64 results back to index

pages: 819 words: 181,185

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Derivatives Markets
** by
David Goldenberg

Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, correlation coefficient, 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, Myron Scholes, Norbert Wiener, Paul Samuelson, 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, yield curve, zero-coupon bond, zero-sum game

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. 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 zero-coupon 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–rτ. The current price of the bond is therefore, We can use this result to price any zero-coupon bond. Suppose that its face value (value at maturity) is $F, it has τ years to maturity and the annualized, continuously compounded rate is r% per year. Then the current price must be e–rτ*F. ■ CONCEPT CHECK 4 Given the information above, suppose that F=$1,000, τ=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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Our long position in the fixed-rate bond can be decomposed as the sum of three zero-coupon bonds, and one NP repayment bond as indicated in the multi-level cash flow diagram, Figure 8.15. TABLE 8.8 LIBOR Yield Curve (Spot Rates) Maturity Zero-Coupon Bond Yields 1 year 6.0% 2 years 6.5% 3 years 7.0% FIGURE 8.15 The Implicit Fixed-Rate Bond in a Swap, Written in Terms of Zero-Coupon Bonds The LIBOR zero-yield curve says that the appropriate discount rate to apply to the cash flow from Bond 1 is 6.00%, the appropriate discount rate to apply to the cash flow from Bond 2 is 6.5%, and the appropriate discount rate to apply to the cash flows from Bond 3 and from Bond 4 is 7.0%. This leads to the pricing formulas for the three zero-coupon bonds indicated: B0,1, B0,2, B0,3, and the notional principal bond NPB0,3.

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

Black-Scholes formula, Brownian motion, correlation coefficient, Credit Default Swap, delta neutral, discrete time, Emanuel Derman, fixed income, 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

Black-Scholes formula, Brownian motion, capital asset pricing model, cellular automata, delta neutral, discounted cash flows, discrete time, diversified portfolio, fixed income, 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?

pages: 222 words: 70,559

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

Buckminster Fuller, buy and hold, 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.

pages: 447 words: 104,258

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

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, Satyajit Das, 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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Mathematical Finance: Theory, Modeling, Implementation
** by
Christian Fries

Black-Scholes formula, Brownian motion, continuous integration, discrete time, fixed income, implied volatility, interest rate derivative, martingale, quantitative trading / quantitative ﬁnance, random walk, short selling, Steve Jobs, stochastic process, stochastic volatility, volatility smile, Wiener process, zero-coupon bond

The structured bond and its (hedge-)swap are separate products, since they are often offered by separate institutions.4 Zero Structures Besides (structured) coupon paying bonds, another common type of bonds are those for which the coupon is accrued instead of payed. Then, as for the zero coupon bond, there will be a single payment at maturity, see Figure 12.3, right. An accruing product is called a zero structure. A bond with accruing coupons is sometimes called a zero coupon bond. For an accruing zero coupon bond we may define a corresponding swap too. To do so we consider the following (equivalent) representation of the bond: At the end of each coupon period the notional and the period’s coupon is paid. The amount defines the new notional for the following period and is reinvested (this corresponds to accruing the coupon), see Figure 12.3, left.

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. ©2004, 2005, 2006 Christian Fries Version 1.3.19 [build 20061210]- 13th December 2006 http://www.christian-fries.de/finmath/ CHAPTER 12. EXOTIC DERIVATIVES T1 T2 T3 N1 ⋅ (1+C1) ⋅ (1+C2) ⋅ (1+C3) N1 N3 + N3 ⋅ C3 =: N4 N3 N2 + N2 ⋅ C2 =: N3 N2 N1 N1 + N1 ⋅ C1 =: N2 Zero Coupon Bond (Accruing Structured Coupon) T4 = T1 T2 T3 T4 Figure 12.3.: Cashflows for a zero coupon bond. Left with imaginary exchange of notionals at the end of each period, right with effective cashflows only. N1 ⋅ C1 N2 ⋅ C2 N3 ⋅ C3 N1 ⋅ L1 N2 ⋅ L2 N3 ⋅ L3 N3 + N3 ⋅ C3 =: N4 N3 N2 + N2 ⋅ C2 =: N3 N2 N1 + N1 ⋅ C1 =: N2 N1 Swap N3 + N3 ⋅ L3 N3 N2 + N2 ⋅ L2 N2 N1 + N1 ⋅ L1 N1 = Figure 12.4.: Cashflows for a swap who’s fixed leg corresponds to the zero coupon bond in Figure 12.3. Left with imaginary exchange of notionals at the end of each period, right with effective cashflows only. 162 This work is licensed under a Creative Commons License. http://creativecommons.org/licenses/by-nc-nd/2.5/deed.en Comments welcome. ©2004, 2005, 2006 Christian Fries Version 1.3.19 [build 20061210]- 13th December 2006 http://www.christian-fries.de/finmath/ 12.2.

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Left with imaginary exchange of notionals at the end of each period, right with effective cashflows only. . 12.2. Cashflows for a swap who’s fixed leg corresponds to the coupon bond in Figure 12.1. Left with imaginary exchange of notionals at the end of each period, right with effective cashflows only. . . . . . . . . . . 12.3. Cashflows for a zero coupon bond. Left with imaginary exchange of notionals at the end of each period, right with effective cashflows only. 12.4. Cashflows for a swap who’s fixed leg corresponds to the zero coupon bond in Figure 12.3. Left with imaginary exchange of notionals at the end of each period, right with effective cashflows only. . . . . . . . . 12.5. Bermudan Swaption . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 162 164 Discretization and Implementation of Itô Processes . . . . . . . Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . .

pages: 219 words: 15,438

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

buy and hold, compound rate of return, corporate governance, Dissolution of the Soviet Union, diversified portfolio, dividend-yielding stocks, fixed income, George Santayana, index fund, intangible asset, invisible hand, large denomination, low cost airline, 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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By this means, "wealth" would balloon though not an erg of productive work had been done. The satirical nonsense of the bezzle is dwarfed by the realworld nonsense of the zero-coupon bond. With zeros, one party to a contract can experience "income" without his opposite experiencing the pain of expenditure. In our illustration, a company capable of earning only $100 million dollars annually-and therefore capable of paying only that much in interest-magically creates "earnings" for bondholders of $150 million. As long as major investors willingly don their Peter Pan wings and repeatedly say "I believe," there is no limit to how much "income" can be created by the zero-coupon bond. Wall Street welcomed this invention with the enthusiasm lessenlightened folk might reserve for the wheel or the plow. Here, finally, was an instrument that would let the Street make deals at prices no longer limited by actual earning power.

pages: 345 words: 86,394

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Frequently Asked Questions in Quantitative Finance
** by
Paul Wilmott

Albert Einstein, asset allocation, beat the dealer, Black-Scholes formula, Brownian motion, butterfly effect, buy and hold, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, lateral thinking, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, 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.

pages: 246 words: 16,997

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

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 t 1 2 − 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."

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

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.

pages: 416 words: 39,022

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

asset allocation, Brownian motion, business continuity plan, business process, capital asset pricing model, computer age, corporate governance, discrete time, diversified portfolio, fixed income, 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.

pages: 353 words: 88,376

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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

Albert Einstein, asset allocation, asset-backed security, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, fixed income, implied volatility, index fund, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, money market fund, mortgage debt, Myron Scholes, 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.

pages: 349 words: 134,041

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

accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy and hold, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, 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, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, 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, Right to Buy, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, 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.

pages: 250 words: 77,544

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Personal Investing: The Missing Manual
** by
Bonnie Biafore,
Amy E. Buttell,
Carol Fabbri

asset allocation, asset-backed security, business cycle, buy and hold, diversification, diversified portfolio, Donald Trump, employer provided health coverage, estate planning, fixed income, Home mortgage interest deduction, index fund, Kickstarter, money market fund, mortgage tax deduction, risk tolerance, risk-adjusted returns, Rubik’s Cube, Sharpe ratio, stocks for the long run, Vanguard fund, Yogi Berra, zero-coupon bond

They would clip the paper coupons attached to their bonds and send them in to collect their interest payments. Zero coupon bonds work a little differently. First, instead of making regular interest payments, this type of bond pays one lump sum at maturity that combines interest and principal payments. In addition, you buy a zero coupon bond at a discount from its face value. When the bond matures, you receive the face value, which is the purchase price and all the interest you earned, compounded at the bond’s interest rate (coupon rate). For example, a bond with a $1,000 face value that matures in 20 years and has a 6% interest rate may sell initially for $307. At the end of 20 years, you get $1,000, which is your purchase price plus the interest at 6% (compounded twice a year). One characteristic of zero coupon bonds is their variability in price. For complex financial reasons that would try the patience of Ben Bernanke, zero coupon bond prices fluctuate more than those of regular bonds, so you may notice that variation if you compare the two types of bonds.

