Capital Markets

Institutions, Instruments, and Risk Management

fifth edition

Frank J. Fabozzi

The MIT Press

Cambridge, Massachusetts
London, England
Contents

Preface xxvii
Acknowledgments xxxv

PART I: INTRODUCTION 1

1 Financial Assets and Financial A/Iarkets 3

Learning Objectives 3
Financial Assets 4
Debt versus Equity Claims 5
The Value of a Financial Asset 5
Financial Assets versus Tangible Assets 8
The Role of Financial Assets 8
Properties of Financial Assets 9
Financial Markets 13
The Role of Financial Markets 13
Classification of Financial Markets 14
Globalization of Financial Markets 16
Classification of Global Financial Markets 17
Derivative Markets 18
Financial Markets and the Real Economy 19
Asset Classes 21
Key Points 23
Questions 25

2 Overview of Risks and Risk Management 29

Learning Objectives 29
Defining Risk 30
Risk versus Uncertainty 31
Systematic Risk versus Idiosyncratic Risk 32
 Financial Risk Management 33
Identifying Financial Risks 33
Quantifying Risks 33
Evaluating How to Deal with Each Identified Risk
Investment Risk 37
Credit Risk 37
Price Risk 40
Reinvestment Risk 42
Inflation Risk 43
Liquidity Risk 43
Foreign Exchange Rate Risk 44
Longevity Risk 44
Funding Risk 46
Leverage Risk 46
Funding Liquidity Risk 48
Timing Risk 48
Fixed-Floating Financing Risk 50
Systemic Financial Risk 50
Financial Innovation 51
Key Points 52
Questions 55

PART II: THE PLAYERS 61

3 Overview of Market Participants 63

Learning Objectives 63
Investors and Issuers 64
Households 64
Nonfinancial Corporations 65
Governments 66
Depository Institutions 66
Institutional Investors 66
Securities Brokers and Dealers 71
Nonprofit Organization 71
Foreign Investors 72
Financial Institutions 75
Financial Intermediaries 76
Role of Governments in Financial Markets 78
Regulation of Financial Markets 80
Acting as Financial Intermediaries 83
Contents ix

Influencing Financial Markets through the Actions of the Central Bank 84

Providing Financial Assistance and Support for Bailouts 86
Credit Rating Agencies 91
The Role of CRAs in the Financial System 93
Use of Ratings by Regulators 93
Nonregulatory Use of Ratings 94
Concems Regarding CRAs 95
Other International Participants 98
Bank for International Settlements 98
Financial Stability Board 99
Key Points 100
Questions 103

4 Depository Institutions 107

Learning Objectives 107
The Asset/Liability Problem of Depository Institutions 108
Regulators of Banks 110
The Federal Reserve 111
Office of the Comptroller of the Currency 112
Federal Deposit Insurance Corporation 113
Bank Regulation 115
Safety and Soundness Regulation 115
Deposit Insurance 120
Bank Activities 123
Bank Funding 124
Deposits 125
Reserve Requirements and Borrowing in the Federal Funds Market 125
Borrowing at the Fed Discount Window 126
Other Nondeposit Borrowing 126
Nonbank Depository Institutions: Thrifts 127
Savings Institutions 127
Credit Unions 129
Shadow Banking 130
Key Points 133
Questions 137

5 Insurance Companies and Defined Benefit Pension Plans 141

Learning Objectives 141
Insurance Companies 142
Stock versus Mutual Insurance Companies 143
Insurance Companies versus Types of Products 145
 Fundamentals of the Insurance Industry 145
Regulation of Insurance Companies 146
Types of Life Insurance 149
Other Investment-Oriented Policies 151
Taxation of Life Insurance 153
General Account and Separate Account Products 153
Insurance Company Investment Strategies 154
Failures of Insurance Companies 155
Catastrophic Risk and Its Management 156
Insurance-Based Investment Banking 158
Defined Benefit Pension Funds 159
Defined Benefit Pension Plans and Variants 161
Regulation 162
Private-Sector Defined Benefit Pension Plan Problems 163
The Pension Benefit Guaranty Corporation 167
Public-Sector Defined Benefit Pension Plan Problems 168
Key Points 169
Questions 171

