Financial Market Analysis

DAVID BLAKE is Professor of Pension Economics and Director of the Pensions Institute at Cass Business School, London, and Chairman of Square Mile Consultants, a training and research consultancy. He was formerly Director of the Securities Industry Programme at City University Business School, Research Fellow at both the London Business School and the London School of Economics and Professor of Financial Economics at Birkbeck College, University of London. He is consultant to many organisations, including Merrill Lynch, Deutsche Bank, Union Bank of Switzerland, Paribas Capital Markets, McKinsey & Co., the Office of Fair Trading, the Office for National Statistics, the Government Actuary's Department, the National Audit Office, the Department for Work and Pensions, HM Treasury, the Bank of England, the Prime Minister's Policy Directorate and the World Bank. In June 1996, he established the Pensions Institute, which undertakes high-quality research on all pension-related issues and publishes details of its research activities on the internet.

"This book is a valuable addition to the library of any student of finance." (CIB News, November 2000)

• Preface xixAbbreviations xxiI Introduction to Financial Markets 11 The Financial System 51.1 Participants 51.1.1 End-users of the financial system 51.1.2 General financial intermediaries 71.1.3 Specialist financial intermediaries 121.1.4 Market-makers 161.2 Securities 161.3 Markets 201.3.1 The classification of financial markets 201.3.2 Financial markets in the UK 251.4 Trading arrangements 381.4.1 Types of order 391.4.2 Types of account 391.4.3 Stock borrowing agreements 411.4.4 Clearing and settlement of trades 421.4.5 Official intervention in markets 431.5 Regulation 441.6 The financial system in a temporal context 511.6.1 The recent past: the Big Bang of October 1986 511.6.2 The near future 53Appendix: The City Research Project 1991-95 692 The market determination of discount rates 792.1 The price of time and risk 792.2 The expected real interest rate 802.3 The expected inflation rate 822.4 The expected liquidity premium 832.5 The expected risk premium 842.6 Interest rates and discount rates 873 Financial arithmetic 893.1 Future values: single payments 893.1.1 Simple interest 893.1.2 Compound interest: annual compounding 903.1.3 Compound interest: more frequent compounding 903.1.4 Flat and effective rates of interest 923.2 Present values: single payments 923.2.1 Present value: annual discounting 923.2.2 Present values: more frequent discounting 933.3 Future values: multiple payments 933.3.1 Irregular payments 933.3.2 Regular payments: annual payments with annual compounding 943.3.3 Regular payments: annual payments with more frequent compounding 953.3.4 Regular payments: more frequent payments and compounding 963.4 Present values: multiple payments 963.4.1 Irregular payments 963.4.2 Regular payments: annual payments with annual discounting 973.4.3 Regular payments: annual payments with more frequent discounting 973.4.4 Regular payments: more frequent payments and discounting 983.4.5 Perpetuities 1003.5 Rates of return 1003.5.1 Single-period rale of return 1003.5.2 Internal rate of return or money-weighted rate of return 1013.5.3 Time-weighted rate of return or geometric mean rate of return 103Appendix: A simple iterative method for calculating internal rates of return 104II The Analysis and Valuation of Securities 1074 Monty market securities 1114.1 Securities quoted on a yield basis 1124.1.1 Money market deposits 1124.1.2 Negotiable certificates of deposit 1134.2 Securities quoted on a discount basis 1164.3 Recent innovations 1205 Bonds 1235.1 Types of bond 1235.2 The fair pricing of bonds 1275.3 Clean and dirty bond prices 1285.4 Yield measures on bonds 1295.4.1 Current yield 1305-4.2 Simple yield to maturity 1315.4.3 Yield to maturity 1315.4.4 Holding-period yield 1355.4.5 Yield to par 1355.4.6 Yield to call and yield to put 1355.4.7 Yield to average life and yield to equivalent life 1365.4.8 Index-linked yields 1385.5 Yield curves 1415.5.1 The yield to maturity yield curve 1425.5.2 The coupon yield curve 1425.5.3 The par yield curve 1425.5.4 The spot (or zero-coupon) yield curve 1445.5.5 The forward yield curve 