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____________ An Arbitrage Guide to Financial Markets ____________

Robert Dubil

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____________ An Arbitrage Guide to Financial Markets ____________

Wiley Finance Series

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Modelling Prices in Competitive Electricity MarketsDerek Bunn (Editor)

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Applied Quantitative Methods for Trading and InvestmentChristian L. Dunis, Jason Laws and Patrick Naim (Editors)

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Hedge Funds: A Resource for InvestorsSimone Borla

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The Simple Rules: Revisiting the Art of Financial Risk ManagementErik Banks

Option TheoryPeter James

Risk-adjusted Lending ConditionsWerner Rosenberger

Measuring Market RiskKevin Dowd

An Introduction to Market Risk ManagementKevin Dowd

Behavioural FinanceJames Montier

Asset Management: Equities DemystifiedShanta Acharya

An Introduction to Capital Markets: Products, Strategies, ParticipantsAndrew M. Chisholm

Hedge Funds: Myths and LimitsFrancois-Serge Lhabitant

The Managers Concise Guide to RiskJihad S. Nader

Securities Operations: A Guide to Trade and Position ManagementMichael Simmons

Modeling, Measuring and Hedging Operational RiskMarcelo Cruz

Monte Carlo Methods in FinancePeter Jackel

Building and Using Dynamic Interest Rate ModelsKen Kortanek and Vladimir Medvedev

Structured Equity Derivatives: The Definitive Guide to Exotic Options and Structured NotesHarry Kat

Advanced Modelling in Finance Using Excel and VBAMary Jackson and Mike Staunton

Operational Risk: Measurement and ModellingJack King

Interest Rate ModellingJessica James and Nick Webber

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____________ An Arbitrage Guide to Financial Markets ____________

Robert Dubil

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Library of Congress Cataloging-in-Publication Data

Dubil, Robert.An arbitrage guide to financial markets / Robert Dubil.p. cm.(Wiley finance series)Includes bibliographical references and indexes.ISBN 0-470-85332-8 (cloth : alk. paper)1. InvestmentsMathematics.. 2. Arbitrage. 3. Risk. I. Title. II. Series.HG4515.3.D8 2004332.6dc22 2004010303

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 0-470-85332-8

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To Britt, Elsa, and Ethan

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____________________________________________________________________________________________________________________________________________ Contents ____________________________________________________________________________________________________________________________________________

1 The Purpose and Structure of Financial Markets 11.1 Overview 11.2 Risk sharing 21.3 The structure of financial markets 81.4 Arbitrage: Pure vs. relative value 121.5 Financial institutions: Asset transformers and broker-dealers 161.6 Primary and secondary markets 181.7 Market players: Hedgers vs. speculators 201.8 Preview of the book 22

Part One SPOT 25

2 Financial Math ISpot 272.1 Interest-rate basics 28

Present value 28Compounding 29Day-count conventions 30Rates vs. yields 31

2.2 Zero, coupon and amortizing rates 32Zero-coupon rates 32Coupon rates 33Yield to maturity 35Amortizing rates 38Floating-rate bonds 39

2.3 The term structure of interest rates 40Discounting coupon cash flows with zero rates 42Constructing the zero curve by bootstrapping 44

2.4 Interest-rate risk 49Duration 51Portfolio duration 56

Convexity 57Other risk measures 58

2.5 Equity markets math 58A dividend discount model 60Beware of P/E ratios 63

2.6 Currency markets 64

3 Fixed Income Securities 673.1 Money markets 67

U.S. Treasury bills 68Federal agency discount notes 69Short-term munis 69Fed Funds (U.S.) and bank overnight refinancing (Europe) 70Repos (RPs) 71Eurodollars and Eurocurrencies 72Negotiable CDs 74Bankers acceptances (BAs) 74Commercial paper (CP) 74

3.2 Capital markets: Bonds 79U.S. government and agency bonds 83Government bonds in Europe and Asia 86Corporates 87Munis 88

3.3 Interest-rate swaps 903.4 Mortgage securities 943.5 Asset-backed securities 96

4 Equities, Currencies, and Commodities 1014.1 Equity markets 101

Secondary markets for individual equities in the U.S. 102Secondary markets for individual equities in Europe and Asia 103Depositary receipts and cross-listing 104Stock market trading mechanics 105Stock indexes 106Exchange-traded funds (ETFs) 107Custom baskets 107The role of secondary equity markets in the economy 108

4.2 Currency markets 1094.3 Commodity markets 111

5 Spot Relative Value Trades 1135.1 Fixed-income strategies 113

Zero-coupon stripping and coupon replication 113Duration-matched trades 116Example: Bulletbarbell 116Example: Twos vs. tens 117

viii Contents

Negative convexity in mortgages 118Spread strategies in corporate bonds 121Example: Corporate spread widening/nar