Robert Dubil – An Arbitrage Guide to Financial Markets
Description
An Arbitrage Guide to Financial Markets is the first book to explicitly show the linkages of markets for equities, currencies, fixed income, and commodities. Using a unique structural approach, it dissects all markets the same way: into spot, forward, and contingent dimensions, bringing out the simplicity and the commonalities of all markets. The book shuns stochastic calculus in favor of cash flow details of arbitrage trades. All math is simple, but there is lots of it. The book reflects the relative value mentality of an institutional trader seeking profit from misalignments of various market segments.
The book is aimed at entrants into investment banking and dealing businesses, existing personnel in non-trading jobs, and people outside of the financial services industry trying to gain a view into what drives dealers in today’s highly integrated marketplace. A committed reader is guaranteed to leave with a deep understanding of all current issues.
“This is an excellent introduction to the financial markets by an author with a strong academic approach and practical insights from trading experience. At a time when the proliferation of financial instruments and the increased use of sophisticated mathematics in their analysis, make an introduction to financial markets intimidating to most, this book is very useful. It provides an insight into the core concepts across markets and uses mathematics at an accessible level. It equips readers to understand the fundamentals of markets, valuation and trading. I would highly recommend it to anyone looking to understand the essentials of successfully trading, structuring or using the entire range of financial instruments available today.” —Varun Gosain, Principal, Constellation Capital Management, New York
“Robert Dubil, drawing from his extensive prior trading experience, has made a significant contribution by writing an easy-to-understand book about the complex world of today’s financial markets, using basic mathematical concepts. The book is filled with insights and real-life examples about how traders approach the market and are required reading for anyone with an interest in understanding markets or a career in trading.” —George Handjinicolaou, Partner, Italian Capital, New York
“This book provides an excellent guide to the current state of the financial markets. It combines academic rigor with the author’s practical experience of the financial sector, giving both students and practitioners an insight into the arbitrage pricing mechanism.” —Zenji Nakamura, Managing Director, Europe Fixed Income Division, Nomura International plc, London
Table of Contents
- 1 The Purpose and Structure of Financial Markets 1
- 1.1 Overview 1
- 1.2 Risk sharing 2
- 1.3 The structure of financial markets 8
- 1.4 Arbitrage: Pure vs. relative value 12
- 1.5 Financial institutions: Asset transformers and broker-dealers 16
- 1.6 Primary and secondary markets 18
- 1.7 Market players: Hedgers vs. speculators 20
- 1.8 Preview of the book 22
- Part One SPOT 25
- 2 Financial Math I—Spot 27
- 2.1 Interest-rate basics 28
- Present value 28
- Compounding 29
- Day-count conventions 30
- Rates vs. yields 31
- 2.2 Zero, coupon and amortizing rates 32
- Zero-coupon rates 32
- Coupon rates 33
- Yield to maturity 35
- Amortizing rates 38
- Floating-rate bonds 39
- 2.3 The term structure of interest rates 40
- Discounting coupon cash flows with zero rates 42
- Constructing the zero curve by bootstrapping 44
- 2.4 Interest-rate risk 49
- Duration 51
- Portfolio duration 56
- Convexity 57
- Other risk measures 58
- 2.5 Equity markets math 58
- A dividend discount model 60
- Beware of P/E ratios 63
- 2.6 Currency markets 64
- 3 Fixed Income Securities 67
- 3.1 Money markets 67
- U.S. Treasury bills 68
- Federal agency discount notes 69
- Short-term munis 69
- Fed Funds (U.S.) and bank overnight refinancing (Europe) 70
- Repos (RPs) 71
- Eurodollars and Eurocurrencies 72
- Negotiable CDs 74
- Bankers’ acceptances (BAs) 74
- Commercial paper (CP) 74
- 3.2 Capital markets: Bonds 79
- U.S. government and agency bonds 83
- Government bonds in Europe and Asia 86
- Corporates 87
- Munis 88
- 3.3 Interest-rate swaps 90
- 3.4 Mortgage securities 94
- 3.5 Asset-backed securities 96
- 4 Equities, Currencies, and Commodities 101
- 4.1 Equity markets 101
- Secondary markets for individual equities in the U.S. 102
- Secondary markets for individual equities in Europe and Asia 103
- Depositary receipts and cross-listing 104
- Stock market trading mechanics 105
- Stock indexes 106
- Exchange-traded funds (ETFs) 107
- Custom baskets 107
- The role of secondary equity markets in the economy 108
- 4.2 Currency markets 109
- 4.3 Commodity markets 111
- 5 Spot Relative Value Trades 113
- 5.1 Fixed-income strategies 113
- Zero-coupon stripping and coupon replication 113
- Duration-matched trades 116
- Example: Bullet–barbell 116
- Example: Twos vs. tens 117
- Negative convexity in mortgages 118
- Spread strategies in corporate bonds 121
- Example: Corporate spread widening/narrowing trade 121
- Example: Corporate yield curve trades 123
- Example: Relative spread trade for high and low grades 124
- 5.2 Equity portfolio strategies 125
- Example: A non-diversified portfolio and benchmarking 126
- Example: Sector plays 128
- 5.3 Spot currency arbitrage 129
- 5.4 Commodity basis trades 131
- Part Two FORWARDS 133
- 6 Financial Math II—Futures and Forwards 135
