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An Introduction to International Capital Markets An Introduction to International Capital Markets For other titles in the Wiley Finance Series please see www.wiley.com/finance An Introduction to International Capital Markets Products, Strategies, Participants Second Edition Andrew M. Chisholm A John Wiley and Sons, Ltd., Publication This edition first published 2009 2009 John Wiley & Sons, Ltd Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com. The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Library of Congress Cataloging-in-Publication Data Chisholm, Andrew, 1959- An introduction to international capital markets : products, strategies, participants / Andrew M. Chisholm. – 2nd ed. p. cm. – (Wiley finance series) Rev. ed. of: An introduction to capital markets : products, strategies, participants. 2002. Includes bibliographical references and index. ISBN 978-0-470-75898-4 (cloth : alk. paper) 1. Capital market. 2. International finance. I. Chisholm, Andrew, 1959- Introduction to capital markets. II. Title. HG4523.C485 2009 332.041–dc22 2009013327 ISBN 978-0-470-75898-4 A catalogue record for this book is available from the British Library. Typeset in 10/12pt Times by Laserwords Private Limited, Chennai, India Printed in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire For Sheila Wipe your glosses with what you know. James Joyce. Contents Acknowledgements xv 1 Introduction: The Market Context 1 1.1 Capital and the Capital Markets 1 1.2 The Euromarkets (International Capital Markets) 4 1.3 Modern Investment Banking 5 1.4 The Clients of Investment Banks 8 1.5 About this Book 11 2 The Money Markets 15 2.1 Chapter Overview 15 2.2 Domestic Money Markets 15 2.3 US Domestic Markets 16 2.4 The European Central Bank (ECB) 18 2.5 Sterling Money Markets 19 2.6 The Bank of Japan 20 2.7 Systemic Risks and Moral Hazards 20 2.8 Treasury Bills 21 2.9 Discounting Treasury Bills 21 2.10 US Commercial Paper 24 2.11 Credit Risk on USCP 25 2.12 Bankers’ Acceptances 26 2.13 The Eurocurrency Markets 26 2.14 Eurocurrency Loans and Deposits 27 2.15 Eurocurrency Interest and Day-Count 29 2.16 Eurocurrency Certificates of Deposit 30 2.17 CD Yield-to-Maturity 31 2.18 Euro-Commercial Paper 31 2.19 Repos and Reverses 32 2.20 Repo: Case Study 33 2.21 Other Features of Repos 33 2.22 Chapter Summary 34 viii Contents 3 The Foreign Exchange Market 37 3.1 Chapter Overview 37 3.2 Market Structure 37 3.3 FX Dealers and Brokers 38 3.4 Spot Foreign Exchange Deals 39 3.5 Sterling and Euro Quotations 40 3.6 Factors Affecting Spot FX Rates 41 3.7 Spot FX Trading 44 3.8 Spot Position Keeping 45 3.9 FX Risk Control 47 3.10 Cross-Currency Rates 49 3.11 Outright Forward FX Rates 50 3.12 Outright Forward FX Hedge: Case Study 51 3.13 Forward FX Formula 52 3.14 FX or Forward Swaps 53 3.15 FX Swap Two-Way Quotations 55 3.16 Chapter Summary 56 4 Major Government Bond Markets 59 4.1 Chapter Overview 59 4.2 Introduction to Government Bonds 59 4.3 Sovereign Risk 60 4.4 US Government Notes and Bonds 62 4.5 US Treasury Quotations 64 4.6 US Treasury Strips 66 4.7 Bond Pricing 67 4.8 Pricing Coupon Bonds: Examples 68 4.9 Detailed Bond Valuation: US Treasury 69 4.10 Bond Yield 71 4.11 Reinvestment Assumptions 72 4.12 Annual and Semi-Annual Bond Yields 73 4.13 UK Government Bonds 74 4.14 Japanese Government Bonds (JGBs) 77 4.15 Eurozone Government Bonds 77 4.16 Chapter Summary 78 5 Bond Price Sensitivity 81 5.1 Chapter Overview 81 5.2 Bond Market Laws 81 5.3 Other Factors Affecting Price Sensitivity 83 5.4 Macaulay’s Duration 83 5.5 Calculating Macaulay’s Duration 84 5.6 Duration of a Zero 85 5.7 Modified Duration 86 5.8 Price Value of a Basis Point 87 5.9 Convexity 88 Contents ix 5.10 Measuring Convexity 88 5.11 Convexity Behaviour 90 5.12 Portfolio Duration 91 5.13 Dedication 92 5.14 Immunization 94 5.15 Duration-Based Hedges 96 5.16 Convexity Effects on Duration Hedges 97 5.17 Chapter Summary 98 6 The Yield Curve 99 6.1 Chapter Overview 99 6.2 Real and Nominal Interest Rates 99 6.3 Compounding Periods 100 6.4 The Yield Curve Defined 101 6.5 Theories