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Capital Markets Institutions, Instruments, and Risk Management fifth edition
Frank J. Fabozzi
The MIT Press Cambridge, Massachusetts London, England
Contents
Preface xxvii Acknowledgments xxxv PART I: INTRODUCTION 1 1
Financial Assets and Financial A/Iarkets 3 Learning Objectives 3 Financial Assets 4 Debt versus Equity Claims 5 The Value of a Financial Asset 5 Financial Assets versus Tangible Assets 8 The Role of Financial Assets 8 Properties of Financial Assets 9 Financial Markets 13 The Role of Financial Markets 13 Classification of Financial Markets 14 Globalization of Financial Markets 16 Classification of Global Financial Markets 17 Derivative Markets 18 Financial Markets and the Real Economy 19 Asset Classes 21 Key Points 23 Questions 25
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Overview of Risks and Risk Management 29 Learning Objectives 29 Defining Risk 30 Risk versus Uncertainty 31 Systematic Risk versus Idiosyncratic Risk 32
Financial Risk Management 33 Identifying Financial Risks 33 Quantifying Risks 33 Evaluating How to Deal with Each Identified Risk Investment Risk 37 Credit Risk 37 Price Risk 40 Reinvestment Risk 42 Inflation Risk 43 Liquidity Risk 43 Foreign Exchange Rate Risk 44 Longevity Risk 44 Funding Risk 46 Leverage Risk 46 Funding Liquidity Risk 48 Timing Risk 48 Fixed-Floating Financing Risk 50 Systemic Financial Risk 50 Financial Innovation 51 Key Points 52 Questions 55 PART II: THE PLAYERS 61 3
Overview of Market Participants 63 Learning Objectives 63 Investors and Issuers 64 Households 64 Nonfinancial Corporations 65 Governments 66 Depository Institutions 66 Institutional Investors 66 Securities Brokers and Dealers 71 Nonprofit Organization 71 Foreign Investors 72 Financial Institutions 75 Financial Intermediaries 76 Role of Governments in Financial Markets Regulation of Financial Markets 80 Acting as Financial Intermediaries 83
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Influencing Financial Markets through the Actions of the Central Bank 84 Providing Financial Assistance and Support for Bailouts 86 Credit Rating Agencies 91 The Role of CRAs in the Financial System 93 Use of Ratings by Regulators 93 Nonregulatory Use of Ratings 94 Concems Regarding CRAs 95 Other International Participants 98 Bank for International Settlements 98 Financial Stability Board 99 Key Points 100 Questions 103 4
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Depository Institutions 107 Learning Objectives 107 The Asset/Liability Problem of Depository Institutions 108 Regulators of Banks 110 The Federal Reserve 111 Office of the Comptroller of the Currency 112 Federal Deposit Insurance Corporation 113 Bank Regulation 115 Safety and Soundness Regulation 115 Deposit Insurance 120 Bank Activities 123 Bank Funding 124 Deposits 125 Reserve Requirements and Borrowing in the Federal Funds Market Borrowing at the Fed Discount Window 126 Other Nondeposit Borrowing 126 Nonbank Depository Institutions: Thrifts 127 Savings Institutions 127 Credit Unions 129 Shadow Banking 130 Key Points 133 Questions 137 Insurance Companies and Defined Benefit Pension Plans 141 Learning Objectives 141 Insurance Companies 142 Stock versus Mutual Insurance Companies 143 Insurance Companies versus Types of Products 145
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Fundamentals of the Insurance Industry 145 Regulation of Insurance Companies 146 Types of Life Insurance 149 Other Investment-Oriented Policies 151 Taxation of Life Insurance 153 General Account and Separate Account Products 153 Insurance Company Investment Strategies 154 Failures of Insurance Companies 155 Catastrophic Risk and Its Management 156 Insurance-Based Investment Banking 158 Defined Benefit Pension Funds 159 Defined Benefit Pension Plans and Variants 161 Regulation 162 Private-Sector Defined Benefit Pension Plan Problems 163 The Pension Benefit Guaranty Corporation 167 Public-Sector Defined Benefit Pension Plan Problems 168 Key Points 