Fundamentals of Financial Instruments

An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives


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  • ISBN: 978-0470824900
  • My Rating: 8/10

Fundamentals of Financial Instruments provides an introduction to different financial instruments like stocks, bonds, and derivatives.

Fundamentals of Financial Instruments is packed with a lot of information. As a newbie to most topics discussed in the book it was simply overwhelming, and I had to skip some parts because they were too advanced for my current level (but I will to go back to reread them). I liked the many examples provided by the author, though I found his writing style a bit dry.

My notes

An Introduction to Financial Institutions, Instruments, and Markets

Economic systems are designed to collect savings in an economy and allocate the available resources efficiently to those who either seek funds for current consumption in excess of what their resources would permit or to invest in productive assets. The key role of an economic system is to ensure efficient allocation.

Economic systems may be classified as either command economies or free-market economies. These are the two extreme ends of the economic spectrum. Most modern economies tend to display characteristics of both kinds of systems, and they differ only with respect to the level of government control.

In a command economy, like that of the former Soviet Union, all production and allocation decisions are made by a central planning authority. The planning authority is expected to estimate the resource requirements of various economic agents and then rank them in order of priority in relevance to social needs. Production plans and resource-allocation decisions are then made to ensure that resources are directed to users in descending order of need.

In principle, a market economy works as follows. Economic agents are expected to make the most profitable use of the resources at their disposal.

Profit is defined as the revenues from sales minus the costs of production of the goods sold. Profit is a function of the prices of the inputs or the factors of production – such as land, labor, and capital – and the prices of the output. An optimal economic decision is defined as one that maximizes profit.

In such a system [i.e. a market economy], the prices of both inputs and outputs are determined by factors of supply and demand.

For such [market] economies to work in an optimal fashion, prices must accurately convey the value of a good or a service from the standpoints of both producers who employ factors of production and consumers who consume the end products. The informational accuracy of prices results in the efficient allocation of resources for the following reasons. If the inputs for the production process such as labor and capital are accurately priced, then producers can make optimal production-related decisions. Similarly, if the consumers of goods and services perceive their prices to be accurate, they will make optimal consumption decisions. The accuracy of input-related costs and output prices will be manifest in the form of profit maximization, which is the primary motivating factor for agents in such economies to engage in economic enterprise.

Economic agents are usually divided into three categories or sectors: government, business, and household.

A proprietorship, also know as a sole proprietorship, is a business owned by a single person [...]. The owner is fully responsible for all debts and obligations of the business. In other words, creditors – entities to which the business owes money – may stake a claim against all assets of the proprietor, whether they are business-related assets or personal assets. In legal parlance, this is referred to as unlimited liability [...].

A partnership is a business entity owned by at least two people or partners. [...] In a general partnership, the partners have unlimited liability and a partner is personally responsible not only for her own acts but also for the actions of her other partners as well as employees. [...] In a limited partnership, there are two categories of partners, namely general partners and limited partners. The general partners are usually a corporation and have management control. They are characterized by unlimited liability. The limited partners, on the other hand, are like shareholders in a corporation: their potential loss is limited to the investment they have made.

A corporation or a limited company is a legal entity that is distinct and separate from its owners, who are referred to as shareholders or stockholders. [...] Shareholders of a corporation enjoy limited liability.

An economic unit may be a surplus budget unit (SBU) or a deficit budget unit (DBU). A surplus budget unit is one with an income that exceeds its expenditure, whereas a deficit unit is one with expenses that exceed its income.

The record of all economic transactions between a country and the rest of the world (ROW) is known as its balance of payments (BOP).

The balance of trade is equal to the sum total of merchandise exports and imports. It consists of all raw materials and manufactured goods bought, sold, or given away. If it shows a surplus, it indicates that exports of goods from the country exceed imports into it; if it shows a deficit, it would indicate that imports exceed exports.

The current account balance refers to the sum total of the following accounts:

  • Exports of goods, services, and income;
  • Imports of goods, services, and income; and
  • Net unilateral transfers.
Services include tourism, transportation, engineering, and business services. Fees from patents and copyrights are also recognized under this category. Income includes revenue from financial assets, such as dividends from shares and interest from debt securities. Unilateral transfers are one-way transfers of assets, such as worker remittances from foreign countries, and direct foreign aid. A current account that shows a deficit indicates that the country's liabilities have increased; if it shows a surplus, it means that a country's assets held abroad have increased.

"A financial asset is a claim against the income or wealth of a business firm, a household, or a government agency, which is represented usually by a certificate, a receipt, a computer record file, or another legal document, and is usually created by or is related to the lending of money."

In the case of loans, the claim constitutes a promise to pay the interest either at maturity or at periodic intervals and to repay the principal at maturity. Such claims are referred to as debt securities or as fixed income securities. In the case of fund transfers characterized by the assumption of ownership stakes, the claims are known as equity shares. Unlike debt securities, which represent an obligation on the part of the borrower, equity shares represent a right to the profits of the issuing firm during its operation and to such assets that may remain after all creditors are fully paid as in the event of the venture's liquidation.

