The Handbook of Financial Instruments E-Book

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Frank J. Fabozzi Series
• Sprache: Englisch

Seitenzahl: 1552

Veröffentlichungsjahr: 2018

Beschreibung

An investor's guide to understanding and using financial instruments The Handbook of Financial Instruments provides comprehensive coverage of a broad range of financial instruments, including equities, bonds (asset-backed and mortgage-backed securities), derivatives (equity and fixed income), insurance investment products, mutual funds, alternative investments (hedge funds and private equity), and exchange traded funds. The Handbook of Financial Instruments explores the basic features of each instrument introduced, explains their risk characteristics, and examines the markets in which they trade. Written by experts in their respective fields, this book arms individual investors and institutional investors alike with the knowledge to choose and effectively use any financial instrument available in the market today. John Wiley & Sons, Inc. is proud to be the publisher of the esteemed Frank J. Fabozzi Series. Comprising nearly 100 titles-which include numerous bestsellers--The Frank J. Fabozzi Series is a key resource for finance professionals and academics, strategists and students, and investors. The series is overseen by its eponymous editor, whose expert instruction and presentation of new ideas have been at the forefront of financial publishing for over twenty years. His successful career has provided him with the knowledge, insight, and advice that has led to this comprehensive series. Frank J. Fabozzi, PhD, CFA, CPA, is Editor of the Journal of Portfolio Management, which is read by thousands of institutional investors, as well as editor or author of over 100 books on finance for the professional and academic markets. Currently, Dr. Fabozzi is an adjunct Professor of Finance at Yale University's School of Management and on the board of directors of the Guardian Life family of funds and the Black Rock complex of funds.

Leseprobe

THE FRANK J. FABOZZI SERIES

Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate

Handbook of Global Fixed Income Calculations by Dragomir Krgin

Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi

Real Options and Option-Embedded Securities by William T. Moore

Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi

The Exchange-Traded Funds Manual by Gary L. Gastineau

Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi

Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu

Handbook of Alternative Assets by Mark J. P. Anson The Exchange-Traded Funds Manual by Gary L. Gastineau The Global Money Marketsby Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

The Handbook of Financial Instruments

FRANK J. FABOZZI

Copyright © 2002 by Frank J. Fabozzi. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201748-6011, fax [phone], e-mail: [email protected].

