interest rate swap

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Derivatives Markets by David Goldenberg

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Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Norbert Wiener, price mechanism, random walk, reserve currency, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, Y2K, yield curve, zero-coupon bond

Futures Contracts 241 Cross-Hedging, Adjusting the Hedge for non S&P 500 Portfolios 243 7.5.7 7.5.8 7.6 7.7 The Spot Eurodollar Market 245 7.6.1 Spot 3-month Eurodollar Time Deposits 246 7.6.2 Spot Eurodollar Market Trading Terminology 248 7.6.3 LIBOR3, LIBID3, and Fed Funds 250 7.6.4 How Eurodollar Time Deposits are Created 252 Eurodollar Futures 254 7.7.1 Contract Specifications 254 7.7.2 The Quote Mechanism, Eurodollar Futures 256 7.7.3 Forced Convergence and Cash Settlement 258 7.7.4 How Profits and Losses are Calculated on Open ED Futures Positions 262 DETAILED CONTENTS PART 2 Trading Structures Based on Forward Contracts CHAPTER 8 8.1 Swaps as Strips of Forward Contracts 8.1.1 274 Strips of Forward Contracts 277 Basic Terminology for Interest-Rate Swaps: Paying Fixed and Receiving Floating 278 8.2.2 8.2.3 8.4 273 275 8.2.1 8.3 271 Commodity Forward Contracts as Single Period Swaps 8.1.2 8.2 STRUCTURED PRODUCTS, INTEREST-RATE SWAPS xiii Paying Fixed in an IRD (Making Fixed Payments) 278 Receiving Variable in an IRD (Receiving Floating Payments) 279 Eurodollar Futures Strips 280 Non-Dealer Intermediated Plain Vanilla Interest-Rate Swaps 281 Dealer Intermediated Plain Vanilla Interest-Rate Swaps 284 8.4.1 An Example 284 8.4.2 Plain Vanilla Interest-Rate Swaps as Hedge Vehicles 286 Arbitraging the Swaps Market 292 8.4.3 8.5 Swaps: More Terminology and Examples 293 8.6 The Dealer’s Problem: Finding the Other Side to the Swap 294 8.7 Are Swaps a Zero Sum Game?

PART 2 Trading Structures Based on Forward Contracts This page intentionally left blank CHAPTER 8 STRUCTURED PRODUCTS, INTEREST-RATE SWAPS 8.1 Swaps as Strips of Forward Contracts 8.1.1 8.1.2 Commodity Forward Contracts as Single Period Swaps 275 Strips of Forward Contracts 277 8.2 Basic Terminology for Interest-Rate Swaps: Paying Fixed and Receiving Floating 8.2.1 274 Paying Fixed in an IRD (Making Fixed Payments) 278 278 8.2.2 Receiving Variable in an IRD (Receiving Floating Payments) 279 8.2.3 Eurodollar Futures Strips 280 8.3 Non-Dealer Intermediated Plain Vanilla Interest-Rate Swaps 281 8.4 Dealer Intermediated Plain Vanilla Interest-Rate Swaps 284 8.4.1 An Example 284 8.4.2 Plain Vanilla Interest-Rate Swaps as Hedge Vehicles 286 Arbitraging the Swaps Market 292 8.4.3 8.5 Swaps: More Terminology and Examples 293 8.6 The Dealer’s Problem: Finding the Other Side to the Swap 294 8.7 Are Swaps a Zero Sum Game?

224; bank borrowing in spot Eurodollar (ED) market 250; ‘buying’ and ‘selling’ Eurodollar (ED) futures 256; calculation of adjusted hedge ratios 245; solution to 269; calculation of optimal (riskminimizing) hedge ratio 240; cash settlement and effective price on S&P 500 spot index units 234; solution to 269; exchange rate risk, currency positions and 218; solution to 268; foreign exchange (FX) risk and jet fuel market 219; solution to 268–9; underlying spot 3-month Eurodollar (ED) time deposit 261; solution to 270; contract month listings 214, 215, 228; contract offerings 227–8; contract size 214, 215, 227, 228; contracts offered 257–8; currency forward positions vs. currency futures positions 220; currency futures 213–17; contract specifications 213–15; pricing vs. currency forward pricing 225; quote mechanism, future price quotes 216–17; risk management strategies using 217–24; daily price limits 228, 229; daily settlements 216, 260; diversifiable risk 225; dividend-adjusted geometric mean (for S&P 500) 227; dollar equivalency 227, 234, 239–40; economy-wide factors, risk and 225–6; effective payoff 220, 233; EFP eligibility 214; Eurodollar (ED) deposit creation 253; Eurodollar (ED) futures 220–1, 245, 246, 249, 250, 252–64; cash settlement, forced convergence and 258–61; contract specifications 254–5; forced convergence, cash settlement and INDEX 258–61; open positions, calculation of profits and losses on 262–4; quote mechanism 256–8; exchange rate risks and currency futures positions 217–20; Lufthansa example 217–20; exchange rule 214, 228; exchange-traded funds (ETFs) 226; exercises for learning development 266–8; Fed Funds Rate (FFR) 251; Federal Funds (FF) 249–50, 251, 252; Federal Reserve system (US) 249; financial futures contracts, selection of 213; FLIBOR (Futures LIBOR) 256, 257, 262, 263, 264, 267–8; forced conversion of Eurodollar (ED) futures 260; foreign exchange (FX) reserves, currency composition of 247–8; forward price change, present value of 242; hedging 224–5; hedging a cross hedge 244; issues in 224–5; quantity uncertainty 224–5; holding period rate of return 237; idiosyncratic risk 225; index points 226; interest rate derivatives (IRDs) 254; International Monetary Fund (IMF) 246; JPY/USD futures 213–15; key concepts 265–6; last trade date/time view calendar 214, 228; lending (offering) Eurodollars (EDs) 249–50; liabilities, Eurodollars (EDs) and 246; LIBID (London Interbank Bid Rate) 249–50, 252; LIBOR (London Interbank Offered Rate) 249, 250–4, 262, 263–4; Federal Funds (FF) vs. 251–2; liquidity and 220, 222, 231, 237, 252, 258; lock-in characteristics 220, 233; market risk 225–6; minimum price increment 214, 215; naive hedge ratio (NHR) 234, 240–1, 243; open interest 258; placing Eurodollars (EDs) 248–9; position accountability 214, 215, 228, 229; raw price change, present value of 243; realized daily cash flows, creation of 243; risk management strategies using currency futures 217–24; risk management using stock index futures 231–45; cross-hedging 243–5; monetizing S&P 500 Spot Index 231–4; naive hedge ratio, adjustment for risk- 645 minimizing hedge ratio 239–41; non S&P 500 portfolios, adjustment of hedge for 243–5; pricing and hedging preliminaries 231; profits from traditional hedge 235–6; risk, return analysis of traditional hedge 236–8; risk minimizing hedge using forward vs. futures contracts 241–3; risk-minimizing hedging 238–9; rolling hedge strategy: efficient market hypothesis (EMH) 223; interpretations of profits from rolling hedge 221–3; Metallgesellschaft example 223; numerical example of 223–4; rule book chapter 228; settlement procedure 214, 228, 229, 258–9; S&P 500 Fact Sheet 226; S&P 500 Futures 228; spot commodities, S&P 500 futures contracts as 233–4; spot Eurodollar market 245–54; Eurodollar time deposits, creation of 252–4; spot 3-month Eurodollar time deposits 246–8; spot trading terminology 248–50; Stigum’s Money Market (Stigum, M.) 252; stock index futures 225–30; commentary 230; S&P 500 futures quotes, quote mechanism for 230; S&P 500 Spot Index 225–7; S&P 500 Spot Index, effective payoff on monetization of 233; S&P 500 Spot Index, monetization of 231–4; S&P 500 Stock Index Futures Contract Specifications 227–9; tailing the hedge 241–2; taking Eurodollars (EDs) 249; ticker symbol 214, 215, 228, 229, 261; timing in Eurodollar (ED) futures 257; tick size 228, 229; trading hours 214, 228; traditional hedge, risk and return analysis on 236–8; basis risk 238; holding period rate 237; intermediate execution, basis risk and 237–8; liquidity advantage in execution 237; unallocated foreign exchange (FX) reserves 248 financial innovation using European PutCall Parity 401–5; American Put-Call Parity (no dividends) 403–5; generalized forward contracts 401–3 financial institutions and use of swaps 299–301 646 INDEX finite-maturity financial instruments, options as 20, 354 fixed leg in interest-rate swaps 293 fixed payments in interest-rate swaps 278–9 fixed-rate mortgages 7 FLIBOR (Futures LIBOR): financial futures contracts 256, 257, 262, 263, 264, 267–8; interest-rate swaps 278, 287 floating leg in interest-rate swaps 293 floating payments in interest-rate swaps 279–80 floating-rate bond implicit in swap 306 floating-rate payments as expected cash flows 306 floor-brokers 140 floor-traders 140 foreign currencies: forward prices on 24–5; futures prices on 25–6; see also currency futures foreign economy (FE) 103–4 foreign exchange (FX) forward contracts: example of pricing 107–9; pricing using no-arbitrage 106–7 foreign exchange (FX) markets, price quotes in 103–5 foreign exchange (FX) rates (New York, March 11, 2014) 30–1 foreign exchange (FX) reserves, currency composition of 247–8 foreign exchange (FX) risk 3–5 forward contracts: differences between futures contracts and 122; on dividendpaying stocks, pricing with no-arbitrage 100–3; hedging with 37, 43–5; on stocks with dividend yield, pricing with net interest model 99–100; swaps as strips of 274–8; valuation of (assets without dividend yield): default on 76; interpretation via synthetic contracts 78–82; leverage and 80–2; no up-front payments on 75; payment on maturity, expectation of 81; price vs. value for 73; valuing at expiration 74–5; valuing at initiation 75–8 forward market contracting: buying forward 7–8; Clearing House intermediation 14–15; concept checks: controlling for counterparty risk 12–13; exploration of forward rates in long-term mortgage market 9–10; exploration of spot rates in long-term mortgage market 11; solution 29; intermediation by Clearing House 15–16; solution 29–30; spot markets, dealing with price quotes in 6–7; counterparty risk 11; default 11–12; exit mechanism 15–16; features of 8; fixedrate mortgages 7; forward agreement, terms of 8; forward contracts, differences between futures contracts and 122; forward market 8; forward prices 9, 24–5; forward transactions 8; historical data, checking on 9–10; interest-rate risk management 9–10; intermediation 13–14, 14–15; liquidity, enablement of 16; locked-in prices 12; market levels 11; market organization, importance of 13, 14; obligations, transfer of 16; offsetting trades 15–16; overnight averages 11; price quotes in forward markets 9–11; problems with forward markets 11–13; ‘reversing’ of trades 15–16; short positions 7; SouthWest Airlines, case example 12–13; spot, forward, and futures contracting 7–13; standardization 14; transfer of obligations 16; see also hedging with forward contracts; valuation of forward contracts forward prices 9, 24–5; change in, present value of 242; no-arbitrage, forward pricing with 102–3 front stub period 294 fundamental theorem of asset pricing number one (FTAP1): equivalent martingale measures (EMMs) 509, 511–12, 517, 528–9, 530, 532, 533; model-based option pricing (MBOP) 450, 451, 452; option pricing in continuous time 540; risk-neutral valuation 596–7, 601–2, 605, 606, 624, 631 fundamental theorem of asset pricing number two (FTAP2): binomial option pricing model (BOPM) 490; modelbased option pricing (MBOP) 452; INDEX option pricing in continuous time 540; risk-neutral valuation 596–7, 601–2, 605, 606, 624, 631; risk-neutral valuation and another version of 606 future value (FV) 69–70, 382, 386, 390, 395 Futures Commission Merchant (FCM) 122, 123, 124, 125, 137, 140 futures contracts: futures market contracting 17; market organization for: ‘buying’ and ‘selling’ of 126–7; daily value of 146; differences between forward contracts and 122; futures price and 127; market participants 122–5 futures market contracting 17–26; concept check, price quotes in futures markets 19; contract size 19; contract specifications 17, 18–19; delivery dates 19; fancy forward prices 19, 25; futures contract 17; futures market 17; futures prices 17, 25–6; futures transaction 17; key definition, futures contract 17; mapping out spot, forward, and futures prices 20–6; ‘Open Outcry Futures’ 19; price quotes in futures markets 17–19; seller’s options 17; as solution to forward market problems 13–16; volatility (uncertainty) 22; see also hedging with futures contracts; market organization for futures contracts futures trading: hedging with forward contracts 35; market organization for futures contracts: cash flow implications of 144; daily settlement, perspectives on 144; delivery obligations 142; offsetting trades 142–4; phases of 125–6 gap management problem, solutions for 300–1 Gaussian distributions 543, 546, 548, 557, 565, 577 general equilibrium (GE) 453; models of, risk-neutral valuation and 615 generalized forward price 402 geometric Brownian motion (GBM) 553–61; continuous version 559–61; discrete version 553–9 647 Girsanov’s theorem 605 Globex and Globex LOB 134–6 Globex trades, rule for recording of 135 Gold pricing on London Bullion Market 20–3 guaranteeing futures obligations 139–41 hedge ratio: dollar bond position and 478; model-based option pricing (MBOP) and 455 hedging: financial futures contracts 224–5; hedging a cross hedge 244; issues in 224–5; quantity uncertainty 224–5; hedged position profits, graphical method for finding 55; hedgers 37; hedging definitions 168; minimum variance hedging 185–8; estimation of risk minimization hedge ratio 187–8; OLS regression 187–8; risk minimization hedge ratio, derivation of 186–7; motivation for hedging with forward contracts 33–7; objective of 167–8; as portfolio theory 165–8; reverse hedge 618, 620, 621; riskless hedge 607, 616, 620, 628, 632; rolling hedge strategy: efficient market hypothesis (EMH) 223; interpretations of profits from rolling hedge 221–3; Metallgesellschaft example 223; numerical example of 223–4; short hedge 168; synthesis of negative correlation, hedging as 165–7 hedging a European call option in BOPM (N=2) 477–85; complete hedging program (for BOPM, N=2) 484–5; concept check, value confirmation 485; hedge ratio and dollar bond position, definition of (step 2) 478; parameterization (step 1) 477–8; replicating portfolio, construction of (step 3) 478–84; concept check: interpretation of hedge ratio 482; down state, replication in 481; hedge ratio, interpretation of 482–3; replication over period 2 (under scenario 1) 479–82; replication under scenario 2 (over period 2) 484; scenarios 478–9; solving equations for ?


pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

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Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, mortgage debt, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

Related Terms: • Bond • Interest Rate Swap • Premium • Coupon • Money Market Account Interest Rate Swap What Does Interest Rate Swap Mean? An agreement between two parties (known as counterparties) in which one stream of future interest payments is exchanged for another stream, based on a specified principal amount. Interest rate swaps often involve exchanging a fixed payment for a floating payment, which is linked to an interest rate (most often the LIBOR). The Investopedia Guide to Wall Speak 143 A company typically uses interest rate swaps to limit or manage its exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than it would have been able to get without the swap. Investopedia explains Interest Rate Swap Interest rate swaps are the exchange of one set of cash flows (based on interest rate specifications) for another.

An overbought security is the opposite of one that is oversold. Related Terms: • Law of Demand • Relative Strength Index—RSI • Technical Analysis • Oversold • Stochastic Oscillator Overnight Index Swap What Does Overnight Index Swap Mean? An interest rate swap in which the overnight rate is exchanged for another fixed interest rate. Investopedia explains Overnight Index Swap Generally short-term, the interest of the overnight rate portion of the swap is compounded and paid at maturity. Related Terms: • Arbitrage • Interest Rate • Swap • Index • Interest Rate Swap Oversold What Does Oversold Mean? (1) A condition in which the price of an underlying asset has fallen sharply to a level below its fundamental value. This condition is usually a result of market overreaction or panic selling. (2) A situation in technical analysis in which the price of an asset has fallen to such a degree—usually on high volume—that an oscillator has reached a lower bound.

Traditionally, the exchange of one security for another for the purpose of changing the maturity (bonds), the quality of issues (stocks or bonds), or one’s investment objectives. Swaps include currency swaps and interest rate swaps. Investopedia explains Swap If companies in different countries have regional advantages on interest rates, a swap will benefit both firms. For example, one firm may have a lower fixed interest rate while another has access to a lower floating interest rate. To take advantage of this situation, the companies would do an interest rate swap. Related Terms: • Arbitrage • Credit Default Swap • Interest Rate Swap • Commodity • Currency Swap Swing Trading What Does Swing Trading Mean? A style of trading that is used to capture quick gains in a stock over a one- to four-day trading period. It is done to capitalize on the shortterm swings in the market.


pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mutually assured destruction, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk-adjusted returns, risk/return, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

DM/CHF payments IBM World Bank $ payments DM/CHF payments DM/CHF bondholders $ payments $ bondholders Figure 1.2 N 1981 World Bank – IBM currency swap DAS_C02.QXP 8/7/06 4:22 PM Page 37 1 N Financial WMDs – derivatives demagoguery 37 The currency swap evolved into the interest rate swap, shown in Figure 1.3. Floating rate swap payments Borrower B Borrower A Fixed rate swap payments Floating rate interest payments Floating rate lender Fixed rate interest payments Fixed rate lender Figure 1.3 N Interest rate swap The currency swap and the interest rate swap are still the mainstay of the derivatives markets. Nobody knew it then, but there was going to be a whole lotta swapping going on. The golden age/LIBOR minus 50 I came across my first swap in the early 1980s. A company had a lot of dollar debt on which the interest rate was reset every six months based on LIBOR.

It was a bit like a seesaw – the return on the inverse FRN can’t be negative, it is floored at 0% pa. It is tricky to have negative interest rates: I wondered what that actually meant. I guessed the investor paid the borrower. It was definitely weird. The trick was figuring out how the deal was put together. The investor basically purchased a bond with an embedded interest rate swap. It looked like Figure 1.4. Investment in bond Investment/repayment of principal Bond Investor 8.50% pa Interest rate swap 8.75% pa Dealer Investor LIBOR Purchase by investor of cap on LIBOR (strike rate = 17.25% pa) 17.25% pa Inverse FRN Investor LIBOR Figure 1.4 N Inverse floater The only extra bit is that the investor also bought an interest rate cap, that is, a series of options designed to protect the investor if interest rates went DAS_C02.QXP 8/7/06 4:22 PM Page 47 1 N Financial WMDs – derivatives demagoguery 47 up above 17.25% pa.

Crem observed, making one of his only contributions to the class. Nero stood back and scrutinized his handiwork. Nero was right. If the investor wanted we could engineer in as much leverage as he liked. ‘Sir would like more leverage on the side? Coming right up.’ We would add a few more interest rate swaps to the deal, as DAS_C02.QXP 8/7/06 4:22 PM Page 50 Tr a d e r s , G u n s & M o n e y 50 US$100 million investment in bond Investment/repayment of principal Bond Investor 8.50% pa US$400 million interest rate swap 8.75% pa × 4 = 35.00% pa Dealer Investor 4 × LIBOR Purchase by investor of cap on LIBOR (strike rate = 10.875% pa) 43.50% pa Inverse FRN Investor 4 × LIBOR Figure 1.5 N Leveraged inverse floater shown in Figure 1.5. This is a four times leveraged deal. We added an extra $300 million in swaps to the trade.


pages: 430 words: 109,064

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

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Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bernie Madoff, Bonfire of the Vanities, bonus culture, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Gordon Gekko, greed is good, Home mortgage interest deduction, Hyman Minsky, income per capita, interest rate derivative, interest rate swap, Kenneth Rogoff, laissez-faire capitalism, late fees, Long Term Capital Management, market bubble, market fundamentalism, Martin Wolf, moral hazard, mortgage tax deduction, Ponzi scheme, price stability, profit maximization, race to the bottom, regulatory arbitrage, rent-seeking, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, sovereign wealth fund, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

Mathematical models also made it possible to break down complicated trades into simpler ones, a critical factor in the development of sophisticated financial products. The modern derivatives revolution began with the invention of the interest rate swap (by Salomon Brothers) in 1981. In this transaction, Company A pays interest at a fixed rate to Company B and Company B pays interest at a floating rate (which can go up or down as economic conditions change) to Company A. Interest rate swaps allow companies to exchange fixed rate payments for floating rate payments, or vice versa—“swapping” interest rate risks between the two parties.‡ Similarly, currency swaps allow companies to swap currency risks by exchanging different currencies (or combinations of currencies). Interest rate swaps can also be combined with currency swaps. These two basic derivatives became popular ways for companies to manage financial or operational risks.

(Because the evolution of derivatives has run ahead of regulatory and accounting rules, derivatives can also serve other purposes, such as helping companies smooth their earnings over multiple periods or reduce their tax bills by deferring earnings into the future.) By the middle of 2008, the market for over-the-counter (customized) interest rate swaps had grown to over $350 trillion in face value (the amount on which interest is calculated) and over $8 trillion in gross market value.*73 The derivatives dealers—both investment banks and large commercial banks—were taking a piece of every interest rate swap in fees. Even better, the dealers would typically hedge their exposures; ideally, for every swap with one client, they would conduct an opposite swap with another client, so the two trades canceled out—leaving nothing but fees from both clients. But ordinary swaps were easy for any derivatives dealer to duplicate, and competition between banks soon drove profit margins down near zero.

