Guide to Financial Markets

GUIDE TO FINANCIAL MARKETS

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

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GUIDE TO FINANCIAL

MARKETS

Why they exist and how they work

Sixth edition

Marc Levinson

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THE ECONOMIST IN ASSOCIATION WITH

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

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

Contents

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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

England’s 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themselves are out of date, as almost all of the dealing once done face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 season’s 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 ﬁrm’s 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.

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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

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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 year’s 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

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Why markets matter 5

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 2008–09 in the United States and

2008–13 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

TABLE 1.2 The world’s 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

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6 GUIDE TO FINANCIAL MARKETS

in the low-interest-rate environment of 2002–05. 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.

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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 2006–07, 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 2010–13, 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

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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.

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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 2008–09 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

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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 trust’s shares from

stockbrokers. Worldwide, mutual funds had net assets of $27 trillion

at the end of 2012.

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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

Mexico

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

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12 GUIDE TO FINANCIAL MARKETS

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

fund managers may share in their fund’s 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 company’s prospects or a country’s economic outlook, and

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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 world’s 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

Today’s 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 UK’s 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

Page numbers in italics indicate

ﬁgures; those in bold type indicate

tables.

accounting rules 171–172, 186

adjustable bonds 87

Africa: currency trading 28

after-hours trading 209

Agricultural Bank of China 160

agricultural equipment, loans on

129

agricultural ﬁnance agencies 58

aircraft, loans on 128–129

algorithmic trading 12–13, 18, 191, 192

all-or-none orders 205

All-Ordinaries Index (Australia) 224

Alternative Investment Market,

London 181

alternative trading systems see dark

pools

Altria Group 160

American depositary receipts (ADRs)

186, 187

American International Group (AIG)

