39 results back to index

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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

In effect, a pound a year from now is therefore worth less than a pound today. The interest paid on a riskless loan expresses this. We can quantify precisely how much less by using risk-free bonds. A zero-coupon bond with principal £1 maturing in a year is precisely the same as receiving the sum of £1 in a year. We can therefore change the timing of a cashflow through the use of zero-coupon bonds. (A cashflow is a flow of money that occurs at some time.) If we are to receive a definite cashflow of LX at time T, then that is the same as being given X zero-coupon bonds today, and we can convert it into a cashflow today by simply selling X zero-coupon bonds of maturity T. The two cashflows at time 7' will then cancel each other. If the market value of a T-maturity bond is P(T), then £X at time 7' is equivalent to £XP (T ) today.

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This means that we have precisely hedged the forward contract at zero cost, so the contract must be worth zero or there would be an arbitrage. If we have a forward contract struck at K', we can decompose it as a forward contract struck at K, with K as above, and the right to receive £(K - K') at time T. The right to receive £(K - K') is the same as holding K - K' zero-coupon bonds. Note that if K < K', we are really borrowing K' - K zero-coupon bonds. The forward contract struck at K has zero value so the value of the contract must be the value of the zero-coupon bonds, that is e' T (K - K') = (eGr-d)T So - K)(2.3) and we are done. The second part of the theorem motivates a definition. The forward price of a stock for a contract at time T is e(' -d)T So. 2.7 Mathematically defining arbitrage 27 2.7 Mathematically defining arbitrage We have seen that arbitrage can price various simple contracts precisely in a way that allows for no doubt in the price, and the price is independent of our views on how asset prices will evolve.

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If we call a marketmaker and ask to buy or sell, he will always quote a pair of prices straddling the theoretical price; thus there is always a spread around the theoretical curve. 13.4.2 Gilts The lowest yielding instruments are, of course, the riskless ones - for example, UK government bonds which are generally known as gilts. The UK government does not generally issue zero-coupon bonds so all we can observe in the market is the 13.4 Curves and more curves 315 price of coupon-bearing bonds. However, a coupon-bearing bond is decomposable into a sum of zero-coupon bonds. This is clear if we remember that the bond is really just a sequence of cashflows. The cashflows are the coupon at each couponpayment date and the repayment of the principal at maturity. Any cashflow is just a zero-coupon bond with expiry equal to the timing of the flow and notional equal to the size of the cashflow. This means that we can attempt to fit a theoretical discount curve for zerocoupon bonds to the observed prices of UK gilts.

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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

There are many kinds of bonds like treasury bills and notes, treasury, mortgage and debenture bonds, commercial papers, and others with various particular arrangements concerning the issuing institution, duration, number of payments, embedded rights and guarantees. 2.2.1 Zero-Coupon Bonds The simplest case of a bond is a zero-coupon bond , which involves just a single payment. The issuing institution (for example, a government, a bank or a company) promises to exchange the bond for a certain amount of money F , called the face value, on a given day T , called the maturity date. Typically, the life span of a zero-coupon bond is up to one year, the face value being some round ﬁgure, for example 100. In eﬀect, the person or institution who buys the bond is lending money to the bond writer. Given the interest rate, the present value of such a bond can easily be computed.

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Of course, if the interest rates are independent of maturity, then this formula is the same as (10.1). 230 Mathematics for Finance Remark 10.1 To determine the initial term structure we need the prices of zero-coupon bonds. However, for longer maturities (typically over one year) only coupon bonds may be traded, making it necessary to decompose coupon bonds into zero-coupon bonds with various maturities. This can be done by applying formula (10.3) repeatedly to ﬁnd the yield with the longest maturity, given the bond price and all the yields with shorter maturities. This procedure was recognised by the U.S. Treasury, who in 1985 introduced a programme called STRIPS (Separate Trading of Registered Interest and Principal Securities), allowing an investor to keep the required cash payments (for certain bonds) by selling the rest (the ‘stripped’ bond) back to the Treasury. Example 10.9 Suppose that a one-year zero-coupon bond with face value $100 is trading at $91.80 and a two-year bond with $10 annual coupons and face value $100 is trading at $103.95.

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It is convenient to think of this account as a tradable asset, which is indeed the case, since the bonds themselves are tradable. A long position in the money market involves buying the asset, that is, investing money. A short position amounts to borrowing money. First, consider an investment in a zero-coupon bond closed prior to maturity. An initial amount A(0) invested in the money market makes it possible to purchase A(0)/B(0, T ) bonds. The value of each bond will fetch B(t, T ) = e−(T −t)r = ert e−rT = ert B(0, T ) 44 Mathematics for Finance at time t. As a result, the investment will reach A(t) = A(0) B(t, T ) = A(0)ert B(0, T ) at time t ≤ T . Exercise 2.35 Find the return on a 75-day investment in zero-coupon bonds if B(0, 1) = 0.89. Exercise 2.36 The return on a bond over six months is 7%. Find the implied continuous compounding rate. Exercise 2.37 After how many days will a bond purchased for B(0, 1) = 0.92 produce a 5% return?

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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

This is what you would receive if you invested in a zero-coupon bond with face value Ft,T payable at time T. So instead of borrowing the value of the underlying commodity, we invest (lend) in such a bond, B. A Long Spot Position–A Long Forward Position=Investing in a Zero Coupon Bond with face value equal to the forward price. 82 FORWARD CONTRACTS AND FUTURES CONTRACTS Rearranging B., this says that, C. A Long Spot Position=A Long Forward Position+Investing in a Zero Coupon Bond with face value equal to the forward price. Rearranging this, we get the same result as in A because—(investing in a zerocoupon bond with face value equal to the forward price) is the same as borrowing by issuing that zero-coupon bond. That is, D. A Long Forward Position=A Long Spot Position–Investing in a Zero-Coupon Bond with face value equal to the forward price, or E.

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The answer simply requires us to apply the discount factor which we know is e–r . The current price of the bond is therefore, B(t,T)=e–r*$1 =$e–r. We can use this result to price any zero-coupon bond. Suppose that its face value (value at maturity) is $F, it has years to maturity and the annualized, continuously compounded rate is r % per year. Then the current price must be e–r*F. n CONCEPT CHECK 4 Given the information above, suppose that F=$1,000, =2 months, and r=2%. a. What is the current price of the corresponding zero-coupon bond? Here is another interesting example. Suppose that the zero-coupon bond has face value equal to the current forward price of an underlying commodity, Ft,T . That is, this zero-coupon bond will have as its payoff the forward price Ft,T . An economic situation that corresponds to this payoff is that of the short in a forward contract.

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130; solution to 160; trading crude oil futures 147; solution to 161; option pricing in continuous time: arbitrage opportunity construction 554; Bachelier option pricing formula, derivation of 550; Black-Scholes options pricing from Bachelier 582–3; risk-neutral transition density function (RNTDF) 544; riskneutral transition density function (RNTDF) for ABM process to which GBM is reducible 569; solving riskneutralized GBM-reduced process SDE 568; solution to 594; transition density function variance calculation 545; solution to 594; veriﬁcation of N(-z)= 1–N(z) for any z in Bachelier calculation 548; option trading strategies: covered call strategies, choice of 426; solution to 434; covered call write, upside potential of 422; solution to 433; cushioning calls 422; In-the-Money covered call writes 421; solution to 433; market for call options, dealing with proﬁt potential and 354; solution to 367; payout present value on longing zero-coupon riskless bond 362; solution to 367; positions taken, deﬁnition of risk relative to 427; proﬁt diagram for long call option, working on 418; rationalization of proﬁts, short call positions 357; stock price ﬂuctuations, dealing with 353; solution to 366–7; upside volatility in short positions, dealing with 359; options markets: individual equity options, product speciﬁcations for 326; solution to 342; mini equity options, product speciﬁcations for 326; solution to 342; MRK OV-E price quote 337; option positions 331; option sales 332; solution to 342; option’s rights 331; payoff diagram construction 338; put option positions 332; rational option pricing (ROP): adjusted intrinsic value (AIV) for calls, calculation of 413; solution to 413; adjusted intrinsic value (AIV) for puts, calculation of 381; solution to 413; directional trades and relative trades, difference between 372; dominance principle and value of European call option 376; solution to 413; exercise price of options, working with 391; forward contracts, overpaying on 403; generalized forward contracts, current value on 404; rational option pricing (ROP) or model-based option pricing (MBOP) 407; short stock position, risk management of 399; solution to 413–14; working from strategies to current costs and back 393; solution to 413; spot, forward, and futures contracting: drawing conclusions from spot price charts 22–3; solution to 32; foreign currencies, forward prices on 25; foreign currencies, futures prices on 26; solution INDEX to 32; past as guide to future price behavior 21; spot market contracting: exploration of spot rates in long-term mortgage market 11; solution to 29; present and future spot prices 21; solution to 32; price quotes in spot markets 6–7; solution to 29; valuation of forward contracts (assets with dividend yield): arbitrage opportunities, working with 101–2; solution 118–19; calculation of total stock price return minus dividend yield 99; solution 118; direct and indirect costs 89; solution 117–18; modeling continuous dividend yields for stocks 94; modeling continuous dividend yields for stocks: solution 118; modeling zero-coupon bond yields 92; pricing currency forwards 105; solution 119; pricing foreign exchange contracts 106; stock price, effect of dividend payments on 97; valuation of forward contracts (assets without dividend yield): annualized, continuously compounded 3%, worth after 2 months? 71; annualized, continuously compounded 6%, worth after 12 months? 71; solution to 85; annualized, continuously compounded 10%, worth after 3 months? 71; calculation of equilibrium forward prices 78; solution 86; pricing zero-coupon bond with face value equal to current forward price of underlying commodity 73; solution to 86; pricing zero-coupon bonds 72; solution to 86; settling a forward commitment 72; zero-coupon bond, pricing on basis of forward contract at compounded riskfree rate 73 consensus in risk-neutral valuation 598–9; with consensus 599; without consensus 599–601 consumption capital asset pricing model (CCAPM) 605 contango and backwardation 198–9 context in study of options markets 326–7 contingent claim pricing 514–17 continuation region 385 641 continuous compounding and discounting 69–71 continuous dividends from stocks, modeling yields from 93–4 continuous yields, modeling of 90–4 contract life, payments over 88 contract month listings 214, 215, 228 contract offerings 227–8 contract size 19, 214, 215, 227, 228 contract speciﬁcations 17, 18–19 contracts offered 257–8 convenience, risk-neutral valuation by 631–2 convenience yield 89 convergence of futures to cash price at expiration 189 convexity of option price 406 correlation effect 165–6 cost-of-carry 89; model of, spread and price of storage for 195 counterparty risk 11, 12–13, 140 covered call hedging strategy 419–27; economic interpretation of 426–7; protective put strategies, covered calls and 419; writes, types of 420–6 credit spreads 298–9 cumulative distribution function 544 currency futures 213–17; contract speciﬁcations 213–15; forward positions vs. futures positions 220; pricing vs. currency forward pricing 225; quote mechanism, future price quotes 216–17; risk management strategies using 217–24 currency spot and currency forwards 103–9 currency swaps, notional value of 274 current costs: of generating alternative payoffs 78; payoffs and 66; related strategies and, technique of going back and forth between 393 current price as predictor of future stock prices 531 daily price limits 228, 229 daily settlement process 144–51, 153; ﬁnancial futures contracts and 216, 260 642 INDEX dealer intermediated plain vanilla swaps 284–93; arbitraging swaps market 292–3; asked side in 286; bid side in 285; dealer’s spread 286; example of 284–6; hedging strategy: implications of 291–2; outline of 288–90; plain vanilla swaps as hedge vehicles 286–92 dealer’s problem, ﬁnding other side to swap 294–8; asked side in 295; bid side in 295; credit spreads in spot market (AA-type ﬁrms) 296; dealer swap schedule (AA-type ﬁrms) 295; selling a swap 296; swap cash ﬂows 298; synthetic ﬂoating-rate ﬁnancing (AA-type ﬁrms) 297; transformation from ﬁxed-rate to ﬂoating rate borrowing 297–8 decision-making: option concept in 324; process of, protection of potential value in 36–7 default in forward market contracting 11–12 deferred spot transactions 78–9 delayed exercise premium 331, 337 delivery dates 19 demutualization 139–40 derivative prices: co-movements between spot prices and 26; underlying securities and 66 directional trades 371–2 discounted option prices 527–8 discounted stock price process 524–5, 527–8, 530 discrete-time martingale, deﬁnition of 521 diversiﬁable risk 225 diversiﬁcation, maximum effect of 419–20 dividend-adjusted geometric mean (for S&P 500) 227 dividend payments, effect on stock prices 94–8 dividend payout process 97, 111; connection between capital gains process and 111–13 dollar equivalency 227, 234, 239–40 dollar returns, percentage rates of 366 domestic economy (DE) 103–4, 105 dominance principle 372, 373; implications of 374–88 double expectations (DE) 534–5 duration for interest-rate swaps 300 dynamic hedging 473–506; BOPM as riskneutral valuation relationship (RNVR) formula (N > 1) 490–3; hedging a European call option (N=2) 477–85; implementation of binomial option pricing model for (N=2) 485–90; multiperiod BOPM model (N=3) 494; multiperiod BOPM model (N > 1), path integral approach 493–500; numerical example of binomial option pricing model (N=2) 487–90; option price behavior (N=2) 476; path structure for multi-period BOPM model (N=3) 497; stock price behavior (N=2) 475–6; stock price evolution (N-period binomial process), summary of 499; value contributions for multi-period BOPM model (N=3) 498; see also binomial option pricing model (BOPM) economy-wide factors, risk and 225–6 effective date 293 effective payoff 220, 233 effective price, invoice price on delivery and 153–6 efﬁcient market hypotheses (EMH) 517; features of 532; guide to modeling prices 529–33; option pricing in continuous time 558, 560, 561; semi-strong form of 531; strong form of 531, 532; weak form of 531 EFP eligibility 214 embedded leverage 79–80 endogenous variables 614–15 equilibrium forward prices 402; comparison with equilibrium futures prices 193–5; valuation of forward contracts (assets without dividend yield) 78 equilibrium (no-arbitrage) in full carrying charge market 190–3; classical short selling a commodity 192; Exchange Traded Funds (ETF) 191–2; formal arbitrage opportunity 192; non-interest carrying changes, arb without 192–3; setting up arb 190; unwinding arb 190–2 INDEX equity in customer’s account 145, 148 equivalent annual rate (EAR) 70 equivalent martingale measures (EMMs) 507–38; arithmetic Brownian motion (ABM) model of prices 530–1; computation of EMMs 529; concept checks: contingent claim pricing, working with 514; martingale condition, calculation of 525; option pricing, working with 514; two period investment strategy under EMM, proof for (t=0) 521; solution to 538; contingent claim pricing 514–17; concept check: interpretation of pricing a European call option 514; pricing a European call option 514–15; pricing any contingent claim 515–17; current price as predictor of future stock prices 531; discounted option prices 527–8; discounted stock price process 524–5, 527–8, 530; discrete-time martingale, deﬁnition of 521; double expectations (DE) 534–5; efﬁcient market hypotheses (EMH) basis for modeling 517; features of 532; guide to modeling prices 529–33; semi-strong form of 531; strong form of 531, 532; weak form of 531; equivalent martingale representation of stock prices 524–6; examples of EMMs 517–21; exercises for learning development of 537; fair game, notion of 518–19; fundamental theorem of asset pricing (FTAP_1) 509, 511–12, 517, 528–9, 530, 532, 533; ‘independence,’ degrees of 536; investment strategy under, twoperiod example 519–21; key concepts 537; martingale properties 533–6; nonconstructive existence theorem for 529; numeraire, concept of 524; option prices, equivalent martingale representation of 526–8; option pricing in continuous time 540; option price representation 543; physical probability measure, martingale hypothesis for 530; pricing states 509; primitive ArrowDebreu (AD) securities, option pricing and 508–14; concept check: pricing 643 ADu() and ADd() 514; exercise 1, pricing B(0,1) 510; exercise 2, pricing ADu() and ADd() 511–14; random variables 536; random walk model of prices 530–1; risk-averse investment 522; risk-neutral investment 521–2, 523; riskneutral valuation 596–7; construction of 601–3; risk premiums in stock prices and 532–3; riskless bonds 509; Sharpe ratio 526; state-contingent ﬁnancial securities 508; ‘state prices’ 509; stock prices and martingales 521–6; sub (super) martingale, deﬁnition of 524; summary of EMM approach 528–9; tower property (TP) 533–4; uncorrelated martingale increments (UCMI) 531, 535–6; wealth change, fair game expectation 520 Eurodollar (ED) deposit creation 253 Eurodollar (ED) futures 220–1, 245, 246, 249, 250, 252–64; ‘buying’ and ‘selling’ futures 256; cash settlement, forced convergence and 258–61; contract speciﬁcations for 254–5; forced conversion of 260; interest-rate swaps 278; strips of 280–1; lending (offering) 249–50; liabilities and 246; open positions, calculation of proﬁts and losses on 262–4; placing 248–9; quote mechanism 256–8; spot Eurodollar market 245–54; taking 249; timing in 257 European call options: synthesis of: modelbased option pricing (MBOP) 453–64; hedge ratio and dollar bond position, deﬁnition of (step 2) 455; implications of replication (step 4) 462–4; parameterization (step 1) 454; replicating portfolio, construction of 456–62; replication, pricing by 463; valuation at expiration 446; see also hedging a European call option in BOPM (N=2) European options 328, 333, 342, 357, 375, 398, 445, 553 European Put-Call Parity 416, 417, 418, 419, 426, 429; ﬁnancial innovation with 401–5; implications of 394–400; 644 INDEX American option pricing model, analogue for European options 396–8; European call option 394–6; European option pricing model, interpretation of 397–8; European put option 398–9; synthesis of forward contracts from puts and calls 399–400 exchange membership 139–40 exchange rate risks and currency futures positions 217–20; Lufthansa example 217–20 exchange rates, New York closing snapshot (April 7, 2014) 104 exchange rule in ﬁnancial futures contracts 214, 228 exchange-traded funds (ETFs) 191–2, 226 exercise of options 328 exercise price 328, 336 exercises for learning development: binomial option pricing model (BOPM) 501–5; equivalent martingale measures (EMMs) 537; ﬁnancial futures contracts 266–8; hedging with forward contracts 56–61; hedging with futures contracts 205–7; interest-rate swaps 315–16; market organization for futures contracts 158–9; model-based option pricing (MBOP) 469–71; option pricing in continuous time 590–3; option trading strategies 364–6, 431–3; options markets 341–2; rational option pricing (ROP) 409–12; risk-neutral valuation 634–5; spot, forward, and futures contracting 27–9; valuation of forward contracts (assets with dividend yield) 116–17; valuation of forward contracts (assets without dividend yield) 83–5 exit mechanism in forward market contracting 15–16 exogenous variables in risk-neutral valuation 614–15 expiration date in options markets 336 expiration month code 336 fair game, notion of 518–19 fancy forward prices 19, 25 Fed Funds Rate (FFR) 251 Federal Funds (FF) 249–50, 251, 252 Federal Reserve system (US) 249 ﬁnancial engineering techniques 337–8 ﬁnancial futures contracts 211–70; all-orNone (AON) orders 215; Bank of International Settlements (BIS) 246; basis risk 223, 237, 238; cross hedging and 244; block trade eligibility 214, 228; block trade minimum 214, 228; commentary 216–17; concept checks: backwardation and contango, markets in?