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For complex financial reasons that would try the patience of Ben Bernanke, zero coupon bond prices fluctuate more than those of regular bonds, so you may notice that variation if you compare the two types of bonds. Zero coupon bonds are great when you’re saving for a goal in the future. You can invest a smaller amount today in zero coupon bonds that mature when you need the money. In between, you don’t have to worry about reinvesting the bond interest. Convertible bonds are corporate bonds with an option to convert the bond into shares of the company’s common stock. They offer the lower risk and more stable returns of a bond along with the potential upside of a stock. For that reason, the interest rates they pay are lower than for regular bonds. Bonds 135 Understanding Bond Prices As you learned on page 129, when you buy a bond, you get regular interest payments based on the interest rate set when the bond was issued.

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See URL website resources asset allocation, 161, 165 college cost calculator, 208 company financial status, 112 credit card calculator, 41 evaluating stocks, 104 fee and tax calculator, 99 fund information, 79–90 fund-screening tools, 95 growth rate for a stock, 110–111 health costs, 224 health savings account qualification, 218 individual health insurance, 216 lazy portfolios, 168–169 long-term care costs, 226 Missing CD website, 9, 15 price ratios for companies, 121 REIT income and expenses, 147 REIT screening tools, 150 risk tolerance tests, 160 Roth conversion calculator, 185 Section 529 college savings plans, 206 Social Security benefits calculator, 28 TinyURL website, 7 turnover ratios, 117 Wage Index website, 16 whole-life insurance policies, 33 William Bernstein’s No-Brainer Portfolio, 168 wins, 50 wrap fees, 91 Index zero coupon bonds, 135

pages: 504 words: 139,137

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

activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, business cycle, buy and hold, 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, money market fund, mortgage debt, Myron Scholes, 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, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, 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.

pages: 1,202 words: 424,886

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Stigum's Money Market, 4E
** by
Marcia Stigum,
Anthony Crescenzi

accounting loophole / creative accounting, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Black-Scholes formula, Brownian motion, business climate, buy and hold, capital controls, central bank independence, centralized clearinghouse, corporate governance, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, disintermediation, distributed generation, diversification, diversified portfolio, financial innovation, financial intermediation, fixed income, full employment, high net worth, implied volatility, income per capita, intangible asset, interest rate derivative, interest rate swap, large denomination, locking in a profit, London Interbank Offered Rate, margin call, market bubble, market clearing, market fundamentalism, money market fund, mortgage debt, Myron Scholes, offshore financial centre, paper trading, pension reform, Ponzi scheme, price mechanism, price stability, profit motive, Real Time Gross Settlement, reserve currency, risk tolerance, risk/return, seigniorage, shareholder value, short selling, technology bubble, the payments system, too big to fail, transaction costs, two-sided market, value at risk, volatility smile, yield curve, zero-coupon bond, zero-sum game

The offset to this advantage in the United States is that taxable investors must pay taxes on interest that accrues to them on zeros as that interest accrues whereas they actually get interest years later when the bond matures. Consequently, in the United States zeros are most attractive to tax-exempt or low-taxed investors: pension funds and individuals investing their retirement monies in IRAs and other types of retirement accounts. They are also seen as attractive to investors seeking capital gains, given that the duration on a zero-coupon bond is longer than on coupon securities with the same maturity date (the duration on a zero-coupon bond is always equal to its length to maturity). Zero-coupon bonds are also attractive to savers and investors wishing to have a known cash flow at a specific date in the future. THE ZOO Beating the U.S. Treasury to the punch, in August of 1982, Merrill, counting on the idea that Treasuries packaged as zeros could lure into long-term government bonds many investors who would not otherwise buy them, came up with an idea of how to do this packaging: buy long bonds, put them into a bank, and issue receipts against all coupon payments and the principal repayment that the Treasury is scheduled to make.

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Throughout this chapter we focus on fixed coupons; however, the same principles apply to floating-rate bonds. ZERO-COUPON BONDS We start by analyzing how to value the simplest type of bond: one that pays no coupons. It therefore gives the investor one cash flow only: the repayment of principal at maturity. Such a bond can be easily valued by Alex Edmans is a Ph.D. candidate in financial economics at MIT and previously worked in both fixed income and investment banking for Morgan Stanley. discounting this future cash flow back to today. In general, if r is the periodic discount rate (i.e., the rate of return available on bonds of equivalent risk) and A is the principal to be received t periods from today, the current price of the bond is given by: For example, consider a zero-coupon bond that promises to pay $100 three years from now (Bond A).

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Since the semiannual coupon rate of 4% exceeds the 3% available elsewhere, an investor will be willing to pay more than par value for it. In general, if the coupon rate exceeds the yield, the bond will be a premium bond. If it equals the yield, it is a par bond. If it is less than the yield, it is a discount bond—as we have seen, one example is a zero-coupon bond as the coupon rate is zero. Again, we have an inverse relationship between the bond’s price and its yield. The intuition is the same as for the zero-coupon bond: cash flows are independent of outside investment opportunities. If the rate of return available elsewhere rises from 3%, outside opportunities are more attractive, but the bond will still pay only $40 every six months and $100 at maturity. Therefore it will be worth less; indeed, once the yield crosses 4%, the price of the bond will drop to below $100.

pages: 482 words: 121,672

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

accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, beat the dealer, Bernie Madoff, bitcoin, butter production in bangladesh, buttonwood tree, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Detroit bankruptcy, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, financial repression, fixed income, framing effect, George Santayana, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, money market fund, mortgage tax deduction, new economy, Own Your Own Home, passive investing, Paul Samuelson, 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, stocks for the long run, survivorship bias, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond, zero-sum game

Moreover, bonds proved to be excellent diversifiers with low or negative correlation with common stocks from 1980 through 2014. 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 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). But their attractiveness for investment varies considerably with market conditions. And with the very low interest rates of the mid-2010s, investors must approach the bond market with considerable caution. Zero-Coupon Bonds Can Be Useful to Fund Future Liabilities These securities are called zero coupons or simply zeros because owners receive no periodic interest payments, as they do in a regular interest-coupon-paying bond.

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A FITNESS MANUAL FOR RANDOM WALKERS AND OTHER INVESTORS 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: How to Investigate a Promenade through Bond Country Zero-Coupon Bonds Can Be Useful to Fund Future Liabilities No-Load Bond Funds Can Be 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? Foreign Bonds Exercise 7A: Use Bond Substitutes for Part of the Aggregate Bond Portfolio during Eras of Financial Repression Exercise 8: Tiptoe through the Fields of Gold, Collectibles, and Other Investments Exercise 9: Remember That Investment Costs Are Not Random; Some Are Lower Than Others Exercise 10: Avoid Sinkholes and Stumbling Blocks: Diversify Your Investment Steps A Final Checkup 13.

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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, 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, “smart beta” strategies, Roth IRAs, 529 college savings plans, zero-coupon bonds, financial and commodity futures and options, and new trading techniques such as “portfolio insurance” and “high-frequency 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 eleventh edition also provides a clear and easily accessible description of the academic advances in investment theory and practice.

pages: 1,164 words: 309,327

**
Trading and Exchanges: Market Microstructure for Practitioners
** by
Larry Harris

active measures, Andrei Shleifer, asset allocation, automated trading system, barriers to entry, Bernie Madoff, business cycle, buttonwood tree, buy and hold, compound rate of return, computerized trading, corporate governance, correlation coefficient, data acquisition, diversified portfolio, fault tolerance, financial innovation, financial intermediation, fixed income, floating exchange rates, High speed trading, index arbitrage, index fund, information asymmetry, information retrieval, interest rate swap, invention of the telegraph, job automation, law of one price, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market clearing, market design, market fragmentation, market friction, market microstructure, money market fund, Myron Scholes, Nick Leeson, open economy, passive investing, pattern recognition, Ponzi scheme, post-materialism, price discovery process, price discrimination, principal–agent problem, profit motive, race to the bottom, random walk, rent-seeking, risk tolerance, risk-adjusted returns, selection bias, shareholder value, short selling, Small Order Execution System, speech recognition, statistical arbitrage, statistical model, survivorship bias, the market place, transaction costs, two-sided market, winner-take-all economy, yield curve, zero-coupon bond, zero-sum game

Notes normally mature two to five years after they are issued, and bonds normally mature ten or more years after they are issued. Bills do not pay interest. Instead, they sell at a discount from their face value. Zero coupon bonds pay no interest. They simply return their principal value at maturity. Since they pay no interest, buyers will buy them only at a discount from their face value. Zero coupon bonds therefore are also known as pure discount bonds. The greater the time to maturity, the greater the discount. A straight bond is equivalent to a bundle of zero coupon bonds consisting of one zero-coupon bond due on each interest payment date plus a zero-coupon bond due when the straight bond matures. The principal values of the various bonds correspond to the various payments due on the straight bond. Commercial paper is a short-term debt security issued by a corporation.