1465.5.6 The annuity yield curve 1505.5.7 Rolling yield curve 1505.6 Theories of the yield curve 1525.6.1 The expectations hypothesis 1525.6.2 The liquidity preference theory 1535.6.3 The segmentation or preferred habitat theory 1545.7 Fitting the yield curve 1545.7.1 Polynomial curve fitting 1545.7.2 Regression analysis 1555.7.3 Matrix modelling 1565.8 Interest rate risk 1585.8.1 Duration 1585.8.2 Convexity 1645.8.3 Dispersion 1665.9 Floating rate notes 1665.10 Recent innovations: the gilt repurchase market 1706 Shares 1816.1 Types of share in the firm 1816.2 The financial structure of the firm 1836.2.1 The income statement and statement of retained earnings 1836.2.2 Inflation accounting 1846.2.3 Depreciation 1846.2.4 Corporation tax and corporate capital gains tax 1856.2.5 The effect of accounting conventions on reported earnings 1886.2.6 The balance sheet 1906.3 The fair pricing of shares 1926.3.1 Valuation based on expected dividends 1926.3.2 Valuation based on expected earnings 1946.4 Dividend policy 1966.5 Earnings analysis 1986.5.1 Constant or normal growth models 1986.5.2 Differential growth models 2016.5.3 Forecasting earnings 2056.6 The value of the firm: the effect of leverage 2067 Foreign currency 2157.1 The foreign exchange market 2157.1.1 Spot foreign exchange transactions 2167.1.2 Forward foreign exchange transactions 2197.2 Exchange rate risk 2227.3 Covering foreign exchange transactions 2267.3.1 Covering forward transactions 2267.3.2 Covering spot transactions 2287.4 The fair pricing of foreign currency 2307.4.1 Consistent cross exchange rates 2307.4.2 Purchasing power parity 2317.4.3 International Fisher effect 2347.4.4 Covered interest rate parity 2357.4.5 Uncovered interest rale parity 2368 Forwards and futures 2398.1 Forward and futures contracts 2398.1.1 Forward contracts 2398.1.2 Futures contracts 2408.2 Financial futures contracts 2448.2.1 Short-term interest rale futures 2478.2.2 Long-term interest rate futures 2508.2.3 Currency futures 2578.2.4 Stock index futures 2578.3 The fair pricing of forward and financial futures contracts 2608.3.1 Fair pricing with no uncertainty 2608.3.2 Futures prices and expected spot prices 2628.3.3 Fair pricing of the short-term interest rate contract 2638.3.4 Fair pricing of the long-term interest rate contract 2648.3.5 Fair pricing of the currency contract 2668.3.6 Fair pricing of the stock index contract 2679 Options, warrants and convertibles 2739.1 Option contracts 2739.2 Option combinations 2779.3 Financial options contracts 2839.3.1 Equity options 2889.3.2 Interest-rate options 2919.3.3 Currency options 2979.3.4 Stock index options 2979.3.5 Restricted-life traded options 3019.3.6 Traditional options 3029.3.7 Over-the-counter options 3029.4 The fair pricing of options contracts 3039.4.1 Factors influencing the premium 3039.4.2 Boundary conditions for options 3049.4.3 The binomial model of the fair European call option price 3099.4.4 The Black-Scholes model of die fair European call option price 3129.4.5 Properties of the Black-Scholes model: the Greeks 3169.4.6 Pricing a European put option 3219.4.7 Modifications to the Black-Scholes model 3229.5 Exotic options 3279.6 Warrants and convertibles 3349.6.1 Warrants 3349.6.2 Convertibles 336Appendix A: Accounting issues with options and futures contracts 338Appendix B: Taxation issues with options and futures contracts 340Appendix C: Standard normal distribution table 34210 Synthetic securities 34910.1 The basic building blocks of synthetic securities 34910.2 Synthetic options and futures 35210.3 Swaps 35710.3.1 Interest rate swaps 35810.3.2 Basis swaps 36310.3.3 Currency swaps 36310.3.4 Asset swaps 36910.3.5 More esoteric swaps 37010.3.6 The risks involved in swaps 37110.3.7 The uses of swaps 37210.4 Forward rate agreements 37310.5 Caps, floors and collars 37510.6 Bundled and unbundled securities 37810.6.1 Bundled securities 37810.6.2 Unbundled securities 380III Portfolio Analysis, Management and Performance Measurement 38511 Market efficiency: theory and evidence 38911.1 Allocative operational and informational efficiency 38911.2 The EMH the fair game model and random walk 39011.3 The EMH and information 39211.4 The EMH and an information-efficient equilibrium 39311.5 Tests of the efficient markets hypothesis 39411.5.1 Evidence favouring the efficient markets hypothesis 39411.5.2 Evidence against the efficient markets hypothesis 39811.5.3 Are the financial markets efficient? 