169 Questions 171 Managers of Collect!ve Investment Vehicles 175 Learning Objectives 175 Investment Company Shares 176 Open-End and Closed-End Funds 177 Fund Sales Charges and Annual Operating Expenses 179 Economic Motivation for Funds 181 Types of Funds by Investment Objective 182 The Concept of a Family of Funds 183 Exchange-Traded Funds 184 Types of ETFs and ETF Sponsors 186 The Process of Creating and Redeeming ETF Shares 186 Tracking the Performance of ETFs 187 Uses of ETFs 188 Hedge Funds 188 Attributes of Hedge Funds 189 Types of Hedge Funds 191 Concerns with Hedge Funds in Financial Markets 193 Real Estate Investment Trusts 194 Types of REITs 195
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Venture Capital Funds 196 Venture Capital Firms 197 Investing in a Venture Capital Fund 198 Stages of a Venture Capital Fund 198 Key Points 199 Questions 202 7
Investment Banking Firms 205 Learning Objectives 205 Public Offering (Underwriting) of Securities 207 Trading of Securities 210 Riskless Arbitrage 210 Risk Arbitrage 212 Proprietary Trading 214 Execution of Trades for Clients 217 Research and Trading 217 Private Placement of Securities 217 Securitization of Assets 218 Mergers and Acquisitions 218 Merchant Banking 220 Financial Restructuring Advising 221 Securities Finance 221 Prime Brokerage 222 Trading and Creation of Derivative Instruments 222 Asset Management 223 Key Points 223 Questions 226
PART III: BASICS OF CASH AND DERIVATIVES MARKETS 229 8
Primary and Secondary Markets 231 Learning Objectives 231 Primary Market 232 Federal Securities Law and Regulation of the Issuance of Securities Variations in the Underwriting of Securities 239 World Capital Markets Integration and Fundraising Implications 2 Motivation for Raising Funds outside the Domestic Market 244 Secondary Markets 245 Function of Secondary Markets 246 Architectural Structure of Secondary Markets 246 Trading Locations 248 Role of Brokers and Dealers in Real Markets 257
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Market Efficiency Key Points 262 Questions 265
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Introduction to Linear Payoff Derivatives: Futures, Forwards, and Swaps 271 Learning Objectives 271 Classification of Derivatives 272 Linear versus Nonlinear Payoff Derivatives 272 Types of Linear Payoff Derivative Contracts 274 Futures Contracts 274 Forward Contracts 277 Swaps 278 Applications 280 Pricing of Futures and Forward Contracts 283 Numerical Illustration 283 Theoretical Futures Price Based on Arbitrage Model 286 Price Convergence on the Delivery Date 289 A Closer Look at the Theoretical Futures Price 289 General Principles of Hedging with Futures 291 Risks Associated with Hedging 291 Short Hedge and Long Hedge 292 Hedging Illustrations 292 The Role of Linear Payoff Derivatives in Financial Markets 303 Effect of Futures and Swaps on the Volatility of the Underlying Asset 304 Is Increased Asset Price Volatility Bad? 304 Key Points 305 Questions 307
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Introduction to Nonlinear Payoff Derivatives: Options, Credit Default Swaps, Caps, and Floors 313 Learning Objectives 313 Types of Nonlinear Payoff Derivatives 314 Options 314 Exotic Options 326 Caps and Floors 327 Credit Default Swaps 329 Pricing of Options 330 Basic Components of the Option Price 330 Put-Call Parity Relationship 331 Factors That Influence the Option Price 333 Option Pricing Models 335
Contents
Economic Role of Nonlinear Payoff Derivatives Key Points 344 Questions 346 11
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Securitization and Its Role in Financial Markets 351 Learning Objectives 351 Securitization and the Creation of a Securitized Product 352 The Parties to a Securitization 353 Securitized Products Created and Transaction Structure 354 Benehts of Securitization to Financial Markets 358 Concerns with Securitization 360 Need for the Development of an Accommodating Legal Structure 362 The Role of the SPV 363 Legal Challenges 365 Securitization as a Corporate Risk Management Tool 366 The Subprime Mortgage Crisis and Securitization 367 The Dodd-Frank Act and Securitization 369 Key Points 371 Questions 373