…

Farmers, miners, and manufacturers create most physical commodities, and national central banks create most currencies. 3.3.2.1 Definitions of Some Common Financial Assets Equities Stocks represent ownership of corporate assets, net of corporate liabilities. Stock values depend on corporate assets, liabilities, and income. They also depend critically on how well traders expect corporate managers will use corporate assets in the future. * * * ▶ Stripping Bonds When traders want more zero-coupon bonds than are available, zero-coupon bonds become expensive relative to straight bonds. Fixed-income arbitrageurs then buy straight bonds and clip the coupons. They bundle the coupons by their interest payment dates and sell the bundles and the remaining final principal payments as zero coupon bonds. Traders call this process stripping a bond. The term comes from a time when all bonds were bearer bonds. The owners of bearer bonds are not registered with bond issuers. Since issuers cannot keep track of who owns their bearer bonds, they make interest payments only when the bondholders present them with interest coupons clipped from the side of the paper upon which the bonds are printed.

…

Investors and borrowers prefer to trade instruments that produce cash flows which occur just when they need them. Hedgers like to trade instruments that closely replicate the risks which worry them. Gamblers like instruments that excite them. * * * ▶ Zero Coupon Bonds Zero coupon bonds that mature at various dates are attractive to investors and borrowers because they use them as building blocks to construct any cash flow that they want. With enough different maturity dates from which to choose, traders can construct a portfolio of zero coupon bonds to represent any cash flow. ◀ * * * Profit-motivated traders trade only because they expect to profit directly from trading. The primary profit-motivated traders are dealers and speculators. Dealers sell liquidity to impatient traders when they allow them to trade when they want to trade.

pages: 416 words: 118,592

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

accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, beat the dealer, Bernie Madoff, BRICs, butter production in bangladesh, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, 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, money market fund, mortgage tax deduction, new economy, Own Your Own Home, passive investing, Paul Samuelson, 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, stocks for the long run, survivorship bias, The Myth of the Rational Market, the rule of 72, 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.

pages: 244 words: 79,044

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

activist fund / activist shareholder / activist investor, Bernie Madoff, capital asset pricing model, corporate raider, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, intangible asset, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, NetJets, new economy, Ponzi scheme, post-work, 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.

pages: 253 words: 79,214

**
The Money Machine: How the City Works
** by
Philip Coggan

activist fund / activist shareholder / activist investor, algorithmic trading, asset-backed security, Bernie Madoff, Big bang: deregulation of the City of London, bonus culture, Bretton Woods, call centre, capital controls, carried interest, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, disintermediation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, endowment effect, financial deregulation, financial independence, floating exchange rates, Hyman Minsky, index fund, intangible asset, interest rate swap, Isaac Newton, joint-stock company, labour market flexibility, large denomination, London Interbank Offered Rate, Long Term Capital Management, merger arbitrage, money market fund, moral hazard, mortgage debt, negative equity, Nick Leeson, Northern Rock, pattern recognition, purchasing power parity, quantitative easing, reserve currency, Right to Buy, Ronald Reagan, shareholder value, South Sea Bubble, sovereign wealth fund, technology bubble, time value of money, too big to fail, tulip mania, Washington Consensus, yield curve, zero-coupon bond

One of the most prominent ‘variations’ is the zero-coupon bond, which, as its name suggests, pays no interest at all. Instead it is issued at a discount to its face value. Say it is issued with a face value of £100; its selling price may then be £50. When the bond matures in five years’ time, the borrower will repay the full £100. The investor has effectively received all the interest in a lump, rather than spread out over the years. This can be particularly attractive to investors in countries which have tax regimes that differentiate between income and capital gains. The difference between the prices at which the bond is bought and sold is treated by some tax systems as a capital gain; capital gains taxes are normally below the highest rates of income tax. If the investor is going to pay less tax on a zero-coupon bond, he will be willing to accept an interest rate effectively rather lower than that on a straight bond.

…

If the investor is going to pay less tax on a zero-coupon bond, he will be willing to accept an interest rate effectively rather lower than that on a straight bond. Both investor and borrower thus benefit. It is possible to calculate the ‘interest’ on a zero-coupon bond, though this sounds an odd concept. Assume that the bond has a one-year maturity and a face value of £100, and that it is sold for £80. An investor who buys the bond on issue will make a £20 gain if he holds it until maturity. A profit of £20 on an investment of £80 is a return of 25 per cent per annum. If the bond had a two-year maturity, an issue price of £64 would achieve the same return (25 per cent of £64 is £16, which, added on to £64, makes £80). Another variation is the partly paid bond. This allows investors to pay only a proportion of the bond’s face when the bond is issued and to pay the rest later on.

…

Similar, in principle, to options WHOLESALE MARKET Another name for the money markets, so called because of the large amounts which are lent and borrowed YIELD The return on a security expressed as a proportion of its price YIELD CURVE A diagram which shows the relationship of short-term rates to long-term ones. If long-term rates are above short-term, the curve is said to be positive or upward-sloping: if they are lower, the curve is said to be negative or inverted ZERO COUPON BOND Bond which pays no interest but is issued at a discount to its face value Acknowledgements A book covering such a wide field could not be produced without the help and advice of many people. First and foremost, I would like to thank Nick Shepherd and Diane Pengelly for reading through all the chapters and pointing out the numerous grammatical errors and nonsensical statements. Many others read through individual chapters: my father, Ken Ferris, John Presland, David Bowen, Clifford German, Paul and Vanessa Gilbert, Lynton Jones, David Morrison and Nigel Falls, and I thank them for their helpful comments.

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

Black-Scholes formula, Brownian motion, buy and hold, 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.

**
Principles of Corporate Finance
** by
Richard A. Brealey,
Stewart C. Myers,
Franklin Allen

3Com Palm IPO, accounting loophole / creative accounting, Airbus A320, Asian financial crisis, asset allocation, asset-backed security, banking crisis, Bernie Madoff, big-box store, Black-Scholes formula, break the buck, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, carried interest, collateralized debt obligation, compound rate of return, computerized trading, conceptual framework, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-subsidies, discounted cash flows, disintermediation, diversified portfolio, equity premium, eurozone crisis, financial innovation, financial intermediation, fixed income, frictionless, fudge factor, German hyperinflation, implied volatility, index fund, information asymmetry, intangible asset, interest rate swap, inventory management, Iridium satellite, Kenneth Rogoff, law of one price, linear programming, Livingstone, I presume, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, market friction, money market fund, moral hazard, Myron Scholes, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, prediction markets, price discrimination, principal–agent problem, profit maximization, purchasing power parity, QR code, quantitative trading / quantitative ﬁnance, random walk, Real Time Gross Settlement, risk tolerance, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, Silicon Valley, Skype, Steve Jobs, The Nature of the Firm, the payments system, the rule of 72, time value of money, too big to fail, transaction costs, University of East Anglia, urban renewal, VA Linux, value at risk, Vanguard fund, yield curve, zero-coupon bond, zero-sum game, Zipcar

Calculate the PV of the following bonds assuming annual coupons: (i) 5%, two-year bond; (ii) 5%, five-year bond; and (iii) 10%, five-year bond. c. Explain intuitively why the yield to maturity on the 10% bond is less than that on the 5% bond. d. What should be the yield to maturity on a five-year zero-coupon bond? e. Show that the correct yield to maturity on a five-year annuity is 5.75%. f. Explain intuitively why the yield on the five-year bonds described in part (c) must lie between the yield on a five-year zero-coupon bond and a five-year annuity. 21. Duration Calculate durations and modified durations for the 3% bonds in Table 3.2. You can follow the procedure set out in Table 3.4 for the 9% coupon bonds. Confirm that modified duration predicts the impact of a 1% change in interest rates on the bond prices. 22.

