Fundamentals of Financial Instruments E-Book

Sunil K. Parameswaran

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 1117

Veröffentlichungsjahr: 2022

Beschreibung

In the newly revised Second Edition of Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives, renowned finance trainer Sunil Parameswaran delivers a comprehensive introduction to the full range of financial products commonly offered in the financial markets.

Using clear, worked examples of everything from basic equity and debt securities to complex instruments—like derivatives and mortgage-backed securities – the author outlines the structure and dynamics of the free-market system and explores the environment in which financial instruments are traded. This one-of-a-kind book also includes:

• New discussions on interest rate derivatives, bonds with embedded options, mutual funds, ETFs, pension plans, financial macroeconomics, orders and exchanges, and Excel functions for finance
• Supplementary materials to enhance the reader’s ability to apply the material contained within
• A foundational exploration of interest rates and the time value of money

Fundamentals of Financial Instruments is the ideal resource for business school students at the undergraduate and graduate levels, as well as anyone studying financial management or the financial markets. It also belongs on the bookshelves of executive education students and finance professionals seeking a refresher on the fundamentals of their industry.

Leseprobe

Table of Contents

Cover

Title Page

Copyright

Dedication

Preface

Preface to the First Edition

Acknowledgments

About the Author

CHAPTER 1: An Introduction to Financial Institutions, Instruments, and Markets

THE ROLE OF AN ECONOMIC SYSTEM

A COMMAND ECONOMY

A MARKET ECONOMY

CLASSIFICATION OF ECONOMIC UNITS

AN ECONOMY'S RELATIONSHIP WITH THE EXTERNAL WORLD

THE BALANCE OF TRADE

THE CURRENT ACCOUNT BALANCE

FINANCIAL ASSETS

MONEY

MONEY AS A UNIT OF ACCOUNT OR A STANDARD OF VALUE

MONEY AS A MEDIUM OF EXCHANGE

MONEY AS A STORE OF VALUE

MONEY IS PERFECTLY LIQUID

EQUITY SHARES

DEBT SECURITIES

PREFERRED SHARES

FOREIGN EXCHANGE

DERIVATIVES

FORWARD AND FUTURES CONTRACTS

OPTIONS CONTRACTS

SWAPS

MORTGAGES AND MORTGAGE-BACKED SECURITIES

HYBRID SECURITIES

PRIMARY MARKETS AND SECONDARY MARKETS

EXCHANGES AND OVER-THE-COUNTER (OTC) MARKETS

BROKERS AND DEALERS

THE NEED FOR BROKERS AND DEALERS

TRADING POSITIONS

THE BUY-SIDE AND THE SELL-SIDE

INVESTMENT BANKERS

DIRECT AND INDIRECT MARKETS

MUTUAL FUNDS

MONEY AND CAPITAL MARKETS

THE EUROCURRENCY MARKET

THE INTERNATIONAL BOND MARKET

GLOBALIZATION OF EQUITY MARKETS

DUAL LISTING

FUNGIBILITY

ARBITRAGE

ARBITRAGE WITH ADRs

GDRs

RISK

AFTER THE TRADE – CLEARING AND SETTLEMENT

DEMATERIALIZATION AND THE ROLE OF A DEPOSITORY

CUSTODIAL SERVICES

GLOBALIZATION – THE NEW MANTRA

NOTES

CHAPTER 2: Mathematics of Finance

INTEREST RATES

THE REAL RATE OF INTEREST

THE FISHER EQUATION

SIMPLE INTEREST & COMPOUND INTEREST

PROPERTIES

A SYMBOLIC DERIVATION

PRINCIPLE OF EQUIVALENCY

CONTINUOUS COMPOUNDING

FUTURE VALUE

PRESENT VALUE

HANDLING A SERIES OF CASH FLOWS

THE INTERNAL RATE OF RETURN

EVALUATING AN INVESTMENT

ANNUITIES: AN INTRODUCTION

ANNUITY DUE

PERPETUITIES

THE AMORTIZATION METHOD

AMORTIZATION WITH A BALLOON PAYMENT

THE EQUAL PRINCIPAL REPAYMENT APPROACH

TYPES OF INTEREST COMPUTATION

LOANS WITH A COMPENSATING BALANCE

TIME VALUE OF MONEY–RELATED FUNCTIONS IN EXCEL

COMPUTING THE PRESENT AND FUTURE VALUES OF ANNUITIES AND ANNUITIES DUE IN EXCEL

AMORTIZATION SCHEDULES AND EXCEL

NOTE

CHAPTER 3: Equity Shares, Preferred Shares, and Stock Market Indices

INTRODUCTION

PAR VALUE VERSUS BOOK VALUE

ACCOUNTING FOR A STOCK ISSUE

VOTING RIGHTS

DIVIDENDS

TREASURY STOCK

ACCOUNTING FOR TREASURY STOCK

SPLITS AND REVERSE SPLITS

PREEMPTIVE RIGHTS

INTERPRETING STATED RATIOS

HANDLING FRACTIONS

PHYSICAL CERTIFICATES VERSUS BOOK ENTRY

TRACKING STOCK

REPORT CARDS

TYPES OF STOCKS

RISK AND RETURN AND THE CONCEPT OF DIVERSIFICATION

PREFERRED SHARES

DIVIDEND DISCOUNT MODELS

A GENERAL VALUATION MODEL

THE CONSTANT GROWTH MODEL

THE TWO-STAGE MODEL

THE THREE-STAGE MODEL

THE H MODEL

STOCK MARKET INDICES

PRICE-WEIGHTED INDICES

THE IMPORTANCE OF PRICE

VALUE-WEIGHTED INDICES

CHANGING THE BASE PERIOD CAPITALIZATION

EQUALLY WEIGHTED INDICES

TRACKING PORTFOLIOS

HANDLING A RIGHTS ISSUE

THE FREE-FLOATING METHODOLOGY

WELL-KNOWN GLOBAL INDICES

MARGIN TRADING AND SHORT-SELLING

TERMINOLOGY

CASE A: THE MARKET RISES

CASE B: THE MARKET DECLINES

CASE A: THE MARKET RISES

CASE B: THE MARKET DECLINES

INTEREST AND COMMISSIONS

CASE A: THE MARKET RISES

CASE B: THE MARKET DECLINES

MAINTENANCE MARGIN

SHORT-SELLING

MAINTENANCE OF A SHORT POSITION

SHORTING AGAINST THE BOX

THE RISK FACTOR

THE ECONOMIC ROLE OF SHORT SALES

THE UPTICK RULE

NOTES

CHAPTER 4: Bonds

INTRODUCTION

TERMS USED IN THE BOND MARKET

VALUATION OF A BOND

PAR, PREMIUM, AND DISCOUNT BONDS

EVOLUTION OF THE PRICE

ZERO-COUPON BONDS

VALUING A BOND IN BETWEEN COUPON DATES

DAY-COUNT CONVENTIONS

ACTUAL-ACTUAL

THE TREASURY'S APPROACH

CORPORATE BONDS

ACCRUED INTEREST

NEGATIVE ACCRUED INTEREST

YIELDS

THE CURRENT YIELD

SIMPLE YIELD TO MATURITY

YIELD TO MATURITY

APPROXIMATE YIELD TO MATURITY

ZERO-COUPON BONDS AND THE YTM

ANALYZING THE YTM

THE REALIZED COMPOUND YIELD

REINVESTMENT AND ZERO-COUPON BONDS

THE HOLDING PERIOD YIELD

TAXABLE EQUIVALENT YIELD

CREDIT RISK

BOND INSURANCE

EQUIVALENCE WITH ZERO-COUPON BONDS

SPOT RATES

THE COUPON EFFECT

BOOTSTRAPPING

FORWARD RATES

THE YIELD CURVE AND THE TERM STRUCTURE

SHAPES OF THE TERM STRUCTURE

THEORIES OF THE TERM STRUCTURE

THE LIQUIDITY PREMIUM HYPOTHESIS

THE MONEY SUBSTITUTE HYPOTHESIS

THE MARKET SEGMENTATION HYPOTHESIS

THE PREFERRED HABITAT THEORY

THE SHORT RATE

FLOATING RATE BONDS

SIMPLE MARGIN

BONDS WITH EMBEDDED OPTIONS

CALLABLE BONDS

YIELD TO CALL

PUTABLE BONDS

CONVERTIBLE BONDS

USING SHORT RATES TO VALUE BONDS

PRICE VOLATILITY

A CONCISE FORMULA

DURATION AND PRICE VOLATILITY

PROPERTIES OF DURATION

DOLLAR DURATION

CONVEXITY

A CONCISE FORMULA

DOLLAR CONVEXITY

PROPERTIES OF CONVEXITY

IMMUNIZATION

TREASURY AUCTIONS

WHEN ISSUED TRADING

PRICE QUOTES

STRIPS

INFLATION INDEXED BONDS

COMPUTING PRICE GIVEN YIELD AND VICE VERSA IN EXCEL

COMPUTING DURATION IN EXCEL

NOTES

CHAPTER 5: Money Markets

INTRODUCTION

MARKET SUPERVISION

THE FEDERAL RESERVE SYSTEM

KEY DATES IN THE CASE OF CASH MARKET INSTRUMENTS

THE MODIFIED FOLLOWING BUSINESS DAY CONVENTION

THE END/END RULE

THE INTERBANK MARKET

TYPES OF LOANS

LIBOR

LIBID

SONIA

TRANSITIONING FROM LIBOR

INTEREST COMPUTATION METHODS

TERM MONEY MARKET DEPOSITS

MONEY MARKET FORWARD RATES

FEDERAL FUNDS

FEDERAL FUNDS VERSUS CLEARINGHOUSE FUNDS

CORRESPONDENT BANKS: NOSTRO AND VOSTRO ACCOUNTS

TREASURY BILLS

REOPENINGS

YIELDS ON DISCOUNT SECURITIES

NOTATION

DISCOUNT RATES AND T-BILL PRICES

THE BOND EQUIVALENT YIELD (BEY)

CASE A:

T

M

< 182 DAYS

THE MONEY MARKET YIELD

CASE B: TM > 182 DAYS

HOLDING PERIOD RETURN

VALUE OF AN 01

CONCEPT OF CARRY

CONCEPT OF A TAIL

T-BILL RELATED FUNCTIONS IN EXCEL

TBILLPRICE

TBILLYIELD

TBILLEQ

DISC

TREASURY AUCTIONS

TYPES OF AUCTIONS

RESULTS OF AN AUCTION

PRIMARY DEALERS AND OPEN MARKET OPERATIONS

REPURCHASE AGREEMENTS

REVERSE REPOS

GENERAL COLLATERAL VERSUS SPECIAL REPOS

MARGINS

SALE AND BUYBACK

COLLATERAL

REPOS AND OPEN MARKET OPERATIONS

NEGOTIABLE CDs

NOTATION

COST OF A CD FOR THE ISSUING BANK

TERM CDs

CDs VERSUS MONEY MARKET TIME DEPOSITS

COMMERCIAL PAPER

LETTERS OF CREDIT AND BANK GUARANTEES

YANKEE PAPER

CREDIT RATING

MOODY'S RATING SCALE

S&P'S RATING SCALE

FITCH'S RATING SCALE

BILLS OF EXCHANGE

DOCUMENTS AGAINST PAYMENT (DAP) VERSUS DOCUMENTS AGAINST ACCEPTANCE (DAA) TRANSACTIONS

ELIGIBLE AND NONELIGIBLE BANK BILLS

BUYING AND SELLING BILLS

BANKERS' ACCEPTANCE

ACCEPTANCE CREDITS

EUROCURRENCY DEPOSITS

APPENDIX

NOTES

CHAPTER 6: Forward and Futures Contracts

INTRODUCTION

MARKING TO MARKET FOR A TRADER IN PRACTICE

DELIVERY OPTIONS

PROFIT DIAGRAMS

VALUE AT RISK

THE EXPECTED SHORTFALL

SPOT-FUTURES EQUIVALENCE

PRODUCTS AND EXCHANGES

CASH-AND-CARRY ARBITRAGE

REVERSE CASH-AND-CARRY ARBITRAGE

REPO AND REVERSE REPO RATES

SYNTHETIC SECURITIES

VALUATION

THE CASE OF ASSETS MAKING PAYOUTS

PHYSICAL ASSETS

NET CARRY

BACKWARDATION AND CONTANGO

THE CASE OF MULTIPLE DELIVERABLE GRADES

RISK ARBITRAGE

THE CASE OF MULTIPLICATIVE ADJUSTMENT

THE CASE OF ADDITIVE ADJUSTMENT

TRADING VOLUME AND OPEN INTEREST

DELIVERY

CASH SETTLEMENT

HEDGING AND SPECULATION

ROLLING A HEDGE

TAILING A HEDGE

THE MINIMUM VARIANCE HEDGE RATIO

ESTIMATION OF THE HEDGE RATIO AND THE HEDGING EFFECTIVENESS

CROSS-HEDGING

SPECULATION

LEVERAGE

CONTRACT VALUE

FORWARD VERSUS FUTURES PRICES

HEDGING THE RATE OF RETURN ON A STOCK PORTFOLIO

CHANGING THE BETA

PROGRAM TRADING

STOCK PICKING

PORTFOLIO INSURANCE

IMPORTANCE OF FUTURES

NOTES

CHAPTER 7: Options Contracts

INTRODUCTION

NOTATION

EXERCISING OPTIONS

MONEYNESS

EXCHANGE-TRADED OPTIONS

OPTION CLASS AND OPTION SERIES

FLEX OPTIONS

CONTRACT ASSIGNMENT

ADJUSTING FOR CORPORATE ACTIONS

NONNEGATIVE OPTION PREMIA

INTRINSIC VALUE AND TIME VALUE

TIME VALUE OF AMERICAN OPTIONS

TIME VALUE AT EXPIRATION

PUT-CALL PARITY

IMPLICATIONS FOR THE TIME VALUE

PUT-CALL PARITY WITH DIVIDENDS

IMPLICATIONS FOR THE TIME VALUE

A VERY IMPORTANT PROPERTY FOR AMERICAN CALLS

EARLY EXERCISE OF OPTIONS: AN ANALYSIS

PROFIT PROFILES

SPECULATION WITH OPTIONS

HEDGING WITH OPTIONS

VALUATION

THE BINOMIAL OPTION PRICING MODEL

THE TWO-PERIOD MODEL

VALUATION OF EUROPEAN PUT OPTIONS

VALUING AMERICAN OPTIONS

IMPLEMENTING THE BINOMIAL MODEL IN PRACTICE

THE BLACK-SCHOLES MODEL

PUT-CALL PARITY

INTERPRETATION OF THE BLACK-SCHOLES FORMULA

THE GREEKS

OPTION STRATEGIES

FUTURES OPTIONS

PUT-CALL PARITY

THE BLACK MODEL

NOTES

CHAPTER 8: Foreign Exchange

INTRODUCTION

CURRENCY CODES

BASE AND VARIABLE CURRENCIES

DIRECT AND INDIRECT QUOTES

EUROPEAN TERMS AND AMERICAN TERMS

BID AND ASK QUOTES

APPRECIATING AND DEPRECIATING CURRENCIES

CONVERTING DIRECT QUOTES TO INDIRECT QUOTES

POINTS

RATES OF RETURN

THE IMPACT OF SPREADS ON RETURNS

ARBITRAGE IN SPOT MARKETS

ONE-POINT ARBITRAGE

TWO-POINT ARBITRAGE

TRIANGULAR ARBITRAGE

CROSS RATES

MARKET RATES AND EXCHANGE MARGINS

VALUE DATES

THE FORWARD MARKET

OUTRIGHT FORWARD RATES

SWAP POINTS

BROKEN-DATED CONTRACTS

COVERED INTEREST ARBITRAGE

A PERFECT MARKET

FOREIGN EXCHANGE SWAPS

THE COST

THE MOTIVE

INTERPRETATION OF THE SWAP POINTS

