Handbook of finance volume 1

Andrew Alford, PhD Managing Director, Quantitative Investment Strategies, Goldman Sachs Asset Management Michele Allman-Ward Managing Partner, Allman-Ward Associates No¨el Amenc, PhD Pro

Frank J Fabozzi

Editor

John Wiley & Sons, Inc.

iii

ii

ii

Frank J Fabozzi

Editor

John Wiley & Sons, Inc.

iii

Copyright
c 2008 by John Wiley & Sons, Inc All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Handbook of finance / Frank J Fabozzi, editor

JWPR026-Fabozzi fm June 25, 2008 5:43

About the Editor

Frank J Fabozziis Professor in the Practice of Finance

and Becton Fellow in the Yale School of Management

Prior to joining the Yale faculty, he was a Visiting

Pro-fessor of Finance in the Sloan School of Management at

Massachusetts Institute of Technology Professor Fabozzi

is a Fellow of the International Center for Finance at Yale

University and on the Advisory Council for the

Depart-ment of Operations Research and Financial Engineering

at Princeton University He is an affiliated professor at the

Institute of Statistics, Econometrics and Mathematical

Fi-nance at the University of Karlsruhe (Germany) He is the

editor of the Journal of Portfolio Management and an ciate editor of the Journal of Fixed Income, Journal of Asset

asso-Management, Journal of Structured Finance, and the Review of Futures Markets He earned a doctorate in economics from

the City University of New York in 1972 In 2002, sor Fabozzi was inducted into the Fixed Income AnalystsSociety’s Hall of Fame and is the 2007 recipient of the

Profes-C Stewart Sheppard Award given by the CFA Institute

He earned the designations of Chartered Financial lyst and Certified Public Accountant He has authored andedited numerous books on various topics in finance

Ana-v

vi

PART 1 Market Players and Markets 1

1 Overview of Financial Instruments and

4 Monetary Policy: How the Fed Sets,

Implements, and Measures Policy Choices 29

David M Jones and Ellen J Rachlin

5 Institutional Aspects of the Securities Markets 37

James R Thompson, Edward E Williams, and M.

Chapman Findlay, III

K Thomas Liaw

John D Finnerty

8 An Arbitrage Perspective of the Purpose and

Frank J Jones and Frank J Fabozzi

12 The Information Content of Short Sales 151

Steven L Jones and Glen Larsen

13 Emerging Stock Market Investment 163

Larry Speidell and Jarrod W Wilcox

Equity Derivatives

14 Listed Equity Options and Futures 175

Bruce Collins and Frank J Fabozzi

Bruce Collins and Frank J Fabozzi

Frank J Fabozzi and George P Kegler

viii Contents

25 The Euro Government Bond Market 285

Antonio Villarroya

26 The German Pfandbrief and European

Graham “Harry” Cross

Moorad Choudhry, Frank J Fabozzi, and Steven

V Mann

Steven V Mann and Frank J Fabozzi

Maria Mednikov Loucks, John A Penicook, and Uwe

Schillhorn

Structured Products

32 Introduction to Mortgage-Backed Securities 347

Frank J Fabozzi, Anand K Bhattacharya, and William

S Berliner

33 Structuring Collateralized Mortgage

Obligations and Interest-Only/Principal-Only

Andrew Davidson, Anthony Sanders, Lan-Ling Wolff,

and Anne Ching

34 Commercial Mortgage-Backed Securities 367

James Manzi, Diana Berezina, and Mark Adelson

35 Nonmortgage Asset-Backed Securities 375

Frank J Fabozzi, Laurie S Goodman, and Douglas J.

Lucas

36 Synthetic Asset-Backed Securities 385

Moorad Choudhry

William L Messmore, Beth Starr, Sunita Ganapati,

Mark Retik, and Paul Puleo

38 Collateralized Debt Obligations 395

Douglas J Lucas, Laurie S Goodman, and Frank

J Fabozzi

Fixed Income and Inflation Derivatives

39 Interest Rate Futures and Forward Rate

Frank J Fabozzi and Steven V Mann

Frank J Fabozzi and Gerald W Buetow

41 Interest Rate Options and Related Products 427

Frank J Fabozzi, Steven V Mann, and Moorad

Choudhry

42 Introduction to Credit Derivatives 435

Vinod Kothari

43 Fixed Income Total Return Swaps 447

Mark J.P Anson, Frank J Fabozzi, Moorad Choudhry, and Ren-Raw Chen

Bond Market

Daniel E Gallegos and Chris Barr

45 Bond Spreads and Relative Value 463

Moorad Choudhry

46 The Determinants of the Swap Spread and Understanding the LIBOR Term Premium 469

Moorad Choudhry

Susan Hudson-Wilson

48 Investing in Commercial Real Estate for

G Timothy Haight and Daniel D Singer

49 Types of Commercial Real Estate 505

G Timothy Haight and Daniel D Singer

50 Commercial Real Estate Loans and Securities 515

Rebecca J Manning, Douglas J Lucas, Laurie S.

Goodman, and Frank J Fabozzi

51 Commercial Real Estate Derivatives 525

Jeffrey D Fisher and David Geltner

PART 5 Alternative Investments 535

55 Assessing Hedge Fund Investment Risk

in Common Hedge Fund Strategies 575

Ellen J Rachlin

56 Diversify a Portfolio with Tangible

Henry G Jarecki and Terrence F Martell

57 The Fundamentals of Commodity Investments 593

Frank J Fabozzi, Roland F ¨uss, and Dieter G Kaiser

PART 7 Foreign Exchange 675

64 An Introduction to Spot Foreign Exchange 677

PART 9 Securities Finance 741

69 An Introduction to Securities Lending 743

Mark C Faulkner

70 Mechanics of the Equity Lending Market 757

Jeff Cohen, David Haushalter, and Adam V Reed

71 Securities Lending, Liquidity, and Capital

72 Repurchase Agreements and Dollar Rolls 769

Frank J Fabozzi and Steven V Mann

12 Implementing Investment Strategies: The Art

Wayne H Wagner and Mark Edwards

13 Investment Management for Taxable

David M Stein and James P Garland

14 Socially Responsible Investment 137

Kuntara Pukthuanthong-Le and Lee R Thomas III

Mark P Kritzman with the assistance of Paul A.

22 Introduction to Performance Analysis 221

No¨el Amenc, Felix Goltz, Lionel Martellini, and V´eronique Le Sourd

23 Evaluating Portfolio Performance:

LPM-Based Risk Measures and the

Banikanta Mishra and Mahmud Rahman

x Contents

PART 2 Equity Portfolio Management 237

24 Overview of Active Common Stock Portfolio

Frank J Fabozzi, Sergio M Focardi, Petter N Kolm,

and Robert R Johnson

25 Investment Analysis: Profiting from a

Bruce I Jacobs and Kenneth N Levy

26 Investment Management: An Architecture for

Bruce I Jacobs and Kenneth N Levy

27 Portfolio Construction with Active Managers:

Vineet Budhraja, Rui J P de Figueiredo, Jr, Janghoon

Kim, and Ryan Meredith

28 Quantitative Modeling of Transaction and

Petter N Kolm, Frank J Fabozzi, and Sergio M.

Focardi

29 Quantitative Equity Portfolio Management 289

Andrew Alford, Robert Jones, and Terrence Lim

30 Growth and Value Investing—Keeping

Eric H Sorensen and Frank J Fabozzi

31 Fundamental Multifactor Equity Risk Models 307

Frank J Fabozzi, Raman Vardharaj, and Frank

J Jones

32 Tracking Error and Common Stock Portfolio

Raman Vardharaj, Frank J Fabozzi, and Frank J Jones

Bruce I Jacobs and Kenneth N Levy

34 A Support Level for Technical Analysis 335

Robert A Schwartz, Reto Francioni, and Bruce W.