264–265, 272

American Stock Exchange 183, 243,

244

American-style options 240

Amsterdam 154

bourse 181

analysts, securities 169

annuities 12

Antwerp Stock Exchange 178

arbitrage 3, 92, 242

ARCA options exchange 244

Archipelago exchange 183

Argentina

bonds 73, 110, 144, 145

ﬁnancial crisis in (2001–02) 34, 106,

107, 145

international debt securities 144

stock exchange loss of business 182

unemployment in 34

Aristotle 197–198

Asia

asset-backed securities 113

currency trading 28

emerging markets 187

ﬁnancial crisis in (1998) 5, 106

high-yield markets 101

initial public offerings (IPOs) 160

price/earnings ratio of technology

shares 173

and securitisation 116

Asia-Paciﬁc region: bond issuance 77

asset value 168

asset-backed securities 156–157, 267

basics of 131

buying 135

and CDOs 116–117

deﬁned 75

ﬂoating-rate 133

home-equity 128

issuance of 116, 117

measuring performance 135–136

mortgage-backed securities 112

non-mortgage securities 112, 112

novel types of 129–130

private-sector debt market 76

risk 8, 111–112

trading 115–116

assets

income from 3

interest-bearing 21

trading 115

valuation 2

ASX 50 share index 224

ASX 200 share index 224

at best instruction 188

at-the-market orders 204

auction markets 189–190

auctions, bond sale 7–80

Index

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

276 GUIDE TO FINANCIAL MARKETS

Australia

auto-loan securities 128

banks’ bond issuance 126

securitisation 126

Australian Stock Exchange 225

automotive loans 113, 117, 128–129

Autostrade 139

balance-of-payments

crises 33, 36

deﬁcits 33, 38, 138

surplus 38

Banco do Brasil 161

bands 35–36

bank certiﬁcates of deposit 44, 50

bank deposits 169

Bank for International Settlements 5,

43, 46, 270

Bank of America 176

Bank of Canada 65, 66

Bank of England: Central

Moneymarkets Ofﬁce 62–63

Bank of Japan 62, 68

Bank of Venice 70

bankers’ acceptances 55, 63

Bankers Trust Company 271–272

banking

banking crises (1990s) 6

and bond markets 78

certiﬁcates of deposit 44

clearing organisations 29

commercial banks 15, 44

and commercial paper 54

consolidation 15, 18

credit lines 54

currency dealing 24

disintermediation 44

forced mergers due to insolvency 15

foreign banks set up ofﬁces in

London 139

gross position 29

interbank loans 58–59

and intermediation 47

lending 4, 6

liberalisation 15

as a main source of credit 44

market share 13, 44

net position 29

overnight loans 59

and price quotations 39–40

and repos 60, 61

securitisation 115, 126

short-term demand deposits 44

speculators 23

underwriting risk 134–135

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

265

barrier options 20

base rate 65

basic hedge 248

basis trading 231

basket trades 192

BATS Global Markets electronic

exchange 184

bear spread 232

Bear Stearns 270

Beckman Coulter 178

Becton Dickinson 178

“below investment grade” 64, 90, 91,

101, 102, 103, 106, 144

benchmark index 108

betas 173, 175

Big Mac Index 38

Black-Scholes option-pricing model

246

block trades 192

BM&F Bovespa exchange, São Paulo

206, 213

Bogotá exchange 25

Bolsa de Mercadorias & Futuros, Brazil

25, 26, 237

bond funds 50

bond futures 76

bond indexes see under bond markets

bond insurance 100

Bond Issue Arrangement Committee

(Japan) 76

bond issuers 46

bond markets 5–6, 70–110

the biggest national markets 76–77

bond futures 76

bond indexes 108–110

benchmark 108

index shortcomings 109–110

weighted 108–109

the changing nature of the market

81–84

electronic trading 82–84

secondary dealing 82–83

settlement 84

and countries with less active

money markets 46–47

deﬁned 46

domestic and international 140

emerging-market bonds 83, 105–107,

106

enhancing security 99–100

bond insurance 100

covenants 99

sinking funds 100

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

Index 277

exchange rates and bond prices and

returns 94–95, 95

high-yield debt (or junk) 101–103,

102

inﬂation and returns on bonds 94

interest rates and bond prices

92–93, 93

international markets 103–105, 104

Eurobonds 104

foreign bonds 103–104

interpreting the price of a bond

91–92

investing 3

the issuers 73

corporations 75–76