40512 Speculation and arbitrage 41512.1 Speculation 41512.1.1 The process of speculation 41512.1.2 Trading strategies with futures 41712.1.3 Trading strategies with options 42612.2 Arbitrage 43412.2.1 The process of arbitrage 43412.2.2 Arbitrage strategies with futures 43512.2.3 Arbitrage strategies with options 439Appendix A: The collapse of Barings Bank 441Appendix B: Technical analysis 44413 Portfolio analysis and asset pricing 46113.1 Portfolio analysis 46113.1.1 Choice under uncertainty: the consumption of risk and return 46113.1.2 Portfolios under uncertainty: the production of risk and return 46513.1.3 Diversification 46813.1.4 The minimum standard deviation portfolio opportunity set and the efficient set 47413.1.5 The efficient set when there is a riskless security 47613.1.6 Market equilibrium, portfolio optimally and the pricing of efficient portfolios 47713.1.7 Pricing inefficient portfolios and the decomposition of total risk 48213.2 Asset pricing 48913.2.1 The capital asset pricing model 48913.2.2 The multi-factor model 50113.2.3 The arbitrage pricing model 50114 Portfolio management 51114.1 The functions of portfolio management 51114.2 Assessing the investing client’s utility function 51414.3 Passive portfolio management 51914.3.1 Passive portfolio management for an expected utility-maximizing client 51914.3.2 Passive portfolio management for a safety-first client 52114.4 Active portfolio management and adjustment 52814.4.1 Active share portfolio management and adjustment 52814.4.2 Active treasury portfolio management 53714.4.3 Active bond portfolio management and adjustment 53814.5 Mixed active-passive portfolio management 54214.6 Investment management styles 54414.6.1 Traditional investment management 54514.6.2 Quantitative investment management 54714.7 Recent innovations: hedge funds and bear funds 548Appendix: Investment-Objectives Questionnaire 55015 Portfolio performance measurement 55915.1 The components of portfolio performance measurement 55915.1.1 Ex post returns 55915.1.2 Adjusting for risk 56215.1.3 Benchmarks of comparison 56215.2 Measures of portfolio performance 56415.2.1 Performance measures based on risk-adjusted excess returns 56415.2.2 Performance measures based on alpha values 56715.3 The decomposition of total return 57015.4 Treasury performance measurement 57415.5 Asset-liability managed portfolios 57415.6 Portfolios containing financial futures and options contracts 57815.6.1 Individual treatment of futures 57815.6.2 Individual treatment of options 57915.6.3 A worked example 58015.7 Performance measurement with multiple fund managers 58615.8 The Roll critique of performance measurement 58815.9 Evidence on the performance of fund managers 588Appendix: A note on the different uses of the geometric mean and the arithmetic mean 59016 Hedging and efficient portfolio management 59716.1 The objective of hedging 59716.2 Money market hedges 59916.3 Hedging using futures 60116.3.1 Hedging with short-term interest rate futures contracts 60116.3.2 Hedging with stock index futures contracts 60416.3.3 Hedging with long-term interest rate futures contracts 61316.3.4 Hedging with currency futures contracts 61716.4 Hedging using options 62016.4.1 Hedging with individual stock options contracts 62116.4.2 Hedging with stock index options contracts 62716.4.3 Hedging with short-term interest rale options contracts 63016.4.4 Hedging with long-term interest rate options contracts 63116.4.5 Hedging with currency options contracts 63216.5 Hedging with swaps and swaptions 63316.6 Hedging with FRAs 63716.7 Hedging with caps, floors and collars 63716.8 Portfolio insurance 63816.9 Efficient portfolio management 643IV Postscript 65517 The failure of financial markets 65917.1 The anatomy of the crash 65917.2 The consequences of the crash 66117.3 The causes of the crash 66317.4 Conclusion 66918 Recent developments in financial market analysis 67318.1 Value-at-risk analysis 67318.2 Speculative bubbles 67618.3 Volatility effects in financial markets 67818.4 Chaos 68218.5 Neural networks 693