Weber

35 Volatility and Structure: Building Blocks of

Classical Chart Pattern Analysis 347

B ¨ulent Bayg ¨un and Robert Tzucker

44 Fixed Income Portfolio Investing: The Art of

Chris P Dialynas and Ellen Rachlin

45 Analysis and Evaluation of Corporate

52 Overview of ABS Portfolio Management 513

Karen Weaver and Eugene Xu

PART 4 Alternative Investments 521

53 Integrating Alternative Investments into the

Vineet Budhraja, Rui J P de Figueiredo, Janghoon Kim, and Ryan Meredith

54 Some Considerations in the Use of Currencies 531

Bruce Collins and Ozgur Kan

PART 5 Corporate Finance 539 Basics

55 Introduction to Financial Management and

Frank J Fabozzi and Pamela P Drake

56 Introduction to International Corporate

Frank J Fabozzi and Pamela P Drake

JWPR026-Fabozzi fm June 25, 2008 5:43

57 Corporate Strategy and Financial Planning 563

Frank J Fabozzi and Pamela P Drake

Mark J P Anson and Frank J Fabozzi

59 Measuring the Performance of Corporate

Harold Bierman, Jr.

Capital Structure and Dividend Policy

60 Capital Structure Decisions in Corporate

Frank J Fabozzi and Pamela P Drake

61 Capital Structure: Lessons from Modigliani

Frank J Fabozzi and Pamela P Drake

62 Bondholder Value versus Shareholder

Claus Huber

63 Recapitalization of Troubled Companies 631

Enrique R Arzac

64 Dividend and Dividend Policies 645

Frank J Fabozzi and Pamela P Drake

Capital Budgeting

65 The Investment Problem and Capital

Frank J Fabozzi and Pamela P Drake

66 Estimating Cash Flows of Capital Budgeting

Frank J Fabozzi and Pamela P Drake

Frank J Fabozzi and Pamela P Drake

Pamela P Drake and Frank J Fabozzi

74 Issuer Prospective in Structuring

Asset-Backed Securities Transactions 757

Frank J Fabozzi and Vinod Kothari

75 Structuring Efficient Asset-Backed

Len Blum and Chris DiAngelo

76 Funding through the Use of Trade Receivable

Adrian Katz and Jeremy Blatt

77 Operational Issues in Securitization 789

Vinod Kothari

Henry A Davis and Frank J Fabozzi

79 The Fundamentals of Equipment Leasing 815

Working Capital Management

82 Basic Treasury Management Concepts 851

James Sagner and Michele Allman-Ward

83 Advanced Treasury Management Concepts 861

James Sagner and Michele Allman-Ward

84 Management of Accounts Receivable 871

Pamela P Drake and Frank J Fabozzi

Pamela P Drake and Frank J Fabozzi

Mergers and Acquisitions

Aswath Damodaran

Pascal Quiry, Maurizio Dallocchio, Yann Le Fur, and Antonio Salvi

Pascal Quiry, Maurizio Dallocchio, Yann Le Fur, and Antonio Salvi

3 Overview of Risk Management and

Erik Banks

No¨el Amenc, Jean-Ren´e Giraud, Lionel Martellini,

and V´eronique Le Sourd

10 Risk Measures and Portfolio Selection 101

Svetlozar T Rachev, Christian Menn, and Frank J.

Fabozzi

11 Statistical Models of Operational Loss 109

Carol Alexander

12 Risk Management in Freight Markets with

Juby George and Radu Tunaru

Fixed Income Risk Management

Ludovic Breger and Oren Cheyette

14 Effective Duration and Convexity 153

Gerald W Buetow, Jr and Robert R Johnson

15 Duration Estimation for Bonds and Bond

Frank J Fabozzi

Frank J Fabozzi and Steven V Mann

17 Improving Guidelines for Interest Rate

Steven K Kreider, Scott F Richard, and Frank J.