lower levels of government 74–75

national governments 73–74

securitisation vehicles 75–76

issuing bonds 77–80

selling direct 81

setting the interest rate 80–81

swaps 79–80

underwriters and dealers 78–79

no more coupons 81

properties of bonds 87–89

coupon 88

current yield 88

duration 89

maturity 87–88

yield to maturity 88

ratings of risk 89–91, 90

repurchase agreements 100–101

and rise in interest rates (2013) 8

robust activity (2000–2001) 6

spreads 98–99

types of bonds 84–87

adjustable bonds 87

callable bonds 85

convertible bonds 86

non-refundable bonds 85

perpetual debentures 85

putable bonds 85

straight bonds 85

STRIPS 86

structured securities 87

zero-coupon bonds 86

why issue bonds? 72–73

avoiding short-term ﬁnancial

constraints 73

controlling risk 72–73

matching revenue and expenses

minimising ﬁnancing costs 72

promoting intergenerational

equity 72

the yield curve 95–98, 97

bond options 236

bond returns 170

bonds

acceleration provision 91

adjustable 87

below-investment-grade 101, 102,

103, 144

book-entry 81

bulldog 104

callable 85, 87

capital-indexed 87

convertible 86, 87, 159

corporate 75, 76, 82, 83, 92, 99, 101,

106, 107

deﬁned 70

dim sum 104

domestic 4, 5, 75, 77, 105, 107, 148,

153

emerging-market 105–107, 106,

144–146

equity-linked 147

euro 152

exchange rates and bond prices and

returns 94–95, 95

fallen angels 102, 103

ﬁxed-rate 111, 147, 148, 266

ﬂoating-rate 87, 147

foreign 103–104, 153

and foreign-exchange trading 21, 22

general-obligation 74

global 149

and globalisation 16

government 71, 82, 83, 98–99, 106,

152, 248

high-yield 101–103, 102

indebtedness of banks 6

inﬂation-indexed 87

interest rates and bond prices

92–93, 93

interest-indexed 87

international bond issues 140, 141,

149–150

issuing see under bond markets

large-scale purchases of 7

long-term 56, 93, 98, 101, 108, 148,

260

“marked to market” 82

maturities 142

mortgage 113, 118

municipal 74, 83, 100

non-refundable 85

paper 81

properties of 87–89

coupon 88

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

278 GUIDE TO FINANCIAL MARKETS

current yield 88

duration 89

maturity 87–88

yield to maturity 88

putable 85, 87

raising capital 3

registered 81

revenue 74

rising stars 102–103

samurai 104

selling 156

sale on best-efforts basis 150

sale on ﬁxed-price re-offer basis

149–150

short-term (notes) 70, 260

sovereign 73, 108

special-purpose 74–75

step-up 87, 91

straight 85

transactions 5

US dollar 152

variable-rate 87

warrant 87

Yankee 104, 138

zero-coupon 86, 87

book-entry bonds 81

Borsa Italiana, Milan 183

Boston Options Exchange 244

bought deal 150

Bowie, David 129–130

Brazil

bonds 71, 73, 74, 106

currency options contracts 25

debt crisis (1999) 57

emerging markets 187

ﬂoating rates 37

longer-term ﬁnancing 57

Brazilian Mercantile and Futures

Exchange 202

“breaking the buck” 49

Brent Crude oil futures 206

Bretton Woods system 18, 33, 138

brokerage commissions 200

brokerage ﬁrms 15, 178, 182, 188, 189,

190

Brussels

and introduction of the euro 27–28

stock exchange 181, 182–183

Buffett, Warren 270–271

bulk commodities (physicals) 204

bull spread 232

bulldog bonds 104

Bundesanleihen (Bunds) 73, 99, 241

business plans 156

buy orders 208

buy-outs, leveraged 101

CAC-40 index 224

calendar strip 232

call auction markets 190

call options 234, 240, 244, 247–248, 262

naked 249

call premium 85

call rate 67

callable bonds 85, 87

Canada

asset-backed commercial paper 131

auto-loan securities 128

bankers’ acceptances 55

commercial paper 53

discount rate 65

option trading 243

provincial bonds 74

reduced government debt (1990s)

securitisation 123–124

short-term borrowing 56

Canada Mortgage and Housing

Corporation 123–124

cancel order 189

capital

cross-border ﬂow of 103, 153

equity 157

long-term 3, 7

raising 3, 13

short-term 44, 47

working 3

capital gains 165, 175

deﬁned 9

capital markets

ﬁnancing 3–4, 6

foreign 186

open 187

and stock exchanges 179

capital-indexed bonds 87

capitalisation

company 194

German stockmarket 170

market 176, 180, 181, 188

and stock splits 170–171

stockmarket 181

capitalisation issue (stock dividend)

