keith redhead - gbv · keith redhead routledge jj taylor & francis croup london and new york....
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Personal Finance and Investments
A behavioural finance perspective
Keith Redhead
Routledgej j Taylor & Francis Croup
LONDON AND NEW YORK
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Detailed Contents
CHAPTER 1 - Introduction 1Functions of Financial Systems 3
Investors and Borrowers 4
Personal Financial Planning 5
Budgeting 7
Managing Liquidity 7
Financing Large Purchases 7
Long-term Investing 8
Insurance 9
The Nature of Investment Risk 9
CORE Principles of Personal Financial Planning 10
CHAPTER 2 -The psychology of personal investment decisions 13Choice under Constraint 13
Objectives 13
Types of Risk 14
Constraints 16
Characteristics of Investments 18
Human Capital 19
Risk Management 20
C i EXHIBIT 2.1: Mis-selling or miscommunication? Apparent mis-selling of financial products may
V^ be the result of different perceptions of risk between advisers and clients
The Psychology of Personal Finance 23
Self-deception 24
Heuristic Simplification 26
The Catering Theory of Dividends 32
The Social Dimension 32
Influence of Emotion and Mood 33
Prospect Theory 34
The Disposition Effect 38
Avoidance of Psychological Biases 40
Saving and Self-Control 40
Habitual Non-Savers 42
Self-control, Personality Traits, and Social Mood 43
Influences on Retirement Saving Behaviour 44
Automatic Enrolment in Pension Schemes 45
Save More Tomorrow (SMarT) 45
Classifying Investors 46
The Need for Targeted Marketing 49
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DETAILED CONTENTS
The Possibility of Misleading Marketing 49Maximin and Minimax 50
CHAPTER 3 - Interest rates and money market investments 55
Simple Interest and Compound Interest 55The Average Compound Rate of Interest 57Variable and Fixed Interest Rates 58Convention for Quoting Interest Rates 58Nominal and Real Rates of Interest 59
Measuring Inflation - RPI and CPI 63Rates of Interest versus Rates of Discount 64Interest Yield and Total Return 65Short Maturity (Money Market) Investments 65
J^> EXHIBIT 3.1: Legal ScGeneral Cash Trust
Foreign Currency Deposits 68Relative Performance of Money Market Investments 69
CHAPTER 4 - Investing in bonds 72Government Bonds, Corporate Bonds, and Eurobonds 72Default Risk and Bond Rating Agencies 74
J$ EXHIBIT 4.1: M&G Corporate Bond Fund
Alternative Forms of Coupon Payment 77Gilts (Gilt-edged Securities) 77
Issuing Gilts 77o
Conventional Gilts 78Double-dated Gilts 78Undated Gilts 79Index-linked Gilts 79Rump Stocks 80
Gilt Strips 80
jW EXHIBIT 4.2: Henderson Global Investors UK Gilt Fund (as at 31108/2001)
GiltYields 82Gilt Price Volatility 83Preference Shares 84The Relative Performance of Bonds 84
CHAPTER 5 - Property investment and mortgages 87Buying Your Own Home 87
Opportunities for Gearing 88Lack of Diversification 88Lack of Liquidity 89
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DETAILED CONTENTS
Buy-to-Let 89Property Unit Trusts, Real Estate Investment Trusts, and Property Companies 89
J$ EXHIBIT 5.1: Legal ^General UK Property Trust (28/05/2007)
Determinants of Property Prices 91The Role of Anchoring in Property Valuation 92Momentum in Property Price Trends 93A Comparison of Property and Stock Market Investments 94Mortgages and the Purchase of Property 95Characteristics of Repayment Mortgages 96
The Tilt 98Fixed-Rate Mortgages 99
The Miles Report on the UK Mortgage Market 101The Potential Use of Bond Options 103
Capped-Rate Mortgages 104Other Forms of Mortgage 105
Islamic Mortgages 106Equity Release Mortgages and Home Reversion Plans 106The Mortgage and Endowment Equations 107
jw EXHIBIT 5.2: Endowment Mortgage and Repayment Mortgage
Have E n d o w m e n t Mortgages Been a Bad Choice? I l l
Collateralised Loans as Opt ions 112
CHAPTER 6 - Stock exchanges 117The Functions of a Stock Exchange 117Primary and Secondary Markets 118Stock Exchange Listing 119Types of Stock Exchange 119Stock Market Trading Systems 120