PART IV: RISK AND RETURN THEORIES 375 12
Return Distributions and Risk Measures 377 Learning Objectives 377 Measuring the Rate of Return 378 Return Distributions 379 Describing a Probability Distribution 379 Continuous Probability Distributions Used to Describe Returns Family of Stable Distributions 386 Some Stylized Facts about Stock Returns 388 Joint Probability Distributions 389 Covariance and Correlations 390 Copula Functions and Tail Dependence 391 Portfolio Risk Measures 392 Coherent Measures of Risk 393 Alternative Portfolio Risk Measures 393 Safety-First Risk Measures 394 Reward-Risk Ratios 397 The Reward Measure 398 The Risk Measure 400
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Key Points 400 Questions 404 13
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Portfolio Selection Theory 411 Learning Objectives 411 The Concept of Portfolio Diversification 412 Markowitz Portfolio Theory 414 Expected Portfolio Return 414 Measuring Portfolio Risk 415 The Role of Correlation on Portfolio Risk and the Diversification Effect Constructing Portfolios 417 Selecting the Optimal Portfolio 421 Criticisms of Portfolio Theory 423 Behavioral Finance Theory and Investor Decision Making 425 Markowitz Portfolio Theory in Practice 428 Key Points 430 Questions 431 Asset Pricing Theories 435 Learning Objectives 435 Economic Assumptions 436 Assumptions about Investor Behavior 436 Assumptions about Capital Markets 437 Capital Market Theory 437 Deriving the Formula for the CML 439 Interpreting the CML Equation 441 The Capital Asset Pricing Model 442 Systematic and Unsystematic Risk 442 Quantifying Systematic Risk 443 Estimating Beta 446 The Security Market Line 448 The SML, CML, and Market Model 449 Tests of the CAPM 450 The Multifactor CAPM 453 The Arbitrage Pricing Theory Model 454 Assumptions of the APT Model 454 Derivation of the APT Model 455 Comparison of the APT Model and CAPM 457 Advantages of the APT Model 458
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Factor Models in Practice 458 Statistical Factor Models 458 Macroeconomic Factor Models 459 Fundamental Factor Models 460 Some Principles to Take Away 460 Key Points 461 Questions 463 PART V: INTEREST RATE DETERMINATION AND DEBT PRICING 465 15
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The Theory and Structure of Interest Rates 467 Learning Objectives 467 The Theory of Interest Rates 468 Description of Preferences between Current and Future Consumption Opportunity in the Loan Market 470 Economic Forces Affecting the Market Rate 472 Carryover through Investment 473 Consumer Choices 473 Market Equilibrium 478 Efficiency Properties of Markets 482 Real and Nominal Interest Rates: Fisher's Law 483 The Structure of Interest Rates 484 The Base Interest Rate 484 The Risk Premium 485 Term to Maturity 487 Inclusion of Options 488 Taxability of Interest 489 Alternative Benchmark Interest Rates 491 Key Points 494 Questions 495 Valuation of Debt Contracts and Their Price Volatility Characteristics 499 Learning Objectives 499 Features of Debt Contracts 500 Basic Valuation Principles 501 Return from a Bond: Yield to Maturity Measure 502 Price of an Option-Free Bond 504 Reasons for Changes in Bond Price 504 What Determines the Premium-Par Yield 505 Reinvestment of Cash Flow and Yield 506
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Bond Price Volatility 507 Review of Price/Yield Relationship 507 Price Volatility Properties 507 Characteristics of a Bond That Affect Price Volatility 510 Measure of Price Volatility: Duration 510 Convexity 519 Key Points 521 Questions 523 17