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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

The price relationship is rather straightforward for a zero-coupon bond of price B0-cpn. As an example, a 5-year zero-coupon bond @ 5% is estimated from Eq. 1.7, that is in discrete compounding: in continuous compounding: B0-cpn = 100 / (1 + 0.05)5 = 78.35 B0-cpn = 100 * e-0.05*5 = 77.88, supposing the rate is 5% in both cases. These relationships indicate that investing in the bond at its present value brings $100 to the investor at maturity, the return of such an investment corresponding to the interest rate of the zero-coupon bond. For a classic bullet coupon bond, we can extrapolate the above result by considering that a coupon bond on n installments may be viewed as a sum of a series of n zero-coupon bonds, that is, for a bond involving n semi- or annual coupons: one zero-coupon bond for each of coupon payments, until the n−1th installment: their maturities correspond to those of the interest payments; each single repayment is equal to the coupon; one zero-coupon bond for the last (nth) installment, at maturity, corresponding to the payment of the last coupon plus the reimbursement of the principal.

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In practice, however, the use of convexity can be more problematic than the use of duration in the case of lack of market liquidity, affecting the market bond price. Here are some properties of convexity: As yields decrease, both duration and convexity increase, and conversely. Among bonds with equal duration: the higher the coupon, the higher the convexity; the zero-coupon bond has the smallest convexity. This can easily be checked by building (B, y) curves for a zero-coupon bond and for various coupon bonds of same duration: we see that the flattest curve is the one of the zero coupon. Among bonds with same maturity, the zero-coupon bond has not only the greatest duration but also the greatest convexity. Beyond its role of improving the sensitivity calculation from only the use of duration, the convexity may also play some role in selecting bonds for a portfolio. Suppose that a portfolio manager needs to buy a bond with a given duration and has a choice between two bonds, A of lower convexity and B with higher convexity.

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Let us now shift both cash flows PV and FV by + a time T. Their durations are now valuing T and t+T respectively. Buying a forward or future contract of maturity T on a zero-coupon bond maturing at t after T can be viewed as the combination of one short cash flow PV, corresponding to the payment of the contract at its maturity T, plus one long cash flow FV, at time t later – see Figure 3.8. Figure 3.8 A single cash flow valuing FV after time t Hence, the duration Dfwd is the sum of both durations of PV (as a negative cash flow) and FV: The extension to a coupon bond is straightforward, since a coupon bond can be split into a series of zero-coupon bonds. The duration Dopt of bond options (cf. Chapter 11, Section 11.2) will understandably involve the duration DB of its underlying bond, the delta Δ of the option (i.e., the quantity of underlying used to hedge the option position, cf.

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The Oil Factor: Protect Yourself-and Profit-from the Coming Energy Crisis
** by
Stephen Leeb,
Donna Leeb

Amazon: amazon.com — amazon.co.uk — amazon.de — amazon.fr

Buckminster Fuller, diversified portfolio, fixed income, hydrogen economy, income per capita, index fund, mortgage debt, North Sea oil, oil shale / tar sands, oil shock, peak oil, profit motive, reserve currency, rising living standards, Ronald Reagan, shareholder value, Silicon Valley, Vanguard fund, Yom Kippur War, zero-coupon bond

In addition, the dollar income that you are getting from your bonds becomes worth more for the same reasons that cash gains in value. Zero coupon bonds have even more potential. These are bonds that don’t pay coupons at regular intervals during their life span. Rather, you buy them at a discount to par and they are guaranteed to mature at par. For instance, you could buy a zero coupon bond that is guaranteed to pay you $10,000 in fifteen years. Your purchase price, say, is $2,000. During inflationary times, this isn’t so attractive, because in fifteen years $10,000 might be worth next to nothing, maybe even less than the $2,000 you put up initially. You gain little in real terms or even lose. But during deflation, they are suddenly a great deal because that guaranteed $10,000 at the end of the rainbow keeps gaining in value. Typically during times of deflation, the gains from zero coupon bonds are 50 percent higher than the gains from regular coupon-paying bonds.

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Stick to government bonds and ultra-high-quality corporate bonds. For regular bonds, our first choice is the Fidelity Investment Grade Bond Fund (1-800-544-8888), a well-managed fund that invests in high-grade bonds. As for zero coupon bonds, we’d recommend the American Century Zero-Coupon Bond Funds (1-800-345-2021). Key Points: • In the coming years of economic and market volatility, deflationary scares will be the counterpoint to inflationary pressures. Investors need to hold some deflation insurance at all times. When our oil indicator flashes a negative signal, emphasize deflation plays more heavily. • Deflation plays include T-bills, regular bonds, and zero coupon bonds. Zeros will appreciate most sharply during deflationary interludes but during inflationary stretches will offer nothing; T-bills and coupon-paying bonds provide steady income.

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Cash, Bonds, and Zeros Historically the only investments that perform well during the kind of economy-ravaging deflation that would occur this time around are fixed income instruments such as cash and bonds—and in particular zero coupon bonds. The most analogous period is 1929-32, and as figure 17a, “Bonds in the Depression,” shows, fixed income investments were the only shelter. More recently, deflationary fears arose when oil prices surged and acted as the catalyst that punctured the tech bubble. The sharp fall in the market threatened to cause an economic meltdown. And from mid-1999 through early 2003, bonds rose 40 percent, while zero coupon bonds scored 100 percent gains. Let’s look in more detail at various deflation hedges. The first is cash, by which we mean money put into very short-term money market accounts, and preferably those guaranteed by the government or that invest only in government securities.

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Financial Modelling in Python
** by
Shayne Fletcher,
Christopher Gardner

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Brownian motion, discrete time, interest rate derivative, London Interbank Offered Rate, stochastic volatility, yield curve, zero day, zero-coupon bond

The second from last line of the implementation is the code representation of the above formula. class fixed leg payoff: def call (self, t, controller): event = controller.get event() flow = event.flow() id = event.reset id() obs = flow.observables()[id] model = controller.get model() env = controller.get environment() fixed rate = obs.coupon rate() requestor = model.requestor() state = model.state().fill(t, requestor, env) cpn = fixed rate*flow.notional()*flow.year fraction()\ *controller.pay df(t, state) return cpn Note that we delegate to the controller for the actual calculation of the zero coupon bond. The implementation of the pay df method on the controller class is given below: def pay df(self, t, state): if t < 0: historical df = self. model.state().create variable() historical df = self. historical df return historical df else: flow = self. event.flow() fill = self. model.fill() requestor = self. model.requestor() T = self. env.relative date(flow.pay date())/365.0 return fill.numeraire rebased bond(t, T, flow.pay currency()\ , self. env, requestor, state) endif In a pattern that should be familiar, the fil component of the model is called upon to perform the calculation of the numeraire-rebased zero coupon bond. It should also be noted that the implementation returns a value for discount factors in the past; the value being determined by the historical df argument passed in at construction time of the controller.

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Indeed Boost.Python offers many more features to help the C++ programmer to seamlessly expose C++ classes to Python and embed Python into C++. 218 Financial Modelling in Python Note that, as expected, the stochastic discount factor is a Q-martingale, in fact it is an exponential martingale, whereas the zero coupon bond price is not a Q-martingale because, as can be seen below, its SDE has a non-zero drift. d P(t, T ) = P(t, T ) (r (t)dt + (φ(t) − φ(T )) C(t)dW (t)) . (C.11) For non path-dependent pricing problems it is normally convenient to work in the so-called forward QT -measure. In this measure the numeraire at time t is simply P(t, T) and Girsanov’s theorem implies that W̄ (t), as define below, is a QT -Brownian motion d W̄ (t) = dW (t) + (φ(T ) − φ(t)) C(t)dt. Substitution of equation (C.12) into equation (C.10) yields t P(t, T ) P(0, T ) C(s)d W̄ (s) = exp − φ(T ) − φ(T ) P(t, T ) P(0, T ) 0 2 t 1 − φ(T ) − φ(T ) C(s)2 ds , ∀t ≤ T ≤ T. 2 0 (C.12) (C.13) In other words, the numeraire-rebased zero coupon bond in the forward QT -measure is a QT martingale.

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The requestor component encapsulates the need for a model pricer to gain access to both primary and secondary information: in essence a model pricer makes ‘requests’ of the model for this information. In the case of the Hull–White model there are only a few pieces of information required: a discount factor, a localvolatility and a term volatility. In the language of Appendix C, the t 2 term volatility is simply 0 C (s)ds and the local volatility is φ(t) − φ(T ). Note that, taken together with the relevant discount factors, any zero coupon bond can be written in terms of the local volatility and the term volatility. What we actually store in the environment for the term volatility is the following t 2 0 C (s)ds . t 0 exp(2λs)ds (8.1) The reason for this is that the above variable is more natural to use when calibrating the model to market prices. The requestor for the Hull–White model can be found in the ppf.model.hull white.requestor module as detailed below: class requestor: def discount factor(self, t, ccy, env): key = "zc.disc."

**
The Essays of Warren Buffett: Lessons for Corporate America
** by
Warren E. Buffett,
Lawrence A. Cunningham

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compound rate of return, corporate governance, Dissolution of the Soviet Union, diversified portfolio, dividend-yielding stocks, fixed income, index fund, invisible hand, large denomination, low cost carrier, oil shock, passive investing, price stability, Ronald Reagan, the market place, transaction costs, Yogi Berra, zero-coupon bond

Neither our bonds nor those of certain other companies that issued similar bonds last year (notably Loews and Motorola) resemble the great bulk of zero-coupon bonds that have been issued in recent years. Of these, Charlie and I have been, and will continue to be, outspoken critics. As I will later explain, such bonds have often been used in the most deceptive of ways and with deadly consequences to investors. But before we tackle that subject, let's travel back to Eden, to a time when the apple had not yet been bitten. If you're my age you bought your first zero-coupon bonds during World War II, by purchasing the famous Series E U.S. Savings Bond, the most widely-sold bond issue in history. (After the war, these bonds were held by one out of two U.S. households.) Nobody, of course, called the Series E a zero-coupon bond, a term in fact that I doubt had been invented. But that's precisely what the Series E was.

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Further illuminating the folly of junk bonds is an essay in this collection by Charlie Munger that discusses Michael Milken's approach to finance. Wall Street tends to embrace ideas based on revenue-generating power, rather than on financial sense, a tendency that often perverts good ideas to bad ones. In a history of zero-coupon bonds, for example, Buffett shows that they can enable a purchaser to lock in a compound rate of return equal to a coupon rate that a normal bond paying periodic interest would not provide. Using zero-coupons thus for a time enabled a borrower to borrow more without need of additional free cash flow to pay the interest expense. Problems arose, however, when zero-coupon bonds started to be issued by weaker and weaker credits whose free cash flow could not sustain increasing debt obligations. Buffett laments, "as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end."

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We suggest this cause: many of the foolish buyers, and their advisers, were trained by finance professors who pushed beloved models (efficient market theory and modern portfolio theory) way too far, while they ignored other models that would have warned of danger. This is a common type of "expert" error .... H. Zero-Coupon Bonds25 Berkshire issued $902.6 million principal amount of ZeroCoupon Convertible Subordinated Debentures, which are now listed on the New York Stock Exchange. Salomon Brothers handled the underwriting in superb fashion, providing us helpful advice and a flawless execution. Most bonds, of course, require regular payments of interest, usually semi-annually. A zero-coupon bond, conversely, requires no current interest payments; instead, the investor receives his yield by purchasing the security at a significant discount from maturity value. The effective interest rate is determined by the original issue price, the maturity value, and the amount of time between issuance and maturity.

**
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

If you knew what this function was you would be able to value fixed-coupon bonds of all maturities by using the discount factor to present value a payment at time T to today, t. Unfortunately you are not told what this r function is. Instead you only know, by looking at market prices of various fixed-income instruments, some constraints on this r function. As a simple example, suppose you know that a zero-coupon bond, principal $100, maturing in one year, is worth $95 today. This tells us that Suppose a similar two-year zero-coupon bond is worth $92, then we also know that This is hardly enough information to calculate the entire r(t) function, but it is similar to what we have to deal with in practice. In reality, we have many bonds of different maturity, some without any coupons but most with, and also very liquid swaps of various maturities. Each such instrument is a constraint on the r(t) function.

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The risk-neutral forward curve evolves according to dF (t; T) = m(t, T) dt + ν(t, T) dX. Zero-coupon bonds then have value given by the principal at maturity is here scaled to $1. A hedging argument shows that the drift of the risk-neutral process for F cannot be specified independently of its volatility and so This is equivalent to saying that the bonds, which are traded, grow at the risk-free spot rate on average. A multi-factor version of this results in the following risk-neutral process for the forward rate curve In this the dXi are uncorrelated with each other. Brace, Gatarek and Musiela The Brace, Gatarek & Musiela (BGM) model is a discrete version of HJM where only traded bonds are modelled rather than the unrealistic entire continuous yield curve. If Zi(t) = Z (t; Ti) is the value of a zero-coupon bond, maturing at Ti, at time t, then the forward rate applicable between Ti and Ti+1 is given by where τ = Ti+1 − Ti.

