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Financial Instruments and Markets: A Casebook

Book Description

Create value while you manage risk

Today's increasingly volatile financial markets have caused an explosion of new financial instruments designed to transfer risk--from collateralized mortgage-backed securities to swaptions that trade directly between financial actors. And now these complex financial instruments have become standard operating procedure at most large and mid-sized businesses. Managers overseeing any substantial business, financial or non-financial, must thoroughly understand these financial instruments and their value in hedging and diversifying to succeed.

With this unique casebook, you'll have the opportunity to gain the analytical, institutional, and functional knowledge you need to use these instruments to solve new problems. Featuring cases from the authors' MBA and Executive Education level courses at Harvard Business School, the book covers the basics of financial instruments, from terminology to pricing, and the markets in which these instruments trade. Throughout, the emphasis is on how these securities accomplish risk transfer from actors who do not want risk to those who are willing to take it on--for a fee of course.

These cases include:

  • Deutsche Bank: Finding Relative Value Trades

  • Ticonderoga Capital: Inverse Floating Rate Bonds

  • 100-Year Liabilities at Prudential Insurance

  • Swedish Lottery Bonds

  • The Enron Odyssey: The Special Purpose of SPEs

  • Building Hedge Funds at Prospero Capital

  • Dell Computer Corporation: Share Repurchase Program

  • First American Bank: Credit Default Swaps

  • Morgan Stanley and TRAC-X: The Battle for the CDS Indexes Market

  • and more

Table of Contents

  1. Cover Page
  2. Title Page
  3. Copyright
  4. Acknowledgments
  5. About the Authors
  6. Table of Contents
  7. 1: Introduction
    1. WHY STUDY FINANCIAL INSTRUMENTS?
    2. TEACHING FINANCIAL INSTRUMENTS USING THE CASE METHOD
    3. BOOK STRUCTURE
    4. ALTERNATIVE WAYS TO WORK THROUGH THE BOOK
    5. APPENDIX: CASE DESCRIPTIONS
  8. FIXED-INCOME SECURITIES: CONCEPTS
  9. 2: Note on Bond Valuation and Returns
    1. CLASSIFYING BONDS
    2. BOND PRICING
    3. PRICE-YIELD RELATIONSHIP
    4. COMPOUNDING CONVENTIONS AND CONVERSIONS
    5. PROBLEM SET
    6. APPENDIX—OVERVIEW OF BOND MARKETS
  10. 3: Deutsche Bank: Finding Relative-Value Trades
    1. THE DEUTSCHE BANK FIXED INCOME RESEARCH GROUP
    2. LOOKING FOR A RELATIVE-VALUE TRADE
  11. 4: Note on Duration and Convexity
    1. DURATION
    2. CONVEXITY
    3. USEFUL CONCEPTS AND TOOLS
    4. PROBLEM SET
  12. 5: Ticonderoga: Inverse Floating Rate Bond
    1. BOWER'S TASK: HEDGE INTEREST RATE RISK
  13. 6: 100-Year Liabilities at Prudential Insurance
    1. U.S. LIFE INSURANCE INDUSTRY IN 2003
    2. PRUDENTIAL FINANCIAL, INC. HISTORY AND RECENT DEVELOPMENTS
    3. ASSET LIABILITY AND RISK MANAGEMENT AT PRUDENTIAL INSURANCE
    4. PRUDENTIAL INSURANCE'S 100-YEAR LIABILITY PORTFOLIO
