You are on page 1of 46

Guide to Financial Markets

Guide to Financial Markets.indd 1 23/10/2013 14:14


other economist books

Guide to Analysing Companies


Guide to Business Modelling
Guide to Business Planning
Guide to Cash Management
Guide to Commodities
Guide to Decision Making
Guide to Economic Indicators
Guide to Emerging Markets
Guide to the European Union
Guide to Financial Management
Guide to Hedge Funds
Guide to Investment Strategy
Guide to Management Ideas and Gurus
Guide to Managing Growth
Guide to Organisation Design
Guide to Project Management
Guide to Supply Chain Management
Numbers Guide
Style Guide

Book of Business Quotations


Book of Isms
Book of Obituaries
Brands and Branding
Business Consulting
Business Strategy
Buying Professional Services
Doing Business in China
Economics
Managing Talent
Managing Uncertainty
Marketing
Marketing for Growth
Megachange the world in 2050
Modern Warfare, Intelligence and Deterrence
Organisation Culture
Successful Strategy Execution
The World of Business

Directors: an AZ Guide
Economics: an AZ Guide
Investment: an AZ Guide
Negotiation: an AZ Guide

Pocket World in Figures

Guide to Financial Markets.indd 2 29/10/2013 14:40


Guide to Financial
Markets
Why they exist and how they work

Sixth edition

Marc Levinson

Guide to Financial Markets.indd 3 29/10/2013 16:52


THE ECONOMIST IN ASSOCIATION WITH
PROFILE BOOKS LTD

Published by Profile Books Ltd


3a Exmouth House
Pine Street
London ec1r 0jh
www.profilebooks.com

Copyright The Economist Newspaper Ltd, 1999, 2000, 2002, 2006, 2010, 2014
Text copyright Marc Levinson, 2014

All rights reserved. Without limiting the rights under copyright reserved above, no part
of this publication may be reproduced, stored in or introduced into a retrieval system,
or transmitted, in any form or by any means (electronic, mechanical, photocopying,
recording or otherwise), without the prior written permission of both the copyright
owner and the publisher of this book.

The greatest care has been taken in compiling this book. However, no responsibility
can be accepted by the publishers or compilers for the accuracy of the information
presented.

Where opinion is expressed it is that of the author and does not necessarily coincide
with the editorial views of The Economist Newspaper.

While every effort has been made to contact copyright-holders of material produced or
cited in this book, in the case of those it has not been possible to contact successfully,
the author and publishers will be glad to make amendments in further editions.

Typeset in EcoType by MacGuru Ltd


info@macguru.org.uk

Printed in Great Britain by Clays, Bungay, Suffolk

A CIP catalogue record for this book is available from the British Library

Hardback isbn: 978 1 78125 106 5


Paperback isbn: 978 1 78125 107 2
e-book isbn: 978 1 84765 953 8

The paper this book is printed on is certified by the


1996 Forest Stewardship Council A.C. (FSC).
It is ancient-forest friendly. The printer holds FSC chain of custody SGS-COC-2061

Guide to Financial Markets.indd 4 29/10/2013 14:43


Contents

1 Why markets matter 1


2 Foreign-exchange markets 17
3 Money markets 44
4 Bond markets 70
5 Securitisation 111
6 International fixed-income markets 137
7 Equity markets 154
8 Futures and options markets 197
9 Derivatives markets 253

Index 275

Guide to Financial Markets.indd 5 23/10/2013 14:14


Guide to Financial Markets.indd 6 23/10/2013 14:14
1 Why markets matter

The euro is slightly higher against the yen. The Dow Jones
Industrial Average is off 18 points in active trading. A Chinese airline
loses millions of dollars with derivatives. Following the Bank of
Englands decision to lower its base rate, monthly mortgage payments
are set to fall.
All these events are examples of financial markets at work. That
markets exercise enormous influence over modern life comes as no
news. But although people around the world speak glibly of Wall
Street, the bond market and the currency markets, the meanings
they attach to these time-worn phrases are often vague and usually out
of date. This book explains the purposes different financial markets
serve and clarifies the way they work. It cannot tell you whether your
investment portfolio is likely to rise or to fall in value. But it may help
you understand how its value is determined, and how the different
securities in it are created and traded.

In the beginning
The word market usually conjures up an image of the bustling,
paper-strewn floor of the New York Stock Exchange or of traders
motioning frantically in the futures pits of Chicago. These images
themselves are out of date, as almost all of the dealing once done face
to face is now handled computer to computer, often with minimal
human intervention. And formal exchanges such as these are only
one aspect of the financial markets, and far from the most important
one. There were financial markets long before there were exchanges
and, in fact, long before there was organised trading of any sort.

Guide to Financial Markets.indd 1 23/10/2013 14:14


2 Guide to financial markets

Financial markets have been around ever since mankind settled


down to growing crops and trading them with others. After a bad
harvest, those early farmers would have needed to obtain seed for the
next seasons planting, and perhaps to get food to see their families
through. Both of these transactions would have required them to
obtain credit from others with seed or food to spare. After a good
harvest, the farmers would have had to decide whether to trade away
their surplus immediately or to store it, a choice that any 21st-century
commodities trader would find familiar. The amount of fish those
early farmers could obtain for a basket of cassava would have varied
day by day, depending upon the catch, the harvest and the weather;
in short, their exchange rates were volatile.
The independent decisions of all of those farmers constituted a
basic financial market, and that market fulfilled many of the same
purposes as financial markets do today.

What do markets do?


Financial markets take many different forms and operate in diverse
ways. But all of them, whether highly organised, like the London
Stock Exchange, or highly informal, like the money changers on the
street corners of some African cities, serve the same basic functions.

Price setting. The value of an ounce of gold or a share of stock


is no more, and no less, than what someone is willing to pay to
own it. Markets provide price discovery, a way to determine the
relative values of different items, based upon the prices at which
individuals are willing to buy and sell them.
Asset valuation. Market prices offer the best way to determine
the value of a firm or of the firms assets, or property. This is
important not only to those buying and selling businesses, but
also to regulators. An insurer, for example, may appear strong if
it values the securities it owns at the prices it paid for them years
ago, but the relevant question for judging its solvency is what
prices those securities could be sold for if it needed cash to pay
claims today.

Guide to Financial Markets.indd 2 23/10/2013 14:14


Why markets matter 3

Arbitrage. In countries with poorly developed financial markets,


commodities and currencies may trade at very different prices
in different locations. As traders in financial markets attempt to
profit from these divergences, prices move towards a uniform
level, making the entire economy more efficient.
Raising capital. Firms often require funds to build new facilities,
replace machinery or expand their business in other ways.
Shares, bonds and other types of financial instruments make this
possible. The financial markets are also an important source of
capital for individuals who wish to buy homes or cars, or even
to make credit-card purchases.
Commercial transactions. As well as long-term capital,
the financial markets provide the grease that makes many
commercial transactions possible. This includes such things
as arranging payment for the sale of a product abroad, and
providing working capital so that a firm can pay employees if
payments from customers run late.
Investing. The stock, bond and money markets provide an
opportunity to earn a return on funds that are not needed
immediately, and to accumulate assets that will provide an
income in future.
Risk management. Futures, options and other derivatives
contracts can provide protection against many types of risk, such
as the possibility that a foreign currency will lose value against
the domestic currency before an export payment is received.
They also enable the markets to attach a price to risk, allowing
firms and individuals to trade risks so they can reduce their
exposure to some while retaining exposure to others.

The size of the markets


Estimating the overall size of the financial markets is difficult. It is
hard in the first place to decide exactly what transactions should be
included under the rubric financial markets, and there is no way to
compile complete data on each of the millions of sales and purchases
occurring each year. Total capital market financing was approximately

Guide to Financial Markets.indd 3 23/10/2013 14:14


4 Guide to financial markets

$6.5 trillion worldwide in 2011, excluding purely domestic loans that


were not resold in the form of securities (see Table 1.1).

Table 1.1 Amounts raised in financial markets


Net of repayments, $bn

2000 2004 2006 2008 2011

International bank loans 714 1,343 2,816 1,279 185


International bonds and notes 1,148 1,560 2,617 2,436 1,212
International money-market instruments 87 61 168 82 6
Domestic bonds and notes 865 2,461 2,322 2,282 2,566
Domestic money-market instruments 377 774 983 1,462 611
International equity issues 318 214 371 392 485
Domestic equity issues 901 593 717 999 617
Total excluding domestic loans 4,410 7,006 9,994 6,374 4,448

Sources: Bank for International Settlements; World Federation of Exchanges; Thomson Reuters

The figure of $4.5 trillion for 2011, sizeable as it is, represents only a
single years activity. Another way to look at the markets is to estimate
the value of all the financial instruments they trade. When measured
in this way, the financial markets accounted for $180 trillion of capital
in 2011 (see Table 1.2). This figure excludes many important financial
activities, such as insurance underwriting, bank lending to individuals
and small businesses, and trading in financial instruments such as
futures and derivatives that are not means of raising capital. If all of
these other financial activities were to be included, the total size of
the markets would be much larger.

Cross-border measure
Another way of measuring the growth of finance is to examine the
value of cross-border financing. Cross-border finance is by no means
new, and at various times in the past (in the late 19th century, for
example) it has been quite large relative to the size of the world
economy. The period since 1990 has been marked by a huge increase

Guide to Financial Markets.indd 4 23/10/2013 14:14


Why markets matter 5

Table 1.2 The worlds financial markets


Year end, $trn

2000 2004 2006 2008 2011

International bonds and notes 6.1 13.2 18.4 23.9 28.5


International money-market instruments 0.3 0.7 0.9 1.1 1.0
Domestic bonds and notes 23.8 35.9 49.7 59.7 69.6
Domestic money-market instruments 6.0 8.2 10.1 12.8 11.5
International bank loans 8.3 13.9 18.9 22.5 22.3
Equities 31.1 37.2 50.7 32.6 47.4
Total value outstanding 75.6 109.1 148.7 152.6 180.3

Sources: Bank for International Settlements; World Federation of Exchanges

in the amount of international financing broken by financial crises


in Asia and Russia in 1998, the recession in the United States in 2001,
and the financial meltdowns of 200809 in the United States and
200813 in Europe. The total stock of cross-border finance in 2013,
including international bank loans and debt issues, was more than
$52 trillion, according to the Bank for International Settlements.
Looking strictly at securities provides an even more dramatic
picture of the growth of the financial markets. A quarter of a century
ago, cross-border purchases and sales of securities amounted to only
a tiny fraction of most countries economic output. Today, annual
cross-border share and bond transactions are several times larger than
GDP in a number of advanced economies Japan being a notable
exception.