Financial assets are essentially sought after for three reasons.

  1. They serve as a store of value or purchasing power.
  2. They promise future returns to their owners.
  3. They are fungible – that is, they can be easily converted into other assets and vice versa.

In a modern economy, all financial assets are valued in terms of money, and all flows of funds between lenders and borrowers occur via the medium of money.

Equity shares or shares of common stock of a company are financial claims issued by the firm that confer ownership rights on the investors, who are known as shareholders. [...] Shareholders will periodically receive cash payments called dividends from the firm. In addition, the shareholders are exposed to profits and losses when they seek to dispose off their shares at a subsequent point in time. These profits and losses are referred to as capital gains and losses.

The maximum loss that a shareholder may sustain is limited to her investment in the business.

A debt instrument is a financial claim issued by a borrower to a lender of funds. Unlike equity shareholders, investors in debt securities are not conferred with ownership rights. These securities [...] represent a promise to pay interest on the principal amount either at periodic intervals or at maturity, as well as to repay the principal itself at a prespecified maturity date.

The interest payments that are promised to the lenders at the outset represent contractual obligations on the part of the borrower. In other words, the borrower is required to meet these obligations irrespective of the performance of the firm in a given financial year. It is also the case that, in the event of an exceptional performance, the borrowing entity does not have to pay any more to the debt holders than what was promised at the outset. It is for this reason that debt securities are referred to as fixed income securities.

Debt instruments can be secured or unsecured. In the case of secured debt, the terms of the contract will specify the assets of the firm that have been pledged as security or collateral. In the event of the failure of the company, the bondholders have a right over these assets.

Debt instruments can be either negotiable or nonnegotiable. Negotiable securities are instruments that can be endorsed from one party to another, so they can be bought and sold easily in the financial markets. A nonnegotiable instrument is one that cannot be transferred.

Preferred stocks are a hybrid of debt and equity. They are similar to debt in the sense that holders of such securities are usually promised a fixed rate of return. However, such dividends are payable from the post-tax profits of the firm, as in the case of equity shares.

The order of priority of the stakeholders of the firm from the standpoint of payments is bondholders first, preferred shareholders second, and then equity shareholders. The term preferred arises because such shareholders are given preference over equity shareholders, and not because the shareholders prefer such instruments.

The term foreign exchange refers to transactions pertaining to the currency of a foreign nation. Foreign-exchange markets are markets in which foreign currencies are bought and sold. [...] The price of one country's currency in terms of the currency of another is referred to as the exchange rate. Foreign currencies are traded among a network of buyers and sellers, comprising mainly commercial banks and large multinational corporations, and not on an organized exchange. The market for foreign exchange is referred to as an over-the-counter (OTC) market.

Derivative securities, which are more appropriately termed derivative contracts, are assets that confer on their owners certain rights or obligations as the case may be. These contracts owe their availability to the existence of markets for an underlying asset or a portfolio of assets on which such agreements are written. In other words, these assets are derived from the underlying asset.

The three major categories of derivative securities are (1) forward and futures contracts, (2) options contracts, and (3) swaps.

In the case of a forward or a futures contract, the actual transaction does not take place when an agreement is reached between the two parties. What happens in such cases is that, at the time of negotiating the deal, the two parties merely agree on the terms on which they will transact at a future point in time. The actual transaction per se occurs only at a future date that is decided at the outset and at a price that also is decided at the beginning.

There is one major difference between the two types of contracts. Futures contracts are standardized, whereas forward contracts are customized.

Options contracts that give the holder the right to acquire the underlying asset are known as call options. [...] There exist options contracts that give the holder the right to sell the underlying asset. These are known as put options.

If the contract were to permit exercise only at the time of expiration, the option, whether a call or a put, is known as a European option. If such an option is not exercised at the time of expiration, then the contract itself will expire. There exists another type of contract in which the holder has the right to transact at any point in time between the time of acquisition of the right and the expiration date of the contract. These are referred to as American options.

An options contract, whether a call or a put, requires the buyer to pay a price to the seller at the outset for giving him the right to transact. This price is known as the option price or option premium. This price is nonrefundable if the contract were not to be exercised subsequently. If and when an options contract is exercised, the buyer will have to pay a price per unit of the underlying asset if he is exercising a call option, and he will have to receive a price per unit of the underlying asset if he is exercising a put option. This price is known as the exercise price or strike price.

A swap is a contractual agreement between two parties to exchange cash flows calculated on the basis of prespecified terms at predefined points in time.

A swap in which both payments are denominated in the same currency is referred to as an interest rate swap. [...] There also exist swaps where two parties exchange cash flows denominated in two different currencies. Such swaps are referred to as currency swaps.

A mortgage is a loan that is backed by the collateral of a specified real estate property.

A mortgage by itself is a fairly illiquid asset for the party that makes the loan to the home buyer. [...] To rotate their capital, lenders will typically pool mortgage loans and issue debt securities that are backed by the underlying pool. Such securities [...] are referred to as mortgage-backed securities. The process of converting an illiquid asset such as a home loan into liquid marketable securities is referred to as securitization. [...] The securities generated in the process are referred to as asset-backed securities.