The Term Structure of Interest Rates 527 Learning Objectives 527 The Yield Curve and the Term Structure 528 Using the Yield Curve to Price a Bond 529 Constructing the Theoretical Spot Rate Curve 530 Using Spot Rates to Value a Bond 534 Forward Rates 534 Relationship between Spot Rates and Short-Term Forward Rates 539 Forward Rate as a Hedgeable Rate 540 Historical Shapes Observed for the Treasury Yield Curve 540 Determinants of the Shape of the Term Structure 542 The Pure Expectations Theory 543 The Liquidity Theory 546 The Preferred Habitat Theory 546 Market Segmentation Theory 547 The Main Influences on the Shape of the Yield Curve 548 Key Points 550 Questions 552
PART VI: EQUITY MARKETS 557 18
The Structure of the Common Stock Market 559 Learning Objectives 559 Regulators of Equities Markets 560 Securities and Exchange Commission 560 Financial Industry Regulatory Authority 562 State Regulation 562 Equity Trading Venues 563 Exchange Market for Listed Stocks 564 Exchange Market for Unlisted Stocks 566 Alternative Trading Systems 568
Contents
Execution of an Order 571 Execution of an Order Placed with a Broker 571 Market Trading Regulation 572 Regulatory Background 573 Market Regulation 574 Other Types of Common Stock Trading 579 Offshore Trading 579 Rule 144a Securities 579 American Depositary Receipts 580 Trading of Stocks Outside the Country Where They Are Domiciled 580 Global Depositary Receipts 581 Euro Equity 582 Key Points 583 Questions 587 19
Common Stock Strategies and Trading Arrangements 589 Learning Objectives 589 Stock Market Indexes 590 Major International Stock Market Indexes 591 Pricing Efficiency of the Stock Market 592 Forms of Efficiency 593 Micro versus Macro Stock Market Efficiency 594 Implications for Investing in Common Stock 594 Global Investing Strategies 596 Trading Mechanics 598 Types of Orders 598 Margin Transactions 600 Trading (Transaction) Costs 602 Explicit Costs 602 Implicit Costs 604 Classification of Trading Costs 605 Research on Trading Costs 605 Trading Arrangements for Institutional Investors 606 Block Trades 606 Program Trades 607 High-Frequency Trading 610 Key Points 614 Questions 618
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PART VII: DEBT MARKETS 20
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The Money Market for Private Debt Instruments 625 Learning Objectives 625 Interbank Funding Market 627 Federal Funds Market 627 Future of the Interbank Funding Market 630 Repo Market 631 Credit Risks 632 Participants in the Market 634 Determinants of the Repo Rate 635 Commercial Paper Market 636 Nonfinancial and Financial CP 637 Asset-Backed CP 639 Defaults in the CP Market and the Recent Financial Crisis 640 Yields on CP 641 Non-U.S. CP Markets 642 Large-Denomination Negotiable Certificates of Deposit 642 CD Issuers 643 CD Yields 643 Banker's Acceptances 644 Illustration of the Creation of a BA 645 Accepting Banks 646 Eligible BAs 646 Credit Risk 647 Funding Agreements 647 Money Market Funds 648 Types of MMFs 649 SEC MMF Rules Adopted and Proposed as a Result of the Financial Crisis Key Points 653 Questions 656 Treasury and Agency Securities Markets 659 Learning Objectives 659 U.S. Department of the Treasury and Debt Management 660 Office of Debt Management 660 Treasury Debt Management and the Financial Crisis 666 The Market for U.S. Treasury Securities 667 Types of Treasury Securities 668 The Primary Market 670
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The Secondary Market 675 Regulation of the Secondary Market 676 Stripped Treasury Securities 677 Coupon Stripping and the Theoretical Value of Treasury Securities The Market for Federal Agency Securities 681 Tennessee Valley Authority 682 Fannie Mae 683 Freddie Mac 683 Federal Agricultural Mortgage Corporation 684 Federal Home Loan Bank System 684 Federal Farm Credit Bank System 684 Key Points 685 Questions 687