International breakdown
The ways in which firms and governments raise funds in international
markets have changed substantially. In 1993, bonds accounted for
59% of international financing. By 1997, before the financial crises in
Asia and Russia shook the markets, only 47% of the funds raised on
international markets were obtained through bond issues. Equities
became an important source of cross-border financing in 2000, when
share prices were high, but bonds and loans regained importance

Guide to Financial Markets.indd 5 23/10/2013 14:14


6 Guide to financial markets

in the low-interest-rate environment of 200205. In 2008, syndicated


lending fell off as lack of capital forced banks to restrain their lending
activities. Issuance of international bonds was relatively flat in the
years following 2008, as non-financial companies increased their
bond issuance even while banks reduced their outstanding bond
indebtedness. Table 1.3 lists the amounts of capital raised by the main
instruments used in international markets.

Table 1.3 Financing on international capital markets


Type of instrument, $bn

2000 2004 2008 2012

Bonds and money-market instruments 1,241 1,621 2,416 705


Equities 317 214 392 630
Syndicated loans 1,485 1,807 1,682 1,841
Total 3,043 3,642 4,490 3,176

Source: Bank for International Settlements

Turn-of-the-century slowdown
By all these measures, financial markets grew rapidly during the 1990s.
At the start of the decade, active trading in financial instruments was
confined to a small number of countries, and involved mainly the
same types of securities, bonds and equities that had dominated
trading for two centuries. By the first years of the 21st century, financial
markets were thriving in dozens of countries, and new instruments
accounted for a large proportion of market dealings.
The expansion of financial-market activity paused in 1998
in response to banking and exchange-rate crises in a number of
countries. The crises passed quickly, however, and in 1999 financial-
market activity reached record levels following the inauguration of the
single European currency, interest-rate decreases in Canada, the UK
and Continental Europe, and a generally positive economic picture,
marred by only small rises in interest rates, in the United States.
Equity-market activity slowed sharply in 2000 and 2001, as share
prices fell in many countries, but bond-market activity was robust.

Guide to Financial Markets.indd 6 23/10/2013 14:14


Why markets matter 7

Trading in foreign-exchange markets fell markedly at the turn of the


century. Credit and equity markets around the world were buoyant
in 200607, but then contracted abruptly as financial crisis led to
the failures of several major financial institutions and a dramatic
reduction in lending. Although credit markets began to recover
in 2009, their expansion was subdued because of the prolonged
financial crisis affecting the euro zone, recession or sluggish growth in
a number of major economies, and new regulatory requirements that
constrained bank lending and discouraged use of certain financing
methods, notably securitisation. By making large-scale purchases of
bonds in 201013, the major central banks played a significant role in
supporting credit-market expansion to meet the needs of businesses
and households.
The long-run trends of increased financial-market activity can be
traced to four main factors:

Lower inflation. Inflation rates around the world have fallen


markedly since the 1980s. Inflation erodes the value of financial
assets and increases the value of physical assets, such as houses
and machines, which will cost far more to replace than they
are worth today. When inflation is high, as was the case in the
United States, Canada and much of Europe during the 1970s
and throughout Latin America in the 1980s, firms avoid raising
long-term capital because investors require a high return on
investment, knowing that price increases will render much of
that return illusory. In a low-inflation environment, however,
financial-market investors require less of an inflation premium,
as they do not expect general increases in prices to devalue their
assets.
Pensions. A significant change in pension policies occurred
in many countries starting in the 1990s. Since the 1930s, and
even earlier in some countries, governments have operated
pay-as-you-go schemes to provide income to the elderly. These
schemes, such as the old age pension in the UK and the social
security programme in the United States, tax current workers
to pay current pensioners and therefore involve no saving or
investment. Changes in demography and working patterns have

Guide to Financial Markets.indd 7 23/10/2013 14:14


8 Guide to financial markets

made pay-as-you-go schemes increasingly costly to support,


as there are fewer young workers relative to the number of
pensioners. This has stimulated interest in pre-funded individual
pensions, whereby each worker has an account in which money
must be saved, and therefore invested, until retirement. Although
these personal investment accounts have to some extent
supplanted firms private pension plans, they have also led to
a huge increase in financial assets in countries where private
pension schemes were previously uncommon.
Stock and bond market performance. Many countries stock
and bond markets performed well during most of the 1990s and
in the period before 2008, with the global bond-market boom
continuing until interest rates began to rise in 2013. Stockmarkets,
after several difficult years, rose steeply in many countries in
2012 and 2013. A rapid increase in financial wealth feeds on
itself: investors whose portfolios have appreciated are willing to
reinvest some of their profits in the financial markets. And the
appreciation in the value of their financial assets gives investors
the collateral to borrow additional money, which can then be
invested.
Risk management. Innovation has generated many new
financial products, such as derivatives and asset-backed
securities, whose basic purpose is to redistribute risk. This led
to enormous growth in the use of financial markets for risk-
management purposes. To an extent previously unimaginable,
firms and investors could choose which risks they wished to
bear and use financial instruments to shed the risks they did
not want, or, alternatively, to take on additional risks in the
expectation of earning higher returns. The risk that the euro
will trade above $1.40 during the next six months, or that the
interest rate on long-term US Treasury bonds will rise to 6%, is
now priced precisely in the markets, and financial instruments to
protect against these contingencies are readily available. The risk
management revolution thus resulted in an enormous expansion
of financial-market activity. The credit crisis that began in
2007, however, revealed that the pricing of many of these risk-
management products did not properly reflect the risks involved.

Guide to Financial Markets.indd 8 23/10/2013 14:14


Why markets matter 9

As a result, these products have become more costly, and are


being used more sparingly, than in earlier years.

The investors
The driving force behind financial markets is the desire of investors to
earn a return on their assets. This return has two distinct components:

Yield is the income the investor receives while owning an


investment.
Capital gains are increases in the value of the investment itself,
and are often not available to the owner until the investment is
sold.

Investors preferences vary as to which type of return they prefer,


and these preferences, in turn, will affect their investment decisions.
Some financial-market products are deliberately designed to offer only
capital gains and no yield, or vice versa, to satisfy these preferences.
Investors can be divided broadly into two categories:

Individuals. Collectively, individuals own a small proportion


of financial assets. Most households in the wealthier countries
own some financial assets, often in the form of retirement
savings or of shares in the employer of a household member.
Most such holdings, however, are quite small, and their
composition varies greatly from one country to another.
In 2010, equities accounted for 9% of households financial
assets in Germany but 34% in Finland. The great majority of
individual investment is controlled by a comparatively small
number of wealthy households. Nonetheless, individual
investing has become increasingly popular. In the United States,
bank certificates of deposit accounted for more than 10% of
households financial assets in 1989 but only 3.9% in 2010, as
families shifted their money into securities held in retirement
accounts. The 200809 stockmarket crash caused households
to hold a smaller proportion of their assets in equities, but the
extremely low interest rates available on bond investments and

Guide to Financial Markets.indd 9 23/10/2013 14:14


10 Guide to financial markets

bank deposits drove individual investors back towards equities


in 2013.
Institutional investors. Insurance companies and other
institutional investors (see below), including high-frequency
traders, are responsible for most of the trading in financial
markets. The assets of institutional investors based in the 34
member countries of the OECD totalled more than $62 trillion
in 2011.The size of institutional investors varies greatly from
country to country, depending on the development of collective
investment vehicles. Investment practices vary considerably
as well. At the end of 2011, after a significant decrease in share
prices, for example, US institutional investors kept roughly
identical proportions of their assets in the form of shares and
in bonds. Until recently, British institutional investors tended
to hold a greater proportion of assets in shares, whereas
institutional investors in Japan have tended to favour bonds and
loans over shares.

Mutual funds
The fastest-growing institutional investors are investment companies,
which combine the investments of a number of individuals with the
aim of achieving particular financial goals in an efficient way. Mutual
funds and unit trusts are investment companies that typically accept
an unlimited number of individual investments. The fund declares the
strategy it will pursue, and as additional money is invested the fund
managers purchase financial instruments appropriate to that strategy.
Investment trusts, some of which are known in the United States as
closed-end funds, issue a limited number of shares to investors at the
time they are established and use the proceeds to purchase financial
instruments in accordance with their strategy. In some cases, the trust
acquires securities at its inception and never sells them; in other cases,
the fund changes its portfolio from time to time. Investors wishing to
enter or leave the unit trust must buy or sell the trusts shares from
stockbrokers. Worldwide, mutual funds had net assets of $27 trillion
at the end of 2012.

Guide to Financial Markets.indd 10 23/10/2013 14:14


Why markets matter 11

Table 1.4 Financial assets of institutional investors, 2011


$bn

Investment funds Insurance companies and pension funds

Australia 255 1,336


Canada 768 1,572
France 1,513 2,381
Germany 1,567 2,381
Italy 205 707
Japan 3,745 6,058
Mexicoa 93 144
Netherlands 475 1,634
Sweden 238 513
Switzerland 475 1,154
Turkey 161 143
UK 1,065 4,288
US 11,927 17,172

a 2010.
Source: OECD, average exchange rates from US Internal Revenue Service

Hedge funds
A third type of investment company, a hedge fund, can accept
investments from only a small number of wealthy individuals or big
institutions. In return it is freed from most types of regulation meant
to protect consumers. Hedge funds are able to employ aggressive
investment strategies, such as using borrowed money to increase the
amount invested and focusing investment on one or another type of
asset rather than diversifying. If successful, such strategies can lead to
very large returns; if unsuccessful, they can result in sizeable losses
and the closure of the fund.
All investment companies earn a profit by charging investors a fee
for their services. Some, notably hedge funds, may also take a portion
of any gain in the value of the fund. Hedge funds have come under
particular criticism because their fee structures may give managers

Guide to Financial Markets.indd 11 23/10/2013 14:14


12 Guide to financial markets

an undesirable incentive to take large risks with investors money, as


fund managers may share in their funds gains but not its losses.

Insurance companies
Insurance companies are the most important type of institutional
investor, owning one-third of all the financial assets owned by
institutions. In the past, most of these holdings were needed to back
life insurance policies. In recent years, a growing share of insurers
business has consisted of annuities, which guarantee policy holders
a sum of money each year as long as they live, rather than merely
paying their heirs upon death. The growth of pre-funded individual
pensions has benefited insurance companies, because on retirement
many workers use the money in their accounts to purchase annuities.

Pension funds
Pension funds aggregate the retirement savings of a large number of
workers. Typically, pension funds are sponsored by an employer, a
group of employers or a labour union. Unlike individual pension
accounts, pension funds do not give individuals control over how
their savings are invested, but they do typically offer a guaranteed
benefit once the individual reaches retirement age. Pension-fund
assets came to about $16 trillion in the OECD countries at the end of
2009. Three countries, the United States, the UK and Japan, account for
the overwhelming majority of this amount. Pension funds, although
huge, are slowly diminishing in importance as individual pension
accounts gain favour.

Algorithmic traders
Algorithmic trading, also known as high-frequency trading, has
expanded dramatically in recent years as a result of increased
computing power and the availability of low-cost, high-speed
communications. Investors specialising in this type of trading
program computers to enter buy and sell orders automatically in
an effort to exploit tiny price differences in securities and currency
markets. They typically have no interest in fundamental factors,
such as a companys prospects or a countrys economic outlook, and

Guide to Financial Markets.indd 12 23/10/2013 14:14


Why markets matter 13

own the asset for only a brief period before reselling it. Algorithmic
trading firms control only a tiny proportion of the worlds financial
assets, but they account for a large proportion of the trading in some
markets.