Order-driven Systems 120Quote-driven Systems 123Bid-offer Spreads 124Markets in which the Trading Systems Operate 125
Types of Order 126Selling Shares in the Primary Market 126
j^ ) EXHIBIT 6.1: Rights Issues
Types of Share 128
CHAPTER 7 - Stock ind ices 131
Types of Index 131Index Weighting 132
Adjusting for Changes in the Constituent Stocks of an Index 137Evaluating Alternative Stock Indices 139
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DETAILED CONTENTS
' EXHIBIT 7.1 :An example of an investment fund that aims to track the FTSE 100 index
CHAPTER 8 -The rationale and conduct of regulation 145Correction of Market Imperfections 145Economies of Scale and Delegated Monitoring 146Confidence in Minimum Standards 146Hazards of Regulation 147
Costs of Regulation 148Moral Hazard 148
Informal Self-Regulation 149Regulation of Investment Business in the UK 150
The Financial Services Authority (FSA) 150Financial Advisers and their Clients 151The Financial Ombudsman 152The Pensions Regulator, the Pension Protection Fund, and the Pensions Ombudsman 152
Quality Assurance in Investment Services 152Comparative Regulatory Systems 154
The Enforcement Theory of Regulation 155The European Union and the Regulation of Investments Business 156Enron, Worldcom, and Lemons 157
Shares as Lemons 157Bonds as Lemons 158
CHAPTER 9 - Mutual funds (unit trusts, OEICs, investment trusts) 163Benefits of Mutual Funds 163Differences between Unit Trusts, Investment Trusts, and OEICs 164
Investment Trust Share Buy-Backs 168
Jtq/ EXHIBIT 9.1: Example of an investment trust using share buy-backs (share repurchases)
Explanations for Investment Trust Discounts and Premiums 172Index (Tracker) Funds 174Tracking Error 175Exchange-Traded Funds (ETFs) 176Effects of Fund Charges 177
J © EXHIBIT 9.2: M&£ Fund of Investment Trust Shares
Charges, Commission, and Factory Gate Pricing 184Are Investors Deterred by High Charges? 185
Effects of Taxation on Investment Returns 185Individual Savings Accounts (ISAs) 188
CAT-marking 188Self-select ISAs 189Fund Supermarkets 189
Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs) 189
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DETAILED CONTENTS
Pound Cost Averaging 190
Dilution Levies, Dilution Adjustments, and Fair Value Pricing 193
Mutual Funds and the Provision of Liquidity 194
Evidence on the Performance of Mutual Funds 196
Star Performers and the Role of Chance 199
CHAPTER 10 - Life assurance and assurance-related investments 202
Term Assurance 202
Whole-of-Life Policies 203
Endowment Policies 204
Friendly Society Policies 205
Investment Bonds 205
With-Profits Funds 208
The Significance of Financial Strength 211
Criticisms ,212
CHAPTER 11 - Pensions 214
Jw EXHIBIT 11.1: The French State Tensions Reserve Fund
Types of Pension Schemes 216
Js^) EXHIBIT 11.2-.Teachers' Pension Scheme (England and Wales)
Occupational Pension Schemes in the UK 219
National Pension Savings Scheme 221
|!\ EXHIBIT 11.3: Pensions Commission (Turner Commission) - Key Conclusions of the First Report
W^ 'Pensions: Challenges and Choices' (2004)
Pension Transfers and Pension Unlocking 222o
Pension Funds 223
Accumulation of Pension Funds 224
Evidence on the Rate of Growth of Pension Funds 225
Annuities 225
Annuities as Pensions 227
Alternative Types of Annuity 228
Income Drawdown (Unsecured Pensions) and Phased Retirement Schemes 230
Applying the Principle of Diversification 231
Calculating a Level Annuity 231
Company Pension Scheme Balance Sheets 233
Life Cycle Analysis of Pension Funding 236
Fixing a Proportion of Pre-retirement Income 236
Fixing a Constant Consumption Stream 238
Variations on the Basic Equation 239
Estimated Effects of Delaying Pension Fund Contributions 239
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DETAILED CONTENTS
CHAPTER 12 -The importance and significance ofinstitutional investors 242Rise of the Institutional Investor 242Institutional Investors and Private Equity 244The Liquidity Theory of Asset Prices 245Short-Termism 247Influence of Institutional Investors on Companies and Analysts 250The Sandier Report 253