Managers of Collect!ve Investment Vehicles 175

Learning Objectives 175
Investment Company Shares 176
Open-End and Closed-End Funds 177
Fund Sales Charges and Annual Operating Expenses 179
Economic Motivation for Funds 181
Types of Funds by Investment Objective 182
The Concept of a Family of Funds 183
Exchange-Traded Funds 184
Types of ETFs and ETF Sponsors 186
The Process of Creating and Redeeming ETF Shares 186
Tracking the Performance of ETFs 187
Uses of ETFs 188
Hedge Funds 188
Attributes of Hedge Funds 189
Types of Hedge Funds 191
Concerns with Hedge Funds in Financial Markets 193
Real Estate Investment Trusts 194
Types of REITs 195
Contents

Venture Capital Funds 196

Venture Capital Firms 197
Investing in a Venture Capital Fund 198
Stages of a Venture Capital Fund 198
Key Points 199
Questions 202
7 Investment Banking Firms 205
Learning Objectives 205
Public Offering (Underwriting) of Securities 207
Trading of Securities 210
Riskless Arbitrage 210
Risk Arbitrage 212
Proprietary Trading 214
Execution of Trades for Clients 217
Research and Trading 217
Private Placement of Securities 217
Securitization of Assets 218
Mergers and Acquisitions 218
Merchant Banking 220
Financial Restructuring Advising 221
Securities Finance 221
Prime Brokerage 222
Trading and Creation of Derivative Instruments 222
Asset Management 223
Key Points 223
Questions 226
PART III: BASICS OF CASH AND DERIVATIVES MARKETS 229
8 Primary and Secondary Markets 231
Learning Objectives 231
Primary Market 232
Federal Securities Law and Regulation of the Issuance of Securities
Variations in the Underwriting of Securities 239
World Capital Markets Integration and Fundraising Implications 2
Motivation for Raising Funds outside the Domestic Market 244
Secondary Markets 245
Function of Secondary Markets 246
Architectural Structure of Secondary Markets 246
Trading Locations 248
Role of Brokers and Dealers in Real Markets 257
xii Contents

Market Efficiency 259

Key Points 262
Questions 265

9 Introduction to Linear Payoff Derivatives: Futures, Forwards, and Swaps 271

Learning Objectives 271
Classification of Derivatives 272
Linear versus Nonlinear Payoff Derivatives 272
Types of Linear Payoff Derivative Contracts 274
Futures Contracts 274
Forward Contracts 277
Swaps 278
Applications 280
Pricing of Futures and Forward Contracts 283
Numerical Illustration 283
Theoretical Futures Price Based on Arbitrage Model 286
Price Convergence on the Delivery Date 289
A Closer Look at the Theoretical Futures Price 289
General Principles of Hedging with Futures 291
Risks Associated with Hedging 291
Short Hedge and Long Hedge 292
Hedging Illustrations 292
The Role of Linear Payoff Derivatives in Financial Markets 303
Effect of Futures and Swaps on the Volatility of the Underlying Asset 304
Is Increased Asset Price Volatility Bad? 304
Key Points 305
Questions 307

10 Introduction to Nonlinear Payoff Derivatives: Options, Credit Default Swaps, Caps,

and Floors 313
Learning Objectives 313
Types of Nonlinear Payoff Derivatives 314
Options 314
Exotic Options 326
Caps and Floors 327
Credit Default Swaps 329
Pricing of Options 330
Basic Components of the Option Price 330
Put-Call Parity Relationship 331
Factors That Influence the Option Price 333
Option Pricing Models 335
Contents xiii

Economic Role of Nonlinear Payoff Derivatives 341

Key Points 344
Questions 346

11 Securitization and Its Role in Financial Markets 351

Learning Objectives 351
Securitization and the Creation of a Securitized Product 352
The Parties to a Securitization 353
Securitized Products Created and Transaction Structure 354
Benehts of Securitization to Financial Markets 358
Concerns with Securitization 360
Need for the Development of an Accommodating Legal Structure 362
The Role of the SPV 363
Legal Challenges 365
Securitization as a Corporate Risk Management Tool 366
The Subprime Mortgage Crisis and Securitization 367
The Dodd-Frank Act and Securitization 369
Key Points 371
Questions 373