A convertible bond is a debt security that permits the investor to convert the bond into shares of equity at a predecided rate.

A warrant is a right given to the investor that allows her to subscribe to the equity shares of the company at a future date at a predetermined price. Such rights are usually offered along with debt securities in order to make the bonds more attractive to investors. Once issued, the warrants can be detached from the parent security and traded in the secondary market.

The function of a primary market is to facilitate the acquisition of new financial instruments by investors, both institutional and individual. When a company goes in for an issue of equity shares to the public, it will be termed a primary market transaction. [...] Once a financial asset has been created and sold to an investor in the primary market, subsequent transactions in that instrument between two investors are said to take place in the secondary market.

A securities exchange is an organized trading system in which traders interact to buy and sell securities. [...] Two types of orders can be placed by an investor. In the case of market orders, the investor merely specifies the quantity he seeks with the understanding that he will accept whatever price he is offered. However, investors who are very particular about the price they pay or receive will place what are known as limit orders.

To ensure that traders are given access to the best available prices, all limit buy orders are ranked in descending order of price while limit sell orders are ranked in ascending order of price. This is known as the price priority rule. Potential buyers are given access to the lowest price on the sell side while potential sellers are given access to the highest price on the buy side. If two or more limit buy or sell orders were to have the same limit price, then the order that came in first would be ranked higher. This is known as the time priority rule.

A trader is said to have a long position when he owns an asset. An investor with a long position will gain if the price subsequently rises and will lose if it subsequently falls. [...] Investors who take long positions in anticipation of rising prices are said to be bullish in nature and are termed bulls.

All traders in the market need not be bullish about the future. Some may be of the opinion that prices are going to decline. Such investors will assume what are termed short positions. A trader is said to have taken a short position when he has sold an asset that he does not own. This is accomplished by borrowing the asset from another investor. Such a transaction is called a short sale. In such cases, the trader will have to eventually purchase the asset and return it to the lender. [...] When a person with a short position acquires the asset, he is said to be covering his position. Short sellers therefore seek to sell high and buy low. Short selling is considered a bearish activity, and such investors are termed bears.

A mutual fund is a [...] collection of stocks, bonds, and other assets that are purchased by pooling the investments made by a large group of investors. The assets of the fund are managed by a professional investment company.

The net asset value (NAV) of a fund at any point in time is equal to the total value of all securities in its portfolio minus any outstanding liabilities divided by the total number of shares issued by the fund.

There are two broad categories of mutual funds: open ended and closed ended. Open-ended funds permit investors to acquire as well as redeem shares at any point in time at the prevailing NAV. The capital of these funds is variable. Closed-ended funds make a one-time issue of shares to investors. However, usually such funds are listed on a stock exchange, which ensures that investors have the freedom to trade. Shares of such funds may be priced above or below the prevailing NAV.

The market in which instruments with one year or less to maturity are traded is called the money market, whereas the market in which medium- to long-term instruments are traded is called a capital market. All money market securities have to be debt securities because equity shares never mature. Capital market securities can be equity securities or medium- to long-term debt securities.

A Eurocurrency is a freely traded currency deposited in a bank outside its country of origin. For example, Eurodollars are dollars deposited outside the United States [...].

Eurobonds are bonds denominated in one or more currencies other than the currency of the country in which they are sold. For example, bonds denominated in a currency other than the Japanese yen sold in Japan would be called Eurobonds. A bond denominated in the currency of the country in which it is sold, but issued by an entity from a foreign country, is called a foreign bond. For example, if a U.S. company were to sell yen denominated bonds in Japan, it would be classified as a foreign bond.

Dual or multiple listing allows the shares of a company to be traded on the exchanges of many different countries. Foreign equity is traded in global markets in the form of depository receipts (DRs). On the U.S. exchanges, they are traded in the form of American depository receipts (ADRs).

Mathematics of Finance

Inflation refers to the change in the purchasing power of money, or the change in the price level. Usually inflation is positive, which means that the purchasing power of money will be constantly eroding. There could be less common situations on which inflation is negative, a phenomenon termed deflation.

The rate of interest as measured by our ability to buy goods and services is termed the real rate of interest.

Assets such as Treasure securities give us returns in terms of money, without any assurance as to what our ability to acquire goods and services will be at the time of repayment. The rate of return yielded by such securities in dollar terms is termed the nominal or money rate of return.

The relationship between the nominal and real rates of return is called the Fisher hypothesis after the economist who first postulated it.

The unit in which time is measured for the purpose of stating the rate of interest is called the measurement period. The most common measurement period is one year [...].

The unit of time over which interest is paid once and is reinvested to earn additional interest is referred to as the interest conversion period. The interest conversion period will typically be less than or equal to the measurement period. The measurement period may be a year, whereas the interest conversion period may be three months. Interest is compounded every quarter in this case.