CHAPTER 13 - Portfolio diversification 261Expected Return and Risk 262The Principle of Diversification 264The Efficiency Frontier 267The Markowitz Equations 268ForeignJnvestments and Portfolio Risk 276
jgf*/ EXHIBIT 13.1: Example of an international fund
Asymmetric Correlation and Leptokurtosis 280Consistency and the Role of Direct Property Investment in Portfolios 282Direct Property Investment in Institutional and Private Portfolios 283Markowitz Diversification versus the 1 /N Strategy 283The Significance of Including a Risk-Free Asset Amongst the Investment Alternatives 286Asset Allocation Lines 289Behavioural Portfolios 290Value-at-Risk 291
Using Value-at-Risk to Ascertain Investor Risk Preferences 294Post-Modern Portfolio Theory 294Time Diversification 296The Roles of Financial Advice and Financial Education 298
CHAPTER 14 - Capital market theory: The capital asset pricing model 301The Meaning of Beta 301Estimating Future Values of Beta 304The Single Index Model 305The Security Market Line 306Trading Rules Based on the Security Market Line (Capital Asset Pricing Model) 307
Estimating Anticipated Returns 309Supply and Demand 311
Other Investment Management Applications 312Using the Single Index Model to Make the Capital Asset Pricing Model Operational 313Multifactor Forms of the Capital Asset Pricing Model 314Conditional and Unconditional Forms of the Capital Asset Pricing Model 316
CHAPTER 15 - Capital market theory: Alternatives and criticisms 318
Assumptions of the Capital Asset Pricing Model 318
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DETAILED CONTENTS
The Arbitrage Pricing Model 319The Role of Arbitrage 319An Example of Arbitrage 320The Nature of Risk Factors 322
Empirical Evidence 322Returns on Bonds 322Criticisms of Capital Market Theory 323The Zero-Beta Capital Asset Pricing Model 324Empirical Evidence 325Mutual Funds and the Death of Beta 326
CHAPTER 16 - Styles of portfolio construction 331
Active and Passive Management 331Passive Management 332Index Tracking 332Methods of Index Tracking 335
Full Replication 335Stratified Sampling 335Optimisation 336
J y EXHIBIT 16.1: M&_G Index Tracker Fund
Synthetic Index Funds (Futures Funds) 338Tracking Error 339Passive Core (Core-Satellite) Funds 341Stages of Portfolio Construction 341
Country Diversification versus Sector (Industry) Diversification 342Strategic and Tactical Asset Allocation 343Goals-Based Investing 343Value Stocks and Growth Stocks 346Implications of Style Investing 347Style Rotation 348Passive Strategies, Active Strategies, and Parrondo's Paradox 349Hedge Funds 350
Hedge Fund Performance 355Long-Term Capital Management 357
Socially Responsible Investing 359
j& EXHIBIT 16.2: Example of a Socially Responsible Investment Fund
J y EXHIBIT 16.3: Example of a Socially Responsible Investment Fund based on religious principles
Emerging Market Funds 363
Jjy EXHIBIT 16.4: Example of an emerging marketsjund
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DETAILED CONTENTS
CHAPTER 17 - Evaluating the performance of fund managers 368Money- and Time-Weighted Measures of Return 369The Evaluation of Risk 370Reward perUnitofRisk 371
The Sharpe andTreynor Measures 371M Squared 372Information Ratios 372A Generalised Sharpe Ratio 373
Differential Return 373Jensen's Alpha 374Appraisal Ratios 375Use of the Capital Market Line 375
Problems with Portfolio Performance Evaluation 377Comparison Portfolios 378Value-at-Risk and the Omega Measure 378
Attribution 380Style Analysis 382
Assessing Market-Timing Skills 383Holdings-Based Performance Measurement 385Persistence of Performance 386
Using Transition Matrices to Measure Persistence of Performance 387
CHAPTER 18 -The economic environment 393
Business Cycles and Stock Markets 394Saving Ratios and the Economy 398