PART IV: RISK AND RETURN THEORIES 375

12 Return Distributions and Risk Measures 377

Learning Objectives 377
Measuring the Rate of Return 378
Return Distributions 379
Describing a Probability Distribution 379
Continuous Probability Distributions Used to Describe Returns 382
Family of Stable Distributions 386
Some Stylized Facts about Stock Returns 388
Joint Probability Distributions 389
Covariance and Correlations 390
Copula Functions and Tail Dependence 391
Portfolio Risk Measures 392
Coherent Measures of Risk 393
Alternative Portfolio Risk Measures 393
Safety-First Risk Measures 394
Reward-Risk Ratios 397
The Reward Measure 398
The Risk Measure 400
xiv Contents

Key Points 400

Questions 404

13 Portfolio Selection Theory 411

Learning Objectives 411
The Concept of Portfolio Diversification 412
Markowitz Portfolio Theory 414
Expected Portfolio Return 414
Measuring Portfolio Risk 415
The Role of Correlation on Portfolio Risk and the Diversification Effect 416
Constructing Portfolios 417
Selecting the Optimal Portfolio 421
Criticisms of Portfolio Theory 423
Behavioral Finance Theory and Investor Decision Making 425
Markowitz Portfolio Theory in Practice 428
Key Points 430
Questions 431

14 Asset Pricing Theories 435

Learning Objectives 435
Economic Assumptions 436
Assumptions about Investor Behavior 436
Assumptions about Capital Markets 437
Capital Market Theory 437
Deriving the Formula for the CML 439
Interpreting the CML Equation 441
The Capital Asset Pricing Model 442
Systematic and Unsystematic Risk 442
Quantifying Systematic Risk 443
Estimating Beta 446
The Security Market Line 448
The SML, CML, and Market Model 449
Tests of the CAPM 450
The Multifactor CAPM 453
The Arbitrage Pricing Theory Model 454
Assumptions of the APT Model 454
Derivation of the APT Model 455
Comparison of the APT Model and CAPM 457
Advantages of the APT Model 458
Contents xv

Factor Models in Practice 458

Statistical Factor Models 458
Macroeconomic Factor Models 459
Fundamental Factor Models 460
Some Principles to Take Away 460
Key Points 461
Questions 463

PART V: INTEREST RATE DETERMINATION AND DEBT PRICING 465

15 The Theory and Structure of Interest Rates 467

Learning Objectives 467
The Theory of Interest Rates 468
Description of Preferences between Current and Future Consumption 468
Opportunity in the Loan Market 470
Economic Forces Affecting the Market Rate 472
Carryover through Investment 473
Consumer Choices 473
Market Equilibrium 478
Efficiency Properties of Markets 482
Real and Nominal Interest Rates: Fisher's Law 483
The Structure of Interest Rates 484
The Base Interest Rate 484
The Risk Premium 485
Term to Maturity 487
Inclusion of Options 488
Taxability of Interest 489
Alternative Benchmark Interest Rates 491
Key Points 494
Questions 495

16 Valuation of Debt Contracts and Their Price Volatility Characteristics 499

Learning Objectives 499
Features of Debt Contracts 500
Basic Valuation Principles 501
Return from a Bond: Yield to Maturity Measure 502
Price of an Option-Free Bond 504
Reasons for Changes in Bond Price 504
What Determines the Premium-Par Yield 505
Reinvestment of Cash Flow and Yield 506
xvi Contents

Bond Price Volatility 507

Review of Price/Yield Relationship 507
Price Volatility Properties 507
Characteristics of a Bond That Affect Price Volatility 510
Measure of Price Volatility: Duration 510
Convexity 519
Key Points 521
Questions 523

17 The Term Structure of Interest Rates 527

Learning Objectives 527
The Yield Curve and the Term Structure 528
Using the Yield Curve to Price a Bond 529
Constructing the Theoretical Spot Rate Curve 530
Using Spot Rates to Value a Bond 534
Forward Rates 534
Relationship between Spot Rates and Short-Term Forward Rates 539
Forward Rate as a Hedgeable Rate 540
Historical Shapes Observed for the Treasury Yield Curve 540
Determinants of the Shape of the Term Structure 542
The Pure Expectations Theory 543
The Liquidity Theory 546
The Preferred Habitat Theory 546
Market Segmentation Theory 547
The Main Influences on the Shape of the Yield Curve 548
Key Points 550
Questions 552