168

capped options 240, 260

car purchase: raising capital 3

carbon dioxide emissions 217

cash ﬂow

and asset-backed commercial paper

130

and bonds 81

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

Index 279

deﬁned 167

expected 134

and ﬁxed-rate bonds 111

irregular 45

negative 167

positive 167

cash management 62

central banks

and bond markets 84

and the crawling peg 36–37

and gold standard 32

and inﬂation 34, 38

interest rates 65–66

intervention by 23, 39

keeping the exchange rate stable

34, 35

managing ﬂoating rates 38–39

monetary policy 64–65

and money markets 45, 49

open-market operations 65–66

stripping government bonds 86

survey of currency-trading activity

and Thailand’s ﬁnancial crisis 272

Central Japan Commodities Exchange

202

Central Moneymarkets Ofﬁce, Bank

of England 62–63

certiﬁcates of deposit (CDs) see time

deposits

change 14–16

consolidation 15

deregulation 15

globalisation 15–16

liberalisation 15

technology 14

cheque-writing accounts 44

Chicago Board Options Exchange

(CBOE) 233, 239, 244

Chicago Board of Trade 1, 198, 202,

213, 217, 220–221, 222, 225, 233, 235

Northern Spring Wheat contract

206–207

Chicago Mercantile Exchange 19, 24,

25–26, 25, 202, 206, 210, 221, 225,

228, 232, 235

Chicago Stock Exchange 184

Chilean Stock Exchange 184

China

agricultural futures 213

bond market 71, 77, 105, 106

commodies exchanges 202

commodity contracts 200–201

emerging markets 187

pegs and baskets 36

rapid industrial growth 216

and securitisation 116, 126

stock exchanges 179

trade in stock index options 236

Chinese Telecom 225

clearing 103, 226–227, 251

clearing houses 62–63, 227, 228, 229,

251, 270

clearing members 227, 228–229

clearing organisations 29

closed-end funds 10

CMBS (commercial mortgage-backed

securities) 119–120

CME Group, US 25, 208

co-operative agreements 230

coal futures contracts 216

Coffee, Sugar and Cocoa Exchange

203

collars 20, 260

collateralised debt obligation (CDO)