20 Hedging Fixed Income Securities with

Shrikant Ramamurthy

Robert R Reitano

PART 2 Interest Rate Modeling 233

22 The Concept and Measures of Interest Rate

27 The Credit Analysis of Municipal Bonds 287

Sylvan G Feldstein and Frank Fabozzi

Pamela P Drake and Frank J Fabozzi

32 Equity Analysis Using Traditional and

Frank J Fabozzi and James L Grant

33 The Franchise Factor Approach to Firm

Martin L Leibowitz and Stanley Kogelman

Kuntara Pukthuanthong-Le

35 The Valuation of Private Firms 383

Stanley Jay Feldman

Valuing Fixed Income Securities

36 General Principles of Bond Valuation 399

Frank J Fabozzi and Steven V Mann

37 Yield Curves and Valuation Lattices 411

Frank J Fabozzi, Andrew Kalotay, and Michael Dorigan

38 Using the Lattice Model to Value Bonds with Embedded Options, Floaters, Options,

JWPR026-Fabozzi fm June 25, 2008 5:43

40 A Framework for Valuing Treasury

Priya Misra, Kodjo Apedjinou, and Anshul Pradhan

41 Quantitative Models to Value Convertible

Filippo Stefanini

Derivatives Valuation

42 Introduction to the Pricing of

Frank J Fabozzi

43 Black-Scholes Option Pricing Model 459

Svetlozar T Rachev, Christian Menn, and Frank

J Fabozzi

Gerald W Buetow and Frank J Fabozzi

Frank J Fabozzi and Gerald W Buetow

46 Pricing Options on Interest Rate Instruments 495

Radu Tunaru and Brian Eales

47 Credit Default Swaps Valuation 507

Ren-Raw Chen, Frank J Fabozzi, and Dominic O’Kane

48 The Valuation of Fixed Income Total Return

Ren-Raw Chen and Frank J Fabozzi

Jeroen Kerkhof

Valuing Commodity, Foreign Exchange,

and Real Estate Products

50 The Pricing and Economics of Commodity

52 Pricing Commercial Real Estate Derivatives 557

David Geltner and Jeffrey D Fisher

PART 5 Mathematical Tools and

Techniques for Financial Modeling

Basic Tools and Analysis

Pamela P Drake and Frank J Fabozzi

Pamela P Drake and Frank J Fabozzi

Pamela P Drake and Frank J Fabozzi

56 Calculating Investment Returns 617

Bruce J Feibel

Statistical Tools

57 Basic Data Description for Financial

Markus Hoechstoetter, Svetlozar T Rachev, and Frank J Fabozzi

Bala Arshanapalli and William Nelson

62 Moving Average Models for Volatility and Correlation, and Covariance Matrices 711

Carol Alexander

63 Introduction to Stochastic Processes 725

Svetlozar T Rachev, Christian Menn, and Frank

J Fabozzi

64 Bayesian Probability for Investors 739

Jarrod W Wilcox

Optimization and Simulation Tools

65 Monte Carlo Simulation in Finance 751

67 Introduction to Stochastic Programming and

Koray D Simsek

Dessislava A Pachamanova, Petter N Kolm, Frank

J Fabozzi, and Sergio M Focardi

xiv

Chair of Risk Management and Director of Research,

ICMA Centre, Business School, The University of

Reading

Roever W Alexander, CFA

Managing Director, U.S Fixed Income Strategy,

JPMorgan Securities, Inc

Andrew Alford, PhD

Managing Director, Quantitative Investment Strategies,

Goldman Sachs Asset Management

Michele Allman-Ward

Managing Partner, Allman-Ward Associates

No¨el Amenc, PhD

Professor of Finance, Edhec Graduate School of

Business, Director, Edhec Risk and Asset Management

Research Centre

Mark J P Anson, PhD, JD, CPA, CFA, CAIA

President and Executive Director of Nuveen Investment

Professor of Finance and Economics, Graduate School

of Business, Columbia University

Erik Banks

Managing Director, Risk Advisory, Unicredit Group

Europe

Chris Barr, CFA

Principal, Barclays Global Investors

B ¨ulent Bayg ¨un, PhD

Head of Global Quantitative Strategy, Barclays Capital

Senior Research Analyst, Citi Alternative Investments

Gerald W Buetow, Jr., PhD, CFA

President and Founder, BFRC Services, LLC

Rachel A J Campbell, PhD

Assistant Professor of Finance, Rotterdam School

of Management, Erasmus University & MaastrichtUniversity, The Netherlands

xv

xvi Contributors

Findlay M Chapman, III

Principal, Findlay, Phillips and Associates

Ren-Raw Chen, PhD

Associate Professor of Finance, Rutgers University

Daniel L Chesler, CMT, CTA

President, Chesler Analytics

Graham “Harry” Cross

Financial Tutor, 7City Learning

Christopher L Culp

Senior Advisor, Lexecon Senior Fellow in Financial

Regulation, Competitive Enterprise Institute Adjunct

Professor of Finance, Graduate School of Business,

University of Chicago

Alexandre Schutel Da Silva

Vice President, Quantitative Investments Group,

Lehman Brothers Asset Management

Professor of Finance and David Margolis Teaching

Fellow, Stern School of Business, New York

Harindra De Silva, PhD, CFA

Managing Director, Analytic Investors, Inc

Pamela P Drake, PhD, CFA

J Gray Ferguson Professor of Finance and DepartmentHead of Finance and Business Law, James MadisonUniversity

Robert Dubil, PhD

Associate Professor, Lecturer of Finance, David EcclesSchool of Business, University of Utah

Steven I Dym, PhD

President, Mariner Capital Partners

Brian Eales, BA, MSc (Econ)

Academic Leader, London Metropolitan University

Robert F Engle, PhD

Michael Armellino Professorship in the Management ofFinancial Services, Leonard N Stern School of Business,New York University

Frank J Fabozzi, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School ofManagement

Dorsey D Farr, PhD, CFA

Principal, French Wolf & Farr

Mark C Faulkner

Managing Director, Spitalfields Advisors

JWPR026-Fabozzi fm June 25, 2008 5:43

C ONTRIBUTORS xvii

Bruce J Feibel, CFA

Global Director of Products, Eagle Investment

Systems

Stanley Jay Feldman, PhD

Chairman, Axiom Valuation Solutions and Associate

Professor of Finance, Bentley University

Sylvan G Feldstein, PhD

Director, Investment Department, Guardian Life

Insurance Company of America

Niall Ferguson

Manager of Client Service Analytics, Bridgewater

Associates

John D Finnerty, PhD

Professor of Finance and Director of the MS in

Quantitative Finance Program, Fordham University

Graduate School of Business Managing Principal,

Finnerty Economic Consulting, LLC

Professor of Finance, Union Investment Endowed Chair

of Asset Management, European Business School (EBS),

International University-Schloss Reichartshausen

Daniel E Gallegos

Principal, Barclays Global Investors

Sunita Ganapati

James P Garland, CFA

President, The Jeffrey Company

Adjunct Professor of Finance and Economics, Columbia

University Graduate School of Business and President,

CBT Worldwide, Inc

Jean-Ren´e Giraud

Director of Business Development, Edhec Risk and

Asset Management Research Centre

Felix Goltz

Senior Research Engineer, Edhec Risk and AssetManagement Research Centre

Laurie S Goodman, PhD

Co-head of Global Fixed Income Research Manager

of U.S Securitized Products Research, UBS

Director, Research, Dow Jones Indexes

Brian K Haendiges, FSA, CRC, CRA

Head, Institutional Defined Contribution Plans, INGRetirement Services

G Timothy Haight, DBA

President, Menlo College and Chair of the Board, Board

of Commonwealth Business Bank (Los Angeles)

Markus Hoechstoetter, Dr rer pol.

Lecturer, School of Economics and BusinessEngineering, University of Karlsruhe

Susan Hudson-Wilson, CFA

Member, Boards of Hawkeye Partners, LLC, Property &Portfolio Research, Inc and University of VermontEndowment

Claus Huber, CFA, FRM, PhD

Chief Risk Officer, Credaris Portolio Management

Bruce I Jacobs, PhD

Principal, Jacobs Levy Equity Management

Brian J Jacobsen, PhD, CFA, CFP

Associate Professor of Business Administration,Wisconsin Lutheran College Chief Economist Partner,Capital Market Consultants, LLC

Henry G Jarecki, MD

Chairman, The Falconwood Corporation

Teo Jasic, Dr rer pol.

Postdoctoral Research Fellow at the Chair of Statistics,Econometrics and Mathematical Finance at theUniversity of Karlsruhe in the School of Economics andBusiness Engineering and a Partner of an InternationalManagement Consultancy Firm in Frankfurt, Germany

xviii Contributors

Robert Johnson, PhD, CFA

Deputy Chief Executive Officer, CFA Institute

David M Jones, PhD

President, DMJ Advisors, LLC

Frank J Jones, PhD

Professor, Accounting and Finance Department, San

Jose State University

Robert Jones, CFA

Managing Director, and Chief Investment Officer for

Quantitative Equity, Quantitative Investment

Strategies, Goldman Sachs Asset Management

Steven L Jones, PhD

Associate Professor of Finance, Indiana University,

Kelley School of Business–Indianapolis

Dieter G Kaiser, PhD

Director Alternative Investments, Institutional

Advisors GmbH Research Fellow, Centre for Practical

Quantitative Finance, Frankfurt School of Finance

Management

Andrew Kalotay, PhD

President, Andrew Kalotay Associates

Ozgur Kan, PhD, CFA, FRM

Product Specialist, Moody’s Investors Service

Vice President, Morgan Stanley

Janghoon Kim, CFA

Research Analyst, Citi Alternative Investments

Christoph Klein, CFA

Director, Portfolio Management, Deutsche Asset

Management

Stanley Kogelman

Chief Investment Officer, Summer Hill Inc & Partner,

Advanced Portfolio Management

Petter N Kolm, PhD

Clinical Associate Professor and Deputy Director of the

Mathematics in Finance M.S Program, Courant

Institute, New York University

Vinod Kothari

Independent financial consultant and trainer on

securitization, visiting Faculty, Indian Institute of

Management, Kolkata, India

Steven K Kreider, PhD

Managing Director, Morgan Stanley InvestmentManagement

Mark P Kritzman, CFA

President and CEO, Windham Capital Management,LLC

James Lam

President, James Lam & Associates Senior ResearchFellow, Beijing University

Glen A Larsen, Jr., PhD, CFA

Professor of Finance, Indiana University, Kelley School

Kenneth N Levy, CFA

Principal, Jacobs Levy Equity Management

Thomas K Liaw, PhD

Professor of Finance and Chair, St John’s University

Terrence Lim, PhD, CFA

Managing Director, Quantitative Investment Strategies,Goldman Sachs Asset Management

Maria Mednikov Loucks, CFA

Senior Managing Director, Black River AssetManagement

Saxe Distinguished Professor of Finance, Zicklin School

of Business, Baruch College/CUNY

Lionel Martellini, PhD

Professor of Finance, Edhec Graduate School of

Business, Scientific Director, Edhec Risk and Asset

Management Research Centre

Greg M McMurran

Chief Investment Officer, Analytic Investors, Inc

Christian Menn, Dr rer pol.

