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Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange,and Derivatives


This is a careful introduction to securities, securitized products, futures options and vanilla swaps covering their basic structure, market and trading and elementary pricing methods. It will appeal to readers requiring a gentle explanation of the fundamental concepts underlying the main classes of financial instruments, where every step is clearly illustrated by a simple numerical example. There are many specialized advanced mathematical texts on pricing and hedging financial instruments, but few other texts can compete with the clarity of Sunil Parameswaran's Fundamentals of Financial Instruments as an introduction to the general subject.
—Pofessor Carol Alexander, air of Financial Risk Management, ICMA Centre, Henley Business School at Reading; air of the Board, Professional Risk Manager’s International Association

"his book is a comprehensive survey of financial instruments with illustrations to enable an assiduous reader to understand not only their definitions but also the mechanics and numerical implementation. It will prove a valuable reference."
—Professor Simon Benninga, Faculty of Management, Tel Aviv University

"The book contains an excellent and comprehensive coverage of all important financial products and instruments which are extensively used in financial markets. It provides the reader with the fundamentals of valuation, nature of the markets and a wide range of applications of these instruments. It will be a very useful text in MBA courses dealing with financial markets and instruments."
—Professor P.G. Apte, Professor, Indian Institute of Management, Bangalore, India

Sunil K. Parameswaran is a Professor of Finance at the T.A. Pai Management Institute in Manipal, where he anchors courses in the area of Finance. His primary areas of interest are Securities Markets, Financial Derivatives, Fixed Income Securities, International Finance, and Banking. For the past seven years Dr. Parameswaran has also been a corporate trainer and management consultant. He has delivered training programs on Global Securities Markets and Global Banking to many multinational IT firms located in India including WIPRO Technologies, HCL Technologies, MINDTREE Consulting; JPMorgan Chase, Société Générale, ANZ Information Technology, and Kanbay (now a part of Cap Gemini). Dr. Parameswaran also has several years of teaching experience at leading business schools in the U.S., Singapore, Australia, and India.
Dr. Parameswaran obtained his Ph.D. in Finance from the Fuqua School of Business at Duke University in North Carolina, U.S.A. He obtained his M.B.A. from the Indian Institute of Management, Bangalore. A prolific writer, he has published several books, primarily in the field of Financial Derivatives.
Preface xiii