There were also two representatives of industry organizations at the meeting.4 * Because the accounting treatment of derivatives was unclear, the amount of capital that banks had to set aside for their derivatives positions was generally disproportionately low compared to the amount of risk they were taking on. Because they could generate higher profits with less capital, their “return on equity” was higher. † Derivatives are essentially zero-sum transactions. The face value, or notional value, of a derivative is the basis on which the value of the transaction is calculated. For example, in an interest rate swap, the payments made by the two parties are calculated as interest rates (percentages) on the notional value; the amount of money that changes hands is much lower than the notional value. The market value of a derivative contract is calculated by the Bank for International Settlements as the current value of the contract to the party that is “in the money”—in other words, the amount of money that would change hands in order to close out the contract at this moment. 1 THOMAS JEFFERSON AND THE FINANCIAL ARISTOCRACY Great corporations exist only because they are created and safeguarded by our institutions; and it is therefore our right and our duty to see that they work in harmony with these institutions.


pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

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asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, Nick Leeson, Northern Rock, offshore financial centre, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve

Ideally, the treasury of a company is a cost center: it leaves the risk taking and profit generating to the core parts of the business and focuses on reducing financing costs. With about €2 billion of debt, there was a routine reason for the treasury of Poste Italiane—the Italian post office—to be using interest rate swaps. The derivatives would transform its cost of borrowing into a lower, shorter-term benchmark rate that closely tracked European Central Bank rates. Although interest rate swaps are not standardized instruments that trade on an exchange, they are heavily traded by banks, hedge funds, and corporate end users in a highly competitive market. In such markets, bid-offer spreads are tight. For a standardized, vanilla interest rate swap, the spread was as low as one basis point (a hundredth of a percentage point) of the underlying debt transformed with the derivative. For a swap on $1 billion of debt lasting ten years, that means the bank makes about $1 million in revenue.

Imagine that once you had committed yourself to one of these two financing routes, an invisible toggle switch allowed you to change your mind, canceling out the interest payments you didn’t want to make in return for making the payments that you did. Thus was the interest rate swap, the world’s most popular derivative, born. Swaps first proved their value in the 1980s, when the U.S. Federal Reserve jacked up short-term interest rates to fight inflation. With swaps, you could transform this short-term risk into something less volatile by paying a longer-term rate. Swaps again proved useful in 1997, when Asian central banks used high short-term interest rates to fight currency crises. Just how heavily traded these contracts became can be gauged from the total “notional” amount of debt that was supposed to be transformed by the swaps (which is not the same as their value): by June 2008, a staggering $356 trillion of interest rate swaps had been written, according to the Bank for International Settlements.2 As with forward contracts on currencies and commodities, the rates quoted on these swaps are considered to be a more informative way of comparing different borrowing timescales (the so-called yield curve) than the underlying government bonds or deposit rates themselves.

One answer was to quarantine derivatives in a special public venue called an exchange, a centuries-old innovation to ensure that markets work fairly and safely. But it was too late to box derivatives in that way—by the time I attended that conference in 1997, a fast-growing alternative was already eclipsing exchange-traded derivatives. These were over-the-counter (OTC) derivatives traded directly and privately with large investment banks, with the interest rate swap being the most obvious example. The banks that created and traded OTC derivatives did not want to take only one side of the market, such as only buying yen or only lending money at a five-year interest rate. The derivative-dealing banks set themselves up as secretive mini-exchanges. They would seek out customers with opposing views and line them up without the other’s knowledge. The bank sitting between them would not be exposed to the market’s going up or down and could simply skim off a percentage from both sides, dominating the all-important pricing mechanism that was the derivatives market’s big selling point.


pages: 368 words: 32,950

How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile by Alexander Davidson

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accounting loophole / creative accounting, algorithmic trading, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Big bang: deregulation of the City of London, capital asset pricing model, central bank independence, corporate governance, Credit Default Swap, dematerialisation, discounted cash flows, diversified portfolio, double entry bookkeeping, Edward Lloyd's coffeehouse, Elliott wave, Exxon Valdez, forensic accounting, global reserve currency, high net worth, index fund, inflation targeting, interest rate derivative, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Nick Leeson, North Sea oil, Northern Rock, pension reform, Piper Alpha, price stability, purchasing power parity, Real Time Gross Settlement, reserve currency, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond

In foreign exchange turnover (April 2006), the UK has a 32 per cent share,  6 HOW THE CITY REALLY WORKS ___________________________________ unchanged from the previous year, against the 18 per cent share of the United States, its nearest rival. The UK has a 42 per cent turnover in foreign equities, down from 43 per cent in 2005, and compared with 33 per cent in the United States. The UK is the market leader in international bonds (2006), with 70 per cent of the secondary market, unchanged since 1992. In over-the-counter (OTC) derivatives, the UK has a 43 per cent market share (April 2004), of which about three-quarters are interest rate swaps and similar products, which makes it the global leader, according to IFSL statistics. The United States has 24 per cent. In marine insurance net premium income, the UK has a 20 per cent market share (2005), while the United States has 11 per cent. London’s share of world hedge fund assets reached 21 per cent in June 2006, which represents a steady gain since 2003, when it was 14 per cent, but it has a long way to catch up with the United States at 66 per cent.

Some bonds will be included on the asset side of the balance sheet, where in terms of risk weighting under Basel II (see Chapter 3), they are more attractive than loans. Issuers of bonds usually offer a fixed rate of return, which is what investors prefer. But if the bonds fall in value, investors may feel they have lost out. This is why investors use the swaps market, which enables them to swap fixed for floating rates. The majority of the swaps market consists of interest rate swaps (see Chapters 8 and 11). Mergers and acquisitions Mergers and acquisitions (M&A) is the area where investment banks are often compared and judged. They will advise a company planning a takeover or that is a likely bid target, and may help it to raise capital for the purpose. The prospective buyer of a quoted company can be another company, from Europe, the United States or elsewhere. Alternatively, it can be a private equity firm, which is able to acquire a listed company and take it private.

Derivatives include four basic transactions: spot, forward, option and swap. More complex terminology may be used, depending on which of the asset classes are involved. The asset classes are credit fixed income, financials, interest rate market, equity and commodities. Credit fixed income includes credit derivatives, bonds, commercial paper and loans; financials include foreign exchange and forwards; interest rate markets include interest rate swaps and options, and deposits, as well as forward rate agreements and overnight index swaps. Of the rest, equity covers the stock market; commodities include soft commodities such as food, feedstuffs and beverages, including grains, pork _________________________________ INTRODUCTION TO DERIVATIVES 61  bellies, shrimp, wines, wheat and corn, as well as hard commodities, which are industrial raw materials such as oil, gas, electricity, nuclear fuel and metals.


pages: 447 words: 104,258

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

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algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative finance, random walk, risk/return, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

collars collateralized debt obligations (CDOs) color sensitivity commodities commodity futures backwardation contango market price non-financial producers/users trading calculations conditional swaps Conditional VaR (C-VaR) confidence levels constant maturity swaps (CMSs) contango continuous interest compounding continuous interest rates continuous time continuous variables contracts contracts for difference (CFD) contribution, performance convenience yield conversion factors (CFs) convertible bonds (CBs) bond floor CB premium conversion ratio Hard Call protection outcome of operation pricing graph risk premium stock price parity convexity adjustments see also bond convexity copper prices copulas correlation basket options credit derivatives implied Portfolio Theory Spearman’s coefficient VaR calculations volatility counterparty risk futures see also credit risk counter-value currency (c/v) Courtadon model covered period, FRAs Cox, Ingersoll and Ross model Cox–Ross–Rubenstein (CRR) model credit default swaps (CDSs) on basket cash settlement with defined recovery rate market operations variants credit derivatives CDSs credit risk main features valuation application example basket derivatives binomial model CDO pricing correlation measures credit risk models useful measures Merton model “credit events” credit exposure credit risk behind the underlying components data use dangers default rates Merton model models in practice quantification recovery rates credit VaR crossing CRR see Cox–Ross–Rubenstein model CRSs see currency rate swaps crude oil market CTD see cheapest to deliver cubic splines method currencies futures options performance attribution spot instruments currency rate swaps (CRSs) c/v see counter-value currency C-VaR see Conditional VaR D see discount factors DCF see discounted cash flows method decision-making deep ITM (DITM) deep OTM (DOTM) default rates default risk see credit risk delta delta-gamma neutral management delta-normal method, VaR derivatives credit valuation problems volatility Derman see Black, Derman, Toy process deterministic phenomena diff swaps diffusion processes Dirac functions dirty prices discounted cash flows (DCF) method discount factors (D) duration D forward rates IRSs risk-free yield curve spot rates yield curve interpolations discrete interest compounding discrete time discrete variables DITM see deep ITM DOTM see deep OTM drift duration of bonds see bond duration duration D dVega/dTime dynamic replication see delta-Gamma neutral management dZ Black–Scholes formula fractional Brownian motion geometric Wiener process martingales properties of dZ(t) standard Wiener process economic capital ED see exposure at default effective duration, bonds efficient frontier efficient markets EGARCH see exponential GARCH process EONIA see Euro Over-Night Index Average swaps equities forwards futures Portfolio Theory stock indexes stocks valuation EUR see Euros EURIBOR rates CMSs EONIA/OIS swaps FRAs futures in-arrear swaps IRSs quanto/diff swaps short-term rates Euro Over-Night Index Average (EONIA) swaps European options basket options bond options caplets CRR pricing model exchange options exotic options floorlets Monte Carlo simulations option pricing rho Euros (EUR) CRSs forward foreign exchange futures spot market swap rate markets volatility Euro Stoxx EWMA see exponentially weighted moving average process Excel functions MA process Monte Carlo simulations excess return exchange options exotic options basket options Bermudan options binomial pricing model Black–Scholes formula currency options exchange options interest rates Monte Carlo simulations options on bonds options on non-financial underlyings PFCs pricing methods see also second generation options exotic swaps see also second generation swaps expected credit loss expected return exponential GARCH (EGARCH) process exponentially weighted moving average (EWMA) process exposure at default (ED) fair price/value “fat tails” problem financial models ARCH process ARIMA process ARMA process AR process GARCH process MA process MIDAS process finite difference pricing methods fixed leg of swap fixed rate, swaps floating rate notes/bonds (FRNs) floating rates floorlets floors forecasting ARIMA ARMA process AR process MA process foreign exchange (FX) see currencies; forex swaps; forward foreign exchange forex (FX) swaps forward foreign exchange 1 year calculations forex swaps forward forex swaps forward-forward transactions forward spreads NDF market operations forward rate agreements (FRAs) forwards Black–Scholes formula bonds CFDs CRSs equities foreign exchange FRAs futures vs forwards prices options PFCs rates swaps volatility forward zero-coupon rate 4-moments CAPM fractional Brownian motion FRAs see forward rate agreements FRNs see floating rate notes/bonds futures bonds commodities currencies equities forwards vs futures prices IRR margining system market price option pricing pricing settlement at maturity short-term interest rates stock indexes theoretical price future value (FV) bond duration short-term rates spot rates zero-coupon swaps FX see foreign exchange; forex swaps gain-loss ratio (Bernardo Ledoit) gamma gamma processes GARCH see generalized ARCH process Garman–Klass volatility Gaussian copulas Gaussian distribution Gaussian hypothesis generalized ARCH (GARCH) process EWMA process I/E/MGARCH processes non-linear models regime-switching models variants volatility general Wiener process application fractional Brownian motion gamma processes geometric Wiener process Itô Lemma Itô process jump processes volatility modeling see also standard Wiener process geometric average geometric Wiener process German Bund see Bund (German T-Bond) global VaR Gordon–Shapiro method government bonds Greece Greeks see sensitivities Hard Call protection Heath, Jarrow and Morton (HJM) model Heaviside function hedging bond futures delta-gamma neutral management futures 129–30 immunization vs hedging money market rate futures stock index futures heteroskedasticity hidden layers, NNs high frequency trading “high” prices historical method, VaR historical volatility HJM see Heath, Jarrow and Morton model Ho and Lee model Hull and White model Hurst coefficient IGARCH see integrated GARCH process immunization implied correlation implied repo rate (IRR) implied volatility definition historical volatility surface volatility curves volatility smiles in-arrear swaps indexes basket options capitalization-weighted price/value-weighted see also stock indexes inflation-linked bonds inflation swaps Information Ratio (IR) initial margin in the money (ITM) caps convertible bonds deep ITM options innovation term, AR instantaneous returns integrated GARCH (IGARCH) process interbank rates see EURIBOR rates; LIBOR rates interest rate options BDT process Black and Karasinski model caps collars floors forward rates HJM model LMM model single rate processes swaptions yield curve modeling interest rates day counting discount factors futures FV/PV interest compounding IRSs options short-term spot rates term structure see also yield interest rate swaps (IRSs) bond duration and CRSs fixed/floating rates pricing methods prior to swap pricing method revaluation vanilla swaps yield curve see also constant maturity swaps intermediate period, FRAs International Swaps and Derivatives Association (ISDA) intraday margining settlements intraday volatility investor decision-making IR see Information Ratio IRR see implied repo rate IRSs see interest rate swaps ISDA see International Swaps and Derivatives Association ITM see in the money Itô process Itô’s Lemma Japanese yen (JPY) Jarrow, Robert A. see also Heath, Jarrow and Morton model Jensen’s alpha JPY see Japanese yen jump processes Karasinski see Black and Karasinski model Klass see Garman–Klass volatility Kupiec’s VaR backtest kurtosis Laplace transform Lee see Ho and Lee model Lehman Brothers leptokurtic distributions Lévy processes liability swaps LIBOR market model (LMM) LIBOR rates Black–Scholes variations caps pricing CMSs floors pricing FRAs futures in-arrear swaps IRSs quanto/diff swaps short-term rates swaps linear method, yield curves liquidity LMM see LIBOR market model log-normal distribution models L’Oreal cosmetics Black–Scholes formula fractional Brownian motion jump processes Monte Carlo simulations risk and return sensitivities Sharpe’s CAPM “low” prices MA see moving average process Macaulay duration see also duration D Madan, D.B.

Both the types of cash flows, being based on a fixed or on a floating rate, are paid at their respective maturity, and netted in case of common maturity dates. Exchanged cash flows can be assets cash flows originating from assets payments, in this case one talk about asset swaps, or cash flows originating from debts interest payments, hence the naming of liability swaps. If the whole set of exchanged cash flows involves a common single currency, the swap is called an interest rate swap (IRS). If the exchange of cash flows involves two currencies, one talks of currency rate swap (CRS) or cross currency rate swap (CCRS).2 A swap is an unconditional product: the exchange of cash flows cannot depend from any kind of condition. A contrario, credit default swaps and similar derivatives on a default risk are not swaps, strictly speaking, because there are conditional. We will look at these in Chapter 13.

Table 6.1 Series of cash flows Note that, in this table, the “− 6M LIBOR” are in italics, except the first one: this is the central point of swap pricing. Indeed, in a vanilla swap, floating rates interest cash flows are paid at the expiry dates, so that only the first LIBOR is known at swap inception but not the following ones (noted in italics). Note also that in such a swap, the only cash flows exchanged are interest cash flows (the principal amount is not involved at all), hence the name interest rate swap. 6.1.2 An example of CRS liability swap (data from February 2002) A supranational institution, here called SNL, has issued a 6-year bond of Norwegian krone (NOK) 750 million @ 61/2% p.a. (ACT/ACT), immediately swapped into its own EUR currency, that is, EUR 85 227 272.73, at the current EUR/NOK spot rate of 8.8000 (the rationale of this swapped issue will appear later). The whole operation involves the exchanges shown in Figures 6.2–6.4.


pages: 265 words: 93,231

The Big Short: Inside the Doomsday Machine by Michael Lewis

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Asperger Syndrome, asset-backed security, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, facts on the ground, financial innovation, fixed income, forensic accounting, Gordon Gekko, high net worth, housing crisis, illegal immigration, income inequality, index fund, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, medical residency, moral hazard, mortgage debt, pets.com, Ponzi scheme, Potemkin village, quantitative trading / quantitative finance, short selling, Silicon Valley, too big to fail, value at risk, Vanguard fund

AIG Financial Products was created in 1987 by refugees from Michael Milken's bond department at Drexel Burnham, led by a trader named Howard Sosin, who claimed to have a better model to trade and value interest rate swaps. Nineteen eighties financial innovation had all sorts of consequences, but one of them was a boom in the number of deals between big financial firms that required them to take each other's credit risks. Interest rate swaps--in which one party swaps a floating rate of interest for another party's fixed rate of interest--was one such innovation. Once upon a time, Chrysler issued a bond through Morgan Stanley, and the only people who wound up with credit risk were the investors who bought the Chrysler bond. Chrysler might sell its bonds and simultaneously enter into a ten-year interest rate swap transaction with Morgan Stanley--and just like that, Chrysler and Morgan Stanley were exposed to each other.

If Chrysler went bankrupt, its bondholders obviously lost; depending on the nature of the swap, and the movement of interest rates, Morgan Stanley might lose, too. If Morgan Stanley went bust, Chrysler, along with anyone else who had done interest rate swaps with Morgan Stanley, stood to suffer. Financial risk had been created out of thin air, and it begged to be either honestly accounted for or disguised. Enter Sosin, with his supposedly new and improved interest rate swap model--even though Drexel Burnham was not at the time a market leader in interest rate swaps. There was a natural role for a blue-chip corporation with the highest credit rating to stand in the middle of swaps and long-term options and the other risk-spawning innovations. The traits required of this corporation were that it not be a bank--and thus subject to bank regulation, and the need to reserve capital against risky assets--and that it be willing and able to bury exotic risks on its balance sheet.

At some unquantifiable risk to themselves, they shared with me their thoughts and feelings. For that I'm eternally grateful. * United Jewish Appeal. * ISDA had been created back in 1986, by my bosses at Salomon Brothers, to deal with the immediate problem of an innovation called an interest rate swap. What seemed like a simple trade to the people doing it--I pay you a fixed rate of interest in exchange for your paying me a floating rate--wound up needing a blizzard of rules to govern it. Beneath the rules was the simple fear that the party on the other side of a Wall Street firm's interest rate swap might go bust and fail to pay off its bets. The interest rate swap, like the credit default swap, exposed Wall Street firms to other people's credit, and other people to the credit of Wall Street firms, in new ways. * The two major rating agencies employ slightly different terminology to convey the same idea.


pages: 586 words: 159,901

Wall Street: How It Works And for Whom by Doug Henwood

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accounting loophole / creative accounting, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, capital asset pricing model, capital controls, central bank independence, corporate governance, correlation coefficient, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, debt deflation, declining real wages, deindustrialization, dematerialisation, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, experimental subject, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, George Gilder, hiring and firing, Hyman Minsky, implied volatility, index arbitrage, index fund, interest rate swap, Internet Archive, invisible hand, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, moral hazard, mortgage debt, mortgage tax deduction, oil shock, payday loans, pension reform, Plutocrats, plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, transcontinental railway, women in the workforce, yield curve, zero-coupon bond

But where much of the rise in exchange-traded instruments was simply a matter of Europe and Japan catching up with U.S. financial futures markets, OTC growth was mainly the proliferation of new instruments worldwide. In 1986, notional principal in interest rate swaps was $400 billion, with another $100 billion in currency swaps outstanding; at the end of 1990, the figures were $2.3 trillion and $578 billion, respectively, to which had been added another $56l billion in caps, floors, collars, and swaptions; in 1997, notional principal on interest rate swaps totaled $22.1 trillion, and currency swaps, $1.5 trillion (Bank for International Settlements 1998). The biggest users of currency swaps once were nonfinancial corporations — the multinationals that dominate world trade, who borrow and do business in scores of currencies around the world.

But financial institutions have been steadily increasing their use, with 40% of notional principal outstanding, a bit ahead of nonfinancial firms, with governments a distant third. Financial institutions dominate the market for interest rate swaps; after all, interest-bearing paper is the basic commodity they deal in. Corporations accounted for just 23% and governments, 6%. The U.S. share of swap markets is surprisingly small — less than a third of interest INSTRUMENTS rate swaps and quarter of the currency kind — and the dollar's share has been shrinking steadily, from 79% of interest rate swaps in 1987 to 30% in 1996, with the yen and the European currencies rising dramatically. No doubt European and Asian economic integration is at work here, though the merger of Continental countries into the euro will change everything.

As with exchange-traded derivatives, the custom kind — also called over-the-counter (OTC) — can serve as a hedge or a bet, or even both at once. Details of custom derivatives may be more than many readers want to know, but they do involve the full richness of financial imagination. Swaps were pioneered in the late 1970s, but the first deal to attract wide attention was a currency swap between IBM and the World Bank in 1981, and the first interest rate swap was one involving the Student Loan Marketing Association (Sallie Mae), a U.S.-government-sponsored vendor of student loans (Abken 1991).^^ Unlike exchange-traded derivatives, swaps don't really involve a claim on an underlying asset; in most cases, the partners in the swap, called counterparties, swap two sets of cash flows, cash flows that are usually thrown off by positions in other securities (bond interest, stock dividends, etc.).


pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond

Future product innovations and trading arrangements should mitigate illiquidity, opacity, and counterparty risks. Swap–Treasury spread positions I start with interest rate swaps because swap–Treasury spreads may be viewed as a common element in various non-government vs. government spreads. Non-government assets tend to have more stable spreads over the swap curve than over Treasuries. Although swap–government spreads are often classified as credit spreads, it has long been recognized that the credit risk component in swap spreads is negligible. I first explain why counterparty credit risk hardly impacts swaps and then review the link between swap spreads and LIBOR–repo spreads:• Interest rate swap contracts have minimal default exposure because the principal is not at risk—just one side of profits/losses. This default exposure is much lower than for comparable AA-rated bank bonds where principal and coupon payments are fully at risk.