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Municipal Securities Markets 691 Learning Objectives 691 Tax-Exempt versus Taxable Municipal Securities Market 693 Yields in the Municipal Securities Markets 694 Types and Features of Municipal Securities 695 Tax-Backed Debt 695 Revenue Bonds 696 Hybrid and Special Bond Structures 696 Municipal Notes 699 Redemption Features 700 Credit Risk 700 Default and Recovery Rates 700 Factors Considered by Credit Rating Agencies in Assigning Ratings 702 Municipal Bankruptcy 702 Tax Risks Associated with Investing in Municipal Securities 704 Regulation of the Municipal Securities Market 704 Primary Market for Municipal Securities 706 Initial Disclosure 706 Competitive versus Negotiated Offering 707 Secondary Market for Municipal Securities 708 Key Points 709 Questions 712
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Corporate Senior Instruments Markets 715 Learning Objectives 715 Credit Risk and the Rating of Corporate Debt 716 Factors Considered by Credit Rating Agencies 718
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XX B ankruptcy and Creditor Rights 719 The Bankruptcy Process 720 Absolute Priority: Theory and Practice 720 Bank Loans 722 Syndicated Bank Loans 723 Secondary Market for Syndicated Bank Loans 725 Lease Financing 725 Corporate Bonds 726 Basic Features of a Corporate Bond Issue 727 Bonds with Special Features 730 High-Yield Sector 732 Corporate Bond Defaults and Recovery Rates 735 Corporate Bond Rating Transitions 736 Secondary Market 736 Private-Placement Market for Corporate Bonds 740 Medium-Term Notes 741 The Primary Market 742 Structured MTNs 743 Preferred Stock 743 Key Points 745 Questions 747 24
International Bond Markets 749 Learning Objectives 749 Classification of Global Bond Markets 750 Classification by Trading Blocs 752 The Eurobond Market 752 Securities Issued In the Eurobond Market 753 Comparing Yields on Eurobonds and U.S. Bonds 754 The Non-U.S. Government Bond Market 755 Methods of Distribution of New Government Securities Infiation-Indexed Bonds 756 Sovereign Bond Ratings 756 Emerging Market Bonds 757 Some Special Structures and Bond Types 758 The European Covered Bond Market 758 Infrastructure Bonds 760 Green Bonds 760 European Union Regulation of Bond Market 761
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Key Points 762 Questions 764 25
The Residential Mortgage Market 765 Learning Objectives 765 Origination of Residential Mortgage Loans 766 The Mortgage Origination Process 767 The Risks Associated with Mortgage Origination 768 Mortgage Servicers 769 Types of Residential Mortgage Loans 770 Interest Rate Type 770 Repayment Structure 772 Treatment of Prepayments 774 Lender's Recourse 775 Lien Status 775 Credit Classification 775 Credit Guarantees 777 Conforming versus Nonconforming Status 778 Investment Risks 779 Credit Risk 779 Liquidity Risk 779 Price Risk 780 Prepayments and Cash Flow Uncertainty 780 Development of the Secondary Mortgage Market 780 Key Points 782 Appendix: Mortgage Mathematics 785 Fully Amortizing Fixed-Rate Loans 786 Adjustable-Rate Mortgage 787 Interest-Only Type of Mortgage 788 Questions 788
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The Market for U.S. Agency Residential Mortgage-Backed Securities 793 Learning Objectives 793 U.S. Agency Pass-Through Securities 794 Cash Flow Characteristics 795 Issuers of Agency Pass-Through Securities 795 Prepayment Risks Associated with Pass-Through Securities 797 Prepayment Conventions 799 Average Life 806
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U.S. Agency CMOs 806 Sequential-Pay CMOs 807 Accrual Bonds 811 Planned Amortization Class Tranches 813 U.S. Agency Stripped Mortgage-Backed Securities 815 The Future of Fannie Mae and Freddie Mac 817 FHFA Strategie Plan for the Conservatorships of Fannie Mae and Freddie Mac 818 Key Points 821 Questions 822 27
The Market for Credit-Sensitive Securitized Products 825 Learning Objectives 825 Collateral Type 826 Existing Asset versus Future Flow Securitizations 826 Amortizing versus Nonajnortizing Assets 828 Fixed-Rate versus Floating-Rate Assets 829 Credit Risks Associated with Investing in ABS 829 Asset Risks 829 Structural Risks 830 Third-Party Providers 831 Credit Enhancement 832 Determination of the Amount of Credit Enhancement 832 Forms of Credit Enhancement 832 Originator-Provided Credit Enhancement 832 Structural Credit Enhancement 834 Third-Party Credit Enhancement 834 Private-Label Residential Mortgage-Backed Securities 835 The Subprime MBS Meltdown 835 Commercial Mortgage-Backed Securities 838 Commercial Mortgage Loans 838 Types of CMBS Deals 840 CMBS Structure 841 How CMBS Trade in the Market 842 Review of Major Non-Mortgage-Related Types of ABS 843 Credit Card Receivable-Backed Securities 843 Auto Loan-Backed Securities 844 Rate Reduction Bonds 845 Student Loan-Backed Securities 846 Small Business Administration Loan-Backed Securities 847