A CLARIFICATION

SHORT-DATE CONTRACTS

OPTION FORWARDS

NONDELIVERABLE FORWARDS

RANGE FORWARDS

FUTURES MARKETS

HEDGING USING CURRENCY FUTURES

A SELLING HEDGE

A BUYING HEDGE

EXCHANGE-TRADED FOREIGN CURRENCY OPTIONS

SPECULATING WITH FOREX OPTIONS

EXCHANGE RATES AND COMPETITIVENESS

NOTES

CHAPTER 9: Mortgages and Mortgage-backed Securities

INTRODUCTION

MARKET PARTICIPANTS

MORTGAGE ORIGINATION

RISKS IN MORTGAGE LENDING

OTHER MORTGAGE STRUCTURES

PSA PREPAYMENT BENCHMARK

ANALYSIS

EXTENSION RISK AND CONTRACTION RISK

ACCRUAL BONDS

FLOATING RATE TRANCHES

NOTIONAL INTEREST-ONLY TRANCHE

INTEREST-ONLY AND PRINCIPAL-ONLY STRIPS

PAC BONDS

NOTES

CHAPTER 10: Swaps

INTRODUCTION

MARKET TERMINOLOGY

KEY DATES

INHERENT RISK

THE SWAP RATE

ILLUSTRATIVE SWAP RATES

DETERMINING THE SWAP RATE

THE MARKET METHOD

VALUATION OF A SWAP DURING ITS LIFE

TERMINATING A SWAP

THE ROLE OF BANKS IN THE SWAP MARKET

MOTIVATION FOR THE SWAP

COMPARATIVE ADVANTAGE AND CREDIT ARBITRAGE

SWAP QUOTATIONS

MATCHED PAYMENTS

AMORTIZING SWAPS

EXTENDABLE AND CANCELABLE SWAPS

SWAPTIONS

CURRENCY SWAPS

CROSS-CURRENCY SWAPS

VALUATION

CURRENCY RISKS

HEDGING WITH CURRENCY SWAPS

NOTES

CHAPTER 11: Mutual Funds, ETFs, and Pension Funds

INTRODUCTION

PROS AND CONS OF INVESTING IN A FUND

SHARES AND UNITS

OPEN-END VERSUS CLOSED-END FUNDS

PREMIUM/DISCOUNT OF A CLOSED-END FUND

UNIT TRUSTS

CALCULATING THE NAV

COSTS

SALES CHARGES

PRICE QUOTES

ANNUAL OPERATING EXPENSES

SWITCHING FEES

DIVIDEND OPTIONS

TYPES OF MUTUAL FUNDS

MONEY MARKET FUNDS

GILT FUNDS

DEBT FUNDS

DIVERSIFIED DEBT FUNDS

FOCUSED DEBT FUNDS

HIGH YIELD DEBT FUNDS

DEBT FUNDS AND BOND DURATION

EQUITY FUNDS

AGGRESSIVE GROWTH FUNDS

GROWTH FUNDS

SPECIALTY FUNDS

SECTOR FUNDS

OFFSHORE FUNDS

SMALL CAP EQUITY FUNDS

OPTION INCOME FUNDS

FUND OF FUNDS

EQUITY INDEX FUNDS

VALUE FUNDS

EQUITY INCOME FUNDS

BALANCED FUNDS

ASSET-ALLOCATION FUNDS

COMMODITY FUNDS

REAL ESTATE FUNDS

TAX-EXEMPT FUNDS

RISK CATEGORIES

THE PROSPECTUS

STRUCTURE OF A MUTUAL FUND

SERVICES

INVESTMENT TECHNIQUES

THE TOTAL RETURN

COMPUTATION OF RETURNS

TAXATION ISSUES

ALTERNATIVES TO MUTUAL FUNDS

TYPES OF PLANS

IRAs

CASH BALANCE PLANS

NOTE

CHAPTER 12: Orders and Exchanges

IMPORTANT ACRONYMS

MARKET ORDERS AND LIMIT ORDERS

THE LIMIT PRICE

THE LIMIT ORDER BOOKS

ILLUSTRATION OF A LIMIT ORDER BOOK

LIMIT ORDERS VERSUS MARKET ORDERS

MARKETABLE LIMIT ORDERS

TRADE PRICING RULES

STOP-LOSS AND STOP-LIMIT ORDERS

TRAILING STOP-LOSS ORDERS

MARKET TO LIMIT ORDERS

EQUIVALENCE WITH OPTIONS

VALIDITY CONDITIONS

GOOD TILL CANCELED (GTC) ORDERS

GOOD TILL DAYS ORDERS

ORDERS WITH QUANTITY RESTRICTIONS

A POINT ON ORDER SPECIFICATION

OPEN-OUTCRY TRADING SYSTEMS

ELECTRONIC MARKETS VERSUS OPEN-OUTCRY MARKETS

CALL MARKETS

NOTES

CHAPTER 13: The Macroeconomics of Financial Markets

ECONOMIC GROWTH

GROSS DOMESTIC PRODUCT

GDP VERSUS GNP

INFLATION ADJUSTMENT

TRANSNATIONAL COMPARISONS

THE BIG MAC INDEX

INFLATION

TYPES OF INFLATION

INTEREST RATES

THE FEDERAL BUDGET DEFICIT

MEASURES OF BUDGET DEFICITS

THE PRIMARY DEFICIT

FISCAL POLICY

BUDGET DEFICITS AND THE CAPITAL MARKET

THE ROLE OF THE CENTRAL BANK

BUDGET DEFICITS AND MONETARY POLICY

CROSS-BORDER BORROWING

CENTRAL BANKS AND FOREIGN EXCHANGE MARKETS

STERILIZED AND UNSTERILIZED INTERVENTIONS

EXCHANGE RATES

ISSUES WITH A RESERVE CURRENCY

CROSS-BORDER IMPLICATIONS OF CENTRAL BANK ACTIONS

QUANTITATIVE EASING

QUANTITATIVE EASING VERSUS OPEN-MARKET OPERATIONS

CHAPTER 14: Interest Rate Derivatives

FORWARD RATE AGREEMENTS (FRAs)

SETTLING AN FRA