116, 117, 117

collateralised mortgage obligations

(CMOs) 131–132, 133

Colombian Stock Exchange 184

commercial mortgage-backed

securities (CMBS) 118, 119–120

commercial paper 50, 52–55, 53, 62, 63,

64, 66, 83

asset-backed 130–131

short-term 141, 142, 143, 143

Commerzbank Index 195

commissions 190, 191

commodities

characteristics of 198

contracts 200–201

futures 204, 218–219, 218

markets 197

options 237, 252

storage fees 252

traders 2

common stock (ordinary shares) 158

companies

acquisitions of 107

bankers’ acceptances 55

bankruptcy 54

bond issuance 6

capitalisation of 194

and commercial paper 52, 53, 54

corporate bonds 75

domestic 15

emerging-market 107

ﬁnancial distress 45

foreign direct investment in 22

and globalisation 15–16

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

local 13

competition

among futures and options

exchanges 200

increased 14

and option exchanges 242–243, 243

price 220

computers

abundant computing power 14

and algorithmic trading 12, 18, 192

book-entry bonds 81

electronic auction markets 189–190

futures and options trading 200

“high-frequency” trading 18

replacing face-to-face dealing 1

scanning markets for price

anomalies 31

and stock exchanges 182, 184, 189

swaps trading 149

consolidation 15, 18

construction equipment, loans on

129

consumer spending, and a rise in the

prime rate 68

continuous auction trading 207–208

contracts

commodity 200–201

derivative 26, 222–223

energy futures 203, 216, 217, 217

enforcing 14

ﬁnancial futures 210

forward 20, 25, 31, 76, 148, 197, 253,

257, 272

futures 19, 20, 22, 198, 203, 205–207,

216, 231, 257

index 252

interest-rate options 76

options 22

convertible bonds 86, 87, 159

convertible preferred stock 159

convexity 93

corporate bonds 75, 76

indexes 136

costs

regulatory 14

trading 14, 19

counterparties 253, 255, 256, 257, 259,

264, 272, 273

coupon 88

covenants 99

covered calls 239, 249

covered interest arbitrage 30–31

covered interest parity 31

crawling peg 36–37

credit, regulating the amount of 64–65

credit cards

balances 170

purchases 3

securities 127–128

credit crisis (from 2007), and risk-

management products 8–9

credit events 263–264, 266

credit markets 7

credit ratings 54, 63–64, 64, 91, 101,

106, 110, 144, 145

credit risk 133–134

credit-linked notes 267

creditworthiness 63, 66, 99, 119, 256,

264, 270

cross-border ﬁnance 4–5

cross-margining 230

currencies

bands 35, 36

comparing currency valuations

37–38

destabilisation 33

emerging-market 28, 107

favourite 26–28, 27, 28

ﬂoating 35, 36

risk 105, 107

settlement 28–29

strengthening/weakening against

those of other countries 30

currency

coinage 17

and exchange rates 18, 23

government intervention 23

growth in currency trading 18, 22

no longer linked to gold 18

paper money 18

risk management 3

sovereign wealth funds 23

spot transactions 19

value of 17

currency board 33–34

currency cross-rates 41, 42

currency indexes 42

currency markets 21–22

and algorithmic trading 12

foreign currency 13

gearing up 21–22

currency options 237–238, 238

contracts 25–26

currency-price tables 40, 41

currency swaps 24, 26, 259–260, 260

current yield 88

current-account imbalances 32

Czech Republic: trade-weighted

exchange rate 42

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

Index 281

Daiwa Bond Index 109

Dalian Commodity Exchange 213

dark pools 185, 186, 192

DAX (Deutsche Aktienindex) 225–226,

226, 250

Performance Index 195

DAX-30 index 224

day order 189

day trading 191

dealer markets 190

dealers, and bonds 79, 82, 86, 101

debentures 85

perpetual (irredeemable) 85

debt

credit-card 128

emerging-market 105–106

margin 194

mezzanine 75

restructuring 74

senior 75

sovereign 105

subordinated 75

debt-to-equity ratio (gearing) 157

delivery 230, 231, 232, 235

delta 247–248

hedging 250

demand and supply 150

demutualisations 182, 183

Denmark

pegs to the euro 33

and securitisation 113, 118, 124

depositary receipts 186–187

Depository Trust Company, New

York 63

depression

and gold standard 32–33

Great Depression 52

and interest rates 34

deregulation 15, 44, 47–48, 52, 216

derivatives 8

barrier options and collars 20

currency 255

customised 256

deﬁned 20

exchange-rate 26

foreign-exchange swaps 20, 21, 25

forward contracts 20, 25

forward rate agreements 20

futures contracts 203–204

hedging 269

over-the-counter 238, 253–257, 254,

262, 270

“plain vanilla” 269

risk management 3

trading in 4

Derivatives Exchange, Malaysia 213

derivatives markets 20–21, 21, 22, 29,

253–273

accounting risks 272–273

categories of derivatives 253

credit events 263–264

derivatives disasters 270–272

notional value 254–255, 255

pricing derivatives 268

regulatory issues 273

risks of derivatives 255–257

counterparty risk 256

legal risk 256

price risk 256

settlement risk 257

settling derivative trades 270

special features used in derivatives

268

types of derivatives 257–268

commodity derivatives 261

credit derivatives 263–266, 265

currency swaps 259–260, 260

equity derivatives 262–263, 262

forwards 257

interest-rate options 260–261

interest-rate swaps 258–259, 258

synthetic securities 266–268,

267

Detroit, Michigan, bond investors’

losses 74

Deutsche Bank 242

Deutsche Börse 182, 202–203

Deutsche Telecom 160

devaluation 33, 36

and the crawling peg 37

and exchange-rate bands 36

and the gold standard 32

and the IMF 33

Mexico devalues the peso 145

development banks 58

difference (“diff”) options 260–261

dim sum bonds 104

Direct Edge electronic exchange 184

discount brokerages 191

discount rate 65, 89

disintermediation 44

dispute settlement 14

dividends 167–168

yields 167, 168

dollar: displaced by euro as main

currency of bond issuance 106, 143

Dow Jones Euro Stoxx 50 index 195,

224

Dow Jones Industrial Average (DJIA)