Only unprecedented central bank actions—“whatever it takes” was the motto—brought these spreads back down and caused a semblance of normality to return to financial markets. Table 3.5. Summary statistics of U.S. money market rate spreads, 1980–2009 Assets not covered in this chapter include many interesting cases with too short histories or poor data quality. Candidates range from the obvious to esoteric: emerging market debt, inflation-linked bonds, convertible bonds, interest rate swaps, credit derivatives, various structured products, exchange-traded funds, catastrophe bonds, distressed debt, and carbon trading. 3.5 REAL RETURN HISTORIES The results above focused on nominal returns, as does most of this book. To compensate for what some readers might find to be insufficient emphasis on real returns, Table 3.6 presents the compound average real returns for many assets, decade by decade for the 110 years, and also for the 19th century (actually the 98-year period from 1802 to 1899) where possible.

At least the prospect of outright default seems more remote for the U.S. than for many other countries. The fewer chances a fiscally stretched government has to inflate, or devalue its debt through a depreciating currency, the greater is its temptation to default. In most countries, government bonds still have the lowest yields, but it is no longer unthinkable to see government yields rising above high-quality corporate yields. Indeed, even in developed markets, long-dated interest rate swaps are increasingly trading below government yields, and sovereign credit default swap spreads have dramatically increased since 2008. The time horizon also matters. Long-dated Treasuries are arguably a more natural riskless asset for long-horizon investors, given the uncertain reinvestment rate for short-dated bills. Pension funds match their liabilities best by buying long-dated real or nominal bonds. 4.6 BIASED RETURNS For many asset classes, returns may be positively or negatively biased over a given historical sample.


pages: 224 words: 13,238

Electronic and Algorithmic Trading Technology: The Complete Guide by Kendall Kim

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algorithmic trading, automated trading system, backtesting, corporate governance, Credit Default Swap, diversification, en.wikipedia.org, family office, financial innovation, fixed income, index arbitrage, index fund, interest rate swap, linked data, market fragmentation, natural language processing, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, short selling, statistical arbitrage, Steven Levy, transaction costs, yield curve

Information was based solely on conversations with Firm Bond Desk eSpeed ICAP MarketAxess TheMuniCenter TradeWeb Exhibit 11.6 U.S. Treasuries x x x x x MBS x x Agency x x x x Corporate Bonds x x x x Munis European Issues x x x x x x Products supported. Source: Aite Group. Derivatives x x x Electronic and Algorithmic Trading for Different Asset Classes 119 Firms eSpeed Products Interest Rate Swaps ICAP Interest Rate Swaps Q3 2004 Europe Credit Derivatives Q4 2004 Europe and U.S. MarketAxess Thomson TradeWeb Exhibit 11.7 Launch Date 2003 Credit Derivatives Q3 2005 Q1 2005 for Interest Rate Swaps Euro Q3 2005 for U.S. Q3 2005 for Credit Derivatives U.S. Market Focus Europe and U.S. Europe and U.S. Europe and U.S. Europe and U.S. Expansion into derivatives. Source: Firms. brokers or dealers. Buy-side investors had to call dealers to get liquidity and pricing information, which was often incomplete or conflicting.2 11.4 Types of Systems Auction Systems Auction systems enable participants to conduct electronic auctions of securities offerings.

Electronic access to stocks has been more prevalent than for futures and options, but these asset classes are catching up particularly in foreign exchange. A growing number of trading platforms now support trading in over-the-counter (OTC) derivatives. According to the Bond Market Association in 2004, 25 platforms now allow users to execute transactions in 111 112 Electronic and Algorithmic Trading Technology interest rate swaps, credit default swaps, options, futures, and other derivative products. This is nearly double the number of platforms that supported derivatives trading in 2003. The equities markets will execute trades using some sort of algorithmic model, but the same will most likely be true for other products such as futures, options, and foreign exchange. Fixed income will be one of the last to move along because it is predominantly a dealer market, but when it does, the first asset class will most likely be the most liquid sectors such as the U.S.

More thinly traded sectors such as credit markets don’t offer consistent enough pricing to effectively utilize an algorithmic trading model.1 The late arrival of electronic trading in fixed-income markets compared to equities reflects distinct differences between the two. By 2008, electronic trading will account for over 60% of total U.S. fixed-income trading volume (see Exhibits 11.2 and 11.3), as leading platforms continue to expand into less liquid products, according to the Aite Group. Competition is expanding into less liquid Fixed-income instruments, which include European markets, algorithmic trading, and OTC derivative products such as interest rate swaps and credit derivatives. The marketplace has also witnessed contraction in the number of trading platforms from its peak in 2000, when over 70 electronic fixed-income trading platforms existed, to fewer than 30 platforms remaining at the end of 2004. Realistically, only a handful of those remaining platforms can be considered legitimate. The U.S. fixed-income market has evolved substantially since the late 1990s when most electronic trading took place on interdealer markets.


pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

—Saying among traders The global fixed-income markets are vast in terms of the value of outstanding bonds, the turnover of these bonds, and the size of the related derivatives markets. The most important fixed-income market is the government bond market, followed by the markets for corporate bonds and mortgage bonds. The key derivatives markets include bond futures, interest-rate swaps, credit default swaps, options, and swaptions, which give the option to enter into an interest-rate swap. Almost all bond prices depend heavily on the risk-free interest rate, so there is significant co-movement among bond yields and bond returns. Therefore, fixed-income arbitrage traders often trade on the relative value among fixed-income securities to exploit price differences among closely related securities. The close connection between the securities means that a lot of the risk is hedged away by going long and short.

• Bond carry trade: A bond’s carry is its yield-to-maturity in excess of the financing rate. For example, a 10-year Japanese government bond has a high carry if the Japanese yield curve is steep. Some macro investors trade on bond carry across countries, buying bonds in countries with high carry while shorting bonds in countries with low carry. Such trades can be implemented with cash bonds (financed in repo), bond futures, or interest-rate swaps. • Yield-curve carry trade: Macro investors also trade bonds of different maturities within the same country. This is called a yield-curve trade. Chapter 14 provides more sophisticated measures of bond carry (that include a so-called roll-down effect) and discusses in more detail how to implement bond and yield-curve trades. • Commodity carry trade: The carry of a commodity futures contract is the amount of money one makes if the spot commodity price does not change.

Panel B shows, at four selected dates, the entire yield curve where the (off-the-run) bonds originally issued as 30-year bonds are represented as diamonds and all other securities are plotted as solid circles. The disconnect between on- and off-the-run 10-year bonds during the global financial crisis is evident. Sources: Panel A: Using data from AQR Capital Management. Panel B: Gürkaynak and Wright (2012). 14.6. SWAPS AND SWAP SPREADS An interest-rate swap is a derivative that exchanges the cash flows of a fixed-rate loan to those of a floating-rate loan. The counterparty paying the fixed rate is called the “payer,” and the counterparty receiving the fixed rate is called the “receiver.” We will take the viewpoint of the receiver (who faces an interest-rate risk similar to that of an investor who is long on a bond). The receiver earns a fixed rate called the swap rate, YTMswap, and must pay a floating LIBOR rate, .

Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi

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affirmative action, Affordable Care Act / Obamacare, Bernie Sanders, Bretton Woods, carried interest, clean water, collateralized debt obligation, collective bargaining, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, desegregation, diversification, diversified portfolio, Donald Trump, financial innovation, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, moral hazard, mortgage debt, obamacare, passive investing, Ponzi scheme, prediction markets, quantitative easing, reserve currency, Ronald Reagan, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

Humorously, the Times piece came out just weeks after Gasparino had derided as “the mother of all conspiracy theories” the notion that “during those dark days of 2008, right after the Lehman collapse, and with AIG on the verge of death, Blankfein picked up the phone and called his old partner, then–Treasury Secretary Hank Paulson, and asked to be bailed out.” The financial services industry was faced with yet another potential catastrophe in early 2010 when some of the interest rate swaps Goldman had created for the nation of Greece blew up. The Greece scandal was a variation on a predatory scam that banks like Goldman and JPMorgan had been using to fleece municipalities in the United States for years; the swaps essentially allowed cities, counties, and countries to refinance their debt in a scheme that was very similar to the mortgage-refi schemes used by predatory lenders in the mid-2000s. The idea behind an interest rate swap, which is yet another type of unregulated derivative instrument, goes like this: a debtor who is paying variable-rate interest pays a bank like Goldman a fee in exchange for the security of fixed interest.

In this case the Nostradamus was McArdle, who a half year before Greece blew up was reaming me for being too general in my description of Goldman’s aggressive forays into the unregulated derivatives market. “At any rate,” she wrote, “none of these derivatives have much to do with CDOs or CDSs; you might as well conflate stocks and bonds because they’re both ‘securities.’ No one, as far as I know, is now proposing that we need to curtail the use of interest rate swaps [emphasis mine].” An earlier example of an interest rate swap disaster had been Jefferson County, Alabama, which in 2008 had been virtually bankrupted by a series of swap deals it entered into with JPMorgan, deals that forced the county to institute mass layoffs and unpaid leave and left its residents facing a generation of massively inflated sewer bills. In a rare instance of restraint, Goldman was not actually involved with the JeffCo swap deals—but only because it had accepted a $3 million payment from JPMorgan to back off the kill and allow Morgan to do the deals all by itself.

Even as she spends every day publicly flubbing political SAT questions, she’s always dead-on when it comes to her basic message, which is that government is always the problem and there are no issues the country has that can’t be worked out with basic common sense (there’s a reason why many Tea Party groups are called “Common Sense Patriots” and rally behind “common sense campaigns”). Common sense sounds great, but if you’re too lazy to penetrate the mysteries of carbon dioxide—if you haven’t mastered the whole concept of breathing by the time you’re old enough to serve in the U.S. Congress—you’re not going to get the credit default swap, the synthetic collateralized debt obligation, the interest rate swap. And understanding these instruments and how they were used (or misused) is the difference between perceiving how Wall Street made its money in the last decades as normal capitalist business and seeing the truth of what it often was instead, which was simple fraud and crime. It’s not an accident that Bachmann emerged in the summer of 2010 (right as she was forming the House Tea Party Caucus) as one of the fiercest opponents of financial regulatory reform; her primary complaint with the deeply flawed reform bill sponsored by Senator Chris Dodd and Congressman Barney Frank was that it would “end free checking accounts.”


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The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

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affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

Counterparties could do this by simply sending Lehman a fax on September 15, 2008. The Long-Dated Swap Imbalance Lehman was in the intermediary business.4 To illustrate the damage that Lehman’s bankruptcy did to the financial system, assume that all of Lehman’s exposure was from market making, giving the firm only counterparty risks from its large OTC book. Then consider one part of Lehman’s book: 30-year interest-rate swaps (IRS). An interest-rate swap is an agreement between two parties to exchange a series of cash flows over a defined number of years. In a typical IRS, one party pays a fixed interest rate for the entire period and the other party pays a floating rate, which depends on prevailing interest rates at the time of payment. Payments are usually made every six months, although they can be made at any interval. Investors tend to invest in their preferred habitats—the places that make the most sense for their businesses.

See also Greed and housing bubble blame for circle of greed causing Federal Reserve and financial crisis of 2008 and overview of Huang, Chi-Fu HUD (Housing and Urban Development), affordable-housing goal of Hufschmid, Hans Hunsader, Eric Scott Hybrid ARM ICD (Investment Corporation of Dubai) IG (investment grade) index III Fund LP Illiquid securities Implied volatility Income distribution Index art Indices: ABX index average returns of CDX index CMBX index IG index IndyMac Insurance, basics of Interest-rate risk Interest rates Interest-rate swap (IRS) International Swaps and Derivatives Association Internet stock bubble of 2000 Investment banks. See also specific banks capital markets client services conflicts of interest corporate and risk management demise of equities exposure to residential real estate fixed income foreign exchange global distribution leverage of Main Street and mortgage market and overview of profits research stock prices structure technology Investment Corporation of Dubai (ICD) Investment grade (IG) index Investors, interconnected IRS (interest-rate swap) Isaacs, Jeremy M. Italian swap and government zero curve Italian swap spread Italy, debt burden of Iwanowski, Ray Japanese box trade Japanese swap spread Japanese warrant trade Jittery markets Johnson, James Jones, Bob J.P.

TABLE 4.1 The LTCM Portfolio in August 1998 Many of these trades had both a liquid component and an illiquid component. (A liquid security is one that can easily be bought and sold near its last traded price, such as a Treasury bond. An illiquid security is one that might be hard to buy or sell; its purchase price may move significantly from the last quoted price.) The Short U.S. Swap Trade LTCM traders made many swap trades during the firm’s lifetime. A plain vanilla interest-rate swap is a basic transaction in which one party agrees to pay a floating interest rate to another party over a specific time period, and the other party agrees to pay a fixed interest rate over the same specific time period. Of course, LTCM traders didn’t use the vanilla version. They made money on the swap spread: the difference between a swap interest yield that represents the cost of borrowing between banks, and the government bond yield, which is the government’s cost of borrowing.


pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, mortgage debt, mortgage tax deduction, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

Because the value of a bond rises and falls in an inverse relationship to the trajectory of interest rates, investors who have bought a bond can protect themselves from an interest-rate rise by selling a future: as they lose money on one, they gain on the other. The first futures were for a type of mortgage-­backed security; they paved the way for much more actively traded contracts in Treasury-bond futures. Other types of derivatives followed. The first interest-rate swap, in which a borrower paying a floating-rate loan agrees to swap payments with a borrower who has taken out a fixed-rate loan, was agreed to in 1981. Equity-derivatives contracts based on the S&P 500 index were introduced in 1982. Credit-default swaps, which act as a kind of insurance policy against default by a corporate borrower, were invented in the 1990s. The size of the derivatives markets grew relentlessly in the years leading up to the 2007–2008 crisis, expanding by an annual average rate of 24 percent between 1995 and 2007, much quicker than the equity (11 percent growth) and bond (9 percent) markets.24 All of the strands of financial development that were at work in prior centuries were at work during the age of derivatives.

They have the financial resources to get things off the ground quickly, and because they are not subject to the same commercial imperatives as the private sector, they are willing to experiment. The role of the US government in promoting the securitization markets is well known. Ginnie Mae, a government-owned corporation, was the first to sell securities backed by a portfolio of mortgage loans in 1970; the first collateralized mortgage obligation was issued by Fannie Mae in 1983. The first currency and interest-rate swap was written in London between the World Bank and IBM, in an agreement that saw the World Bank exchange its surplus dollars for the computing firm’s stock of unwanted Swiss francs and deutsche marks. The first credit-default swap transaction, in 1994, saw the European Bank for Reconstruction and Development, a multilateral organization ostensibly dedicated to funding the transition economies of Eastern Europe, insure JP Morgan against the risk of Exxon defaulting.12 Political goals are also important in driving financial markets forward.

They are then sliced into different tranches: the most senior tranches of CDOs of mortgage-backed securities were given high ratings during the most recent US housing boom because the performance of all the different mortgages in the pool was thought to be diversified. Counterparty risk: The risk that the other party to a contract will not live up to its obligations. The counterparty risk in an interest-rate swap is that one of the parties to the swap will not pay up. Credit-default swap: A credit-default swap is a form of insurance against default by a bond issuer. Credit ratings: An evaluation by a credit-rating agency of the creditworthiness of a debtor. Ratings are widely used by investors and are embedded in international rules, including those on how much equity banks have to use to fund themselves.


pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond

In December 2004, Harvard entered into $2.3 billion interest rate swaps to lock in financing costs at historically low rates.10 The university gained budgetary certainty—a hedge. In 2008, as credit markets seized up and central banks slashed rates, the swaps went into loss because Harvard was contracted to pay higher rates than current market rates. As the value of the contracts plunged, Harvard, like Jefferson County, was forced to lodge cash with its bankers, coinciding with a fall in the value of Harvard’s endowment fund of 30 percent (from $36 billion at its peak to $26 billion). Its cash account used to fund ongoing expenditure lost $1.8 billion. To limit losses, Harvard borrowed money to terminate the swaps, paying $498 million to banks during 2009 to cancel $1.1 billion of interest rate swaps. It agreed to pay $425 million over 30–40 years to offset an additional $764 million in swaps.

Maunsell had a close relationship with Macquarie, being entitled to success fees if the bank won its bid. Indiana Finance Authority’s consultant came up with 50 percent lower traffic forecasts, valuing the toll road at half the $3.8 billion purchase price. A third consultant concluded that Maunsell’s forecasts exceeded the highway capacity after 2020. Macquarie used derivatives, known as accreting interest rate swaps, to lower early payments by increasing later payments. Complex securities, such as TICKETs (tradeable interest bearing convertible to equity trust securities), with low early interest rates that increased over time, were used. The arrangements were identical to those used in subprime mortgages. Projects routinely issued debt linked to inflation, prized by pension funds and insurance companies trying to minimize risk from change in price levels.

Environmental Protection Agency, filed a lawsuit against the County alleging discharge of untreated sewage into the Cahaba river watershed. As part of a settlement, the County agreed to build a sewer system collecting overflows and cleaning the water. The original $3.2 billion cost ultimately doubled. Between 1997 and 2002, Jefferson County issued $2.9 billion in sewer bonds. In 2002, bankers advised refinancing the debt using adjustable rate bonds and interest rate swaps, saving millions of dollars in interest cost. In an adjustable rate bond, the interest rate is reset periodically by reference to market rates. Between 2002 and 2004, Jefferson County issued more than $3 billion of adjustable rate bonds, predominantly auction rate securities (ARSs), bonds with a long maturity where the rate is regularly reset through a Dutch auction6 typically held every 7, 28, or 35 days.


pages: 369 words: 94,588

The Enigma of Capital: And the Crises of Capitalism by David Harvey

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accounting loophole / creative accounting, anti-communist, Asian financial crisis, bank run, banking crisis, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business climate, call centre, capital controls, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, deskilling, equal pay for equal work, European colonialism, failed state, financial innovation, Frank Gehry, full employment, global reserve currency, Google Earth, Guggenheim Bilbao, illegal immigration, indoor plumbing, interest rate swap, invention of the steam engine, Jane Jacobs, joint-stock company, Joseph Schumpeter, Just-in-time delivery, land reform, liquidity trap, Long Term Capital Management, market bubble, means of production, megacity, microcredit, moral hazard, mortgage debt, new economy, New Urbanism, Northern Rock, oil shale / tar sands, peak oil, place-making, Ponzi scheme, precariat, reserve currency, Ronald Reagan, sharing economy, Silicon Valley, special drawing rights, special economic zone, statistical arbitrage, structural adjustment programs, the built environment, the market place, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, Thorstein Veblen, too big to fail, trickle-down economics, urban renewal, urban sprawl, white flight, women in the workforce

The ‘shadow banking system’ emerges 1980 Currency swaps 1981 Portfolio insurance introduced; interest rate swaps; futures markets in Eurodollars, in Certificates of Deposit and in Treasury instruments 1983 Options markets on currency, equity values and Treasury instruments; collateralised mortgage obligation introduced 1985 Deepening and widening of options and futures markets; computerised trading and modelling of markets begins in earnest; statistical arbitrage strategies introduced 1986 Big Bang unification of global stock, options and currency trading markets 1987–8 Collateralised Debt Obligations (CDOs) introduced along with Collateralised Bond Obligations (CBOs) and Collateralised Mortgage Obligations (CMOs) 1989 Futures on interest rate swaps 1990 Credit default swaps introduced along with equity index swaps 1991 ‘Off balance sheet’ vehicles known as special purpose entities or special investment vehicles sanctioned 1992–2009 Rapid evolution in volume of trading across all of these instruments.

Then, towards the end of the 1980s, to offset the volatility, the practice of hedging (placing two-way bets on currency futures) became more common. An ‘over the counter’ market arose outside of the regulatory framework and the rules of the exchanges. This was the kind of private initiative that led to an avalanche of new financial products in the 1990s – credit default swaps, currency derivatives, interest rate swaps, and all the rest of it – which constituted a totally unregulated shadow banking system in which many corporations became intense players. If this shadow system could operate in New York, then why not also in London, Frankfurt, Zurich and Singapore? And why confine the activity to banks? Enron was supposed to be about making and distributing energy but it increasingly merely traded in energy futures and when it went bankrupt in 2002 it was shown to be nothing but a derivatives trading company that had been caught out in high-risk markets.