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The assumption that there are no arbitrage opportunities in the market is fundamental to classical finance theory. This idea is popularly known as ‘there’s no such thing as a free lunch.’ Example An at-the-money European call option with a strike of $100 and an expiration of six months is worth $8. A European put with the same strike and expiration is worth $6. There are no dividends on the stock and a six-month zero-coupon bond with a principal of $100 is worth $97. Buy the call and a bond, sell the put and the stock, which will bring in $ − 8 − 97 + 6 + 100 = $1. At expiration this portfolio will be worthless regardless of the final price of the stock. You will make a profit of $1 with no risk. This is arbitrage. It is an example of the violation of put-call parity. Long Answer The principle of no arbitrage is one of the foundations of classical finance theory.

**
A Primer for the Mathematics of Financial Engineering
** by
Dan Stefanica

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asset allocation, Black-Scholes formula, capital asset pricing model, constrained optimization, delta neutral, discrete time, Emanuel Derman, implied volatility, law of one price, margin call, quantitative trading / quantitative ﬁnance, Sharpe ratio, short selling, time value of money, transaction costs, volatility smile, yield curve, zero-coupon bond

The convexity C of a bond with price B and yield y is 1 82 B C=B8 y 2· 2.8. NUMERICAL IMPLEMENTATION OF BOND MATHEMATICS 73 From (2.62) and (2.64), we conclude that y = r(O, T). In other words, the yield of a zero coupon bond is the same as the zero rate corresponding to the maturity of the bond. This explains why the zero rate curve r(O, t) is also called the yield curve. As expected, the duration of a zero coupon bond is equal to the maturity of the bond. From (2.58) and (2.64), we obtain that D = - ~ 8B = _ _ 1_ (-T Fe- yT ) = T Fe- yT B' 8y . The convexity of a zero coupon bond can be computed from (2.60) and (2.64): 1 1 82B C = - = -(T2 Fe- yT ) B 8y2 Fe- yT (2.60) = T2. Using (2.56), it is easy to see that C _ - ",n t2 -yt· L..,1i=1 i Ci t e B . (2.61) 2.8 The following approximation of the percentage change in the price of the bond for a given a change in the yield of the bond is more accurate than (2.59) and will be proved in section 5.6 using Taylor expansions: flB 13 ~ - Dfly + 1 2,C(fly)2.

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(2.61) 2.8 The following approximation of the percentage change in the price of the bond for a given a change in the yield of the bond is more accurate than (2.59) and will be proved in section 5.6 using Taylor expansions: flB 13 ~ - Dfly + 1 2,C(fly)2. Numerical implementation of bond mathematics When specifying a bond, the maturity T of the bond, as well as the cash flows Ci and the cash flows dates ti, i = 1 : n, are given. The price of the bond can be obtained from formula (2.53), i.e., B 2.7.1 = Zero Coupon Bonds i=l A zero coupon bond is a bond that pays back the face value of the bond at maturity and has no other payments, i.e., has coupon rate equal to 0. If F is the face value of a zero coupon bond with maturity T, the bond pricing formula (2.53) becomes B = F e -r(O,T)T, (2.62) ° where B is the price of the bond at time and r (0, T) is the zero rate corresponding to time T. If the instantaneous interest rate curve r(t) is given, the bond pricing formula (2.54) becomes (2.63) provided that the zero rate curve r(O, t) is known for any t > 0, or at least for the cash flow times, i.e., for t = ti, i = 1 : n.

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Bonds. 2.1 Double integrals. . . . . . . . . . 2.2 Improper integrals . . . . . . . . . . . . . . 2.3 Differentiating improper integrals . . . . . . 2.4 Midpoint, Trapezoidal, and Simpson's rules. 2.5 Convergence of Numerical Integration Methods 2.5.1 Implementation of numerical integration methods 2.5.2 A concrete example. . 2.6 Interest Rate Curves . . . . . 2.6.1 Constant interest rates 2.6.2 Forward Rates. . . . . 2.6.3 Discretely compounded interest 2.7 Bonds. Yield, Duration, Convexity . . 2.7.1 Zero Coupon Bonds. . . . . . . 2.8 Numerical implementation of bond mathematics 2.9 References 2.10 Exercises . 3 Probability concepts. Black-Scholes formula. Greeks and Hedging. 3.1 Discrete probability concepts. . . . . . . . . 3.2 Continuous probability concepts. . . . . . . 3.2.1 Variance, covariance, and correlation 3.3 The standard normal variable 3.4 Normal random variables . . . 3.5 The Black-Scholes formula. . 3.6 The Greeks of European options. 3.6.1 Explaining the magic of Greeks computations 3.6.2 Implied volatility . . . . . . . . . . . . 3.7 The concept of hedging. ~- and r-hedging . 3.8 Implementation of the Black-Scholes formula. 3.9 References 3.10 Exercises. . . . . . . . . . . . . . . . . . . . 4 45 45 48 51 52 56 58 62 64 66 66 67 69 72 73 77 78 81 81 83 85 89 91 94 97 99 103 105 108 110 111 Lognormal variables.

**
Asset and Risk Management: Risk Oriented Finance
** by
Louis Esch,
Robert Kieffer,
Thierry Lopez

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asset allocation, Brownian motion, business continuity plan, business process, capital asset pricing model, computer age, corporate governance, discrete time, diversified portfolio, implied volatility, index fund, interest rate derivative, iterative process, P = NP, p-value, random walk, risk/return, shareholder value, statistical model, stochastic process, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

As for the second factor, it can be assumed that for equal levels of maturity, the rate is the same for all securities in accordance with the law of supply and demand. In reality, the coupon policies of the various issuers introduce additional differences; in the following paragraphs, therefore, we will only be dealing with zero-coupon bonds whose rate now depends only on their maturities. This simpliﬁcation is justiﬁed by the fact that a classic bond is a simple ‘superimposition’ of zero-coupon securities, which will be valuated by discounting of the various ﬁnancial ﬂows (coupons and repayment) at the corresponding rate.14 We are only dealing with deterministic structures for interest rates; random cases are dealt with in Section 4.5. If we describe P (s) as the issue price of a zero-coupon bond with maturity s and R(s) as the rate observed on the market at moment 0 for this type of security, called the spot rate, these two values are clearly linked by the relation P (s) = (1 + R(s))−s .

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There may be premiums (positive or negative) on issue and/or on repayment. The bonds described above are those that we will be studying in this chapter; they are known as ﬁxed-rate bonds. There are many variations on this simple bond model. It is therefore possible for no coupons to be paid during the bond’s life span, the return thus being only the difference between the issue price and the redemption value. This is referred to as a zero-coupon bond .1 This kind of security is equivalent to a ﬁxed-rate investment. There are also bonds more complex than those described above, for example:2 • Variable rate bonds, for which the value of each coupon is determined periodically according to a parameter such as an index. 1 A debenture may therefore, in a sense, be considered to constitute a superimposition of zero-coupon debentures. Read for example Colmant B., Delfosse V. and Esch L., Obligations, Les notions ﬁnancières essentielles, Larcier, 2002.

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For a ﬁxed period of time (such as one year), it is possible to use a rate of return equivalent to the return on one equity: Pt + Ct − Pt−1 Pt−1 This concept is, however, very little used in practice. 4.1.2.1 Actuarial rate on issue The actuarial rate on issue, or more simply the actuarial rate (r) of a bond is the rate for which there is equality between the discounted value of the coupons and the repayment value on one hand and the issue price on the other hand: P = T Ct (1 + r)−t + R(1 + r)−T t=1 Example Consider for example a bond with a period of six years and nominal value 100, issued at 98 and repaid at 105 (issue and reimbursement premiums 2 and 5 respectively) and a nominal rate of 10 %. The equation that deﬁnes its actuarial rate is therefore: 98 = 10 10 10 10 10 10 + 105 + + + + + 1+r (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 (1 + r)6 This equation (sixth degree for unknown r) can be resolved numerically and gives r = 0.111044, that is, r = approximately 11.1 %. The actuarial rate for a zero-coupon bond is of course the rate for a risk-free investment, and is deﬁned by P = R(1 + r)−T Bonds 117 The rate for a bond issued and reimbursable at par (P = N V = R), with coupons that are equal (Ct = C for all t) is equal to the nominal rate: r = rn . In fact, for this particular type of bond, we have: P = T C(1 + r)−t + P (1 + r)−T t=1 =C (1 + r)−1 − (1 + r)−T −1 + P (1 + r)−T 1 − (1 + r)−1 =C 1 − (1 + r)−T + P (1 + r)−T r From this, it can be deduced that r = C/P = rn . 4.1.2.2 Actuarial return rate at given moment The actuarial rate as deﬁned above is calculated when the bond is issued, and is sometimes referred to as the ex ante rate.

**
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

However, because calculating a bond’s YTM is complex and involves trial and error, it usually is done with a programmable business calculator. Related Terms: • Bond • Interest Rate • Yield • Coupon • Par Value Z zero-couPon bond What Does Zero-Coupon Bond Mean? A debt security that does not pay interest (a coupon) but is traded at a deep discount and paid in full at face value upon maturity; also called an accrual bond. Investopedia explains Zero-Coupon Bond Some zero-coupon bonds are issued as such, whereas others are bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price more than coupon bonds do. Related Terms: • Bond • Discount Rate • Maturity • Coupon • Face Value 327 This page intentionally left blank Index Note: page numbers in bold indicate definition 10-K/10-Q report, 1 401(k) plan, 1-2 403(b) plan, 2 ABS.

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The effective annual rate of return after considering the effect of compounding interest; APY assumes that funds will remain in the investment vehicle for a full 365 days and = (1 + periodic rate)# Periods - 1 is calculated as follows: Investopedia explains Annual Percentage Yield (APY) APY is similar to the annual percentage rate insofar as it standardizes varying interest rate agreements into an annualized percentage number. For example, suppose you are considering whether to invest in a one-year zero-coupon bond that pays 6% at maturity or a high-yield money market account that pays 0.5% per month with monthly compounding. At first glance, the yields appear identical— 12 months multiplied by 0.5% equals 6%—but when the effects of compounding are included, it can be seen that the second investment actually yields more: 6.17% (1.005^(12 – 1) = 0.0617). Related Terms: • Certificate of Deposit—CD • Compound Annual Growth Rate—CAGR • Compounding • Money Market Account • Yield Annuity What Does Annuity Mean?

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This also is referred to as the coupon rate or coupon percent rate. Investopedia explains Coupon For example, a $1,000 bond with a coupon of 7% will pay $70 a year. It is called a coupon because some bonds literally have coupons attached to them. Holders receive interest by stripping off the coupons and redeeming them. This is less common today as more records are kept electronically. Related Terms: • Bond • Premium • Zero-Coupon Bond • Interest Rate • Yield Covariance What Does Covariance Mean? A measure of the degree by which the returns on two risky assets move in tandem. A positive covariance means that asset returns move together; a negative covariance means the returns move inversely. One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. Another method is to multiply the correlation between the two variables by the standard deviation of each variable. 56 The Investopedia Guide to Wall Speak Investopedia explains Covariance Financial assets that have a high covariance with each other will not provide very much diversification.

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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

The Japanese investors were keen on the high rates; specifically, they wanted to buy zero coupon bonds. Now in a normal bond you get regular interest payments and in a zero coupon bond, you get all your interest at the end. For example, let’s DAS_C08.QXP 8/7/06 222 4:49 PM Page 222 Tr a d e r s , G u n s & M o n e y say you own a $100 bond that pays 10% for ten years. Normally you would get $10 interest each year and get your $100 back after ten years. In a zero coupon bond you don’t get any interest but at the end of ten years you get back $259. The $259 is the $100 you invested plus $159 of interest, which is $10 for each of the ten years and the interest on the interest. The two bonds are exactly the same in terms of the return you get, but there are interesting differences. Zero coupon bonds are very sensitive to changes in interest rates, which the Japanese investors liked.

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There was also a tax advantage: if you got normal interest rates then you paid tax on them but with a zero coupon bond, you paid $100 today for a payment of $259 in ten years. Was the $159 income or something else? It all depended where you were. In Japan, at the time, the $159 was treated as a capital gain and wasn’t taxed. This made it even more attractive for the investors – tax The MoF became free income. Understandably, Japanese investors concerned about this were keen on US$ zero coupon bonds and blatant form of tax bought a lot of them. The MoF became avoidance. The solution concerned about this blatant form of tax was very Japanese. avoidance. The solution was very Japanese: the MoF let it be known that they preferred that investors limit their purchases of dollar zero coupon bonds. The investors complied. It was the way Japan Inc. worked.

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This was shares without tears, investment without fear. The deal was an ingenious collage. The investor was buying a zero coupon bond, a bond that paid no interest. The investor bought it at a discount to its face value. For example, the investor would pay $74 to buy a DAS_C04.QXP 8/7/06 258 4:51 PM Page 258 Tr a d e r s , G u n s & M o n e y bond worth $100. Over five years, this was the same as getting 6.00% pa. The $26 discount was the interest. In the capital guaranteed note, the investor paid $100 anyway. The $26 interest was used to buy a call option on the stocks, which provided the upside for the investor should the stock market rally. If it fell then the zero coupon bond matured and guaranteed the return of principal to the investor. The structure worked well. Billions were sold. The dealers gouged the investors on the interest rate on the zero and the option but it still worked.

**
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

So which yield are we plotting at the 10-year point in figure 14.1? To clarify this question, fixed-income traders often look at the term structure of zero-coupon bond yields, i.e., the yield on a bond where C = 0 so that its entire value comes from the face value, which is paid at a single point in time. Traders observe zero-coupon bonds both by looking at the prices of such traded bonds and by inferring the zero-coupon bond yields from the prices of coupon bonds. Indeed, a coupon bond can be viewed as a portfolio of zero-coupon bonds—one for each coupon payment and one for payment of the face value. Hence, coupon bond values can be derived from zero-coupon bond yields, and vice versa. Figure 14.1. The yield curve, also called the term structure of interest rates. Bond Returns and Duration Having understood bond prices and bond yields, we just need to understand bond returns—i.e., how much money one can make in percentage from holding a bond.

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Hence, the price sensitivity to yield changes is negative, and its absolute value is called the duration, D: By the magic of fixed-income mathematics, the duration can be shown (by differentiating equation 14.1) to be equal to the weighted-average time to maturity of all the remaining cash flows (coupons and face value) where each weight wti is the fraction of the bond’s present value being paid at that time Equation 14.4 explains the term “duration”: Dt is a weighted average of the times ti – t to the remaining cash flows. For instance, the duration of a 5-year zero-coupon bond is naturally equal to its time to maturity, 5. The magic is that Dt is also given by equation 14.3, that is, it also tells us how sensitive a bond price is to changes in its yield. Hence, equations 14.3 and 14.4 together tell us that the prices of longer term bonds are more yield sensitive than those of shorter term bonds. With this definition of duration, we can compute the price change ΔP that occurs with a sudden change in yield, ΔYTMt: Here, the last equality introduces the “modified duration,” .

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If the YTM changes, then this yield change leads to an additional effect given via the modified duration (computed next time period at the current yield): If the yield rises as in figure 14.2, then the bond return will be reduced during this period, as seen in equation 14.7. If this happens, however, then the expected return going forward will be higher, as the bond now earns a higher yield. Indeed, if a zero-coupon bond is held to maturity, its return will still average its original YTM. Yield and Return of a Leveraged Bond Traders are often interested in their excess return over the risk-free rate and, correspondingly, a bond’s yield above the short rate. Indeed, bonds are often leveraged, that is, bought with borrowed money (where the bond is used as collateral) and the bond’s excess return is effectively the return of such a leveraged position.