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ISBN: 0-471-22092-2

Contents

Preface

Contributing Authors

Chapter 1 Overview of Financial Instruments

DEBT VERSUS EQUITY INSTRUMENTS

CHARACTERISTICS OF DEBT INSTRUMENTS

VALUATION OF A FINANCIAL INSTRUMENT

FINANCIAL MARKETS

BORROWING FUNDS TO PURCHASE FINANCIAL INSTRUMENTS

Note

Chapter 2 Fundamentals of Investing

SETTING INVESTMENT OBJECTIVES

ESTABLISHING AN INVESTMENT POLICY

Notes

Chapter 3 Calculating Investment Returns

SINGLE PERIOD RATE OF RETURN

PERFORMANCE OF AN INVESTMENT: MONEY WEIGHTED RETURNS

PERFORMANCE OF THE INVESTMENT MANAGER: TIME WEIGHTED RETURNS

MULTIPLE PERIOD RETURN CALCULATION

SUMMARY

Chapter 4 Common Stock

COMMON STOCK VERSUS PREFERRED STOCK

WHERE STOCK TRADING OCCURS

TRADING MECHANICS

TRADING COSTS

TRADING ARRANGEMENTS FOR RETAIL AND INSTITUTIONAL INVESTORS

PRICE LIMITS AND COLLARS

STOCK MARKET INDICATORS

PRICING EFFICIENCY OF THE STOCK MARKET

OVERVIEW OF COMMON STOCK PORTFOLIO MANAGEMENT

Notes

Chapter 5 Sources of Information for Investing in Common Stock

SOURCES OF FINANCIAL INFORMATION

INFORMATION PREPARED BY THE COMPANY

INTERVIEWING COMPANY REPRESENTATIVES

INFORMATION PREPARED BY GOVERNMENT AGENCIES

INFORMATION PREPARED BY FINANCIAL SERVICE COMPANIES

SUMMARY

Notes

Chapter 6 Money Market Instruments

U.S. TREASURY BILLS

GOVERNMENT SPONSORED AGENCY INSTRUMENTS

COMMERCIAL PAPER

ASSET-BACKED COMMERCIAL PAPER

MEDIUM-TERM NOTES

LARGE-DENOMINATION NEGOTIABLE CDS

FEDERAL FUNDS

BANKERS ACCEPTANCES

REPURCHASE AGREEMENTS

Notes

Chapter 7 U.S. Treasury Securities

TYPES OF SECURITIES

THE PRIMARY MARKET

THE SECONDARY MARKET

ZERO-COUPON TREASURY SECURITIES

SUMMARY

Notes

Chapter 8 Inflation-Indexed Bonds

MECHANICS AND MEASUREMENT

DURATION

QUOTATION AND SETTLEMENT

Notes

Chapter 9 Federal Agency Securities

FEDERALLY RELATED INSTITUTIONS

GOVERNMENT-SPONSORED ENTERPRISES

Notes

Chapter 10 Municipal Securities

TAX-EXEMPT AND TAXABLE MUNICIPAL SECURITIES

TAX PROVISIONS AFFECTING MUNICIPALS

TYPES OF MUNICIPAL SECURITIES

DEBT RETIREMENT STRUCTURE

CREDIT RISK

TAX RISK

SECONDARY MARKET

YIELDS ON MUNICIPAL BONDS

Notes

Chapter 11 Corporate Bonds

CORPORATE BANKRUPTCY AND CREDITOR RIGHTS

SECURED DEBT1

UNSECURED DEBT

INDENTURES

CORPORATE BOND RATINGS

SPECULATIVE-GRADE BONDS

CORPORATE BOND INDEXES

MEDIUM-TERM NOTES

YIELD AND YIELD SPREADS

CONVERTIBLE BONDS

Notes

Chapter 12 Preferred Stock

PREFERRED STOCK ISSUANCE

PREFERRED STOCK RATINGS

CONVERTIBLE PREFERRED STOCK

Notes

Chapter 13 Emerging Markets Debt

EMERGING MARKETS DEBT INSTRUMENTS

ANALYTICS/MARKET CONVENTIONS

SOVEREIGN CREDIT ANALYSIS

PORTFOLIO CONSIDERATIONS

ACTIVE MANAGEMENT OPPORTUNITIES

CONCLUSION

Notes

Chapter 14 Agency Mortgage-Backed Securities

WHY IT IS IMPORTANT TO UNDERSTAND REAL ESTATE-BACKED SECURITIES

MORTGAGES

MORTGAGE PASSTHROUGH SECURITIES

AGENCY PASSTHROUGHS

STRIPPED MORTGAGE-BACKED SECURITIES

AGENCY COLLATERALIZED MORTGAGE OBLIGATIONS

SUMMARY

Chapter 15 Nonagency MBS and Real Estate-Backed ABS

COLLATERAL FOR RESIDENTIAL REAL ESTATE-BACKED SECURITIES

PREPAYMENT CONVENTIONS

NONAGENCY MBS

REAL ESTATE-BACKED ASSET-BACKED SECURITIES

OTHER PRODUCTS BACKED BY REAL ESTATE MORTGAGES

Notes

Chapter 16 Commercial Mortgage-Backed Securities

HISTORY

TYPES OF CMBS IN TODAY’s MARKET

STRUCTURE OF CMBS

OPTIONALITY

EVALUATING CREDIT QUALITY IN COMMERCIAL MORTGAGE-BACKED SECURITIES

THE UNDERLYING COMMERCIAL REAL ESTATE MORTGAGES

UNDERWRITING CRITERIA

STRUCTURING—TRANSFERRING RISKS AND RETURNS

CONCLUSION

Notes

Chapter 17 Non-Real Estate Asset-Backed Securities

FEATURES OF AN ABS

CREDIT RISKS ASSOCIATED WITH INVESTING IN ABS

Notes

Chapter 18 Credit Card ABS

SECURITIZATION OF CREDIT CARD RECEIVABLES

THE CREDIT CARD ABS MARKET

CONCLUSION

Notes

Chapter 19 Leveraged Loans

WHAT IS A SYNDICATED LOAN?