Other institutions
Other types of institutions, such as banks, foundations and university
endowment funds, are also substantial players in the markets.

The rise of the formal markets


Every country has financial markets of one sort or another. In countries
as diverse as China, Peru and Zimbabwe, investors can purchase
shares and bonds issued by local companies. Even in places whose
governments loudly reject capitalist ideas, traders, often labelled
disparagingly as speculators, make markets in foreign currencies
and in commodities such as oil. The formal financial markets have
expanded rapidly in recent years, as governments in countries marked
by shadowy, semi-legal markets have sought to organise institutions.
The motivation was in part self-interest: informal markets generate no
tax revenue, but officially recognised markets do. Governments have
also recognised that if businesses are to thrive they must be able to
raise capital, and formal means of doing this, such as selling shares on
a stock exchange, are much more efficient than informal means such
as borrowing from moneylenders.
Investors have many reasons to prefer formal financial markets to
street-corner trading. Yet not all formal markets prosper, as investors
gravitate to certain markets and leave others underutilised. The busier
ones, generally, have important attributes that smaller markets often
lack:

Liquidity, the ease with which trading can be conducted. In an


illiquid market an investor may have difficulty finding another
party ready to make the desired trade, and the difference, or
spread, between the price at which a security can be bought
and the price for which it can be sold, may be high. Trading is
easier and spreads are narrower in more liquid markets. Because

Guide to Financial Markets.indd 13 23/10/2013 14:14


14 Guide to financial markets

liquidity benefits almost everyone, trading usually concentrates


in markets that are already busy.
Transparency, the availability of prompt and complete
information about trades and prices. Generally, the less
transparent the market, the less willing people are to trade there.
Reliability, particularly when it comes to ensuring that trades
are completed quickly according to the terms agreed.
Legal procedures adequate to settle disputes and enforce
contracts.
Suitable investor protection and regulation. Excessive
regulation can stifle a market. However, trading will also be
deterred if investors lack confidence in the available information
about the securities they may wish to trade, the procedures for
trading, the ability of trading partners and intermediaries to
meet their commitments, and the treatment they will receive
as owners of a security or commodity once a trade has been
completed.
Low transaction costs. Many financial-market transactions are
not tied to a specific geographic location, and the participants
will strive to complete them in places where trading costs,
regulatory costs and taxes are reasonable.

The forces of change


Todays financial markets would be almost unrecognisable to
someone who traded there only two or three decades ago. The speed
of change has been accelerating as market participants struggle to
adjust to increased competition and constant innovation.

Technology
Almost everything about the markets has been reshaped by the
forces of technology. Abundant computing power and cheap
telecommunications have encouraged the growth of entirely new
types of financial instruments and have dramatically changed the
cost structure of every part of the financial industry.

Guide to Financial Markets.indd 14 23/10/2013 14:14


Why markets matter 15

Deregulation
The trend towards deregulation has been worldwide. It is not long
since authorities everywhere kept tight controls on financial markets
in the name of protecting consumers and preserving financial stability.
But since 1975, when the United States prohibited stockbrokers from
setting uniform commissions for share trading, the restraints have
been loosened in one country after another. Although there are great
differences, most national regulators agree on the principles that
individual investors need substantial protection, but that dealings
involving institutional investors require little regulation.

Liberalisation
Deregulation has been accompanied by a general liberalisation of
rules governing participation in the markets. Many of the barriers
that once separated banks, investment banks, insurers, investment
companies and other financial institutions have been lowered,
allowing such firms to enter each others businesses. The big market
economies, most recently Japan and South Korea, have also allowed
foreign firms to enter financial sectors that were formerly reserved for
domestic companies.

Consolidation
Liberalisation has led to consolidation, as firms merge to take
advantage of economies of scale or to enter other areas of finance.
Almost all the UKs leading investment banks and brokerage houses,
for example, have been acquired by foreigners seeking a bigger
presence in London, and many of the medium-sized investment
banks in the United States were bought by commercial banks wishing
to use new powers to expand in share dealing and corporate finance.
Financial crisis led to further consolidation, as the insolvency of many
major banks and investment banks led to forced mergers in 2008.

Globalisation
Consolidation has gone hand in hand with globalisation. Most of
the important financial firms are now highly international, with
operations in all the major financial centres. Many companies and

Guide to Financial Markets.indd 15 23/10/2013 14:14


16 Guide to financial markets

governments take advantage of these global networks to issue shares


and bonds outside their home countries. Investors increasingly take
a global approach as well, putting their money wherever they expect
the greatest return for the risk involved, without worrying about
geography.

This book
The following chapters examine the most widely used financial
instruments and discuss the way the markets for each type of
instrument are organised. Chapter 2 establishes the background
by explaining the currency markets, where exchange rates are
determined. The money markets, where commercial paper and
other instruments are used for short-term financing, are discussed in
Chapter 3. The bond markets, the most important source of financing
for companies and governments, are the subject of Chapter 4. Asset-
backed securities, complicated but increasingly important instruments
that have some characteristics in common with bonds but also some
important differences, receive special attention in Chapter 5. Chapter
6 deals with offshore markets, including the market for euro-notes.
Chapter 7 discusses the area that may be most familiar to many
readers shares and equity markets. Chapter 8 covers exchange-
traded futures and options, and Chapter 9 discusses other sorts of
derivatives. The markets for syndicated loans and other kinds of bank
credit are beyond the scope of this book, as are insurance products
of all sorts.

Guide to Financial Markets.indd 16 23/10/2013 14:14


Index

Page numbers in italics indicate stock exchange loss of business 182


figures; those in bold type indicate unemployment in 34
tables. Aristotle 197198
Asia
accounting rules 171172, 186 asset-backed securities 113
adjustable bonds 87 currency trading 28
Africa: currency trading 28 emerging markets 187
after-hours trading 209 financial crisis in (1998) 5, 106
Agricultural Bank of China 160 high-yield markets 101
agricultural equipment, loans on initial public offerings (IPOs) 160
129 price/earnings ratio of technology
agricultural finance agencies 58 shares 173
aircraft, loans on 128129 and securitisation 116
algorithmic trading 1213, 18, 191, 192 Asia-Pacific region: bond issuance 77
all-or-none orders 205 asset value 168
All-Ordinaries Index (Australia) 224 asset-backed securities 156157, 267
Alternative Investment Market, basics of 131
London 181 buying 135
alternative trading systems see dark and CDOs 116117
pools defined 75
Altria Group 160 floating-rate 133
American depositary receipts (ADRs) home-equity 128
186, 187 issuance of 116, 117
American International Group (AIG) measuring performance 135136
264265, 272 mortgage-backed securities 112
American Stock Exchange 183, 243, non-mortgage securities 112, 112
244 novel types of 129130
American-style options 240 private-sector debt market 76
Amsterdam 154 risk 8, 111112
bourse 181 trading 115116
analysts, securities 169 assets
annuities 12 income from 3
Antwerp Stock Exchange 178 interest-bearing 21
arbitrage 3, 92, 242 trading 115
ARCA options exchange 244 valuation 2
Archipelago exchange 183 ASX 50 share index 224
Argentina ASX 200 share index 224
bonds 73, 110, 144, 145 at best instruction 188
financial crisis in (200102) 34, 106, at-the-market orders 204
107, 145 auction markets 189190
international debt securities 144 auctions, bond sale 780

Guide to Financial Markets.indd 275 23/10/2013 14:15


276 Guide to financial markets

Australia bankruptcy 49, 54, 74, 194, 195, 229,


auto-loan securities 128 265
banks bond issuance 126 barrier options 20
securitisation 126 base rate 65
Australian Stock Exchange 225 basic hedge 248
automotive loans 113, 117, 128129 basis trading 231
Autostrade 139 basket trades 192
BATS Global Markets electronic
balance-of-payments exchange 184
crises 33, 36 bear spread 232
deficits 33, 38, 138 Bear Stearns 270
surplus 38 Beckman Coulter 178
Banco do Brasil 161 Becton Dickinson 178
bands 3536 below investment grade 64, 90, 91,
bank certificates of deposit 44, 50 101, 102, 103, 106, 144
bank deposits 169 benchmark index 108
Bank for International Settlements 5, betas 173, 175
43, 46, 270 Big Mac Index 38
Bank of America 176 Black-Scholes option-pricing model
Bank of Canada 65, 66 246
Bank of England: Central block trades 192
Moneymarkets Office 6263 BM&F Bovespa exchange, So Paulo
Bank of Japan 62, 68 206, 213
Bank of Venice 70 Bogot exchange 25
bankers acceptances 55, 63 Bolsa de Mercadorias & Futuros, Brazil
Bankers Trust Company 271272 25, 26, 237
banking bond funds 50
banking crises (1990s) 6 bond futures 76
and bond markets 78 bond indexes see under bond markets
certificates of deposit 44 bond insurance 100
clearing organisations 29 Bond Issue Arrangement Committee
commercial banks 15, 44 (Japan) 76
and commercial paper 54 bond issuers 46
consolidation 15, 18 bond markets 56, 70110
credit lines 54 the biggest national markets 7677
currency dealing 24 bond futures 76
disintermediation 44 bond indexes 108110
forced mergers due to insolvency 15 benchmark 108
foreign banks set up offices in index shortcomings 109110
London 139 weighted 108109
gross position 29 the changing nature of the market
interbank loans 5859 8184
and intermediation 47 electronic trading 8284
lending 4, 6 secondary dealing 8283
liberalisation 15 settlement 84
as a main source of credit 44 and countries with less active
market share 13, 44 money markets 4647
net position 29 defined 46
overnight loans 59 domestic and international 140
and price quotations 3940 emerging-market bonds 83, 105107,
and repos 60, 61 106
securitisation 115, 126 enhancing security 99100
short-term demand deposits 44 bond insurance 100
speculators 23 covenants 99
underwriting risk 134135 sinking funds 100