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For more on this, see Section 3-1. 3There is one type of bond on which the borrower is obliged to pay interest only if it is covered by the year’s earnings. These so-called income bonds are rare and have largely been issued as part of railroad reorganizations. 4Any bond that is issued at a discount is known as an original issue discount bond. A zero-coupon bond is often called a “pure discount bond.” The capital appreciation on a discount bond is not taxed as income as long as it amounts to less than .25% a year (IRS Code Section 1272). 5The ultimate of ultimates was an issue of a perpetual zero-coupon bond on behalf of a charity. 6Instead of issuing a capped floating-rate loan, a company sometimes issues an uncapped loan and at the same time buys a cap from a bank. The bank pays the interest in excess of the specified level. 7In the U.S. corporate bond market, accrued interest is calculated on the assumption that a year is composed of twelve 30-day months; in some other markets (such as the U.S.

…

Currency risk Suppose that in 2020 two-year interest rates are 5.2% in the United States and 1.0% in Japan. The spot exchange rate is ¥120.22/$. Suppose that one year later interest rates are 3% in both countries, while the value of the yen has appreciated to ¥115.00/$. a. Benjamin Pinkerton from New York invested in a U.S. two-year zero-coupon bond at the start of the period and sold it after one year. What was his return? b. Madame Butterfly from Osaka bought some dollars. She also invested in the two-year U.S. zero-coupon bond and sold it after one year. What was her return in yen? c. Suppose that Ms. Butterfly had correctly forecasted the price at which she sold her bond and that she hedged her investment against currency risk. How could she have done so? What would have been her return in yen? 9. Investment decisions It is the year 2018 and Pork Barrels Inc. is considering construction of a new barrel plant in Spain.

pages: 313 words: 101,403

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

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

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.

**
Risk Management in Trading
** by
Davis Edwards

asset allocation, asset-backed security, backtesting, Black-Scholes formula, Brownian motion, business cycle, computerized trading, correlation coefficient, Credit Default Swap, discrete time, diversified portfolio, fixed income, implied volatility, intangible asset, interest rate swap, iterative process, John Meriwether, London Whale, Long Term Capital Management, margin call, Myron Scholes, Nick Leeson, p-value, paper trading, pattern recognition, random walk, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, statistical model, stochastic process, systematic trading, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

Debt securities issued by the U.S. government have different names based on maturity. Treasury bills have terms of less than one year. Treasury notes typically have terms of 2, 3, 5, and 10 years. Treasury bonds have a maturity of 30 years. These are generally considered very safe investments and have a correspondingly low interest rate. These all work similarly and are typically referred to by the name Treasuries. Zero Coupon Bonds. As their name implies, zero coupon bonds do not have a coupon payment. Instead, they are issued at a discount to their par value. Asset‐Backed Securities (ABS). An asset‐backed security is a type of collateralized bond that has an asset or pool of assets pledged to (Continued) 50 RISK MANAGEMENT IN TRADING KEY CONCEPT: (Continued ) help repay the bond. The asset backing the loan might be a physical asset (like manufacturing equipment) or an expected stream of income (like taxes or rental income).

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The bond will continue to pay the same coupon rate for the life of the bond. The current yield is calculated as a percent of its trading price. (See Equation 2.2, Current Yield). Current Yield = Annual Interest Payment Trading Price To compare two bonds, it is necessary to consider both the current price of the bond (relative to its face value) and the size of the coupon payments. A bond with no coupon payments might still be quite valuable. For example, a zero coupon bond which is trading at 50 percent of its par value will still have a substantial payoff if the issuer doesn’t default before maturity. To compare bonds with different prices and coupon payments, bond traders will use a calculation called yield to maturity. (See Equation 2.3, Yield to Maturity.) The yield to maturity calculation can be approximated as: YTM = F−P n F+P 2 C+ where C F P n Coupon.

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See unexpected loss unexpected loss, 240–241 V validation, data, 96–97 value of options, 204–207 value-at-risk limits, in practice, 170 value-at-risk sensitivity, 162–163 value-at-risk as size measure, 147 defined, 143–147 misuse of, 171–173 non-parametric, 167–169 parametric, 150–161 zero and, 164 VAR. See value-at-risk variables, 62–63 variance, 69–70 variance/covariance matrix, 165–167 vega, 203, 230–232 time and, 232 volatile earnings, created via hedging, 187 volatility, 69–70, 201 estimating, 153–161 volume notation, 202 W wrong-way risk, 255 Z zero coupon bonds, 49 zero, value-at-risk and, 164

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

asset allocation, backtesting, buy and hold, capital asset pricing model, commoditize, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, intangible asset, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, stocks for the long run, survivorship bias, the rule of 72, 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.

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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.

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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.”

pages: 368 words: 32,950

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

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, buy and hold, 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, intangible asset, interest rate derivative, interest rate swap, John Meriwether, 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, Right to Buy, 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.

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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.

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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

pages: 612 words: 179,328

**
Buffett
** by
Roger Lowenstein

asset allocation, Bretton Woods, buy and hold, cashless society, collective bargaining, computerized trading, corporate raider, credit crunch, cuban missile crisis, Eugene Fama: efficient market hypothesis, index card, index fund, interest rate derivative, invisible hand, Jeffrey Epstein, John Meriwether, Long Term Capital Management, moral hazard, Paul Samuelson, random walk, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, selection bias, The Predators' Ball, traveling salesman, Works Progress Administration, Yogi Berra, young professional, zero-coupon bond

He tied together Berkshire’s recent history and Wall Street’s current crisis with a seemingly innocent thread: many of the now-toppling LBOs, such as Federated, the corporate parent of Bloomingdale’s, had also been financed with zeros. Of course, Buffett had a larger theme in mind. On Wall Street, it was often the good ideas that got you into trouble, for what the wise did in the beginning, “fools do in the end.”36 Thus it was with LBOs and zero-coupon bonds. As was his style in such essays, Buffett started small and in the distant past. He invited readers to “travel back to Eden, to a time when the apple had not yet been bitten.”37 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. Nobody called it a zero-coupon, but that’s what the Series E was. The interest was paid in a lump sum, when the bond matured. The ordinary Americans who bought the Series E were no fools.

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He also made arbitrage profits on Beatrice, Federated Department Stores, Kraft, Interco, Southland, and other deal stocks.7 But Buffett, who had learned arbitrage from Ben Graham, deviated from Wall Street’s arbitrageurs in one Graham-like respect. As the action got hotter, Buffett was less eager to go along. Years earlier, at the Columbia seminar on takeovers, he had warned that bankers using phony currency would one day push the bidding to unsound levels. After the $25 billion RJR Nabisco deal, he judged that this was a prophecy no more. Deal-makers were financing LBOs with “zero-coupon bonds,” a type of funny money that enabled buyers to borrow huge sums and defer their interest payments (and reality) for years. Given the ease with which such scrip was printed—and the willingness of investors to suspend disbelief—it is hardly surprising that deal prices had made for the stratosphere. Quoting Buffett: Some extraordinary excesses have developed in the takeover field. As Dorothy says: “Toto, I have a feeling we’re not in Kansas any more.”8 Buffett wrote that in February 1989, just as the RJR Nabisco deal was closing.

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., Buffett raised $400 million by selling bonds that were convertible into shares of Berkshire. The people who bought this paper got a fixed return and a “lottery ticket” on Berkshire’s stock. This time, Buffett’s terms were sweeter than sugar. His interest rate was only 5.5 percent. The low rate was a measure of the investors’ faith that Berkshire’s share price would continue rising. (They were betting on the lottery ticket.) What’s more, since these were “zero-coupon” bonds, Berkshire would owe interest, but not actually pay it, until the bonds matured, fifteen years later. But owing to a quirk in the tax laws, Berkshire could deduct the interest all along, as though it were paying. And there was more. Berkshire could redeem the “zeros” in three years. Thus, the investors were betting not just that Berkshire’s stock would rise, but that it would do so in a hurry.

pages: 507 words: 145,878

**
The Predators' Ball: The Inside Story of Drexel Burnham and the Rise of the JunkBond Raiders
** by
Connie Bruck

corporate raider, diversified portfolio, Edward Thorp, financial independence, fixed income, Irwin Jacobs, 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.

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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.