Associate, Sal Oppenheim Jr & Cie, Frankfurt,

Germany

Ryan Meredith, CFA, FFA

Senior Research Analyst, Citi Alternative Investments

Visiting Professor of Finance, University of Michigan

and Professor of Finance XIM-Bhubaneswar, India

Priya Misra

Senior Vice President, Lehman Brothers Inc

Stefan Mittnik, PhD

Professor of Financial Econometrics at the University of

Munich, Germany, and Research Director at the Ifo

Institute for Economic Research in Munich

William T Moore, PhD

David & Esther Berlinberg Professor, Vice Provost for

Academic Affairs, University of South Carolina

Affiliated Professor of Finance, EDHEC Business

School, Nice, France

Dessislava A Pachamanova, PhD

Assistant Professor of Operations Research, Babson

College

Anthony F L Pecore

Research Analyst, Franklin Templeton Investments

John A Penicook, CFA

Managing Director, UBS Global AssetManagement

Professor of Corporate Finance, HEC Paris

Svetlozar T Rachev, PhD, DrSci

Chair-Professor, Chair of Econometrics, Statistics andMathematical Finance, School of Economics andBusiness Engineering, University of Karlsruhe andDepartment of Statistics and Applied Probability,University of California, Santa Barbara

Donald M Raymond, PhD, CFA

Senior Vice President, Public Market Investments,Canada Pension Plan Investment Board

Adam V Reed, PhD

Assistant Professor of Finance, University of NorthCarolina at Chapel Hill

Robert R Reitano, PhD, FSA

Professor of the Practice in Finance, BrandeisUniversity, International Business School

Mark Retik

xx Contributors

Victor Ricciardi

Assistant Professor of Finance, Kentucky State

University, and Editor, Social Science Research

Network Behavioral & Experimental Finance,

eJournal

Scott F Richard, PhD

Managing Director, Morgan Stanley Investment

Management

W Alexander Roever, CFA

Managing Director, U.S Fixed Income Strategy,

JPMorgan Securities, Inc

Paul Ross

Investment Associate, Bridgewater Associates

James Sagner

Managing Principal, Sagner/Marks and Associate

Professor in the School of Business of Metropolitan

College of New York

Managing Director and Global Head of Quantitative

Structured Products, Morgan Stanley Investment

Management

Uwe Schillhorn, CFA

Executive Director, UBS Global Asset Management

Robert A Schwartz, PhD

Marvin M Speiser Professor of Finance and University

Distinguished Professor, Zicklin School of Business,

Baruch College, CUNY

Shani Shamah

Consultant, E J Consultants

William F Sharpe, PhD

STANCO 25 Professor of Finance, Emeritus at Stanford

University’s Graduate School of Business

Larry Speidell, CFA

General Partner, Ondine Asset Management, LLC

Beth Starr

Managing Director, Lehman Brothers

State Street Corporation Meir Statman, PhD

Glenn Klimek Professor of Finance, Santa ClaraUniversity

Filippo Stefanini

Deputy Chief Investment Officer, Aletti GestielleAlternative SGR Professor of Risk Management,Faculty of Engineering at Bergamo University

in Italy

David M Stein, PhD

Managing Director, Parametric Portfolio Associates

Stoyan V Stoyanov, PhD

Chief Financial Researcher, FinAnalytica Inc

Lee R Thomas III, PhD

Managing Partner and CEO, Flint Rock CapitalManagement

Inflation Trading, Barclays Capital

Raman Vardharaj, CFA

Senior Quantitative Analyst, RS Investments

Karen Weaver, CFA

Managing Director, Global Head of SecuritizationResearch and Regional Research Head—the Americas,Deutsche Bank Securities, Inc

Bruce W Weber, PhD

Professor of Information Management, LondonBusiness School

JWPR026-Fabozzi fm June 25, 2008 5:43

C ONTRIBUTORS xxi

Robert Whaley, PhD

Valere Blair Potter Professor of Management, The

Owen Graduate School of Management, Vanderbilt

University

Shane Whelan, FSAI, FSA, FFA, PhD

Lecturer in Actuarial Science, School of Mathematical

Sciences, University College Dublin, Ireland

Jarrod W Wilcox, PhD, CFA

President, Wilcox Investment Inc

xxii

JWPR026-Fabozzi fm June 25, 2008 5:43

Preface

Over the past two decades, financial

profession-als have had available to them excellent ence books on specialty areas in finance There arehandbooks on corporate financial management, financial

refer-instruments, portfolio strategies, structured finance,

capi-tal budgeting, derivatives, and the list goes on But to truly

understand financial markets throughout the world, it is

necessary to understand how financial decision makers—

such as corporate treasurers, chief financial officers,

port-folio managers, traders, and security analysts—make

deci-sions and the tools that they employ in doing so From that

perspective, the idea for this handbook was conceived

Finance is the application of economic principles and

concepts to business decision making and problem

solv-ing The field of finance can be considered to comprise

three broad categories: financial markets and instruments,

financial management, and investment management

The field of financial markets and instruments deals with

the role of financial markets in an economy, the structure

and organization of financial markets, the efficiency of

markets, the role of the various players in financial

mar-kets (i.e., governments, regulators, financial institutions,

investment banks and securities firms, and institutional

and retail investors), and the determinants of asset

pric-ing and interest rates

Financial management, sometimes referred to as business

finance, is the specialized field in finance that is concerned

primarily with financial decision-making within a

busi-ness entity and encompasses many different types of

deci-sions (While financial management is sometimes referred

to as corporate finance, the principles are applied to the

management of municipalities and nonprofit profit

enti-ties.) We can classify financial management decisions into

two groups: investment decisions and financing decisions

Investment decisions are concerned with the use of funds—

the buying, holding, or selling of all types of assets

Basi-cally, the types of assets acquired are either working

capi-tal, such as inventory and receivables, or long-term assets

Decisions involving the former are called working

tal decisions and those involving the latter are called

capi-tal budgeting decisions Financing decisions are concerned

with the acquisition of funds to be used for investing and

financing day-to-day operations Basically, this involves

the selection of the firm’s capital structure—that is, the

combination of equity and debt used to finance the firm—

and is referred to as the capital structure decision The

fi-nancing decision also involves the determination of howmuch of the company’s earnings to retain and how much

to distribute to shareholders in the form of dividends This

decision is referred to as the dividend decision Whether a

financial decision involves investing or financing, the core

of the decision will rest on two specific factors: expected

return and risk Expected return is the difference between potential benefits and potential costs Risk is the degree of

uncertainty associated with the expected returns

Investment management is the area of finance that focuses

on the management of portfolios of assets for tional investors and individuals The activities involved

institu-in institu-investment management, also referred to as asset

man-agement, include working with clients to set investment

objectives and an investment policy to accomplish thoseobjectives, the selection a portfolio strategy consistentwith the investment objectives and investment policy, andthe construction of the specific assets to include in a port-folio based on the portfolio strategy Investment manage-ment begins with the decision as to how to allocate fundsacross the major asset classes (e.g., stocks, bonds, real es-tate, alternative investments) This decision, referred to

as the asset allocation decision, requires a thorough

under-standing of the expected returns and risks associated withinvesting in a specific asset class Again, we see the im-portance of understanding expected return and risk Theinvestment strategy employed can be classified as eitheractive or passive and the decision as to which type to fol-low depends on the client’s view of the efficiency (i.e., thedifficulty of obtaining superior returns) of the market forthe asset class The portfolio construction phase involvesassembling the best portfolio given the client’s investmentobjectives, given the investment constraints set forth in theinvestment policy, and the estimated expected return andrisk of the individual assets that are potential candidatesfor inclusion in the portfolio

These three general areas use theories and analyticaltools developed in other disciplines For example, theo-ries about the pricing of assets and the determination ofinterest rates draw from theories in economics In fact,

many academics refer to finance as financial economics.