King 79, 80 hunger, world 80 I Icarian communes 130 Iceland bankrupt 6, 37 exposure of national banks to toxic assets 141 idealism 133 immigration 59, 131 anti-immigrant fervour 103 colonisation of urban neighbourhoods 247 encouraging 14 Immigration and Nationality Act (1965) 14 imperialism 108, 109, 113, 144, 171, 204, 207, 212 Inca gold 47, 144 India anti-land grab movement 257 British goods 108, 158 British-imperialist-controlled 144 caste distinctions 62 colonial occupation 205 democracy 200 growth 222 labour reserves 64 Maoist movements in rural India 226 and oil market 83 partition 208 plundering of wealth from 109, 113 rural uprisings in 38 Indian Supreme Court 179 individualism 131, 132, 150, 170, 175, 197, 199 Indonesia Asian Currency Crisis 271 excessive urban development 8 industrial development 256 ‘industrial reserve army’ 15, 58, 59 industrial revolution 160 industrialisation 6, 33, 35, 68, 92, 172, 209 infant mortality 137, 152 inflation 15, 108, 114, 222 accelerating 113 ‘grand inflation’ (16th century) 48 and oil prices 80 rapid 111 Weimar 141 ‘informal sector’ 145 infrastructure disasters 86 educational 93 investment in 86, 167, 222 payment for use of 86–7 social 93 inheritance taxes 44 innovation 89, 90 communications 42, 93 labour-saving 94 organisational 97, 101 product 95 technological 67, 96–7, 101, 103 transport 42, 93 waves of 92–3 insider trading 99 insurance companies 4–5 intellectual property rights 34, 40, 221, 245–6 interest rate swaps 262 interest rates and austerity programmes 246, 251 Fed cuts 5, 261 International Monetary Fund (IMF) 5, 28, 34, 36, 51, 69, 200, 223, 246, 247 and asset values 6 bail-outs in Asian Currency Crisis 261 ‘Fifty Years is Enough’ campaign 55 ‘structural adjustment programs’ 19, 261 internet 190 investment capital 93, 203 debt-fuelled 166 devaluation of prior investments 93 infrastructure 86, 167, 222 in production 114 profitable 19 spreading of investment risks 85 subsidies for 36 iPods 131, 150 Iran: US threats 210 Iraq: US interventionism 210 Ireland: property-led crisis (2007–10) 5–6, 261 Isaacs, William 8 Israel dispossession of Palestinian land 247 kibbutzim 130 ivory 73 J Jacobs, Jane 171, 177 Japan boom of 1980s 8 collapse of stock market 8 depression in economy 45 falling exports 6 industrialisation 68, 92 invasion of US auto market 15 negative population growth 146 plunging land prices 8, 9 property-market led bank crisis 261 reconstruction of economy after Second World War 202 rise in the 1960s 35 joint stock companies 49 J.P.

Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

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Asian financial crisis, asset allocation, backtesting, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk-adjusted returns, risk/return, Sharpe ratio, short selling, stochastic process, systematic trading, technology bubble, transaction costs, value at risk

The second candidates are financial or commodity indices that have been used previously in the mutual or hedge funds performance measurement literature. Among the large set of potential candidates, we have selected: the return on the Goldman Sachs Commodity Index (GSCI), previously used by Capocci and Hübner (2004); the return on Moody’s Commodity Index (MCOM); the U.S. Moody’s Baa Corporate Bond Yield to proxy for the default risk premium (DEF) as well as the monthly change on this yield (∆DEF); the U.S. 10-year/6-month Interest Rate Swap Rate to proxy for the maturity risk premium (MAT) as well as its monthly change (∆MAT); and finally the monthly change in the U.S. dollar/Swiss franc exchange rate to proxy for the currency risk premium (FX). These data series were extracted from the JCFQuant database. The Performance of CTAs in Changing Market Conditions 119 Finally, we use the option strategy factor proposed by Agarwal and Naik (2002) and Liang (2003) to capture the optionality component of CTA returns.

The values are significant at the 5 percent level. 0.154 0.163 0.194 0.173 CTA Index Systematic Fin/Metal Diversified R2adj 0.335 0.371 0.333 0.358 (continued) CTA Index Systematic Fin/Metal Diversified TABLE 6.6 — — — — — — — — Bear −0.001 −0.001 −0.001 −0.002 — — — — RUS3 Strong Bull RUS2 — — — — — — — — UMD — — — — — — — — HDMZD −0.153 −0.202* −0.180 −0.199 0.289* 0.376** 0.274** 0.417* ∆MAT — — — — 0.522* 0.591* −0.263 0.781* ∆DEF 122 TABLE 6.7 PERFORMANCE Tailor-Made Model Results for Currency Index R2adj Entire Period Weak Bull Moderate Bull Strong Bull Bear Alpha ATMC DEF MAT 0.099 −3.188 −0.485** 2.364* — 0.332 — 0.090 — 0.372 −0.757* — 3.923 — — 0.273 — FX UMD HDMZD RUS2 0.099 0.083* 0.122** — 0.409* 0.569** 0.030 — — — — — — — — — — −3.172 — — — — — — — — — — ATMC = series of returns on the one-month ATM call written on the Russell 3000 index. DEF = U.S. Moody’s Baa corporate bond yield. MAT = U.S. 10-year/6-month Interest Rate Swap Rate. FX = monthly change in the U.S. dollar/Swiss franc exchange rate. UMD (Up Minus Down) = average return on the two high prior return portfolios minus the average return on the two low prior return portfolios. HDMZD (High Dividend Minus Zero Dividend) = average return of the highestdividend-paying stocks versus the stocks that do not dispense dividends. RUS2 = square of the excess returns on the Russell 3000. ** The values are significant at the 10 percent level.

FX = monthly change in the U.S. dollar/Swiss franc exchange rate. UMD (Up Minus Down) = average return on the two high prior return portfolios minus the average return on the two low prior return portfolios. HDMZD (High Dividend Minus Zero Dividend) = average return of the highest-dividend-paying stocks versus the stocks that do not dispense dividends. ∆MAT = change in the U.S. 10-year/6-month Interest Rate Swap Rate. GSCI = return on the Goldman Sachs Commodity Index. RUS2 = square of the excess returns on the Russell 3000. RUS3 = cube of the excess returns on the Russell 3000. MCOM = return on Moody’s Commodity Index. ** The values are significant at the 10 percent level. ** The values are significant at the 5 percent level. Entire Period Weak Bull Moderate Bull Strong Bull Bear R2adj TABLE 6.8 Differentiated Model Results for Discretionary Index 124 PERFORMANCE PERFORMANCE MEASUREMENT Performance under Changing Market Conditions Thanks to the effort put in the previous section to explain CTA expected returns over the subperiods, we can go beyond the use of the Sharpe ratio to characterize abnormal performance as extensively used in the CTA performance literature.


pages: 515 words: 132,295

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

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3D printing, accounting loophole / creative accounting, additive manufacturing, Airbnb, algorithmic trading, Asian financial crisis, asset allocation, bank run, Basel III, bonus culture, Bretton Woods, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, centralized clearinghouse, clean water, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, crowdsourcing, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial intermediation, Frederick Winslow Taylor, George Akerlof, gig economy, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, High speed trading, Home mortgage interest deduction, housing crisis, Howard Rheingold, Hyman Minsky, income inequality, index fund, interest rate derivative, interest rate swap, Internet of things, invisible hand, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, knowledge economy, labor-force participation, labour mobility, London Whale, Long Term Capital Management, manufacturing employment, market design, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, offshore financial centre, oil shock, passive investing, pensions crisis, Ponzi scheme, principal–agent problem, quantitative easing, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Snapchat, sovereign wealth fund, Steve Jobs, technology bubble, The Chicago School, The Spirit Level, The Wealth of Nations by Adam Smith, Tim Cook: Apple, Tobin tax, too big to fail, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund

But by the 1990s, and much more so after 2000, derivatives began to explode and expand in a way that made it clear that at least some of what was being traded had nothing to do with protecting people or companies in the real economy, but was more about speculation—one could call it gambling—with an increasingly complex array of financial instruments, on things like interest rate swaps, credit default swaps, and even bets on what the weather would be like from day to day. Derivatives are best known to most people as the “financial weapons of mass destruction” that Warren Buffett has warned us about, the complex securities that blew up our financial system in 2008. These financial instruments—be they interest rate swaps, foreign exchange bets, or grain futures—have very real, very tangible impacts. Yet to the banks, hedge funds, and the other institutions that trade them, they are simply another part of the economy that can be arbitraged for profit.

The culprit: a $1.25 trillion swaps portfolio gone bad. Gensler remembers going out to LTCM’s headquarters in Greenwich, Connecticut, on a Sunday to investigate. “It quickly became clear to me that we had no idea what the ramifications would be in our financial system, and where, because these trades were booked in the Cayman Islands,” he says. “It was a terrible feeling.”24 Derivatives—be they interest rate swaps, foreign exchange bets, or energy futures—have real-world impacts, as we’ve already seen. Yet to the banks, hedge funds, and the other institutions that trade them, they are simply another moneymaking vehicle, something to be bought and sold. What’s more, most of us play a part in the cycle that drives up commodity prices and disproportionately enriches the financial sector, via our retirement savings.

That Wall Street debt was “the biggest contributing factor to the increase in Detroit’s legacy expenses,” explains Turbeville, who wrote an influential report in 2013 outlining the role that finance had played in Detroit’s demise.35 The long and short of it was that the people negotiating the debt settlement on behalf of the city were completely outsmarted and outflanked by financiers, who cut deals for millions of dollars of extremely long-term interest rate swaps that were subject to immediate termination if the city’s credit deteriorated, which of course it quickly did. The termination of the contracts required immediate payment of all projected profits that would be earned by the banks had the contract not been terminated. That meant that Detroit was suddenly on the hook for a huge lump-sum payment that made its cash flow position completely untenable.


pages: 261 words: 86,905

How to Speak Money: What the Money People Say--And What It Really Means by John Lanchester

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asset allocation, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, blood diamonds, Bretton Woods, BRICs, Capital in the Twenty-First Century by Thomas Piketty, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collective bargaining, credit crunch, Credit Default Swap, crony capitalism, Dava Sobel, David Graeber, disintermediation, double entry bookkeeping, en.wikipedia.org, estate planning, financial innovation, Flash crash, forward guidance, Gini coefficient, global reserve currency, high net worth, High speed trading, hindsight bias, income inequality, inflation targeting, interest rate swap, Isaac Newton, Jaron Lanier, joint-stock company, joint-stock limited liability company, Kodak vs Instagram, liquidity trap, London Interbank Offered Rate, London Whale, loss aversion, margin call, McJob, means of production, microcredit, money: store of value / unit of account / medium of exchange, moral hazard, neoliberal agenda, New Urbanism, Nick Leeson, Nikolai Kondratiev, Nixon shock, Northern Rock, offshore financial centre, oil shock, open economy, paradox of thrift, Plutocrats, plutocrats, Ponzi scheme, purchasing power parity, pushing on a string, quantitative easing, random walk, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, road to serfdom, Ronald Reagan, Satoshi Nakamoto, security theater, shareholder value, Silicon Valley, six sigma, South Sea Bubble, sovereign wealth fund, Steve Jobs, The Chicago School, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, trickle-down economics, Washington Consensus, working poor, yield curve

Third, and finally, one of the most brilliant things the financial services industry ever did was to take the word “debt,” which people were brought up to consider a bad thing that you want to avoid, and to rename it as “credit,” which sounds like a good thing that you want more of. This is a major example of reversification at work. credit default swap (CDS) A financial instrument arising from interest rate swaps. The simplest way of looking at a CDS is as a form of insurance. If you are receiving interest from someone to whom you’ve lent money, you may start to wonder what happens if she starts to have trouble paying you. If you get worried, you might want to insure the interest you’re getting, so that in the event of a default by your borrower, you still get your money. That’s a credit default swap: you pay someone a fee to take on the risk of default, and in return, in the event of a default, she pays you the money you are owed.

That means mortgage defaults will rise, so 7. there will be downward pressure on house prices, and 8. some people will be in negative equity, which will stop them from spending money, 9. the currency will rise, because higher guaranteed rates of investment will attract money into buying the country’s debt, so 10. life will become harder for manufacturing businesses, because their exports will be more expensive. Also, 11. inflation will fall—remember, inflation means that money is worth less, whereas a rise in interest rates means that money is more expensive. There’s more, too, but these eleven things provide a starting point for all the things that are completely taken for granted by people who speak money when they hear “interest rates.” interest rate swaps Financial techniques in which two parties do what it says on the tin: they swap interest rates. The most common example is when A has a floating interest rate and B has a fixed rate, and they both, for their differing reasons, would prefer to be on the other kind of deal. So they enter into a contract where A pays B’s interest rate, and B pays A’s. Much of this action is between sophisticated market players who are betting on their judgment about the movement in rates; some of it is a form of hedging, of complex calculations designed to set off against each other and minimize risks about the movement of interest rates.

Much of this action is between sophisticated market players who are betting on their judgment about the movement in rates; some of it is a form of hedging, of complex calculations designed to set off against each other and minimize risks about the movement of interest rates. Unfortunately some of these swaps were mis-sold by banks, with the effect of severely damaging small businesses that didn’t know what they were getting into and thought they were reducing their risks. Instead they were locking themselves into unfavorable deals that were ruinously expensive to undo. The UK interest rate swap scandal has attracted less attention and opprobrium than the PPI scandal, perhaps because the victims tended to be small businesses rather than individuals, but in its essential detail—banks knowingly selling customers an unsuitable product—it was the same. inventory The amount of stuff a business has in stock. It’s an entire branch of management and logistics—not the most riveting to outsiders, and management of inventory is a classic example of something that the customer notices only when it goes wrong.


pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

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Albert Einstein, asset allocation, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Norbert Wiener, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

On the credit event, settlement may be the delivery of the reference asset in exchange for the contingent payment or settlement may be in cash (that is, value of the instrument before default less value after, recovery value). The mark-to-market value of the CDS depends on changes in credit spreads. Therefore they can be used to get exposure to or hedge against changes in credit spreads. To price these contracts one needs a model for risk of default. However, commonly, one backs out an implied risk of default from the prices of traded CDSs. Diff(erential) swap is an interest rate swap of floating for fixed or floating, where one of the floating legs is a foreign interest rate. The exchange of payments are defined in terms of a domestic notional. Thus there is a quanto aspect to this instrument. One must model interest rates and the exchange rate, and as with quantos generally, the correlation is important. Digital option is the same as a binary option. Extendible option/swap is a contract that can have its expiration date extended.

On later payment dates this principal can then be amortized again, starting from its current level at the previous payment date and not based on its original level. This makes this contract very path dependent. The contract can be priced in either a partial differential equation framework based on a one- or two-factor spot-rate based model, or using Monte Carlo simulations and a Libor market-type model. Interest rate swap is a contract between two parties to exchange interest on a specified principal. The exchange may be fixed for floating or floating of one tenor for floating of another tenor. Fixed for floating is a particularly common form of swap. These instruments are used to convert a fixed-rate loan to floating, or vice versa. Usually the interval between the exchanges is set to be the same as the tenor of the floating leg.

These contracts are so liquid that they define the longer-maturity end of the yield curve rather than vice versa. Inverse floater is a floating-rate interest-rate contract where coupons go down as interest rates go up. The relationship is linear (up to any cap or floor) and not an inverse one. Knock-in/out option are types of barrier option for which the payoff is contingent on a barrier level being hit/missed before expiration. LIBOR-in-arrears swap is an interest rate swap but one for which the floating leg is paid at the same time as it is set, rather than at the tenor later. This small difference means that there is no exact relationship between the swap and bond prices and so a dynamic model is needed. This amounts to pricing the subtle convexity in this product. Lookback option is a path-dependent contract whose payoff depends on the maximum or minimum value reached by the underlying over some period of the option’s life.


pages: 314 words: 101,452

Liar's Poker by Michael Lewis

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barriers to entry, Bonfire of the Vanities, cognitive dissonance, corporate governance, financial independence, financial innovation, Home mortgage interest deduction, interest rate swap, London Interbank Offered Rate, margin call, mortgage tax deduction, nuclear winter, Ponzi scheme, The Predators' Ball, yield curve

Then he turns around, and sure enough, the lapels jut like wings from his shoulders. The Salomon salesmen, having schmoozed their client, move in to finish him off. They recommend that the thrift managers buy a billion dollars' worth of interest rate swaps. The thrift managers clearly don't know what an interest rate swap is; they look at each other and shrug. One of the Salomon salesmen tries to explain. The thrift men don't want to hear; they want to play golf. But the Salomon salesmen have them by the short hairs and won't let go. "Just give us a billion of them interest rate swaps, so we can be off," the thrift managers finally say. End of skit. *In the interest of variety, thrift will be used interchangeably with savings and loans throughout the text, as it is on Wall Street. That was the sort of person who dealt in home mortgages, a mere sheep rancher next to the hotshot cowboys on Wall Street.


pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

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Asian financial crisis, asset-backed security, bank run, Black-Scholes formula, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Exxon Valdez, fear of failure, financial innovation, fixed income, high net worth, Home mortgage interest deduction, interest rate swap, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, market fundamentalism, Maui Hawaii, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, shareholder value, short selling, South Sea Bubble, statistical model, telemarketer, too big to fail, value at risk

The essential purpose of derivatives has always been to swap one kind of risk for another; that’s why many common derivatives are called swaps. The earliest derivatives attempted to mitigate interest rate risk and currency risk. In the volatile economic environment of the 1980s, when interest rates and currency values could swing suddenly and unpredictably, big companies were desperate for ways to protect themselves; derivatives became the way. An interest rate swap allowed a company to lock in an interest rate and pay a fee to another entity—a counterparty, as they were called on Wall Street—willing to take the risk that rates would suddenly jump. (If rates dropped instead, the counterparty would make a nice profit.) The counterparty, in turn, would often want to hedge, or reduce, its own risks by entering into an offsetting trade with another entity.

See Derivatives Cribiore, Alberto Cuomo Andrew Currency swaps Dallas, Bill Dallavecchia, Enrico Daurio, Jon Davis Square III Defaults, on subprimes Depository Institutions Deregulation and Monetary Control Act (1980) D’Erchia, Peter Derivatives of AIG Financial Products CDOs CDOs, multisector CDOs, synthetic credit default swaps currency swaps danger and warning about futures classification defeat high ratings, reasons for interest rate swaps of J.P. Morgan LTCM collapse netting out quants’ development of regulatory efforts structured investment vehicles (SIVs) tranches of See also specific instruments Deutsche Bank, ABS index Dimon, Jamie Dodge, Patti Donilon, Tom Dooley, Bill Drexel Burnham Lambert Dubrish, Robert Dugan, John Dunne, Jimmy Dynamic hedging Dyron, Dick Edper Edwards, Jeff Eichel, Scott Eisman, Steve Empiris LLC Enron European Bank for Reconstruction and Development (EBRD) Evans, Gay Everquest Exception pricing system Exxon Valdez Fakahany, Ahmass Falcon, Armando, Jr.

“Hank,” AIG FP, control of biographical information earnings management by on FM Watch leaves AIG risk-management system of and Sosin style/personality of See also AIG Financial Products; American International Group (AIG) Greenberger, Michael Greenlining Institute Greenspan, Alan antiregulatory position on capital reserves “Committee to Save the World,” as derivatives supporter interest rate cuts on LTCM collapse subprimes, neglect of issue Gregory, Joe Guardian Savings & Loan Guldimann, Till, Value at Risk (VaR) developed by Gutierrez, Michael Habayeb, Elias Hagler, Grayland Scott, Reverend Hard-money lenders leading companies legislation and expansion of operation of second-lien mortgages by subprime MBS, first Harris, Patricia Hawke, John Hedge funds, at Bear Stearns, collapse of Hedging, dynamic hedging Hibbert, Eric High loan-to-value lending (HLTV) Holder, Steve Holding companies Home equity loans Homeownership and baby boomers Bush initiatives Clinton initiatives increase for credit risks and interest rates loan defaults, rise in Mozilo support of Home Ownership and Equity Protection Act (HOEPA) Home values drop in homes abandoned by owners increase in (2001-2006) Household Finance Howard, Tim HSBC Hudson Mezzanine Hunter, Allan Oakley Hybrid CDOs Icahn, Carl IKB IMARC Implicit government guarantee, Fannie Mae Incentive compensation Independent Swaps and Derivatives Association (ISDA) IndyMac Interest rates cuts and home buying increases Interest rate swaps Investment firms. See Wall Street; specific firms ISDA swap contract J. Aron Jedinak, Russell and Rebecca Johnson, Jim biographical information Fannie expansion under on Maxwell style/personality of J.P. Morgan Bear Stearns acquired by BISTRO CEOs. See Weatherstone, Sir Dennis credit default swaps derivatives lobbying by quants/quantitative analysis risk management special purpose entity (SPE) synthetics trading business entry Value at Risk (VaR) measure Jungman, Michael Junk bonds Kamilla, Rajiv Kapnick, Scott Karaoglan, Alain Kemp, Jack Kendall, Leon Kennedy, Judy Killian, Debbie Killinger, Kerry Kim, Dow Kindleberger, Charles Koch, Richard Kolchinsky, Eric Komansky, David Kronthal, Jeff firing of and Fleming Merrill CDOs returns to Merrill Kudlow, Larry Kurland, Stanford as Countrywide president leaves Countrywide style/personality of Kushman, Todd LaFalsce, John Lattanzio, Dale firing of and Merrill CDOs Lay, Ken Lazio, Rick Leach, Jim Lee, Wayne Lehman, David Lehman, Phil Lehman Brothers collapse of fraudulent activities losses (2007) Paulson during collapse Letters of credit Levine, Howard Levitt, Arthur Levy, Gus Lewis, Bob Lewis, Ken Lewis, Michael Lippman, Greg Lipton, Andrew Litton, Larry Litton Loan Servicing Lobbying derivatives supporters by Fannie Mae Lockhart, Jim Loeb, David Long Beach Mortgage establishment of federal investigations of Long Beach Savings & Loan establishment of Goldman deals loans, selling to Wall St.


pages: 354 words: 26,550

High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems by Irene Aldridge

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algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business process, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, New Journalism, p-value, paper trading, performance metric, profit motive, purchasing power parity, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic trading, trade route, transaction costs, value at risk, yield curve

Aside from their fixed-income quality, bonds and interest rate products exhibit little similarity. Both interest rate and bond markets use spot, futures, and swap contracts. Spot trading in both interest rate products and bonds implies instantaneous or “on-the-spot” delivery and transfer of possession of the traded security. Futures trading denotes delivery and transfer of possession at a prespecified date. Swap trading is a contractual transfer of cash flows between two parties. Interest rate swaps may specify swapping of a fixed rate for a floating rate; bond swaps refer mostly to a trading strategy whereby the investor sells one bond and buys another at a comparable price, but with different characteristics. In fixed-income markets, many investors are focused on the product payouts rather than on the prices of the investments themselves. Highfrequency traders taking advantage of short-term price deviations win, as do longer-term investors.