- 6.1 Commodity futures mechanics 138
- 6.2 Interest-rate futures and forwards 141
- Overview 141
- Eurocurrency deposits 142
- Eurodollar futures 142
- Certainty equivalence of futures 146
- Forward-rate agreements (FRAs) 147
- Certainty equivalence of FRAs 149
- 6.3 Stock index futures 149
- Locking in a forward price of the index 150
- The fair value of futures 150
- Fair value with dividends 152
- Single stock futures 153
- 6.4 Currency forwards and futures 154
- The fair value of currency forwards 155
- Covered interest-rate parity 156
- Currency futures 158
- 6.5 Convenience assets—backwardation and contango 159
- 6.6 Commodity futures 161
- 6.7 Spot–Forward arbitrage in interest rates 162
- Synthetic LIBOR forwards 163
- Synthetic zeros 164
- Floating-rate bonds 165
- Synthetic equivalence guaranteed by arbitrage 166
- 6.8 Constructing the zero curve from forwards 167
- 6.9 Recovering forwards from the yield curve 170
- The valuation of a floating-rate bond 171
- Including repo rates in computing forwards 171
- 6.10 Energy forwards and futures 173
- 7 Spot–Forward Arbitrage 175
- 8 Swap Markets 199
- 8.1 Swap-driven finance 199
- Fixed-for-fixed currency swap 200
- Fixed-for-floating interest-rate swap 203
- Off-market swaps 205
- 8.2 The anatomy of swaps as packages of forwards 207
- Fixed-for-fixed currency swap 208
- Fixed-for-floating interest-rate swap 209
- Other swaps 210
- Swap book-running 210
- 8.3 The pricing and hedging of swaps 211
- 8.4 Swap spread risk 217
- 8.5 Structured finance 218
- Inverse floater 219
- Leveraged inverse floater 220
- Capped floater 221
- Callable 221
- Range 222
- Index principal swap 222
- 8.6 Equity swaps 223
- 8.7 Commodity and other swaps 224
- 8.8 Swap market statistics 225
- Part Three OPTIONS 231
- 9 Financial Math III—Options 233
- 9.1 Call and put payoffs at expiry 235
- 9.2 Composite payoffs at expiry 236
- Straddles and strangles 236
- Spreads and combinations 237
- Binary options 240
- 9.3 Option values prior to expiry 240
- 9.4 Options, forwards, and risk-sharing 241
- 9.5 Currency options 242
- 9.6 Options on non-price variables 243
- 9.7 Binomial options pricing 244
- One-step examples 244
- A multi-step example 251
- Black–Scholes 256
- Dividends 257
- 9.8 Residual risk of options: Volatility 258
- Implied volatility 260
- Volatility smiles and skews 261
- 9.9 Interest-rate options, caps, and floors 264
- Options on bond prices 265
- Caps and floors 265
- Relationship to FRAs and swaps 267
- An application 268
- 9.10 Swaptions 269
- Options to cancel 270
- Relationship to forward swaps 270
- 9.11 Exotic options 272
- Periodic caps 272
- Constant maturity options (CMT or CMS) 273
- Digitals and ranges 273
- Quantos 274
- 10 Option Arbitrage 275
- 10.1 Cash-and-carry static arbitrage 275
- Borrowing against the box 275
- Index arbitrage with options 277
- Warrant arbitrage 278
- 10.2 Running an option book: Volatility arbitrage 279
- Hedging with options on the same underlying 279
- Volatility skew 282
- Options with different maturities 284
- 10.3 Portfolios of options on different underlying 284
- Index volatility vs. individual stocks 285
- Interest-rate caps and floors 286
- Caps and swaptions 287
- Explicit correlation bets 288
- 10.4 Options spanning asset classes 289
- Convertible bonds 289
- Quantos and dual-currency bonds with fixed conversion rates 290
- Dual-currency callable bonds 291
- 10.5 Option-adjusted spread (OAS) 291
- 10.6 Insurance 292
- Long-dated commodity options 293
- Options on energy prices 294
- Options on economic variables 294
- A final word 294
- Appendix CREDIT RISK 295
- 11 Default Risk (Financial Math IV) and Credit Derivatives 297
- 11.1 A constant default probability model 298
- 11.2 A credit migration model 300
- 11.3 Alternative models 301
- 11.4 Credit exposure calculations for derivatives 302
- 11.5 Credit derivatives 305
- Basics 306
- Credit default swap 306
- Total-rate-of-return swap 307
- Credit-linked note 308
- Credit spread options 308
- 11.6 Implicit credit arbitrage plays 310
- Credit arbitrage with swaps 310
- Callable bonds 310
- 11.7 Corporate bond trading 310
Index 313
Author Information
ROBERT DUBIL is a former Director of Risk Analytics in the Corporate Risk Management Group at Merrill Lynch (1999-2001), head of Exotic Fixed Income Derivatives Trading at UBS (1996-99) and Chase Manhattan (1994-95), an equity and debt derivatives trader at Merrill Lynch (1992-94), and a quantitative researcher at Nomura (1990-92) and JP Morgan (1989-90). He worked in New York, London, Tokyo, Hong Kong, and Sydney. He holds a Ph.D. and MBA from the University of Connecticut, and an MA from Wharton. His recent articles covering liquidity risks and banking regulation can be found in the Journal of Applied Finance, Financial Services Review, Journal of Entrepreneurial Finance and Business Ventures, Journal of Wealth Management, and the Journal of Investing. He is currently an Associate Professor of Finance at San Jose State University in California.
The Wiley Advantage
The first book truly explains how real deals are made in modern capital market operations.
All concepts are explained using detailed numerical examples of real finance transactions. This explains why most institutions rely on the interaction of dealers on large trading floors to take advantage of inter-market arbitrages. Written by a highly experienced practitioner.
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