STRUCTURING AND SYNDICATING LOANS

WINNING A MANDATE

TYPES OF SYNDICATED LOAN FACILITY

SYNDICATING A LOAN BY FACILITY

SECONDARY SALES

PRICING

VOTING RIGHTS

COVENANTS

Notes

Chapter 20 Collateralized Debt Obligations

STRUCTURE OF A CDO

ARBITRAGE TRANSACTIONS

CASH FLOW TRANSACTIONS

MARKET VALUE TRANSACTIONS

SYNTHETIC CDOS

MANAGING A CDO PORTFOLIO

Notes

Chapter 21 Investment Companies

TYPES OF INVESTMENT COMPANIES

FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES

ADVANTAGES OF INVESTING IN MUTUAL FUNDS

TYPES OF FUNDS BY INVESTMENT OBJECTIVE

THE CONCEPT OF A FAMILY OF FUNDS

STRUCTURE OF A FUND

RECENT CHANGES IN THE MUTUAL FUND INDUSTRY

ALTERNATIVES TO MUTUAL FUNDS

Notes

Chapter 22 Exchange-Traded Funds and Their Competitors

ETFS AND OTHER TRADABLE BASKET PRODUCTS

TAXES AND TAX EFFICIENCY IN ETFS AND THEIR COMPETITORS

Notes

Chapter 23 Stable-Value Pension Investments

STABLE-VALUE PRODUCTS

THE EVOLUTION OF STABLE VALUE

STABLE-VALUE PORTFOLIO MANAGEMENT

THE FUTURE OF STABLE VALUE

Chapter 24 Investment-Oriented Life Insurance

INSURANCE

INVESTMENT-ORIENTED LIFE INSURANCE

SUMMARY

Notes

Chapter 25 Hedge Funds

HEDGE FUND REGULATION

HEDGE FUND STRATEGIES

SHOULD HEDGE FUNDS BE PART OF AN INVESTMENT PROGRAM?

IS HEDGE FUND PERFORMANCE PERSISTENT?

A HEDGE FUND INVESTMENT STRATEGY

SELECTING A HEDGE FUND MANAGER

DUE DILIGENCE FOR HEDGE FUND MANAGERS

RISK REVIEW

ADMINISTRATIVE REVIEW

LEGAL REVIEW

REFERENCE CHECKS

Notes

Chapter 26 Private Equity

VENTURE CAPITAL

LEVERAGED BUYOUTS

DEBT AS PRIVATE EQUITY

Notes

Chapter 27 Real Estate Investment

TWO DISTINGUISHING CHARACTERISTICS OF REAL ESTATE INVESTMENTS

THE NATURE OF THE INVESTORS

THE INVESTMENT CHARACTERISTICS OF EACH QUADRANT

REAL ESTATE IN THE MIXED ASSET PORTFOLIO

LEVERAGE

INVESTMENT EXECUTION

OVERVIEW OF ADDITIONAL ISSUES

CONCLUSION

Notes

Chapter 28 Equity Derivatives

THE ROLE OF DERIVATIVES

EQUITY DERIVATIVES MARKET

LISTED EQUITY OPTIONS

FUTURES CONTRACTS

OTC EQUITY DERIVATIVES

Notes

Chapter 29 Interest Rate Derivatives

INTEREST RATE OPTIONS

INTEREST RATE SWAPS

INTEREST RATE CAPS AND FLOORS

Chapter 30 Mortgage Swaps

FEATURES OF MORTGAGE SWAPS

INDEX AMORTIZING SWAP

TOTAL RETURN INDEX SWAPS

APPLICATIONS OF MORTGAGE AND TOTAL RETURN INDEX SWAPS

DISADVANTAGES OF MORTGAGE SWAPS

Notes

Chapter 31 Credit Derivatives

ClEDIT RISK

CREDIT DERIVATIVE INSTRUMENTS

APPLICATIONS FOR PORTFOLIO MANAGERS

RISKS IN CREDIT DEFAULT SWAPS

CONCLUSIONS

Notes

Chapter 32 Managed Futures

INDUSTRY BASICS

HISTORY OF MANAGED FUTURES

PRIOR EMPIRICAL RESEARCH

RETURN DISTRIBUTIONS OF MANAGED FUTURES

MANAGED FUTURES AS DOWNSIDE RISK PROTECTION FOR STOCKS AND BONDS

CONCLUSION

Notes

Index

EULA

Guide

Cover

Table of Contents

Preface

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e1

Preface

One of the most important investment decisions that an investor encounters is the allocation of funds among the wide range of financial instruments. That decision requires an understanding of the investment characteristics of all asset classes. The objective of The Handbook of Financial Instruments is to explain financial instruments and their characteristics.

In Chapter 1, financial assets and financial markets are defined. Also explained in the chapter are the general characteristics of common stock and fixed-income securities, the properties of financial markets, the general principles of valuation, the principles of leverage, mechanisms for borrowing funds in the market using securities as collateral, and the role of derivative products.