Instead of pricing default risk into the rate explicitly, exchanges trading interest rate futures require borrowers to post collateral accounts that reflect the creditworthiness of the borrower. Swap products are the most populous interest rate category, yet most still trade OTC. Selected swap products have made inroads into electronic trading. CME Group, for example, has created electronic programs for 30day Fed Funds futures and CBOT 5-year, 10-year, and 30-year interest rate swap futures; 30-day Fed Funds options; 2-year, 5-year and 10-year Treasury note options; and Treasury bond options. As Table 4.2 shows, however, electronic trading volumes of interest rate products remain limited. Bond Markets Bonds are publicly issued debt obligations. Bonds can be issued by a virtual continuum of organizations ranging from federal governments through local governments to publicly held corporations.


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Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

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accounting loophole / creative accounting, asset-backed security, bank run, banking crisis, Black-Scholes formula, Bretton Woods, business climate, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial innovation, fixed income, housing crisis, interest rate derivative, interest rate swap, locking in a profit, Long Term Capital Management, McMansion, mortgage debt, North Sea oil, Northern Rock, Renaissance Technologies, risk tolerance, Robert Shiller, Robert Shiller, short selling, sovereign wealth fund, statistical model, The Great Moderation, too big to fail, value at risk, yield curve

Morgan’s books to EBRD, so Morgan would be respecting its client relationship without eating up its internal credit lines. Andrew Donaldson, the EBRD’s director, liked the idea. He agreed that it was highly unlikely Exxon would default, and he was impressed by the steady stream of income from the fees. It was much higher than anything else he could earn on a highly rated bond or loan. “It seemed like a win-win situation,” Donaldson later recalled. Just as Salomon Brothers’ early interest-rate swaps deal between IBM and the World Bank had met two sets of needs, the Exxon deal was brilliantly transferring risk in a way that suited both parties. For several weeks, Masters made endless phone calls to London from New York as she and Donaldson—together with a phalanx of lawyers—worked out legal terms for the deal. In most sectors of finance, well-established rules governed deals. But the credit derivatives concept was so new that they had to be crafted on the fly; Masters was making history as she went.

These developments might have been appealing. Chase Manhattan had always had a formidable sales force, covering numerous corners of the financial world that J.P. Morgan had never managed to reach. It also had its own pool of creative financiers, including some in the CDO world. And, of course, the combined bank now had the advantage of vast size. The combined bank was estimated to control about half of the market for interest-rate swaps, a potentially formidable platform. Indeed, in early 2001, a few months after the merger was completed, the bank was named “Derivatives House of the Year.” Yet, as the J.P. Morgan swaps alums tried to adjust to the Chase influence, it was impossible to recapture the thrill of their early achievements. The fraternal spirit had dissipated, as had the fun, in the new dog-eat-dog atmosphere.


pages: 576 words: 105,655

Austerity: The History of a Dangerous Idea by Mark Blyth

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accounting loophole / creative accounting, balance sheet recession, bank run, banking crisis, Black Swan, Bretton Woods, capital controls, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, deindustrialization, disintermediation, diversification, en.wikipedia.org, ending welfare as we know it, Eugene Fama: efficient market hypothesis, eurozone crisis, financial repression, fixed income, floating exchange rates, Fractional reserve banking, full employment, German hyperinflation, Gini coefficient, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, interest rate swap, invisible hand, Irish property bubble, Joseph Schumpeter, Kenneth Rogoff, liquidationism / Banker’s doctrine / the Treasury view, Long Term Capital Management, market bubble, market clearing, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Occupy movement, offshore financial centre, paradox of thrift, price stability, quantitative easing, rent-seeking, reserve currency, road to serfdom, savings glut, short selling, structural adjustment programs, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, unorthodox policies, value at risk, Washington Consensus

Figure 7.1 The Bubble behind the Bust (1987–2011) Sovereigns are stretched, and eventually liquidity support and zero rates will come to an end on what will be a much weaker underlying economy. Equities will decline in value, commodities too, as global demand weakens, and housing, outside a few markets, is not going to be increasing in value at 7 to 10 percent a year anytime soon. But deprived of fuel for the asset cycle, all those wonderful paper assets that can be based off these booms—commodity ETFs, interest rate swaps, CDOs and CDSs—to name but a few—will cease to be the great money machine that they have been to date. Having pumped and dumped every asset class on the planet, finance may have exhausted its own growth model. The banks’ business model for the past twenty-five years may be dying. If so, saving it in the bust is merely, and most expensively, prolonging the agony. Anticipating John Quiggin’s Zombie Economics, we may have endured austerity to bring back the nearly dead.

(with Keynes), 123, 124–125 Henry, James, 244 Hirschman, Albert, 39, 100, 108, 109 Holland, 4 Hoover, Herbert, 119, 187 Hubbard, Glenn, 243 Hume, David, 17, 100–101, 167 on government debt, 107, 108–109 “On Money”, 107 producing austerity, 114–115 relationship between and market and the state, 115–122, 123 Hungary and austerity, 221 hyperinflation in the 1920s, 56 Hutchinson, Martin, 207, 209 Iceland bailout in, 231 economic strategies in, 235–240 Stock Exchange, 237 inflation, 240, 241 ING, 83 Inoue, Junnosuke, 198, 200 Inside Job, (documentary), 21 interest rate swaps, 234 international capital-flow cycle, 11 International Monetary Fund, 3, 17, 45, 55 and austerity, 122, 206, 213, 221 and bailouts, 71–73, 221 and loans to Ireland, 235 and the Bretton Woods institutions, 162–163 and the consolidation in Denmark, 207 and the hidden “Treasury View”, 163–165 and the situation in Iceland, 238–239 and the success of the REBLL states, 216 and “the Washington consensus”, 102, 161–163, 164 Polak model, 163–165 World Economic Outlook, 212, 215 See also Kahn, Dominique Strauss Ireland, 3, 4, 5, 205, 222 austerity in, 17, 169–170, 179, 205, 206 expansion, 207–208, 209 bailout in, 221, 231 capital-flow cycle in, 11 economic strategies in, 235–240 Eurozone current account imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 fiscal adjustment in, 173 government debt 2006–2012, 46, 47, 53, 62, 65, 66 real estate in rise in prices, 27, 64–68 Italy, 1, 3, 4, 5, 222 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 fiscal adjustment in, 173 government debt 2006–2012, 47, 53, 62 slow growth crisis, 68–71 slow-growth problem, 69 sovereign debt of, 108 Janeway, Bill, 125 Jayadev, Arjun, 212, 213 Japan and Keynesianism, 225 and the London Naval Treaty, 199, d austerity in, 17, 178–180, 197–200, 204 Bank of Japan, 197 Seiyukai party, 199 Showa Depression, 198 See also Hamaguchi, Prime Minister; Korekiyo, Takahashi Johnson, Simon, 11, 72 Kahn, Dominique Strauss, 222 Kahn, R.


pages: 361 words: 97,787

The Curse of Cash by Kenneth S Rogoff

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Andrei Shleifer, Asian financial crisis, bank run, Ben Bernanke: helicopter money, Berlin Wall, bitcoin, blockchain, Bretton Woods, capital controls, Carmen Reinhart, cashless society, central bank independence, cryptocurrency, debt deflation, distributed ledger, Edward Snowden, ethereum blockchain, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial intermediation, financial repression, forward guidance, frictionless, full employment, George Akerlof, German hyperinflation, illegal immigration, inflation targeting, informal economy, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, Kenneth Rogoff, labor-force participation, large denomination, liquidity trap, money: store of value / unit of account / medium of exchange, moral hazard, moveable type in China, New Economic Geography, offshore financial centre, oil shock, open economy, payday loans, price stability, purchasing power parity, quantitative easing, RAND corporation, RFID, savings glut, secular stagnation, seigniorage, The Great Moderation, the payments system, transaction costs, unbanked and underbanked, unconventional monetary instruments, underbanked, unorthodox policies, Y2K, yield curve

That risk should be more than enough to discourage your average billionaire from this practice. On top of that, the Internal Revenue Service exercises considerable discretion over the timing of the refund; it is hardly a fully liquid asset. There are many solutions to the tax prepayment problem, and it is just not a serious obstacle. We discussed in chapter 10 the logistical complications that negative rates could create for bond issuers, and how they might be resolved. Relatedly, interest rate swap markets have become a key element of the financial ecosystem, allowing firms to conveniently hedge interest rate risk. A world of negative rates might require a restructuring of some of the institutions and legal frameworks surrounding these markets, but again, early experience in Europe suggests that this issue may not be nearly as problematic as some feared. Some worry that in a world of negative interest rates, the custom of allowing the recipient of a check to decide when to cash it could be problematic.

., 234n6 history of currency, 15–17; birth of paper currency in China, 21–25; early coinage, 17–20; Franklin and paper currency in the colonial United States, 26–28; from gold-backed to pure fiat paper currency, 28–30; origin of coinage, 21; private notes in Europe, 25–26 hoarding, problem of, 87–88, 97, 115, 175, 233n8 Hong Kong: currency/GDP ratio, 2015, 36; currency per capita, 37, 40; foreign demand for paper currency of, 34; foreign holdings of currency, 41, 236n13 Hong Kong Monetary Authority, 138 horizontal equity, 59 human trafficking, 73–74 Ice Cube (musician, actor), 233n5 illegal drug market, estimated size of, 69 illegal immigration, 2, 74–76 Incas, 16–17 India, 73, 204, 215 inflation: Bitcoin and, 213; cumulative change in a currency’s value versus the dollar, examples of, 184; of early Chinese paper currencies, 23–25; fiscally engineered, 157; governmental default on debt and, 184–86; government intentions regarding, the negative interest rate and, 183–84; higher, drawbacks to, 149–50; historical examples of high, 183–84; optimal choice of inflation target, effect of proposal on, 105–6; quantitative easing and, 136–37; rates of and wages/unemployment, 247n1; 4% target for, 121, 125–26, 133, 147–50, 152–53; target inflation rates, the zero bound constraint and, 147–51; targeting, relaxing rigidity of the framework for, 152–54, 231–32; tightening policies of Volcker and Thatcher in response to, 119–20; in the United States, periods of, 27–28; war financing and, 27–28; the zero bound problem and collapse of, 120 inflation-targeting evangelism, 120, 232 inflation tax, 80, 82 interest-paying anonymous bearer bonds, 233n6 interest rates: central bank cuts in response to recent crises, 131–32; financial stability and, 177; monetary cost seigniorage and, 87; negative (see negative interest rates); New York Federal Reserve discount rates, 1929–1939, 128–29; nominal and real, 121, 243n1; nominal policy for the United States, Eurozone, and United Kingdom, 2000–2015, 130; opportunity cost seigniorage and, 82–83; on paper currency, Gesell’s proposal for, 163–67; quantitative easing and, 137–38 (see also quantitative easing); United Kingdom, 1930–present, 128; United Kingdom and United States short-term market, 1929–1939, 129; zero bound, at or near the, 130–32 interest rate swap markets, 180 Internal Revenue Service (IRS), 60 international dimensions to phasing out paper currency, 199; coordinated action, benefits of, 202–4; emerging markets, 204–5; foreign notes as substitutes for domestic ones, 199–201; forgone profits from supplying the world underground with currency, 202–4 international monetary policy coordination, 205–6 Irons, Jeremy (actor, Moonlighting), 74 ISIS (Islamic State of Iraq and Syria), 77 Israel, 131 Issing, Otmar, 7 Italy: cash used for different kinds of purchases, percentage of, 55–56; currency/GDP ratio, 1995, 46; restrictions on the use of cash, 64; seigniorage revenues from currency, 85; underground economy, estimated size of, 62–63 Itami, Juzo, 236n8 Itskhoki, Oleg, 250n18 Jackson, Andrew (US president), 192 Japan: cash circulating, amount of, 35–36, 235n6; currency/GDP ratio, 1953–2015, 35; currency per capita, 37, 40; double-digit inflation, 183; interest rates near the zero bound, 131; large-denomination notes, 31; loss of seigniorage as nonissue, 203; negative interest rates by the central bank, 123; negative interest rates in, 5; paper currency phaseout, costs and benefits of, 89–90; underground economy, 35; zero bound, continued struggle with, 122.


pages: 471 words: 124,585

The Ascent of Money: A Financial History of the World by Niall Ferguson

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Admiral Zheng, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collateralized debt obligation, colonial exploitation, Corn Laws, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, German hyperinflation, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, interest rate swap, Isaac Newton, iterative process, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour mobility, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Naomi Klein, Nick Leeson, Northern Rock, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, structural adjustment programs, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Malthus, Thorstein Veblen, too big to fail, transaction costs, value at risk, Washington Consensus, Yom Kippur War

In 2006, for example, the volume of leveraged buyouts (takeovers of firms financed by borrowing) surged to $753 billion. An explosion of ‘securitization’, whereby individual debts like mortgages are ‘tranched’ then bundled together and repackaged for sale, pushed the total annual issuance of mortgage backed securities, asset-backed securities and collateralized debt obligations above $3 trillion. The volume of derivatives - contracts derived from securities, such as interest rate swaps or credit default swaps (CDS) - has grown even faster, so that by the end of 2007 the notional value of all ‘over-the-counter’ derivatives (excluding those traded on public exchanges) was just under $600 trillion. Before the 1980s, such things were virtually unknown. New institutions, too, have proliferated. The first hedge fund was set up in the 1940s and, as recently as 1990, there were just 610 of them, with $38 billion under management.

When the price passes the agreed strike price, the option is ‘in the money’ - and so is the smart guy who bought it. A put option is just the opposite: the buyer has the right, but not the obligation, to sell an agreed quantity of something to the seller of the option. A third kind of derivative is the swap, which is effectively a bet between two parties on, for example, the future path of interest rates. A pure interest rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit default swap, meanwhile, offers protection against a company’s defaulting on its bonds. Perhaps the most intriguing kind of derivative, however, are the weather derivatives like natural catastrophe bonds, which allow insurance companies and others to offset the effects of extreme temperatures or natural disasters by selling the so-called tail risk to hedge funds like Fermat Capital.


pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

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asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, implied volatility, interest rate swap, market friction, market microstructure, p-value, performance metric, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, yield curve

But hedging some risks in-house may bring benefits (e.g. reduction of tax burden, smoothing of returns, easier planning) that are not directly attainable by the shareholder. Financial firms, of course, should be the experts at managing market risks; it is their métier. Indeed, over the last generation, there has been a marked increase in the size of market risks handled by banks in comparison to a reduction in the size of their credit risks. Since the 1980s, banks have provided products (e.g. interest rate swaps, currency protection, index linked loans, capital guaranteed investments) to facilitate the risk management of their customers. They have also built up arbitrage and proprietary trading books to profit from perceived market anomalies and take advantage of their market views. More recently, banks have started to manage credit risks actively by transferring them to the capital markets instead of warehousing them.

For instance in Chapter I.6 we introduce utility functions, which are used to assess the optimal trade-off between risk and return. The first and second derivatives of an investor’s utility function tell us whether the investor is risk averse, risk loving or risk neutral. 2 Quantitative Methods in Finance context refers to a financial instrument that is a contract on a contract, such as a futures contract on an interest rate, or an option on an interest rate swap.3 We shall employ numerous sensitivities throughout these volumes. For instance, the first order yield sensitivity of a bond is called the modified duration. This is the first partial derivative of the bond price with respect to the yield, expressed as a percentage of the price; and the second order yield sensitivity of a bond is called the convexity. This is the second derivative of the bond price with respect to its yield, again expressed as a percentage of the price.


pages: 435 words: 127,403

Panderer to Power by Frederick Sheehan

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Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, British Empire, call centre, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversification, financial deregulation, financial innovation, full employment, inflation targeting, interest rate swap, inventory management, Isaac Newton, Long Term Capital Management, margin call, market bubble, McMansion, Menlo Park, mortgage debt, new economy, Northern Rock, oil shock, place-making, Ponzi scheme, price stability, reserve currency, rising living standards, rolodex, Ronald Reagan, Sand Hill Road, savings glut, shareholder value, Silicon Valley, Silicon Valley startup, South Sea Bubble, supply-chain management, supply-chain management software, The Great Moderation, too big to fail, transaction costs, trickle-down economics, VA Linux, Y2K, Yom Kippur War

. … [O]ne of the key lessons from our banking history [is] that private counterparty supervision is still the first line of regulatory defense.” “Counterparty” may need an explanation. Banks have counterparty risk to their borrowers: the borrower may not repay a loan. That was a concern when the value of LTCM’s collateral fell below the amount of money it had borrowed. There is also counterparty risk in a derivative contract. A hypothetical example: when Citigroup and J. P. Morgan enter an interest-rate swap, Citigroup will receive floating-rate interest payments every six months, and J. P. Morgan will receive fixed-rate interest payments at the same time.5 The interest-rate payments are computed based on a principal amount upon which the interest is earned: $100 million, for instance. The “counterparty” risk is that one of the participants fails and cannot pay back the $100 million of principal.

On September 21, when it seems (interpreting the transcript) the Fed first read LTCM’s balance sheet, its leverage was 55 to 1. A staffer offered more bad news: “The off-balance-sheet leverage was 100 to 1 or 200 to 1—I don’t know how to calculate it.”17 The staffer wasn’t alone. 14 Ibid., p. 118. 15 Ibid., pp. 110–111. 16 Ibid., p. 108. 17 Ibid., p. 108. Greenspan’s “first line of regulatory defense” didn’t know whether LTCM was trading interest-rate swaps or stolen cars. Greenspan expressed his exasperation several times during the meeting: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of institutions is just mind boggling.”18 So boggled was the man that Greenspan (and his successor Ben Bernanke) allowed the commercial banking system to leverage as never before, writing over $100 trillion worth of derivatives contracts between then and 2008—without so much as a dollar bill of reserves for these off-balance-sheet structures.


pages: 566 words: 155,428

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, banks create money, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial innovation, fixed income, friendly fire, full employment, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, market clearing, market fundamentalism, McMansion, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, price mechanism, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, working-age population, yield curve, Yogi Berra

Well, actually, you don’t have to imagine it. We did it. In the case of derivatives, a little history is instructive. While their ancestry dates back centuries, modern financial derivatives really came into their own in the late 1980s and early 1990s. The International Swaps and Derivatives Association (ISDA), the industry’s trade association, estimates that the notional value of outstanding privately negotiated derivatives—mostly interest-rate swaps—amounted to under $1 trillion at the end of 1987. But they grew like kudzu, to $11 trillion by the end of 1992 and a staggering $69 trillion by 2001. WHAT IS A DERIVATIVE? “Derivative” is a generic term for any security or contract whose value is derived from that of some underlying natural security, such as a stock or a bond. Instead of owning the asset, and either profiting or losing as its price rises or falls, a derivative is a bet on some aspect of its behavior.