There are investment management strategies that utilize

xxiii

xxiv Preface

theories and concepts that draw from the field of

psychol-ogy, giving rise to the specialized field in finance known as

behavioral finance The complex nature of financial markets

requires a finance professional to draw from the fields

of statistics and econometrics in order to describe the

movement in asset prices and returns, as well as to

ob-tain meaningful measures of risk The field of financial

risk management, used both in financial management and

investment management, employ these tools These same

tools are used by investment managers in formulating and

testing potential strategies and in the valuation (pricing)

of complex financial instruments known as derivatives

Investment managers and financial managers utilize

so-phisticated mathematical models developed in the area of

operations research/management science to aid in

mak-ing optimal allocation decisions such as in portfolio

con-struction and the selection of capital projects Managers

also use simulation models, a tool of operations research,

in a variety of activities that involve corporate and

invest-ment decisions Financial engineering, sometimes referred

to as mathematical finance, is the relatively new

special-ized field in finance that uses statistical and mathematical

tools to deal with problems in all areas of finance and risk

management

This multivolume reference provides a bird’s-eye view

of finance that will help the reader appreciate the wide

range of topics that the discipline of “finance”

encom-passes While there are handbooks that address

special-ized areas within finance, the purpose of this three-volume

handbook is to cover all of the areas mentioned above and

is intended for professionals involved in finance, as well

as the student of finance

This three-volume handbook offers coverage of both

es-tablished and cutting-edge theories and developments in

finance It contains chapters from global experts in

in-dustry and academia, and offers the following unique

features:

r The handbook was written by more than 190 experts

from around the world This diverse collection of

exper-tise has created the most definitive coverage of

estab-lished and cutting-edge financial theories, applications,

and tools in this ever-evolving field

r The series emphasizes both technical and managerial

issues This approach provides researchers, educators,

students, and practitioners with a balanced

understand-ing of the topics and the necessary background to deal

with issues related to finance

r Each chapter follows a format that includes the author,

chapter abstract, keywords, introduction, body,

sum-mary, and references This enables readers to pick and

choose among various sections of a chapter and creates

consistency throughout the entire handbook

r Each chapter provides extensive references for

addi-tional readings, enabling readers to further enrich their

understanding of a given topic

r Numerous illustrations and tables throughout the work

highlight complex topics and assist further

understand-ing

r Each chapter provides cross-references within the body

of the chapter This helps readers identify other chapters

within the handbook related to a particular topic, which

provides a one-stop knowledge base for a given topic

r Each volume includes a complete table of contents and

index for easy access to various parts of the handbook

TOPIC CATEGORIES

The allocation of the topics among the three volumes ofthe handbook required a good deal of time, with morethan two dozen restructurings of the table of contents foreach volume before reaching what I believe to be the mostuseful allocation for readers There was no simple for-mula The decision involved feedback from practitioners,academics, and graduate students The final allocation tothe three volumes was as follows

Volume I (Financial Markets and Instruments) covers the

general characteristics of the different asset classes, tive instruments, the markets in which financial instru-ment trade, and the players in the market Topics include:

deriva-r Market Players and Markets

r Common Stock

r Fixed Income Instruments

r Real Estate

r Alternative Investments

r Investment Companies, Exchange-Traded Funds, and

Life Insurance Products

r Foreign Exchange

r Inflation-Hedging Products

r Securities Finance

Volume II (Investment Management and Financial

Man-agement) covers the theories, issues, decisions, and

imple-mentation for both investment management and financialmanagement Topics include:

r Investment Management

r Equity Portfolio Management

r Fixed Income Portfolio Management

r Alternative Investments

r Corporate Finance

The analytical tools, the measurement of risk, and the

techniques for valuation are the subject of Volume III

(Val-uation, Financial Modeling, and Quantitative Tools) Topics

include:

r Risk Management

r Interest Rate Modeling

r Credit Risk Modeling and Analysis

r Valuation

r Mathematical Tools and Techniques for Financial

Mod-eling and AnalysisThe chapters can serve as material for a wide spectrum

of courses, such as the following:

JWPR026-Fabozzi fm June 25, 2008 5:43

Guide to the Handbook of Finance

The Handbook of Finance is a comprehensive overview

of the field of finance This reference work consists

of three separate volumes and 229 chapters Eachchapter provides a comprehensive overview of the se-

lected topic intended to inform a broad spectrum of

read-ers ranging from finance professionals to academicians to

students to the general business community

To derive the greatest possible benefit from the Handbook

of Finance, we have provided this guide It explains how

the information within the handbook can be located

ORGANIZATION

The Handbook of Finance is organized to provide maximum

ease of use for its readers The material is broken down

into three distinct volumes:

r Volume I (Financial Markets and Instruments) covers the

general characteristics of the different asset classes,

derivative instruments, the markets in which financial

instrument trade, and the players in the market

r Volume II (Investment Management and Financial

Manage-ment) covers the theories, issues, decisions, and

imple-mentation for both investment management and

finan-cial management

r Volume III (Valuation, Financial Modeling, and

Quantita-tive Tools) tackles the analytical tools, the measurement

of risk, and the techniques for valuation

TABLE OF CONTENTS

A complete table of contents for the entire handbook

ap-pears in the front of each volume This list of titles

rep-resents topics that have been carefully selected by the

editor, Frank J Fabozzi The Preface includes a more

de-tailed description of the volumes and parts the chapters

are grouped under

INDEX

A Subject Index for the entire handbook is located at the

end of each volume The subjects in the index are listed

alphabetically and indicate the volume and page numberwhere information on this topic can be found

CHAPTERS

Each chapter in the Handbook of Finance begins on a new

page, so that the reader may quickly locate it The author’sname and affiliation are displayed at the beginning of thechapter

All chapters in the handbook are organized according

to a standard format, as follows:

r Title and author

Each chapter begins with an outline indicating the content

to come The outline is intended as an overview and thuslists only the major headings of the chapter Lower-levelheadings also may be found within the chapter

Keywords

The keywords section contains terms that are important

to an understanding of the chapter

Introduction

The text of each chapter begins with an introductory tion that defines the topic under discussion and summa-rizes the content By reading this section, the reader gets ageneral idea about the content of a specific chapter

sec-xxv

xxvi Guide to the Handbook of Finance

Body

The body of each chapter discusses the items that were

listed in the outline section

Summary

The summary section provides a review of the materials

discussed in each chapter It imparts to the reader the most

important issues and concepts discussed

References

The references section lists both publications cited in thechapter and secondary sources to aid the reader in lo-cating more detailed or technical information Reviewarticles and research papers that are important to anunderstanding of the topic are also listed The refer-ences provide direction for further research on the giventopic

xxviii

JWPR026-Fabozzi part-1 June 17, 2008 10:52

PART 1

Market Players and Markets

Chapter 1 Overview of Financial Instruments and Financial Markets 3

Chapter 4 Monetary Policy: How the Fed Sets, Implements,

Chapter 5 Institutional Aspects of the Securities Markets 37

Chapter 8 An Arbitrage Perspective of the Purpose and Structure

1

2

JWPR026-Fabozzi c01 June 24, 2008 9:11

CHAPTER 1

Overview of Financial Instruments and

Financial Markets

FRANK J FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Provisions for Paying off Debt Instruments 5

Classification of Financial Markets 6

Abstract: Broadly speaking, an asset is any possession that has value in an exchange.