194, 195, 224

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

282 GUIDE TO FINANCIAL MARKETS

Dow Jones Transportation Average

194

Dow Jones Utility Average 19

duration, bond 89

Dutch East India Company 154

earnings, ﬁrm’s 166

earnings before interest, taxes,

depreciation and amortisation

(EBITDA) 166

earnings per share 177

East Asia, 1997 crisis 35

economic growth 37, 64, 65, 67, 129,

166, 169, 170

economies of scale 15

Economist, The 232

Big Mac Index 38

education lending agencies 58

efﬁcient market hypothesis 171

electricity

deregulation 216

utilities 217

electronic information systems, and

price quotations 39–40

electronic trading 208–209

auction markets 189–190

bond markets 82–84

eliminate order 189

emerging markets

bonds 71, 83, 105–107, 106, 145–146

borrowers, biggest 146, 146

companies 107

countries 187–188, 188

government debt 57

treasury-bill issuance 56, 57

currencies 28

debt 106

portfolios 110

employers

and pension funds 12

shares in 9

employment 94

entertainment securitisations 129–130

equities 4, 5, 6

a cross-border ﬁnancing source 5

foreign 272–273

and individual investing 9–10

the origins of 154–155, 155, 156

equity funds 50

equity market capitalisation 155, 155

equity markets 120–196

activity slows (2000–2001) 6

balancing act 157

clearing and settlement 193

competition in trading 190–191

depositary receipts 186–188

emerging markets 187–188, 188

equity 157

factors affecting share prices

166–174

analysts’ recommendations 169

asset value 168

beta 173

bond returns 170

cash ﬂow 167

dividends 167–168, 168

earnings 166

fads 170

general economic news 170

inclusion in an index 169

interest rates 169

key numbers 171–172

market efﬁciency 171

price/earnings ratio 172–173, 172

return on capital 174

return on equity 173–174

stock splits 170–171

value added 174

ﬂotation process 162–166

different approaches to selling

shares 163–164

investing in IPOs 164–165

share repurchases 165–166

how stock exchanges work 189–190

institutional trading 191–193

basket trades 192

block trades 192

program or algorithmic trades

192

short sales 192–193

international listings 186

investing on margin 193–194

measuring market performance

194–196

price measures 194–196, 196

risk measures 196

measuring return 175

obtaining share price information

176–177, 177

off-market trading 185–186

origin of equities 154–155, 155, 156

over-the-counter market 177–178

raising capital 155–158

balancing act 157

equity 157

loans 156–157

venture capital 157–158

stock exchanges 178–184, 179, 180

the biggest exchanges 180–184,

181, 183

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

Index 283

trading shares 188–189

types of equity 158–162

common stock or ordinary

shares 158–159

convertible preferred stock 159

ﬂotation 160–161, 161

issuing shares 159–160

preferred stock 159–160

private offering 161–162

secondary offering 162

warrants 159

venture capital 157–158

equity options 235, 252

equity-index options 241

Estonia

currency pegged to the euro 34

the euro adopted as its currency 34

Eurex 202, 208, 218, 225, 226, 226, 236,

241, 244

Euribor 59

euro, the

and commercial paper 54

dollar/euro trades 27

and exchange-market activity 18

and issuance of international

securities 141, 142

launch of (January 1999) 18, 27–28,

141, 223

and reduction of trading in

European centres 27–28

replaces dollar as main currency of

bond issuance 106, 143

Euro Libor 236–237

Euro-Stars index of 29 euro-zone

stocks 195

Eurobonds 104, 139, 153

Euroclear, Brussels 63

Eurodollar paper 141

Eurodollars 137, 221

Eurokiwis 141

Euromarkets 137–139, 141, 149, 153

Euronext 181, 182–183, 203, 208, 213,

243

Europe

asset-backed commercial paper 131

asset-backed securities 113

auto-loan securities 128

bond insurance 100

CMBS issuance 120

corporate-bond market 77

credit-card securities 128

ﬁnancial meltdown (2008–13) 5

high-yield markets 101

large government deﬁcits (from

2008) 57

mortgage securities 123

repo market 62

and securitisation 116, 127

venture capital 158

European Central Bank (ECB) 65,

66–67

European depositary receipts (EDRs)