Chapter 2 provides the fundamentals of investing. This is done in terms of the phases of the investment management process. The topics included in the chapter are traditional and alternative asset classes, how asset classes are determined, various types of risk, active versus passive portfolio management, and active versus indexed portfolio construction.

Chapter 3 explains the proper methodology for computing investment returns. Complications associated with calculating investment returns include selection of the appropriate inputs in the calculation, treatment of client contributions and withdrawals from an investment account, the timing of contributions and withdrawals, the difference between return earned by the investment manager on the funds invested and the return earned by the client, and how to determine annual returns from subperiod returns (e.g., different methods for averaging).

Equity, more popularly referred to as common stock, is the subject of Chapters 4 and 5. Chapter 4 describes the markets where common stock is traded, the types of trades that can be executed by retail and institutional investors (e.g., block trades and program trades), transaction costs, stock market indicators, the pricing efficiency of the equity market, common stock portfolio management, active portfolio management (e.g., top-down versus bottom-up approaches, fundamental versus technical analysis, popular active stock market strategies, and equity style management). Where an investor can obtain information about the issuers of common stock and the type of information available is the subject of Chapter 5.

Chapters 6 through 20 cover fixed income products—money market instruments, Treasury securities (fixed principal and inflation indexed securities), federal agency securities, municipal securities, corporate bonds, preferred stock, emerging market debt, leveraged loans, and structured products. Structured products covered include agency mortgage-backed securities, nonagency mortgage-backed securities, real estate-backed asset-backed securities (e.g., home equity loan-backed securities and manufactured home loan-backed securities), commercial mortgage-backed securities, non-real estate-backed securities (e.g., credit card receivable-backed securities, auto loan-backed securities, Small Business Administration loan-backed securities, student loan-backed securities, aircraft lease-backed securities, and rate reduction bonds), and collateralized debt obligations.

Chapter 21 provides comprehensive coverage of investment companies, more popularly referred to as mutual funds. Topics covered are the types of investment companies, fund sales charges and annual operating expenses, multiple share classes, types of funds by investment objective, regulation of funds, the advantages and disadvantages of mutual funds, and alternatives to mutual funds. One alternative to a mutual fund is an exchange-traded fund. The advantages of an exchange-traded fund are explained Chapter 22, which also covers competitor products.

Stable value products are covered in Chapter 23. These products provide for a guaranteed return of principal at a contractually specified rate, the guarantee being only as good as the issuer of the contract. Examples include fixed annuities and traditional guaranteed investment contracts (GICs), separate account GICs, and bank investment contracts. Comprehensive coverage of investment-oriented life insurance products is provided in Chapter 24. These products include cash value life insurance (variable life, universal life, and variable universal life) and annuities (variable, fixed, and GICs). General account versus separate account products and the taxability of life insurance products are also discussed in the chapter.

Two major alternative asset classes are hedge funds and private equity. They are the subject of Chapters 25 and 26, respectively. The coverage of hedge funds includes regulation, strategies employed by hedge funds (e.g., long/short hedge funds, global macro hedge fund, short selling hedge funds, arbitrage hedge funds, and market neutral hedge funds), evidence on performance persistence, selecting a hedge fund manager, and the various aspects of due diligence. Private equity includes four strategies for private investing—venture capital (i.e., financing of start-up companies), leverage buyouts, mezzanine financing (hybrid of private debt and private equity), and distressed debt investing. Each of these strategies is reviewed in Chapter 26.

Real estate investment is covered in Chapter 27. The topics covered include the distinguishing features of real estate investments, the nature of the investors, components of the real estate investment universe (private equity, private debt, commercial mortgage-backed securities, and public equity) and their risk/return characteristics, the primary reasons to consider real estate in an investment portfolio, and how to bring real estate into a portfolio (i.e., execution).

Derivative instruments are covered in Chapters 28-31—futures/forward contracts, options, futures options, swaps, caps, and floors. The focus is on how these instruments can be employed to control risk. Chapter 28 covers equity derivatives and describes the fundamentals of pricing stock index futures and options on individual stocks. Chapter 29 is devoted to interest rate derivatives and how they are employed to control interest rate risk. Because of the unique investment characteristics of mortgage-backed securities, instruments are available that can be used by institutional investors to control the interest rate and prepayment risks associated with these securities and to obtain exposure to the market on a leveraged basis. These products, mortgage swaps, are described in Chapter 30. In addition to controlling interest rate risk, investors are concerned with credit risk. Instruments for controlling this risk, credit derivatives, are explained in Chapter 31.