DETERMINING BOUNDS FOR THE FRA RATE

EURODOLLAR FUTURES

CALCULATING PROFITS AND LOSSES ON ED FUTURES

LOCKING IN A BORROWING RATE

LOCKING IN A LENDING RATE

THE NO-ARBITRAGE PRICING EQUATION

CREATING A FIXED-RATE LOAN

30-YEAR T-BOND FUTURES CONTRACTS

CONVERSION FACTORS

INTEREST RATE OPTIONS

STATE PRICES

CALLABLE AND PUTABLE BONDS

CAPS, FLOORS, AND COLLARS

CAPTIONS AND FLOORTIONS

NOTES

Sources and References

CHAPTER 1

CHAPTER 2

CHAPTER 3

CHAPTER 4

CHAPTER 5

CHAPTER 6

CHAPTER 7

CHAPTER 8

CHAPTER 9

CHAPTER 10

CHAPTER 11

CHAPTER 12

CHAPTER 14

Index

End User License Agreement

List of Tables

Chapter 1

TABLE 1.1 Commercial Banks and Depositories (Similarities and Differences)

Chapter 2

TABLE 2.1 The Compounding Process

TABLE 2.2

TABLE 2.3 Vector of Cash Flows

TABLE 2.4 Present and Future Values of the Cash Flows

TABLE 2.5 Vector of Cash Flows

TABLE 2.6 An Amortization Schedule

TABLE 2.7 Amortization with a Balloon Payment

TABLE 2.8 Equal Principal Repayment Schedule

Chapter 3

TABLE 3.1 Asset Returns

TABLE 3.2 Earnings Record

TABLE 3.3 Dividend Distribution: The Case of Noncumulative Shares

TABLE 3.4 Dividend Distribution: The Case of Cumulative Shares

TABLE 3.5 Valuation of Cash Flows as Per the Three-Stage Model

TABLE 3.6 Prices of the Constituent Stocks on the Base Date

TABLE 3.7 Prices of the Constituent Stocks on the Following Day

TABLE 3.8 Prices of the Constituent Stocks on the Following Day, Assuming a ...

TABLE 3.9 Theoretical Post-Split Stock Prices

TABLE 3.10 Prices of the Component Stocks of the Reconstituted Index

TABLE 3.11 Prices of the Constituent Stocks on a Given Day

TABLE 3.12 Prices on the Following Day: Two Different Scenarios

TABLE 3.13 Prices, Number of Shares Outstanding, and Market Capitalization o...

TABLE 3.14 Prices, Number of Shares Outstanding, and Market Capitalization o...

TABLE 3.15 Market Capitalization of the Component Stocks of the Reconstitute...

TABLE 3.16 Prices of the Stocks Constituting an Equally Weighted Index at th...

TABLE 3.17 Prices of the Stocks Constituting an Equally Weighted Index on th...

TABLE 3.18 Components of a Value-weighted Index

TABLE 3.19 Components of a Value-weighted Index

TABLE 3.20 Tick Sizes on the TSE

TABLE 3.21 Illustration of Uptick, Downtick, and Zero Tick

Chapter 4

TABLE 4.1 Illustration of Leverage

TABLE 4.2 Illustration of a Tax Shield

TABLE 4.3 Calculation of the Numerator

TABLE 4.4 Calculation of the Denominator

TABLE 4.5 Investment Grade Ratings

TABLE 4.6 Speculative Grade Ratings

TABLE 4.7 Cash Flows from a Two-Year Bond

TABLE 4.8 Prices of Plain-Vanilla Bonds with Varying Times to Maturity

TABLE 4.9 Vector of Spot Rates

TABLE 4.10 Computation of Duration

TABLE 4.11 Computation of Convexity

TABLE 4.12 An Immunized Portfolio

TABLE 4.13 Index Levels, Inflation Rates, and Index Ratios

TABLE 4.14 Cash Flows for a P-Linker

TABLE 4.15 Cash Flow for a C-Linker

Chapter 5

TABLE 5.1 Major Central Banks

TABLE 5.2 The District Federal Reserve Banks

TABLE 5.3 Bids in Ascending Order of Yield

TABLE 5.4 Day-Counts for Valuing the Term CD

Chapter 6

TABLE 6.1 Observed Futures Prices

TABLE 6.2 Margin Account of the Long

TABLE 6.3 Margin Account of the Short

TABLE 6.4 Illustration of a Contango Market

TABLE 6.5 Illustration of a Backwardation Market

TABLE 6.6 Spot Prices Prior to Expiration

TABLE 6.7 Spot Prices and Delivery-Adjusted Spot Prices at Expiration

TABLE 6.8 Prices, Number of Shares Outstanding, and Market Capitalization

TABLE 6.9 Prices, Number of Shares Outstanding, and Market Capitalization on...