Guide to Financial Markets.indd 276 23/10/2013 14:15


Index 277

exchange rates and bond prices and the yield curve 9598, 97
returns 9495, 95 bond options 236
high-yield debt (or junk) 101103, bond returns 170
102 bonds
inflation and returns on bonds 94 acceleration provision 91
interest rates and bond prices adjustable 87
9293, 93 below-investment-grade 101, 102,
international markets 103105, 104 103, 144
Eurobonds 104 book-entry 81
foreign bonds 103104 bulldog 104
interpreting the price of a bond callable 85, 87
9192 capital-indexed 87
investing 3 convertible 86, 87, 159
the issuers 73 corporate 75, 76, 82, 83, 92, 99, 101,
corporations 7576 106, 107
lower levels of government 7475 defined 70
national governments 7374 dim sum 104
securitisation vehicles 7576 domestic 4, 5, 75, 77, 105, 107, 148,
issuing bonds 7780 153
selling direct 81 emerging-market 105107, 106,
setting the interest rate 8081 144146
swaps 7980 equity-linked 147
underwriters and dealers 7879 euro 152
no more coupons 81 exchange rates and bond prices and
properties of bonds 8789 returns 9495, 95
coupon 88 fallen angels 102, 103
current yield 88 fixed-rate 111, 147, 148, 266
duration 89 floating-rate 87, 147
maturity 8788 foreign 103104, 153
yield to maturity 88 and foreign-exchange trading 21, 22
ratings of risk 8991, 90 general-obligation 74
repurchase agreements 100101 global 149
and rise in interest rates (2013) 8 and globalisation 16
robust activity (20002001) 6 government 71, 82, 83, 9899, 106,
spreads 9899 152, 248
types of bonds 8487 high-yield 101103, 102
adjustable bonds 87 indebtedness of banks 6
callable bonds 85 inflation-indexed 87
convertible bonds 86 interest rates and bond prices
non-refundable bonds 85 9293, 93
perpetual debentures 85 interest-indexed 87
putable bonds 85 international bond issues 140, 141,
straight bonds 85 149150
STRIPS 86 issuing see under bond markets
structured securities 87 large-scale purchases of 7
zero-coupon bonds 86 long-term 56, 93, 98, 101, 108, 148,
why issue bonds? 7273 260
avoiding short-term financial marked to market 82
constraints 73 maturities 142
controlling risk 7273 mortgage 113, 118
matching revenue and expenses municipal 74, 83, 100
72 non-refundable 85
minimising financing costs 72 paper 81
promoting intergenerational properties of 8789
equity 72 coupon 88

Guide to Financial Markets.indd 277 23/10/2013 14:15


278 Guide to financial markets

current yield 88 buy-outs, leveraged 101


duration 89
maturity 8788 CAC-40 index 224
yield to maturity 88 calendar strip 232
putable 85, 87 call auction markets 190
raising capital 3 call options 234, 240, 244, 247248, 262
registered 81 naked 249
revenue 74 call premium 85
rising stars 102103 call rate 67
samurai 104 callable bonds 85, 87
selling 156 Canada
sale on best-efforts basis 150 asset-backed commercial paper 131
sale on fixed-price re-offer basis auto-loan securities 128
149150 bankers acceptances 55
short-term (notes) 70, 260 commercial paper 53
sovereign 73, 108 discount rate 65
special-purpose 7475 option trading 243
step-up 87, 91 provincial bonds 74
straight 85 reduced government debt (1990s)
transactions 5 57
US dollar 152 securitisation 123124
variable-rate 87 short-term borrowing 56
warrant 87 Canada Mortgage and Housing
Yankee 104, 138 Corporation 123124
zero-coupon 86, 87 cancel order 189
book-entry bonds 81 capital
Borsa Italiana, Milan 183 cross-border flow of 103, 153
Boston Options Exchange 244 equity 157
bought deal 150 long-term 3, 7
Bowie, David 129130 raising 3, 13
Brazil short-term 44, 47
bonds 71, 73, 74, 106 working 3
currency options contracts 25 capital gains 165, 175
debt crisis (1999) 57 defined 9
emerging markets 187 capital markets
floating rates 37 financing 34, 6
longer-term financing 57 foreign 186
Brazilian Mercantile and Futures open 187
Exchange 202 and stock exchanges 179
breaking the buck 49 capital-indexed bonds 87
Brent Crude oil futures 206 capitalisation
Bretton Woods system 18, 33, 138 company 194
brokerage commissions 200 German stockmarket 170
brokerage firms 15, 178, 182, 188, 189, market 176, 180, 181, 188
190 and stock splits 170171
Brussels stockmarket 181
and introduction of the euro 2728 capitalisation issue (stock dividend)
stock exchange 181, 182183 168
Buffett, Warren 270271 capped options 240, 260
bulk commodities (physicals) 204 car purchase: raising capital 3
bull spread 232 carbon dioxide emissions 217
bulldog bonds 104 cash flow
Bundesanleihen (Bunds) 73, 99, 241 and asset-backed commercial paper
business plans 156 130
buy orders 208 and bonds 81

Guide to Financial Markets.indd 278 23/10/2013 14:15


Index 279

defined 167 rapid industrial growth 216


expected 134 and securitisation 116, 126
and fixed-rate bonds 111 stock exchanges 179
irregular 45 trade in stock index options 236
negative 167 Chinese Telecom 225
positive 167 clearing 103, 226227, 251
cash management 62 clearing houses 6263, 227, 228, 229,
central banks 251, 270
and bond markets 84 clearing members 227, 228229
and the crawling peg 3637 clearing organisations 29
and gold standard 32 closed-end funds 10
and inflation 34, 38 CMBS (commercial mortgage-backed
interest rates 6566 securities) 119120
intervention by 23, 39 CME Group, US 25, 208
keeping the exchange rate stable co-operative agreements 230
34, 35 coal futures contracts 216
managing floating rates 3839 Coffee, Sugar and Cocoa Exchange
monetary policy 6465 203
and money markets 45, 49 collars 20, 260
open-market operations 6566 collateralised debt obligation (CDO)
stripping government bonds 86 116, 117, 117
survey of currency-trading activity collateralised mortgage obligations
27 (CMOs) 131132, 133
and Thailands financial crisis 272 Colombian Stock Exchange 184
Central Japan Commodities Exchange commercial mortgage-backed
202 securities (CMBS) 118, 119120
Central Moneymarkets Office, Bank commercial paper 50, 5255, 53, 62, 63,
of England 6263 64, 66, 83
certificates of deposit (CDs) see time asset-backed 130131
deposits short-term 141, 142, 143, 143
change 1416 Commerzbank Index 195
consolidation 15 commissions 190, 191
deregulation 15 commodities
globalisation 1516 characteristics of 198
liberalisation 15 contracts 200201
technology 14 futures 204, 218219, 218
cheque-writing accounts 44 markets 197
Chicago Board Options Exchange options 237, 252
(CBOE) 233, 239, 244 storage fees 252
Chicago Board of Trade 1, 198, 202, traders 2
213, 217, 220221, 222, 225, 233, 235 common stock (ordinary shares) 158
Northern Spring Wheat contract companies
206207 acquisitions of 107
Chicago Mercantile Exchange 19, 24, bankers acceptances 55
2526, 25, 202, 206, 210, 221, 225, bankruptcy 54
228, 232, 235 bond issuance 6
Chicago Stock Exchange 184 capitalisation of 194
Chilean Stock Exchange 184 and commercial paper 52, 53, 54
China corporate bonds 75
agricultural futures 213 domestic 15
bond market 71, 77, 105, 106 emerging-market 107
commodies exchanges 202 financial distress 45
commodity contracts 200201 foreign direct investment in 22
emerging markets 187 and globalisation 1516
pegs and baskets 36 insurance 10, 11, 12

Guide to Financial Markets.indd 279 23/10/2013 14:15


280 Guide to financial markets

investment 10, 11, 15, 44, 45, 50 credit, regulating the amount of 6465
local 13 credit cards
competition balances 170
among futures and options purchases 3
exchanges 200 securities 127128
increased 14 credit crisis (from 2007), and risk-
and option exchanges 242243, 243 management products 89
price 220 credit events 263264, 266
computers credit markets 7
abundant computing power 14 credit ratings 54, 6364, 64, 91, 101,
and algorithmic trading 12, 18, 192 106, 110, 144, 145
book-entry bonds 81 credit risk 133134
electronic auction markets 189190 credit-linked notes 267
futures and options trading 200 creditworthiness 63, 66, 99, 119, 256,
high-frequency trading 18 264, 270
replacing face-to-face dealing 1 cross-border finance 45
scanning markets for price cross-margining 230
anomalies 31 currencies
and stock exchanges 182, 184, 189 bands 35, 36
swaps trading 149 comparing currency valuations
consolidation 15, 18 3738
construction equipment, loans on destabilisation 33
129 emerging-market 28, 107
consumer spending, and a rise in the favourite 2628, 27, 28
prime rate 68 floating 35, 36
continuous auction trading 207208 risk 105, 107
contracts settlement 2829
commodity 200201 strengthening/weakening against
derivative 26, 222223 those of other countries 30
energy futures 203, 216, 217, 217 currency
enforcing 14 coinage 17
financial futures 210 and exchange rates 18, 23
forward 20, 25, 31, 76, 148, 197, 253, government intervention 23
257, 272 growth in currency trading 18, 22
futures 19, 20, 22, 198, 203, 205207, no longer linked to gold 18
216, 231, 257 paper money 18
index 252 risk management 3
interest-rate options 76 sovereign wealth funds 23
options 22 spot transactions 19
convertible bonds 86, 87, 159 value of 17
convertible preferred stock 159 currency board 3334
convexity 93 currency cross-rates 41, 42
corporate bonds 75, 76 currency indexes 42
indexes 136 currency markets 2122
costs and algorithmic trading 12
regulatory 14 foreign currency 13
trading 14, 19 gearing up 2122
counterparties 253, 255, 256, 257, 259, currency options 237238, 238
264, 272, 273 contracts 2526
coupon 88 currency-price tables 40, 41
covenants 99 currency swaps 24, 26, 259260, 260
covered calls 239, 249 current yield 88
covered interest arbitrage 3031 current-account imbalances 32
covered interest parity 31 Czech Republic: trade-weighted
crawling peg 3637 exchange rate 42

Guide to Financial Markets.indd 280 23/10/2013 14:15


Index 281

Daiwa Bond Index 109 Derivatives Exchange, Malaysia 213


Dalian Commodity Exchange 213 derivatives markets 2021, 21, 22, 29,
dark pools 185, 186, 192 253273
DAX (Deutsche Aktienindex) 225226, accounting risks 272273
226, 250 categories of derivatives 253
Performance Index 195 credit events 263264
DAX-30 index 224 derivatives disasters 270272
day order 189 notional value 254255, 255
day trading 191 pricing derivatives 268
dealer markets 190 regulatory issues 273
dealers, and bonds 79, 82, 86, 101 risks of derivatives 255257
debentures 85 counterparty risk 256
perpetual (irredeemable) 85 legal risk 256
debt price risk 256
credit-card 128 settlement risk 257
emerging-market 105106 settling derivative trades 270
margin 194 special features used in derivatives
mezzanine 75 268
restructuring 74 types of derivatives 257268
senior 75 commodity derivatives 261
sovereign 105 credit derivatives 263266, 265
subordinated 75 currency swaps 259260, 260
debt-to-equity ratio (gearing) 157 equity derivatives 262263, 262
delivery 230, 231, 232, 235 forwards 257
delta 247248 interest-rate options 260261
hedging 250 interest-rate swaps 258259, 258
demand and supply 150 synthetic securities 266268,
demutualisations 182, 183 267
Denmark Detroit, Michigan, bond investors
pegs to the euro 33 losses 74
and securitisation 113, 118, 124 Deutsche Bank 242
depositary receipts 186187 Deutsche Brse 182, 202203
Depository Trust Company, New Deutsche Telecom 160
York 63 devaluation 33, 36
depression and the crawling peg 37
and gold standard 3233 and exchange-rate bands 36
Great Depression 52 and the gold standard 32
and interest rates 34 and the IMF 33
deregulation 15, 44, 4748, 52, 216 Mexico devalues the peso 145
derivatives 8 development banks 58
barrier options and collars 20 difference (diff) options 260261
currency 255 dim sum bonds 104
customised 256 Direct Edge electronic exchange 184
defined 20 discount brokerages 191
exchange-rate 26 discount rate 65, 89
foreign-exchange swaps 20, 21, 25 disintermediation 44
forward contracts 20, 25 dispute settlement 14
forward rate agreements 20 dividends 167168
futures contracts 203204 yields 167, 168
hedging 269 dollar: displaced by euro as main
over-the-counter 238, 253257, 254, currency of bond issuance 106, 143
262, 270 Dow Jones Euro Stoxx 50 index 195,
plain vanilla 269 224
risk management 3 Dow Jones Industrial Average (DJIA)
trading in 4 194, 195, 224