186, 187

European Energy Exchange 203

European Exchange Rate Mechanism

35–36

European Investment Bank, bond

issuers 144

European Union

and bond interest 153

debt securities trading in 83

Euronext bread-wheat contract 213

government bonds 99

reduced government debt (1990s)

share prices quoted in euros 182

European-style options 240

Euroyen 141

ex-dividend stock 168

exchange of futures for physicals 231

exchange rates

abandonment of ﬁxed exchange

rates 204

bond prices and returns 94–95, 95

covered interest arbitrage 30–31

covered interest parity 31

and currency trading 18, 23

determined by market forces 18

exchange-rate crises (1990s) 6

forward 30

the fundamental price in any

economy 17

and futures market 19

government intervention 23, 107

managing see under foreign-

exchange markets

and real interest rates 30

stabilisation of 223

trade-weighted 42–43, 43

volatile 2, 30

why they change 30–31

execute order 189

expiration dates 240

exporters 22

extension risk 134

Facebook 161

fallen angels 102, 103

Fannie Mae 74, 118, 118–119, 121, 122,

125, 126

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

284 GUIDE TO FINANCIAL MARKETS

Farmer Macs 122–123

farmers, early

and a basic ﬁnancial market 2

volatile exchange rates 2

Federal Agricultural Mortgage Credit

Corporation (FAMCC) 122–123

Federal Home Loan Bank System 58

Federal Home Loan Mortgage

Corporation (FHLMC) 122

Federal National Mortgage

Association (FNMA) 118, 121

Federal Reserve Board 121, 131

ﬁll-or-kill orders 189, 205

ﬁlm distribution companies 129

ﬁnancial crises

Asia and Russia (1998) 5

Europe ﬁnancial meltdown (2008–

13) 5, 141, 143

and credit markets 7

United States ﬁnancial meltdown

(2008–09) 5

United States recession (2001) 5

worldwide 45–46, 52, 53, 101, 107,

113–114, 187, 232

ﬁnancial futures 204

ﬁnancial industry, consolidation in

182

ﬁnancial institutions, failures of 7

ﬁnancial markets

attributes of larger markets 13–14

forces of change 14–16

consolidation 15

deregulation 15

globalisation 15–16

liberalisation 15

technology 14

growth in 1990s 6

historic 1–2

investors 9–13

algorithmic traders 12–13

hedge funds 11–12

insurance companies 12

mutual funds 10, 11

pension funds 12

other institutions 13

rise of the formal markets 13–14

roles of 2–3

size of 3–6, 4, 5

cross-border measure 4–5

international breakdown 5–6, 6

turn-of-the-century slowdown 6–9

ﬁnancial meltdowns

Europe (2008–13) 5

United States (2008–09) 5

ﬁnancial reports 171–172, 186

Financial Times Stock Exchange

(FTSE) 224, 242

100 stock index 194, 241

Fitch 63–64, 64, 90

ﬁxed-rate systems

Bretton Woods 33

gold standard 32–33

pegs 33–34

shortcomings 34–35

ﬂex options 239

ﬂoating rates 37, 125

managing 38–39

ﬂoor trading 189, 190, 192

ﬂoors 260

ﬂotation 160–161, 161

all-or-nothing offering 163

best-efforts basis 163

investment banker as underwriter

163

ﬂotation process see under equity

markets

follow-on offering 162

Ford Motor Company 252

foreign direct investment 22

foreign-exchange markets 17–43

average daily turnover 17

comparing currency valuations

37–38

indications of overshooting 38

currency markets and related

markets 21–22

gearing up 21–22

fall in trading at turn of the century

favourite currencies 27–28, 27, 28

growth of trading 18

Herstatt risk 29

history 17–18

how currencies are traded 19–21

the derivatives market 20–21, 21

the futures market 19

the options market 20

the spot market 19

main trading locations 23–26, 24, 25

managing exchange rates 32–37

ﬁxed-rate shortcomings 34–35

ﬁxed-rate systems 32–34

ﬂoating rates 37

semi-ﬁxed systems 35–37

managing ﬂoating rates 38–39

obtaining price information 39–42

cross-rates 41, 42

currency indexes 42

forward rates 40, 41

the players 22–23

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Index 285

exporters and importers 22

governments 23

investors 22