  14. FIXED-INCOME SECURITIES: APPLICATIONS
  15. 7: Deutsche Bank: Discussing the Equity Risk Premium
    1. THE DEUTSCHE BANK FIXED INCOME RESEARCH GROUP
    2. EQUITY RISK PREMIUM, AND FIXED INCOME VERSUS EQUITIES
  16. 8: Swedish Lottery Bonds
    1. THE SWEDISH NATIONAL DEBT OFFICE (SNDO)
    2. LOTTERY BONDS AS AN INSTRUMENT FOR RETAIL MARKET BORROWING
    3. ISSUING LOTTERY BONDS
    4. LOTTERY BOND 2003:1—TO BE OR NOT TO BE
  17. 9: Bank Leu's Prima Cat Bond Fund
    1. THE INSURANCE AND REINSURANCE MARKETS
    2. CATASTROPHE BONDS
    3. THE CAT BOND MARKET IN 2001
    4. BANK LEU AND CAT BONDS
  18. 10: Catastrophe Bonds at Swiss Re
    1. THE INSURANCE AND REINSURANCE MARKETS
    2. CATASTROPHE BONDS
    3. THE CAT BOND MARKET BY YEAR END 2001
    4. SWISS RE, A 139-YEAR-OLD REINSURER
  19. 11: Mortgage Backs at Ticonderoga
    1. ASSET BACKED SECURITIES (ABS)
    2. MORTGAGE BACKED SECURITIES
    3. CREATING COLLATERALIZED MORTGAGE OBLIGATIONS (CMO)
    4. TRADING IN MORTGAGE BACKS
    5. TRADING MORTGAGE BACKS AT TICONDEROGA
  20. 12: KAMCO and the Cross-Border Securitization of Korean Non-Performing Loans
    1. KOREA'S FINANCIAL CRISIS AND NON-PERFORMING LOAN PROBLEM
    2. THE KOREA ASSET MANAGEMENT COMPANY (KAMCO)
    3. THE CROSS-BORDER NPL SECURITIZATION PROPOSAL
    4. THE DECISION
    5. APPENDIX 1: THE LOGIC AND HISTORY OF SECURITIZING NON-PERFORMING LOANS
    6. APPENDIX 2: SECURITIZATION IN KOREA
    7. END NOTES
  21. 13: Nexgen: Structuring Collateralized Debt Obligations (CDOs)
    1. NEXGEN FINANCIAL SOLUTIONS
    2. COLLATERALIZED DEBT OBLIGATIONS (CDOS) AND CREDIT DEFAULT SWAPS (CDSS)
    3. FINDING A SOLUTION
  22. 14: Note on Forward Contracts and Swaps
    1. FORWARD CONTRACTS
    2. SPOT-FORWARD PARITY
    3. ADJUSTMENTS TO SPOT-FORWARD PARITY
    4. FORWARD CONTRACT ON COMMODITIES AND BONDS
    5. INTRODUCTION TO SWAPS
    6. PROBLEM SET
  23. 15: The Enron Odyssey (A): The Special Purpose of “SPEs”
    1. ENRON CORP.: THE COMPANY AND ITS HISTORY
    2. THE ENRON STRATEGY: “ASSET LIGHT”
    3. SPECIAL PURPOSE ENTITIES (SPEs)
    4. ENRON'S SPEs
    5. CONCLUSION
  24. EQUITY OPTIONS: CONCEPTS
  25. 16: Note on Basic Option Properties
    1. CALL AND PUT OPTIONS
    2. OPTION VALUE SENSITIVITIES
    3. PAYOFFS FOR STOCKS AND BONDS
    4. PUT-CALL PARITY
    5. UPPER AND LOWER BOUNDS FOR OPTION PRICES
    6. PROBLEM SET
  26. 17: Dell Computer Corporation: Share Repurchase Program
    1. BACKGROUND
    2. EMPLOYEE STOCK OPTIONS PLAN
    3. SHARE REPURCHASE PROGRAM
  27. 18: Note on Option Valuation
    1. THE BINOMIAL MODEL
    2. RISK-NEUTRAL VALUATION AND PROBABILITIES
    3. TWO-PERIOD BINOMIAL TREE, USING RISK-NEUTRAL VALUATION
    4. TWO-PERIOD VALUATION OF AN AMERICAN OPTION
    5. CALIBRATING THE BINOMIAL TREE TO WORK WITH MARKET DATA
    6. BLACK-SCHOLES/MERTON FORMULA
    7. IMPLIED VOLATILITY: USING THE BLACK-SCHOLES/MERTON FORMULA PRACTICALLY
    8. PROBLEM SET
  28. 19: Sally Jameson—1999
  29. EQUITY OPTIONS: APPLICATIONS
  30. 20: Pine Street Capital