Guide to Financial Markets.indd 281 23/10/2013 14:15


282 Guide to financial markets

Dow Jones Transportation Average depositary receipts 186188


194 emerging markets 187188, 188
Dow Jones Utility Average 19 equity 157
duration, bond 89 factors affecting share prices
Dutch East India Company 154 166174
analysts recommendations 169
earnings, firms 166 asset value 168
earnings before interest, taxes, beta 173
depreciation and amortisation bond returns 170
(EBITDA) 166 cash flow 167
earnings per share 177 dividends 167168, 168
East Asia, 1997 crisis 35 earnings 166
economic growth 37, 64, 65, 67, 129, fads 170
166, 169, 170 general economic news 170
economies of scale 15 inclusion in an index 169
Economist, The 232 interest rates 169
Big Mac Index 38 key numbers 171172
education lending agencies 58 market efficiency 171
efficient market hypothesis 171 price/earnings ratio 172173, 172
electricity return on capital 174
deregulation 216 return on equity 173174
utilities 217 stock splits 170171
electronic information systems, and value added 174
price quotations 3940 flotation process 162166
electronic trading 208209 different approaches to selling
auction markets 189190 shares 163164
bond markets 8284 investing in IPOs 164165
eliminate order 189 share repurchases 165166
emerging markets how stock exchanges work 189190
bonds 71, 83, 105107, 106, 145146 institutional trading 191193
borrowers, biggest 146, 146 basket trades 192
companies 107 block trades 192
countries 187188, 188 program or algorithmic trades
government debt 57 192
treasury-bill issuance 56, 57 short sales 192193
currencies 28 international listings 186
debt 106 investing on margin 193194
portfolios 110 measuring market performance
employers 194196
and pension funds 12 price measures 194196, 196
shares in 9 risk measures 196
employment 94 measuring return 175
entertainment securitisations 129130 obtaining share price information
equities 4, 5, 6 176177, 177
a cross-border financing source 5 off-market trading 185186
foreign 272273 origin of equities 154155, 155, 156
and individual investing 910 over-the-counter market 177178
the origins of 154155, 155, 156 raising capital 155158
equity funds 50 balancing act 157
equity market capitalisation 155, 155 equity 157
equity markets 120196 loans 156157
activity slows (20002001) 6 venture capital 157158
balancing act 157 stock exchanges 178184, 179, 180
clearing and settlement 193 the biggest exchanges 180184,
competition in trading 190191 181, 183

Guide to Financial Markets.indd 282 23/10/2013 14:15


Index 283

trading shares 188189 mortgage securities 123


types of equity 158162 repo market 62
common stock or ordinary and securitisation 116, 127
shares 158159 venture capital 158
convertible preferred stock 159 European Central Bank (ECB) 65,
flotation 160161, 161 6667
issuing shares 159160 European depositary receipts (EDRs)
preferred stock 159160 186, 187
private offering 161162 European Energy Exchange 203
secondary offering 162 European Exchange Rate Mechanism
warrants 159 3536
venture capital 157158 European Investment Bank, bond
equity options 235, 252 issuers 144
equity-index options 241 European Union
Estonia and bond interest 153
currency pegged to the euro 34 debt securities trading in 83
the euro adopted as its currency 34 Euronext bread-wheat contract 213
Eurex 202, 208, 218, 225, 226, 226, 236, government bonds 99
241, 244 reduced government debt (1990s)
Euribor 59 57
euro, the share prices quoted in euros 182
and commercial paper 54 European-style options 240
dollar/euro trades 27 Euroyen 141
and exchange-market activity 18 ex-dividend stock 168
and issuance of international exchange of futures for physicals 231
securities 141, 142 exchange rates
launch of (January 1999) 18, 2728, abandonment of fixed exchange
141, 223 rates 204
and reduction of trading in bond prices and returns 9495, 95
European centres 2728 covered interest arbitrage 3031
replaces dollar as main currency of covered interest parity 31
bond issuance 106, 143 and currency trading 18, 23
Euro Libor 236237 determined by market forces 18
Euro-Stars index of 29 euro-zone exchange-rate crises (1990s) 6
stocks 195 forward 30
Eurobonds 104, 139, 153 the fundamental price in any
Euroclear, Brussels 63 economy 17
Eurodollar paper 141 and futures market 19
Eurodollars 137, 221 government intervention 23, 107
Eurokiwis 141 managing see under foreign-
Euromarkets 137139, 141, 149, 153 exchange markets
Euronext 181, 182183, 203, 208, 213, and real interest rates 30
243 stabilisation of 223
Europe trade-weighted 4243, 43
asset-backed commercial paper 131 volatile 2, 30
asset-backed securities 113 why they change 3031
auto-loan securities 128 execute order 189
bond insurance 100 expiration dates 240
CMBS issuance 120 exporters 22
corporate-bond market 77 extension risk 134
credit-card securities 128
financial meltdown (200813) 5 Facebook 161
high-yield markets 101 fallen angels 102, 103
large government deficits (from Fannie Mae 74, 118, 118119, 121, 122,
2008) 57 125, 126

Guide to Financial Markets.indd 283 23/10/2013 14:15


284 Guide to financial markets

Farmer Macs 122123 Financial Times Stock Exchange


farmers, early (FTSE) 224, 242
and a basic financial market 2 100 stock index 194, 241
volatile exchange rates 2 Fitch 6364, 64, 90
Federal Agricultural Mortgage Credit fixed-rate systems
Corporation (FAMCC) 122123 Bretton Woods 33
Federal Home Loan Bank System 58 gold standard 3233
Federal Home Loan Mortgage pegs 3334
Corporation (FHLMC) 122 shortcomings 3435
Federal National Mortgage flex options 239
Association (FNMA) 118, 121 floating rates 37, 125
Federal Reserve Board 121, 131 managing 3839
fill-or-kill orders 189, 205 floor trading 189, 190, 192
film distribution companies 129 floors 260
financial crises flotation 160161, 161
Asia and Russia (1998) 5 all-or-nothing offering 163
Europe financial meltdown (2008 best-efforts basis 163
13) 5, 141, 143 investment banker as underwriter
and credit markets 7 163
United States financial meltdown flotation process see under equity
(200809) 5 markets
United States recession (2001) 5 follow-on offering 162
worldwide 4546, 52, 53, 101, 107, Ford Motor Company 252
113114, 187, 232 foreign direct investment 22
financial futures 204 foreign-exchange markets 1743
financial industry, consolidation in average daily turnover 17
182 comparing currency valuations
financial institutions, failures of 7 3738
financial markets indications of overshooting 38
attributes of larger markets 1314 currency markets and related
forces of change 1416 markets 2122
consolidation 15 gearing up 2122
deregulation 15 fall in trading at turn of the century
globalisation 1516 7
liberalisation 15 favourite currencies 2728, 27, 28
technology 14 growth of trading 18
growth in 1990s 6 Herstatt risk 29
historic 12 history 1718
investors 913 how currencies are traded 1921
algorithmic traders 1213 the derivatives market 2021, 21
hedge funds 1112 the futures market 19
insurance companies 12 the options market 20
mutual funds 10, 11 the spot market 19
pension funds 12 main trading locations 2326, 24, 25
other institutions 13 managing exchange rates 3237
rise of the formal markets 1314 fixed-rate shortcomings 3435
roles of 23 fixed-rate systems 3234
size of 36, 4, 5 floating rates 37
cross-border measure 45 semi-fixed systems 3537
international breakdown 56, 6 managing floating rates 3839
turn-of-the-century slowdown 69 obtaining price information 3942
financial meltdowns cross-rates 41, 42
Europe (200813) 5 currency indexes 42
United States (200809) 5 forward rates 40, 41
financial reports 171172, 186 the players 2223

Guide to Financial Markets.indd 284 23/10/2013 14:15


Index 285

exporters and importers 22 futures and options markets 197252


governments 23 the characteristics of commodities
investors 22 198
speculators 23 clearance and settlement 226227,
role of 17 251252
settlement 2829 terminating options 251252
trade-weighted exchange rate 4243, commodity futures market 212218
43 agricultural futures 212214, 212,
why exchange rates change 3031 214
covered interest arbitrage 3031 commodity-related futures 218
covered interest parity 31 energy futures 216217, 217
real interest rates 30 metals futures 214216, 215
foreign-exchange swaps 20, 21, 24, 25 contract terms 205207
forward contracts (forwards) 20, 25, 31, contract size 206
76, 148, 197, 253, 257, 272 delivery date 206
forward exchange rate 30 position limits 207
forward markets 31, 39 price limits 206207
forward rate agreements 20 quality 206
forward rates 31, 40, 41 settlement 207
forward transactions 24 delivery 230
France exchange-traded options 233239
and bond markets 7677, 95 commodity options 237
French notional bond contract 201 currency options 237238, 238
longer-term debt 56 equity options 235
Obligations assimilable du trsor index options 235236, 236
(OATs) 73 interest-rate options 236237
short-term debt 56 new types of options 238239
Frankfurt stockmarket 195 puts and calls 233234
Freddie Macs 74, 122 underlying every option 233
fund managers winners and losers 234
hedge funds 1112 expiration dates 240
mutual funds and unit trusts 10 factors affecting option prices
and NYSE indexes 196 246248
fundamental analysis 169 gamma 248
futures rho 248
agricultural 210, 212214, 212, 214 vega 248
cattle 210 volatility 247248
coffee 210, 213 financial futures markets 220225
commodity 204, 210 currency futures 222223, 223
copper 210 interest-rate futures 220221, 221
currency 20, 2425, 202, 222223, share-price futures 225
223 stock-index futures 223224, 224
energy 216217, 217 other financial futures 225, 226
environmental 217 futures contracts 203204
financial 202, 204, 210, 220225 futures and options exchanges
gold 215 200202, 201
interest-rate 220222, 221 gains and losses 239240
metal 202, 214216, 215 hedging strategies 248
natural gas 216, 217 baring all 249
orange juice 210, 218, 218 covering yourself 249
risk management 3 dynamic hedging 250251
share-price 235 spreading 250
stock-index 223224, 224 straddling 249250
sugar 213 turbo charging 250
trading in 4 how futures are traded 204205