Chapter 7

TABLE 7.1 Illustration of Put-Call Parity: Strategy 1

TABLE 7.2 Illustration of Put-Call Parity: Strategy 2

TABLE 7.3 Illustration of Put-call Parity for a Dividend-paying Stock

TABLE 7.4 Lower Bound for Call Options

TABLE 7.5 Payoffs and Profits for Long Call and Put Positions

TABLE 7.6 Payoffs and Profits for Short Call and Put Positions

TABLE 7.7 Profit from the Hedged Position for Various Values of the Terminal...

TABLE 7.8 Profit from the Hedged Position for Various Values of the Terminal...

TABLE 7.9 Payoffs from a Bull Spread with Calls

TABLE 7.10 Payoffs from a Bull Spread with Puts

TABLE 7.11 Profit from the Bull Spread

TABLE 7.12 Payoffs from a Bear Spread with Calls

TABLE 7.13 Payoffs from a Bear Spread with Puts

TABLE 7.14 Profit from the Bear Spread

TABLE 7.15 Payoffs from a Long Butterfly Spread

TABLE 7.16 Premiums for Call Options

TABLE 7.17 Profit from the Butterfly Spread

TABLE 7.18 Payoffs from a Long Straddle

TABLE 7.19 Profit from a Long Straddle

TABLE 7.20 Payoffs from an Out-of-the-money Long Strangle

TABLE 7.21 Payoffs from an In-the-money Long Strangle

TABLE 7.22 Profit from a Long Strangle

Chapter 8

TABLE 8.1 Symbols for Major Currencies

Chapter 9

TABLE 9.1 Observed Values for LIBOR

TABLE 9.2 Observed Values for LIBOR

TABLE 9.3 Mortgage Rates in the Presence of a Cap

TABLE 9.4 Observed Values for LIBOR

TABLE 9.5 Monthly Payments & Outstanding Balances

TABLE 9.6 Illustration of Negative Amortization

TABLE 9.7 Monthly Payments for a GPM

TABLE 9.8 Amortization Schedule for a GPM

TABLE 9.9 Mortgage Loans, Their Rates, and Times to Maturity

TABLE 9.10 Calculation of WAC and WAM

TABLE 9.11 Amortization Schedule in the Absence of Prepayments

TABLE 9.12 Amortization Schedule in the Presence of Prepayments

TABLE 9.13 Cash Flows for a Security with a Par Value of $1.000

TABLE 9.14 Bond Equivalent Yields

TABLE 9.15 Cash Flows Assuming 100 PSA

TABLE 9.16 Cash Flows Assuming 200 PSA

TABLE 9.17 Amortization for Tranche A

TABLE 9.18 Amortization for Tranche B

TABLE 9.19 Amortization for Tranche C

TABLE 9.20 Amortization for Tranche D

TABLE 9.21 Maturity and Average Life of the Securities

TABLE 9.22 Amortization for Tranche A in the Presence of a Z-bond

TABLE 9.23 Amortization for Tranche B in the Presence of a Z-bond

TABLE 9.24 Amortization for Tranche C in the Presence of a Z-bond

TABLE 9.25 Amortization for the Z-Bond

TABLE 9.26 Maturity and Average Life of the Securities in the Presence of a ...

TABLE 9.27 Coupon Rates for a Sequential Pay CMO

TABLE 9.28 Principal Payments for a 100 PSA to 250 PSA Range

TABLE 9.29 Principal Payments at 150 PSA

TABLE 9.30 Principal Payments at 250 PSA

TABLE 9.31 Principal Payments at 0 PSA

TABLE 9.32 Principal Payments at 400 PSA

Chapter 10

TABLE 10.1 6-M Libor as Observed at Six-Monthly Intervals

TABLE 10.2 Amounts Payable by the Two Counterparties

TABLE 10.3 Cash Flows for a Fixed-Fixed Currency Swap

TABLE 10.4 Bid–Ask Quotes for Euro-denominated IRS

TABLE 10.5 Observed Term Structure

TABLE 10.6 Discount Factors as per Market Convention

TABLE 10.7 The Term Structure of Interest Rate After Two Months

TABLE 10.8 Term Structure for US Dollars and the Euro

Chapter 11

TABLE 11.1 The Fund's Portfolio on a Given Day

TABLE 11.2 The Fund's Portfolio on the Following Day

TABLE 11.3 The Fund's Portfolio Composition If the Incoming Money Is Deploye...

TABLE 11.4 The Fund's Portfolio Composition If the Incoming Money Is Deploye...

TABLE 11.5 An Illustration of Dollar-cost Averaging

TABLE 11.6 An Illustration of Value Averaging

TABLE 11.7 The Year-wise NAVs

TABLE 11.8 Evolution of the Reinvestment Factor Through Time

TABLE 11.9 The Dividend Payout and the NAV at the End of Each Month of the Y...

TABLE 11.10 The Monthly Cash Flow Schedule for the Investor

Chapter 12

TABLE 12.1 Limit Order Book for XYZ Stock at 11:30 a.m. on 15 July 20XX

TABLE 12.2 Limit Order Book for a Stock

TABLE 12.3 Illustration of a Market to Limit Order

TABLE 12.4 List of Orders Received Prior to the Market Being Called

TABLE 12.5 Computation of the Maximum Tradeable Quantity

Chapter 14

TABLE 14.1 Vector of Spot Rates

List of Illustrations

Chapter 1

FIGURE 1.1

Chapter 2

FIGURE 2.1 Timeline for an Annuity

FIGURE 2.2 Timeline for an Annuity Due

Chapter 3

FIGURE 3.1

FIGURE 3.2

FIGURE 3.3

FIGURE 3.4

FIGURE 3.5

FIGURE 3.6

FIGURE 3.7

Chapter 4

FIGURE 4.1 Cash Flows from a Plain-Vanilla Bond

FIGURE 4.2 Evolution of the Short Rate

FIGURE 4.3 A Segment of the Short-Rate Tree

FIGURE 4.4 The Price-yield Relationship

Chapter 6

FIGURE 6.1 Profit Profile – Long Futures

FIGURE 6.2 Profit Profile – Short Futures

Chapter 7

FIGURE 7.1 Profit Diagram for a Long Call Position

FIGURE 7.2 Profit Diagram for a Long Put Position

FIGURE 7.3 Profit Diagram for a Short Call Position

FIGURE 7.4 Profit Diagram for a Short Put Position

FIGURE 7.5 Stock Price Tree for the One-period Case

FIGURE 7.6 Stock Price Tree for the Two-period Case

FIGURE 7.7 Stock Price Tree for the Two-period Example

FIGURE 7.8 Profit Profile: Bull Spread

FIGURE 7.9 Profit Profile: Bear Spread

FIGURE 7.10 Profit Profile: Butterfly Spread

FIGURE 7.11 Profit Profile: Straddle

FIGURE 7.12 Profit Profile: Strangle

Chapter 8

FIGURE 8.1 The Evolution of the Exchange Rate

Chapter 14

FIGURE 14.1 No-Arbitrage Interest Rate Tree

FIGURE 14.2 State Price Tree

Guide

Cover

Table of Contents

Title Page

Copyright

Dedication

Preface

Preface to the First Edition

Acknowledgments

About the Author

Begin Reading

Sources and References

Index

End User License Agreement

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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

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For a list of available titles, visit our Web site at www.WileyFinance.com.