Acknowledgments xv

Chapter 1 An Introduction to Financial Institutions, Instruments, and Markets 1

The Role of an Economic System 1

A Command Economy 2

A Market Economy 3

Classification of Economic Units 4

An Economy’s Relationship with the External World 7

The Balance of Trade 9

The Current Account Balance 9

Financial Assets 10

Primary Markets and Secondary Markets 22

Exchanges and OTC Markets 24

Brokers and Dealers 27

The Need for Brokers and Dealers 29

Trading Positions 31

The Buy Side and the Sell Side 31

Investment Bankers 32

Direct and Indirect Markets 33

Mutual Funds 36

Money and Capital Markets 40

The Eurocurrency Market 41

The International Bond Market 43

Globalization of Equity Markets 45

Dual Listing 46

Fungibility 49

Risk 51

After the Trade: Clearing and Settlement 54

Dematerialization and the Role of a Depository 54

Custodial Services 55

Globalization: The New Mantra 56

Chapter 2 Mathematics of Finance 59

Interest Rates 59

The Real Rate of Interest 60

The Fisher Equation 60

Simple Interest 64

Compound Interest 66

Properties 68

A Symbolic Derivation 71

Principle of Equivalency 72

Continuous Compounding 73

Future Value 74

Present Value 76

Handling a Series of Cash Flows 77

The Internal Rate of Return 79

Evaluating an Investment 79

Annuities: An Introduction 82

Perpetuities 87

The Amortization Method 88

Amortization with a Balloon Payment 91

The Equal Principal Repayment Approach 92

Types of Interest Computation 93

Loans with a Compensating Balance 94

Chapter 3 Equity Shares, Preferred Shares, and Stock Market Indexes 97

Introduction 97

Par Value versus Book Value 99

Voting Rights 100

Statutory versus Cumulative Voting 101

Proxies 101

Dividends 102

Dividend Yield 104

Dividend Reinvestment Plans 105

Stock Dividends 106

Treasury Stock 107

Splits and Reverse Splits 108

Costs Associated with Splits and Stock Dividends 110

Preemptive Rights 110

Interpreting Stated Ratios 113

Handling Fractions 113

Physical Certificates versus Book Entry 114

Tracking Stock 115

Report Cards 115

Types of Stocks 115

Risk and Return and the Concept of Diversification 116

Preferred Shares 119

Callable Preferred Stock 120

Convertible Preferred Shares 121

Cumulative Preferred Shares 122

Adjustable Rate Preferred Shares 124

Participating Preferred Shares 125

Dividend Discount Models 125

A General Valuation Model 125

The Constant Growth Model 126

The Two-Stage Model 127

The Three-Stage Model 128

The H Model 130

Stock Market Indexes 131

Price-Weighted Indexes 131

Changing the Divisor 133

The Importance of Price 135

Value-Weighted Indexes 136

Changing the Base-Period Capitalization 139

Equally Weighted Indexes 140

Tracking Portfolios 141

The Free-Floating Methodology 149

Well-Known Global Indexes 150

Margin Trading and Short Selling 150

Terminology 150

Maintenance Margin 156

Regulation T and NYSE and NASD Rules 157

Short Selling 157

Chapter 4 Bonds 167

Valuation of a Bond 170

Par, Premium, and Discount Bonds 172

Evolution of the Price 173

Zero-Coupon Bonds 175

Valuing a Bond in between Coupon Dates 176

Day-Count Conventions 177

ActualActual 177

The Treasury’s Approach 179

Corporate Bonds 180

Accrued Interest 181

Yields 183

Taxable-Equivalent Yield 192

Credit Risk 194

Bond Insurance 195

Equivalence with Zero-Coupon Bonds 195

The Yield Curve and the Term Structure 199

Bonds with Embedded Options 206

Price Volatility 211

Duration and Price Volatility 214

Dollar Duration 215

Convexity 215

Treasury Auctions 219

When Issued Trading 223

Price Quotes 223

Bond Futures 224


Chapter 5 Money Markets 227

Introduction 227

Market Supervision 231

The Interbank Market 234

Interest-Computation Methods 238

Term Money Market Deposits 240

Federal Funds 240

Correspondent Banks: Nostro and Vostro Accounts 242

Payment Systems 243

Fed Funds and Reserve Maintenance 244

Treasury Bills 245

Yields on Discount Securities 246

Discount Rates and T-Bill Prices 247

Primary Dealers and Open-Market Operations 257

Commercial Paper 271

Letters of Credit and Bank Guarantees 272

Yankee Paper 274

Credit Rating 275

Bills of Exchange 277

Eurocurrency Deposits 280

Money Market Futures 282

Chapter 6 Forward and Futures Contracts 283

Introduction 283

SpotFutures Equivalence 296

Cash-and-Carry Arbitrage 299

Synthetic Securities 300

The Case of Assets Making Payouts 301

Physical Assets 303

The Case of Multiple Deliverable Grades 307

Trading Volume and Open Interest 314

Cash Settlement 316

Hedging and Speculation 317

Estimation of the Hedge Ratio and the Hedging

Effectiveness 321

Speculation 322

Leverage 325

Contract Value 325

Forward versus Futures Prices 327

Locking in Borrowing and Lending Rates 327

Hedging the Rate of Return on a Stock Portfolio 329

Changing the Beta 331

Program Trading 332

Stock Picking 336

Portfolio Insurance 338

The Importance of Futures 340

Chapter 7 Options Contracts 343

Moneyness 349

Exchange-Traded Options 350

Speculation with Options 369

The Two-Period Model 378

Valuation of European Put Options 381

Valuing American Options 382

Implementing the Binomial Model in Practice 383

The Black-Scholes Model 384

The Greeks 387

Option Strategies 388

Chapter 8 Foreign Exchange 405

Introduction 405

Currency Codes 406

European Terms and American Terms 408

Appreciating and Depreciating Currencies 409

Converting Direct Quotes to Indirect Quotes 410

The Impact of Spreads on Returns 412

Arbitrage in Spot Markets 413

Cross Rates 417

Value Dates 418

The Forward Market 419

Outright Forward Rates 420

Swap Points 420

Broken-Dated Contracts 422

A Perfect Market 424

The Cost 426

Interpretation of the Swap Points 430

Short-Date Contracts 431

Option Forwards 434

Nondeliverable Forwards 438

Futures Markets 438

Hedging Using Currency Futures 441

Exchange-Traded Foreign Currency Options 444

The Garman-Kohlhagen Model 446

Put-Call Parity 448

The Binomial Model 448

Chapter 9 Mortgages and Mortgage-Backed Securities 451

Introduction 451

Market Participants 451

Government Insurance and Private Mortgage

Insurance 454

Risks in Mortgage Lending 455

Other Mortgage Structures 457

Negative Amortization 463

Graduated-Payment Mortgage 465

WAC and WAM 467

Pass-Through Securities 468

Extension Risk and Contraction Risk 492

Accrual Bonds 492

Floating-Rate Tranches 497

Notional Interest Only Tranche 498

Interest-Only and Principal-Only Strips 500

PAC Bonds 500

Agency Pass-Throughs 506

Chapter 10 Swaps 509

Introduction 509

Contract Terms 512

Market Terminology 514

Inherent Risk 515

The Swap Rate 515

Illustrative Swap Rates 515

Determining the Swap Rate 516

The Market Method 518

Valuation of a Swap During Its Life 519

Terminating a Swap 520

The Role of Banks in the Swap Market 521

Comparative Advantage and Credit Arbitrage 523

Swap Quotations 524

Matched Payments 525

Currency Swaps 526

Cross-Currency Swaps 528

Currency Risks 530

Hedging with Currency Swaps 530

Appendix 1 533

Appendix 2 535

Bibliography 537

Web Sites 541

Index 543