Financial Market Rates and Flows

by Van Horne, James C.

• ISBN13: 9780130180445
• ISBN10: 0130180440
• Edition: 6th
• Format: Paperback
• Copyright: 2001-01-01
• Publisher: Prentice Hall

Summary

This book explores the behavior of interest rates as they relate to changing market conditions, and examines how risk can be managed. It successfully bridges the gap between interest-rate theory and its application to fixed-income security portfolio management.Coverage includes the function of financial markets, the flow-of-funds system, foundations for interest rates, inflation and returns, derivative securities, the influence of taxes, and the social l allocation of capital.For those in the financial community, in business, and in government, who are concerned with investing in or issuing fixed-income securities.

Table of Contents

Preface	xv
The Function of Financial Markets	1	(15)
Savings-Investment Foundation	1	(1)
Efficiency of Financial Markets	2	(7)
Stages of Efficiency	3	(1)
Financial Assets	3	(2)
The Role of Financial Intermediaries	5	(2)
Disintermediation and Securitization	7	(1)
Country Efficiency	8	(1)
Financial Innovation	9	(2)
The Catalyst for Change	10	(1)
Types of Innovations	11	(1)
The Implications of Savings	11	(3)
Degrees of Moneyness	13	(1)
Interest Rates and Arbitrage Efficiency	14	(1)
Summary	14	(1)
Selected References	15	(1)
The Flow-of-Funds System	16	(14)
The Structure of the System	16	(4)
Sectoring	18	(1)
Source-and-Use Statements	18	(1)
The Preparation of a Matrix and Its Use	19	(1)
Federal Reserve Flow-of-Funds Data	20	(6)
Credit Flows	21	(2)
Implications of Analysis	23	(3)
Debt Outstanding	26	(1)
Summary	26	(3)
Selected References	29	(1)
Foundations for Interest Rates	30	(18)
The Interest Rate in an Exchange Economy	30	(10)
The Individual Choice	30	(1)
Optimum with Exchange	31	(3)
Combined Effect	34	(1)
Market Equilibrium	35	(5)
Interest Rates in a World with Risk	40	(3)
Behavior of Individual Economic Units	40	(1)
Utility for Financial Assets	41	(1)
Utility for Financial Liabilities	42	(1)
Utility for Other Assets	43	(1)
Market Equilibrium	43	(3)
Maximizing Utility for the Economic Unit	44	(1)
The Action of All Economic Units	45	(1)
Summary	46	(1)
Selected References	47	(1)
Prices and Yields for Bonds and Money Market Instruments	48	(11)
Review of Present Values	48	(2)
Annuities	49	(1)
Present Value When Interest Is Compounded More than Once a Year	49	(1)
Continuous Compounding	50	(1)
The Price of a Bond	50	(3)
Coupons and Principal Payments	50	(1)
Price When Next Coupon Payment Is Less than Six Months Away	51	(2)
Zero-Coupon Bonds	53	(1)
Yield Calculations for Bonds	53	(3)
Implicit Reinvestment Rate Assumption	54	(1)
Current Yield	54	(1)
Holding-Period Return	54	(1)
Yield-to-Maturity for Zero-Coupon Bonds	55	(1)
Yield for Perpetuities	55	(1)
Money Market Instrument Returns	56	(1)
Bank Discount Rate	56	(1)
Implications	57	(1)
Summary	57	(1)
Selected References	58	(1)
Inflation and Returns	59	(18)
The Historical Record in Brief	59	(1)
The Nature of Inflation Premiums	60	(5)
Unanticipated Inflation	62	(2)
The Fisher Effect	64	(1)
Nominal Interest Rates and Inflation, Theoretically	65	(2)
Tax Effects	65	(1)
Expected Inflation and Inflation Risk Premiums	66	(1)
Empirical Evidence on Nominal Interest Rates	67	(3)
Problems in Empirical Testing	67	(1)
Testing for the Effect of Inflation	68	(1)
A Summing Up	69	(1)
Nominal Contracting Effects	70	(2)
Debtor-Creditor Claims	70	(1)
Depreciation	70	(1)
Inventories	71	(1)
Corporate Value	71	(1)
Empirical Testing	71	(1)
Inflation-Indexed Bonds	72	(2)
The Mechanics	72	(1)
Behavior of TIPS	72	(1)
Implied Inflation Expectations	73	(1)
Other Aspects	74	(1)
Summary	74	(1)
Selected References	75	(2)
The Term Structure of Interest Rates	77	(18)
Definition of Term Structure	77	(2)
The Pure Expectations Theory	79	(4)
Forward Rates of Interest	79	(1)
Substitutability of Maturities	80	(2)
Technical Problems	82	(1)
Arbitrage and Market Efficiency	83	(1)
Uncertainty and Term Premiums	83	(2)
Market Segmentation	85	(1)
Cox-Ingersoll-Ross Theory	86	(3)
General Equilibrium Notions	86	(1)
Term Structure Implications	87	(2)
Other-Models of the Term Structure	89	(2)
Multifactor Models	89	(1)
Lattice-Type Models	90	(1)
Empirical Evidence	91	(1)
Summary	92	(1)
Selected References	93	(2)