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., 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.

pages: 300 words: 77,787

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

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, intangible asset, invisible hand, Kenneth Rogoff, market bubble, money market fund, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, selection bias, 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 Trade Lifecycle: Behind the Scenes of the Trading Process (The Wiley Finance Series)
** by
Robert P. Baker

asset-backed security, bank run, banking crisis, Basel III, Black-Scholes formula, Brownian motion, business continuity plan, business process, collapse of Lehman Brothers, corporate governance, credit crunch, Credit Default Swap, diversification, fixed income, hiring and firing, implied volatility, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, market clearing, millennium bug, place-making, prediction markets, short selling, statistical model, stochastic process, the market place, the payments system, time value of money, too big to fail, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

We have restricted the illustration of cashflows to three common types: a fixed coupon bond (Figure 3.10), a floater (Figure 3.11), and a zero coupon bond (Figure 3.12). Perhaps the simplest type of bond is one that pays fixed coupons. Here all the cashflows are known at the outset of the trade. We give the issuer the purchase price at the start of the trade and they pay fixed coupons at periodic intervals until the bond reaches maturity. At that time, they pay the last, fixed coupon plus the redemption amount which is set at 100 by convention. A floating coupon bond (also known as a floater) pays a coupon based on a reference entity. The coupon is fixed just prior to the due date in the same manner as swap fixings described above. Hence we know the time when coupons will be due, but we do not know the amounts until just before payment. A zero coupon bond pays no coupons. We pay the purchase price at the start and receive the redemption at the end so there are just two, fixed cashflows. 3.9 OPTION Options are discussed in section 5.2.

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The value diagrams are also in section 5.2. 28 THE TRADE LIFECYCLE Redemption plus final coupon Fixed coupons Issue Date Maturity Issue Price FIGURE 3.10 Cashflows on fixed bond Redemption plus final float coupon Float coupons Issue Date Maturity Issue Price FIGURE 3.11 Cashflows on floating bond 29 Understanding Traded Products – Follow the Money Redemption Issue Date Maturity Issue Price FIGURE 3.12 Cashflows on zero coupon bond The basic mechanics of purchasing an option are the payment of a fixed premium at the start of the trade and the possibility of a payout at some future time, depending on how market prices change relative to an agreed fixed price, known as the strike. A European option can, by definition, only be exercised at one time in the future. This means the time of the payout cashflow is known from the start.

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Floating Rate Note (FRN) When the coupon is paid at variable rates, the bond is known as a floating rate note or floater. The exact payment is determined only just before the coupon date and is derived from a benchmark index, such as LIBOR. The process of determining the coupon is known as a fixing. The coupon is often an amount over the benchmark (e.g. LIBOR plus 50 basis points). This is known as the margin. Zero coupon bonds These bonds pay no coupons. The bonds are offered at the issue date for a discounted price (e.g. 63%) and are redeemed at maturity for par (100%). The gain to the purchaser arises from this price differential and is an alternative to the coupon payment of standard bonds. This means the issuer does not have to worry about having to find intermediate income to service the coupon payments. Amortising bonds Sometimes the capital borrowed is repaid to investors in instalments, rather than all at the end.

pages: 701 words: 199,010

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

affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, business cycle, 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, John Meriwether, Kickstarter, 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, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, 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, Sam Peltzman, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, 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.

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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.

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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.

**
The Global Money Markets
** by
Frank J. Fabozzi,
Steven V. Mann,
Moorad Choudhry

asset allocation, asset-backed security, bank run, Bretton Woods, buy and hold, collateralized debt obligation, credit crunch, discounted cash flows, discrete time, disintermediation, fixed income, high net worth, intangible asset, interest rate derivative, interest rate swap, large denomination, locking in a profit, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, money market fund, moral hazard, mortgage debt, paper trading, Right to Buy, short selling, stocks for the long run, time value of money, value at risk, Y2K, yield curve, zero-coupon bond, zero-sum game

The function tells us there are 14 days between August 27, 2001 and September 11, 2001 using a 30/360 day count. Note that the actual number of days between these two dates is 15. DISCOUNT INSTRUMENTS Many money market instruments are discount securities (e.g. U.S. Treasury bills, agency discount notes, and commercial paper). Unlike bonds that pay coupon interest, discount securities are like zero-coupon bonds in that they are sold at a discount from their face value and are redeemed for full face value at maturity. Further, most discount securities use an ACT/360 day count convention. In this section, we discuss how yields on discount securities are quoted, how discount securities are priced, and how the yields on discount securities can be adjusted so that they can be compared to the yields on interest-bearing securities.

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Accrual Tranches In Deal 1, the payment rules for interest provide for all tranches to be paid interest each month. In many sequential-pay CMO structures, at least one tranche does not receive current interest. Instead, the interest for that tranche would accrue and be added to the principal balance. Such a bond class is commonly referred to as an accrual tranche or a Z bond (because the bond is similar to a zero-coupon bond). The interest that would have been paid to the accrual tranche is then used to speed up pay down of the principal balance of earlier tranches. To see this, consider Deal 2, a hypothetical CMO structure with the same collateral as Deal 1 and with four tranches, each with a coupon rate of 7.5%. The difference is in the last tranche, Z, which is an accrual tranche. The structure for Deal 2 is shown in Exhibit 9.5.

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See Annualized yield; Bank discount; Bondequivalent yield; CD equivalent yield; Commercial paper; Current yield; Interest-bearing securities; Stop yield behavior. See U.S. Treasury bills Index CD yield conversion. See Simple yield curve, 188, 286. See also Money markets riding, 41–42 usage, 39–42 spreads, 51, 75 margin, 111 usage, 39 Yield Analysis (YA), 10, 61, 64, 73, 108, 111 Yield Calculations, 62 Zero-coupon bonds, 14, 168 Zero-coupon discount factor, 267–268 Zero-coupon swap, 259–260 Zimmerman, Thomas, 192

pages: 2,045 words: 566,714

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

Affordable Care Act / Obamacare, airline deregulation, asset allocation, business cycle, collective bargaining, distributed generation, employer provided health coverage, estate planning, Home mortgage interest deduction, intangible asset, medical malpractice, medical residency, money market fund, mortgage debt, mortgage tax deduction, passive income, Ponzi scheme, profit motive, rent control, Right to Buy, 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.

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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.

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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.

pages: 1,845 words: 567,850

**
J.K. Lasser's Your Income Tax 2014
** by
J. K. Lasser

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

However, under an exception, market discount rules will not apply to the new bond if the old market discount bond was issued before July 19, 1984, and the terms and interest rates of both bonds are identical. - - - - - - - - - - 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.

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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. - - - - - - - - - - 4.21 Discount on Short-Term Obligations Short-term obligations (maturity of a year or less from date of issue) may be purchased at a discount from face value. If you are on the cash basis, the discount on short-term obligations other than tax-exempt obligations must be reported as interest income in the year the obligations are sold or redeemed unless you elect to include the accrued discount in income currently. EXAMPLE In May 2012, you paid $970 for a short-term note with a face amount of $1,000. In January 2013, you receive payment of $1,000 on the note. On your 2013 tax return, you report $30 as interest.

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See Qualifying widows or widowers Wills, contesting Winnings Withdrawals from 401(k) plans of nondeductible IRA contributions premature by reservists from Roth IRAs, penalties on saver’s credit and Withholdings additional Medicare taxes and for Armed Forces personnel backup for children and child tax credit to cover prior tax underpayments estimated tax and FICA filing for refund of on Form W-2 on gambling winnings on government payments for household employees for housekeepers on late-filed original returns on lump-sum distributions from retirement plans and retirement distributions for retirement plans on Social Security benefits on tips on wages Work camps Work clothes Workers abroad Workers’ compensation Workforce, amortization of Working condition fringe benefits Working interests, in oil and gas wells “Workouts,” mortgage loan Work-related costs of education Wrongful death actions Wrongful termination Y Year-end benefits Year-end dividends Year-end donations Year-end purchases Year-end sales Year-end securities transactions Z Zero coupon bond discount, reporting Zero coupon bond discount

**
J.K. Lasser's Your Income Tax 2016: For Preparing Your 2015 Tax Return
** by
J. K. Lasser Institute

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

You must annually report a ratable portion of the discount. 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.

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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. 4.23 Sale or Retirement of Bonds and Notes Gain or loss on the sale, redemption, or retirement of debt obligations issued by a government or corporation is generally capital gain or loss. A redemption or retirement of a bond at maturity must be reported as a sale on Schedule D of Form 1040 (5.8) although there may be no gain or loss realized. The accrued amount of OID is reported annually as interest income (4.19) and added to basis; this includes the accrued OID for the year the bond is sold. If the bonds are sold or redeemed before maturity, you realize capital gain for the proceeds over the adjusted basis (as increased by accrued OID) of the bond, provided there was no intention to call the bond before maturity.

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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.

pages: 389 words: 109,207

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

Albert Einstein, anti-communist, asset allocation, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, Edward Thorp, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John Meriwether, John von Neumann, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Myron Scholes, New Journalism, Norbert Wiener, offshore financial centre, Paul Samuelson, publish or perish, quantitative trading / quantitative ﬁnance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Rubik’s Cube, 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, zero-sum game

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.