The quoted rate of interest per measurement period is called the nominal rate of interest.

The effective rate of interest may be defined as what a dollar invested at the beginning of a measurement period would have earned by the end of the period. The effective rate will be equal to the quoted or nominal rate if the length of the interest conversion period is the same as that of the measurement period. However, if the interest conversion period is shorter than the measurement period or, in other words, if interest is compounded more than once per measurement period, then the effective rate will exceed the nominal rate of interest.

Simple interest is usually used for short-term or current account transactions, that is, for investments for a period of one year or less. Consequently, simple interest is the norm for money market calculations. [...] However, in the case of capital market securities – that is, medium- to long-term debt securities and equities – we use the compound interest principle.

When the frequencies of compounding are different, comparisons between alternative investments ought to be based on the effective rates of interest and not on the nominal rates.

When an amount is deposited for a certain time period at a given rate of interest, the amount that is accrued at the end of the designated period of time is called the future value of the original investment.

Sometimes [...] we may have a terminal value in mind and seek to calculate the quantum of the initial investment that will result in the desired terminal cash flow, given an interest rate and investment horizon. In this case, instead of computing the terminal value of a given principal, we seek to compute the principal that corresponds to a given terminal value. The principal amount that is obtained in this fashion is referred to as the present value (PV) of the terminal cash flow.

The process of finding the principal corresponding to a given future amount is called discounting, and the interest rate that is used is called the discount rate.

An annuity is a series of payments made at equally spaced intervals of time. If all the payments are identical, then we term it as a level annuity. [...] If the first payment is made or received at the end of the first period, then we call it an ordinary annuity. [...] The interval between successive payments is called the payment period.

The difference between an annuity and an annuity due is that in the latter case the cash flows occur at the beginning of the period.

An annuity that pays forever is called a perpetuity.

Amortization refers to the process of repaying a loan by means of regular installment payments at periodic intervals. Each installment includes payment of interest on the principal outstanding at the start of the period, as well as a partial repayment of the outstanding principal itself. In contrast, an ordinary loan entails the payment of interest at periodic intervals, and the repayment of principal in the form of a single lump-sum payment at maturity.

If the lender were to use a simple interest approach, then a borrower need only pay interest for the actual period of time for which he has used the funds. Each time he makes a partial repayment of the principal, the interest due will decrease for subsequent periods.

Equity Shares, Preferred Shares, and Stock Market Indexes

At the outset, when a firm is incorporated, a stated number of shares will be authorized for issue by the promoters. The value of such shares is referred to as the authorized capital of the firm. However, the entire authorized capital need not be raised immediately. Often a portion of what has been authorized is held for issue at a later date, if and when the firm should require additional capital. What is actually issued is less than or equal to what is authorized, and the amount that is actually raised is referred to as the issued capital. The value of the shares that is currently being held by investors is referred to as the outstanding capital.

A firm will typically pay out a percentage of its earned profits during the financial year in the form of cash to its shareholders. These cash payouts that shareholders receive from the firm are referred to as dividends. The entire profits earned by a firm will usually not be distributed to the shareholders. Most companies will choose to retain a part of what they have earned to meet future requirements of cash on account of activities such as expansion and diversification. The profits that are retained or reinvested in the firm are called retained earnings.

Common stock usually has a par value, which is also known as face value or stated value. The par value has no significance and in countries such as the United States it can be fixed at a low and arbitrary level. [...] The issue price of a share need not be equal to its par value, and it will often be in excess of its par value. [...] The excess of the issue price over the par value is referred to as the share premium.

The book value is the value of a firm as obtained from the balance sheet or books of account, hence the name. The term refers to the value of the assets behind a share per the balance sheet. It is derived by adding the par value, the share premium, and the retained earnings and dividing by the number of shares issued by the firm.

The market value is the value assigned to the shares of the company by the stock market, and it is determined by multiplying the number of shares issued by the firm with the current market price per share.

To enjoy the right to vote, an investor must be a shareholder of record. What this means is the following. The registrar of a firm will be maintaining a record of its current shareholders. Only a person who is listed on the corporation's register of shareholders as of a date known as the record date is an eligible shareholder from the standpoint of being eligible to cast his vote.

In the context of a dividend payment, four dates are important. The first is what is termed the declaration date. It is the date on which the decision to pay a dividend is declared by company directors and the amount of the dividend is announced. The dividend announcement will mention a second date called the record date. [...] only those shareholders whose names appear as of the record date on the register of shareholders will be eligible to receive the forthcoming dividend. A third and extremely critical date is what is termed the ex-dividend date, which is specified by the stock exchange on which the shares are traded. [...] The importance of the ex-dividend date is that an investor who purchases shares on or after the ex-dividend date will not be eligible to receive the forthcoming dividend. [...] Before the ex-dividend date, the shares are said to be traded on a cum-dividend basis: the right to receive the dividend is inherent in the shares. [...] Finally, we have a date called the distribution date that is purely of academic interest. This is the date on which the dividends are actually paid or distributed.