Contents
Key Points 848 Questions 852 PART VIII: DERIVATIVE MARKETS 855 28
The Market for Equity Derivatives 857 Learning Objectives 857 Exchange-Traded Stock Options 858 Stock Option Pricing Models 859 Black-Scholes Option Pricing Model 859 Option Strategies 866 Pricing Efficiency of the Stock Options Market 872 Warrants 873 Stock Index Options 874 Pricing Efficiency of the Stock Index Options Markets 875 Portfolio Strategies with Stock Index Options 877 The Stock Index Futures Market 878 Pricing of Stock Index Futures 879 Pricing Efficiency of the Stock Index Futures Market 881 Portfolio Strategies with Stock Index Futures 883 Single-Stock and Narrow-Based Stock Futures Contracts 890 Equity Swaps 890 Applications 891 Equity Market Volatility Indexes 892 Issues Associated with Equity Derivatives 893 Are Derivative Index Markets Beneficial to the Financial Markets? 893 What Has Been the Effect on Stock Price Volatility? 897 Key Points 898 Questions 900
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The Market for Interest Rate Risk Transfer Vehicles: Exchange-Traded Products 907 Learning Objectives 907 Interest Rate Futures Contracts 908 Features of Selected Futures Contracts 908 Pricing of Interest Rate Futures Contracts 913 Applications of Interest Rate Futures 916 Exchange-Traded Interest Rate Options 919 Exchange-Traded Futures Options 919 Applications of Interest Rate Options 921 Option Pricing Models 923
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Key Points 925 Questions 926 30
The Market for Interest Rate Risk Transfer Vehicles: OTC Instruments 929 Learning Objectives 929 Over-the-Counter Interest Rate Options 930 Compound or Split-Fee Options 931 Forward Rate Agreements 931 Interest Rate Swaps 932 Interpretation of a Swap 933 Applications 934 Development of the Interest Rate Swap Market 940 Role of the Intermediary 943 Terminology, Conventions, and Market Quotations 944 Calculation of the Swap Rate 946 Valuing a Swap 955 Beyond the Piain Vanilla Swap 957 Interest Rate Agreements 960 Risk/Return Characteristics 961 Applications 961 Dodd-Frank Act Provisions Dealing with OTC Derivatives 962 Key Points 963 Questions 964
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The Market for Credit Risk Transfer Vehicles: Credit Derivatives and Collateralized Debt Obligations 971 Learning Objectives 971 Credit Derivatives 973 ISDA Documentation 974 Credit Default Swaps 975 Single-Name CDSs 976 Basket CDSs 979 CDS Index 979 Collateralized Debt Obligations 980 Structure of a CDO 982 Difference between a CDO and an ABS 983 Arbitrage versus Balance Sheet Transactions 983 Synthetic CDOs 987 Future of CDO Products 988
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Credit-Linked Notes 989 Concerns with CRT Vehicles 990 Whether There Is a Clean Transfer of Risk 990 The Risk That Market Participants Fail to Understand the Associated Risks 991 A Potentially High Concentration of Risk 992 Adverse Selection 993 Key Points 993 Questions 995 32
The Market for Foreign Exchange and Risk Control Instruments Learning Objectives 997 Foreign Exchange Rates 998 Exchange Rate Quotation Conventions 998 Foreign Exchange Rate Risk 1000 Spot Market 1001 Cross Rates 1002 Dealers 1002 Instruments for Hedging Foreign Exchange Rate Risk 1003 Currency Forward Contracts 1003 Currency Futures Contracts 1009 Currency Option Contracts 1010 Currency Swaps 1010 Key Points 1014 Questions 1016 Index 1019
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