Fundamentals of Financial Instruments

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

SUNIL PARAMESWARAN

Second Edition

Copyright © 2022 by John Wiley & Sons Singapore Pte. Ltd.

Published by John Wiley & Sons Singapore Pte. Ltd.1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628

All rights reserved.

Edition HistoryJohn Wiley & Sons Singapore Pte. Ltd. (1e, 2011)

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Other Wiley Editorial OfficesJohn Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USAJohn Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United KingdomJohn Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, CanadaJohn Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, AustraliaWiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany

Library of Congress Cataloging-in-Publication Data is Available:

9781119816614 (Hardback)9781119816645 (ePDF)9781119816638 (ePub)

Cover Design: WileyCover Image: © naqiewei/Getty ImagesAuthor photo: Courtesy of Sunil Parameswaran

To my students in India, Australia, Singapore, and the United States over the past 30 years.

Preface

Readers the world over have appreciated the first edition of this book, which appeared over a decade ago. Some people pointed out that I should include more material on financial institutions and the key features of the markets in which financial products trade.

Consequently, I have included a detailed chapter on mutual funds, pension funds, and exchange-traded funds. There is also a new chapter on orders and exchanges, which deals with continuous markets in detail, with a brief focus on call markets as well. Macroeconomic issues are key for understanding financial markets, and hence there is a new chapter on such issues. The chapter is by no means exhaustive, and people wishing to acquire a more detailed perspective would have to look for an economics text.

Interest rate derivatives are perhaps the hardest product to explain in futures and options. Consequently, while the book continues to have three separate chapters on futures, options, and swaps, I have opted to include a chapter on interest rate derivatives and on financial products with such derivatives built in, such as callable bonds and putable bonds.

Excel has many useful functions for students and professionals in the field of Finance. I have described the use of many of these functions at key places in the book.

The previous edition had some statistical information on markets, and certain qualitative descriptive features, which I felt were better to remove. I have eliminated such features in the second edition. I feel that a chapter on clearing and settlement may be relevant for the kind of audience that this book aims to address. I will bring that in if and when there is a third edition.

Readers are welcome to share their comments and suggestions with me. Constructive advice and criticism is welcome and will be incorporated while undertaking revision of the material in future. My email is: [email protected]

I hope that the book serves as a source of pertinent and comprehensive knowledge for readers everywhere.

Sunil K. Parameswaran

Director & CEO

Tarheel Consultancy Services

Manipal, India

November 2021

Preface to the First Edition

This book grew out of my lecture notes used for corporate training programs in India and abroad. The feedback from participants has been invaluable in polishing and refining the exposition. The eventual flow and clarity that I believe I have been able to achieve is in no small measure due to the critical and incisive inputs of my students as well as professional acquaintances.

There is typically no course exclusively on financial instruments in most MBA curricula. Consequently, this topic invariably gets combined with material on financial institutions as part of a course on Financial Markets. I, however, believe that there is a strong case for offering a comprehensive course on financial instruments for second-year MBA students. However, care should be taken to ensure that material which is covered in traditional courses like Financial Derivatives and Fixed Income Securities is not repeated any more than is necessary. Many students who take such a course may not be majoring in Finance and consequently may not take specialized courses such as Derivatives. For them therefore the specter of substantial overlap is less of an issue. Even for students of Finance, despite the inevitable repetition of facets of topics such as Bonds, Futures, and Options, a course on instruments is a comprehensive and integrated offering that will serve them in good stead in the future.

The book starts from first principles and builds in intensity. Exposure to one or more courses on Financial Management will certainly be useful for the reader as he or she navigates through the material. While the book is a standalone treatise on the subject, readers may like to augment it with standard texts on issues in Finance such as Security Analysis, Bond Markets, Futures & Options, and International Finance.

The issues covered in this book are universal and of relevance for students of Finance as well as market professionals irrespective of where they may happen to be located. However, most of the illustrations and examples pertain to markets in the developed world, particularly the United States, and the products that trade in them. Consequently the book should have appeal for readers in all parts of the world.

Readers are welcome to share their comments and suggestions with me. Constructive advice and criticism is welcome and will be incorporated while undertaking revision of the material in future. My E-mail ID is: [email protected]

I hope that the book serves as a source of pertinent and comprehensive knowledge for readers everywhere.

Sunil K. Parameswaran

T.A. Pai Management Institute

Manipal – 576104

Karnataka, India

Acknowledgments

I am indebted to all my students in India and Australia who went through this material and offered ideas for embellishing the content and polishing the exposition. The participants at my Executive Education programs offered invaluable advice. Because most of them were non-Finance professionals, primarily from the Information Technology field, they had unusual and interesting perspectives which helped augment the more traditional feedback from business school students and associates.

I am extremely grateful to John Wiley & Sons, Singapore, for giving me the opportunity to develop and promote this book. In particular I owe a tremendous debt to my former publisher, Nick Wallwork, for taking a chance with an unknown Indian academic. Gladys Ganaden, who subsequently took over, has been an enormous source of support and encouragement. She is the primary force behind the second edition of the book, for she perceived the need and inspired me to write it. I am indebted to her.

The editorial team of Purvi and Pradesh has been very supportive of this project right from the outset and I owe them an enormous debt. Donna, who was the copyeditor, has done a wonderful job, and has provided invaluable support at the copyediting and typesetting phases.

And finally, I am indebted to my mother for her patience and moral support.

About the Author

Sunil K. Parameswaran is the director and CEO of Tarheel Consultancy Services, a corporate training and management consultancy firm set up by him in 2004.

Sunil is a Visiting Faculty at some of the leading business schools in India, where he anchors courses in the area of Finance. His primary areas of interest are Securities Markets; Financial Derivatives; Fixed Income Securities; and International Finance.

For the past 20 years Sunil has been active as a corporate trainer and management consultant. He has delivered training programs on Global Securities Markets and Global Banking to some of the multinational IT firms located in India. Sunil also has over 30 years of teaching experience and has taught at leading business schools in the United States (University of Iowa), Singapore (National University of Singapore), Australia (La Trobe University), and India.

His past clients include WIPRO Technologies, HCL, Capgemini, Accenture, Microland, and JPMC.

Sunil obtained his PhD in Finance from the Fuqua School of Business at Duke University in North Carolina. He obtained his MBA from the Indian Institute of Management, Bangalore, and holds an undergraduate degree in Chemistry from St. Stephen's College, New Delhi.