The annual dividend yield is defined as the annual dividend amount divided by the current share price, expressed in percentage terms.

Dividend reinvestment plans (DRIPs) are schemes that allow shareholders to opt to have cash dividends automatically reinvested in additional shares of stock.

A stock dividend is a dividend that is distributed in the form of shares of stock rather than in the form of cash.

The term treasury stock refers to shares that were at one point in time issued to the public but that have subsequently been reacquired by the firm. These shares are held by the company and can subsequently be reissued, if and when employees were to exercise their stock options. Unlike the shares issued by the firm that are held by the shareholders, treasury shares have no voting rights, are ineligible for dividends, and are not included in the denominator used for computation of the earnings per share (EPS).

An n:1 stock split means that n new shares will be issued to the existing shareholders in lieu of one existing share.

Why do companies split their shares? Companies generally go in for such a course of action if, in the perception of management, the share price of the firm has become too high. Although in theory there is nothing wrong with the stock price being at a relatively high level, companies that would like to attract a broad class of investors will try to ensure that their scrip is within an affordable price range for small and medium investors.

The opposite of a stock split is a reverse split or a consolidation.

[...] existing shareholders must be given the first right to buy the additional shares being issued in proportion to the shares they already own. Of course, the right to acquire the shares confers them with an option and does not require a mandatory course of action. This requirement ensures that existing shareholders have a preemptive right to acquire new shares as and when they are issued. In other words, they have an opportunity to maintain their proportionate ownership in the company.

Usually, the rights issue is made at a price that is lower than the prevailing market price of the share. If so, then the right acquires a value of its own. The existing shareholders in this case can either exercise their rights and acquire additional shares or sell the rights to someone else.

Tracking stocks, also known as targeted stocks, are issued by many companies in addition to the usual equity shares. A tracking stock tracks the performance of a specific business unit or operating division of a company. The value of such stock is determined by the performance of this division rather than that of the company as a whole.

Most stocks are classified as either growth stocks or cyclical stocks. A cyclical stock is one whose fortunes rise and fall in tandem with the business cycle; that is, the stock price rises during an economic boom and falls during a recession. [...] The term growth stocks is used for the stocks of companies whose sales and earnings have grown faster than those of an average firm and that can be reasonably expected to display a similar trend in the future.

Preferred shares are similar to equity shares in the sense that they are financial claims that confer ownership rights on the shareholders. The term preferred connotes the fact that such shares have certain associated privileges. In other words, they get preference over equity shareholders in certain respects. Current dividends due on the preferred shares must be paid before any dividends for the year can be declared for the equity shareholders. If a company were to file for bankruptcy and be liquidated, the preferred shareholders have to be paid their due before the balance, if any, can be paid to the equity shareholders.

[...] preferred shares are similar to debt securities in the sense that the rate of dividends is fixed and not a function of the profits earned during the year. However, unlike bonds, preferred stocks represent ownership of the firm, and the dividend is not a legal liability, which makes preferred stocks similar to equity shares.

At times, management may be of the opinion that, although it is imperative to offer a high dividend under present circumstances, the forecast for the future is such that interest rates are headed downward. If so, the company could issue callable preferred stock. As the name suggests, such shares can be prematurely recalled or retired by the company at a predetermined price, unlike conventional or plan vanilla preferred shares, which are noncallable.

In the case of noncumulative preferred shares, if the issuing firm were to skip a dividend, then the dividend lost is lost forever from the standpoint of the shareholder. However, if the preferred shares were to be cumulative in nature, then all outstanding dividends, including the current dividend, must be paid before the management can contemplate declaring dividends for the equity shareholders.

The value of an asset is the present value of all the cash flows that an investor expects to receive from it. The value of a financial asset is a function of (1) the size of the cash flows, (2) the timing of the cash flows, and (3) the risk of the cash flows.

A stock market index is constructed by considering the prices, or the market capitalization, of a predefined basket of securities. The objective of constructing an index is to enable us to track the performance of the securities market.

The term buying stock on margin refers to a process of investment in which an investor funds the acquisition of the stock by borrowing a part of the funds from the broker. [...] The minimum percentage of the market value of the securities that has to be deposited by the customer is called the margin rate. The difference between the market value of the securities and the minimum amount that has to be deposited by the customer is called the loan value. The loan value represents the maximum amount that can be borrowed from the broker. [...] The actual amount that is borrowed from the broker is called the broker's loan or is referred to as a debit balance to indicate that the investor is indebted to the broker and owes him money. The difference between the market value and the debit balance is called the owner's equity.

Losses will lead to a reduction in the owner's equity, and sustained losses can lead to a significant reduction in the equity level. To protect himself, a broker will fix a threshold level called the maintenance margin level. If the account were to become undermargined because of adverse market movements, the investor may eventually receive a notice – a margin call – for additional margin from the broker. If the investor were to fail to respond to such a call, which in essence is a demand for additional collateral, the broker is at liberty to liquidate all or some of the securities in the account.