Assets can be classified as tangible or intangible A tangible asset is one whose valuedepends on particular physical properties—examples are buildings, land, and machin-ery Assets, by contrast, represent legal claims to some future benefit Their value bears

no relation to the form, physical or otherwise, in which these claims are recorded

Financial assets, also referred to as financial instruments, are intangible assets For nancial assets, the typical benefit or value is a claim to future cash Financial markets areclassified as cash/spot markets and derivatives markets Financial markets play a keyrole in the financial system of all economies In most economies financial instrumentsare created and subsequently traded in some type of financial market

fi-Keywords: financial assets, financial instruments, issuer, investor, debt instrument,

equity instrument, fixed income instruments, maturity, coupon rate,floating-rate securities, amortizing instrument, call provision, put provision,prepayment, search costs, liquidity, price discovery process, capital market,secondary market, primary market, over-the-counter market, derivativesmarkets, derivative instruments, futures contract, option contract

Participants in financial markets must understand the

wide range of financial instruments and the role of

fi-nancial markets In this chapter, an overview of the

in-struments (both cash and derivative inin-struments), issuers,

and investors is provided The role of financial assets and

financial markets are also explained

ISSUERS AND INVESTORS

The entity that has agreed to make future cash payments

is called the issuer of the financial instrument; the owner

of the financial instrument is referred to as the investor.

Here are seven examples of financial instruments:

1 A loan by Bank of America (investor/commercial bank)

to an individual (issuer/borrower) to purchase a car

2 A bond issued by the U.S Department of the Treasury

3 A bond issued by Nike Inc

4 A bond issued by the city of San Francisco

5 A bond issued by the government of Australia

6 A share of common stock issued by Caterpillar, Inc., anAmerican company

7 A share of common stock issued by Toyota Motor poration, a Japanese company

Cor-3

4 Overview of Financial Instruments and Financial Markets

In the case of the car loan by Bank of America, the terms

of the loan establish that the borrower must make

spec-ified payments to the commercial bank over time The

payments include repayment of the amount borrowed

plus interest The cash flow for this asset is made up of

the specified payments that the borrower must make

In the case of a U.S Treasury bond, the U.S government

(the issuer) agrees to pay the holder or the investor the

in-terest payments every six months until the bond matures,

then at the maturity date repay the amount borrowed

The same is true for the bonds issued by Nike Inc., the

city of San Francisco, and the government of Australia

In the case of Nike, Inc the issuer is a corporation, not a

government entity In the case of the city of San Francisco,

the issuer is a municipal government The issuer of the

Australian government bond is a central government

The common stock of Caterpillar, Inc entitles the

in-vestor to receive dividends distributed by the company

The investor in this case also has a claim to a pro rata share

of the net asset value of the company in case of liquidation

of the company The same is true of the common stock of

Toyota Motor Corporation

DEBT VERSUS EQUITY

INSTRUMENTS

Financial instruments can be classified by the type of claim

that the holder has on the issuer When the contractual

ar-rangement is one in which the issuer agrees to pay interest

and repay the amount borrowed, the financial instrument

is said to be a debt instrument The car loan, the U.S

Trea-sury bond, the Nike Inc bond, the city of San Francisco

bond, and the Australian government bond are examples

of debt instruments requiring fixed payments

In contrast to a debt obligation, an equity instrument

ob-ligates the issuer of the financial instrument to pay the

holder an amount based on earnings, if any, after the

hold-ers of debt instruments have been paid Common stock is

an example of an equity claim A partnership share in a

business is another example

Some securities fall into both categories in terms of their

attributes Preferred stock, for example, is an equity

instru-ment that entitles the investor to receive a fixed amount

This payment is contingent, however, and due only after

payments to debt instrument holders are made Another

“combination” instrument is a convertible bond, which

al-lows the investor to convert debt into equity under certain

circumstances Both debt instruments and preferred stock

are called fixed-income instruments.

CHARACTERISTICS OF DEBT

INSTRUMENTS

There are a good number of debt instruments available

to investors Debt instruments include loans, money

mar-ket instruments, bonds, mortgage-backed securities, and

asset-backed securities In the chapters that follow, each

will be described There are features of debt instrumentsthat are common to all debt instruments and they are de-scribed below In later chapters, there will be a furtherdiscussion of these features as they pertain to debt instru-ments of particular issuers

Maturity

The term to maturity of a debt obligation is the number ofyears over which the issuer has promised to meet the con-ditions of the obligation At the maturity date, the issuerwill pay off any amount of the debt obligation outstand-ing The convention is to refer to the “term to maturity” assimply its “maturity” or “term.” As we explain later, theremay be provisions that allow either the issuer or holder ofthe debt instrument to alter the term to maturity

The market for debt instruments is classified in terms

of the time remaining to its maturity A money marketinstrument is a debt instrument which has one year or lessremaining to maturity Debt instruments with a maturitygreater than one year are referred to as a capital marketdebt instrument

Par Value

The par value of a bond is the amount that the issuer agrees

to repay the holder of the debt instrument by the maturitydate This amount is also referred to as the principal, facevalue, or maturity value Bonds can have any par value.Because debt instruments can have a different par value,the practice is to quote the price of a debt instrument as apercentage of its par value A value of 100 means 100% ofpar value So, for example, if a debt instrument has a parvalue of$1,000 and is selling for$900, it would be said to

be selling at 90 If a debt instrument with a par value of

$5,000 is selling for$5,500, it is said to be selling for 110

Coupon Rate

The coupon rate, also called the nominal rate or the contract

rate, is the interest rate that the issuer/borrower agrees topay each year The dollar amount of the payment, referred

to as the coupon interest payment or simply interest

pay-ment, is determined by multiplying the coupon rate by the

par value of the debt instrument For example, the interestpayment for a debt instrument with a 7% coupon rate and

a par value of$1,000 is$70 (7% times$1,000)

The frequency of interest payments varies by the type ofdebt instrument In the United States, the usual practicefor bonds is for the issuer to pay the coupon interest in twosemiannual installments Mortgage-backed securities andasset-backed securities typically pay interest monthly Forbonds issued in some markets outside the United States,coupon payments are made only once per year Loan in-terest payments can be customized in any manner

Zero-Coupon Bonds

Not all debt obligations make periodic coupon interestpayments Debt instruments that are not contracted tomake periodic coupon payments are called zero-coupon

JWPR026-Fabozzi c01 June 24, 2008 9:11

M ARKET P LAYERS AND M ARKETS 5

instruments The holder of a zero-coupon instrument

re-alizes interest income by buying it substantially below its

par value Interest then is paid at the maturity date, with

the interest earned by the investor being the difference

between the par value and the price paid for the debt

instrument So, for example, if an investor purchases a

zero-coupon instrument for 70, the interest realized at the

maturity date is 30 This is the difference between the par

value (100) and the price paid (70)

There are bonds that are issued as zero-coupon

instru-ments Moreover, in the money market there are several

types of debt instruments that are issued as discount

instruments

There is another type of debt obligation that does not

pay interest until the maturity date This type has

contrac-tual coupon payments, but those payments are accrued

and distributed along with the maturity value at the

ma-turity date These instruments are called accrued coupon

instruments or accrual securities or compound interest

se-curities

Floating-Rate Securities

The coupon rate on a debt instrument need not be

fixed over its life Floating-rate securities, sometimes called

floaters or variable-rate securities, have coupon payments

that reset periodically according to some reference rate

The typical formula for the coupon rate on the dates when

the coupon rate is reset is:

