Preface xxiii Preface to the First Edition xxiv Acknowledgments xxv About the Author xxvi Chapter 1 An Introduction to Financial Institutions, Instruments, and Markets 1 The Role of an Economic System 1 A Command Economy 2 AMarket Economy 2 Classification of Economic Units 4 An Economy''s Relationship with the ExternalWorld 6 The Balance of Trade 8 The Current Account Balance 8 Financial Assets 9 Money 10 Money as a Unit of Account or a Standard of Value 10 Money as a Medium of Exchange 11 Money as a Store of Value 11 Money Is Perfectly Liquid 11 Equity Shares 12 Debt Securities 12 Preferred Shares 14 Foreign Exchange 14 Derivatives 14 Forward and Futures Contracts 15 Options Contracts 16 Swaps 18 Mortgages and Mortgage-backed Securities 19 Hybrid Securities 19 Primary Markets and Secondary Markets 19 Exchanges and Over-the-Counter (OTC) Markets 21 Brokers and Dealers 22 The Need for Brokers and Dealers 23 Trading Positions 24 The Buy-side and the Sell-side 25 Investment Bankers 25 Direct and Indirect Markets 26 Mutual Funds 27 Money and Capital Markets 30 The Eurocurrency Market 31 The International Bond Market 32 Globalization of Equity Markets 34 Dual Listing 35 Fungibility 37 Arbitrage 37 Arbitrage with ADRs 38 GDRs 39 Risk 39 After the Trade - Clearing and Settlement 41 Dematerialization and the Role of a Depository 42 Custodial Services 43 Globalization - The New Mantra 43 Chapter 2 Mathematics of Finance 46 Interest Rates 46 The Real Rate of Interest 46 The Fisher Equation 48 Simple Interest & Compound Interest 49 Variables and Corresponding Symbols 50 Simple Interest 50 Compound Interest 51 Properties 53 Effective Versus Nominal Rates of Interest 55 A Symbolic Derivation 56 Principle of Equivalency 56 Continuous Compounding 57 Future Value 58 Present Value 59 The Mechanics of Present Value Calculation 59 Handling a Series of Cash Flows 60 The Internal Rate of Return 61 Evaluating an Investment 63 The Future Value Approach 63 The Present Value Approach 63 The Rate of Return Approach 63 Annuities: An Introduction 64 Present Value 64 Future Value 65 Annuity Due 66 Present Value 66 Future Value 67 Perpetuities 67 The Amortization Method 68 Amortization with a Balloon Payment 70 The Equal Principal Repayment Approach 71 Types of Interest Computation 71 The Simple Interest Approach 72 The Add-on Rate Approach 72 The Discount Technique 73 Loans with a Compensating Balance 73 Time Value of Money-related Functions in Excel 73 The Future Value (FV) Function in Excel 74 The Present Value Function in Excel 75 Computing the Present and Future Values of Annuities and Annuities Due in Excel 75 Amortization Schedules and Excel 76 Chapter 3 Equity Shares, Preferred Shares, and Stock Market Indices 78 Introduction 78 Par Value Versus Book Value 79 Accounting for a Stock Issue 80 Voting Rights 80 Statutory Versus Cumulative Voting 81 Proxies 81 Dividends 82 Dividend Yield 83 Dividend Reinvestment Plans 84 Stock Dividends 85 Treasury Stock 86 Accounting for Treasury Stock 86 Splits and Reverse Splits 87 Costs Associated with Splits and Stock Dividends 89 Preemptive Rights 89 Interpreting Stated Ratios 91 Handling Fractions 91 Physical Certificates Versus Book Entry 92 Tracking Stock 92 Report Cards 93 Types of Stocks 93 Interest-sensitive Stocks 93 Risk and Return and the Concept of Diversification 94 Preferred Shares 96 Callable Preferred Stock 97 Convertible Preferred Shares 97 Cumulative Preferred Shares 98 Adjustable-Rate Preferred Shares 100 Participating Preferred Shares 100 Dividend Discount Models 100 A General Valuation Model 101 The Constant Growth Model 102 The Two-Stage Model 102 The Three-Stage Model 103 The H Model 105 Stock Market Indices 105 Price-weighted Indices 105 Changing the Divisor 107 The Importance of Price 109 Value-weighted Indices 110 Changing