speculators 23

role of 17

settlement 28–29

trade-weighted exchange rate 42–43,

why exchange rates change 30–31

covered interest arbitrage 30–31

covered interest parity 31

real interest rates 30

foreign-exchange swaps 20, 21, 24, 25

forward contracts (forwards) 20, 25, 31,

76, 148, 197, 253, 257, 272

forward exchange rate 30

forward markets 31, 39

forward rate agreements 20

forward rates 31, 40, 41

forward transactions 24

France

and bond markets 76–77, 95

French notional bond contract 201

longer-term debt 56

Obligations assimilable du trésor

(OATs) 73

short-term debt 56

Frankfurt stockmarket 195

Freddie Macs 74, 122

fund managers

hedge funds 11–12

mutual funds and unit trusts 10

and NYSE indexes 196

fundamental analysis 169

futures

agricultural 210, 212–214, 212, 214

cattle 210

coffee 210, 213

commodity 204, 210

copper 210

currency 20, 24–25, 202, 222–223,

223

energy 216–217, 217

environmental 217

ﬁnancial 202, 204, 210, 220–225

gold 215

interest-rate 220–222, 221

metal 202, 214–216, 215

natural gas 216, 217

orange juice 210, 218, 218

risk management 3

share-price 235

stock-index 223–224, 224

sugar 213

trading in 4

futures and options markets 197–252

the characteristics of commodities

198

clearance and settlement 226–227,

251–252

terminating options 251–252

commodity futures market 212–218

agricultural futures 212–214, 212,

214

commodity-related futures 218

energy futures 216–217, 217

metals futures 214–216, 215

contract terms 205–207

contract size 206

delivery date 206

position limits 207

price limits 206–207

quality 206

settlement 207

delivery 230

exchange-traded options 233–239

commodity options 237

currency options 237–238, 238

equity options 235

index options 235–236, 236

interest-rate options 236–237

new types of options 238–239

puts and calls 233–234

underlying every option 233

winners and losers 234

expiration dates 240

factors affecting option prices

246–248

gamma 248

rho 248

vega 248

volatility 247–248

ﬁnancial futures markets 220–225

currency futures 222–223, 223

interest-rate futures 220–221, 221

share-price futures 225

stock-index futures 223–224, 224

other ﬁnancial futures 225, 226

futures contracts 203–204

futures and options exchanges

200–202, 201

gains and losses 239–240

hedging strategies 248

baring all 249

covering yourself 249

dynamic hedging 250–251

spreading 250

straddling 249–250

turbo charging 250

how futures are traded 204–205

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286 GUIDE TO FINANCIAL MARKETS

how options are traded 244

how prices are set 210

limits on price movements 211

price movements 210

quoted price 210

spot price 211

term factor 211

margin of security 227–230

cross-margining 230

margin calls 228–229

marking to market 228

measuring performance 232–233

merger pressures 202–203

motivations for options trading

241–242

arbitrage 242

hedging 241

income 242

leveraged speculation 241–243

risk management 241

obtaining price information 211–212,

244–245, 245

option exchanges 242–244, 243

reading commodity futures price

tables 218–219, 218

reading ﬁnancial futures price

tables 225–226, 226

styles 240

American-style options 240

capped options 240

European-style options 240

trading 207–209

continuous-auction or open-

outcry trading 207–208

electronic trading 208–209, 209

single-price auction trading 208

trading strategies 231–232

basic trading 231

dynamic hedging 231

index arbitrage 231

spreads 231

straddles 232

strips 232

triple-witching dates 241

types of contracts

commodity futures 204

ﬁnancial futures 204

why trade futures and options?

199–200

hedging 199

speculation 199–200

futures commission merchants 204,

227–228

futures contracts 19, 20, 25, 62, 198

futures exchanges 184

Futures Industry Association 236

futures market 19

gamma 248

GE Capital 152

gearing 157

gearing up 21–22