Managed futures, an alternative asset class, is the subject of Chapter 32. The term managed futures refers to the active trading of futures and forward contracts. The underlying for the futures/forward contracts traded can be financial instruments (stock indexes or bonds), commodities, or currencies (i.e., foreign exchange).

The Handbook of Financial Instruments provides the most comprehensive coverage of financial instruments that has ever been assembled in a single volume. I thank all of the contributors to this book for their willingness to take the time from their busy schedules to contribute.

Frank J. Fabozzi

Contributing Authors

William J. Adams

Massachusetts Financial Services

Mark J. P. Anson

CalPERS

John B. Brynjolfsson

PIMCO Real Return Bond Fund

John R. Caswell

Galliard Capital Management

Moorad Choudhry

City University Business School

Bruce M.Collins

QuantCast

Joseph F. DeMichele

Delaware Investments

John Dunlevy

Beacon Hill Asset Management

Frank J. Fabozzi

Yale University

Bruce Feibel

Eagle Investment Systems

Michael J. Fleming

Federal Reserve Bank of New York

Gary L. Gastineau

ETF Advisors, LLC

Laurie S. Goodman

UBS Warburg

Duane C. Hewlett

Delaware Investments

Susan Hudson-Wilson

Property & Portfolio Research, LLC

Robert R. Johnson

Association for Investment Management and Research

Frank J. Jones

The Guardian Life Insurance Company of America

George P. Kegler

Cassian Market Consultants

Maria Mednikov Loucks

UBS Asset Management

Steven V. Mann

University of South Carolina

John N. McElravey

Banc One Capital Markets, Inc.

Steven Miller

Standard & Poor’s

John A. Penicook, Jr.

UBS Asset Management

Pamela P. Peterson

Florida State University

Uwe Schillhorn

UBS Asset Management

Karl P. Tourville

Galliard Capital Management

David Yuen

Franklin Templeton Investments

Thomas A. Zimmerman

UBS Warburg

Chapter 1Overview of Financial Instruments

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Broadly speaking, an asset is any possession that has value in an exchange. Assets can be classified as tangible or intangible. A tangible asset is one whose value depends on particular physical properties—examples are buildings, land, or machinery. Intangible assets, by contrast, represent legal claims to some future benefit. Their value bears no relation to the form, physical or otherwise, in which these claims are recorded. Financial assets are intangible assets. For financial assets, the typical benefit or value is a claim to future cash. This book deals with the various types of financial assets or financial instruments.

The entity that has agreed to make future cash payments is called the issuer of the financial instrument; the owner of the financial instrument is referred to as the investor. Here are seven examples of financial instruments:

A loan by Fleet Bank (investor/commercial bank) to an individual (issuer/borrower) to purchase a car

A bond issued by the U.S. Department of the Treasury

A bond issued by Ford Motor Company

A bond issued by the city of Philadelphia

A bond issued by the government of France

A share of common stock issued by Microsoft Corporation, an American company

A share of common stock issued by Toyota Motor Corporation, a Japanese company

In the case of the car loan by Fleet Bank, the terms of the loan establish that the borrower must make specified payments to the commercial bank over time. The payments include repayment of the amount borrowed plus interest. The cash flow for this asset is made up of the specified payments that the borrower must make.

In the case of a U.S. Treasury bond, the U.S. government (the issuer) agrees to pay the holder or the investor the interest payments every six months until the bond matures, then at the maturity date repay the amount borrowed. The same is true for the bonds issued by Ford Motor Company, the city of Philadelphia, and the government of France. In the case of Ford Motor Company, the issuer is a corporation, not a government entity. In the case of the city of Philadelphia, the issuer is a municipal government. The issuer of the French government bond is a central government entity.

The common stock of Microsoft entitles the investor to receive dividends distributed by the company. The investor in this case also has a claim to a pro rata share of the net asset value of the company in case of liquidation of the company. The same is true of the common stock of Toyota Motor Corporation.

DEBT VERSUS EQUITY INSTRUMENTS

Financial instruments can be classified by the type of claim that the holder has on the issuer. When the claim is for a fixed dollar amount, the financial instrument is said to be a debt instrument. The car loan, the U.S. Treasury bond, the Ford Motor Company bond, the city of Philadelphia bond, and the French government bond are examples of debt instruments requiring fixed payments.