**
Money Mavericks: Confessions of a Hedge Fund Manager
** by
Lars Kroijer

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Bernie Madoff, capital asset pricing model, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, new economy, Ponzi scheme, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

Because Bure had so many bad associations, it was also likely that brand-name Swedish investment companies would shy away from having Bure appear in their holdings. The rights issue was structured as follows: for every share you held in the company you would be given one new share, two warrants with a five-year exercise period and a strike price of 0.75 SEK, and a zero-coupon bond with a par value of 2.50 SEK that would mature five years after issue (zero-coupon bonds don’t pay interest but trade at a discount to the eventual payment that reflects the time to maturity and credit risk). Jesus, it was confusing. After the recent mess, who would understand that, much less want to invest in it? After spending a couple of weeks analysing Bure, we came to the view that the company was trading at about a 45 per cent discount to the net asset value.

…

Although high, this discount level is not unusual for a European holding company, particularly when the values in the non-quoted businesses are not transparent and there is turmoil in the organisation. Two things about Bure intrigued us. The new and convoluted capital structure left shareholders confused and we felt there was a good chance that one of these three instruments (share, warrant or zero-coupon bond) would be severely mispriced. Also, we felt that the new management was open and willing to acknowledge that nothing was sacred in trying to turn the business round. I asked if this included the possibility that the organisation might be worth more if it ceased to exist and they replied, ‘Theoretically, yes’. Then again, without a dominant shareholder to support management, a shareholder-friendly attitude was clearly the order of the day.

…

Index Abramovich, Roman Absolute Returns for Kids (ARK) added value, 2nd, 3rd, 4th, 5th Africa poverty alleviation projects Aker Yards, 2nd, 3rd, 4th, 5th, 6th alpha and beta, 2nd, 3rd AP Fondet arbitrage, merger 2nd asset-stripping assets under management (AUM), 2nd, 3rd, 4th, 5th background checking bank bailouts 2008–09 Bank of Ireland Bear Stearns Berkeley Square, 2nd, 3rd Berkshire Hathaway Bezos, Jeff Black-Scholes-Merton option-pricing formula Blair, Tony Bloomberg, 2nd bonds corporate, 2nd government, 2nd, 3rd zero-coupon bonuses, 2nd, 3rd British Airways Buffett, Warren Bure burn-out Busson, Arpad capital gross invested, 2nd, 3rd regulatory seed, 2nd capital asset pricing model (CAPM) cascade effect, 2nd cash deposits, 2nd insurance The Children’s Investment Fund Management (TCI) churning Collery, Peter compensation structures, 2nd, 3rd, 4th see also bonuses competitive edge, 2nd, 3rd, 4th, 5th Conti, Massimo, 2nd corporate bonds, 2nd correlation, market, 2nd, 3rd, 4th, 5th, 6th, 7th country indices Credit Suisse, 2nd, 3rd Cuccia, Enrico Dagens Industry debt crises (2011) debt investments derivative trading discounted fees, 2nd discounts to net asset value diversification, 2nd, 3rd, 4th dividends, 2nd early investors edge, competitive, 2nd, 3rd, 4th, 5th efficient market frontier Enskilda Baken entertainment events entrepreneurship, 2nd equity redistribution Eurohedge, 2nd, 3rd European Fund Manager of the Year Award event assessment, 2nd exchange traded funds (ETFs), 2nd, 3rd, 4th expenses firm, 2nd, 3rd, 4th, 5th fund-related, 2nd, 3rd, 4th, 5th, 6th, 7th, 8th family life, 2nd fees see incentive fees; management fees; performance fees Fidelity Financial Times firm costs, 2nd, 3rd, 4th, 5th Ford, Tom Fresenius FSA (Financial Services Authority), 2nd, 3rd, 4th, 5th fundamental value analysis funds of funds, 2nd, 3rd, 4th, 5th, 6th futures gearing, 2nd, 3rd, 4th, 5th, 6th Gentry, Baker, 2nd, 3rd Goldman Sachs, 2nd government bonds, 2nd, 3rd gross invested capital, 2nd, 3rd Gross, Julian Grosvenor Square HBK Investments, 2nd, 3rd headhunting health, 2nd hedge funds collapse of, 2nd expenses see expenses fees see incentive fees; management fees; performance fees industry growth, 2nd, 3rd mid-cap/large-cap bias nature of operational planning opportunities for young managers ownership structures partnership break-ups short-term performance staff recruitment, 2nd starting up top managers value generated by Henkel herd mentality, 2nd Hohn, Chris holding company discounts incentive fees, 2nd, 3rd, 4th index funds, 2nd, 3rd, 4th, 5th, 6th insurance, cash deposit insurance sector, 2nd interviews investor activism Italian finance JP Morgan Keynes, John Maynard Korenvaes, Harlen, 2nd Lage, Alberto, 2nd, 3rd large-cap bias Lazard Frères, 2nd, 3rd, 4th, 5th Lebowitz, Larry leverage, 2nd Liechtenstein, Max liquidity London bombings (7 July 2005) long run, 2nd, 3rd long securities Long Term Capital Management (LTCM) Lyle, Dennis Macpherson, Elle managed accounts management fees, 2nd, 3rd, 4th, 5th, 6th, 7th, 8th discounted, 2nd funds of funds, 2nd mutual funds tracker funds Mannesmann market capitalisation, 2nd, 3rd market correlation, 2nd, 3rd, 4th, 5th, 6th, 7th market exposure, 2nd, 3rd, 4th, 5th, 6th market neutrality, 2nd mean variance optimisation Mediobanca merger arbitrage, 2nd Merrill Lynch Merton, Robert mid-cap bias Montgomerie, Colin Morgan Stanley, 2nd, 3rd, 4th, 5th, 6th, 7th TMT (telecom, media and technology) conferences Morland, Sam, 2nd, 3rd MSCI World index, 2nd, 3rd mutual funds NatWest Nelson, Jake net asset-value (NAV), 2nd Nokia Norden O’Callaghan, Brian, 2nd, 3rd, 4th, 5th, 6th, 7th, 8th, 9th, 10th, 11th, 12th, 13th Och, Dan oil tanker companies oilrig sector, 2nd options trading out-of-the-money put options ownership structure partnership break-ups pension funds, 2nd performance fees, 2nd, 3rd, 4th Perry, Richard personal networks Philips, David portfolio theory poverty alleviation prime brokerage private jet companies Ramsay, Gordon Rattner, Steve recruitment, 2nd redemption notices regulatory capital returns, 2nd rights issues risk, 2nd, 3rd risk profile, 2nd, 3rd, 4th, 5th, 6th, 7th Rohatyn, Felix Ronaldo Rosemary Asset Management Rothschild, Mayer Royal Bank of Scotland Rubenstein, David rump (stub) trades salaries see compensation structures Samson, Peter SAS airline SC Fundamental seed capital, 2nd shipping companies short securities short-term performance six-stigma events Smith Capital Partners, 2nd softing special situations stakeholders Standard & Poor’s 500 index, 2nd, 3rd, 4th standard deviation, 2nd, 3rd, 4th star managers Start-up of the Year awards Stern, Dan stub trades Superfos Svantesson, Lennart talent introduction groups tax, 2nd, 3rd, 4th Telefonica Moviles time horizon for investments, 2nd, 3rd Torm Totti, David tracker funds trade commission trade sourcing trade theses US market value investing Vanguard index fund, 2nd VIX index, 2nd Vodafone warrants, 2nd, 3rd Westbank Wien, Byron Wilson, Susan world indices, 2nd zero-coupon bonds Zilli, Aldo PEARSON EDUCATION LIMITED Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearson.com/uk First published in Great Britain in 2010 Second edition 2012 Electronic edition published 2012 © Pearson Education Limited 2012 (print) © Pearson Education Limited 2012 (electronic) The right of Lars Kroijer to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988.

**
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing
** by
Burton G. Malkiel

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accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, mortgage tax deduction, new economy, Own Your Own Home, passive investing, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, The Myth of the Rational Market, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

Of course, the actual long-run rate of inflation may be considerably greater than 2 percent. But the 4 percent real return they promise gives a reasonably generous margin of safety. In my view, there are four kinds of bond purchases that you may want especially to consider: (1) zero-coupon bonds (which allow you to lock in high yields for a predetermined length of time); (2) no-load bond mutual funds (which permit you to buy shares in bond portfolios); (3) tax-exempt bonds and bond funds (for those who are fortunate enough to be in high tax brackets); and (4) U.S. Treasury inflation-protection securities (TIPS). Zero-Coupon Bonds Can Generate Large Future Returns Suppose you were told you could invest $10,000 now and be guaranteed by the government that you would get back double that amount in about fifteen years. The ability to do so is possible through the use of zero-coupon securities.

…

A FITNESS MANUAL FOR RANDOM WALKERS Exercise 1: Gather the Necessary Supplies Exercise 2: Don’t Be Caught Empty-Handed: Cover Yourself with Cash Reserves and Insurance Cash Reserves Insurance Deferred Variable Annuities Exercise 3: Be Competitive—Let the Yield on Your Cash Reserve Keep Pace with Inflation Money-Market Mutual Funds (Money Funds) Bank Certificates of Deposit (CDs) Internet Banks Treasury Bills Tax-Exempt Money-Market Funds Exercise 4: Learn How to Dodge the Tax Collector Individual Retirement Accounts Roth IRAs Pension Plans Saving for College: As Easy as 529 Exercise 5: Make Sure the Shoe Fits: Understand Your Investment Objectives Exercise 6: Begin Your Walk at Your Own Home—Renting Leads to Flabby Investment Muscles Exercise 7: Investigate a Promenade through Bond Country Zero-Coupon Bonds Can Generate Large Future Returns No-Load Bond Funds Are Appropriate Vehicles for Individual Investors Tax-Exempt Bonds Are Useful for High-Bracket Investors Hot TIPS: Inflation-Indexed Bonds Should You Be a Bond-Market Junkie? Exercise 8: Tiptoe through the Fields of Gold, Collectibles, and Other Investments Exercise 9: Remember That Commission Costs Are Not Random; Some Are Lower than Others Exercise 10: Avoid Sinkholes and Stumbling Blocks: Diversify Your Investment Steps A Final Checkup 13.

…

Financial innovation over the same period has been equally rapid. In 1973, when the first edition of this book appeared, we did not have money-market funds, NOW accounts, ATMs, index mutual funds, ETFs, tax-exempt funds, emerging-market funds, target-date funds, floating-rate notes, volatility derivatives, inflation protection securities, equity REITs, asset-backed securities, Roth IRAs, 529 college savings plans, zero-coupon bonds, financial and commodity futures and options, and new trading techniques such as “portfolio insurance” and “flash trading,” to mention just a few of the changes that have occurred in the financial environment. Much of the new material in this book has been included to explain these financial innovations and to show how you as a consumer can benefit from them. This tenth edition also provides a clear and easily accessible description of the academic advances in investment theory and practice.

**
Mathematical Finance: Core Theory, Problems and Statistical Algorithms
** by
Nikolai Dokuchaev

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Black-Scholes formula, Brownian motion, buy low sell high, discrete time, fixed income, implied volatility, incomplete markets, martingale, random walk, short selling, stochastic process, stochastic volatility, transaction costs, volatility smile, Wiener process, zero-coupon bond

The new market can be considered as a multistock market model with N stocks (N−1 options plus the original stock). Is this market arbitrage-free? (Hint: consider first N=2 and Ti≥T.) 5.13 Bond markets Bonds are being sold an initial time for a certain price, and the owners are entitled to obtain certain amounts of cash (higher than this initial price) in fixed time (we restrict our consideration to zero-coupon bonds only). Therefore, the owner can have fixed income. Typically, there are many different bonds on the market with different times of maturity, and they are actively traded, so the analysis of bonds is very important for applications. For the bond-and-stock market models introduced above, we refer to bonds as a riskfree investment similar to a cash account. For instance, it is typical for the Black-Scholes market model where the bank interest rate is supposed to be constant.

…

To ensure that the process θ(t) is finite and the model is arbitrage-free, some special conditions on a must be imposed such that equation (5.25) is solvable with respect to θ. To satisfy these restrictions, the bond market model deals with ã being linear functions of σ. In addition, we have feature (ii): the process (ã, σ) must be chosen to ensure that the price process is bounded (for instance, a.s. if Si(t) is the price for a zero-coupon bond with the payoff 1 at terminal (maturing) time T). Consider the case when the bank interest rate r(t) is non-random and known. Let P(t) be the price of a bond with payoff 1 at terminal time T (said to be the maturity time). Clearly, the only price of the bond that does not allow arbitrage for seller and for buyer is In this case, investment in the bond gives the same profit as investment in the cash account.

…

The choice of this measure may be affected by risk and risk premium associated with particular bonds. (For instance, some bonds are considered more risky than others; to ensure liquidity, they are offered for some lower price, so the possible reward for an investor may be higher.) Models for bond prices are widely studied in the literature (see the review in Lambertone and Lapeyre, 1996). An example: a model of the bond market Let us describe a possible model of a market with N zero-coupon bonds with bond prices Pk(t), where © 2007 Nikolai Dokuchaev and where is a given set of maturing times, Continuous Time Market Models 105 We consider the case where there is a driving n-dimensional Wiener process w(t). Let be a filtration generated by this Wiener process. We assume that the process r(t) is (To cover some special models, we do not assume that r(t)≥0.) In addition, adapted to we assume that we are given an and bounded process q(t) that takes values in Rn.

**
My Life as a Quant: Reflections on Physics and Finance
** by
Emanuel Derman

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Berlin Wall, bioinformatics, Black-Scholes formula, Brownian motion, capital asset pricing model, Claude Shannon: information theory, Emanuel Derman, fixed income, Gödel, Escher, Bach, haute couture, hiring and firing, implied volatility, interest rate derivative, Jeff Bezos, John von Neumann, law of one price, linked data, Long Term Capital Management, moral hazard, Murray Gell-Mann, pre–internet, publish or perish, quantitative trading / quantitative ﬁnance, Richard Feynman, Sharpe ratio, statistical arbitrage, statistical model, Stephen Hawking, Steve Jobs, stochastic volatility, technology bubble, transaction costs, value at risk, volatility smile, Y2K, yield curve, zero-coupon bond

In fact, it is impossible to model one bond without modeling all of them. A five-year bond and a three-year bond have other commonalities, too.You can think of a five-year Treasury bond that pays interest every six months as a collection of ten zero-coupon bonds with maturities spread six months apart over the next five years. Similarly, a three-year Treasury bond is a collection of six zero-coupon bonds respectively maturing every successive six months over the next three years. Decomposed in this way, the bonds' ingredients are shared: Both contain the first six zero-coupon bonds. Therefore, in modeling the three-year bond, you are also implicitly modeling parts of the five-year bond. In essence, Ravi's model allowed impermissible violations of the law of one price that lies beneath all rational financial modeling.

…

Stocks are relatively simple; they guarantee no future dividend payments and have no natural termination date, so their future prices are unconstrained. Treasury bonds are much more intricate: Because they promise to repay their principal when they mature, their price on that date is constrained to be par. Furthermore, since all Treasury bonds can be decomposed into a sum of more primitive zero-coupon bonds of varying maturities, they are all interrelated. My new boss Ravi had heuristically modified the Black-Scholes stock option model to make it work, at least approximately, for short-dated Treasury bond options. He had written a computer program to implement it, and the bond options desk now priced and hedged their options by means of it. As they got more experienced at using it, Peter Freund's desk discovered that Ravi's model was fine for short-terns options but questionable for longer-term ones; it suffered from a variety of theoretical inconsistencies stemming from its inadequate modeling of the longterm behavior of bond prices.

**
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

Globally, net issues of international debt security markets reached US $2,733 billion in 2006, up from US $1,850 billion in 2005, with the UK contributing US $414 billion, up from US $362 billion, marking a decline in UK market share from 20 to 15 per cent, according to the May 2007 IFSL report. ____________________________________________ CREDIT PRODUCTS 93 The United States gained in market share from 11 to 18 per cent over the same period, leapfrogging the UK as its net issues rose from US $205 billion to US $505 billion. Spain, France, Italy and others lost market share, while the Netherlands and Ireland gained. Zero-coupon bonds Zero-coupon bonds do not pay interest in their life. Investors buy them at a deep discount from par value, which they receive in full when the bond reaches maturity. The bonds give investors predictability, but the price swings easily with interest rate changes and the market is fairly illiquid. If investors should sell before maturity, they may not make a proﬁt. Gains are subject to capital gains tax.