the Divisor 111 Changing the Base Period Capitalization 113 EquallyWeighted Indices 113 Tracking Portfolios 114 Rebalancing a Tracking Portfolio 114 EquallyWeighted Portfolios 114 Price-weighted Portfolios 116 Rights Issues 117 Value-weighted Portfolios 117 Handling a Rights Issue 119 The Free-floating Methodology 120 Well-known Global Indices 121 Margin Trading and Short-selling 121 Terminology 121 Case A: The Market Rises 124 Case B: The Market Declines 124 Case A: The Market Rises 125 Case B: The Market Declines 125 Interest and Commissions 125 Case A: The Market Rises 126 Case B: The Market Declines 126 Maintenance Margin 126 Short-selling 127 Maintenance of a Short Position 130 Shorting Against the Box 131 The Risk Factor 131 The Economic Role of Short Sales 132 The Uptick Rule 132 Chapter 4 Bonds 134 Introduction 134 Terms Used in the Bond Market 136 Face Value 136 Term to Maturity 136 Coupon 136 Yield to Maturity 137 Valuation of a Bond 137 Par, Premium, and Discount Bonds 138 Evolution of the Price 139 Zero-coupon Bonds 140 Valuing a Bond in Between Coupon Dates 141 Day-Count Conventions 142 Actual-Actual 142 The Treasury''s Approach 143 Corporate Bonds 144 Accrued Interest 144 Negative Accrued Interest 145 Yields 146 The Current Yield 147 Simple Yield to Maturity 148 Yield to Maturity 148 Approximate Yield to Maturity 149 Zero-coupon Bonds and the YTM 150 Analyzing the YTM 150 The Realized Compound Yield 152 Reinvestment and Zero-Coupon Bonds 152 The Holding Period Yield 153 Taxable Equivalent Yield 153 Credit Risk 154 Bond Insurance 156 Equivalence with Zero-coupon Bonds 156 Spot Rates 156 The Coupon Effect 157 Bootstrapping 158 Forward Rates 158 The Yield Curve and The Term Structure 159 Shapes of the Term Structure 159 Theories of the Term Structure 160 The Pure or Unbiased Expectations Hypothesis 160 The Liquidity Premium Hypothesis 160 The Money Substitute Hypothesis 161 The Market Segmentation Hypothesis 161 The Preferred Habitat Theory 161 The Short Rate 162 Floating Rate Bonds 163 Simple Margin 165 Bonds with Embedded Options 165 Callable Bonds 165 Yield to Call 166 Putable Bonds 167 Convertible Bonds 168 Using Short Rates to Value Bonds 168 Price Volatility 170 A Concise Formula 171 Duration and Price Volatility 171 Properties of Duration 172 Dollar Duration 172 Convexity 172 A Concise Formula 174 Dollar Convexity 175 Properties of Convexity 175 Immunization 175 Analysis 176 Treasury Auctions 177 When Issued Trading 179 Price Quotes 179 STRIPS 179 Inflation Indexed Bonds 180 Computing Price Given Yield and Vice Versa in Excel 182 Computing Duration in Excel 185 Chapter 5 Money Markets 187 Introduction 187 Market Supervision 190 The Federal Reserve System 190 Key Dates in the Case of Cash Market Instruments 191 The Modified Following Business Day Convention 192 The End/End Rule 192 The Interbank Market 193 Types of Loans 193 LIBOR 194 LIBID 194 SONIA 194 Transitioning from LIBOR 195 Interest Computation Methods 195 Term Money Market Deposits 197 Money Market Forward Rates 197 Federal Funds 198 Federal Funds Versus Clearinghouse Funds 199 Correspondent Banks: Nostro and Vostro Accounts 200 Treasury Bills 200 Reopenings 201 Yields on Discount Securities 202 Notation 202 Discount Rates and T-bill Prices 202 The Bond Equivalent Yield (BEY) 203 Case A: Tm 182 days 205 Holding Period Return 207 Value of an 01 208 Concept of Carry 208 Concept of a Tail 208 T-Bill Related Functions in Excel 209 TBILLPRICE 209 TBILLYIELD 210 TBILLEQ 210 DISC 210 Treasury Auctions 211 Types of Auctions 211 Results of an Auction 212 Primary Dealers and Open Market Operations 213 Repurchase Agreements 213 Reverse Repos 214 General Collateral Versus Special Repos 215 Margins 215 Sale and Buyback 217 Collateral 217 Repos and Open Market Operations 217 Negotiable CDs 218