Price Volatility, Coupon Rate, and Maturity	95	(24)
The Coupon Effect	95	(2)
Sensitivity of Price to Various Properties	96	(1)
The Duration Measure and Its Changing Behavior	97	(7)
An Illustration	98	(1)
Relationship between Duration and Maturity	99	(1)
Relationship between Duration and Coupon Payment	100	(1)
Relationship between Duration and Changes in Interest Rates	101	(1)
Volatility and Duration	102	(1)
Modified Duration Formula	103	(1)
Convexity	104	(4)
The Convexity Measure	104	(1)
Illustration of Price-Change Estimates Using Modified Duration and Convexity	105	(1)
Further Observations on Convexity	106	(1)
Portfolio Management	106	(2)
Immunization of Bond Portfolios	108	(5)
Immunization with Coupon Issues	108	(1)
An Illustration	109	(1)
Fisher-Weil Duration	110	(1)
Mapping the Stochastic Process	111	(1)
Testing for Immunization Effectiveness	111	(1)
Additional Immunization Considerations	112	(1)
Equilibration between Coupon and Noncoupon Bond Markets	113	(3)
Coupon Stripping	113	(1)
Term Structure of Pure Discount Bonds	114	(1)
Arbitrage Efficiency between the Markets	115	(1)
Summary	116	(1)
Selected References	117	(2)
Default and Liquidity Risk	119	(25)
Risk Premiums and Promised Rates	119	(5)
Distribution of Possible Returns	120	(2)
Credit Ratings and Risk Premiums	122	(2)
Liquidity Risk	124	(2)
Bid-Ask Spreads and Price Concessions	125	(1)
Size and Tiering	125	(1)
On-the-Run vs. Off-the-Run Securities	125	(1)
Empirical Evidence on Default Losses	126	(4)
More Recent Experience	128	(2)
Cyclical Behavior of Risk Premiums	130	(2)
The Market Segmentation Effect	132	(2)
Speculative-Grade, High-Yield Bonds	134	(3)
Development of the Market	134	(1)
Issuers and Use in Acquisitions	135	(1)
Risk versus Return	135	(2)
Event Risk	137	(1)
Risk Structure and the Term Structure	138	(3)
Widening Yield Differentials with Maturity	138	(1)
Crisis-at-Maturity	139	(2)
Summary	141	(1)
Selected References	142	(2)
Derivative Securities: Interest-Rate Futures and Forward Contracts	144	(18)
Introduction to Futures Contract	144	(2)
Features of Futures Markets	146	(3)
Money Market Instruments	146	(1)
Margin Requirements	146	(1)
Marking-to-Market and Price Movements	147	(1)
Longer-Term Instruments	147	(1)
Quality Delivery Options	147	(2)
Hedging and Speculation	149	(5)
Some Hedging Fundamentals	150	(1)
Futures and Spot Prices	150	(1)
Long Hedges	151	(1)
Hedge Ratios	152	(1)
Short Hedges	153	(1)
Basis Risk	154	(2)
More on Basis Risk	154	(2)
Sources of Basis Risk	156	(1)
Forward Contracts	156	(2)
Implicit Forward Arrangements	157	(1)
Futures and Forward Contract Differences	157	(1)
Market Efficiency Between Futures and Forward Rates	158	(2)
Possible Reasons for Deviation of Forward and Futures Rates	158	(2)
Summary	160	(1)
Selected References	160	(2)
Derivative Securities: Options	162	(29)
Option Valuation	162	(9)
Expiration Date Value of an Option	163	(1)
Valuation Prior to Expiration	164	(3)
Hedging with Options	167	(1)
Black-Scholes Option Model	168	(3)
Debt Options	171	(6)
Features of Futures Options	171	(1)
Use of Debt Options	172	(1)
Caps, Floors, Collars, and Corridors	172	(4)
Valuation of Debt Options	176	(1)
Yield Curve Options	177	(2)
Convertible Securities	179	(4)
Conversion Price/Ratio	179	(1)
Debt Plus Option Characteristic	179	(1)
Value of Convertible Securities	180	(1)
Premiums	181	(1)
Other Reasons for Premiums	182	(1)
Summary	183	(1)
Put-Call Parity	183	(2)
Application of Option Pricing Concepts to Valuing Convertible Securities	185	(4)
Selected References	189	(2)
Derivative Securities: Interest-Rate and Credit Swaps	191	(16)
Features of Interest-Rate Swaps	191	(2)
An Illustration	192	(1)
Valuation Issues	193	(3)
Comparative Advantage	193	(1)
Completing Markets	194	(1)
Credit Risk	194	(1)
Skirting Tax Laws and Regulations	195	(1)
Swap Valuation: A Summing Up	196	(1)
Pricing an Interest-Rate Swap	196	(2)
An Illustration of Present-Value Calculations	197	(1)
Equilibrium Pricing	198	(1)
Secondary Market Values	198	(1)
Credit Risk, Maturity, and Systemic Risk	199	(3)
Default Provisions	200	(1)
Value at Risk	201	(1)
Swaptions	202	(1)
Credit Derivatives	202	(3)
Total Return Swaps	203	(1)
Credit Swaps	204	(1)
Defining Default and Liquidity in the Market	204	(1)
Other Credit Derivatives	205	(1)
Summary	205	(1)
Selected References	206	(1)