PART VI: EQUITY MARKETS 557

18 The Structure of the Common Stock Market 559

Learning Objectives 559
Regulators of Equities Markets 560
Securities and Exchange Commission 560
Financial Industry Regulatory Authority 562
State Regulation 562
Equity Trading Venues 563
Exchange Market for Listed Stocks 564
Exchange Market for Unlisted Stocks 566
Alternative Trading Systems 568
Contents xvii

Execution of an Order 571

Execution of an Order Placed with a Broker 571
Market Trading Regulation 572
Regulatory Background 573
Market Regulation 574
Other Types of Common Stock Trading 579
Offshore Trading 579
Rule 144a Securities 579
American Depositary Receipts 580
Trading of Stocks Outside the Country Where They Are Domiciled 580
Global Depositary Receipts 581
Euro Equity 582
Key Points 583
Questions 587

19 Common Stock Strategies and Trading Arrangements 589

Learning Objectives 589
Stock Market Indexes 590
Major International Stock Market Indexes 591
Pricing Efficiency of the Stock Market 592
Forms of Efficiency 593
Micro versus Macro Stock Market Efficiency 594
Implications for Investing in Common Stock 594
Global Investing Strategies 596
Trading Mechanics 598
Types of Orders 598
Margin Transactions 600
Trading (Transaction) Costs 602
Explicit Costs 602
Implicit Costs 604
Classification of Trading Costs 605
Research on Trading Costs 605
Trading Arrangements for Institutional Investors 606
Block Trades 606
Program Trades 607
High-Frequency Trading 610
Key Points 614
Questions 618
xviii Contents

PART VII: DEBT MARKETS 623

20 The Money Market for Private Debt Instruments 625

Learning Objectives 625
Interbank Funding Market 627
Federal Funds Market 627
Future of the Interbank Funding Market 630
Repo Market 631
Credit Risks 632
Participants in the Market 634
Determinants of the Repo Rate 635
Commercial Paper Market 636
Nonfinancial and Financial CP 637
Asset-Backed CP 639
Defaults in the CP Market and the Recent Financial Crisis 640
Yields on CP 641
Non-U.S. CP Markets 642
Large-Denomination Negotiable Certificates of Deposit 642
CD Issuers 643
CD Yields 643
Banker's Acceptances 644
Illustration of the Creation of a BA 645
Accepting Banks 646
Eligible BAs 646
Credit Risk 647
Funding Agreements 647
Money Market Funds 648
Types of MMFs 649
SEC MMF Rules Adopted and Proposed as a Result of the Financial Crisis 651
Key Points 653
Questions 656

21 Treasury and Agency Securities Markets 659

Learning Objectives 659
U.S. Department of the Treasury and Debt Management 660
Office of Debt Management 660
Treasury Debt Management and the Financial Crisis 666
The Market for U.S. Treasury Securities 667
Types of Treasury Securities 668
The Primary Market 670
 Contents xix

The Secondary Market 675

Regulation of the Secondary Market 676
Stripped Treasury Securities 677
Coupon Stripping and the Theoretical Value of Treasury Securities 679
The Market for Federal Agency Securities 681
Tennessee Valley Authority 682
Fannie Mae 683
Freddie Mac 683
Federal Agricultural Mortgage Corporation 684
Federal Home Loan Bank System 684
Federal Farm Credit Bank System 684
Key Points 685
Questions 687

22 Municipal Securities Markets 691

Learning Objectives 691
Tax-Exempt versus Taxable Municipal Securities Market 693
Yields in the Municipal Securities Markets 694
Types and Features of Municipal Securities 695
Tax-Backed Debt 695
Revenue Bonds 696
Hybrid and Special Bond Structures 696
Municipal Notes 699
Redemption Features 700
Credit Risk 700
Default and Recovery Rates 700
Factors Considered by Credit Rating Agencies in Assigning Ratings 702
Municipal Bankruptcy 702
Tax Risks Associated with Investing in Municipal Securities 704
Regulation of the Municipal Securities Market 704
Primary Market for Municipal Securities 706
Initial Disclosure 706
Competitive versus Negotiated Offering 707
Secondary Market for Municipal Securities 708
Key Points 709
Questions 712