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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.

pages: 289 words: 113,211

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

"Robert Solow", affirmative action, Albert Einstein, asset allocation, backtesting, beat the dealer, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commoditize, commodity trading advisor, computer age, computerized trading, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, Edward Thorp, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, intangible asset, Jeff Bezos, John Meriwether, 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, Myron Scholes, new economy, Nick Leeson, oil shock, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, selection bias, 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, William Langewiesche, yield curve, zero-coupon bond, zero-sum game

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.

pages: 425 words: 122,223

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

"Robert Solow", Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, corporate raider, 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, Kenneth Arrow, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, money market fund, Myron Scholes, new economy, New Journalism, Paul Samuelson, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, Thales and the olive presses, 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, zero-sum game

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).

pages: 419 words: 130,627

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Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase
** by
Duff McDonald

bank run, Blythe Masters, Bonfire of the Vanities, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Exxon Valdez, financial innovation, fixed income, G4S, housing crisis, interest rate swap, Jeff Bezos, John Meriwether, Kickstarter, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, money market fund, moral hazard, negative equity, Nelson Mandela, Northern Rock, profit motive, Renaissance Technologies, risk/return, Rod Stewart played at Stephen Schwarzman birthday party, Saturday Night Live, sovereign wealth fund, statistical model, Steve Ballmer, Steve Jobs, technology bubble, The Chicago School, too big to fail, Vanguard fund, zero-coupon bond, zero-sum game

Jay Light noticed the same thing that Mike Ingrisani had at Browning—Dimon had a powerful independent streak, and often a different grasp of what a manager’s priorities should be in case studies. He bore down on fundamental issues such as expense strategy and risk management. One day, in a class discussion of various fixed income investments, Light challenged Dimon on the concept of investing in a long-term zero coupon bond that nevertheless had a 15 percent yield-to-maturity. (In other words, although the bond offered no annual interest payments, it was selling at a price that would offer a 15 percent annualized return at maturity.) Dimon launched a bomb into the middle of class: “If you don’t see the merits of investing in a 15 percent zero coupon bond, Professor Light, then you probably shouldn’t be teaching this class.” James “Longo” Long, who had come to Harvard after a stint at Hewlett-Packard in California, was dismayed by what he considered the lack of concrete “business” experience of many classmates who had worked in investment banking and consulting.

**
Solutions Manual - a Primer for the Mathematics of Financial Engineering, Second Edition
** by
Dan Stefanica

asset allocation, Black-Scholes formula, constrained optimization, delta neutral, implied volatility, law of one price, yield curve, zero-coupon bond

The yield can be computed , e.g. , by using Newton's method , which is discussed in Chapter 8. We obtain that the yield of the bond is 0.056792 , i.e. , 5.6792% , and the duration and convexity of the bond are D = 1. 8901 and C = 3.6895 , respectively. 口 2.1. SOLUTIONS TO CHAPTER 2 EXERCISES 55 ac ∞ ou 叩 po ∞ np 归 ay尼 r江即 rr I payment. 口 Problem 14: By how much would the price of a ten year zero-coupon bond change if the yield increases by ten basis points? (One perce时 age poi时 IS equal to 100 basis points. Thus , 10 basis points is equal to 0.00 1.) Solution: The duration of a zero-coupo丑 bond is equal to the maturity of the bond , i.e. , D = T = 10. For small changes !:1 y in the yield , the percentage change in the value of a bond can be estimated as follows: !:1 B 王一目 -!:1y D = … = - 0.0 1. 0.001 . 10 We conclude that the price of the bond decreases by 1%.

pages: 586 words: 159,901

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

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, business cycle, capital asset pricing model, capital controls, central bank independence, computerized trading, corporate governance, corporate raider, 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, information asymmetry, interest rate swap, Internet Archive, invisible hand, Irwin Jacobs, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, oil shock, Paul Samuelson, payday loans, pension reform, plutocrats, Plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, publication bias, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, selection bias, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, 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.

…

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.

pages: 433 words: 53,078

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Be Your Own Financial Adviser: The Comprehensive Guide to Wealth and Financial Planning
** by
Jonquil Lowe

AltaVista, asset allocation, banking crisis, BRICs, buy and hold, correlation coefficient, cross-subsidies, diversification, diversified portfolio, estate planning, fixed income, high net worth, money market fund, mortgage debt, mortgage tax deduction, negative equity, offshore financial centre, Own Your Own Home, passive investing, place-making, Right to Buy, risk/return, short selling, zero-coupon bond

M10_LOWE7798_01_SE_C10.indd 327 05/03/2010 09:51 328 Part 3 n Building and managing your wealth In a guaranteed fund, your money is invested for a cycle of, say, three months. Part of the fund is invested in, say, zero-coupon bonds from an investment bank. These make no regular interest payments but promise to pay a fixed sum on redemption in three months’ time which will be enough to replace the original capital. The residue of the fund buys call index options which will provide a return linked to the stock market if it rises and no return if the market falls. A protected fund is similar but, instead of guaranteeing the full return of your capital, only part is protected. For example, the fund may promise to return 90 per cent of your capital plus a return linked to the stock market. As with the guaranteed fund, the capital is paid back by using a zero-coupon bond. In this case, a larger slice of the fund can be used to buy call options, which boosts your return if the stock market rises.

pages: 1,042 words: 266,547

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Security Analysis
** by
Benjamin Graham,
David Dodd

activist fund / activist shareholder / activist investor, asset-backed security, backtesting, barriers to entry, business cycle, buy and hold, capital asset pricing model, carried interest, collateralized debt obligation, collective bargaining, corporate governance, corporate raider, 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, intangible asset, invisible hand, Joseph Schumpeter, locking in a profit, Long Term Capital Management, low cost airline, low cost carrier, moral hazard, mortgage debt, Myron Scholes, Right to Buy, 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.

…

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

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, survivorship bias, the market place, transaction costs, value at risk, Wiener process, zero-coupon bond, zero-sum game

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).

pages: 327 words: 90,542

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The Age of Stagnation: Why Perpetual Growth Is Unattainable and the Global Economy Is in Peril
** by
Satyajit Das

"Robert Solow", 9 dash line, accounting loophole / creative accounting, additive manufacturing, Airbnb, Albert Einstein, Alfred Russel Wallace, Anton Chekhov, Asian financial crisis, banking crisis, Berlin Wall, bitcoin, Bretton Woods, BRICs, British Empire, business cycle, business process, business process outsourcing, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Clayton Christensen, cloud computing, collaborative economy, colonial exploitation, computer age, creative destruction, cryptocurrency, currency manipulation / currency intervention, David Ricardo: comparative advantage, declining real wages, Deng Xiaoping, deskilling, disintermediation, disruptive innovation, Downton Abbey, Emanuel Derman, energy security, energy transition, eurozone crisis, financial innovation, financial repression, forward guidance, Francis Fukuyama: the end of history, full employment, gig economy, Gini coefficient, global reserve currency, global supply chain, Goldman Sachs: Vampire Squid, happiness index / gross national happiness, Honoré de Balzac, hydraulic fracturing, Hyman Minsky, illegal immigration, income inequality, income per capita, indoor plumbing, informal economy, Innovator's Dilemma, intangible asset, Intergovernmental Panel on Climate Change (IPCC), Jane Jacobs, John Maynard Keynes: technological unemployment, Kenneth Rogoff, knowledge economy, knowledge worker, light touch regulation, liquidity trap, Long Term Capital Management, low skilled workers, Lyft, Mahatma Gandhi, margin call, market design, Marshall McLuhan, Martin Wolf, Mikhail Gorbachev, mortgage debt, mortgage tax deduction, new economy, New Urbanism, offshore financial centre, oil shale / tar sands, oil shock, old age dependency ratio, open economy, passive income, peak oil, peer-to-peer lending, pension reform, plutocrats, Plutocrats, Ponzi scheme, Potemkin village, precariat, price stability, profit maximization, pushing on a string, quantitative easing, race to the bottom, Ralph Nader, Rana Plaza, rent control, rent-seeking, reserve currency, ride hailing / ride sharing, rising living standards, risk/return, Robert Gordon, Ronald Reagan, Satyajit Das, savings glut, secular stagnation, seigniorage, sharing economy, Silicon Valley, Simon Kuznets, Slavoj Žižek, South China Sea, sovereign wealth fund, TaskRabbit, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the market place, the payments system, The Spirit Level, Thorstein Veblen, Tim Cook: Apple, too big to fail, total factor productivity, trade route, transaction costs, uber lyft, unpaid internship, Unsafe at Any Speed, Upton Sinclair, Washington Consensus, We are the 99%, WikiLeaks, Y2K, Yom Kippur War, zero-coupon bond, zero-sum game