Guide to Financial Markets.indd 285 23/10/2013 14:15


286 Guide to financial markets

how options are traded 244 Futures Industry Association 236


how prices are set 210 futures market 19
limits on price movements 211
price movements 210 gamma 248
quoted price 210 GE Capital 152
spot price 211 gearing 157
term factor 211 gearing up 2122
margin of security 227230 see also leverage
cross-margining 230 General Motors 161, 263
margin calls 228229 general-obligation bonds 74
marking to market 228 Generally Accepted Accounting
measuring performance 232233 Principles (GAAP) 162
merger pressures 202203 Germany
motivations for options trading bond markets 76, 105
241242 Bundesanleihen (Bunds) 73, 99, 241
arbitrage 242 and commercial paper 54
hedging 241 long-term borrowing 56
income 242 money-market funds 48
leveraged speculation 241243 Pfandbriefe 124125, 135, 153
risk management 241 pork contracts 213
obtaining price information 211212, share repurchase programmes 165
244245, 245 technology shares 170
option exchanges 242244, 243 yield curve 96, 97
reading commodity futures price Gibson Greetings 271
tables 218219, 218 gilts 73
reading financial futures price Ginnie Mae 121122, 125, 126
tables 225226, 226 global depositary receipts (GDRs)
styles 240 186, 187
American-style options 240 global warming 217
capped options 240 globalisation 1516
European-style options 240 gold standard 3233, 138
trading 207209 Goldman Sachs 232
continuous-auction or open- Goldman Sachs Commodity Index
outcry trading 207208 (GSCI) 232, 235
electronic trading 208209, 209 good-till-cancelled order 189
single-price auction trading 208 government agency notes 58, 63
trading strategies 231232 Government National Mortgage
basic trading 231 Association (GNMA) 121122
dynamic hedging 231 governments
index arbitrage 231 and bond issue 7374, 76, 80
spreads 231 bond issuers 144
straddles 232 budget deficits 7071
strips 232 economic statistics 171
triple-witching dates 241 and exchange-rate management
types of contracts 32, 107
commodity futures 204 and globalisation 1516
financial futures 204 increased budget deficits to combat
why trade futures and options? recession 57
199200 intervention 23, 39
hedging 199 managing floating rates 3839
speculation 199200 rating short-term government debt
futures commission merchants 204, 64
227228 sovereign wealth funds 23
futures contracts 19, 20, 25, 62, 198 treasury bills 5557
futures exchanges 184 Great Depression 52

Guide to Financial Markets.indd 286 23/10/2013 14:15


Index 287

Greece: government bonds 99 stock exchanges 179


greenhouse gases 217 technology shares 170
gross position 29 trade in stock index options 236
guarantees, securitisation 114 indications of interest 80
Indonesia
hard assets 266 1997 crisis 35
hard call protection 86 currency pegs 107
hedge funds 1112, 185, 265 industrial capacity utilisation 94
speculation 18, 23 inflation
hedging 62, 199, 221, 232, 233, 235, 259, and central banks 34, 38, 6566
271 and covered interest arbitrage 30, 31
basic hedge 248 effects of 7
currency 222 and foreign-exchange markets 17
delta 250 high 7, 52
derivatives 269 and higher interest rates 169
dynamic 231, 250251 and interest-indexed bonds 8
and option contracts 241 low 7, 167
strategies 248 managing 6465
Herstatt risk 29 and real interest rates 30
high-frequency trading 10, 1213, 18, 23 and returns on bonds 94
home purchase, raising capital 3 and the three-month rate 68
home-equity loans 68, 117, 128 and yield curve 96
Hong Kong inflation-indexed bonds 87
currency pegged to US dollar 34 informal markets 13
foreign bonds 104 information service providers 177
Hong Kong Futures Exchange 225 initial margin 227, 228, 229
Hong Kong Stock Exchanges 181, 203 initial public offerings (IPOs) 160161,
housing finance corporations 58 161, 164
Hypothekenpfandbriefe 124 investing in 164165
innovation
Ibovespa (Brazil) 224 adjusting to constant innovation 14
ICE Futures 25 encouraged 115
ICE Futures Europe 237 and risk management 8
illiquid markets 13, 136, 150 insolvency, of major banks and
IMF see International Monetary Fund investment banks 15
immediate order 189 institutional investors 50
implied volatility 247 institutional trading see under equity
importers 22 markets
index arbitrage 231 insurance companies 10, 11, 12, 91,
index equity funds 224 186, 254
index funds 195 insurance underwriting 4
index options 235236, 236 Integrated Latin American Market 184
indexes Intel Corporation 244245, 246
performance 196 Inter-American Development Bank 60
price measures 194195 interbank loans 5859, 63
stock-price 169 interbank markets 23
India Intercontinental Exchange 184, 203,
commodity contracts 200201 206, 243
currency options contracts 25 interest equalisation tax 138, 139
depositary receipts 186 interest rates
economic liberalisation 214 on bank deposits 910
emerging markets 187 benchmark 99
sale of bonds and short-term paper on bond investments 910
144 on a bond issue 7980
and securitisation 116 and bond prices 9293, 93

Guide to Financial Markets.indd 287 23/10/2013 14:15


288 Guide to financial markets

central bank 6566 special drawing rights (SDRs) 33


deregulation of 204 International Petroleum Exchange,
determined by market forces 4445 London 203, 216, 217
euro 243 Brent Crude contract 210
fall in 48, 106 international portfolio investment 22
fixed 128 International Securities Exchange
floating 128, 148 203204, 244
and foreign-exchange markets 17 international spread 231
long-term 48, 56, 66, 71, 101 International Swaps and Derivatives
low-interest-rate environment 6, 77 Association 255
lowering 34 internet
nominal 94 and bond sales 80
and prices 5051, 51 brokerages 191
real 30, 38, 40 and share prices 176
rise in 8, 3334, 36, 59, 64, 99, 108, intervention 23, 39
146, 147, 169 intra-commodity spread 231
short-term 38, 48, 51, 52, 56, 62, intrinsic value 246
6669, 87, 96 inverse (reverse) floaters 261, 271272
interest-rate options 236237, 260261 inverted market 211
contracts 76 investment
intergenerational equity 72 algorithmic traders 1213
intermediation 47 bond 9
internalisation 185 capital gains 9
international agency paper 60, 63 foreign direct 22
International Capital Markets and foreign-exchange markets 17
Association (ICMA) 151 hedge funds 1112
international equity issues 179180, individual 910, 15
180 institutional 1013, 11, 15, 18
international fixed income markets insurance companies 12
137153 international portfolio 22
bond issuance 140, 149150 mutual funds 10
Euromarkets, a brief history of overnight investments 50
137139 pension funds 12
back in business 138139 role of financial markets 3
market surge 138 yield 9
global bonds 149 investment banks
the international bond market and bond indexes 108
today 139, 140, 141142, 142 and bonds 78, 80, 86, 149
the issuers 144146, 145, 146 distribution of shares on best-
looking ahead 153 efforts basis 163
money-market instruments 142143, indexes of performance of asset-
143 backed securities 136
obtaining price information 151152, insolvency 15
152 and IPOs 164165
swaps market 147149, 148 and repos 61
towards international standards 151 and securitisation 113, 119120
trading 150 speculators 23
types of instruments 146147 investment companies 10, 11, 15, 44,
equity-linked bonds 147 45, 50
fixed-rate bonds 147 Investment Company Institute 48
floating-rate bonds 147 investment funds 11, 23, 47, 253
international listings 186 investment managers 108
International Monetary Fund (IMF) investment trusts 10, 50
lending to members 33 investor protection/regulation 14
and share fads 170 Ireland, and securitisation 123

Guide to Financial Markets.indd 288 23/10/2013 14:15


Index 289

irredeemable debentures 85 labour unions 12


Italy Latin America
government bonds 99 depositary receipts 186
local government bonds 74 emerging markets 187
and securitisation 116 and exchange-rate problems 145
volatile stock exchange 196 stock exchanges 184
iX (proposed single exchange) 182 LEAPS (long-term equity participation
securities) 239
Japan legal procedures
bankers cartel 76 enforcing contracts 14
Bond Issue Arrangement settling disputes 14
Committee 76 Lehman Brothers 84, 270
bonds 73, 74 lending, reduction in 6, 7
commodity exchanges 202 lesser maintenance margin 228
cross-border share and bond letters of credit 130
transactions 5 leverage 2122, 72, 101, 174, 267
discount rate 65 see also gearing
economy 67 leveraged speculation 241
foreign bonds 104 liberalisation 15
gensaki market (repos with Libor see London inter-bank offered
Japanese government bonds) 62 rate
government bonds (JPGs) 73 life insurance companies 119120
high-yield markets 101 life insurance policies 12, 129
institutional investors 10 limit down 211
liberalisation 15 limit move 211
long-term bonds 56 limit orders 188189, 204
money-market funds 48 limit up 211
overnight rates 6768, 67 liquidation of the initial contracts 205
and securitisation 116, 125126 liquidity 1314
share price decline 180 and after-hours trading 209
short-term securities 56 and futures and options exchanges
stock exchange merger (2013) 200
183184 futures contracts 257
and trade in government securities lack of 65
84 of main bond markets 105
weighted indexes 109 meeting short-run liquidity needs
yield curve 96, 97 45
Japan Housing Finance Agency 126 and money markets 46, 47
Japanese yen, dollar/yen trades 27 and repos 60
JASDAQ (Tokyo) 181 short-term liquidity transactions 44
Johannesberg SE 25 and speculation 199200
joint ventures 184 and stock exchanges 178
Journal of Commerce 232 Lisbon Stock Exchange 181, 183
JP Morgan Emerging Market Bond listing particulars/prospectus 162
Index Plus (EMBI+) 109 loans
junk bonds 101 automotive 113, 117, 128129, 133
and averting bankruptcy 54
Kansas City Board of Trade 202, bank 72, 139, 156, 258
208 and bankers acceptances 55
Kennedy, President John 138 central bank loan rates 65
Keynes, John Maynard 154 and commercial paper 53
Korea Exchange 25, 242 credit-card 68, 133, 134
Korean Futures Exchange 235 domestic 4
KOSPI (South Korea) 224 floating-rate 59, 258
Kuwait, pegs and baskets 36 home-equity 68, 117, 128