23 Corporate Senior Instruments Markets 715

Learning Objectives 715
Credit Risk and the Rating of Corporate Debt 716
Factors Considered by Credit Rating Agencies 718
XX Contents

B ankruptcy and Creditor Rights 719

The Bankruptcy Process 720
Absolute Priority: Theory and Practice 720
Bank Loans 722
Syndicated Bank Loans 723
Secondary Market for Syndicated Bank Loans 725
Lease Financing 725
Corporate Bonds 726
Basic Features of a Corporate Bond Issue 727
Bonds with Special Features 730
High-Yield Sector 732
Corporate Bond Defaults and Recovery Rates 735
Corporate Bond Rating Transitions 736
Secondary Market 736
Private-Placement Market for Corporate Bonds 740
Medium-Term Notes 741
The Primary Market 742
Structured MTNs 743
Preferred Stock 743
Key Points 745
Questions 747

24 International Bond Markets 749

Learning Objectives 749
Classification of Global Bond Markets 750
Classification by Trading Blocs 752
The Eurobond Market 752
Securities Issued In the Eurobond Market 753
Comparing Yields on Eurobonds and U.S. Bonds 754
The Non-U.S. Government Bond Market 755
Methods of Distribution of New Government Securities 755
Infiation-Indexed Bonds 756
Sovereign Bond Ratings 756
Emerging Market Bonds 757
Some Special Structures and Bond Types 758
The European Covered Bond Market 758
Infrastructure Bonds 760
Green Bonds 760
European Union Regulation of Bond Market 761
Contents xxi

Key Points 762

Questions 764

25 The Residential Mortgage Market 765

Learning Objectives 765
Origination of Residential Mortgage Loans 766
The Mortgage Origination Process 767
The Risks Associated with Mortgage Origination 768
Mortgage Servicers 769
Types of Residential Mortgage Loans 770
Interest Rate Type 770
Repayment Structure 772
Treatment of Prepayments 774
Lender's Recourse 775
Lien Status 775
Credit Classification 775
Credit Guarantees 777
Conforming versus Nonconforming Status 778
Investment Risks 779
Credit Risk 779
Liquidity Risk 779
Price Risk 780
Prepayments and Cash Flow Uncertainty 780
Development of the Secondary Mortgage Market 780
Key Points 782
Appendix: Mortgage Mathematics 785
Fully Amortizing Fixed-Rate Loans 786
Adjustable-Rate Mortgage 787
Interest-Only Type of Mortgage 788
Questions 788

26 The Market for U.S. Agency Residential Mortgage-Backed Securities 793

Learning Objectives 793
U.S. Agency Pass-Through Securities 794
Cash Flow Characteristics 795
Issuers of Agency Pass-Through Securities 795
Prepayment Risks Associated with Pass-Through Securities 797
Prepayment Conventions 799
Average Life 806
xxii Contents

U.S. Agency CMOs 806

Sequential-Pay CMOs 807
Accrual Bonds 811
Planned Amortization Class Tranches 813
U.S. Agency Stripped Mortgage-Backed Securities 815
The Future of Fannie Mae and Freddie Mac 817
FHFA Strategie Plan for the Conservatorships of Fannie Mae and Freddie
Mac 818
Key Points 821
Questions 822

27 The Market for Credit-Sensitive Securitized Products 825

Learning Objectives 825
Collateral Type 826
Existing Asset versus Future Flow Securitizations 826
Amortizing versus Nonajnortizing Assets 828
Fixed-Rate versus Floating-Rate Assets 829
Credit Risks Associated with Investing in ABS 829
Asset Risks 829
Structural Risks 830
Third-Party Providers 831
Credit Enhancement 832
Determination of the Amount of Credit Enhancement 832
Forms of Credit Enhancement 832
Originator-Provided Credit Enhancement 832
Structural Credit Enhancement 834
Third-Party Credit Enhancement 834
Private-Label Residential Mortgage-Backed Securities 835
The Subprime MBS Meltdown 835
Commercial Mortgage-Backed Securities 838
Commercial Mortgage Loans 838
Types of CMBS Deals 840
CMBS Structure 841
How CMBS Trade in the Market 842
Review of Major Non-Mortgage-Related Types of ABS 843
Credit Card Receivable-Backed Securities 843
Auto Loan-Backed Securities 844
Rate Reduction Bonds 845
Student Loan-Backed Securities 846
Small Business Administration Loan-Backed Securities 847
Contents xxiii