Embedded Options and Option-Adjusted Spreads	207	(15)
Option-Adjusted Spreads	207	(2)
The Basic Methodology	208	(1)
An Illustration	208	(1)
Some Caveats	209	(1)
The Nature of the Call Feature	209	(2)
Forms of the Provision	210	(1)
Redemption versus Callability	211	(1)
The Call Feature's Valuation	211	(5)
Interest-Rate Expectations	213	(1)
The Call Feature and Convexity	213	(1)
Valuation in an Option Pricing Context	214	(1)
Empirical Evidence on Call Valuation	215	(1)
Putable Bonds	216	(2)
The Investor's Option	217	(1)
Valuation Implications	217	(1)
The Sinking Fund	218	(2)
Characteristics of the Provision	218	(1)
Value of the Sinking Fund	219	(1)
Summary	220	(1)
Selected References	221	(1)
Mortgage Securities and Prepayment Risk	222	(17)
Some Features of Mortgages	222	(1)
Mortgage Pass-Through Security	223	(1)
Agency Pass-Throughs	223	(1)
Nonagency Pass-Throughs	224	(1)
Mortgage Derivatives	224	(3)
Colleralized Mortgage Obligations (CMOs)	225	(1)
Planned Amortization Class (PAC) and Targeted Amortization Class (TAC) Securities	225	(1)
IOs and POs	226	(1)
Floaters and Inverse Floaters	227	(1)
Prepayment Option and Its Valuation	227	(6)
Prepayment and Convexity	228	(1)
Measures of Prepayment	229	(1)
Coupon Rate and Age	229	(2)
Additional Factors Explaining Prepayment	231	(1)
Modeling Prepayment Experience	232	(1)
Option-Adjusted Spread Approach	233	(1)
Prepayment Behavior of Certain Derivatives	234	(2)
Planned Amortization Class Securities	234	(1)
Interest Only (IO), Principal Only (PO), and Residual Class Securities	234	(2)
Other Asset-Backed Securities	236	(1)
Summary	236	(1)
Selected References	237	(2)
Controlling Currency Risk	239	(21)
Risk and Return from Foreign Investment	239	(2)
Exchange Rate Risk Management	241	(2)
Forward Exchange Market	241	(1)
Illustration of Spot and Forward Exchange Rates	242	(1)
The Euro	242	(1)
Underlying Relationships	243	(6)
The Law of One Price	244	(1)
Purchasing Power Parity	244	(1)
Interest-Rate Parity	245	(2)
Covered Interest Arbitrage	247	(1)
Interest-Rate Parity Approximation	248	(1)
Empirical Evidence Concerning Interest-Rate Parity	249	(1)
Other Ways to Shift Risk	249	(2)
Currency Futures	250	(1)
Currency Options	250	(1)
Currency Swaps	251	(2)
Currency/Interest-Rate Swaps	252	(1)
Valuation Implications	252	(1)
The Amount to Hedge	253	(2)
A Free Lunch?	253	(1)
The Cost of Currency Hedging	254	(1)
Black's Universal Hedging	254	(1)
Closing Thoughts	255	(1)
Institutional Characteristics and Portfolio Management	255	(3)
Euro and Foreign Bonds	255	(1)
Portfolio Management	256	(1)
Emerging Market Debt	257	(1)
Currency-Option and Multi-Currency Bonds	257	(1)
Summary	258	(1)
Selected References	259	(1)
The Influence of Taxes	260	(14)
Tax Treatment of Capital Gains	261	(3)
Original Issue Discount (OID) Bonds	261	(1)
Capital Gains Treatment for Taxable Coupon Bonds	262	(1)
The De Minimis Rule	263	(1)
Capital Gains Treatment for Municipal Bonds	263	(1)
Tax Timing Options	263	(1)
Municipal Bonds and the Taxation of Interest Income	264	(2)
The Nature of the Municipal Market	265	(1)
Taxable versus Tax-Exempt Yields	266	(1)
Value of the Tax-Exemption Feature	266	(5)
Variation of Implied Tax Rate	268	(1)
The Effect of Tax Reform and Supply	269	(1)
Municipal versus Taxable Yield Curves	270	(1)
Preferred-Stock Tax Effects	271	(1)
Straight Preferred-Stock Investments	271	(1)
Auction-Rate Preferred Stock	271	(1)
Summary	272	(1)
Selected References	273	(1)
The Social Allocation of Capital	274	(17)
The Issues Involved	274	(1)
Ceilings on Borrowing Costs	275	(3)
The Effect of Usury Laws	275	(2)
The Negatives of Interest-Rate Ceilings	277	(1)
Government Guarantees and Insurance	278	(2)
The Transfer of Underlying Risk	279	(1)
Option-Pricing Valuation	280	(1)
Interest-Rate Subsidies	280	(2)
The Effect of the Subsidy	280	(1)
Effectiveness of the Subsidy	281	(1)
Financial Intermediation through Borrowing and Relending	282	(2)
The Situation Illustrated	283	(1)
The Effect of Government Intermediation	284	(1)
Regulations Affecting Investor and Borrower Behavior	284	(2)
The Effectiveness of this Approach	285	(1)
The Costs to Society	285	(1)
Qualification for Tax-Exempt Financing	286	(1)
Benefits, Costs, and Externalities	287	(1)
Policy Implications	287	(2)
Summary	289	(1)
Selected References	289	(2)
Index	291