A prolific writer, he has published several books with John Wiley & Sons in Singapore and DeG Press in the United States. His most recent book is Fixed Income Securities, published by DeG Press, Boston/Berlin.

CHAPTER 1An Introduction to Financial Institutions, Instruments, and Markets

THE ROLE OF AN ECONOMIC SYSTEM

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 else for investments in productive assets.

The key role of an economic system is to ensure efficient allocation. Efficient and free flow of resources from one economic entity to another is a sine qua non for a modern economy. This is because the larger the flow of resources and the more efficient their allocation, the greater is the chance that the requirements of all economic agents can be satisfied, and consequently the greater are the odds that the economy's output will be maximized.

The functioning of an economic system entails making decisions about both the production of goods and services and their subsequent distribution. The success of an economy is gauged by the extent of wealth creation. A successful economy consequently is one that makes and implements judicious economic decisions from the standpoints of production and distribution. In an efficient economy, resources will be allocated to those economic agents who are able to derive the optimum value of output by employing the resources allocated to them.

Why are we giving so much importance to the efficiency of an economic system? The emphasis on efficiency is because every economy is characterized by a relative scarcity of resources as compared to the demand for them. In principle, the demand for resources by economic agents can be virtually unlimited, but in practice, economies are characterized by a finite stock of resources. Efficient allocation requires an extraordinary amount of information as to what people need, how best goods and services can be produced to cater to these needs, and how best the produced output can be distributed.

Economic systems may be classified as command economies or as free market economies. This definition refers to the two extreme ends of the economic spectrum. In practice, most modern economies tend to display characteristics of both kinds of systems, and they differ only with respect to the level of government control.

A COMMAND ECONOMY

In a command economy, such as the former Soviet Union, all production and allocation decisions are taken 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 based on their relevance to social needs. Production plans and resource allocation decisions are then made so as to ensure that resources are directed to users in descending order of need. In practice, communist and socialist systems, which were based on this economic model, ensured that citizens complied with the directives of the state by imposing stifling legal, and occasionally, coercive measures.

The failure of the command economies was inherent in their structure. As we have discussed, efficient economic systems needed to aggregate and process an enormous amount of information. When this task was entrusted to a central planning authority, this not only proved to be infeasible in practice, but the quality of information was also substandard. The central planning authority was supposed to be omniscient and was expected to have perfect information as to what resources were available and what the relative requirements of the socioeconomic system were. This was necessary for them to ensure that optimal decisions were made about production as well as distribution.

Command economies were in practice plagued by blatant political interference. The planning authority was often prevented from making optimal decisions due to political pressures. The system gave the planners enormous powers that permeated all facets of the social system and not just the economy. One of the hallmarks of such systems was the absence of pragmatism, and a naïve idealism that was out of touch with realities. Planners used their authority to devise and impose stifling rules and regulations. These regulations, which were in principle intended to ensure optimal decision making, sometimes went to the ridiculous extent of imposing penalties on producers whose output exceeded what was allowed by the permit or license given to them.

Such economies were a colossal failure in practice and were characterized by an output that was invariably far less than the ambitious targets that were set at the outset of each financial year. When confronted with the specter of failure the planners tended to place the blame on those who were responsible for implementing the plans. The bureaucrats in charge of implementation passed the buck back by making allegations of improper decision making on the part of the planners. Eventually the contradictions in the system lead either to the total repeal of such systems or else to substantial structural changes that brought in key features of a market economy.

A MARKET ECONOMY

Such economies work in principle as follows. Economic agents are expected to make the most profitable use of the resources at their disposal. What is profit? Profit is defined as the revenues from sales less the costs of production of the goods sold. Thus, 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 the one that maximizes profit. Economic agents who generate surpluses of income over expenditure will obviously be able to attract more and better resources. Failure, as manifested by sustained losses, will result in those economic agents being denied access to the resources being sought by them.

In such systems the prices of both inputs and outputs are determined by factors of supply and demand. These economies, in contrast to command economies, are characterized by decentralized decision making. In principle, agents are expected to make a rational decision by evaluating competing resource needs based on their ability to generate surpluses. In practice, every decision maker will have a required rate of return on investment. The threshold return, or the return exceeding which the venture will be deemed to be profitable, is the cost of capital for the decision maker. A project is deemed to be worth the investment only if the expected rate of return from it is greater than the cost of the capital that is being invested.

As can be surmised, the key decision variables in these economies are the prices of inputs and outputs. Hence, for such economies to work in an optimal fashion, it is imperative that prices accurately convey the value of a good or a service, from the standpoints of 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 take 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 manifest itself in the form of profit maximization, which is the primary motivating factor for agents in such economies to engage in economic enterprise.

How do such systems ensure that prices of inputs and outputs are informationally accurate? In practice, this is ensured by allowing economic agents to trade in markets for goods and services. If an agent has the perception that the price of an asset is different from the value that he places on it, he will seek to trade. If the prevailing price is lower than the perceived value, buyers will seek to buy more of the good than the quantity on offer. If so, the market price will be bid up due to demand being greater than the amount on offer. This demand supply disequilibrium will persist till the price reaches the optimal level. Similarly, if the price of the good is perceived to be too high relative to the value placed on it by agents, sellers will seek to offload more than what is being demanded. Once again, the supply-demand imbalance will cause prices to decline till equilibrium is restored. Thus, differing perceptions of value will manifest themselves as supply-demand imbalances; resolving these will ultimately help ensure that the prices of assets accurately reflect their value.

Opinion: While free market economies have to a large extent been more successful than command economies, no one would advocate a total absence of the government's role in economic decision making. Unfettered capitalism is unlikely to find acceptance anywhere. There are disadvantaged sections of every society whose fate cannot be left to the market, and whose well-being must be ensured by policy makers to promote overall welfare. While societies characterized by command economies have historically not permitted free speech, in a country like the United States, even mild criticism of the market is considered to be heresy.

CLASSIFICATION OF ECONOMIC UNITS

Economic agents are usually divided into three categories or sectors:

The government sector

The business sector

The household sector

The government sector consists of the central or federal government of a country, state, or provincial governments, and local governments or municipalities. The business sector consists of sole proprietorships, partnerships, and private as well as public limited companies. Sometimes business units are broadly subclassified as financial corporations and nonfinancial corporations.

Proprietorships: A proprietorship, also known as a sole proprietorship, is a business owned by a single person, and represents the easiest way to start a business. The owner may do business in their name or else in a trade name. For instance, a consultant named John Smith may run the business in his name, or choose a name like “Business Systems.” The owner is fully responsible for all debts and obligations of the business. That is, creditors, or 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, as opposed to a corporation where the owners have limited liability, which we will shortly discuss in greater detail.

The start-up costs of a sole proprietorship are usually lower than those of other forms of business. Unlike a corporation, however, such businesses face relative difficulties in raising additional capital when they choose to expand the scope of their operations. Usually, in addition to the owner's personal investment, the only source of funds is a loan from a commercial bank.