Key Points 848

Questions 852

PART VIII: DERIVATIVE MARKETS 855

28 The Market for Equity Derivatives 857

Learning Objectives 857
Exchange-Traded Stock Options 858
Stock Option Pricing Models 859
Black-Scholes Option Pricing Model 859
Option Strategies 866
Pricing Efficiency of the Stock Options Market 872
Warrants 873
Stock Index Options 874
Pricing Efficiency of the Stock Index Options Markets 875
Portfolio Strategies with Stock Index Options 877
The Stock Index Futures Market 878
Pricing of Stock Index Futures 879
Pricing Efficiency of the Stock Index Futures Market 881
Portfolio Strategies with Stock Index Futures 883
Single-Stock and Narrow-Based Stock Futures Contracts 890
Equity Swaps 890
Applications 891
Equity Market Volatility Indexes 892
Issues Associated with Equity Derivatives 893
Are Derivative Index Markets Beneficial to the Financial Markets? 893
What Has Been the Effect on Stock Price Volatility? 897
Key Points 898
Questions 900

29 The Market for Interest Rate Risk Transfer Vehicles: Exchange-Traded Products 907
Learning Objectives 907
Interest Rate Futures Contracts 908
Features of Selected Futures Contracts 908
Pricing of Interest Rate Futures Contracts 913
Applications of Interest Rate Futures 916
Exchange-Traded Interest Rate Options 919
Exchange-Traded Futures Options 919
Applications of Interest Rate Options 921
Option Pricing Models 923
xxiv Contents

Key Points 925

Questions 926

30 The Market for Interest Rate Risk Transfer Vehicles: OTC Instruments 929
Learning Objectives 929
Over-the-Counter Interest Rate Options 930
Compound or Split-Fee Options 931
Forward Rate Agreements 931
Interest Rate Swaps 932
Interpretation of a Swap 933
Applications 934
Development of the Interest Rate Swap Market 940
Role of the Intermediary 943
Terminology, Conventions, and Market Quotations 944
Calculation of the Swap Rate 946
Valuing a Swap 955
Beyond the Piain Vanilla Swap 957
Interest Rate Agreements 960
Risk/Return Characteristics 961
Applications 961
Dodd-Frank Act Provisions Dealing with OTC Derivatives 962
Key Points 963
Questions 964

31 The Market for Credit Risk Transfer Vehicles: Credit Derivatives and Collateralized
Debt Obligations 971
Learning Objectives 971
Credit Derivatives 973
ISDA Documentation 974
Credit Default Swaps 975
Single-Name CDSs 976
Basket CDSs 979
CDS Index 979
Collateralized Debt Obligations 980
Structure of a CDO 982
Difference between a CDO and an ABS 983
Arbitrage versus Balance Sheet Transactions 983
Synthetic CDOs 987
Future of CDO Products 988
Contents xxv

Credit-Linked Notes 989

Concerns with CRT Vehicles 990
Whether There Is a Clean Transfer of Risk 990
The Risk That Market Participants Fail to Understand the Associated
Risks 991
A Potentially High Concentration of Risk 992
Adverse Selection 993
Key Points 993
Questions 995

32 The Market for Foreign Exchange and Risk Control Instruments 997
Learning Objectives 997
Foreign Exchange Rates 998
Exchange Rate Quotation Conventions 998
Foreign Exchange Rate Risk 1000
Spot Market 1001
Cross Rates 1002
Dealers 1002
Instruments for Hedging Foreign Exchange Rate Risk 1003
Currency Forward Contracts 1003
Currency Futures Contracts 1009
Currency Option Contracts 1010
Currency Swaps 1010
Key Points 1014
Questions 1016

Index 1019