See AIG (American International Group) Insurance contract, credit default swaps (CDS) as, 66–67, 132 Interest rates and bond prices, 40 cuts, Keynesian view, 210–12 expectations theory of yield curve, 222–23 funds rate cuts (2007), 91–93, 95, 172 funds rate cuts (2008), 221–23, 352, 372 and high federal debt, 395 and home-price bubble, 33, 38 and inflation, 376–78 low, Fed policy, 38, 46 nominal and real, 376–78 normalizing, future view, 372–74, 378, 431 on repurchase agreements (repos), 53 risk premium. See Interest-rate spreads time value of money, 29 unconventional tactics by Fed. See Unconventional monetary policy (UMP) Interest-rate spreads, 237–43 and bond-related risk, 41–42 and European crisis, 410 in normal economy, 239, 241 quantitative easing (QE) to reduce, 248–56 reducing, methods of, 242–43 widening and crisis, 237–40 Interest-rate swaps, 60 International Swaps and Derivatives Association (ISDA), 60 Internet bubble, 35, 38 Investment banks Bulge Bracket firms. See Bear Stearns; Goldman Sachs; Lehman Brothers; Merrill Lynch; Morgan Stanley credit-ratings, manipulation of, 80–81 as derivative broker-dealers, 61 executive compensation, 81–84 federal bailouts for. See Bailouts and Glass-Steagall repeal, 266–67 largest, asset sizes, 111 leverage ratio of, 52–53 opacity, benefits to, 78–79 in shadow banking system, 60 short-term borrowing problem, 52–53 TARP funds forced on, 200–203, 208 Ireland, financial crisis, 168, 170, 382, 410, 411–12, 413, 418, 428 Italy, financial crisis, 418, 419, 428 Job loss.


pages: 393 words: 115,263

Planet Ponzi by Mitch Feierstein

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Bernie Madoff, centre right, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, disintermediation, diversification, Donald Trump, energy security, eurozone crisis, financial innovation, financial intermediation, Flash crash, floating exchange rates, frictionless, frictionless market, high net worth, High speed trading, illegal immigration, income inequality, interest rate swap, invention of agriculture, Long Term Capital Management, moral hazard, mortgage debt, Northern Rock, obamacare, offshore financial centre, oil shock, pensions crisis, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, purchasing power parity, quantitative easing, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, too big to fail, trickle-down economics, value at risk, yield curve

Many derivatives contracts are based on some notional outstanding amount. So, for example, if you are paying a floating interest rate on some debt, and you’d prefer to pay a fixed interest rate instead, you and I could arrange a deal whereby we enter into a interest rate swap agreement. I’ll pay you a floating rate‌—‌for example, three-month Libor. In exchange, you pay me an agreed fixed rate‌—‌for example, 4%. In effect, you’ve swapped your floating rate obligation for a fixed rate obligation. That achieves your objective. Now, if you borrowed $100 million in the first place, and if our interest rate swap was for that full $100 million, then the notional principal outstanding is $100 million. That doesn’t, however, mean that anything like that amount of cash is at stake. It isn’t. In practice, the two sets of payments (my floating rate payment to you; your fixed rate payment to me) are set against each other.

The Handbook of Personal Wealth Management by Reuvid, Jonathan.

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asset allocation, banking crisis, BRICs, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, market bubble, merger arbitrage, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

Specialists can help evaluate an aircraft’s integrity and history of maintenance and damage, as ____________________________________________________ ADVISORY SERVICES 49 ឣ well as the fairness of the seller’s asking price. It is important to go through these steps so undisclosed damage can be uncovered. Buyers will need to choose from an extensive choice of credit structures, including fixed and variable-rate loans, flexible lines of credit and innovative interest-rate swaps. Lending terms and payment schedules can be designed to accommodate the client’s specific requirements, including issues pertaining to tax efficiency, cash-flow management and other financial goals. In addition, refinancing can be a valuable way to free up some of the equity in an aircraft that is owned outright. If current interest rates are lower than those on an original aircraft loan, refinancing may be a cost-effective option that yields substantial savings.


pages: 322 words: 77,341

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

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asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black-Scholes formula, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, fixed income, George Akerlof, greed is good, hindsight bias, housing crisis, Hyman Minsky, interest rate swap, invisible hand, Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, laissez-faire capitalism, liquidity trap, Long Term Capital Management, loss aversion, Martin Wolf, mortgage debt, mortgage tax deduction, mutually assured destruction, new economy, Nick Leeson, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, tulip mania, value at risk

The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Bill Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest rate swaps, and credit default swaps greatly increased the volume of transactions that bankers could make money on. And the aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services. Not surprisingly, Wall Street ran with these opportunities.


pages: 209 words: 13,138

Empirical Market Microstructure: The Institutions, Economics and Econometrics of Securities Trading by Joel Hasbrouck

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barriers to entry, conceptual framework, correlation coefficient, discrete time, disintermediation, distributed generation, experimental economics, financial intermediation, index arbitrage, interest rate swap, inventory management, market clearing, market design, market friction, market microstructure, martingale, price discovery process, price discrimination, quantitative trading / quantitative finance, random walk, Richard Thaler, second-price auction, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, two-sided market, ultimatum game

Many of the same financial institutions that rely heavily on electronic access to markets have also gone to great lengths and expense to maintain the trading operations for their diverse markets together on large, contiguous trading floors. This facilitates coordination when a deal involves multiple markets. The pricing and offering of a corporate bond, for example, might well involve the government bond, interest-rate swap, credit swap, and/or the interest rate futures desks. Thus, while no longer necessary to realize (in a single market) economies of scale, personal proximity may promote (across multiple markets) economies of scope. 2.3 Dealers 2.3.1 Dealer Markets A dealer is simply an intermediary who is willing to act as a counterparty for the trades of his customers. A dealer, or, more commonly, a network of geographically dispersed electronically linked dealers, may be the dominant mechanism for trade.


pages: 192 words: 75,440

Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel

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backtesting, barriers to entry, collateralized debt obligation, commodity trading advisor, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, family office, fixed income, high net worth, interest rate derivative, interest rate swap, Long Term Capital Management, merger arbitrage, offshore financial centre, random walk, Renaissance Technologies, risk-adjusted returns, rolodex, short selling, side project, statistical arbitrage, systematic trading, unpaid internship, value at risk, yield curve, yield management

Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while protecting principal from market moves. Fixed Income Arbitrage A fund that follows this strategy aims to profit from price anomalies between related interest rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, U.S. and non-U.S. government bond arbitrage, forward yield curve arbitrage, and mortgage-backed securities (MBS) arbitrage. The mortgage-backed market is primarily U.S.-based, over-the-counter (OTC), and particularly complex. Note: Fixed income arbitrage is a generic description of a variety of strategies involving investments in fixed income instruments, and weighted in an attempt to eliminate or reduce exposure to changes in the yield curve.


pages: 192 words: 72,822

Freedom Without Borders by Hoyt L. Barber

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accounting loophole / creative accounting, Affordable Care Act / Obamacare, Albert Einstein, banking crisis, diversification, El Camino Real, estate planning, fiat currency, financial independence, fixed income, high net worth, illegal immigration, interest rate swap, obamacare, offshore financial centre, passive income, quantitative easing, reserve currency, road to serfdom, too big to fail

THE BENEFITS OF OWNING YOUR OWN OFFSHORE INTERNATIONAL BANK Today, even in this challenging economic climate, and in light of the changes in laws related to tax havens and banking, there is still an attractive offshore jurisdiction where it is possible to secure your own Class 1 banking license permitting global banking for only US $98,000. The capitalization and qualification requirements are reasonable. Licensing also includes an excellent correspondent bank relationship. 30 Freedom Without Borders The bank has full power and authority to conduct all banking business that banks in Europe and North America can do (e.g., it can offer CDs and bank paper of all kinds, trade currencies, do interest rate swaps, and offer mortgages). It can conduct banking business with any client in any part of the world, except for the jurisdiction where it’s chartered and licensed. A Class 1 banking license has no requirements or limits on lending, with the exception that the bank may not lend out any loans or advances to directors or shareholders in excess of 1 percent of paid- in capital. Upon issuance of the license, the bank must be capitalized with a minimum of US $1 million in cash or listed securities or other liquid assets, such as precious metals, and the bank must maintain US $500,000 in liquid reserves (cash) on deposit with the National Bank.

Mathematics for Finance: An Introduction to Financial Engineering by Marek Capinski, Tomasz Zastawniak

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Black-Scholes formula, Brownian motion, capital asset pricing model, cellular automata, delta neutral, discounted cash flows, discrete time, diversified portfolio, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, martingale, quantitative trading / quantitative finance, random walk, short selling, stochastic process, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

Glossary of Symbols A B β c C C CA CE E C Cov delta div div0 D D DA E E∗ f F gamma Φ k K i m fixed income (risk free) security price; money market account bond price beta factor covariance call price; coupon value covariance matrix American call price European call price discounted European call price covariance Greek parameter delta dividend present value of dividends derivative security price; duration discounted derivative security price price of an American type derivative security expectation risk-neutral expectation futures price; payoff of an option; forward rate forward price; future value; face value Greek parameter gamma cumulative binomial distribution logarithmic return return coupon rate compounding frequency; expected logarithmic return 305 306 Mathematics for Finance M m µ N N k ω Ω p p∗ P PA PE P E PA r rdiv re rF rho ρ S S σ t T τ theta u V Var VaR vega w w W x X y z market portfolio expected returns as a row matrix expected return cumulative normal distribution the number of k-element combinations out of N elements scenario probability space branching probability in a binomial tree risk-neutral probability put price; principal American put price European put price discounted European put price present value factor of an annuity interest rate dividend yield effective rate risk-free return Greek parameter rho correlation risky security (stock) price discounted risky security (stock) price standard deviation; risk; volatility current time maturity time; expiry time; exercise time; delivery time time step Greek parameter theta row matrix with all entries 1 portfolio value; forward contract value, futures contract value variance value at risk Greek parameter vega symmetric random walk; weights in a portfolio weights in a portfolio as a row matrix Wiener process, Brownian motion position in a risky security strike price position in a fixed income (risk free) security; yield of a bond position in a derivative security Index admissible – portfolio 5 – strategy 79, 88 American – call option 147 – derivative security – put option 147 amortised loan 30 annuity 29 arbitrage 7 at the money 169 attainable – portfolio 107 – set 107 183 basis – of a forward contract 128 – of a futures contract 140 basis point 218 bear spread 208 beta factor 121 binomial – distribution 57, 180 – tree model 7, 55, 81, 174, 238 Black–Derman–Toy model 260 Black–Scholes – equation 198 – formula 188 bond – at par 42, 249 – callable 255 – face value 39 – fixed-coupon 255 – floating-coupon 255 – maturity date 39 – stripped 230 – unit 39 – with coupons 41 – zero-coupon 39 Brownian motion 69 bull spread 208 butterfly 208 – reversed 209 call option 13, 181 – American 147 – European 147, 188 callable bond 255 cap 258 Capital Asset Pricing Model 118 capital market line 118 caplet 258 CAPM 118 Central Limit Theorem 70 characteristic line 120 compounding – continuous 32 – discrete 25 – equivalent 36 – periodic 25 – preferable 36 conditional expectation 62 contingent claim 18, 85, 148 – American 183 – European 173 continuous compounding 32 continuous time limit 66 correlation coefficient 99 coupon bond 41 coupon rate 249 307 308 covariance matrix 107 Cox–Ingersoll–Ross model 260 Cox–Ross–Rubinstein formula 181 cum-dividend price 292 delta 174, 192, 193, 197 delta hedging 192 delta neutral portfolio 192 delta-gamma hedging 199 delta-gamma neutral portfolio 198 delta-vega hedging 200 delta-vega neutral portfolio 198 derivative security 18, 85, 253 – American 183 – European 173 discount factor 24, 27, 33 discounted stock price 63 discounted value 24, 27 discrete compounding 25 distribution – binomial 57, 180 – log normal 71, 186 – normal 70, 186 diversifiable risk 122 dividend yield 131 divisibility 4, 74, 76, 87 duration 222 dynamic hedging 226 effective rate 36 efficient – frontier 115 – portfolio 115 equivalent compounding 36 European – call option 147, 181, 188 – derivative security 173 – put option 147, 181, 189 ex-coupon price 248 ex-dividend price 292 exercise – price 13, 147 – time 13, 147 expected return 10, 53, 97, 108 expiry time 147 face value 39 fixed interest 255 fixed-coupon bond 255 flat term structure 229 floating interest 255 floating-coupon bond 255 floor 259 floorlet 259 Mathematics for Finance forward – contract 11, 125 – price 11, 125 – rate 233 fundamental theorem of asset pricing 83, 88 future value 22, 25 futures – contract 134 – price 134 gamma 197 Girsanov theorem 187 Greek parameters 197 growth factor 22, 25, 32 Heath–Jarrow–Morton model hedging – delta 192 – delta-gamma 199 – delta-vega 200 – dynamic 226 in the money 169 initial – forward rate 232 – margin 135 – term structure 229 instantaneous forward rate interest – compounded 25, 32 – fixed 255 – floating 255 – simple 22 – variable 255 interest rate 22 interest rate option 254 interest rate swap 255 261 233 LIBID 232 LIBOR 232 line of best fit 120 liquidity 4, 74, 77, 87 log normal distribution 71, 186 logarithmic return 34, 52 long forward position 11, 125 maintenance margin 135 margin call 135 market portfolio 119 market price of risk 212 marking to market 134 Markowitz bullet 113 martingale 63, 83 Index 309 martingale probability 63, 250 maturity date 39 minimum variance – line 109 – portfolio 108 money market 43, 235 no-arbitrage principle 7, 79, 88 normal distribution 70, 186 option – American 183 – at the money 169 – call 13, 147, 181, 188 – European 173, 181 – in the money 169 – interest rate 254 – intrinsic value 169 – out of the money 169 – payoff 173 – put 18, 147, 181, 189 – time value 170 out of the money 169 par, bond trading at 42, 249 payoff 148, 173 periodic compounding 25 perpetuity 24, 30 portfolio 76, 87 – admissible 5 – attainable 107 – delta neutral 192 – delta-gamma neutral 198 – delta-vega neutral 198 – expected return 108 – market 119 – variance 108 – vega neutral 197 positive part 148 predictable strategy 77, 88 preferable compounding 36 present value 24, 27 principal 22 put option 18, 181 – American 147 – European 147, 189 put-call parity 150 – estimates 153 random interest rates random walk 67 rate – coupon 249 – effective 36 237 – forward 233 – – initial 232 – – instantaneous 233 – of interest 22 – of return 1, 49 – spot 229 regression line 120 residual random variable 121 residual variance 122 return 1, 49 – expected 53 – including dividends 50 – logarithmic 34, 52 reversed butterfly 209 rho 197 risk 10, 91 – diversifiable 122 – market price of 212 – systematic 122 – undiversifiable 122 risk premium 119, 123 risk-neutral – expectation 60, 83 – market 60 – probability 60, 83, 250 scenario 47 security market line 123 self-financing strategy 76, 88 short forward position 11, 125 short rate 235 short selling 5, 74, 77, 87 simple interest 22 spot rate 229 Standard and Poor Index 141 state 238 stochastic calculus 71, 185 stochastic differential equation 71 stock index 141 stock price 47 strategy 76, 87 – admissible 79, 88 – predictable 77, 88 – self-financing 76, 88 – value of 76, 87 strike price 13, 147 stripped bond 230 swap 256 swaption 258 systematic risk 122 term structure 229 theta 197 time value of money 21 310 trinomial tree model Mathematics for Finance 64 underlying 85, 147 undiversifiable risk 122 unit bond 39 value at risk 202 value of a portfolio 2 value of a strategy 76, 87 VaR 202 variable interest 255 Vasiček model 260 vega 197 vega neutral portfolio volatility 71 weights in a portfolio Wiener process 69 yield 216 yield to maturity 229 zero-coupon bond 39 197 94


pages: 327 words: 103,336

Everything Is Obvious: *Once You Know the Answer by Duncan J. Watts

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affirmative action, Albert Einstein, Amazon Mechanical Turk, Black Swan, butterfly effect, Carmen Reinhart, Cass Sunstein, clockwork universe, cognitive dissonance, collapse of Lehman Brothers, complexity theory, correlation does not imply causation, crowdsourcing, death of newspapers, discovery of DNA, East Village, easy for humans, difficult for computers, edge city, en.wikipedia.org, Erik Brynjolfsson, framing effect, Geoffrey West, Santa Fe Institute, happiness index / gross national happiness, high batting average, hindsight bias, illegal immigration, interest rate swap, invention of the printing press, invention of the telescope, invisible hand, Isaac Newton, Jane Jacobs, Jeff Bezos, Joseph Schumpeter, Kenneth Rogoff, lake wobegon effect, Long Term Capital Management, loss aversion, medical malpractice, meta analysis, meta-analysis, Milgram experiment, natural language processing, Netflix Prize, Network effects, oil shock, packet switching, pattern recognition, performance metric, phenotype, planetary scale, prediction markets, pre–internet, RAND corporation, random walk, RFID, school choice, Silicon Valley, statistical model, Steve Ballmer, Steve Jobs, Steve Wozniak, supply-chain management, The Death and Life of Great American Cities, the scientific method, The Wisdom of Crowds, too big to fail, Toyota Production System, ultimatum game, urban planning, Vincenzo Peruggia: Mona Lisa, Watson beat the top human players on Jeopardy!, X Prize

It’s a reasonable idea, but as the recent real estate bubble demonstrated, faulty assumptions can appear valid for years at a time. So although stretching out the vesting period diminishes the role of luck in determining outcomes, it certainly doesn’t eliminate it. In addition to averaging performance over an extended period, therefore, another way to try to differentiate individual talent from luck is to index performance relative to a peer group, meaning that a trader working in a particular asset class—say, interest rate swaps—should receive a bonus only for outperforming an index of all traders in that asset class. Put another way, if everybody in a particular market or industry makes money at the same time—as all the major investment banks did in the first quarter of 2010—we ought to suspect that performance is being driven by a secular trend, not individual talent. Delaying bonuses and indexing performance to peers are worthy ideas, but they may still not solve the deeper problem of differentiating luck from talent.


pages: 358 words: 106,729

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

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accounting loophole / creative accounting, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, barriers to entry, Bernie Madoff, Bretton Woods, business climate, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, diversification, Edward Glaeser, financial innovation, floating exchange rates, full employment, global supply chain, Goldman Sachs: Vampire Squid, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, market bubble, Martin Wolf, medical malpractice, microcredit, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, price stability, profit motive, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, school vouchers, short selling, sovereign wealth fund, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs. This proposal probably goes too far, as many products are minor tweaks on previous ones, are not life threatening, and cannot really be understood until tried out.


pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

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asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, statistical model, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve

That having been said, there are unique features of some investment strategies (fixed income and exchange traded equities) that have permitted them to be universally accepted as asset classes. Extrapolating these conventions provides an aid in understanding the return and risk properties as well as trading patterns inherent in establishing an accepted asset class. Beyond taking different approaches, there are also different conventions. Some investors view currencies as a separate asset class while fully understanding that currencies may also be viewed as simple short-term interest rate swap between countries. Some investors refuse to pay managers for cash held in a multi-asset portfolio on the grounds that they should only pay when and where their monies are invested in specific assets and that cash is a placeholder. As we find our way through new terrain, there is a range of issues in determining the taxonomy for asset class determination; however, degree of difficulty must not be the stopping point of establishing a process by which we address asset allocation issues.7 The approach must be the creation of a map.


pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, mortgage debt, new economy, Occupy movement, passive investing, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam

The reality of transaction costs, however, suggests that we should pay more attention to total trading volume—including both purchases and sales—an incredible $5.4 trillion in total transactions, not far from one-and-a-half times the $3.8 trillion of equity fund assets of the group. However high the levels of mutual fund trading in stocks have soared relative to traditional norms, they pale by comparison to the trading volumes of hedge funds, to say nothing of the levels of trading in exotic securities such as interest rate swaps, collateralized debt obligations, derivatives such as futures on commodities, stock indexes, stocks, and even bets on whether a given company will go into bankruptcy (credit default swaps). The aggregate nominal value of these instruments, as I noted in Chapter 1, now exceeds $700 trillion. Yes, what we have come to describe as speculation has clearly come to play the starring role in our nation’s huge financial market colossus, with investment taking only a supporting role, if not a cameo role.


pages: 313 words: 34,042

Tools for Computational Finance by Rüdiger Seydel

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bioinformatics, Black-Scholes formula, Brownian motion, continuous integration, discrete time, implied volatility, incomplete markets, interest rate swap, linear programming, London Interbank Offered Rate, mandelbrot fractal, martingale, random walk, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, zero-coupon bond

The buying or selling of the underlying asset by exercising the option at a future date (t = T ) must be distinguished from the purchase of the option (at t = 0, say), for which a premium ist paid. After the Chicago Board of Options Exchange (CBOE) opened in 1973, the volume of the trading with options has grown dramatically. Options are discussed in more detail in Section 1.1. Swaps are contracts regulating an exchange of cash flows at different future times. A common type of swap is the interest-rate swap, in which two parties exchange interest payments periodically, typically fixed-rate payments for floating-rate payments. Counterparty A agrees to pay to counterparty B a fixed interest rate on some notional principal, and in return party B agrees to pay party A interest at a floating rate on the same notional principal. The principal itself is not exchanged. Each of the parties borrows the money at his market.


pages: 385 words: 111,807

A Pelican Introduction Economics: A User's Guide by Ha-Joon Chang

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, Berlin Wall, bilateral investment treaty, borderless world, Bretton Woods, British Empire, call centre, capital controls, central bank independence, collateralized debt obligation, colonial rule, Corn Laws, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, discovery of the americas, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, falling living standards, financial deregulation, financial innovation, Francis Fukuyama: the end of history, Frederick Winslow Taylor, full employment, George Akerlof, Gini coefficient, global value chain, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, Haber-Bosch Process, happiness index / gross national happiness, high net worth, income inequality, income per capita, interchangeable parts, interest rate swap, inventory management, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, knowledge economy, laissez-faire capitalism, land reform, manufacturing employment, Mark Zuckerberg, market clearing, market fundamentalism, Martin Wolf, means of production, Mexican peso crisis / tequila crisis, Northern Rock, obamacare, offshore financial centre, oil shock, open borders, post-industrial society, precariat, principal–agent problem, profit maximization, profit motive, purchasing power parity, quantitative easing, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, Scramble for Africa, shareholder value, Silicon Valley, Simon Kuznets, sovereign wealth fund, spinning jenny, structural adjustment programs, The Great Moderation, The Market for Lemons, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, trade liberalization, transaction costs, transfer pricing, trickle-down economics, Washington Consensus, working-age population, World Values Survey