Legally, the proprietorship is an extension of the owner. The owner is permitted to employ other people. The net profits from the business are clubbed with the proprietor's other income, if any, for the purpose of taxation. The lifespan of these entities is uncertain. For instance, if the owner were to die, the business would cease to exist.

Partnerships: A partnership is a business entity that is owned by at least two people or partners. One of the partners may be a corporation, which we will explain next. Legally, the partnership is an extension of the partners. Like a proprietorship, a partnership is permitted to employ others, and can conduct a business under a trade name. For instance, two lawyers named John Smith and Mike Jones may conduct their business as Smith & Jones, or else under a trade name such as “Legal Point.” In a general partnership the partners have unlimited liability, and the partners are personally responsible not only for their own acts, but also for the actions of other partners and employees.

There are two categories of partnerships in many countries: general partnerships and limited partnerships. A general partnership is what we have just discussed. In a limited partnership there are two categories of partners: 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 the shareholders of a corporation. Their potential loss is limited to the investment that they have made.

Like a sole proprietorship, a partnership is also easy to establish. However, unlike a proprietor, who is the sole decision maker, partners must share authority with the others. Consequently, it is important to draw up a partnership agreement at the outset, where issues such as profit sharing are clearly spelled out. Compared to corporations, partnerships also find it relatively difficult to raise capital to expand their businesses.

Corporations: 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. A corporation may and usually will have multiple owners as well as many employees on its payroll. It must necessarily do business under a given trade name. Because a corporation is a separate legal entity, it has the right to sue and be sued in its own name. Shareholders of a corporation enjoy limited liability. Unlike a proprietorship or partnership, the ownership of a company can easily change hands. Each shareholder will possess shares of the company that can be usually bought and sold in a marketplace known as the stock exchange. While such share transfers may result in one party relinquishing majority control in favor of another, the transfers per se have no implications for the corporation's continued existence or its operations. Unlike proprietorships and partnerships, corporations find it relatively easier to raise both debt or borrowed capital, as well as equity or owners' capital. In most countries, however, corporations are extensively regulated, and are required by statutes to maintain extensive records pertaining to their operations. The cost of incorporation, and the costs of raising equity through share issues, can also be substantial. While owners of a corporation may be a part of its management team, very often ownership and management are segregated by entrusting the management of day-to-day activities to a team of professional managers. In some countries there exist entities known as Private Limited Companies. These companies cannot offer shares to the public, and consequently the shares cannot be traded on a stock exchange. However, the shareholders continue to enjoy limited liability and hence the name. The disclosure norms for public limited companies are generally more stringent than those for private limited companies.

During a given financial year, every economic unit, irrespective of which sector it may belong to, will get some form of income from its operations, and will also incur expenditure in some form. Depending on the relationship between the income earned and the expenditure incurred, an economic unit may be classified into one of the following three categories:

A balanced budget unit

A surplus budget unit

A deficit budget unit

A balanced budget unit (BBU) is one whose income in a period is exactly equal to its expenditure. It must be reiterated that a balanced budget unit is impossible to observe in practice and consequently exists only in the realm of textbooks. For it is virtually impossible for a business or government to ensure that its scheduled income during a period is perfectly matched with its scheduled expenditure during the same period. In practice an economic unit may be a surplus budget unit (SBU) or a deficit budget unit (DBU). A surplus budget unit is one whose income exceeds its expenditure while a deficit unit is one whose expenses exceed its income. Usually, in most countries, governments and businesses invariably tend to be deficit budget units, whereas households consisting of individuals and families generally tend to be savers, that is they tend to have budget surpluses. By this we do not mean that all households and individuals are savers or that all governments and businesses have a budget deficit. What we mean is that while it is not impossible for a government or a business to have a surplus in a financial period, taken as a group, the government sector and the business sector generally tend to be net borrowers. By the same logic, it is not necessary that all households should save, although the category generally has a budget surplus in most periods. Finally, a country may have a budget surplus or a budget deficit.

AN ECONOMY'S RELATIONSHIP WITH THE EXTERNAL WORLD

The record of all economic transactions between a country and the rest of the world is known as the Balance of Payments (BOP). It is a record of a country's trade in goods, services, and financial assets with the rest of the world or, in other words, a record of all economic transactions between a country and the outside world. The transaction may be a requited transfer of economic value or an unrequited transfer of economic value. The term requited, in this context, connotes that the transferor receives a compensation of economic value from the transferee. On the other hand, an unrequited transfer represents a unilateral gift made by the transferor.

For instance, if Microsoft exports software to Germany in return for a payment in euros, it is a requited transaction of economic value. On the other hand, if the Gates Foundation were to donate $10 million to a charity in Zimbabwe, it is an unrequited or unilateral transfer.

Economic transactions can be classified into the following five basic categories. First is the import and export of goods and services in return for a payment in financial terms. For instance, a company in Houston imports crude oil from Saudi Arabia and pays in US dollars. The second category may be illustrated as follows. Sometimes an import or export of a product may be paid for by an equivalent export or import of another. A party in India imports crude oil from Nigeria by paying in the form of wheat. This is nothing but a barter transaction in simple English. The third type of transaction entails the exchange of one financial asset for another. For instance, a party in London buys US Treasury Bonds as an investment and pays the equivalent amount in dollars. The last two categories pertain to unilateral transfers, inward and outward, respectively.

The BOP is typically broken up into three major categories of accounts, each of which is further subdivided into various components. The major categories are:

The Current Account: This accounting head includes imports and exports of goods and services, factor incomes and payments, and unrequited transfers in both directions.

The Capital Account: Under this head we have the transactions that lead to changes in the foreign assets and liabilities of a country.

The Reserve Account: The reserve account is similar to the capital account, in the sense that it also deals with financial assets and liabilities. This account, however, deals only with reserve assets, which are assets used to settle the deficits and surpluses that arise on account of the other two categories taken together.

A reserve asset is one that is acceptable as a means of payment in international transactions, and which is held by and exchanged between the monetary authorities of various countries. It consists of monetary gold, assets denominated in foreign currencies, Special Drawing Rights (SDRs), and reserve positions at the International Monetary Fund (IMF). If there is a deficit in the current and capital accounts taken together, then there will be a depletion of reserves. However, if the two accounts show a surplus when taken together, there will be an increase in the level of reserves.

The balance of payments is an accounting system that is based on the double-entry system of bookkeeping. Consequently, every transaction is recorded on both sides, that is as a credit and as a debit. All transactions that have led to or will lead to a flow of payments into the country from the rest of the world will be shown as credits. The payments themselves should be shown as the corresponding debit entries. Similarly, all transactions which have led to or will lead to a flow of payments from the country to the rest of the world should be recorded as debits, and the corresponding payments should be recorded as credits.