures, opportunities, 51management, 158

price cone, 233f

rating See Foreign currency

rating; Local currencysummary, 64

swap, 249Currency-enhanced

securities, 129

D

Debt, 4 See also Bad debt;

Distressed debt; dated debt; Shorter-dated debt

Longer-continuum, 268fcushion, 95management, 85Decapitalization, 250

scenario, 5 See also

Country-level default scenario

swap See Credit

Deflation, 8Delegated underwriting andservicing security(DUS), 142

Delivery See Accept delivery;

Make deliverydefinition, 118options, 46, 115–120,120fn

value, 121f

process See Chicago Board

of Tradetaking, 77

Delta See Implied delta;

Synthetic optionhedge, 126movement, 210–211price sensitivities, 198fusage, 197, 210

Delta-adjusted amount See

Notional amountDelta-neutral strategy, 126Depreciation, 8

Derivatives, 7 See also Credit

derivatives

Dirty prices, 37, 115, 174 See also U.S Treasury note calculation See Forward

dirty price calculation

Dollar-euro exchange rate, 49

Domestic bond markets,

Treasuries segments, 79

Double-A See Credit risks

Double-B company, 201

Double-B corporate bond, 224f

Dow Jones Industrial Index

(DJIA), 162

Dow Jones Utility Index, 162

Downside credit risk

Modified duration; Portfolio

calculation See U.S Treasury

bill; U.S Treasury STRIPS

relationship See Carry

Duration-neutral positions, 245

DUS See Delegated underwriting

and servicing security

E

Economic cycles, 100Economic hedge, 235Economic weakness, 103

Efficiency See Market

Embedded calls, 148, 257Embedded optionality, 136Embedded puts, 148Embedded short options, 130Emerging markets, 88, 151Employee Retirement IncomeSecurity Act (ERISA), 262underwriters, exemptioneligibility, 263tEntities, triple-A ratings, 87Equities, 227f

bonds, similarities/differences,7t, 98t

buybacks, 250cash flows, 30fdiversification, 227

futures See Cash-settled

equity futuresindex futures, 47life cycle blend, 155market, preferred stock, 129

price cone, 232fprice risk, 182–204returns, 232statistical methods, 205summary, 64

ERISA See Employee Retirement

Income Security ActEuribor rate, 80

Euro

creation, 204–205market, 49zone members, 254Eurodollar-denominated

securities, 205Eurodollars, 80

futures, 192, 205instruments, 192rate, 49

spot, 192European Central Bank, 85

European Community, 105

European option, 145

Eurorates, 49–50

differential, 50Euroyen yield, 80

Event-driven situations, 152

Events See Credit-related events

Exchange, 35 See also Chicago

Mercantile Exchange rate, 8

See also Dollar-euro

exchange rate; Forwardexchange rates

transaction, 77Exchange-traded contracts, 260

Exchange-traded option, 214

Exercise right, 129

Expected expenses, 220calculation, 221Expected losses, 220calculation, 221Expected return, 220Extramarket forces, 256Extramarket incentive, 57

F

Face amount, 20Fallen angel, 201

Fannie Mae See Federal National

Mortgage AssociationFASITs, 262

Fat-tail distributions, 68Federal budgets, market control,238–239

Federal Financial InstitutionsExamination Council(FFIEC), 261

Federal Home Loan Bank(FHLB), 243, 245–246Federal Home Loan MortgageCorporation (FHLMC),129–130, 242

pass-thrus, 136fnFederal National MortgageAssociation (FNMA),129–130, 239, 242pass-thrus, 136fnproduct, 246fn

FFIEC See Federal Financial

Institutions ExaminationCouncil

FHLB See Federal Home Loan

Bank

FHLMC See Federal Home Loan

price change, effect, 181

Fixed-coupon par bond, 104

Forward settlement, 33Forward spread (FS), 61f,

133, 134f

calculation See Non-Treasury

securityinterrelationships, 61f

Forward transaction, 124f See also Offsetting forward

transactionForward yields, spot yields(convergence), 191fForward-dated option, 199Forward-forward arrangement,196

Forward/future profile,206–207

Forwardscash flow ownership,relationship, 40ffutures, contrast, 34interrelationships, 56fmarkets, 79

option, building-blockapproach, 56summary, 51–63undervaluation, 57yield value, 44

Freddie Mac See Federal Home

Loan Mortgage Corporation

Frequency, 19 See also

Compounding frequency

FS See Forward spread

FTSE See Financial Times Stock

ExchangeFund management themes, 154t

Fund strategies, 169t

Funding sources, 247

Futures, 34–45 See also Bonds;

Equity index futurescheap trading, 120

contract See Standard &

Poor’s 500physical settlement, 47unwinding, 35

contrast See Forwards opportunities See Currencies

summary, 51–63undervaluation, 57usage, 125f

G

G-7 See Group of Seven

G-10 See Group of Ten

Global reserve currencies, 205

GNMA See Government

National MortgageAssociation

Going long, 34Gold standard, 7Goods

cost, subsidies, 11–12supply/demand, 11trade bans, 12Government National MortgageAssociation (GNMA),

136, 138pass-thrus, 136fnGroup of Seven (G-7), 67, 88Group of Ten (G-10), 186Growth funds, 154Growth-type index, 154

H

Hedge See Delta; Economic

hedgefunds, 150, 151, 221

Hedging See Market neutral

Held for portfolio, 259Hicks method, usage, 178Historical volatility, 66–68formula, annualizing term, 67usage, 69

Holding companies, 252Home mortgages, purchase, 130

I

Idiosyncratic risk, 219

IMF See International Monetary

FundImplied delta, 211definition, 212Implied forward credit outlook,backed-out, 202