Reference rate± Quoted marginThe quoted margin is the additional amount that the is-

suer agrees to pay above the reference rate (if the quoted

margin is positive) or the amount less than the reference

rate (if the quoted margin is negative) The quoted margin

is expressed in terms of basis points A basis point is equal

to 0.0001 or 0.01% Thus, 100 basis points are equal to 1%

To illustrate a coupon reset formula, suppose that the

reference rate is the 1-month London Interbank Offered

Rate (LIBOR) Suppose that the quoted margin is 150 basis

points Then the coupon reset formula is:

1-month LIBOR+ 150 basis points

So, if 1-month LIBOR on the coupon reset date is 5.5%,

the coupon rate is reset for that period at 7% (5% plus 150

basis points)

The reference rate for most floating-rate securities is an

interest rate or an interest rate index There are some issues

where this is not the case Instead, the reference rate is the

rate of return on some financial index such as one of the

stock market indexes There are debt obligations whose

coupon reset formula is tied to an inflation index

Typically, the coupon reset formula on floating-rate

se-curities is such that the coupon rate increases when the

reference rate increases, and decreases when the reference

rate decreases There are issues whose coupon rate moves

in the opposite direction from the change in the

refer-ence rate Such issues are called inverse floaters or reverse

floaters

A floating-rate debt instrument may have a restriction

on the maximum coupon rate that will be paid at a resetdate The maximum coupon rate is called a cap

Because a cap restricts the coupon rate from increasing, acap is an unattractive feature for the investor In contrast,there could be a minimum coupon rate specified for afloating-rate security The minimum coupon rate is called

a floor If the coupon reset formula produces a coupon ratethat is below the floor, the floor is paid instead Thus, afloor is an attractive feature for the investor

Provisions for Paying off Debt Instruments

The issuer/borrower of a debt instrument agrees to pay the principal by the stated maturity date The is-suer/borrower can agree to repay the entire amount bor-rowed in one lump sum payment at the maturity date.That is, the issuer/borrower is not required to make anyprincipal repayments prior to the maturity date Suchbonds are said to have a bullet maturity An issuer may berequired to retire a specified portion of an issue each year.This is referred to as a sinking fund requirement

There are loans that have a schedule of principal payments that are made prior to the final maturity of theinstrument Such debt instruments are said to be amor-tizing instruments The same is true for mortgage-backedand most asset-backed securities because they are backed

re-by pools of loans

There are debt instruments that have a call provision.This provision grants the issuer/borrower an option toretire all or part of the issue prior to the stated matu-rity date Some issues specify that the issuer must retire apredetermined amount of the issue periodically Varioustypes of call provisions are discussed below

Call and Refunding Provisions

A borrower generally wants the right to retire a debt strument prior to the stated maturity date because it rec-ognizes that at some time in the future the general level ofinterest rates may fall sufficiently below the coupon rate

in-so that redeeming the issue and replacing it with anotherdebt instrument with a lower coupon rate would be eco-nomically beneficial This right is a disadvantage to theinvestor since proceeds received must be reinvested at alower interest rate As a result, a borrower who wants toinclude this right as part of a debt instrument must com-pensate the investor when the issue is sold by offering ahigher coupon rate

The right of the borrower to retire the issue prior tothe stated maturity date is referred to as a “call option.”

If the borrower exercises this right, the issuer is said to

“call” the debt instrument The price that the borrowermust pay to retire the issue is referred to as the call price

Prepayments

For amortizing instruments—such as loans and securitiesthat are backed by loans—there is a schedule of principalrepayments but individual borrowers typically have the

6 Overview of Financial Instruments and Financial Markets

option to pay off all or part of their loan prior to the

uled date Any principal repayment prior to the

sched-uled date is called a prepayment The right of borrowers

to prepay is called the prepayment option Basically, the

prepayment option is the same as a call option

Options Granted to Bondholders

There are provisions in debt instruments that give either

the investor and/or the issuer an option to take some

ac-tion against the other party The most common type of

embedded option is a call feature, which was discussed

earlier This option is granted to the issuer There are two

options that can be granted to the owner of the debt

in-strument: the right to put the issue and the right to convert

the issue

A debt instrument with a put provision grants the

in-vestor the right to sell the issue back to the issuer at a

specified price on designated dates The specified price is

called the put price The advantage of the put provision

to the investor is that if after the issuance date of the debt

instrument market interest rates rise above the debt

instru-ment’s coupon rate, the investor can force the borrower to

redeem the bond at the put price and then reinvest the

proceeds at the prevailing higher rate

A convertible debt instrument is one that grants the

in-vestor the right to convert or exchange the debt instrument

for a specified number of shares of common stock Such a

feature allows the investor to take advantage of favorable

movements in the price of the borrower’s common stock

or equity and is referred to as a conversion provision.

FINANCIAL MARKETS

A financial market is a market where financial instruments

are exchanged (that is, traded) Although the existence of

a financial market is not a necessary condition for the

creation and exchange of a financial instrument, in most

economies financial instruments are created and

subse-quently traded in some type of financial market The

mar-ket in which a financial asset trades for immediate delivery

is called the spot market or cash market The other type of

financial market is called a derivatives market

Role of Financial Markets

Financial markets provide three major economic

func-tions First, the interactions of buyers and sellers in a

fi-nancial market determine the price of the traded asset

Or, equivalently, they determine the required return on

a financial instrument Because the inducement for firms

to acquire funds depends on the required return that

in-vestors demand, it is this feature of financial markets that

signals how the funds in the financial market should be

allocated among financial instruments This is called the

price discovery process

Second, financial markets provide a mechanism for an

investor to sell a financial instrument Because of this

fea-ture, it is said that a financial market offers “liquidity,”

an attractive feature when circumstances either force ormotivate an investor to sell If there were not liquidity,the owner would be forced to hold a financial instrumentuntil the issuer initially contracted to make the final pay-ment (that is, until the debt instrument matures) and anequity instrument until the company is either voluntar-ily or involuntarily liquidated While all financial marketsprovide some form of liquidity, the degree of liquidity isone of the factors that characterize different markets.The third economic function of a financial market is that

it reduces the cost of transacting There are two costs ciated with transacting: search costs and information costs

asso-Search costs represent explicit costs, such as the money

spent to advertise one’s intention to sell or purchase a nancial instrument, and implicit costs, such as the value

fi-of time spent in locating a counterparty The presence fi-ofsome form of organized financial market reduces searchcosts Information costs are costs associated with assess-ing the investment merits of a financial instrument, that

is, the amount and the likelihood of the cash flow pected to be generated In a price efficient market, pricesreflect the aggregate information collected by all marketparticipants

ex-Classification of Financial Markets

There are many ways to classify financial markets Oneway is by the type of financial claim, such as debt mar-kets and equity markets Another is by the maturity of theclaim For example, the money market is a financial mar-ket for short-term debt instruments; the market for debtinstruments with a maturity greater than one year andequity instruments is called the capital market

Financial markets can be categorized as those dealing

with financial claims that are newly issued, called the

pri-mary market, and those for exchanging financial claims

previously issued, called the secondary market or the

mar-ket for seasoned instruments

Markets are classified as either cash markets or

deriva-tive markets The latter is described later in this chapter A

market can be classified by its organizational structure: It

may be an auction market or an over-the-counter market.

DERIVATIVE MARKETS

So far we have focused on the cash market for financial struments With some financial instruments, the contractholder has either the obligation or the choice to buy or sell

in-a finin-anciin-al instrument in-at some future time The price ofany such contract derives its value from the value of theunderlying financial instrument, financial index, or inter-

est rate Consequently, these contracts are called derivative

instruments.