Vindicating Edmund Burke's mistrust of the utopian promises of professors, more extreme policy measures are probable. Extension of the forms of QE can be expected, encompassing purchases of a wider range of assets, including shares, as in Japan. The US is considering canceling Treasury bonds held by the Fed to reduce debt, ignoring the loss to the central bank from the write-down of its holdings. In the UK, one idea considered was for the Bank of England to exchange holdings of government securities for zero coupon bonds, which pay no interest and have no maturity or fixed repayment date, and which were to be valued at face value to avoid loss. The global economy risks becoming trapped in a QE-forever cycle. A weak economy forces policymakers to implement expansionary fiscal measures and QE. If the economy responds, then increased economic activity and the side effects of QE will encourage a withdrawal of the stimulus.

pages: 1,088 words: 228,743

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

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, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commoditize, 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, G4S, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, 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, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, 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, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stocks for the long run, survivorship bias, 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, zero-sum game

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.

pages: 313 words: 34,042

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Tools for Computational Finance
** by
Rüdiger Seydel

bioinformatics, Black-Scholes formula, Brownian motion, commoditize, 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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file:///C:/Documents%20and%...
** by
vpavan

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, asset allocation, Berlin Wall, business cycle, buttonwood tree, buy and hold, corporate governance, corporate raider, disintermediation, diversification, diversified portfolio, Donald Trump, estate planning, fixed income, index fund, intangible asset, interest rate swap, margin call, money market fund, Myron Scholes, new economy, price discovery process, profit motive, risk tolerance, shareholder value, short selling, Silicon Valley, Small Order Execution System, Steve Jobs, stocks for the long run, stocks for the long term, technology bubble, transaction costs, Vanguard fund, women in the workforce, zero-coupon bond, éminence grise

Wall Street: Reference to the entire investment community or a specific geographic area of Lower Manhattan where the NYSE, American Stock Exchange, and many investment banks are located. write-down: Declaring that an asset is worth less than the value at which it was previously carried on the balance sheet. yield: Dividend paid to common stockholders, or the rate of interest paid to bondholders. zero-coupon bond: Bond sold at a steep discount from its face value, which pays no interest. ABOUT THE AUTHORS Arthur Levitt was the twenty-fifth chairman of the U.S. Securities and Exchange Commission. First appointed by President Clinton in July 1993, he was reappointed in May 1998 and in 1999 became the longest-serving SEC chairman. Before joining the commission, Mr. Levitt worked for sixteen years on Wall Street, served as chairman of the American Stock Exchange (1978-1989), and owned Roll Call, a newspaper that covers Capitol Hill.

pages: 349 words: 104,796

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Greed and Glory on Wall Street: The Fall of the House of Lehman
** by
Ken Auletta

business climate, corporate governance, financial independence, fixed income, floating exchange rates, interest rate swap, New Journalism, profit motive, Ronald Reagan, Saturday Night Live, traveling salesman, zero-coupon bond

Following Glucksman’s success in building a trading and sales operation, and prodded by Peterson’s commitment to develop “new products” and to nudge the firm into “the special bracket” group of the five top investment banks, Lehman was committed to becoming a full-service bank, on a par with Goldman, Sachs and Salomon Brothers. Retail, institutional, corporate and governmental customers could already come to Lehman if they were shopping to merge, to divest, to undertake a leveraged buyout, to swap debt for equity, to have bonds underwritten, to trade stocks, to purchase zero coupon bonds or Treasury notes or municipal bonds, to invest in a money fund or real estate. Lehman provided one-stop service, which, in turn, required capital. Against this backdrop, it is not surprising that partners in the fall of 1983 began to discuss “the capital issue”; that they began to worry aloud that Lehman’s capital base as of October 1983 ($254.7 million) was fragile. This had certainly become Pete Peterson’s view, for as he observed in a speech he made in London in September, “Two large organizations, Sears and American Express, have more equity than all of ‘Wall Street’ firms in the entire U.S.

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Trading Risk: Enhanced Profitability Through Risk Control
** by
Kenneth L. Grant

backtesting, business cycle, buy and hold, commodity trading advisor, correlation coefficient, correlation does not imply causation, delta neutral, diversification, diversified portfolio, fixed income, frictionless, frictionless market, George Santayana, implied volatility, interest rate swap, invisible hand, Isaac Newton, John Meriwether, Long Term Capital Management, market design, Myron Scholes, performance metric, price mechanism, price stability, risk tolerance, risk-adjusted returns, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, two-sided market, value at risk, volatility arbitrage, yield curve, zero-coupon bond

For example, 170 TRADING RISK there’s no reason to believe that there are any statistical commonalities between, say, the Swedish rate of inflation and the price of silkworms in Malaysia; and over time we would expect a correlation between these two variables to be roughly zero. In terms of magnitudes, the correlation coefficient has a maximum value of 1.0, or 100%, indicating perfect correlation (e.g., the temperature in Toronto as measured in Fahrenheit and Celsius), and a minimum value of 1.0, or 100%, indicating perfect negative correlation (e.g., the price of a zero-coupon bond and its yield). All values in between are valid, and the process lends itself to all the subjectivity that the human mind can muster. However, you may find the following (admittedly simplistic) rules of thumb to be useful: Value of Correlation Coefficient Less than 50% Between 50% and 10% Between 10% and 10% Between 10% and 50% Greater than 50% Interpretation High negative correlation—merits full investigation.

pages: 426 words: 115,150

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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

asset allocation, Buckminster Fuller, buy low sell high, credit crunch, disintermediation, diversification, diversified portfolio, fiat currency, financial independence, fixed income, fudge factor, full employment, Gordon Gekko, high net worth, index card, index fund, job satisfaction, Menlo Park, money market fund, 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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Financial Statement Analysis: A Practitioner's Guide
** by
Martin S. Fridson,
Fernando Alvarez

business cycle, corporate governance, credit crunch, discounted cash flows, diversification, Donald Trump, double entry bookkeeping, Elon Musk, fixed income, information trail, intangible asset, interest rate derivative, interest rate swap, negative equity, new economy, offshore financial centre, postindustrial economy, profit maximization, profit motive, Richard Thaler, shareholder value, speech recognition, statistical model, time value of money, transaction costs, Y2K, zero-coupon bond

Investors ought to be pleased, rather than alarmed, to see capital expenditures fall precipitously after the buyout. Naturally, this line of reasoning was less persuasive in cases where the sponsors teamed up with the incumbent CEO in a management-led buyout. Investors in many of the 1980s transactions were advised to take comfort as well from the fact that a portion of the annual interest expense consisted of accretion on zero-coupon bonds, rather than conventional cash coupons (interest payments). By way of explanation, investors buy a zero-coupon issue in its initial distribution at a steep discount—say, 50 percent—to its face value. Instead of receiving periodic interest payments, the purchasers earn a return on their investment through a gradual rise in the bond's price. At the bond's maturity, the obligor must redeem the security at 100 percent of its face value.

pages: 385 words: 128,358

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

Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, buy low sell high, capital controls, central bank independence, commoditize, 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, John Meriwether, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Paul Samuelson, 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, zero-sum game

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.

pages: 892 words: 91,000

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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

activist fund / activist shareholder / activist investor, air freight, barriers to entry, Basel III, BRICs, business climate, business cycle, business process, capital asset pricing model, capital controls, Chuck Templeton: OpenTable:, cloud computing, commoditize, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, fixed income, index fund, intangible asset, iterative process, Long Term Capital Management, market bubble, market friction, Myron Scholes, negative equity, 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, stocks for the long run, survivorship bias, 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.