In contrast to a debt obligation, an equity instrument obligates the issuer of the financial instrument to pay the holder an amount based on earnings, if any, after the holders of debt instruments have been paid. Common stock is an example of an equity claim. A partnership share in a business is another example.

Some securities fall into both categories in terms of their attributes. Preferred stock, for example, is an equity instrument that entitles the investor to receive a fixed amount. This payment is contingent, however, and due only after payments to debt instrument holders are made. Another “combination” instrument is a convertible bond, which allows the investor to convert debt into equity under certain circumstances. Both debt instruments and preferred stock that pay fixed dollar amounts are called fixed-income instruments.

CHARACTERISTICS OF DEBT INSTRUMENTS

As will become apparent, there are a good number of debt instruments available to investors. Debt instruments include loans, money market instruments, bonds, mortgage-backed securities, and asset-backed securities. In the chapters that follow, each will be described. There are features of debt instruments that are common to all debt instruments and they are described below. In later chapters, there will be a further discussion of these features as they pertain to debt instruments of particular issuers.

Maturity

The term to maturity of a debt obligation is the number of years over which the issuer has promised to meet the conditions of the obligation. At the maturity date, the issuer will pay off any amount of the debt obligation outstanding. The convention is to refer to the “term to maturity” as simply its “maturity” or “term.” As we explain later, there may be provisions that allow either the issuer or holder of the debt instrument to alter the term to maturity.

The market for debt instruments is classified in terms of the time remaining to its maturity. A money market instrument is a debt instrument which has one year or less remaining to maturity. Debt instruments with a maturity greater than one year are referred to as a capital market debt instrument.

Par Value

The par value of a bond is the amount that the issuer agrees to repay the holder of the debt instrument by the maturity date. This amount is also referred to as the principal, face value, redemption value, or maturity value. Bonds can have any par value.

Because debt instruments can have a different par value, the practice is to quote the price of a debt instrument as a percentage of its par value. A value of 100 means 100% of par value. So, for example, if a debt instrument has a par value of $1,000 and is selling for $900, it would be said to be selling at 90. If a debt instrument with a par value of $5,000 is selling for $5,500, it is said to be selling for 110. The reason why a debt instrument sells above or below its par value is explained in Chapter 2.

Coupon Rate

The coupon rate, also called the nominal rate or the contract rate, is the interest rate that the issuer/borrower agrees to pay each year. The dollar amount of the payment, referred to as the coupon interest payment or simply interest payment, is determined by multiplying the coupon rate by the par value of the debt instrument. For example, the interest payment for a debt instrument with a 7% coupon rate and a par value of $1,000 is $70 (7% times $1,000).

The frequency of interest payments varies by the type of debt instrument. In the United States, the usual practice for bonds is for the issuer to pay the coupon in two semiannual installments. Mortgage-backed securities and asset-backed securities typically pay interest monthly. For bonds issued in some markets outside the United States, coupon payments are made only once per year. Loan interest payments can be customized in any manner.

Zero-Coupon Bonds

Not all debt obligations make periodic coupon interest payments. Debt instruments that are not contracted to make periodic coupon payments are called zero-coupon instruments. The holder of a zero-coupon instrument realizes interest income by buying it substantially below its par value. Interest then is paid at the maturity date, with the interest earned by the investor being the difference between the par value and the price paid for the debt instrument. So, for example, if an investor purchases a zero-coupon instrument for 70, the interest realized at the maturity date is 30. This is the difference between the par value (100) and the price paid (70).

There are bonds that are issued as zero-coupon instruments. Moreover, in the money market there are several types of debt instruments that are issued as discount instruments. These are discussed in Chapter 6.

There is another type of debt obligation that does not pay interest until the maturity date. This type has contractual coupon payments, but those payments are accrued and distributed along with the maturity value at the maturity date. These instruments are called accrued coupon instruments or accrual securities or compound interest securities.

Floating-Rate Securities

The coupon rate on a debt instrument need not be fixed over its lifetime. Floating-rate securities, sometimes called floaters or variable-rate securities, have coupon payments that reset periodically according to some reference rate. The typical formula for the coupon rate on the dates when the coupon rate is reset is:

Reference rate ± Quoted margin

The quoted margin is the additional amount that the issuer agrees to pay above the reference rate (if the quoted margin is positive) or the amount less than the reference rate (if the quoted margin is negative). The quoted margin is expressed in terms of basis points. A basis point is equal to 0.0001 or 0.01%. Thus, 100 basis points are equal to 1%.