The primary role of derivative instruments is to provide

an inexpensive way of protecting against various types

of risk encountered by investors and issuers nately, derivative instruments are too often viewed by thegeneral public—and sometimes regulators and legislativebodies—as vehicles for pure speculation (that is, legalized

Unfortu-JWPR026-Fabozzi c01 June 24, 2008 9:11

M ARKET P LAYERS AND M ARKETS 7

gambling) Without derivative instruments and the

mar-kets in which they trade, the financial systems throughout

the world would not be as efficient or integrated as they

are today

A May 1994 report published by the U.S General

Ac-counting Office (GAO) titled Financial Derivatives: Actions

Needed to Protect the Financial System recognized the

im-portance of derivatives for market participants Page 6 of

the report states:

Derivatives serve an important function of the global

financial marketplace, providing end-users with

op-portunities to better manage financial risks associated

with their business transactions The rapid growth and

increasing complexity of derivatives reflect both the

increased demand from end-users for better ways to

manage their financial risks and the innovative capacity

of the financial services industry to respond to market

demands

Types of Derivative Instruments

The two basic types of derivative instruments are

fu-tures/forward contracts and options contracts A futures

contract or forward contract is an agreement whereby two

parties agree to transact with respect to some financial

instrument at a predetermined price at a specified future

date One party agrees to buy the financial instrument; the

other agrees to sell the financial instrument Both parties

are obligated to perform, and neither party charges a fee

An option contract gives the owner of the contract the

right, but not the obligation, to buy (or sell) a financial

instrument at a specified price from (or to) another party

The buyer of the contract must pay the seller a fee, which is

called the option price When the option grants the owner

of the option the right to buy a financial instrument from

the other party, the option is called a call option If, instead,

the option grants the owner of the option the right to sell a

financial instrument to the other party, the option is called

a put option

Derivative instruments are not limited to financial

in-struments In this handbook we will describe derivative

instruments where the underlying asset is a financial

as-set, or some financial benchmark such as a stock index

or an interest rate, or a credit spread Moreover, there are

other types of derivative instruments that are basically

“packages” of either forward contracts or option contracts

These include swaps, caps, and floors

SUMMARY

Financial instruments can be classified by the type of claim

that the holder has on the issuer (debt and equity) and cash

and derivative instruments With debt instruments there

is an interest rate that is specified by contract It could

be a fixed interest rate or a floating interest rate Other

characteristics of debt instruments are that they have amaturity value and provisions for paying off the principalborrowed Some debt instruments may have call, put orconversion provisions An equity instrument obligates theissuer of the financial instrument to pay the holder anamount based on earnings, if any, after the holders of debtinstruments have been paid

Financial markets provide three major economic tions: (1) the determination of the price of the traded asset(price discovery); (2) a mechanism for an investor to sell

func-a finfunc-ancifunc-al instrument (liquidity); func-and (3) reduction in thecost of transacting (search cost and information costs).Financial markets are classified as cash (spot) marketsand derivative markets Derivative instruments includefuture/forwards contracts and options The primary role

of derivative instruments is to provide investors and suers a vehicle for hedging/controlling different types ofrisk that they encounter when operating in the financialmarket

is-REFERENCES

Brynjolfsson, J., and Fabozzi, F J (eds.) (1999) Handbook

of Inflation Indexed Bonds Hoboken, NJ: John Wiley &

Sons

Fabozzi, F J., Ramsey, C., and Marz, M (eds.) (2000) The

Handbook of Nonagency Mortgage-Backed Securities, 2nd

edition Hoboken, NJ: John Wiley & Sons

Fabozzi, F J (ed.) (2000) Investing in Asset-Backed

Securi-ties Hoboken, NJ: John Wiley & Sons.

Fabozzi, F J (ed.) (2001) Investing in Commercial

Mortgage-Backed Securities Hoboken: NJ: John Wiley & Sons.

Fabozzi, F J (ed.) (2002) The Handbook of Financial

Instru-ments Hoboken, NJ: John Wiley & Sons.

Fabozzi, F J (ed.) (2005) The Handbook of Fixed Income

Securities, 7th edition New York: McGraw-Hill.

Fabozzi, F J (ed.) (2006) The Handbook of Mortgage-Backed

Securities, 6th edition New York: McGraw-Hill.

Fabozzi, F J., and Choudhry, M (eds.) (2004a) The

Hand-book of European Fixed Income Securities Hoboken, NJ:

John Wiley & Sons

Fabozzi, F J., and Choudhry, M (eds.) (2004b) The

Hand-book of European Structured Financial Products Hoboken,

NJ: John Wiley & Sons

Fabozzi, F J., and Jacob, D (eds.) (1999) The Handbook

of Commercial Mortgage-Backed Securities, 2nd edition.

Hoboken, NJ: John Wiley & Sons

Fabozzi, F J., and Modigliani, F (2002) Capital Markets:

Institutions and Instruments, 3rd edition Upper Saddle

River, NJ: Prentice Hall

Fabozzi, F J., Modigliani, F., Jones, F J., and Ferri, M

(2002) Foundations of Financial Markets and Institutions,

3rd edition Upper Saddle River, NJ: Prentice Hall

Fabozzi, F J., and Pilarinu, E (eds.) (2002) Investing

in Emerging Fixed Income Markets Hoboken, NJ: John

Wiley & Sons

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JWPR026-Fabozzi c02 June 24, 2008 9:28

CHAPTER 2

Fundamentals of Investing

FRANK J FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Constructing an Indexed Portfolio 15Constructing an Active Portfolio 15

Abstract: The investment management process involves five steps: setting investment

objectives, establishing an investment policy, selecting a portfolio strategy, constructing

a portfolio, and evaluating performance The investment process involves the analysis

of the investment objectives of the entity whose funds are being invested Given theinvestment objectives, an investor must then establish policy guidelines to satisfy theinvestment objectives This phase begins with the decision as to how to allocate fundsacross the major asset classes and requires a thorough understanding of the risks asso-ciated with investing in each asset class After establishing the investment objectivesand the investment policy, the investor must develop a portfolio strategy Portfoliostrategies can be classified as either active or passive The next step is to construct theportfolio by selecting the specific financial instruments to be included in the portfolio

Periodically, the investor must evaluate the performance of the portfolio and thereforethe portfolio strategy This step begins with the calculation of the investment returnand then evaluates that return relative to the portfolio risk

Keywords: individual investors, institutional investors, asset classes, mutual fund,

systematic risk, unsystematic risk, inflation risk, credit risk, interest raterisk, duration, liquidity risk, exchange rate risk, reinvestment risk, call risk,prepayment risk, active portfolio strategy, passive portfolio strategy,efficient portfolio, performance evaluation

In this chapter the fundamentals of investing will be

re-viewed We will explain these fundamentals in terms of the

steps that are involved in investing These steps include

setting investment objectives, establishing an investment

policy, selecting a portfolio strategy, constructing a

port-folio, and evaluating performance

SETTING INVESTMENT

OBJECTIVES

The investment process begins with a thorough analysis

of the investment objectives of the entity whose funds are

being invested These entities can be classified as individual

investors and institutional investors.

The objectives of an individual investor may be to cumulate funds to purchase a home or other major ac-quisition, to have sufficient funds to be able to retire at aspecified age, or to accumulate funds to pay for collegetuition for children

ac-Institutional investors include:

r Pension funds.

r Depository institutions (commercial banks, savings and

loan associations, and credit unions)

r Insurance companies (life insurance companies,

prop-erty and casualty insurance companies, and health surance companies)

in-r Regulated investment companies (mutual funds).

r Endowments and foundations.

9