    1. HEDGE FUNDS
    2. PINE STREET CAPITAL
    3. CONCLUSION
  31. 21: Tribune Company: The PHONES Proposal
    1. TRIBUNE COMPANY
    2. AMERICA ONLINE, INC.
    3. TRIBUNE SELLING AOL SHARES: THE PHONES SECURITY
    4. END NOTES
  32. 22: Cox Communications, Inc., 1999
    1. COX COMMUNICATIONS, INC. AND THE CABLE/BROADBAND INDUSTRY
    2. FINANCING COX'S GROWTH AND THE GANNETT ACQUISITION
    3. THE RECOMMENDATION
  33. 23: DigaMem Inc.
    1. THE SEMICONDUCTOR INDUSTRY
    2. BUSINESS DESCRIPTION
    3. COMPANY HISTORY
    4. FINANCING DECISIONS
    5. CONCLUSION
  34. 24: ALZA and Bio-Electro Systems (A): Technological and Financial Innovation
    1. THE ROOTS OF ALZA: SYNTEX
    2. THE POTENTIAL OF DRUG DELIVERY SYSTEMS
    3. THE BIRTH AND CRISIS OF ALZA
    4. ALZA AND CIBA-GEIGY
    5. THE REBIRTH OF ALZA
    6. OPPORTUNITIES AND CHALLENGES OF INNOVATION
    7. FINANCING ALTERNATIVES
  35. CREDIT DERIVATIVES
  36. 25: Note on Credit Derivatives
    1. CREDIT RISK
    2. CREDIT DERIVATIVES
    3. MORE COMPLEX STRUCTURES
    4. MAJOR CREDIT DERIVATIVES END USERS
    5. CHALLENGES AHEAD
  37. 26: First American Bank: Credit Default Swaps
    1. FIRST AMERICAN BANK
    2. CAPEX UNLIMITED
    3. APPLYING CREDIT DEFAULT SWAPS TO THE SITUATION
    4. CREDIT DEFAULT SWAP OVERVIEW
    5. ISOLATING CREDIT RISK
    6. CREDIT RISK SEEKERS
    7. CREDIT DEFAULT SWAP BOUNDARIES
  38. 27: Morgan Stanley and TRAC-X: The Battle for the CDS Indexes Market
    1. THE DEVELOPMENT OF CDS INDEXES
    2. WATKINSON'S DECISION
  39. INTEREST RATE DERIVATIVES
  40. 28: Introduction to Interest Rate Options
    1. PAYOFF SCHEMES FOR CALL AND PUT INTEREST RATE OPTIONS
    2. INTEREST RATE CALL OPTION
    3. INTEREST RATE CAPS AND FLOORS
    4. SWAPTIONS
    5. PROBLEM SET
  41. 29: Advising on Currency Risk at ICICI Bank
    1. ICICI BANK LIMITED
    2. POWER FINANCE CORPORATION (PFC) OF INDIA
    3. PFC'S EXPOSURE AND ICICI BANK'S RECOMMENDATION
  42. EQUITY AND OPTIONS EXCHANGES
  43. 30: Deutsche Börse
    1. MARKET OVERVIEW
    2. FRONT-OFFICE TRADING ACTIVITY
    3. BACK OFFICE TRADING ACTIVITIES
    4. DEUTSCHE BÖRSE
    5. COMPETITIVE ENVIRONMENT
    6. CLEARSTREAM
    7. CONCLUSION
  44. 31: The Chicago Board Options Exchange (CBOE)
    1. CBOE AND TRADITIONAL OPTIONS TRADING (1973–1999)
    2. A CHANGING MARKET PLACE AND THE ARRIVAL OF ELECTRONIC TRADING (1999–2004)
    3. THE OPTIONS TRADING INDUSTRY IN 2004—AND CBOE'S PLACE IN IT
    4. CBOE'S ELECTRONIC TRADING INITIATIVE: THE HYBRID TRADING SYSTEM (HyTS)
    5. GOING FORWARD
  45. 32: The International Securities Exchange: New Ground in Options Markets
    1. THE INTERNATIONAL SECURITIES EXCHANGE: COMPANY DESCRIPTION
    2. THE OPTIONS MARKET
    3. THE ISE EXCHANGE STRUCTURE AND MARKET RULES
    4. IMPROVING QUOTE SIZE
    5. CONCLUSION
  46. REAL OPTIONS
  47. 33: RTY Telecom: Network Expansion
    1. THE TECHNOLOGY BEHIND TELECOMMUNICATIONS
    2. THE HISTORY OF THE U.S. TELECOMMUNICATIONS MARKET
    3. RTY TELECOM COMPANY AND THE NORTEL AGREEMENT
  48. Index