To illustrate a coupon reset formula, suppose that the reference rate is the 1-month London interbank offered rate (LIBOR)—an interest rate described in Chapter 6. Suppose that the quoted margin is 150 basis points. Then the coupon reset formula is:

1-month LIBOR + 150 basis points

So, if 1-month LIBOR on the coupon reset date is 5.5%, the coupon rate is reset for that period at 7% (5% plus 200 basis points).

The reference rate for most floating-rate securities is an interest rate or an interest rate index. There are some issues where this is not the case. Instead, the reference rate is the rate of return on some financial index such as one of the stock market indexes discussed in Chapter 4. There are debt obligations whose coupon reset formula is tied to an inflation index. These instruments are described in Chapter 8.

Typically, the coupon reset formula on floating-rate securities is such that the coupon rate increases when the reference rate increases, and decreases when the reference rate decreases. There are issues whose coupon rate moves in the opposite direction from the change in the reference rate. Such issues are called inverse floaters or reverse floaters.

A floating-rate debt instrument may have a restriction on the maximum coupon rate that will be paid at a reset date. The maximum coupon rate is called a cap.

Because a cap restricts the coupon rate from increasing, a cap is an unattractive feature for the investor. In contrast, there could be a minimum coupon rate specified for a floating-rate security. The minimum coupon rate is called a floor. If the coupon reset formula produces a coupon rate that is below the floor, the floor is paid instead. Thus, a floor is an attractive feature for the investor.

Provisions for Paying off Debt Instruments

The issuer/borrower of a debt instrument agrees to repay the principal by the stated maturity date. The issuer/borrower can agree to repay the entire amount borrowed in one lump sum payment at the maturity date. That is, the issuer/borrower is not required to make any principal repayments prior to the maturity date. Such bonds are said to have a bullet maturity. An issuer may be required to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement.

There are loans, mortgage-backed securities, and asset-backed securities pools of loans that have a schedule of principal repayments that are made prior to the final maturity of the instrument. Such debt instruments are said to be amortizing instruments.

There are debt instruments that have a call provision. This provision grants the issuer/borrower an option to retire all or part of the issue prior to the stated maturity date. Some issues specify that the issuer must retire a predetermined amount of the issue periodically. Various types of call provisions are discussed below.

Call and Refunding Provisions

A borrower generally wants the right to retire a debt instrument prior to the stated maturity date because it recognizes that at some time in the future the general level of interest rates may fall sufficiently below the coupon rate so that redeeming the issue and replacing it with another debt instrument with a lower coupon rate would be economically beneficial. This right is a disadvantage to the investor since proceeds received must be reinvested at a lower interest rate. As a result, a borrower who wants to include this right as part of a debt instrument must compensate the investor when the issue is sold by offering a higher coupon rate.

The right of the borrower to retire the issue prior to the stated maturity date is referred to as a “call option.” If the borrower exercises this right, the issuer is said to “call” the debt instrument. The price that the borrower must pay to retire the issue is referred to as the call price.

When a debt instrument is issued, typically the borrower may not call it for a number of years. That is, the issue is said to have a deferred call. The date at which the debt instrument may first be called is referred to as the first call date.

If a bond issue does not have any protection against early call, then it is said to be a currently callable issue. But most new bond issues, even if currently callable, usually have some restrictions against certain types of early redemption. The most common restriction is prohibiting the refunding of the bonds for a certain number of years. Refunding a bond issue means redeeming bonds with funds obtained through the sale of a new bond issue.

Many investors are confused by the terms noncallable and nonrefundable. Call protection is much more absolute than refunding protection. While there may be certain exceptions to absolute or complete call protection in some cases, it still provides greater assurance against premature and unwanted redemption than does refunding protection. Refunding prohibition merely prevents redemption only from certain sources of funds, namely the proceeds of other debt issues sold at a lower cost of money. The bondholder is only protected if interest rates decline, and the borrower can obtain lower-cost money to pay off the debt.

Prepayments

For amortizing instruments—such as loans and securities that are backed by loans—there is a schedule of principal repayments but individual borrowers typically have the option to pay off all or part of their loan prior to the scheduled date. Any principal repayment prior to the scheduled date is called a prepayment. The right of borrowers to prepay is called the prepayment option. Basically, the prepayment option is the same as a call option.

Options Granted to Bondholders

There are provisions in debt instruments that give either the investor and/or the issuer an option to take some action against the other party. The most common type of embedded option is a call feature, which was discussed earlier. This option is granted to the issuer. There are two options that can be granted to the owner of the debt instrument: the right to put the issue and the right to convert the issue.