Excerpts

PREFACEThis book continues to be about interest rates, how they behave with changing market conditions, and how risk can be managed. We are concerned not only with primary securities, like Treasury and corporate bonds, but with derivative securities, like forward and futures contracts, debt options, swaps involving interest rates, credit and currencies, and mortgage derivatives. We will see also that embedded options in a bond or mortgage-backed security, like call and prepayment options, can be valued and option-adjusted spreads can be determined. Finally, our concern is with the management of a fixed-income portfolio and the tradeoff between risk and expected return.Throughout, a rich body of theory is examined, as are the empirical evidence and practice that bear on the theory. The first half of the book is devoted to the foundations for understanding interest-rate behavior: market equilibration, funds flows between financial markets, mathematics of bond and moneymarket yields, inflation, maturity, coupon rate, default risk, and bond price volatility. The remaining chapters use these foundations to explore a variety of derivative securities and their uses, the influence of taxes on interest-rate differentials, and the social allocation of capital. The institutional backdrop is presented in conjunction with concepts, risk, and practice--not as separate chapters. I believe this approach is more lively than the chapter-by-chapter institutional descriptions seen in most books.Because of the rapid change in interest-rate practice and theory, this edition represents another substantial revision. By chapter, the important changes follow. All data inchapter 2on the flow of funds have been updated, and a new section is added on the total debt outstanding for various major sectors of the economy.Chapter 3,Foundations for Interest Rates, has been streamlined and cut back in places. The empirical parts ofchapter 5,Inflation and Returns, have been substantially reworked, and the section on inflation-indexed bonds and Treasury TIPS is largely new. Significant changes appear inchapter 6,The Term Structure of Interest Rates; these changes deal with modeling the term structure, as well as with relevant empirical work. Bond portfolio management, with respect to duration and convexity, has been strengthened inchapter 7,and the arbitrage efficiency between zero-coupon and coupon bonds is illustrated with an actual situation.Perhaps the greatest changes occur inchapter 8,Default and Liquidity Risk. A new section is included on liquidity, and substantial changes have been made in the treatment of credit ratings, default losses and migration patterns, quality yield spreads over time, high-yield debt, and yield spreads with respect to maturity. The chapter also has been resequenced.Chapter 9,the first of several derivative securities chapters, contains 4 new section on forward contracts. In addition, implied repo rates are explained.Chapter 10,Derivative Securities: Options, includes a new treatment of interestrate cap, floor, and collar valuations using "caplets" and "floorlets." A new section on interest-rate corridors also has been developed.Chapter 11,Derivative Securities: Interest-rate and Credit Swaps, contains an entirely new section on credit derivatives, an important market that is continually developing. Also in this chapter is a new section on pricing an interest-rate swap, and an example is presented. The chapter has been reorganized in other ways as well, and the treatment of secondary market values is expanded.Chapter 12,Embedded Options and Option-Adjusted Spreads, includes a new section on putable bonds and their valuation. The section on empirical evidence bearing on the call feature has been largely reworked.Chapter 13on mortgage securities has been completely rewritten to reflect important changes i