For example, it allows you to replace a series of variable future payments or earnings with a series of fixed payments or earnings, like contracts for your mobile phone or fixed-price electricity deals over a period, according to Scott’s instructive analogy.5 The variation in payments or earnings could be due to variations in all sorts of things, so there are many different types of swaps; interest rates (interest rate swaps), exchange rates (currency swaps), commodity prices (commodity swaps), share prices (equity swaps), or even default risk of particular financial products (CDSs). At this point, your head may be spinning at the complexity of things, but that is in a way the point. The complexity of these new financial products is exactly what made them so dangerous, as I shall explain later. Derivative trade took off in the 1980s Derivative markets were not very significant until the early 1980s, although exchanges for currency futures and stock options had been established by the Chicago Board of Trade in the 1970s.6 Then a historic change came in 1982.


pages: 323 words: 92,135

Running Money by Andy Kessler

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Andy Kessler, Apple II, bioinformatics, British Empire, business intelligence, buy low sell high, call centre, Corn Laws, family office, full employment, George Gilder, happiness index / gross national happiness, interest rate swap, invisible hand, James Hargreaves, James Watt: steam engine, joint-stock company, joint-stock limited liability company, knowledge worker, Long Term Capital Management, mail merge, margin call, market bubble, Maui Hawaii, Menlo Park, Network effects, packet switching, pattern recognition, pets.com, railway mania, risk tolerance, Sand Hill Road, Silicon Valley, South China Sea, spinning jenny, Steve Jobs, Steve Wozniak, Toyota Production System

That smart guy would step into the middle of the trade and make money. But now the action was in options and futures. You needed advanced calcu- 16 Running Money lus to figure out the value of those. But Nash wasn’t thinking about puts and calls. Here was an old-fashioned trader looking to get in the flow. He was clearly a guy who couldn’t let go. I’m used to the “roving eye” at meetings. One guy in Denver was trading interest rate swaps for his own account while we talked. He checked the quote screen in his office so often, I thought his eyeballs would pop out. But even he was an amateur compared to this. Fred finished up and there was a long silence. I jumped in. “Thanks again for taking the time to meet with us. We would be honored to have you involved in our fund.” “Yes, yes, but you haven’t told me what makes you unique,” Jack admonished.


pages: 389 words: 109,207

Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone

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Albert Einstein, anti-communist, asset allocation, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John von Neumann, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, New Journalism, Norbert Wiener, offshore financial centre, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, short selling, speech recognition, statistical arbitrage, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond

LTCM’s people were well aware that multiplying profits through leverage also multiplies risk of ruin. They told investors that they had risk under control through their financial engineering. LTCM used a sophisticated form of the industry standard risk reporting system, VaR or “Value at Risk.” After the Black Monday crash of 1987, investment bank J. P. Morgan became concerned with getting a handle on risk. Derivatives, interest rate swaps, and repurchase agreements had changed the financial landscape so much that it was no longer a simple thing for a bank executive (much less a client) to understand what risks the people in the firm were taking. Morgan’s management wanted an executive summary. It would be a number or numbers (just not too many numbers) that executives could look at every morning. Looking at the numbers would reassure the execs that the bank was not assuming too much risk.


pages: 1,073 words: 302,361

Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan

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asset-backed security, Bernie Madoff, buttonwood tree, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, fear of failure, financial innovation, fixed income, Ford paid five dollars a day, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, merger arbitrage, moral hazard, mortgage debt, paper trading, passive investing, Ponzi scheme, price stability, profit maximization, risk tolerance, Ronald Reagan, Saturday Night Live, South Sea Bubble, time value of money, too big to fail, traveling salesman, value at risk, yield curve, Yogi Berra

Aron, in part by broadening the commodities it traded, including oil and grain, among others. Winkelman rode his masterful management and turn-around skills to a seat on the Management Committee and as co-head of fixed-income with a successful trader named Jon Corzine. J. Aron had become a big part of Goldman’s profit story. After years of acting only as an agent in the buying and selling of interest-rate swaps, Goldman had started acting as a principal in that business, too. “We were in the chicken camp on that,” Friedman said, before Goldman found courage. Goldman had also started a $783.5 million distressed investing fund, the Water Street Corporation Recovery Fund—named after a street that runs perpendicular to Broad Street in downtown Manhattan—with $100 million of its partners’ money to invest in the discounted debt securities of companies as a way to control them after a restructuring process.

Greenberg also knew that AIG’s AAA credit rating gave the company a valuable and differentiated advantage in the marketplace by allowing it to borrow money cheaply and then to invest it at higher rates of return, and to make money on the spread. If this kind of thing could be done outside the ken of often onerous state regulations that blanket the insurance industry, even better. To that end, in 1987, Greenberg created AIG Financial Products, known as AIGFP, by hiring a group of traders from the investment bank Drexel Burnham Lambert, led by Howard Sosin, who supposedly had a “better model” for trading and valuing interest-rate swaps and for generally taking and managing the risk that other financial firms wanted to sell. The market for derivatives was in its infancy, but growing, and Greenberg determined that AIG could be at its forefront. According to Greenberg, the overriding strategy at AIGFP was for the business to lay off most of the risks it was taking on behalf of its clients so that AIG was not exposed financially in the event of huge market-moving events that could not be modeled or anticipated.


pages: 543 words: 147,357

Them And Us: Politics, Greed And Inequality - Why We Need A Fair Society by Will Hutton

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, capital controls, carbon footprint, Carmen Reinhart, Cass Sunstein, centre right, choice architecture, cloud computing, collective bargaining, conceptual framework, Corn Laws, corporate governance, credit crunch, Credit Default Swap, debt deflation, decarbonisation, Deng Xiaoping, discovery of DNA, discovery of the americas, discrete time, diversification, double helix, Edward Glaeser, financial deregulation, financial innovation, financial intermediation, first-past-the-post, floating exchange rates, Francis Fukuyama: the end of history, Frank Levy and Richard Murnane: The New Division of Labor, full employment, George Akerlof, Gini coefficient, global supply chain, Growth in a Time of Debt, Hyman Minsky, I think there is a world market for maybe five computers, income inequality, inflation targeting, interest rate swap, invisible hand, Isaac Newton, James Dyson, James Watt: steam engine, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, knowledge worker, labour market flexibility, Long Term Capital Management, Louis Pasteur, low-wage service sector, mandelbrot fractal, margin call, market fundamentalism, Martin Wolf, means of production, Mikhail Gorbachev, millennium bug, moral hazard, mortgage debt, new economy, Northern Rock, offshore financial centre, open economy, Plutocrats, plutocrats, price discrimination, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, railway mania, random walk, rent-seeking, reserve currency, Richard Thaler, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, Rory Sutherland, shareholder value, short selling, Silicon Valley, Skype, South Sea Bubble, Steve Jobs, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, the scientific method, The Wealth of Nations by Adam Smith, too big to fail, unpaid internship, value at risk, Washington Consensus, working poor, éminence grise

They could buy derivatives – essentially promises to settle a deal in the future at a rate linked to today’s rate (arithmetically connected to relative future interest rates) – or they could swap each other’s liabilities and assets. The latter had the same effect as the former, but it was harder to do: you needed a willing counter-party, which in the early days could take weeks to find. Nevertheless, both hedging and swapping fostered a deepening of the interbank market, with one deal prompting a sequence of others and all generating liquidity. Since the first big interest-rate swap deal in 1981 – between the World Bank and IBM – the market had grown to be worth trillions of dollars as banks sought to rearrange their portfolio of liabilities and assets according to whatever risk profile regarding interest rates and currencies they and their clients preferred. Banking was changing from nurturing long-term trust relationships with customers and borrowers to trying to manage and grow a balance sheet based on risk probabilities.


pages: 320 words: 87,853

The Black Box Society: The Secret Algorithms That Control Money and Information by Frank Pasquale

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Affordable Care Act / Obamacare, algorithmic trading, Amazon Mechanical Turk, asset-backed security, Atul Gawande, bank run, barriers to entry, Berlin Wall, Bernie Madoff, Black Swan, bonus culture, Brian Krebs, call centre, Capital in the Twenty-First Century by Thomas Piketty, Chelsea Manning, cloud computing, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, Debian, don't be evil, Edward Snowden, en.wikipedia.org, Fall of the Berlin Wall, Filter Bubble, financial innovation, Flash crash, full employment, Goldman Sachs: Vampire Squid, Google Earth, Hernando de Soto, High speed trading, hiring and firing, housing crisis, informal economy, information retrieval, interest rate swap, Internet of things, invisible hand, Jaron Lanier, Jeff Bezos, job automation, Julian Assange, Kevin Kelly, knowledge worker, Kodak vs Instagram, kremlinology, late fees, London Interbank Offered Rate, London Whale, Mark Zuckerberg, mobile money, moral hazard, new economy, Nicholas Carr, offshore financial centre, PageRank, pattern recognition, precariat, profit maximization, profit motive, quantitative easing, race to the bottom, recommendation engine, regulatory arbitrage, risk-adjusted returns, search engine result page, shareholder value, Silicon Valley, Snapchat, Spread Networks laid a new fibre optics cable between New York and Chicago, statistical arbitrage, statistical model, Steven Levy, the scientific method, too big to fail, transaction costs, two-sided market, universal basic income, Upton Sinclair, value at risk, WikiLeaks

Shahien Nasiripour, “Goldman Sachs Values Assets Low, Sells High to Customers as Senate Panel Alleges Double Dealing,” Huffington Post, April 14, 2011, http://www.huffi ngtonpost.com /2011/04 /14 /goldman-sachs-values-asse _n _849398.html. 99. Kayla Tausche, “Wall Street into Snapchat, and Regulators Are on Alert,” CNBC, July 30, 2013, http://www.cnbc.com /id /100924846. 100. For example, since a “simple fi xed/floating interest-rate swap contract . . . has zero value at the start,” it “is considered neither an asset nor a liability, but is an ‘off-balance-sheet’ item.” Carol J. Loomis, “Derivatives: The Risk That Still Won’t Go Away (Fortune 2009),” CNN Money, May 20, 2012, http://features .blogs .fortune .cnn .com /2012/05 /20 /derivatives -the -risk-that -still-wont-go-away-fortune-2009/. 101. Bill Davidow, “Why the Internet Makes It Impossible to Stop Giant Wall Street Losses,” The Atlantic, May 18, 2012, http://www.theatlantic.com /business/archive/2012/05/why-the-internet-makes-it-impossible-to-stop-giant -wall-street-losses/257356/. 102.


pages: 512 words: 162,977

New Market Wizards: Conversations With America's Top Traders by Jack D. Schwager

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backtesting, Benoit Mandelbrot, Berlin Wall, Black-Scholes formula, butterfly effect, commodity trading advisor, Elliott wave, fixed income, full employment, implied volatility, interest rate swap, Louis Bachelier, margin call, market clearing, market fundamentalism, paper trading, pattern recognition, placebo effect, prediction markets, Ralph Nelson Elliott, random walk, risk tolerance, risk/return, Saturday Night Live, Sharpe ratio, the map is not the territory, transaction costs, War on Poverty

Therefore, you could buy the bond and sell the sterling forward at a huge premium, which over the life of the bond would converge to the spot rate. What was the term of the bond? The bond matured in four tranches: five, seven, nine, and twelve years. I don’t understand. Is it possible to hedge a currency that far forward? Of course it is. Even if you can’t do the hedge in the forward market, you can create the position through an interest rate swap. However, in the case of sterling/dollar, which has a very liquid term forward market, there was certainly a market for at least ten years out. How big was the issue? There were two tranches: the first for $100 millions and the second for $50 million. What happened when you pointed out that the issue was grossly mispriced? The initial response was that I must be wrong somehow. They spent nine hours that day running it past every quant jock in the house until they were convinced I was right.


pages: 386 words: 122,595

Naked Economics: Undressing the Dismal Science (Fully Revised and Updated) by Charles Wheelan

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affirmative action, Albert Einstein, Andrei Shleifer, barriers to entry, Berlin Wall, Bernie Madoff, Bretton Woods, capital controls, Cass Sunstein, central bank independence, clean water, collapse of Lehman Brothers, congestion charging, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, Daniel Kahneman / Amos Tversky, David Brooks, demographic transition, diversified portfolio, Doha Development Round, Exxon Valdez, financial innovation, floating exchange rates, George Akerlof, Gini coefficient, Gordon Gekko, greed is good, happiness index / gross national happiness, Hernando de Soto, income inequality, index fund, interest rate swap, invisible hand, job automation, Joseph Schumpeter, Kenneth Rogoff, libertarian paternalism, low skilled workers, lump of labour, Malacca Straits, market bubble, microcredit, money: store of value / unit of account / medium of exchange, Network effects, new economy, open economy, presumed consent, price discrimination, price stability, principal–agent problem, profit maximization, profit motive, purchasing power parity, race to the bottom, RAND corporation, random walk, rent control, Richard Thaler, rising living standards, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, school vouchers, Silicon Valley, Silicon Valley startup, South China Sea, Steve Jobs, The Market for Lemons, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, transaction costs, transcontinental railway, trickle-down economics, urban sprawl, Washington Consensus, Yogi Berra, young professional

Any investment strategy must obey the basic laws of economics, just as any diet is constrained by the realities of chemistry, biology, and physics. To borrow the title of Wally Lamb’s best-selling novel: I know this much is true. At first glance, the financial markets are remarkably complex. Stocks and bonds are complicated enough, but then there are options, futures, options on futures, interest rate swaps, government “strips,” and the now infamous credit default swaps. At the Chicago Mercantile Exchange, it is now possible to buy or sell a futures contract based on the average temperature in Los Angeles. At the Chicago Board of Trade, one can buy and sell the right to emit SO2. Yes, it’s actually possible to make (or lose) money by trading smog. The details of these contracts can be mind-numbing, yet at bottom, most of what is going on is fairly straightforward.


pages: 401 words: 112,784

Hard Times: The Divisive Toll of the Economic Slump by Tom Clark, Anthony Heath

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Affordable Care Act / Obamacare, British Empire, Carmen Reinhart, credit crunch, Daniel Kahneman / Amos Tversky, debt deflation, deindustrialization, Etonian, eurozone crisis, falling living standards, full employment, Gini coefficient, hiring and firing, income inequality, interest rate swap, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Rogoff, labour market flexibility, low skilled workers, mortgage debt, new economy, Northern Rock, obamacare, oil shock, Plutocrats, plutocrats, price stability, quantitative easing, Ronald Reagan, science of happiness, statistical model, The Wealth of Nations by Adam Smith, unconventional monetary instruments, War on Poverty, We are the 99%, women in the workforce, working poor

This was the big one, or so they said – the ‘once in a century’ event, as Alan Greenspan put it in 2008.3 But the financial elite is interested in financial phenomena – share-price swings and overnight interbank rates – that are only of direct concern to itself. If we're talking people instead of percentages – and talking particularly about the majority of people who do not dabble in stocks or in interest-rate swaps – then is a purely financial crisis really such a big deal? Is there any serious reason to think that disruptive events in the alien world of Wall Street or the City of London would leave us all living in a world turned upside down? The economic case for saying that they would do so starts with the historical observation that slumps which follow financial crises are invariably more significant.


pages: 478 words: 126,416

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, corporate governance, Credit Default Swap, cross-subsidies, dematerialisation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, income inequality, index fund, inflation targeting, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, London Whale, Long Term Capital Management, loose coupling, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, moral hazard, mortgage debt, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, regulatory arbitrage, Renaissance Technologies, rent control, Richard Feynman, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

The asset in Deutsche Bank’s balance sheet – that €768 billion – is the value of those outstanding derivative contracts which currently have a positive value. Under US GAAP, if one derivative contract shows a loss and another derivative contract with the same counterparty shows a profit, then you need record only the net profit or loss in trading with that counterparty. This opportunity to ‘net’ one contract against another applies even if one derivative is an interest rate swap and the other a forward foreign exchange contract. 12. Vickers, J.S., 2011, Independent Commission on Banking Final Report: Recommendations, London, HMSO. 13. Liikanen, E. (chair), 2012, Report of the European Commission’s High-Level Expert Group on Bank Structural Reform, EU Commission, October. 14. Dodd–Frank Wall Street Reform and Consumer Protection Act, Ch. 17, 12 U.S.C., § 1851. 7: The investment channel 1.


pages: 497 words: 144,283

Connectography: Mapping the Future of Global Civilization by Parag Khanna

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1919 Motor Transport Corps convoy, 2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, 3D printing, 9 dash line, additive manufacturing, Admiral Zheng, affirmative action, agricultural Revolution, Airbnb, Albert Einstein, amateurs talk tactics, professionals talk logistics, Amazon Mechanical Turk, Asian financial crisis, asset allocation, autonomous vehicles, banking crisis, Basel III, Berlin Wall, bitcoin, Black Swan, blockchain, borderless world, Boycotts of Israel, Branko Milanovic, BRICs, British Empire, business intelligence, call centre, capital controls, charter city, clean water, cloud computing, collateralized debt obligation, complexity theory, corporate governance, corporate social responsibility, credit crunch, crony capitalism, crowdsourcing, cryptocurrency, cuban missile crisis, data is the new oil, David Ricardo: comparative advantage, deglobalization, deindustrialization, dematerialisation, Deng Xiaoping, Detroit bankruptcy, diversification, Doha Development Round, edge city, Edward Snowden, Elon Musk, energy security, ethereum blockchain, European colonialism, eurozone crisis, failed state, Fall of the Berlin Wall, family office, Ferguson, Missouri, financial innovation, financial repression, forward guidance, global supply chain, global value chain, global village, Google Earth, Hernando de Soto, high net worth, Hyperloop, ice-free Arctic, if you build it, they will come, illegal immigration, income inequality, income per capita, industrial robot, informal economy, Infrastructure as a Service, interest rate swap, Internet of things, Isaac Newton, Jane Jacobs, Jaron Lanier, John von Neumann, Julian Assange, Just-in-time delivery, Kevin Kelly, Khyber Pass, Kibera, Kickstarter, labour market flexibility, labour mobility, LNG terminal, low cost carrier, manufacturing employment, mass affluent, megacity, Mercator projection, microcredit, mittelstand, Monroe Doctrine, mutually assured destruction, New Economic Geography, new economy, New Urbanism, offshore financial centre, oil rush, oil shale / tar sands, oil shock, openstreetmap, out of africa, Panamax, Peace of Westphalia, peak oil, Peter Thiel, Plutocrats, plutocrats, post-oil, post-Panamax, private military company, purchasing power parity, QWERTY keyboard, race to the bottom, Rana Plaza, rent-seeking, reserve currency, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Scramble for Africa, Second Machine Age, sharing economy, Shenzhen was a fishing village, Silicon Valley, Silicon Valley startup, six sigma, Skype, smart cities, Smart Cities: Big Data, Civic Hackers, and the Quest for a New Utopia, South China Sea, South Sea Bubble, sovereign wealth fund, special economic zone, spice trade, Stuxnet, supply-chain management, sustainable-tourism, TaskRabbit, telepresence, the built environment, Tim Cook: Apple, trade route, transaction costs, UNCLOS, uranium enrichment, urban planning, urban sprawl, WikiLeaks, young professional, zero day

One other crucial difference between the two cities is that unlike Detroit Dongguan was not fleeced by the financial markets. China’s municipal debts are exorbitant and its state-owned enterprises badly need restructuring, but both are backed by the $4 trillion of the People’s Bank of China. Meanwhile, days before its bankruptcy, Detroit paid out $250 million to UBS and Bank of America on debts inflated due to interest rate swap agreements, leaving it with pennies to cover almost $20 billion in pension and health-care obligations. Does China have a better model for managing central government relations with cities than America? China has embarked on economic liberalization far more quickly than political democratization, but what is proving to be equally important for its long-term stability is how it manages devolution.

Investment: A History by Norton Reamer, Jesse Downing

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Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

Two other traders suggested it should be lower, so the first trader replied, “OK, I will move the curve down 1 basis point, maybe more if I can.”123 Of course, the other reason the LIBOR scandal is so important is because so much money is tied to LIBOR. Indeed, as MIT professor Andrew Lo has pointed out, LIBOR was never intended to serve as the basis of such a large volume of financial contracts.124 Among the contracts it affects are mortgages, interest rate swaps—where one party agrees to exchange a fixed interest rate for a variable rate that is a certain number of percentage points higher than LIBOR—student loans, and other debt arrangements. In all, some $300 trillion worth of contracts is tied to LIBOR, and, as such, a tiny manipulation of a single basis point translates into enormous transfers of wealth.125 The LIBOR scandal demonstrates another important feature of typical market manipulation today: in highly liquid markets, some form of collusion is typically required.