A debt instrument with a put provision grants the investor the right to sell it back to the borrower at a specified price on designated dates. The specified price is called the put price. The advantage of the put provision to the investor is that if after the issuance date of the debt instrument market interest rates rise above the debt instrument’s coupon rate, the investor can force the borrower to redeem the bond at the put price and then reinvest the proceeds at the prevailing higher rate.

A convertible debt instrument is one that grants the investor the right to convert or exchange the debt instrument for a specified number of shares of common stock. Such a feature allows the investor to take advantage of favorable movements in the price of the borrower’s common stock or equity.

VALUATION OF A FINANCIAL INSTRUMENT

Valuation is the process of determining the fair value of a financial instrument. Valuation is also referred to as “pricing” a financial instrument. Once this process is complete, we can compare a financial instrument’s computed fair value as determined by the valuation process to the price at which it is trading for in the market (i.e., the market price). Based on this comparison, an investor will be able to assess the investment merit of a financial instrument.

There are three possibilities summarized below along with their investment implications.

Market Price versus Fair Value

Investment Implications

Market price equal to fair value

Financial instrument is fairly priced

Market price is less than fair value

Financial instrument is undervalued

Market price is greater than fair value

Financial instrument is overvalued

A financial instrument that is undervalued is said to be “trading cheap” and is a candidate for purchase. If a financial instrument is overvalued, it is said to be “trading rich.” In this case, an investor should sell the financial instrument if he or she already owns it. Or, if the financial instrument is not owned, it is possible for the investor to sell it anyway. Selling a financial instrument that is not owned is a common practice in some markets. This market practice is referred to as “selling short.” We will discuss the mechanics of selling short in Chapter 4. The two reasons why we say that it is possible for an investor to sell short are (1) the investor must be permitted or authorized to do so and (2) the market for the financial instrument must have a mechanism for short selling.

FINANCIAL MARKETS

A financial market is a market where financial instruments are exchanged (i.e., traded). Although the existence of a financial market is not a necessary condition for the creation and exchange of a financial instrument, in most economies financial instruments are created and subsequently traded in some type of financial market. The market in which a financial asset trades for immediate delivery is called the spot market or cash market.

Role of Financial Markets

Financial markets provide three major economic functions. First, the interactions of buyers and sellers in a financial market determine the price of the traded asset. Or, equivalently, they determine the required return on a financial instrument. Because the inducement for firms to acquire funds depends on the required return that investors demand, it is this feature of financial markets that signals how the funds in the financial market should be allocated among financial instruments. This is called the price discovery process.

Second, financial markets provide a mechanism for an investor to sell a financial instrument. Because of this feature, it is said that a financial market offers “liquidity,” an attractive feature when circumstances either force or motivate an investor to sell. If there were not liquidity, the owner would be forced to hold a financial instrument until the issuer initially contracted to make the final payment (i.e., until the debt instrument matures) and an equity instrument until the company is either voluntarily or involuntarily liquidated. While all financial markets provide some form of liquidity, the degree of liquidity is one of the factors that characterize different markets.

The third economic function of a financial market is that it reduces the cost of transacting. There are two costs associated with transacting: search costs and information costs. Search costs represent explicit costs, such as the money spent to advertise one’s intention to sell or purchase a financial instrument, and implicit costs, such as the value of time spent in locating a counterparty. The presence of some form of organized financial market reduces search costs. Information costs are costs associated with assessing the investment merits of a financial instrument, that is, the amount and the likelihood of the cash flow expected to be generated. In a price efficient market, prices reflect the aggregate information collected by all market participants.

Classification of Financial Markets

There are many ways to classify financial markets. One way is by the type of financial claim, such as debt markets and equity markets. Another is by the maturity of the claim. For example, the money market is a financial market for short-term debt instruments; the market for debt instruments with a maturity greater than one year and equity instruments is called the capital market.

Financial markets can be categorized as those dealing with financial claims that are newly issued, called the primary market, and those for exchanging financial claims previously issued, called the secondary market or the market for seasoned instruments.

Markets are classified as either cash markets or derivative markets. The latter is described later in this chapter. A market can be classified by its organizational structure: It may be an auction market or an over-the-counter market. We describe these organizational structures when we discuss the market for common stocks in Chapter 4.

BORROWING FUNDS TO PURCHASE FINANCIAL INSTRUMENTS