…

The investor would then be left with money to reinvest in a world where interest rates are low. To compensate for this reinvestment risk, the callable bond will often pay a high coupon. 12 Credit products Introduction In this chapter, we will cover credit products, as distinct from the interest rate products covered in Chapter 11. We will focus on corporate bonds, international debt securities, junk bonds, asset-backed securities, zero-coupon bonds and equity convertibles. We will consider credit derivatives. Overview Credit products are integral to ﬁnancial markets and help to fuel merger and acquisition activity, which, as we saw in Chapter 7, can keep equity market activity high. A predator will often ﬁnance a company takeover partly out of cheap debt, which has helped to keep credit markets buoyant. Credit products may be seen as parts of a larger whole.

…

Index 419 fraud 204 9/11 terrorist attacks 31, 218, 242, 243, 254, 257 Abbey National 22 ABN AMRO 103 accounting and governance 232–38 scandals 232 Accounting Standards Board (ASB) 236 administration 17 Allianz 207 Alternative Investment Market (AIM) 44–45, 131, 183, 238 Amaranth Advisors 170 analysts 172–78 fundamental 172–74 others 177–78 Spitzer impact 174–75 technical 175–77 anti-fraud agencies Assets Recovery Agency 211–13 City of London Police 209 Financial Services Authority 208 Financial Crime and Intelligence Division 208 Insurance Fraud Bureau 209 Insurance Fraud Investigators Group 209 International Association of Insurance Fraud Agencies 207, 210, 218 National Criminal Intelligence Service 210 Serious Fraud Ofﬁce 213–15 Serious Organised Crime Agency 210–11 asset ﬁnance 24–25 Association of Investment Companies 167 backwardation 101 bad debt, collection of 26–28 Banco Santander Central Hispano 22 Bank for International Settlements (BIS) 17, 27, 85, 98, 114 bank guarantee 23 Bank of Credit and Commerce International (BCCI) 10, 214 Bank of England 6, 10–17 Court of the 11 credit risk warning 98 framework for sterling money markets 81 Governor 11, 13, 14 history 10, 15–16 Inﬂation Report 14 inﬂation targeting 12–13 interest rates and 12 international liaison 17 lender of last resort 15–17 Market Abuse Directive (MAD) 16 monetary policy and 12–15 Monetary Policy Committee (MPC) 13–14 Open-market operations 15, 82 repo rate 12, 15 role 11–12 RTGS (Real Time Gross Settlement) 143 statutory immunity 11 supervisory role 11 Bank of England Act 1988 11, 12 Bank of England Quarterly Model (BEQM) 14 Banking Act 1933 see Glass-Steagall Act banks commercial 5 investment 5 Barclays Bank 20 Barings 11, 15, 68, 186, 299 Barlow Clowes case 214 Barron’s 99 base rate see repo rate Basel Committee for Banking Supervision (BCBS) 27–28 ____________________________________________________ INDEX 303 Basel I 27 Basel II 27–28, 56 Bear Stearns 95, 97 BearingPoint 97 bill of exchange 26 Bingham, Lord Justice 10–11 Blue Arrow trial 214 BNP Paribas 145, 150 bond issues see credit products book runners 51, 92 Borsa Italiana 8, 139 bps 90 British Bankers’ Association 20, 96, 97 building societies 22–23 demutualisation 22 Building Societies Association 22 Capital Asset Pricing Model (CAPM) see discounted cash ﬂow analysis capital gains tax 73, 75, 163, 168 capital raising markets 42–46 mergers and acquisitions (M&A) 56–58 see also ﬂotation, bond issues Capital Requirements Directive 28, 94 central securities depository (CSD) 145 international (ICSD) 145 Central Warrants Trading Service 73 Chancellor of the Exchequer 12, 13, 229 Chicago Mercantile Exchange 65 Citigroup 136, 145, 150 City of London 4–9 Big Bang 7 deﬁnition 4 employment in 8–9 ﬁnancial markets 5 geography 4–5 history 6–7 services offered 4 world leader 5–6 clearing 140, 141–42 Clearing House Automated Payment System (CHAPS) 143 Clearstream Banking Luxembourg 92, 145 commercial banking 5, 18–28 bad loans and capital adequacy 26–28 banking cards 21 building societies 22–23 credit collection 25–26 ﬁnance raising 23–25 history 18–19 overdrafts 23 role today 19–21 commodities market 99–109 exchange-traded commodities 101 ﬂuctuations 100 futures 100 hard commodities energy 102 non-ferrous metals 102–04 precious metal 104–06 soft commodities cocoa 107 coffee 106 sugar 107 Companies Act 2006 204, 223, 236 conﬂict of interests 7 consolidation 138–39 Consumer Price Index (CPI) 13 contango 101 Continuous Linked Settlement (CLS) 119 corporate governance 223–38 best practice 231 Cadbury Code 224 Combined Code 43, 225 compliance 230 deﬁnition 223 Directors’ Remuneration Report Regulations 226 EU developments 230 European auditing rules 234–35 Greenbury Committee 224–25 Higgs and Smith reports 227 International Financial Reporting Standards (IFRS) 237–38 Listing Rules 228–29 Model Code 229 Myners Report 229 OECD Principles 226 operating and ﬁnancial review (OFR) 235– 36 revised Combined Code 227–28 Sarbanes–Oxley Act 233–34 Turnbull Report 225 credit cards 21 zero-per-cent cards 21 credit collection 25–26 factoring and invoice discounting 26 trade ﬁnance 25–26 credit derivatives 96–97 back ofﬁce issues 97 credit default swap (CDS) 96–97 credit products asset-backed securities 94 bonds 90–91 collateralised debt obligations 94–95 collateralised loan obligation 95 covered bonds 93 equity convertibles 93 international debt securities 92–93 304 INDEX ____________________________________________________ junk bonds 91 zero-coupon bonds 93 credit rating agencies 91 Credit Suisse 5, 136, 193 CREST system 141, 142–44 dark liquidity pools 138 Debt Management Ofﬁce 82, 86 Department of Trade and Industry (DTI) 235, 251, 282 derivatives 60–77 asset classes 60 bilateral settlement 66 cash and 60–61 central counterparty clearing 65–66 contracts for difference 76–77, 129 covered warrants 72–73 futures 71–72 hedging and speculation 67 on-exchange vs OTC derivatives 63–65 options 69–71 Black-Scholes model 70 call option 70 equity option 70–71 index options 71 put option 70 problems and fraud 67–68 retail investors and 69–77 spread betting 73–75 transactions forward (future) 61–62 option 62 spot 61 swap 62–63 useful websites 75 Deutsche Bank 136 Deutsche Börse 64, 138 discounted cash ﬂow analysis (DCF) 39 dividend 29 domestic ﬁnancial services complaint and compensation 279–80 ﬁnancial advisors 277–78 Insurance Mediation Directive 278–79 investments with life insurance 275–76 life insurance term 275 whole-of-life 274–75 NEWICOB 279 property and mortgages 273–74 protection products 275 savings products 276–77 Dow theory 175 easyJet 67 EDX London 66 Egg 20, 21 Elliott Wave Theory 176 Enron 67, 114, 186, 232, 233 enterprise investment schemes 167–68 Equiduct 133–34, 137 Equitable Life 282 equities 29–35 market indices 32–33 market inﬂuencers 40–41 nominee accounts 31 shares 29–32 stockbrokers 33–34 valuation 35–41 equity transparency 64 Eurex 64, 65 Euro Overnight Index Average (EURONIA) 85 euro, the 17, 115 Eurobond 6, 92 Euroclear Bank 92, 146, 148–49 Euronext.liffe 5, 60, 65, 71 European Central Bank (ECB) 16, 17, 84, 148 European Central Counterparty (EuroCCP) 136 European Code of Conduct 146–47, 150 European Exchange Rate Mechanism 114 European Harmonised Index of Consumer Prices 13 European Union Capital Requirements Directive 199 Market Abuse Directive (MAD) 16, 196 Market in Financial Instruments Directive (MiFID) 64, 197–99 Money Laundering Directive 219 Prospectus Directive 196–97 Transparency Directive 197 exchange controls 6 expectation theory 172 Exxon Valdez 250 factoring see credit collection Factors and Discounters Association 26 Fair & Clear Group 145–46 Federal Deposit Insurance Corporation 17 Federation of European Securities Exchanges 137 Fighting Fraud Together 200–01 ﬁnance, raising 23–25 asset 24–25 committed 23 project ﬁnance 24 recourse loan 24 syndicated loan 23–24 uncommitted 23 Financial Action Task Force on Money Laundering (FATF) 217–18 ﬁnancial communications 179–89 ____________________________________________________ INDEX 305 advertising 189 corporate information ﬂow 185 primary information providers (PIPs) 185 investor relations 183–84 journalists 185–89 public relations 179–183 black PR’ 182–83 tipsters 187–89 City Slickers case 188–89 Financial Ombudsman Service (FOS) 165, 279–80 ﬁnancial ratios 36–39 dividend cover 37 earnings per share (EPS) 36 EBITDA 38 enterprise multiple 38 gearing 38 net asset value (NAV) 38 price/earnings (P/E) 37 price-to-sales ratio 37 return on capital employed (ROCE) 38 see also discounted cash ﬂow analysis Financial Reporting Council (FRC) 224, 228, 234, 236 Financial Services Act 1986 191–92 Financial Services Action Plan 8, 195 Financial Services and Markets Act 2001 192 Financial Services and Markets Tribunal 94 Financial Services Authority (FSA) 5, 8, 31, 44, 67, 94, 97, 103, 171, 189, 192–99 competition review 132 insurance industry 240 money laundering and 219 objectives 192 regulatory role 192–95 powers 193 principles-based 194–95 Financial Services Compensation Scheme (FSCS) 17, 165, 280 Financial Services Modernisation Act 19 ﬁnancial services regulation 190–99 see also Financial Services Authority Financial Times 9, 298 First Direct 20 ﬂipping 53 ﬂotation beauty parade 51 book build 52 early secondary market trading 53 grey market 52, 74 initial public offering (IPO) 47–53 pre-marketing 51–52 pricing 52–53 specialist types of share issue accelerated book build 54 bought deal 54 deeply discounted rights issue 55 introduction 55 placing 55 placing and open offer 55 rights issues 54–55 underwriting 52 foreign exchange 109–120 brokers 113 dealers 113 default risk 119 electronic trading 117 exchange rate 115 ICAP Knowledge Centre 120 investors 113–14 transaction types derivatives 116–17 spot market 115–16 Foreign Exchange Joint Standing Committee 112 forward rate agreement 85 fraud 200–15 advanced fee frauds 204–05 boiler rooms 201–04 Regulation S 202 future regulation 215 identity theft 205–06 insurance fraud 206–08 see also anti-fraud agencies Fraud Act 2006 200 FTSE 100 32, 36, 58, 122, 189, 227, 233 FTSE 250 32, 122 FTSE All-Share Index 32, 122 FTSE Group 131 FTSE SmallCap Index 32 FTSE Sterling Corporate Bond Index 33 Futures and Options Association 131 Generally Accepted Accounting Principles (GAAP) 237, 257 gilts 33, 86–88 Giovanni Group 146 Glass-Steagall Act 7, 19 Global Bond Market Forum 64 Goldman Sachs 136 government bonds see gilts Guinness case 214 Halifax Bank 20 hedge funds 8, 77, 97, 156–57 derivatives-based arbitrage 156 ﬁxed-income arbitrage 157 Hemscott 35 HM Revenue and Customs 55, 211 HSBC 20, 103 Hurricane Hugo 250 306 INDEX ____________________________________________________ Hurricane Katrina 2, 67, 242 ICE Futures 5, 66, 102 Individual Capital Adequacy Standards (ICAS) 244 inﬂation 12–14 cost-push 12 deﬁnition 12 demand-pull 12 quarterly Inﬂation Report 14 initial public offering (IPO) 47–53 institutional investors 155–58 fund managers 155–56 hedge fund managers 156–57 insurance companies 157 pension funds 158 insurance industry London and 240 market 239–40 protection and indemnity associations 241 reform 245 regulation 243 contingent commissions 243 contract certainty 243 ICAS and Solvency II 244–45 types 240–41 underwriting process 241–42 see also Lloyd’s of London, reinsurance Intercontinental Exchange 5 interest equalisation tax 6 interest rate products debt securities 82–83, 92–93 bill of exchange 83 certiﬁcate of deposit 83 debt instrument 83 euro bill 82 ﬂoating rate note 83 local authority bill 83 T-bills 82 derivatives 85 forward rate agreements (FRAs) 85–86 government bonds (gilts) 86–89 money markets 81–82 repos 84 International Financial Reporting Standards (IFRS) 58, 86, 173, 237–38 International Financial Services London (IFSL) 5, 64, 86, 92, 112 International Monetary Fund 17 International Securities Exchange 138 International Swap Dealers Association 63 International Swaps and Derivatives Association 63 International Underwriting Association (IUA) 240 investment banking 5, 47–59 mergers and acquisitions (M&A) 56–58 see also capital raising investment companies 164–69 real estate 169 split capital 166–67 venture capital 167–68 investment funds 159–64 charges 163 investment strategy 164 fund of funds scheme 164 manager-of-managers scheme 164 open-ended investment companies (OEICs) 159 selection criteria 163 total expense ratio (TER) 164 unit trusts 159 Investment Management Association 156 Investment Management Regulatory Organisation 11 Johnson Matthey Bankers Limited 15–16 Joint Money Laundering Steering Group 221 KAS Bank 145 LCH.Clearnet Limited 66, 140 letter of credit (LOC) 23, 25–26 liability-driven investment 158 Listing Rules 43, 167, 173, 225, 228–29 Lloyd’s of London 8, 246–59 capital backing 249 chain of security 252–255 Central Fund 253 Corporation of Lloyd’s 248–49, 253 Equitas Reinsurance Ltd 251, 252, 255–56 Franchise Performance Directorate 256 future 258–59 Hardship Committee 251 history 246–47, 250–52 international licenses 258 Lioncover 252, 256 Member’s Agent Pooling Arrangement (MAPA) 249, 251 Names 248, one-year accounting 257 regulation 257 solvency ratio 255 syndicate capacity 249–50 syndicates 27 loans 23–24 recourse loan 24 syndicated loan 23–24 London Interbank Offered Rate (LIBOR) 74, 76 ____________________________________________________ INDEX 307 London Stock Exchange (LSE) 7, 8, 22, 29, 32, 64 Alternative Investment Market (AIM) 32 Main Market 42–43, 55 statistics 41 trading facilities 122–27 market makers 125–27 SETSmm 122, 123, 124 SETSqx 124 Stock Exchange Electronic Trading Service (SETS) 122–25 TradElect 124–25 users 127–29 Louvre Accord 114 Markets in Financial Instruments Directive (MiFID) 64, 121, 124, 125, 130, 144, 197–99, 277 best execution policy 130–31 Maxwell, Robert 186, 214, 282 mergers and acquisitions 56–58 current speculation 57–58 disclosure and regulation 58–59 Panel on Takeovers and Mergers 57 ‘white knight’ 57 ‘white squire’ 57 Merrill Lynch 136, 174, 186, 254 money laundering 216–22 Egmont Group 218 hawala system 217 know your client (KYC) 217, 218 size of the problem 222 three stages of laundering 216 Morgan Stanley 5, 136 multilateral trading facilities Chi-X 134–35, 141 Project Turquoise 136, 141 Munich Re 207 Nasdaq 124, 138 National Strategy for Financial Capability 269 National Westminster Bank 20 Nationwide Building Society 221 net operating cash ﬂow (NOCF) see discounted cash ﬂow analysis New York Federal Reserve Bank (Fed) 16 Nomads 45 normal market share (NMS) 132–33 Northern Rock 16 Nymex Europe 102 NYSE Euronext 124, 138, 145 options see derivatives Oxera 52 Parmalat 67, 232 pensions alternatively secured pension 290 annuities 288–89 occupational pension ﬁnal salary scheme 285–86 money purchase scheme 286 personal account 287 personal pension self-invested personal pension 288 stakeholder pension 288 state pension 283 unsecured pension 289–90 Pensions Act 2007 283 phishing 200 Piper Alpha oil disaster 250 PLUS Markets Group 32, 45–46 as alternative to LSE 45–46, 131–33 deal with OMX 132 relationship to Ofex 46 pooled investments exchange-traded funds (ETF) 169 hedge funds 169–71 see also investment companies, investment funds post-trade services 140–50 clearing 140, 141–42 safekeeping and custody 143–44 registrar services 144 settlement 140, 142–43 real-time process 142 Proceeds of Crime Act 2003 (POCA) 211, 219, 220–21 Professional Securities Market 43–44 Prudential 20 purchasing power parity 118–19 reinsurance 260–68 cat bonds 264–65 dispute resolution 268 doctrines 263 ﬁnancial reinsurance 263–64 incurred but not reported (IBNR) claims insurance securitisation 265 non-proportional 261 offshore requirements 267 proportional 261 Reinsurance Directive 266–67 retrocession 262 types of contract facultative 262 treaty 262 retail banking 20 retail investors 151–155 Retail Prices Index (RPI) 13, 87 264 308 INDEX ____________________________________________________ Retail Service Provider (RSP) network Reuters 35 Royal Bank of Scotland 20, 79, 221 73 Sarbanes–Oxley Act 233–34 securities 5, 29 Securities and Futures Authority 11 self-regulatory organisations (SROs) 192 Serious Crime Bill 213 settlement 11, 31, 140, 142–43 shareholder, rights of 29 shares investment in 29–32 nominee accounts 31 valuation 35–39 ratios 36–39 see also ﬂotation short selling 31–32, 73, 100, 157 Society for Worldwide Interbank Financial Telecommunications (SWIFT) 119 Solvency II 244–245 Soros, George 114, 115 Specialist Fund Market 44 ‘square mile’ 4 stamp duty 72, 75, 166 Sterling Overnight Index Average (SONIA) 85 Stock Exchange Automated Quotation System (SEAQ) 7, 121, 126 Stock Exchange Electronic Trading Service (SETS) see Lloyd’s of London stock market 29–33 stockbrokers 33–34 advisory 33 discretionary 33–34 execution-only 34 stocks see shares sub-prime mortgage crisis 16, 89, 94, 274 superequivalence 43 suspicious activity reports (SARs) 212, 219–22 swaps market 7 interest rates 56 swaptions 68 systematic internalisers (SI) 137–38 Target2-Securities 147–48, 150 The Times 35, 53, 291 share price tables 36–37, 40 tip sheets 33 trading platforms, electronic 80, 97, 113, 117 tranche trading 123 Treasury Select Committee 14 trend theory 175–76 UBS Warburg 103, 136 UK Listing Authority 44 Undertakings for Collective Investments in Transferable Securities (UCITS) 156 United Capital Asset Management 95 value at risk (VAR) virtual banks 20 virt-x 140 67–68 weighted-average cost of capital (WACC) see discounted cash ﬂow analysis wholesale banking 20 wholesale markets 78–80 banks 78–79 interdealer brokers 79–80 investors 79 Woolwich Bank 20 WorldCom 67, 232 Index of Advertisers Aberdeen Asset Management PLC xiii–xv Birkbeck University of London xl–xlii BPP xliv–xlvi Brewin Dolphin Investment Banking 48–50 Cass Business School xxi–xxiv Cater Allen Private Bank 180–81 CB Richard Ellis Ltd 270–71 CDP xlviii–l Charles Schwab UK Ltd lvi–lviii City Jet Ltd x–xii The City of London inside front cover EBS Dealing Resource International 110–11 Edelman xx ESCP-EAP European School of Management vi ICAS (The Inst. of Chartered Accountants of Scotland) xxx JP Morgan Asset Management 160–62 London Business School xvi–xviii London City Airport vii–viii Morgan Lewis xxix Securities & Investments Institute ii The Share Centre 30, 152–54 Smithﬁeld Bar and Grill lii–liv TD Waterhouse xxxii–xxxiv University of East London xxxvi–xxxviii