How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

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Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

When it was time to return to Harvard for my second year, it was with an agreement with First Boston to continue to work for them part time during the school year. During my second year at Harvard, I did a specially directed studies course under Michael Porter and worked on some fascinating strategic vision projects regarding data, technology, and competitive practices. But the lure of Wall Street was very strong. My time at First Boston now was largely taken up by a project to study interest rate swaps. Swaps were a new product, traded by appointment, with the business being done “upstairs” in the investment bank, not on the trading floor. When I finished my MBA, First Boston asked me to join full time to put together swaps deals in the Corporate Finance group. I agreed, and there ended my pursuit of a PhD in mathematics. JWPR007-Lindsey 292 April 30, 2007 15:59 h ow i b e cam e a quant Six months after rejoining First Boston, I received a phone call while on the road informing me that I had a new boss and a new job.


pages: 559 words: 155,372

Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley by Antonio Garcia Martinez

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Airbnb, airport security, Amazon Web Services, Burning Man, Celtic Tiger, centralized clearinghouse, cognitive dissonance, collective bargaining, corporate governance, Credit Default Swap, crowdsourcing, death of newspapers, El Camino Real, Elon Musk, Emanuel Derman, financial independence, global supply chain, Goldman Sachs: Vampire Squid, hive mind, income inequality, interest rate swap, intermodal, Jeff Bezos, Malcom McLean invented shipping containers, Mark Zuckerberg, Maui Hawaii, means of production, Menlo Park, minimum viable product, move fast and break things, Network effects, Paul Graham, performance metric, Peter Thiel, Ponzi scheme, pre–internet, Ralph Waldo Emerson, random walk, Sand Hill Road, Scientific racism, second-price auction, self-driving car, Silicon Valley, Silicon Valley startup, Skype, Snapchat, social graph, social web, Socratic dialogue, Steve Jobs, telemarketer, urban renewal, Y Combinator, éminence grise

.* Crowds of traders, dressed in very not–Century 21 finery, surrounded them, like the beginnings of a lynch mob. Alan Brazil, the managing director for mortgage strategies at Goldman Sachs, was rationing out small, paperbound grease pucks, like a World War I commanding officer handing out munitions to his troops before an assault. It was, of course, the White Castle burger-eating contest. All trading turned from interest-rate swaps (minimum notional size: $50 million) to wagering on which young Goldman acolyte would down the most White Castle burgers in an hour. The betting structure was a typical Vegas-style over/under bet on how many burgers would be eaten without puking. The surrounding crowd turned into a howling, gesticulating mass of electrified greed, with the serious traders signaling to each other and actually writing down trades in notebooks, as they would million-dollar positions.


pages: 537 words: 144,318

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

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Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business process, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, savings glut, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, The Great Moderation, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve

My front-end rates trades should have performed, which would have turned my small up year into a big up year. Otherwise, what saved us was being long interest rates in peripheral economies that had very steep yield curves. Regardless, I learned a lot in 2008, and you can put both a positive and negative spin on it. Figure 7.4 LIBOR-OIS Basis, 2008 SOURCE: Bloomberg. OIS An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (e.g., a published interest rate) during the course of the payment period. OIS rates are an indication of market expectations of the effective federal funds rate over the term of the swap. The spread between OIS rates and LIBOR rates reflects credit risk and the expectation of future overnight rates.


pages: 422 words: 113,830

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

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algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, collateralized debt obligation, computer age, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, large denomination, Long Term Capital Management, market bubble, Martin Wolf, Menlo Park, mobile money, Monroe Doctrine, moral hazard, mortgage debt, new economy, oil shale / tar sands, oil shock, peak oil, Plutocrats, plutocrats, Ponzi scheme, profit maximization, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, sovereign wealth fund, The Chicago School, Thomas Malthus, too big to fail, trade route

Garraty, The Great Depression (New York: Harcourt Brace, 1986), pp. 52-57. 64 “Brazil October Inflation Rate Rises to 3-year High,” Bloomberg News, November 7, 2008. 65 “Mexico Inflation Soars to 7-year High in October,” Reuters, November 7, 2008. 66 “China’s October Inflation Matches Decade High of 6.5 Percent,” Bloomberg News, November 13, 2008. 67 “Singapore Inflation Hits 16-year High on Food, Energy,” Reuters India, November 23, 2008. 68 “Inflation in Pakistan at Near-30-year High,” United Press International, November 11, 2008. 69 “Asian Interest-Rate Swaps Signal More Rate Cuts Are Coming,” Bloomberg News, November 5, 2008. 70 “Indonesia’s October Inflation,” Reuters, November 3, 2008. 71 “Philippine Inflation Eases to 11.2 Percent in October,” Agence France-Press, November 5, 2008. 72 “Russia’s Inflation at 0.9 Percent in October,” RIA Novosti, November 5, 2008. 73 “Turkey: October Inflation Reflects Bad News for Consumers,” Turkish Statistics Institute, see europe.net, November 4, 2008. 74 “Inflation Sees a Slight Drop to 20 Pct.,” Egypt Daily News, November 10, 2008. 75 “Saudi Inflation Falls to 10.9 Percent,” Saudi Arabian Monetary Agency, October 12, 2008. 76 “Nigeria Oct.


pages: 515 words: 126,820

Blockchain Revolution: How the Technology Behind Bitcoin Is Changing Money, Business, and the World by Don Tapscott, Alex Tapscott

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Airbnb, altcoin, asset-backed security, autonomous vehicles, barriers to entry, bitcoin, blockchain, Bretton Woods, business process, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, clean water, cloud computing, cognitive dissonance, corporate governance, corporate social responsibility, Credit Default Swap, crowdsourcing, cryptocurrency, disintermediation, distributed ledger, Donald Trump, double entry bookkeeping, Edward Snowden, Elon Musk, Erik Brynjolfsson, ethereum blockchain, failed state, fiat currency, financial innovation, Firefox, first square of the chessboard, first square of the chessboard / second half of the chessboard, future of work, Galaxy Zoo, George Gilder, glass ceiling, Google bus, Hernando de Soto, income inequality, informal economy, interest rate swap, Internet of things, Jeff Bezos, jimmy wales, Kickstarter, knowledge worker, Kodak vs Instagram, Lean Startup, litecoin, Lyft, M-Pesa, Mark Zuckerberg, Marshall McLuhan, means of production, microcredit, mobile money, Network effects, new economy, Oculus Rift, pattern recognition, peer-to-peer lending, performance metric, Peter Thiel, planetary scale, Ponzi scheme, prediction markets, price mechanism, Productivity paradox, quantitative easing, ransomware, Ray Kurzweil, renewable energy credits, rent-seeking, ride hailing / ride sharing, Ronald Coase, Ronald Reagan, Satoshi Nakamoto, Second Machine Age, seigniorage, self-driving car, sharing economy, Silicon Valley, Skype, smart contracts, smart grid, social graph, social software, Stephen Hawking, Steve Jobs, Steve Wozniak, Stewart Brand, supply-chain management, TaskRabbit, The Fortune at the Bottom of the Pyramid, The Nature of the Firm, The Wisdom of Crowds, transaction costs, Turing complete, Turing test, Uber and Lyft, unbanked and underbanked, underbanked, unorthodox policies, X Prize, Y2K, Zipcar

84 Today, we rely on a few talking heads to sound the alarms; a prediction market would act more impartially as an early warning system for investors globally. Prediction markets could complement and ultimately transform many aspects of the financial system. Consider prediction markets on the outcomes of corporate actions—earnings reports, mergers, acquisitions, and changes in management. Prediction markets would inform the insurance of value and the hedging of risk, potentially even displacing esoteric financial instruments like options, interest rate swaps and credit default swaps. Of course, not everything needs a prediction market. Enough people need to care to make it liquid enough to attract attention. Still, the potential is vast, the opportunity significant, and access available to all. ROAD MAP FOR THE GOLDEN EIGHT Blockchain technologies will impact every form and function of the financial services industry—from retail banking and capital markets to accounting and regulation.


pages: 425 words: 122,223

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

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Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buy low sell high, capital asset pricing model, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, new economy, New Journalism, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond

As investors, borrowers, and lenders increased their understanding of these basic concepts, the flow of applications grew from a trickle to a flood. Options were incorporated into the entirely new and complex debt instruments that blossomed during the 1980s. They are responsible for the mushrooming of the market for government-guaranteed home mortgages. Their hedging features made possible the development of the so-called interest rate swaps between major financial institutions, the explosion in daily trading in the foreign exchange markets, the ability of banks to shield themselves from the vagaries of the money markets, and the willingness of major investment banking firms to provide many millions of dollars of instant liquidity to their institutional customers. Seldom has the marriage of theory and practice been so productive.


pages: 540 words: 168,921

The Relentless Revolution: A History of Capitalism by Joyce Appleby

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1919 Motor Transport Corps convoy, agricultural Revolution, anti-communist, Asian financial crisis, asset-backed security, Bartolomé de las Casas, Bernie Madoff, Bretton Woods, BRICs, British Empire, call centre, collateralized debt obligation, collective bargaining, Columbian Exchange, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, deskilling, Doha Development Round, double entry bookkeeping, epigenetics, equal pay for equal work, European colonialism, facts on the ground, failed state, Firefox, Ford paid five dollars a day, Francisco Pizarro, Frederick Winslow Taylor, full employment, Gordon Gekko, Henry Ford's grandson gave labor union leader Walter Reuther a tour of the company’s new, automated factory…, Hernando de Soto, hiring and firing, illegal immigration, informal economy, interchangeable parts, interest rate swap, invention of movable type, invention of the printing press, invention of the steam engine, invisible hand, Isaac Newton, James Hargreaves, James Watt: steam engine, Jeff Bezos, joint-stock company, Joseph Schumpeter, knowledge economy, land reform, Livingstone, I presume, Long Term Capital Management, Mahatma Gandhi, Martin Wolf, moral hazard, Ponzi scheme, profit maximization, profit motive, race to the bottom, Ralph Nader, refrigerator car, Ronald Reagan, Scramble for Africa, Silicon Valley, Silicon Valley startup, South China Sea, South Sea Bubble, special economic zone, spice trade, spinning jenny, strikebreaker, the built environment, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thorstein Veblen, total factor productivity, trade route, transatlantic slave trade, transatlantic slave trade, transcontinental railway, union organizing, Unsafe at Any Speed, Upton Sinclair, urban renewal, War on Poverty, working poor, Works Progress Administration, Yogi Berra, Yom Kippur War

The market in futures not only is volatile but must always cope with this uncertainty.6 And in the case of the securitized mortgages, the number of claimants grew exponentially. The American Dialect Society voted “subprime” the word of 2007.7 During the euphoria over rising housing prices, the lexicon of global finance migrated out of Wall Street into daily newspapers, where you could find references to option adjustable interest rate mortgages, collateralized debt obligations, interest rate swaps, swaptions, and special purpose vehicles! Hedge funds grew fivefold in the first decade of the twenty-first century, attracting managers of pension money, university endowments, and municipal investments, all now suffering with the retraction. Those people who ran hedge funds, established derivatives, and created option adjustable rate mortgages had built a house of cards with mortgage paper.


pages: 700 words: 201,953

The Social Life of Money by Nigel Dodd

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accounting loophole / creative accounting, bank run, banking crisis, banks create money, Bernie Madoff, bitcoin, blockchain, borderless world, Bretton Woods, BRICs, capital controls, cashless society, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, computer age, conceptual framework, credit crunch, cross-subsidies, David Graeber, debt deflation, dematerialisation, disintermediation, eurozone crisis, fiat currency, financial innovation, Financial Instability Hypothesis, financial repression, floating exchange rates, Fractional reserve banking, German hyperinflation, Goldman Sachs: Vampire Squid, Hyman Minsky, illegal immigration, informal economy, interest rate swap, Isaac Newton, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, Joseph Schumpeter, Kula ring, laissez-faire capitalism, land reform, late capitalism, liquidity trap, litecoin, London Interbank Offered Rate, M-Pesa, Marshall McLuhan, means of production, mental accounting, microcredit, mobile money, money: store of value / unit of account / medium of exchange, mortgage debt, new economy, Nixon shock, Occupy movement, offshore financial centre, paradox of thrift, payday loans, Peace of Westphalia, peer-to-peer lending, Ponzi scheme, post scarcity, postnationalism / post nation state, predatory finance, price mechanism, price stability, quantitative easing, quantitative trading / quantitative finance, remote working, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Satoshi Nakamoto, Scientific racism, seigniorage, Skype, Slavoj Žižek, South Sea Bubble, sovereign wealth fund, special drawing rights, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transaction costs, Wave and Pay, WikiLeaks, Wolfgang Streeck, yield curve, zero-coupon bond

Souverainté, Légitimité de la Monnaie, Paris, Association d’Économie Financière. Aglietta, M. and A. Orléan (1998). La Monnaie Souveraine, Paris, Jacob. Aglietta, M. and L. Scialom (2003). “The Challenge of European Integration for Prudential Policy.” LSE Financial Markets Group Special Paper. London, London School of Economics, 152. Agnes, P. (2000). “The ‘End of Geography’ in Financial Services? Local Embeddedness and Territorialization in the Interest Rate Swaps Industry.” Economic Geography 76 (4): 347–66. Ahamed, L. (2009). Lords of Finance: 1929, The Great Depression, and the Bankers Who Broke the World, London, Windmill Books. Akin, D. and J. Robbins (1999). Money and Modernity: State and Local Currencies in Melanesia, Pittsburgh, Pittsburgh University Press. Aldcroft, D. H. (2001). The European Economy 1914–2000, 4th ed., London, Routledge.


pages: 823 words: 206,070

The Making of Global Capitalism by Leo Panitch, Sam Gindin

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accounting loophole / creative accounting, airline deregulation, anti-communist, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Basel III, Big bang: deregulation of the City of London, bilateral investment treaty, Branko Milanovic, Bretton Woods, BRICs, British Empire, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collective bargaining, continuous integration, corporate governance, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency peg, dark matter, Deng Xiaoping, disintermediation, ending welfare as we know it, eurozone crisis, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, floating exchange rates, full employment, Gini coefficient, global value chain, guest worker program, Hyman Minsky, imperial preference, income inequality, inflation targeting, interchangeable parts, interest rate swap, Kenneth Rogoff, land reform, late capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, manufacturing employment, market bubble, market fundamentalism, Martin Wolf, means of production, money: store of value / unit of account / medium of exchange, Monroe Doctrine, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, Northern Rock, oil shock, precariat, price stability, quantitative easing, Ralph Nader, RAND corporation, regulatory arbitrage, reserve currency, risk tolerance, Ronald Reagan, seigniorage, shareholder value, short selling, Silicon Valley, sovereign wealth fund, special drawing rights, special economic zone, structural adjustment programs, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, very high income, Washington Consensus, Works Progress Administration, zero-coupon bond

China’s low domestic consumption left it with a profound dependence on American consumer markets, sustained by the policy of keeping the renminbi low relative to the dollar despite China’s ever larger trade surpluses and capital inflows. Although a managed floating exchange band was implemented in 2005, supported by the introduction of an over-the-counter derivatives market, and of foreign-exchange and interest-rate swaps, the renminbi’s relative appreciation was small in real terms. This was only possible because extensive capital controls were maintained, even as China’s securities and bond markets were opened up to foreigners in line with the WTO accession agreement. But while US institutional investors and investment banks became key players in Chinese financial markets (they were especially involved in major merger and acquisitions activity, and in purchasing the lion’s share of stock offered for sale by SOEs107), China’s capital markets, while growing fast, remained “among the smallest in the world relative to the size of the domestic economy.”108 Despite China’s having consented under the WTO agreement to open its domestic banking sector to foreigners by 2007, the financial system remained dominated by five large state-owned commercial banks primarily engaged in lending to SOEs, while interest rates were administered by the central bank with the primary goal of avoiding upward pressures on the exchange rate.


pages: 554 words: 168,114

Oil: Money, Politics, and Power in the 21st Century by Tom Bower

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Ayatollah Khomeini, banking crisis, bonus culture, corporate governance, credit crunch, energy security, Exxon Valdez, falling living standards, fear of failure, forensic accounting, index fund, interest rate swap, kremlinology, LNG terminal, Long Term Capital Management, margin call, Mikhail Gorbachev, millennium bug, new economy, North Sea oil, offshore financial centre, oil shale / tar sands, oil shock, passive investing, peak oil, Piper Alpha, price mechanism, price stability, Ronald Reagan, shareholder value, short selling, Silicon Valley, sovereign wealth fund, transaction costs, transfer pricing, éminence grise

Too many major oil companies were buying “look-alike” OTCs from the banks so as to avoid the regulators. In 1996 the deregulatory atmosphere had encouraged one trader employed by the Japanese bank Sumitomo to mount a fraud trading copper futures on the London Metal Exchange and OTC copper “swaps,” while in America, Bankers Trust had caused the multinational corporation Procter & Gamble to suffer huge losses through the sale of interest rate “swaps,” and Orange County in California had become insolvent as a result of speculating on OTCs. By 1998, oil had become intrinsic to the OTC explosion. Many transactions were finalized by telephone conversations, with little committed to paper or e-mails. Vitol, Glencore and other traders spent millions of dollars gathering intelligence, but finding evidence even of normal trading was hard. Even if records existed, it was very difficult for the CFTC to obtain access to their computers and paperwork in Switzerland to scrutinize their “swaps” trade.

The Concepts and Practice of Mathematical Finance by Mark S. Joshi

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Black-Scholes formula, Brownian motion, correlation coefficient, Credit Default Swap, delta neutral, discrete time, Emanuel Derman, implied volatility, incomplete markets, interest rate derivative, interest rate swap, London Interbank Offered Rate, martingale, millennium bug, quantitative trading / quantitative finance, short selling, stochastic process, stochastic volatility, the market place, time value of money, transaction costs, value at risk, volatility smile, yield curve, zero-coupon bond

(13.8) Fortunately, this follows immediately from (13.7) since it is equivalent to P(T1) P(T3) _ P(T1) P(T2) P(T2) P(T3) (13.9) ' which is certainly true. The important thing about (13.8) is that it expresses compounding effects. Putting money on deposit for six months at an annualized rate of 5% and then rolling it into another six-month deposit at the same rate is not the same as putting money on deposit for one year at an annual rate of 5%. 13.2.3 Swaps Whilst the forward-rate agreement involves a principal, its close relative, the interest rate swap, does not. Rather than agreeing with a counterparty to put some money on deposit for a fixed period of time in the future at a fixed rate, we instead enter into a contract to pay him the floating rate of interest on a notional, whilst he pays us a rate fixed in advance. As the interest payments go both ways, there is no need to exchange principals. Thus whilst the contract has a notional which multiplies the cashflows, the total sum of money exchanged will actually be quite small in comparison.


pages: 1,335 words: 336,772

The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance by Ron Chernow

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bank run, banking crisis, Big bang: deregulation of the City of London, Bolshevik threat, Boycotts of Israel, Bretton Woods, British Empire, California gold rush, capital controls, collective bargaining, Etonian, financial deregulation, German hyperinflation, index arbitrage, interest rate swap, margin call, Monroe Doctrine, North Sea oil, oil shale / tar sands, paper trading, Plutocrats, plutocrats, Robert Gordon, Ronald Reagan, short selling, strikebreaker, the market place, the payments system, too big to fail, transcontinental railway, Yom Kippur War, young professional

It dealt in Treasury bonds, underwrote municipal bonds, advised cities, provided stock research and brokerage, and traded in gold bullion, silver, and foreign exchange. It continued to have the fanciest private banking operation, wooing rich customers with ads that promised to relieve their anxiety about possessing $50-million portfolios. Abroad, Morgans stepped up capital market activity, specializing in interest-rate swaps, currency swaps, and other financial esoterica. It had merchant banks in Japan, Hong Kong, Belgium, and Germany. In London, the headquarters of its global capital markets operation, it spent $500 million to outfit two historic buildings near the Thames—the vacant Guildhall School of Music and Drama and the City of London School for Girls—with vast trading floors. Eventually fifteen hundred employees would work beneath stained-glass windows and timbered ceilings, flanked by busts of Shakespeare and Milton.


pages: 1,336 words: 415,037

The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

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affirmative action, Albert Einstein, anti-communist, Ayatollah Khomeini, barriers to entry, Bonfire of the Vanities, Brownian motion, capital asset pricing model, card file, centralized clearinghouse, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, Donald Trump, Eugene Fama: efficient market hypothesis, global village, Golden Gate Park, Haight Ashbury, haute cuisine, Honoré de Balzac, If something cannot go on forever, it will stop, In Cold Blood by Truman Capote, index fund, indoor plumbing, interest rate swap, invisible hand, Isaac Newton, Jeff Bezos, joint-stock company, joint-stock limited liability company, Long Term Capital Management, Louis Bachelier, margin call, market bubble, Marshall McLuhan, medical malpractice, merger arbitrage, Mikhail Gorbachev, moral hazard, NetJets, new economy, New Journalism, North Sea oil, paper trading, passive investing, pets.com, Plutocrats, plutocrats, Ponzi scheme, Ralph Nader, random walk, Ronald Reagan, Scientific racism, shareholder value, short selling, side project, Silicon Valley, Steve Ballmer, Steve Jobs, supply-chain management, telemarketer, The Predators' Ball, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, transcontinental railway, Upton Sinclair, War on Poverty, Works Progress Administration, Y2K, zero-coupon bond

Nearly all of its loans consisted of short-term debt that was callable by lenders in days or at most weeks. Only $4 billion of equity supported $146 billion of debt. Dangling off the side of the balance sheet on any given day were tens more billions, perhaps as many as $50 billion a day, of uncleared trades—transactions executed, but not yet settled. These would stall midair. Salomon also had many hundreds of billions of derivative obligations not recorded anywhere on its balance sheet—interest-rate swaps, foreign-exchange swaps, futures contracts—a massive and intricate daisy chain of obligations with counterparties all over the world, many of whom in turn had other interrelated contracts outstanding, all part of a vast entangled global financial web. If the funding disappeared, Salomon’s assets had to be sold—but while the funding could disappear in a few days, the assets would take time to liquidate.