[Short sellers] are bearish and anticipate a decline in the market. Their objective therefore is to sell high and buy low. Short selling requires such investors to sell stocks that they do not own. [...] Short sellers borrow securities from brokers. Short selling is also a form of margin trading. The difference is that margin trading entails the borrowing of cash whereas short selling requires the borrowing of securities.

When an investor borrows and sells a share, the proceeds will be credited to the investor's account. At some point in time, the shares will have to be purchased and returned to the broker. This is called covering the short position. If the price at this point of time is lower than the original purchase price, then the investor stands to make a gain. Otherwise, if the price has risen, he will have to countenance a loss.


Bonds and debentures [...] are referred to as fixed-income securities. The reason is that once the rate of interest is set at the onset of the period for which it is due to be paid, it is not a function of the profitability of the firm. [...] Interest payments are therefore contractual obligations, and failure to pay what was promised at the start of an interest-computation period will amount to default.

The most basic form of a debt security is referred to as a plain vanilla bond. It [...] promises to pay a fixed rate of interest every period, which is usually every six months in the United States, and to repay the principal at maturity. Floating-rate bonds are similar except that the interest rate does not remain constant from period to period but fluctuates with changes in the benchmark to which it is linked. There are also bonds with embedded options. Convertible bonds can be converted to shares of stock by the investor. Callable bonds can be prematurely retired by the issuing company, whereas putable bonds can be prematurely surrendered by the bondholders in return for the repayment of the principal.

Face value is also known as par value, redemption value, and maturity value.

Principal value is the principal amount underlying a bond. It was the amount raised by the issuer from the first holder, and it is the amount repayable by the issuer to the last holder.

Term to maturity is the time remaining in the life of a bond as measured at the point of evaluation.

The contractual interest payment made by the issuer is called a coupon payment.

Like the coupon rate, the yield to maturity (YTM) is also an interest rate. The difference is that although the coupon rate is the rate of interest paid by the issuer, the YTM is the rate of return required by the market. The YTM [...] is the rate of return that a buyer will get if he were to acquire the bond at the prevailing price and hold it to maturity.

[If] the price of the bond is less than its face value, such bonds are said to be "trading at a discount to the par value" and are therefore referred to as discount bonds. If the price of the bond were to be greater than its face value, then it would be said to be "trading at a premium to its face value" and would be referred to as a premium bond. If the price is equal to the face value, then the bond is said to be trading at par.

Unlike a plain vanilla bond that pays coupons at periodic intervals, zero-coupon bonds, also known as deep discount bonds, do not pay any interest. Such instruments are always traded at a discount to the face value, and the holder at maturity will receive the face value.

When a bond is sold between two coupon dates, the next coupon will go to the buyer of the bond. However, because the seller has held the security for a fraction of the coupon period, he is entitled to a part of the next coupon payment. This fraction of the next coupon that belongs to the seller is termed the accrued interest.

Credit or default risk is the risk that the coupons or principal or both may not be paid as scheduled. [...] To give confidence to potential investors about the quality of the issue, issuers get the securities rated by credit-rating agencies. These agencies specialize in evaluating the credit quality of a security issue. They not only provide a rating before the issue but also continuously monitor the health of the issuer throughout the life of the security, modifying their recommendations as and when required.

There are two categories of rated securities: investment grade and speculative grade. Investment grade-rated bonds are of higher quality and carry a lower credit risk. Noninvestment grade, which is also known as speculative grade or junk bond, carries a higher risk of default. Because a riskier security must offer a higher rate of return to compete with securities that are better rated, junk bonds carry a high coupon.

[Callable] bonds contain a call option; that is, they give the issuer the right to call away the bond from the lender before maturity. The issuers can in the case of such bonds change the maturity of the bonds by prematurely recalling them. When will such a bond be recalled? When market interest rates are declining. Under such circumstances, the issuer can recall the existing bonds and replace them with a fresh issue that can be issued with a lower coupon because of the changed circumstances.

Such bonds may be discretely callable or continuously callable. A discretely callable bond may be recalled only at certain prespecified dates [...]. A continuously callable bond may be called at any time after it becomes callable.

Issuers generally specify a call-protection period, which is a period of time during which the bond may not be recalled, regardless of what happens to the market rate of interest. [...] Bonds with a call-protection period are referred to as deferred callable bonds, and they serve to provide holders with relatively greater certainty. The price at which the bond can be recalled is referred to as the call price.

In the case of a putable bond, the holders have a put option: they can prematurely return the bond to the issuer and claim the face value. Such an option will be exercised when the market interest rates have risen. Under such circumstances, the holders can return the old bonds, which are yielding a relatively lower coupon, and use the proceeds to buy bonds yielding a higher coupon.

Convertible bonds allow holders to convert the debt securities into shares of stock of the issuer. The number of shares that an investor will receive if he were to convert the bond is known as the conversion ratio.

Money Markets

Loans in the money market have an original term to maturity of one year or less. In the case of debt securities, we need to distinguish between the original term to maturity of a security and its actual or current term to maturity. The original term to maturity is the time to maturity of the instrument at the time of issue. It cannot change after the issue is made. On the other hand, the actual or current term to maturity is the term remaining to maturity at the point of consideration.