**
Predator's Ball
** by
Connie Bruck

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diversified portfolio, financial independence, fixed income, mortgage debt, offshore financial centre, paper trading, profit maximization, The Predators' Ball, yield management, Yogi Berra, zero-coupon bond

Hot on the heels of Murdoch-Metromedia came Storer Communications, at $1.93 billion further testament to this kind of investment faith. Like Metromedia, Storer did not have enough money to meet its fixed charges out of cash flow, and like Metromedia it contained a healthy quantity of zero-coupon bonds (one third of the total) in its mix of securities. The zero-coupon bond was vital to these deals. Sold at a discount from its face value, it requires no interest payments (hence, “zero-coupon”) until maturity, when the annual accrued interest and the principal are paid out. Drexel had pioneered the heavy use of zero-coupon bonds in junk deals (especially in the communications industry) where the company in the foreseeable future could not make its interest payments. The day of reckoning for many of these deals, with securities issued in 1985 and 1986, would be years away.

…

But Drexel was already working on one of Sharon Steel’s famous 3(a)9 swaps (unregistered exchange offers), in an effort to avert Chapter 11. Moreover, since 1982 the firm had floated nearly a half-billion dollars for various companies of Posner’s, in three private placements (of securities that are not publicly registered and therefore can be issued more quickly and require less disclosure) and two public deals. One of them, issued for DWG back in 1982—$50 million of zero-coupon bonds (which are sold at a discount and pay no interest until the annual accreted interest is paid at maturity)—had a short maturity, due in 1986. Among the heaviest buyers of Posner’s paper, furthermore, were members of Milken’s select coterie, those he most protected. In one $25 million issue for a Posner company in 1982, for example, according to a November 1984 article in Forbes magazine, Fred Carr (First Executive) and Carl Lindner (American Financial) bought the entire issue.

…

., 99 Simon Wiesenthal Foundation, 313 Sinatra, Frank, 16, 60 single-premium deferred annuity (SPDA), 90 Skadden, Arps, Slate, Meagher and Flom, 101, 105, 106, 205, 208, 211, 234, 237, 257 Sloan, Allen, 270 Slovin, Bruce, 237 Smith, Randall, 77, 145–46 social revolution, Milken’s machine as, 19–20 Sokolow, Ira, 318 Solomon, David, 33, 46, 56, 58, 94, 168, 277–78 Solomon Asset Management, 94, 168, 277 Sorte, John, 130, 164, 165, 167–68, 336 Sosnoff, Martin, 132, 291 Southland Corporation, 345 Spear, Arthur, 292 Spiegel, Abraham, 91, 259 Spiegel, Edita, 259 Spiegel, Helene, 259 Spiegel, Thomas, 89–93, 115, 119–120, 132, 182, 270, 277, 279–80, 311 political contributions of, 259, 260 Spiegel family, 15 Sporkin, Stanley, 38 Spy, 236 SSC III Corporation, 280 Staley Continental, 324–27, 337–38 Standard and Poor’s, 27, 281, 283 Standard Oil, 94, 96, 231 Standard Oil of California, 12, 165, 272 Stein, Dennis, 236 Stein, Gertrude, 62 Steinberg, Saul, 12–14, 35–38, 57, 82, 93, 109, 119, 270, 273, 293–294, 296, 324, 352, 355 career path of, 36–37 Coss and, 291 Disney and, 13, 107, 164 greenmail of, 156, 291 lifestyle of, 110 Peltz and, 110, 111, 112 at Predators’ Ball (1985), 14, 15 Reliance L.P. and, 16, 120 Steiner, Jeffrey, 113–14, 126, 144–145, 305 Icahn and, 154, 159, 160–61, 178, 179, 185, 187 on Kingsley, 153–54 Stelzel, Walter, 123, 136 Sterling Bancorp, 112 Sterling National Bank, 198 Sterngold, James, 342–43, 351 Stewart, James, 320, 321–22, 329, 343 Stewart, Joseph, 178, 179 stock, 36, 69–70, 74, 96, 120, 157, 158, 207, 298, 320–28 convertible debt and, 27 equity offerings and, 45 exchange offers and, 66 junk bonds compared with, 28–29, 32 margin rules and, 211–12 options on, 151, 152, 162–63 parking of, 320–21, 327, 328 preferred, 265, 290, 325 swaps of, 110, 120 tax on dividends from, 37 stock market, 269, 270 crash of (1987), 344–46 as judge of intrinsic values, 262 see also New York Stock Exchange Storer Communications, 176, 267 straight debt, 28 defined, 27 Stratton, James, 25 Strong Capital Management, 291 subordinated debt, 45–46, 59, 123, 166, 246 Sullivan, Fred, 15, 156, 199–200, 212, 223 Sun Chemical Corporation, 285–86 Sydorick, David, 278 Sydorick, Thomas, 278 syndicated deals, 331 Tabor, Timothy, 328 takeover entrepreneurs, Upton’s use of term, 204–5 takeovers (mergers and acquisitions; M&A): Air Fund and, 102 egos and appetites and, 14, 15 first successful Drexel-backed, 203–4 four waves of, 96 in Japan, 243–44 Law’s views on, 262–63 Lipton’s views on, 204–5, 206, 256 in 1960s, 96, 263 poison pills and, 168–69, 216, 217, 224, 226, 256 President’s Council of Economic Advisers’ views on, 261–63 problems with, 100 pros and cons of, 261–63 in Reagan vs. Carter administrations, 97 reasons for increase of, 96–97 Rohatyn’s opposition to, 206–7 Scherer’s views on, 261–62 stars of, 101 value of, 96 Tandy, 45 Tappan, 155 Tax Equity and Fiscal Responsibility Act (TEFRA; 1982), 82 taxes, 200, 328 income, see income tax Scherer’s views on, 263 zero-coupon bonds and, 82 Tax Reform Act (1986), 263–64 tax shelters, 54, 313 Taylor, Elizabeth, 236 Taylor, John, 307 Technicolor, Inc., 198–201, 210, 235, 236 stock of, 199–200 Teitelbaum, Naftali, 89 tender offers, 105, 163–66, 172, 185, 255, 349 “highly confident” letter and, 166 in proxy fights, 164–65 Revlon battle and, 207, 209, 210, 211, 216, 217, 218, 231 of W Acquisition Corp., 265 terrorism, TWA and, 172, 181, 183, 184 Tessel Paturick and Company, 151 Texaco, 164 Texas Air Corporation, 173, 243 Texas Gulf Sulphur Company, 306 Texas International, 47, 56 Third World, debt of, 254–55, 353 13D filings, 118–19, 154, 172, 191, 291, 293, 321, 325, 326, 327, 351 Thompson family, 345 Thomson McKinnon, 43 Thorp, Edward, 81–82, 300, 311–12, 327–28 3(a) 9 deals, 76–77, 135, 209, 331 thrift institutions, 212, 269 see also savings-and-loan associations Time, 195 Tisch, Lawrence, 35, 57, 67, 160, 196, 208, 230 Toffler, Alvin, 246 Tokyo, mini-Predators’ Ball in, 243–244, 316, 340 tombstone ads, bracketing in, 30 Touche Ross, 25 trading, traders: investment banking vs., 63–64 principal mentality of, 64, 66 Trafalgar, 111–14 Trafalgar Holdings Ltd., 131–32, 168, 284 transactional banking, 63 Transportation department, U.S., 172 Transworld Corporation, 233–34, 236, 322 Treasury, U.S. 26 Treasury bonds, U.S., 27, 47, 345 stripping of, 82–83 yield on, 94 zero-coupon, 82–83, 124, 267 Treasury Department, U.S., 264 Triangle Acquisition Corporation, 108 Triangle Industries, 13–14, 17, 105–109, 112–19, 141, 145–47, 168, 243, 273 in National Can takeover, see National Can deal stock of, 107–8, 118–19, 128–29, 146 triple-A bonds, 27, 32, 243 Trottman, Stanley, 26–27, 29, 68 Flight Transportation and, 72–73 Trust Company of the West, 57, 277 Tsai, Gerald, 18, 135, 141, 147 “T-shirt organization,” 86 Turner, Ted, 217, 303–4 TWA, 19, 143, 170–88, 191, 202, 263, 297 anti-takeover maneuvers and, 171, 177 cash flow of, 171, 172 flight attendants strike and, 183, 184 Icahn liquidation plan and, 172 Joseph’s attempts to dissuade Icahn and, 170, 171 Lorenzo bid for, 173–78, 181, 187 losses of, 180, 183 Paine Webber and, 178–80 PARS system of, 179–80, 181, 184 SEC bondholder list and, 182 stock of, 170–74, 177–78, 179, 181–182 terrorism and, 172, 181, 183, 184 turnaround at (1986), 183–84, 191 unions and, 172, 174–78, 181, 183, 184 “two-tiered, bust-up junk-bond takeover,” use of term, 204 underwriters, underwriting: bracketing of, 30 commissions and fees for, 46, 47, 66, 74, 300, 304 default rate of, 77 Underwriting Assistance Committee (UAC), 72, 131, 235, 304–7, 351 Union Carbide, 181, 213, 233, 245, 275–76, 280, 288 unions, see labor unions Uniroyal Chemical Company, 141–145, 170, 263 “unit” deals, 73 United Airlines, 173 United Brands Company, 65 “unit offering,” 114–15 Unocal, 17, 127, 130, 166, 171, 203, 218, 322 U.S.

**
Investing Demystified: How to Invest Without Speculation and Sleepless Nights
** by
Lars Kroijer

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Andrei Shleifer, asset allocation, asset-backed security, Bernie Madoff, bitcoin, Black Swan, BRICs, Carmen Reinhart, cleantech, compound rate of return, credit crunch, diversification, diversified portfolio, equity premium, estate planning, fixed income, high net worth, implied volatility, index fund, invisible hand, Kenneth Rogoff, market bubble, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

Also be careful in thinking that adding these kinds of bonds provide you with additional safety; they are typically a poor diversifier of risk as they tie back to the same creditworthiness as the domestic government bonds. Matching time horizon In the discussion above, short-term bonds are the minimal risk asset. This is because longer-term bonds have greater interest risk (the fluctuation in the value of the bond as a result of fluctuations in the interest rate). Consider the example of a one-month zero-coupon bond and a 10-year zero-coupon bond that trade at 100 (zero-coupon bonds don’t pay interest, only the principal back at maturity). Now suppose annual interest rates go from zero to 1% suddenly. What happens to the value of the bonds? The one-month bond declines a little in value to reflect an interest rate of 1%, while the 10-year bond declines to a value of around 90.5 to reflect the higher interest rate. Clearly something that can go from 100 to 90.5 fairly quickly (rate changes are rarely that dramatic) is riskier, even if your chance of eventually being paid in full has not changed.

**
The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk
** by
William J. Bernstein

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asset allocation, backtesting, capital asset pricing model, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

Implementing Your Asset Allocation Strategy 165 Retirement—The Biggest Risk of All This book is focused primarily on the investment process, particularly the establishment and maintenance of efficient allocations. Asset allocation in retirement is no different, except that you will primarily be using your withdrawals to control your allocations, as opposed to deposits and rebalancing. However, there is a risk peculiar to retirement called “duration risk.” In order to explore this, let’s start with the simplest and least risky of all investments, a one-year Treasury bill. A bill is in reality a zero-coupon bond, bought at a discount. For example, a 5% bill will sell at auction for $0.9524 and be redeemed at par ($1). If a few seconds after it is issued yields suddenly rise to 10%, the bill falls in price to $0.9091, with an immediate loss of 4.55% in value. But if our investor holds the bill to maturity, he or she will receive the full 5% return, the same as if there had been no yield rise and price fall.

…

However, a bond is a very different beast than a T-bill: It throws off coupons that can be reinvested at the higher yield. Because of this, the recovery from disaster takes considerably less than 30 years. In fact, it only takes our hapless bondholder 10.96 years to break even. This 10.96-year period is known in financial circles as the duration of the security, and for a coupon-bearing bond it is always less than the maturity, sometimes considerably so. (For a zero-coupon bond, maturity and duration are the same.) There are lots of other definitions of duration, some dizzyingly complex, but “point of indifference” is the simplest and most intuitive. (The other useful definition is the ratio of price-to-yield 166 The Intelligent Asset Allocator change. That is, our 30-year bond will decrease 10.96% in price with each 1% increase in yield.) Duration is also an excellent measure of the risk of an investment.