…

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.

pages: 680 words: 157,865

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Beautiful Architecture: Leading Thinkers Reveal the Hidden Beauty in Software Design
** by
Diomidis Spinellis,
Georgios Gousios

Albert Einstein, barriers to entry, business intelligence, business process, call centre, continuous integration, corporate governance, database schema, Debian, domain-specific language, don't repeat yourself, Donald Knuth, en.wikipedia.org, fault tolerance, Firefox, general-purpose programming language, iterative process, linked data, locality of reference, loose coupling, meta analysis, meta-analysis, MVC pattern, peer-to-peer, premature optimization, recommendation engine, Richard Stallman, Ruby on Rails, semantic web, smart cities, social graph, social web, SPARQL, Steve Jobs, Stewart Brand, traveling salesman, Turing complete, type inference, web application, zero-coupon bond

It has a fruit salad and cream, as represented by the corresponding client links. It is a composite pudding, since this notion indeed represents concoctions that are made of several parts, like the more general notion of COMPOSITE_PART, and are also puddings. Here the parts, reflected in the client links, are a fruit salad and cream. A similar approach can be applied to the contract example, based on a classification of contract types into such categories as “zero-coupon bonds,” “options,” and others to be obtained from careful analysis with the help of experts from that problem domain. Multiple inheritance is essential to this object-oriented form of modeling. Note in particular the definition of a composite part, applying a common pattern for describing such composite structures (see Meyer 1997, 5.1, “Composite figures”): class COMPOSITE_PART inheritPUDDING_PARTLIST[PUDDING_PART]feature ... end where square brackets introduce generic parameters.

pages: 741 words: 179,454

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

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, business cycle, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, 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, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Fall of the Berlin Wall, financial independence, financial innovation, financial thriller, 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, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, John Meriwether, joint-stock company, Jones Act, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, 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, mega-rich, merger arbitrage, Mikhail Gorbachev, Milgram experiment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, negative equity, NetJets, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, 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 Thaler, Right to Buy, 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, Satyajit Das, 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, survivorship bias, 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 new new thing, 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, zero-sum game

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.

pages: 706 words: 206,202

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Den of Thieves
** by
James B. Stewart

corporate raider, creative destruction, discounted cash flows, diversified portfolio, fixed income, fudge factor, George Gilder, index arbitrage, Internet Archive, Irwin Jacobs, margin call, money market fund, 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.

pages: 700 words: 201,953

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The Social Life of Money
** by
Nigel Dodd

accounting loophole / creative accounting, bank run, banking crisis, banks create money, Bernie Madoff, bitcoin, blockchain, borderless world, Bretton Woods, BRICs, business cycle, capital controls, cashless society, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computer age, conceptual framework, credit crunch, cross-subsidies, David Graeber, debt deflation, dematerialisation, disintermediation, eurozone crisis, fiat currency, financial exclusion, 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, Kickstarter, Kula ring, laissez-faire capitalism, land reform, late capitalism, liberal capitalism, liquidity trap, litecoin, London Interbank Offered Rate, M-Pesa, Marshall McLuhan, means of production, mental accounting, microcredit, mobile money, money market fund, money: store of value / unit of account / medium of exchange, mortgage debt, negative equity, new economy, Nixon shock, Occupy movement, offshore financial centre, paradox of thrift, payday loans, Peace of Westphalia, peer-to-peer, 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, Veblen good, Wave and Pay, Westphalian system, 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.

pages: 823 words: 206,070

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The Making of Global Capitalism
** by
Leo Panitch,
Sam Gindin

accounting loophole / creative accounting, active measures, 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, business cycle, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collective bargaining, continuous integration, corporate governance, creative destruction, 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, Kickstarter, land reform, late capitalism, liberal capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, manufacturing employment, market bubble, market fundamentalism, Martin Wolf, means of production, money market fund, money: store of value / unit of account / medium of exchange, Monroe Doctrine, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, 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, zero-sum game

“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.

pages: 920 words: 233,102

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Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State
** by
Paul Tucker

Andrei Shleifer, bank run, banking crisis, barriers to entry, Basel III, battle of ideas, Ben Bernanke: helicopter money, Berlin Wall, Bretton Woods, business cycle, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, centre right, conceptual framework, corporate governance, diversified portfolio, Fall of the Berlin Wall, financial innovation, financial intermediation, financial repression, first-past-the-post, floating exchange rates, forensic accounting, forward guidance, Fractional reserve banking, Francis Fukuyama: the end of history, full employment, George Akerlof, incomplete markets, inflation targeting, information asymmetry, invisible hand, iterative process, Jean Tirole, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, liberal capitalism, light touch regulation, Long Term Capital Management, means of production, money market fund, Mont Pelerin Society, moral hazard, Northern Rock, Pareto efficiency, Paul Samuelson, price mechanism, price stability, principal–agent problem, profit maximization, quantitative easing, regulatory arbitrage, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Robert Bork, Ronald Coase, seigniorage, short selling, Social Responsibility of Business Is to Increase Its Profits, stochastic process, The Chicago School, The Great Moderation, The Market for Lemons, the payments system, too big to fail, transaction costs, Vilfredo Pareto, Washington Consensus, yield curve, zero-coupon bond, zero-sum game

In case that be thought fanciful, precisely this hazard appeared very briefly in the UK during the mid-1990s, when the public finances were under some pressure. During that period, I ran the Bank of England unit that implemented the government’s debt management policy (it was transferred to an agency during the 1997–1998 reforms). I vividly remember a call from my Treasury opposite number to say that another department was floating the idea of issuing zero-coupon bonds. As well as dispensing with the need for cash to pay coupons, the greater attraction was that, under then accounting conventions, the public finances would not register any debt-servicing costs at all. The idea was not taken up, but there was a moment when civil servants plainly wondered whether it would prove irresistible to their political bosses. In short, elected politicians face a bit of a problem in committing to a stable and prudent debt management strategy because their expected life in office is so much shorter than the life of the debt.

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The Bonfire of the Vanities
** by
Tom Wolfe

affirmative action, Berlin Wall, Bonfire of the Vanities, Electric Kool-Aid Acid Test, interchangeable parts, plutocrats, Plutocrats, rent control, Socratic dialogue, traveling salesman, yellow journalism, zero-coupon bond

The Masters of the Universe were a set of lurid, rapacious plastic dolls that his otherwise perfect daughter liked to play with. They looked like Norse gods who lifted weights, and they had names such as Dracon, Ahor, Mangelred, and Blutong. They were unusually vulgar, even for plastic toys. Yet one fine day, in a fit of euphoria, after he had picked up the telephone and taken an order for zero-coupon bonds that had brought him a $50,000 commission, just like that, this very phrase had bubbled up into his brain. On Wall Street he and a few others—how many?—three hundred, four hundred, five hundred?—had become precisely that…Masters of the Universe. There was…no limit whatsoever! Naturally he had never so much as whispered this phrase to a living soul. He was no fool. Yet he couldn’t get it out of his head.

pages: 1,123 words: 328,357

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Post Wall: Rebuilding the World After 1989
** by
Kristina Spohr

American Legislative Exchange Council, Andrei Shleifer, anti-communist, banking crisis, Berlin Wall, Bonfire of the Vanities, Bretton Woods, central bank independence, colonial exploitation, Deng Xiaoping, Dissolution of the Soviet Union, Donald Trump, Doomsday Clock, facts on the ground, failed state, Fall of the Berlin Wall, Francis Fukuyama: the end of history, G4S, Kickstarter, mass immigration, means of production, Mikhail Gorbachev, open economy, price stability, rising living standards, Ronald Reagan, Ronald Reagan: Tear down this wall, software patent, South China Sea, special economic zone, Thomas L Friedman, Transnistria, uranium enrichment, zero-coupon bond

The programme known as the Brady Plan called for the US and multilateral lending agencies, such as the IMF and the World Bank, to cooperate with commercial bank creditors in restructuring and reducing the debt of those developing countries that were pursuing structural adjustments and economic programmes supported by these agencies. The process of creating Brady Bonds involved converting defaulted loans into bonds with US Treasury zero-coupon bonds as collateral. On Brady Bonds, see investopedia.com/terms/b/bradybonds.asp#ixzz5W5P74xLQ Back to text 42. Katada Banking on Stability pp. 127–30; idem ‘Japan’s Two-Track Aid Approach: The Forces behind Competing Triads’ Asian Survey 42, 2 (March/April 2002) pp. 320–42; Erik Lundsgaarde et al. ‘Trade Versus Aid: Donor Generosity in an Era of Globalisation’ Policy Sciences 40, 2 (2007) pp. 157–8.

pages: 1,336 words: 415,037

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

affirmative action, Albert Einstein, anti-communist, Ayatollah Khomeini, barriers to entry, Bob Noyce, Bonfire of the Vanities, Brownian motion, capital asset pricing model, card file, centralized clearinghouse, Charles Lindbergh, collateralized debt obligation, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, Donald Trump, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, global village, Golden Gate Park, Haight Ashbury, haute cuisine, Honoré de Balzac, If something cannot go on forever, it will stop - Herbert Stein's Law, In Cold Blood by Truman Capote, index fund, indoor plumbing, intangible asset, interest rate swap, invisible hand, Isaac Newton, Jeff Bezos, John Meriwether, 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, money market fund, moral hazard, NetJets, new economy, New Journalism, North Sea oil, paper trading, passive investing, Paul Samuelson, 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, yellow journalism, 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.