The key feature of a money market is its ability to help governments and businesses bridge the gap between their receipts and expenditures. In other words, it facilitates what is termed liquidity management.

Money market securities, like other debt securities, are in principle vulnerable to interest-rate risk. However, the prices of such securities are relatively more stable over time. Whereas such securities do not offer prospects for significant capital gains, they also do not raise the specter of significant capital losses for essentially two reasons. First, interest-rate movements over relatively short periods of time usually tend to be moderate. Second, the price impact due to a given interest-rate change is greater, the longer the term to maturity of the cash flow being impacted.

Similarly default risk is minimal in the money market. This is because the ability to borrow in such markets is restricted to well-established institutions with impeccable credit ratings, usually from multiple rating agencies.

Money markets are overseen by the respective central banks.

There are three key dates in the case of [cash market] instruments: transaction date, value date, and maturity date. The transaction date is the date on which the terms and conditions of a financial instrument such as the term to maturity, transaction amount, and price are agreed upon. [...] The value date is the date on which the instrument starts to earn or accrue a return. The value date may or may not be the same as the transaction date. If the two dates were to be the same, then the transaction is said to be for same-day value or value today. In other cases, the value date will be the following business day. Transactions with such a feature are said to be for next-day value or value tomorrow. Finally, there are markets and transactions in which the value date will be two business days after the transaction date. A transaction with such a feature is referred to as a spot transaction and is said to be for spot value. The maturity date is the date on which the instrument ceases to accrue a return.

The interbank market is a market for large or wholesale loans and deposits. As the name suggests, it is primarily an arena for borrowing and lending deals between commercial banks, with tenors less than or equal to one year.

LIBOR is an acronym for London Inter-Bank Offer Rate. It may be defined as the rate at which a top-rated bank in London is prepared to lend to a similar bank. It is the main benchmark rate in the London interbank market.

It is a common practice for banks to maintain accounts with other banks. [...] From the standpoint of a bank, a nostro is its account of money being held by another bank, whereas a vostro is its account of money of another bank that it holds.

Forward and Futures Contracts

[...] a forward contract entails the negotiation of terms and conditions in advance for a trade that is scheduled to take place on a future date. In a forward contract at the time of negotiating the deal, the two parties have to agree on the terms by which they will transact on the future date. The following need to be clearly spelled out: the underlying asset. The delivery date and the transaction venue should also be agreed on. [...] Finally, the price at which the deal will be consummated [...] should also be fixed at the time of negotiating [...].

A forward contract is termed a commitment contract, because it represents an unconditional commitment to buy the underlying asset on the part of the buyer and an equivalent commitment to sell on the part of the seller.

A forward contract is a customized, private, or over-the-counter (OTC) contract. OTC connotes that such trades are not executed on an organized exchange.

[Forward contracts] are referred to as customized agreements because the two parties are at liberty to specify any terms and conditions on which they can mutually agree.

Default risk is an integral part of such contracts. It is for this reason that forward contracts are primarily between institutional parties such as commercial banks, investment banks, large corporations, and insurance companies. Such parties have the resources and skills to assess the credibility of a potential counterparty.

[A futures contract] also is a commitment contract that is written on an underlying asset, but it is offered by an organized futures exchange and is not an OTC product.

[...] futures contracts are standardized contracts. In other words, unlike the case of forward contracts in which the terms and conditions are set based on bilateral negotiations, in futures contracts a third party specifies the permitted terms and conditions. This third party is the futures exchange.

The futures exchange will have an associated entity known as a clearinghouse. The clearinghouse will position itself as the counterparty for each of the two original parties to the trade. In other words, once a trade is consummated between a buyer and a seller, the clearinghouse will intervene and position itself as the effective seller from the standpoint of the buyer and as the effective buyer from the perspective of the seller. [...] The clearinghouse essentially reduces the risk of default for the two parties to the trade. Once the clearinghouse enters the picture, each of the two parties has to only worry about the strength and integrity of the clearinghouse and not about the original counterparty.

To ensure that neither party has to worry about the possibility of default on the part of the other, the clearinghouse will estimate the potential loss for each party and collect it in advance. This deposit is referred to as a margin, and it is a performance guarantee or a good-faith deposit. The rationale is that if a party were to default after providing such a margin, then the funds available with the clearinghouse would be adequate to take care of the interests of the counterparty.

The loss or gain accruing to a party in a futures trade arises over a period of time, so there is a need to periodically compute the gains or losses for a party and adjust the margin position accordingly. Futures exchanges do so at the close of trading every day, a procedure that is termed marking to market.

If adverse price movements were to lead to a situation where the balance in the margin account declines below the maintenance level, the clearinghouse will issue what is termed a margin call. This is a request to the party to top up the funds in the margin account to take the balance back to the initial level. The funds deposited in response to a margin call are referred to as variation margins.