Guide to Financial Markets.indd 289 23/10/2013 14:15


290 Guide to financial markets

interbank 5859, 139 matched book trading 61


international bank 4, 56, 5 matched sale-purchase transactions 65
mortgage 68 MATIF, Paris 201
overnight 59 maturity, bond 8788
repayment 35 medium-term notes 141, 142
repo 61 mergers
short-term 59, 139 among commodity exchanges
small business 129 292293
student 129, 130 and cross-margining 230
subprime 128 forced 15
syndicated 6, 16 Metallgesellschaft 271
uncollateralised 66 MexDer 25
unsecured 59 Mexico
local government notes 58, 63 abandons its crawling peg 37
local governments 58 bond markets 71
locked market 211 bond sales abroad 144
London debt crisis (1995) 57
currency trading 24, 27, 28 devalues the peso 145
foreign banks set up offices 139 floating rates 37
most important location for trade-weighted exchange rate 42
international share trading 186 MF Global 229
London inter-bank offered rate (Libor) MICeZ/RTS, Russia 25
59, 133, 258, 261, 268 Milan stock exchange 202
London Metal Exchange 203, 215216, Monetary Control Act (1980) (US) 44
229, 241 monetary policy
London Stock Exchange 2, 150, 178, and the ECB 66
180183, 196 and money markets 6465
London Stock Exchange Group 202 money changers, street-corner 2
long position 205 money markets 4469
Luxembourg Stock Exchange 150 credit ratings and the money
market 6364, 64
Maebashi Dried Cocoon Exchange tier importance 64
202 defined 44, 46
maintenance margin 194, 229 and foreign-exchange trading 21
managed float 3537 freezing of 4546
bands 3536 futures and the money markets 62
the crawling peg 3637 how trading occurs 6263
pegs and baskets 36 interest rates and prices 5051
target zones 36 investing 3
manufactured-housing securities 129 investing in money markets 4750
margin calls 194, 228229 individual sweep accounts 50
margin loan 194 institutional investors 50
marginal lending rate 65 money-market funds 4748, 48
market efficiency 171 stable value 4950
market in backwardation 211 money markets and monetary
market in contango 211, 219 policy 6466
market orders 188, 204 central bank interest rates 6566
market performance, measuring repos 6062
194196 types of instruments 5160, 51
price measures 194196 bankers acceptances 55
averages 194 commercial paper 50, 5255, 53
indexes 194 government agency notes 58
market-if-touched orders 204 interbank loans 5859
marketmakers 189, 191 international agency paper 60
marking to market 228 local government notes 58

Guide to Financial Markets.indd 290 23/10/2013 14:15


Index 291

time deposits 5960 National Stock Exchange of India 25,


treasury bills 5557, 57 26, 223
watching short-term interest rates net position 29
6669 net value 255
overnight rates 6768, 67 Netherlands, and commercial paper
the prime rate 68 54
spreads 6667 netting 26, 257
UK mortgage rates 69 New York, currency trading 24
what money markets do 46 New York Board of Trade (NYBOT)
money-market funds 4748, 48, 50, 52 206, 213, 218, 235
money-market instruments 142143, New York Cotton Exchange 203
143 New York Mercantile Exchange 202,
moneychangers 19 216
Moodys Investor Services 6364, 64, New York Stock Exchange (NYSE) 1,
90 180184, 194, 203, 225, 239
mortgage-backed securities see under ARCA options exchange 244
securitisation New York Stock Exchange Composite
mortgages Index 195
adjustable-rate mortgage loans 68 NHA MBS 123
agricultural 123 Nikkei 225 index 224
commercial 116 Nikko Bond Performance Index 109
fixed-rate 125, 134 Nomura Bond Performance Index 109
office-building 114 non-mortgage securities see under
primary mortgage market 118 securitisation
secondary mortgage market 118, 123 non-refundable bonds 85
UK mortgage rates 69, 125 normal market 211
US home mortgages go into default notional principal 254
272 notional value 254255, 261
Moscow Narodny Bank 137
Multi-Commodity Exchange of India Obligations assimilable du trsor
203, 214, 216, 223 (OATs) 73
multinational corporations 144, 186 OBX share-price index 224
multiple-index floaters 261 Oeffentliche Pfandbriefe 124
mutual funds 10, 50, 82, 131, 136 off-market trading 185186
mutual ventures 182 offer document 7778
official statement (bond issuance)
naked calls 249 7778
naked puts 249 oil market 13
NASDAQ 178, 180, 181, 184, 191 oil refiners 217
NASDAQ 100 Index 224, 244 open interest 219
NASDAQ Composite Index 195 open order 189
NASDAQ OMX PHLX (previously open repos 61
Philadelphia Stock Exchange) 26, open-market operations 6566
237, 243, 244, 252 open-outcry trading 207208, 209
National Association of Securities Oporto stock exchange 183
Dealers Automated Quotation option traders 246
System (later NASDAQ) 180 optionality factory 132133
National Commodity and Derivatives options 253
Exchange 214 American-style 240
national debt-management offices 86 barrier 20
National Home Loans 125 bond 236
National Housing Act (Canada) 123 capped 240, 260
National Stock Exchange (formerly commodity 237, 252
known as Cincinnati Stock currency 20, 2526, 202, 237238, 238
Exchange) 184 difference (diff) 260261

Guide to Financial Markets.indd 291 23/10/2013 14:15


292 Guide to financial markets

equity 235, 244, 252 pegs 3335, 107


equity-index 241 and baskets 36
European-style 240 the crawling peg 3637
exchange-traded 20, 251, 256 pension funds 11, 12, 50, 82, 91, 167,
flex 239 186
global foreign-exchange market pensions
turnover 24 old age pension (UK) 7
index 235236, 236 pay-as-you-go schemes 78
interest-rate 236237, 260261 pre-funded individual pensions
metal 202 8, 12
multi-asset 261 private pension schemes 8
naked 249 social security programme (US) 7
path-dependent 268 Peoples Bank of China 126
price information 244245, 245 per-share value 49
risk management 3 performance bond 227
spread 260 perpetual debentures 85
step-down 262 Peruvian stock exchange 184
and structured securities 87 PetroChina 160
trading 244 Pfandbriefe 124125, 135, 153
yield 236237 Pfizer 239240
see also call options; put options Philadelphia Stock Exchange (later
and under futures and options NASDAQ OMX PHLX) 26, 178, 243,
markets 244
options contracts 22 Philip Morris International 160161
currency 2526 physicals (bulk commodities) 204, 231
options exchanges 184, 242244, 243 Pittsburgh, Pennsylvania 80
options markets 20, 233, 234, 246 planned amortisation class (Z tranche)
Organisation for Economic Co- 133
operation and Development points (smallest allowable price
(OECD) 10 movements) 207
originator, the 118, 119 pork-belly contract 202
Osaka Stock Exchange 183184 portfolio insurance 251
Oslo Stock Exchange 225 portfolio managers 110, 223
out trades 227 Portugal, stock exchanges 182, 183
over-the-counter, derivatives 238 position limits 207
over-the-counter transactions 82, pound sterling, minor role in London
177178 market 27
currency options 26 preferred stock 158159
international bonds 150 convertible 159
overleveraged (highly geared) firms prepayment risk 134
157 price discovery 2
overnight loans 59 price setting 2
overnight rates 67, 67 price/earnings ratio (the multiple)
overnight repos 61, 100 172173, 172
price/yield curve 93, 93
Pacific Exchange 244 prices
par value 85, 88 agricultural 218
Paris arbitrage 3
and introduction of the euro 2728 bond 91, 9195, 93, 106, 170
stock exchange 181, 182183 commodity 94, 232
pass-throughs 119, 121, 122, 124 domestic currency 39
path-dependent option 268 energy 218, 261
pay-as-you-go schemes 8 international market price
payment for order flow 191 information 151152, 152
payment-in-kind (PIK) 102 lifetime high 219

Guide to Financial Markets.indd 292 23/10/2013 14:15


Index 293

lifetime low 219 real interest rates 30


and low inflation 7 real-time settlement 63
market 2, 192, 235 recession
metals 215 countries enter recession (2001) 107
natural gas 216 and freezing of money markets
obtaining price information 3940, 4546
244245, 245 and gold standard 32
oil 216, 234, 271 United States (2001) 5
option 244245 red herring 162
price analyses of various products redundancies 73
in different countries 38 Refco 229
price movements 210211 reliability 14
price transparency 84 REMICs (real estate mortgage
the quoted price 210 investment conduits) 120
settlement 219 repo rate 60, 6667
share 5, 10, 175, 241, 251 repurchase agreements (repos) 6062,
collapses of 200809 180 65, 66, 100101, 271
factors affecting see under equity reserves
markets foreign-currency 74
obtaining information 176177, gold 138
177 Resolution Trust Corporation 119
worldwide fall (2000) 181 return on capital 174
shares, emerging-market 188 return on equity 173174
stabilising domestic 37 Reuters, and price quotations 3940
volatility 106, 145 Reuters/Commodity Research Board
pricing (of fixed-rated asset-backed Index 235
securities) see under securitisation Reuters/Jeffries Commodities
prime rate 68 Research Bureau Index 232
private offering 161162 revenue bonds 74
private pension schemes 8 reverse repos 61, 100, 101
privatisation 160 reverse stock splits 170171
Procter & Gamble 271 rho 248
program trades 192 rising stars 102103
property insurance policies 129 risk management 3, 89, 197, 233, 241
prospectus (bond issuance) 7778 risk measures 196
protection 263264 risk(s)
public-sector debt 75 accounting 272273
purchasing power parity 38 attaching a price to risk 3
put options 234, 235, 239, 240, 241, and bond markets 71, 72
244, 246 and commercial paper 5455
naked 249 counterparty 63, 256, 264
putable bonds 85, 87 credit 133134
currency 105, 107
QQQ option 244 exchange-rate 20
QQQ trading 243 extension 134
qualified institutional buyers (QIBs) and hedging 199, 221
150 and high-yield issuers 101
quality differential spread 231 legal 256
prepayment 134
rail cars, loans on 129 price 256
raising capital 3 ratings on bond issuance risk 8991,
random walk 171 90
rating agencies 8991, 99, 105, 109, 118, of recording artists 115
134, 144, 145 redistribution of 8
ratio swaps 271 reinvestment 86