of Yield Curves 102 6.6 Zero Coupon or Spot Rates 104 6.7 Bootstrapping 106 6.8 Spot Rates and the Par Curve 108 6.9 Pricing Models Using Spot Rates 108 6.10 Forward Rates 109 6.11 Discount Factors 110 6.12 Chapter Summary 112 7 Credit Spreads and Securitization 113 7.1 Chapter Overview 113 7.2 Basics of Credit Spreads 113 7.3 The Role of the Ratings Agencies 115 7.4 Credit Spreads and Default Probabilities 117 7.5 Credit Default Swaps 118 7.6 Index Credit Default Swaps 121 7.7 Basket Default Swaps 122 7.8 Credit-Linked Notes 123 7.9 Securitization and CDOs 124 7.10 Rationale for Securitization 126 7.11 Synthetic CDOs 126 7.12 Chapter Summary 128 8 Equity Markets and Equity Investment 129 8.1 Chapter Overview 129 8.2 Comparing Corporate Debt and Equity 129 8.3 Additional Features of Common Stock 130 8.4 Hybrid Securities 131 8.5 Equity Investment Styles 132 8.6 Efficient Markets 133 8.7 Modern Portfolio Theory (MPT) 135 8.8 Primary Markets for Common Stock 138 x Contents 8.9 Subsequent Common Stock Issues 140 8.10 Secondary Markets: Major Stock Markets 142 8.11 Depository Receipts 145 8.12 Stock Lending 146 8.13 Portfolio (Basket) Trading 148 8.14 Chapter Summary 148 9 Equity Fundamental Analysis 151 9.1 Chapter Overview 151 9.2 Principles of Common Stock Valuation 151 9.3 The Balance Sheet Equation 152 9.4 The Income Statement 154 9.5 Earnings Per Share (EPS) 156 9.6 Dividend Per Share (DPS) 157 9.7 Ratio Analysis 158 9.8 Liquidity Ratios 159 9.9 Profitability Ratios 159 9.10 Leverage Ratios 161 9.11 Investor Ratios and Valuation 162 9.12 Applying Valuation Multiples 163 9.13 Firm or Enterprise Value Multiples 165 9.14 Chapter Summary 166 10 Cash Flow Models in Equity Valuation 169 10.1 Chapter Overview 169 10.2 The Basic Dividend Discount Model 169 10.3 Constant Dividend Growth Models 170 10.4 The Implied Return on a Share 172 10.5 Dividend Yield and Dividend Growth 172 10.6 Price/Earnings Ratio 173 10.7 Stage Dividend Discount Models 175 10.8 Two-Stage Model: Example 175 10.9 The Capital Asset Pricing Model (CAPM) 176 10.10 Beta 177 10.11 Estimating the Market Risk Premium 178 10.12 The Equity Risk Premium Controversy 178 10.13 CAPM and Portfolio Theory 180 10.14 Free Cash Flow Valuation 183 10.15 Forecasting Free Cash Flows 184 10.16 Weighted Average Cost of Capital (WACC) 185 10.17 Residual Value 186 10.18 WACC and Leverage 187 10.19 Assets Beta Method 189 10.20 Company Value and Leverage 190 10.21 Chapter Summary 191 Contents xi 11 Interest Rate Forwards and Futures 193 11.1 Chapter Overview 193 11.2 Forward Rate Agreements (FRAs) 193 11.3 FRA Application: Case Study 194 11.4 Borrowing Costs with an FRA Hedge 196 11.5 FRA Market Quotations 197 11.6 The Forward Interest Rate 199 11.7 Financial Futures 201 11.8 CME Eurodollar Futures 203 11.9 Eurodollar Futures Quotations 203 11.10 Futures Margining 204 11.11 Margining Example: EURIBOR Futures on Eurex 205 11.12 Hedging with Interest Rate Futures: Case Study 208 11.13 Futures Strips 209 11.14 Chapter Summary 211 Appendix: Statistics on Derivative Markets 211 12 Bond Futures 213 12.1 Chapter Overview 213 12.2 Definitions 213 12.3 The CBOT 30-Year US Treasury Bonds Futures 213 12.4 Invoice Amount and Conversion Factors 214 12.5 Long Gilt and Euro-Bund Futures 216 12.6 Forward Bond Price 217 12.7 Carry Cost 218 12.8 The Implied Repo Rate 218 12.9 The Cheapest to Deliver (CTD) Bond 219 12.10 CTD Behaviour 221 12.11 Hedging with Bond Futures 222 12.12 Basis Risk 223 12.13 Hedging Non-CTD Bonds 224 12.14 Using Futures in Portfolio Management 225 12.15 Chapter Summary 226 13 Interest Rate Swaps 227 13.1 Chapter Overview 227 13.2 Swap Definitions 227 13.3 The Basic Interest Rate Swap Illustrated 228 13.4 Typical Swap Applications 230 13.5 Interest Rate Swap: Detailed Case Study 231 13.6 Interest Rate Swap Terms 233 13.7 Comparative Advantage 234 13.8 Swap Quotations and Spreads 236 13.9 Determinants of Swap Spreads 237 13.10 Hedging Swaps with Treasuries 238 xii Contents 13.11 Cross-Currency Swaps: Case Study 239 13.12 Cross-Currency Swap Revaluation 241 13.13
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