Futures contracts are zero-sum games; that is, taken together, the profit or loss for the long and the short is always zero.

Options Contracts

There are two categories of options: call options and put options. A call option gives the buyer of the option the right to buy the underlying asset at a predecided price, and a put option gives him the right to sell the underlying asset at a prefixed price. The prespecified price in the contract is termed the strike price or exercise price.

The party who buys the option contract, whether it is a call or a put, is referred to as the option buyer or the long. The counterparty who sells the option contracts is termed the option writer or short.

Call and put options that permit the holder to exercise only at the point of contract expiration are referred to as European options. Contracts that give the holder the flexibility of exercising on or before the expiration date of the option are referred to as American options.

The option itself carries an attached price tag, which is referred to as the option price or the option premium. This is the price that an option buyer has to pay to the option seller at the outset for conferring him with the right to transact.

Options like futures contracts are zero-sum games. The profit or loss for the holder is exactly equal to the loss or profit for the writer.

If the current asset price is greater than the exercise price of a call option, the option is said to be in the money (ITM). However, if the spot price is less than the exercise price, the call is said to be out of the money (OTM). If the two are exactly equal, then the option is said to be at the money (ATM). [...] For put options, it is just the opposite.

Foreign Exchange

The market for the sale and purchase of currencies is an over-the-counter market: there is no organized exchange on which currencies are traded. The largest players in the market are commercial banks. These banks typically provide two-way quotes for a number of currencies. They will quote a bid rate for buying a particular currency as well as an ask rate for selling the currency. The difference between the two rates, which is termed the spread, is a source of profit for the dealer.

An exchange rate is the price of one country's currency in terms of the currency of another country.

When quoting the rate of exchange between two currencies, the practice is to keep the number of units of one currency fixed while making changes in the number of units of the other to reflect changes in the rate of exchange. The currency that has unvarying units is referred to as the base currency and the other is termed the variable currency. The practice in the foreign-exchange market is to show the ISO codes for the two currencies involved as ABC-XYZ or ABC/XYZ, with the first code referring to the base currency and the second to the variable currency. A quote of 0.8125 USD/EUR or 0.8125 USD-EUR denotes a quote of 0.8125 euros per U.S. dollar.

When quoting the exchange rate for a currency, it is possible to quote the rate by designating either the domestic or foreign currency as the base currency. Exchange quotes where the domestic currency is the variable currency and the foreign currency is the base currency are referred to as direct quotes. [...] On the other hand, if the exchange rate were to be specified with the domestic currency as the base currency and the foreign currency as the variable currency, it would be deemed an indirect quote.

If an exchange rate were to be quoted with the U.S. dollar as the base currency, then it would be referred to as a quote as per European terms. [...] However, an exchange rate with the U.S. dollar as the variable currency will be categorized as a quote as per American terms.

Consider a quote of 1.2250-1.2375 EUR-USD. The first term represents the rate at which the dealer is willing to buy euros from a client, and the second is the rate at which he is willing to sell euros to the client.

If the value of a currency increases in terms of another currency, then it has appreciated. On the other hand, if the value of a currency declines in terms of another, then it has depreciated.

Exchange-rate quotations in interbank markets are given up to four decimal places, so the last digit corresponds to 1/10'000th of the variable currency. The last two digits in such quotes are called points or pips. The first three digits of a quote are known as the big figure.

Mortgages and Mortgage-Backed Securities

A loan that is collateralized by real estate property is called a mortgage loan. The lender is called the mortgagee, and the borrower is called the mortgagor. In the event that the mortgagor defaults on the loan, the lender can seize the property and sell it to recover what is due him. This is called the right of foreclosure.

The original lender or the party who first extends a loan to the acquirer of the property is called the mortgage originator.

Once a loan is granted, the originator can either hold it as an asset or sell it to an investor who may hold it as an investment or pool it with many other individual mortgage loans and use them as collateral for the issuance of securities. [...] When a mortgage pool is used as collateral for the issuance of a security, it is said to be securitized.

Investors who invest in mortgage loans are exposed to four main risks: (1) default risk; (2) liquidity risk; (3) interest-rate risk; and (4) prepayment risk.

The level-payment mortgage, which entails a constant monthly payment for the life of the mortgage, is the simplest of mortgage structures.

In an adjustable-rate mortgage (ARM), the interest rate is not fixed for the life of the loan but is reset periodically. The monthly payments will rise if the interest rate at the time of resetting is higher than previously, and it will fall if the interest rate declines.

In the case of ARMs, there may be a cap on how much the interest rate may increase or decrease per period. The cap may be a periodic cap or a lifetime cap.

A graduated payment mortgage starts with a level of payment that steadily increases every year up to a point, and then remains steady thereafter.


A swap in which one of the rates is fixed is referred to as a coupon swap. On the other hand, a swap in which both the parties are required to make payments based on varying rates is referred to as a basis swap.

In a coupon swap, the party that agrees to make payments based on a fixed rate is the payer, and the counterparty that is committed to making payments on a floating-rate basis is the receiver.