look at mortgage-backed securities and collateralised debt obligations (CDOs). New material in this chapter includes a look at securitisation post-credit crunch, ...
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CAPITAL MARKET INSTRUMENTS ANALYSIS AND VALUATION 3rd Edition Moorad Choudhry, Didier Joannas, Gino Landuyt, Rod Pienaar, Richard Pereira Palgrave MacMillan 2010
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The views, thoughts and opinions expressed in this book are those of the author in his individual private capacity and should not in any way be attributed to Europe Arab Bank plc or Arab Bank Group, or to Moorad Choudhry as a representative, officer, or employee of Europe Arab Bank plc or Arab Bank Group. The views, thoughts and opinions expressed in this book are those of the author in his individual capacity and should not in any way be attributed to Thomson Reuters or to Didier Joannas as a representative, officer, or employee of Thomson Reuters. The views, thoughts and opinions expressed in this book are those of the author in his individual capacity and should not in any way be attributed to Europe Arab Bank plc or Arab Bank Group, or to Gino Landuyt as a representative, officer, or employee of Europe Arab Bank plc or Arab Bank Group. Neither UBS AG nor any subsidiary or affiliate of UBS AG is in any way connected with the contents of this publication, which represents the independent work, conclusions and opinions of its authors. Accordingly whilst one of its authors, Rod Pienaar, is a current employee of UBS AG, no responsibility for loss occasioned to any person acting or refraining from action as a result of any statement in this publication can be accepted by either UBS AG or any subsidiary or affiliate of the UBS Group.
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Dedicated to the beauty and timeless elegance of Lloyd Cole and The Commotions… Moorad Choudhry
For Chloë and Max Didier Joannas “No steam or gas drives anything until it is confined. No life ever grows great until it is focused, dedicated and disciplined” (Harry Fosdick). Therefore I would like to dedicate this book to my mother as she has been the driving force behind these values which brought me to where I am today. Gino Landuyt
For my parents, if I could choose any two then I'd stick with the two that I have. Rod Pienaar
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PREFACE This book began life as a concise but complete textbook on financial market instruments and analysis, aimed at practitioners and graduate students. The third edition stays on this same course, but also includes a detailed assessment and analysis of the 2007-08 financial crisis or “credit crunch”. The events during this period challenged banks and investors to re-evaluate erstwhile assumptions about the financial markets, which is why it is worth considering them in detail here. We have also updated chapters to account for the changes and developments that have occurred since the 2nd edition was published. This is most significant in the chapter on credit derivatives, where among other things we describe the “big bang” that occurred in April 2009 and which has resulted in North American contracts being traded under new cashflow arrangements.
Features of the third edition This book is organised into seven parts. Part I sets the scene with a discussion on the financial markets, the time value of money and the determinants of the discount rate. Part II describes fixed income instruments, and the analysis and valuation of bonds. This covers in overview fashion the main interest-rate models, before looking in detail at some important areas of the markets, including
fitting the yield curve, and an introduction to spline techniques;
the B-spline method of extracting the discount function;
bond pricing in continuous time;
inflation-indexed bonds.
We have removed the chapter on option-adjusted spread, as this is a specialist technique and better suited to a dedicated book on fixed income. There is a new chapter on bond credit analysis, and the various relative value measures used to assess bond return. Part II also has a new chapter on using QuantLib to construct a term structure model. This replaces the chapter describing the RATE yield curve application that was included in the previous edition. Part III is an introduction to securitisation and structured financial products, with a look at mortgage-backed securities and collateralised debt obligations (CDOs). New material in this chapter includes a look at securitisation post-credit crunch, after banks started to undertake in-house deals in order to be able to raise funding at their central bank. The chapter on CDOs has been completely revised and updated. In part IV we introduce the main analytical techniques used for derivative instruments. This includes futures and swaps, as well as an introduction to options and the Black-Scholes model, still widely used today nearly 30 years after its introduction. Part V considers the basic concepts in equity analysis, using an hypothetical corporate entity for case study purposes. Part VI introduces the value-at-
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risk methodology, while the final part of the book is a new chapter assessing the causes of the 2007-2008 financial market crisis.
Yield curve modelling application In the first two editions of this book we included a specialist computer application, RATE, which was designed to introduce readers to yield curve modelling. For this edition we have decided to use www.quantlib.org (QuantLib), or more specifically its Excel add-in, for the purposes of demonstrating yield curve construction. QuantLib is a free library for quantitative finance. We do not provide a detailed description of what QuantLib does or how to use it because this can all be found on their web site, however chapter [X] provides additional information on term structure construction, using QuantLib to demonstrate the concepts.
Preface to the First Edition The book is a concise introduction to some of the important issues in financial market analysis, with an emphasis on fixed income instruments such as index-linked bonds, asset-backed securities, mortgage-backed securities, and related products such as credit derivatives. However fundamental concepts in equity market analysis, foreign exchange and money markets, and certain other derivative instruments are also covered to complete the volume. The focus is on analysis and valuation techniques, presented for the purposes of practical application. Hence institutional and market-specific data is largely omitted for reasons of space and clarity, as this is abundantly available in existing literature. Students and practitioners alike should be able to understand and apply the methods discussed here. The book attempts to set out a practical approach in presenting the main issues and the reader should benefit from the practical examples presented in the chapters. The material in the book has previously been used by the authors as a reference and guide on consulting projects at a number of investment banks worldwide. The contents are aimed at those with a basic understanding of the capital markets; however it also investigates the instruments to sufficient depth to be of use to the more experienced practitioner. It is primarily aimed at front office, middle office and back office staff working in banks and other financial institutions and who are involved to some extent in the capital markets. Undergraduate and postgraduate students of finance and economics should also find the presentation useful. Others including corporate and local authority treasurers, risk managers, capital market lawyers, auditors, financial journalists and professional students may find the broad coverage to be of value. In particular however, graduate trainees beginning their careers in financial services and investment banking should find the topic coverage ideal, as the authors have aimed to present the key concepts in both debt and equity capital markets.
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Please note that to avoid needless repetition of “he (or she)” in the text the term “he” should be taken to indicate both the male and female gender. Comments on the text are welcome and should be sent to the authors care of Palgrave Mcamillan
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Acknowledgements Love, thanks and respect to Mum, Dad, Amileela, and Linzi. And to the Raynes Park Footy Boys. Where you been? Ain’t see you for weeks…where were you, when I wanted to work? You were still in bed…you’re a total jerk…oh yeah, and I feel like giving in. I said yes, I feel like giving in. It’s all my fault, yes I’m to blame, ain’t got no money, ain’t got no fame, and that’s why I feel like giving in… I know those songs, like Crystal Ball, Dismantled King, you know I love them all, But oh, I still feel like giving in… --- Felt, Ballad of the Band, Creation Records 1986 Moorad Choudhry Surrey, England May 2009 Thanks to Moorad “Goldfinger” Choudhry for making me part of this great adventure – for a third time! Didier Joannas Hong Kong May 2009
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Sitting around waiting for luck to come your way is as misguided as thinking that good things always come to those who “want it enough”. The truth is that determination and desire are necessary but not sufficient. We have to try like crazy; we have to retain a relentless sense of determination;…and yet there are still no guarantees. Even after all that, we may come up empty-handed. That is the bleak but unavoidable logic of anyone who has deep ambitions. --- Ed Smith, What Sport Tells Us About Life, Penguin Viking 2008