Guide to Financial Markets.indd 293 23/10/2013 14:15


294 Guide to financial markets

risk aversion of money-market non-mortgage see under


investors 45 securitisation
servicing 135 prices 12, 13
settlement 257 registration of new 52
synthetic securities 268269 in retirement accounts 9
trading 3 sale of 4, 5, 65
underwriting 134135 short-term 49, 50, 56, 143
RMX exchange 213 structured 87, 131132
Roche Holding 149 synthetic 266268, 267
Rome, and introduction of the euro underlying interest-rate-sensitive
2728 222
Russell 2000 index 244 US Treasury 68
Russia securities analysts 169
bonds 73, 106, 107, 110 Securities and Exchange Commission
exchange-rate problems 145 52
financial crisis in (1998) 5, 57, 107, securities markets, size of 139, 139, 141
272 securities regulator 162
Russian exchange 25 securitisation 7, 111136
asset-backed commercial paper
S&P/Case Shiller Home Price Index 130131
225 buying asset-backed securities 135
Sallie Mae 129 categories of asset-backed securities
samurai bonds 104 112
So Paulo Stock Exchange, Brazil 24, defined 113, 156157
202 market development 116118, 117,
savings, retirement 10, 12 117
school authorities 58 measuring performance 135136
secondary dealing 82 mortgage securities outside the
secondary markets 99, 118, 120, 122, United States 123126, 123
129, 150 Australia 126
secondary offering 162 Canada 123124
securities China 126
acquired by investment trusts 10 Denmark 124
agency 120123, 120 Germany 124125
and algorithmic trading 12 Japan 125126
asset-backed see asset-backed UK 125
securities other parts of Europe 125
available information about 14 mortgage-backed securities 118120,
commercial mortgage-backed 123, 124, 267
(CMBS) 119120 CMBS 118, 119120
credit-card 127128 Fannie Mae led the way 118119
debt 71, 76, 80, 83, 139, 141, 145 pass-through certificates 119
euro-dominated 141 REMICs 120
fixed-income 71, 135 spreads on 133134
floating-rate 261 non-mortgage securities 126130, 127
and foreign-exchange trading 21 automotive loans 128129
government 67, 84, 96, 97, 98, 142, credit-card securities 127128
150 home-equity loans 128
long-term equity participation manufactured-housing securities
(LEAPS) 239 129
longer-term 46, 125 student loans 129, 130
manufactured-housing 129 assorted others 129130
money-market 47, 49, 5051, 58, 61 pricing 133135
mortgage-backed see under asset characteristics 134
securitisation credit risk 133134

Guide to Financial Markets.indd 294 23/10/2013 14:15


Index 295

extension risk 134 ordinary (common stock) 158


prepayment risk 134 raising capital 3, 13
rating 134 selling 13
servicing risk 135 share repurchases 165166
underwriting risk 134135 technology 170, 172
the process 113 trading 188189
securitisation process 113114 the value of share turnover 155, 156
recourse to guarantees 114 shipping containers, loans on 129
structured finance 131133 short sales 192193
the optionality factor 132133 short-term demand deposits 44
of unsound loans 113114 short-term euronotes 142
US agency securities 120123, 120 short-term notes 62, 67
Fannie Maes 121 Singapore
Farmer Macs 122123 foreign bonds 104
Freddie Macs 122 over-the-counter currency options
Ginnie Maes 121122 26
why securitise? 114116 pegs and baskets 36
security single European currency 35, 77, 99,
enhancing 99100 142, 201, 223
bond insurance 100 single-price auction trading 208
covenants 99 sinking funds 100
sinking funds 100 small businesses, bank lending to 4,
sell orders 208 156
semi-fixed systems 3537 small-cap stocks 173
bands 3536 South Korea
the crawling basket 3637 1997 crisis 35
the crawling peg 3637 bond markets 77, 110
pegs and baskets 36 currency pegs 107
target zones 36 exchange-rate problems 145
semi-sovereigns 74, 75 floating rates 37
servicing risk 135 liberalisation 15
session trading 208 merger of stock and futures
settlement 2829, 193, 207, 227, 251 exchanges 243
Shanghai Futures Exchange 216 South Korean stock index 235, 242
Shanghai Stock Exchange 181 sovereign ceiling 105
share-price indexes 235 sovereign wealth funds 23
shareholders funds 114 sovereigns 7374, 75
shares Spain
different approaches to selling bonds 74
163164 and commercial paper 54
early shareholder-owned government bonds 99
enterprises 154 mortgage-backed securities 133134
in employers 9 and securitisation 123
factors affecting prices see under special drawing rights (SDRs) 33
equity markets special-purpose bonds 7475
fads 170 specialists 189
and foreign-exchange markets 22 speculation 199200, 232
gilt-edged 73 leveraged 241
and globalisation 16 speculators 23
indexes of 109, 188 sports securitisations 130
issuing 159160 spot market 19, 21, 21, 24, 24, 29, 31
market value 194 spot price 211
negotiable share certificates 154 spot rates 40
obtaining share price information spot transactions 24
176177, 177 spread option 260

Guide to Financial Markets.indd 295 23/10/2013 14:15


296 Guide to financial markets

spreading 250 Sumitomo 229


spreads 13, 24, 40, 47, 6667, 92, 9899, support tranche 132133
133134, 191, 231 surety bonds 130
stabilisation programmes 144 swap spreads 148
stable value 4950 swaps 79, 147
Standard & Poors (S&P) 6364, 64, credit default 263265, 265, 267, 270,
90, 103 272
500 stock index 191, 195196, 210, currency 24, 26, 259260, 260
224, 235 fixed-for-floating 147148
step-down options 262 foreign-exchange 20, 21, 24, 25
step-up bonds 87, 91 interest-rate 148, 148, 258259, 258,
step-up coupon notes 261 266, 268
stock brokerages 177 ratio 271
stock dividend (capitalisation issue) swaps market 147149, 148
168 swaption 260
stock exchanges 178184 sweep accounts 50
the biggest exchanges 180184, 181, Switzerland, sale of bonds and short-
183 term paper 144
demutualisations 182, 183 Sydney Futures Exchange 221, 237
how they work 189190 syndicates 78, 149150
London 2 synthetic securities 266268, 267
National Stock Exchange of India 25
New York 1 Taiwan, and securitisation 116
order books 192 target zones 36
Philadelphia (now NASDAQ OMX taxation 14
PHLX) 26 and bond issuance 81
Russian exchange 25, 26 interest equalisation tax 138, 139
secondary dealing 82 receipts 58
securities traded 135 revenue generated by formal
selling shares 13 markets 13
stock markets tax anticipation notes 58
crash of 200809 9 tax increases 73
investing 3 tax laws and dividend payments
rise in (201213) 8 167
volatility 196 withholding tax 153
stock price technical analysis 169
indexes 169 Tel Aviv exchange 25
stock price drops (October 1997 and telecommunications 14
September 1998) 196 Tennessee Valley Authority 58
stock splits 170171 term factor 211
stockbrokerage commissions 252 term repos 61
stop order 189 Thailand
straddles/straddling 232, 249250 1997 crisis 35, 272
straight bonds 85 currency pegs 107
strike price 234, 242, 244, 244245 exchange-rate problems 145
strips 232 Thales 198
STRIPS (separately registered interest three-month rate 67, 68
and principal of securities) 86, 132 ticker symbols 176
structured securities 87, 131132 ticks (smallest allowable price
the optionality factor 132133 movements) 207
Student Loan Marketing Association time deposits (certificates of deposit)
(SLMA) 129 5960, 64, 142
student loans 129, 130 time value 246247
subprime loans 128 toggle provisions 102
sulphur dioxide emissions 217 Tokyo, currency trading 24

Guide to Financial Markets.indd 296 23/10/2013 14:15


Index 297

Tokyo Commodity Exchange 201202, setting interest rate on a bond issue


216 79
Tokyo Grain Exchange 213 and share sales 163
Tokyo Stock Exchange 180, 184 underwriting risk 134135
Toronto Stock Exchange 244 unemployment
tracker funds 195196, 224 in Argentina 34
trade-weighted exchange rates 4243, and interest-rate policy 39
43 in United States 129
trading locations 2326, 24, 25 unit trusts 10
tranches 132133, 149 United Arab Emirates, auto-loan
transparency 14 securities 128
transport commissions 58 United States
treasuries, national, intervention by 23 agency securities 120123, 120
treasury bills (t-bills) 23, 5557, 57, 63 asset-backed commercial paper 131
treasury stock 165166 auto-loan securities 128
triple-witching days 241 balance-of-payments deficit 138
Turkey bankers acceptances 55
financial crisis in 106 bond insurance 100
international debt securities 144 bond markets 70, 71, 7374, 76, 77,
two-for-one splits 170 78, 101, 105
bond regulations 150
UK CMBS issuance 120
bond market 105 and commercial paper 52, 53, 53,
collapse of housing market (2008) 54, 64
125 commissions deregulated 190
and commercial paper 54 consolidation in 15
commissions deregulated 190 credit-card securities 127128
consolidation in 15 currency options contracts 25
credit-card securities 128 dark pools 185
foreign bonds 104 deregulation by 4748, 52
high-yield markets 101 discount rate 65
institutional investors 10 economic growth 129
money-market funds 48 economic turmoil (200709) 164
mortgage rates 69 financial meltdown (200809) 5
old-age pensions 7 foreign bonds 104
over-the-counter currency options 26 global bonds 149
share flotation 163 housing-market collapse 267, 272
short-term treasury debt 56 individual investment 9
and spreads 66 initial public offerings (IPOs) 160,
venture capital 158 161, 164
yield curve 96, 97 institutional investors 10
uncovered (naked) calls 239 interest rates 6
underleveraged firms 157 large government deficit (from
underlying 204, 233, 234, 242 2008) 57
commodities/products 207, 210 largest market for equities 181
exchanging 252 manufactured-housing securities
spreading 250 129
volatility 247 mortgage securities 113, 136
underlying assets 204, 206, 231, 247, national debt 56
248 over-the-counter currency options
underlying equity 225 26
underlying interest-rate-sensitive over-the-counter trading 177178
securities 222 prime rate 68
underwriters private-sector debt securities 76
and bond issuance 7879 recession (2001) 5

Guide to Financial Markets.indd 297 23/10/2013 14:15


298 Guide to financial markets

red herring 162 value in vesting 173


reduced government debt (1990s) variable-rate bonds 87
57 variation margin 228
registration of new securities 52 vega 248
REMICs 120 venture capital 157158
repo market 61 Veterans Administration 122
rescue of Fannie Mae and Freddie volatility 106, 173, 177, 188, 196, 247,
Mac 74 248, 249, 268
sale of bonds and short-term paper
144 wages
and securitisation 116, 127 increases 94
settlement time 194 reductions 73
share flotation 163 Walt Disney Co, The 129
shift of short-term capital into Warenterminbrse Hannover 213
investment funds 47 warrant bonds 87
social security programme 7 warrants 159
and spreads 66 weighted average maturity 134
stock exchanges 179 weighted index 108109
stockbrokers prohibited from wheat futures contracts 213, 214
setting uniform commissions for Winnipeg Commodity Exchange 203,
share trading 15 208
time deposits 60 World Bank
and trade in government securities bond issuers 144
84 global bonds 149
trading on NASDAQ stockmarket international agency paper 60
178 price analyses of various products
unemployment 129 in different countries 38
venture capital 158
yield curve 96, 97 Yankee bonds 104, 138
US consumer-price index 225 yield
US Department of Agriculture 123, 225 and bond issuance 81
US dollar current 88
dollar/euro trades 27 defined 9
dollar/yen trades 27 and foreign-exchange markets 18
effect of euros introduction 28 yield curve 68, 9596, 97, 98, 260
US Federal Reserve 49, 66, 272 inverted 96
US municipal bond indexes 235 steepening of 98
US Treasury yield options 236237
bills 56 yield to maturity 88
bonds (Treasuries) 8, 73, 80, 92, 98,
103, 104, 222, 225 Z tranche (planned amortisation class)
and Farmer Macs 123 133
securities 68 zero-coupon bonds 86, 87
Zhengzhou Commodity Exchange 213
value added 174

Guide to Financial Markets.indd 298 23/10/2013 14:15