…

Value stock: A security that sells at a discount to its intrinsic value. Value stocks are often identified by low price-book and priceearnings ratios. Variance: A measure of the scatter of numbers around their average value; the square root of the variance is the standard deviation (SD). Like SD, the variance of a security’s or portfolio’s returns is a proxy for its risk, or volatility. Yield: The percentage of a security’s value paid as dividends. Zero-coupon bond: A bond in which no periodic coupon is paid; principal and reinvested interest are paid in toto at maturity. Bibliography Preface Brinson, Gary P., Hood, L. Randolph, and Beebower, Gilbert L., “Determinants of Portfolio Performance.” Financial Analysts Journal, July/August 1986. Brinson, Gary P., Singer, Brian D., and Beebower, Gilbert L., “Determinants of Portfolio Performance II: An Update.”

**
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

Calculate the discount rate for a k-year bond on day t, where the maturity is in between the maturity of two other bonds with maturity t1 and t2, using the following formula: (D.2) With the new discount factor, we can immediately compute the price of the zero-coupon bond on the next business day. For example, suppose we wish to compute the return of the 10-year zero-coupon bond from day t to day t+1.1 The price of bond with maturity m on day t would be given by .2 The same bond's price one day later would be given by , where is calculated on day t+1 according to the interpolation above. The return of the bond for that constant maturity series is given by: (D.3) Consider an example of this methodology. Suppose that on April 5, 1989, and April 6, 1989, the 10-year and 9-year zero-coupon bond yields were 9.34, 9.372 and 9.374, 9.407, respectively. Table D.1 uses the methodology described above to compute the price of the 10-year on April 5, 1989, the price of the 10-year minus 1-day on April 6, 1989, and the daily return of the 10-year from April 5 to April 6.

…

In fact, the spread of these quantitative techniques may have gradually diminished attractive opportunities in bond arbitrage. Box 2.2 Salomon Arb Group Interview Question Question: Your portfolio group strongly believes that the yield curve is going to flatten very soon. It could be that short-term rates will rise or long-term rates will fall or some combination of the two. Suppose also that you have three instruments available: a 30-year zero-coupon bond, a 1-year Treasury bill, and a cash account. Suppose the modified duration of the 30-year is 28 and the modified duration of the 1-year is 1. What strategy should you pursue to benefit from your beliefs? Suggested Solution: The investor would ideally like to have no interest-rate exposure, but take a view on the flattening yield curve. Thus, one would like to hedge parallel yield curve shifts, but take advantage of the nonparallel moves.

…

As of November 2007 Lehman had $691 billion in assets. Of these, $301 billion were in collateralized lending agreements (e.g., repos and such); the firm also had $258 billion in collateralized financing. Lehman was a net lender of cash. Some traders believe Lehman may have taken initial margin from its prime broker business and used that cash in reverse repos. 5. In a 30-year liability with a given interest rate, the liability is like a zero-coupon bond with a duration of 30. , where y is the bond yield and P is the bond price. 6. Duration is a bond portfolio management concept that expresses how much a portfolio’s value will move for a given change in interest rates. If interest rates go down, a position with long duration makes money. If interest rates go up, the position loses money. 7. When a government issues a bond, it is essentially a fixed-rate payer and has a short or negative duration.

**
J.K. Lasser's Your Income Tax
** by
J K Lasser Institute

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Affordable Care Act / Obamacare, airline deregulation, asset allocation, collective bargaining, distributed generation, employer provided health coverage, estate planning, Home mortgage interest deduction, medical malpractice, medical residency, mortgage debt, mortgage tax deduction, passive income, Ponzi scheme, profit motive, rent control, telemarketer, transaction costs, urban renewal, zero-coupon bond

Current reporting also applies to persons who separate or strip interest coupons from a bond and then retain the stripped bond or stripped coupon; the accrual rule applies to the retained obligation. - - - - - - - - - - Caution Reporting Zero Coupon Bond Discount Zero coupon bond discount is reported annually as interest over the life of the bond, even though interest is not received. This tax cost tends to make zero coupon bonds unattractive to investors, unless the bonds can be bought for IRA and other retirement plans that defer tax on income until distributions are made. Zero coupon bonds also may be a means of financing a child’s education. A parent buys the bond for the child. The child must report the income annually, and if the income is not subject to the parent’s marginal tax bracket under the “kiddie tax” (Chapter 24), the income subject to tax may be minimal. The value of zero coupon bonds fluctuates sharply with interest rate changes. This fact should be considered before investing in long-term zero coupon bonds.

…

This fact should be considered before investing in long-term zero coupon bonds. If you sell zero coupon bonds before the maturity term at a time when interest rates rise, you may lose part of your investment. - - - - - - - - - - For short-term nongovernmental obligations, OID is generally taken into account instead of acquisition discount, but an election may be made to report the accrued acquisition discount. See IRS Publication 550 for details. Basis in the obligation is increased by the amount of acquisition discount (or OID for nongovernmental obligations) that is currently reported as income. Interest deduction limitation for cash-basis investors. A cash-basis investor who borrows funds to buy a short-term discount obligation may not fully deduct interest on the loan unless an election is made to report the accrued acquisition discount as income.

…

OID arises when a bond is issued for a price less than its face or principal amount. OID is the difference between the principal amount (redemption price at maturity) and the issue price. For publicly offered obligations, the issue price is the initial offering price to the public at which a substantial amount of such obligations were sold. All obligations that pay no interest before maturity, such as zero coupon bonds, are considered to be issued at a discount. For example, a bond with a face amount of $1,000 is issued at an offering price of $900. The $100 difference is OID. Generally, part of the OID must be reported as interest income each year you hold the bond, whether or not you receive any payment from the bond issuer. This is also true for certificates of deposit (CDs), time deposits, and similar savings arrangements with a term of more than one year, provided payment of interest is deferred until maturity.

**
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

Every six months, when an interest payment was due, the holder would detach a coupon and redeem it for the interest payment. After all the coupons were detached and the bond reached its maturity date, the bond certificate itself would be submitted for return of the principal. Regan’s idea was to buy new treasury bonds, immediately detach the coupons, and sell the pieces of paper separately. People or companies that expected to need a lump sum down the road could buy a “stripped,” zero-coupon bond maturing at the time they needed the money. It would be cheaper than a whole bond because they wouldn’t be paying for income they didn’t need in the meantime. Other people might want the current income but not care about the future lump-sum payment. They would buy the coupons. An even bigger selling point of Regan’s idea was a loophole in the tax law. Most of the pieces of paper from a dismembered bond would sell for a small fraction of their face value.

…

Most of the pieces of paper from a dismembered bond would sell for a small fraction of their face value. This was as it should be. A zero-coupon $10,000 bond that matures in thirty years is not worth anywhere near $10,000 now. Since there are no interest payments, the buyer can profit only by capital gains. That is possible only if the buyer pays much less than $10,000 for the bond now. Fair enough. Buy a $10,000 bond, strip off the coupons, and resell the zero-coupon bond for, say, $1,000. This, it was theorized, ought to give you the right to claim a $9,000 capital loss on your current year’s taxes. At any rate, nothing in the tax code said how taxpayers were supposed to figure the cost basis of the various parts of the bond. The law said nothing because no one in Congress had thought of stripping treasury bonds at the time the laws were written. Regan took the idea to Michael Milken.

**
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

The more reality INSTRUMENTS financial innovations adjustable rate convertible notes • adjustable rate preferred stock • adjustable/variable rate mortgages • All-Saver certificates • Annericus trust • annuity notes • auction rate capital notes • auction rate notes/debentures • auction rate preferred stock • bull and bear CDs • capped floating rate notes • collateralized connmercial paper • collateralized nnortgage obligations/real estate mortgage investment conduits • collateralized preferred stock • commercial real estate-backed bonds • commodity-linked bonds • convertible adjustable preferred stock • convertible exchangeable preferred stock • convertible mortgages/reduction option loans • convertible reset debentures • currency swaps • deep discount/zero coupon bonds • deferred interest debentures • direct public sale of securities • dividend reinvestment plan • dollar BILS • dual currency bonds • employee stock ownership plan (ESOP) • Eurocurrency bonds • Euronotes/Euro-commercial paper • exchangeable auction rate preferred stock • exchangeable remarketed preferred stock • exchangeable variable rate notes • exchange-traded options • extendible notes • financial futures • floating rate/adjustable rate notes • floating rate extendible notes • floating rate, rating sensitive notes • floating rate tax-exempt notes • foreign-currency-denominated bonds • foreign currency futures and options • forward rate agreements • gold loans • high-yield (junk) bonds • increasing rate notes • indexed currency option notes/ principal exchange linked securities • indexed floating rate preferred stock • indexed sinking fund debentures • interest rate caps/collars/floors • interest rate futures • interest rate reset notes • interest rate swaps • letter of credit/surety bond support • mandatory convertible/equity contract notes • master limited partnership • medium-term notes • money market notes • mortgage-backed bonds • mortgage pass-through securities • negotiable CDs • noncallable long-term bonds • options on futures contracts • paired common stock • participating bonds • pay-in-kind debentures • perpetual bonds • poison put bonds • puttable/adjustable tender bonds • puttable common stock • puttable convertible bonds • puttable-extendible notes • real estate-backed bonds • real yield securities • receivable-backed securities • remarketed preferred stock • remarketed reset notes • serial zero-coupon bonds • shelf registration process • single-point adjustable rate stock • Standard & Poor's indexed notes • state rate auction preferred stock • step-up put bonds • stock index futures and options • stripped mortgage-backed securities • stripped municipal securities • stripped U.S.

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The more reality INSTRUMENTS financial innovations adjustable rate convertible notes • adjustable rate preferred stock • adjustable/variable rate mortgages • All-Saver certificates • Annericus trust • annuity notes • auction rate capital notes • auction rate notes/debentures • auction rate preferred stock • bull and bear CDs • capped floating rate notes • collateralized connmercial paper • collateralized nnortgage obligations/real estate mortgage investment conduits • collateralized preferred stock • commercial real estate-backed bonds • commodity-linked bonds • convertible adjustable preferred stock • convertible exchangeable preferred stock • convertible mortgages/reduction option loans • convertible reset debentures • currency swaps • deep discount/zero coupon bonds • deferred interest debentures • direct public sale of securities • dividend reinvestment plan • dollar BILS • dual currency bonds • employee stock ownership plan (ESOP) • Eurocurrency bonds • Euronotes/Euro-commercial paper • exchangeable auction rate preferred stock • exchangeable remarketed preferred stock • exchangeable variable rate notes • exchange-traded options • extendible notes • financial futures • floating rate/adjustable rate notes • floating rate extendible notes • floating rate, rating sensitive notes • floating rate tax-exempt notes • foreign-currency-denominated bonds • foreign currency futures and options • forward rate agreements • gold loans • high-yield (junk) bonds • increasing rate notes • indexed currency option notes/ principal exchange linked securities • indexed floating rate preferred stock • indexed sinking fund debentures • interest rate caps/collars/floors • interest rate futures • interest rate reset notes • interest rate swaps • letter of credit/surety bond support • mandatory convertible/equity contract notes • master limited partnership • medium-term notes • money market notes • mortgage-backed bonds • mortgage pass-through securities • negotiable CDs • noncallable long-term bonds • options on futures contracts • paired common stock • participating bonds • pay-in-kind debentures • perpetual bonds • poison put bonds • puttable/adjustable tender bonds • puttable common stock • puttable convertible bonds • puttable-extendible notes • real estate-backed bonds • real yield securities • receivable-backed securities • remarketed preferred stock • remarketed reset notes • serial zero-coupon bonds • shelf registration process • single-point adjustable rate stock • Standard & Poor's indexed notes • state rate auction preferred stock • step-up put bonds • stock index futures and options • stripped mortgage-backed securities • stripped municipal securities • stripped U.S. Treasury securities • synthetic convertible debt • tuition futures • unbundled stock units • universal commercial paper • variable coupon/rate renewable notes • variable cumulative preferred stock • variable duration notes • warrants to purchase bonds • yield curve/maximum rate notes • zero-coupon convertible debt source: Finnerty (1992) B1 WALL STREET can be made to correspond to the pure beauty of financial theory, the better life will be.

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A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
** by
Richard Bookstaber

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affirmative action, Albert Einstein, asset allocation, backtesting, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commodity trading advisor, computer age, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, Jeff Bezos, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shock, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, shareholder value, short selling, Silicon Valley, statistical arbitrage, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, yield curve, zero-coupon bond

Three years out of school he had been terminated from trading positions at both Morgan Stanley and First Boston. Then in July 1991 he started work as a trader on Kidder, Peabody’s STRIPS (separate trading 39 ccc_demon_033-050_ch03.qxd 7/13/07 2:42 PM Page 40 A DEMON OF OUR OWN DESIGN of registered interest and principal securities) desk. The STRIPS desk takes Treasury bonds and strips apart their coupons to sell as individual “strips” or zero coupon bonds, and also works in the reverse, pulling together zero coupon bonds from various sources to rebuild or reconstitute Treasuries. Jett lost money in his first month trading at Kidder, was close to flat the following months, and received a negative performance review for the year. He could see the writing on the wall for a third failure in his trading career. So he resourcefully developed a trading strategy to improve his performance.

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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

There are markets for options (puts and calls) and markets for futures, and markets for options on futures. There is program trading, index arbitrage, and risk arbitrage. There are managers who provide portfolio insurance and managers who offer something called tactical asset allocation. There are butterfly swaps and synthetic equity. Corporations finance themselves with convertible bonds, zero-coupon bonds, bonds that pay interest by promising to pay more interest later on, and bonds that give their owners the unconditional right to receive their money back before the bonds come due. The world’s total capital market of stocks, bonds, and cash had ballooned from only $2 trillion in 1969 to more than $22 trillion by the end of 1990; the market for stocks alone had soared from $300 billion to $55 trillion.

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See also Wells Fargo Bank Barr Rosenberg Associates (BARRA) Battle for Investment Survival, The (Loeb) “Behavior of Stock Prices, The” (Fama) Bell Journal Bell Laboratories Beta: see Risk, systematic “Beta Revolution: Learning to Live with Risk” Black Monday (October, 1987, crash) Black/Scholes formula Block trading Boeing Bond(s) convertible discount rates and government high-grade interest rates international junk liquidity maturity risk treasury: see Bond(s), government zero-coupon Bond market Boston Company Brokerage commissions. See also Transaction costs Brownian motion “Brownian Motion in the Stock Market” (Osborne) Butterfly swaps Buy and hold strategy California Public Employees Retirement System Calls: see Options Capital cost of optimal structure of preserving strategy “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Sharpe) Capital Asset Pricing Model (CAPM) non-stock applicability risk/return ratio in time analysis and Capital gains tax Capital Guardian Capital markets theory competition and corporate investment and debt/equity ratios and research CAPM: see Capital Asset Pricing Model CDs CEIR Center for Research in Security Prices (CRSP).

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Security Analysis
** by
Benjamin Graham,
David Dodd

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asset-backed security, backtesting, barriers to entry, capital asset pricing model, carried interest, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fear of failure, financial innovation, fixed income, full employment, index fund, invisible hand, Joseph Schumpeter, locking in a profit, Long Term Capital Management, low cost carrier, moral hazard, mortgage debt, p-value, risk-adjusted returns, risk/return, secular stagnation, shareholder value, The Chicago School, the market place, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, zero-coupon bond

No one had ever heard of a venture capital fund, a private equity fund, an index fund, a quant fund, or an emerging market fund. And, interestingly, “famous investor” was largely an oxymoron—the world hadn’t yet heard of Warren Buffett, for example, and only a small circle recognized his teacher at Columbia, Ben Graham. The world of fixed income bore little resemblance to that of today. There was no way to avoid uncertainty regarding the rate at which interest payments could be reinvested because zero-coupon bonds had not been invented. Bonds rated below investment grade couldn’t be issued as such, and the fallen angels that were outstanding had yet to be labeled “junk” or “high yield” bonds. Of course, there were no leveraged loans, residential mortgage–backed securities (RMBSs), or collateralized bond, debt, and loan obligations. And today’s bond professionals might give some thought to how their predecessors arrived at yields to maturity before the existence of computers, calculators, or Bloomberg terminals.

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Should those bonds falter, there may not be any recovery at all. During the 1980s, a significant percentage of the high yield bond market consisted of securities that had never been sold directly to investors but were parts of packages of securities and cash given to selling shareholders in acquisitions. The investment bank Drexel Burnham Lambert perfected this strategy, creating such instruments as zero-coupon bonds (paying no interest for, say, five years) or “pay-in-kind (PIK) preferreds,” which, instead of paying cash interest, just issued more preferred stock. Almost no one thought these securities were worth their nominal value, but selling shareholders generally approved the transactions. As the decade ended, however, the junk bond market collapsed and so did several of Drexel’s deals. These problems, coupled with Drexel’s legal difficulties with the SEC and prosecutors, led to the firm’s bankruptcy filing in 1990.

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(Schwed), 6 Whitbread, 719 White Motor Company, 560–562, 565, 579, 586–588 White Motor Securities Corporation, 561 White Rock Mineral Springs Company, 303, 305n, 306 White Sewing Machine Company, 306, 307, 308 Willet and Gray, 95 Williams, John Burr, 18, 364n, 476n Willys-Overland Company, 252, 330 Wilson and Company, 245, 428 Winn–Dixie Stores, 275–276 “With Icahn Agreement, Texaco Emerges from Years of Trying Times” (Potts), 272n Withholding of dividends, 378–381 Woolworth, 86 Working capital: basic rules for, 591–594 requirements for, 245–246 safety of speculative senior issues and, 327–330 World War I, interest rates and bond prices and, 25 WorldCom, 545–547, 717 Wright Aeronautical Corporation, 63, 67, 679 Wright-Hargreaves Mines, Ltd., 522–523 X Xcel Energy, 51–53 Y Yahoo!, 53 Yale University, 630–631, 710n Yield: relationship with risk, 164–168 sacrificing safety for, 164–168 Youngstown Sheet and Tube Company, 244, 430, 461, 462, 476n, 501, 683 Z Zero-coupon bonds, 284 1 Losing money, as Graham noted, can also be psychologically unsettling. Anxiety from the financial damage caused by recently experienced loss or the fear of further loss can significantly impede our ability to take advantage of the next opportunity that comes along. If an undervalued stock falls by half while the fundamentals—after checking and rechecking—are confirmed to be unchanged, we should relish the opportunity to buy significantly more “on sale.”

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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

Structural models price all corporate securities in a common framework, grounded in the pioneering theoretical models of Merton (1974) and Black–Scholes (1973). In the classic “Merton model”, a firm’s capital structure is particularly simple: a single zero-coupon debt and a single equity issue. The firm’s equity can be viewed as a call option on the firm’s assets (struck at the maturity value D of its debt), while the firm’s debt consists of a riskless zero-coupon bond (which guarantees the payment of D) and a short put option on the value of the firm (struck at D). Thus the bondholder is effectively writing a put on the firm’s assets, being long equity but short equity volatility. The value of any option depends crucially on the volatility level of the underlying asset (as well as time horizon and leverage, where leverage is the difference between the current value of the firm’s assets and the value of its debt):• While all corporate stakeholders tend to benefit from rising equity prices, a key difference between the exposures of equity-holders and bondholders is that the former benefit from rising volatility while the latter are hurt by it.

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The implications of two hypotheses about yield curve behavior Pure expectations hypothesis Risk premium hypothesis What is the information in forward rates (yield curve steepness)? Market’s rate expectations Required bond risk premia What future events should forward rates forecast? Future interest rate changes Near-term return differentials across bonds What is the best predictor of a 5-year zero-coupon bond’s 1-year return? The 1-year riskless spot rate The 5-year zero’s “rolling yield” (which is also the 1-year forward rate after 4 years) What is the best predictor of next year’s spot yield curve? Implied spot yield curve one year forward Current spot yield curve Roll or slide is another nuanced aspect of carry. The random walk hypothesis assumes that the current yield curve is the best predictor of the future yield curve.

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Monte Carlo Simulation and Finance
** by
Don L. McLeish

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Black-Scholes formula, Brownian motion, capital asset pricing model, compound rate of return, discrete time, distributed generation, finite state, frictionless, frictionless market, implied volatility, incomplete markets, invention of the printing press, martingale, p-value, random walk, Sharpe ratio, short selling, stochastic process, stochastic volatility, the market place, transaction costs, value at risk, Wiener process, zero-coupon bond

SOME BASIC THEORY OF FINANCE backwards Kolmogorov equation 2.27 that if a related process Xt satisfies the stochastic diﬀerential equation dXt = r(Xt , t)Xt dt + σ(Xt , t)dWt then its transition kernel p(t, s, T, z) = ∂ ∂z P [XT (2.47) · z|Xt = s] satisfies a partial diﬀerential equation similar to 2.44; ∂p σ 2 (s, t) ∂ 2 p ∂p = −r(s, t)s − ∂t ∂s 2 ∂s2 (2.48) For a given process Xt this determines one solution. For simplicity, consider the case (natural in finance applications) when the spot interest rate is a function of time, not of the asset price; r(s, t) = r(t). To obtain the solution so that terminal conditions is satisfied, consider a product f (t, s, T, z) = p(t, s, T, z)q(t, T ) where q(t, T ) = exp{− Z (2.49) T r(v)dv} t is the discount function or the price of a zero-coupon bond at time t which pays 1$ at maturity. Let us try an application of one of the most common methods in solving PDE’s, the “lucky guess” method. Consider a linear combination of terms of the form 2.49 with weight function w(z). i.e. try a solution of the form Z V (s, t) = p(t, s, T, z)q(t, T )w(z)dz (2.50) for suitable weight function w(z). In view of the definition of pas a transition probability density, this integral can be rewritten as a conditional expectation: V (t, s) = E[w(XT )q(t, T )|Xt = s] (2.51) the discounted conditional expectation of the random variable w(XT ) given the current state of the process, where the process is assumed to follow (2.18).

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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

No investment is really free of risks. But bonds can come close to the idealization of being riskless. If the seller of a bond has top ratings, then the return of a bond at maturity can be considered safe, and its value is known today with certainty. Such a bond is regarded as “riskless asset.” The rate earned on a riskless asset is the risk-free interest rate. To avoid the complication of re-investing coupons, zero-coupon bonds are considered. The interest rate, denoted r, depends on the time to maturity T . The interest rate r is the continuously compounded interest which makes an initial investment S0 grow to S0 erT . We shall often assume that r > 0 is constant throughout that time period. A candidate for r is the LIBOR1 , which can be found in the ﬁnancial press. In the mathematical ﬁnance literature, the term “bond” is used as synonym for a risk-free investment.

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Valuation: Measuring and Managing the Value of Companies
** by
Tim Koller,
McKinsey,
Company Inc.,
Marc Goedhart,
David Wessels,
Barbara Schwimmer,
Franziska Manoury

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air freight, barriers to entry, Basel III, BRICs, business climate, business process, capital asset pricing model, capital controls, cloud computing, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, index fund, iterative process, Long Term Capital Management, market bubble, market friction, meta analysis, meta-analysis, new economy, p-value, performance metric, Ponzi scheme, price anchoring, purchasing power parity, quantitative easing, risk/return, Robert Shiller, Robert Shiller, shareholder value, six sigma, sovereign wealth fund, speech recognition, technology bubble, time value of money, too big to fail, transaction costs, transfer pricing, value at risk, yield curve, zero-coupon bond

In choosing the bond’s duration, the most theoretically sound approach is to discount each year’s cash flow at a cost of equity that matches the maturity of the cash flow. In other words, year 1 cash flows would be discounted at a cost of equity based on a one-year risk-free rate, while year 10 cash flows would be discounted at a cost of equity based on a 10-year discount rate. To do this, use zero-coupon bonds (known as STRIPS)11 rather than Treasury bonds that make interim payments. The interim payments cause their effective maturity to be much shorter than their stated maturity. Using multiple discount rates is quite cumbersome. Therefore, few practitioners discount each cash flow using its matched bond maturity. Instead, most choose a single yield to maturity that best matches the cash flow stream being valued.

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Thus, when you measure the cost of debt, estimate what a comparable investment would earn if bought or sold today. Below-Investment-Grade Debt In practice, few financial analysts distinguish between expected and promised returns. But for debt below investment grade, using the yield to maturity as a proxy for the cost of debt can cause significant error. To understand the difference between expected returns and yield to maturity, consider the following example. You have been asked to value a oneyear zero-coupon bond whose face value is $100. The bond is risky; there is a 25 percent chance the bond will default and you will recover only half the final payment. Finally, the cost of debt (not yield to maturity), estimated using the CAPM, equals 6 percent.29 29 The CAPM applies to any security, not just equities. In practice, the cost of debt is rarely estimated using the CAPM, because infrequent trading makes estimation of beta impossible.

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Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market
** by
Steven Drobny

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Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, buy low sell high, capital controls, central bank independence, Chance favours the prepared mind, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, diversification, diversified portfolio, family office, fixed income, glass ceiling, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Peter Thiel, price anchoring, purchasing power parity, reserve currency, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

When Mexico devalued at the end of 1994, it came as a complete surprise.A lot of investors were leveraged in Mexican and other Latin American debt, so the devaluation created the fear of further devaluations or the so-called tequila effect.Venezuela, Argentina, and Brazil saw their bonds sell off massively, but the economic reality of the situation in each of those countries was very different. We thought that their Brady bonds were trading at ridiculously low levels. Brady bonds have their principal backed by U.S.Treasuries so when you buy one of those bonds, you basically get two securities:The principal is a U.S. Treasury zero coupon bond, which is easy to price, and the coupon stream, which is represented by local sovereign risk. When the other Latin American Brady bonds sold off in sympathy with Mexico, once you stripped out the zeroes, you were left with sovereign risk for next to nothing. The implied interest rates embedded in these coupons were so high that we felt it was a terrific risk/reward opportunity. The sovereign spread to Treasuries ended up moving from over 1,900 basis points in early 1995 to 400 basis points by early 1997.

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Your Money or Your Life: 9 Steps to Transforming Your Relationship With Money and Achieving Financial Independence: Revised and Updated for the 21st Century
** by
Vicki Robin,
Joe Dominguez,
Monique Tilford

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asset allocation, Buckminster Fuller, buy low sell high, credit crunch, disintermediation, diversification, diversified portfolio, fiat currency, financial independence, fudge factor, full employment, Gordon Gekko, high net worth, index card, index fund, job satisfaction, Menlo Park, Parkinson's law, passive income, passive investing, profit motive, Ralph Waldo Emerson, Richard Bolles, risk tolerance, Ronald Reagan, Silicon Valley, software patent, strikebreaker, Thorstein Veblen, Vanguard fund, zero-coupon bond

So they made what they call a Life Chart for all three of them. For each year from now until they will be eighty-five, they asked themselves, “What needs or desires might come up?” They included all the normal expenses of raising a healthy (but not pampered) child—things like braces, tutoring, summer camp and his first car—and determined how much each might cost. They then bought an investment vehicle called zero-coupon bonds (treasury bonds with no interest, bought at a big discount but repaid at par and especially good for future cash needs), with different bonds coming due in each of the years that their son might need a big-ticket item. And if he doesn’t need braces or want to go to summer camp, they’ll just roll over the money into regular treasury bonds. They also anticipated their own reasonable needs, including housing, health care, education and travel, and calculated how the combination of their cushion and their cache could handle them with ease.

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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

5 In 1987, Howard Rubin, a Merrill Lynch trader, lost $377 million in mortgage trading. MBSs are split into IO (interest only) and PO (principal only) bonds. IOs pay out only the interest payments on the underlying pool of mortgages. Lower rates mean more prepayments, meaning less interest payments reducing the price of the IOs. Higher interest rates mean lower prepayments and more interest payments, increasing the value of the IOs. POs pay only principal, effectively like zero coupon bonds where you paid $800 for a bond that at maturity pays $1,000. POs behave exactly the opposite to IOs. If interest rates go down, then they appreciate in value, as the investor receives the face value of the bond earlier because of higher prepayments. If interest rates go up, then POs decrease in value as you get paid back later. Rubin owned a large amount of POs from Merrill Lynch’s deals that the firm had not managed to sell.

**
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

Strange, like Minsky, suggests that this problem has deepened the more the financial system has grown. Strange argues that the development of money substitutes encourages overbanking, i.e., “the imprudent expansion of credit with increased profits to the banks but increased risk to the system of financial panic and collapse” (Strange 1994b: 96). A new language had to be invented to describe these devices, she argued, incorporating “money market mutual funds, swaps, options, NOW accounts, zero coupon bonds, off balance-sheet financing, and so on” (Strange 1994b: 110). Overbanking, Strange argued, can lead to the death of money, which, “whether it comes about by inflation or by a political revolution sweeping away the government, inevitably brings trade, investment and economic life generally to a standstill” (Strange 1994b: 95, 99). Finance, by generating a volatile international environment through overbanking, is dangerous for society insofar as it is a threat to its money.

**
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

“They plainly did not feel there were equally attractive alternatives in Tokyo.”56 The status of US Treasuries as “the linchpin of the global financial order” was graphically captured in R. Taggart Murphy’s description of what made them so “irresistible” to large Japanese investors: [I]n all the blizzards of financial paper that blew through Tokyo during the 1980s—the Canadian and Australian dollar twofers, the reverse dual currency bonds, the Samurai bonds, the Sushi bonds, the instantly repackaged perpetuals, the zero-coupon bonds, the square trips and double-dip leveraged leases—US Treasury notes bills and bonds held pride of place. These securities . . . backed by the full faith and credit of the US government . . . formed a liquid market of great depth: the securities were traded around the world, and buyers and sellers were thus available twenty-four hours a day. Most other dollar debt securities were priced off Treasuries.

**
Den of Thieves
** by
James B. Stewart

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discounted cash flows, diversified portfolio, fudge factor, George Gilder, index arbitrage, Internet Archive, margin call, Ponzi scheme, rolodex, Ronald Reagan, shareholder value, South Sea Bubble, The Predators' Ball, walking around money, zero-coupon bond

The October "minicrash," as it was quickly dubbed on Wall Street, proved a more long-lasting harbinger of trouble than the dramatic October 1987 crash. Beginning with Integrated and Campeau, and then continuing with alarming regularity, junk-bond issuers began to default on their obligations. Payment terms in highly leveraged deals, especially those completed in the frenzied days prior to the 1987 crash, had managed to disguise the underlying folly of the investments, often through the issuance of so-called "zero-coupon" bonds, "payments in kind," and "re-sets" which required no payments whatsoever for several years. Eventually the piper had to be paid. Like Integrated, the whole junk market began to tumble as companies admitted they couldn't fulfill the promises they had been so eager to make just several years before. By the time the financial data for 1989 were collected and analyzed, a growing suspicion of many participants in the junk-bond market, even of some Milken loyalists, was confirmed: Milken's oft-repeated premise that "investors obtained better returns on low-grade issues than on high-grades" was false.

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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

Buffett, who usually dealt with uncomfortable issues by joking about them, ended the 1999 Berkshire annual report (written winter 2000) by saying that he loved running Berkshire, and “if enjoying life promotes longevity, Methuselah’s record is in jeopardy.” 14. This is sort of an inside joke at Berkshire Hathaway. 15. David Henry, “Buffett Still Wary of Tech Stocks—Berkshire Hathaway Chief Happy to Skip ‘Manias,’” USA Today, May 1, 2000. 16. Buffett owned 14 million barrels of oil at the end of 1997, bought 111 million ounces of silver, and owned $4.6 billion of zero-coupon bonds as well as U.S. Treasuries. The silver represented 20% of the world’s annual mine output and 30% of the above-ground vault inventory (Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett: More in ’04, California Edition. Alabama: AKPE, 2004), purchased on terms to avoid disrupting world supply. 17. Interview with Sharon Osberg. The silver was at JP Morgan in London. 18. Buffett measures his performance not by the company’s stock price, which he didn’t control, but by increase in net worth per share, which he did.