An Overview of Macroeconomic Analysis 398IS-LM Analysis 398Aggregate Demand and Supply 400 ,Inflation and the Phillips Curve 400Interest Rates 402
Stock Markets and the Money Supply Transmission Mechanism 404Political and Demographic Effects on Share Prices 406Exchange Rates 407
CHAPTER 19 - Dividend discount models 410Discounting Cash Flows 410Discounting Expected Future Dividends 412The Gordon Growth Model 413Estimating the Growth Rate of Dividends 414Stochastic Dividend Discount Models 415Multi-Period Models 415Discounting Capital Gains 418Effects of Investment Opportunities on the Share Price 418
Another Perspective on Share Pricing 419
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DETAILED CONTENTS
Problems with Dividend Discount Models 420Alternatives to Expected Dividends 42 3Fusion Investing 424
CHAPTER 20 - Company accounts and economic value added 426
The Balance Sheet 426The Profit and Loss Account 428The Cash Flow Statement 429Analysis of Accounts 430Creative Accounting and the Interpretation of Accounts 431Tobin's q 432The Abnormal Earnings Share Pricing Model 434
Ohlson's Model 435Economic Value Added 436
CHAPTER 2-1 - Ratio analysis 438
Price-Earnings Ratios 438Earnings Per Share 443DividendYield, Earnings Yield, and ROCE 443Other Market Ratios 444Financial Adequacy Ratios 445
Financial Leverage (Gearing) Ratios 445Coverage Ratios 445Short-Term Solvency Ratios 446
Z Scores 446Ratios as Indicators of General Market Movements 447The Yield Gap,;the Yield Ratio, and 'The Fed Model' 448Prbblems with Ratio Analysis 449Following Professional Investment Analysts 450
CHAPTER 22-Technical analysis 454The Nature of Technical Analysis 454Behavioural Finance and Technical Analysis 455Price Charts 457Chart Patterns 459
Price Channels (Trend Channels) 459Reversal Patterns 462Moving Averages 464
Dow Theory 467Elliot Wave Theory 467Other Technical Indicators 468Some Caveats 470Games People Play 471Implications of Crowd Psychology 472
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. DETAILED CONTENTS
Further Evidence from Empirical Research 473Complex, Ill-Structured Tasks 474
CHAPTER 23 - Market efficiency: Concepts and weak form evidence 479
Types of Efficiency 479The Meaning of Informational Efficiency 481Assumptions of the Efficient Market Hypothesis 483Price Anomalies (Arbitrage Failures) 484Empirical Evidence on the Weak Form of the Efficient Market Hypothesis 486
Overshooting (Overreaction) and Mean Reversion 488Momentum and Contrarian Strategies 489Serial Correlation in Volatility 491
The Magnitude and Selection Bias Issues 492
CHAPTER 24 - Noise trading and behavioural finance 494
Noise Trading and Rumours 494Behavioural Finance 497Underreaction 497Overreaction 499Inaccurate Perceptions of Risk 503
Prospect Theory 505Investors Have Feelings 508Criticisms of Behavioural Finance 510
CHAPTER 25 - Market anomalies 513
Earnings Surprises 513The Size Effect 514Value Investing (Ratio Effects) 516Mispricing as an Explanation of Anomalies 518Anomalies or Risk Premiums? 519Calendar Effects 520Other Anomalies 521The Capital Asset Pricing Model and Problems with Testing
the Efficient Market Hypothesis 524Data Mining 525Survivor (ship) Bias 525Testing Impossible Strategies 526
CHAPTER 26 - Further evidence on market efficiency 528Evidence Supporting Semi-Strong Form Efficiency 528Evidence Relating to the Strong Form of the Efficient Market Hypothesis (EMH) 530
The Trades of Insiders 530Using Non-Public Analysis: Mutual Fund Performance 5 31Implications for Rational Retail Investors 533Using Non-Public Analysis: Analysts' Forecasts 535Prediction Markets (Decision Markets) 536
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DETAILED CONTENTS
Degrees of Efficiency and the Adaptive Markets Hypothesis 537The Fractal Market Hypothesis 538
CHAPTER 27 - Stock market bubbles and crashes 540Characteristics of Bubbles and Crashes 540Social and Psychological Factors 542
The Role of Social Mood 546A Psychoanalytic Perspective 548The Implications of Behavioural Finance for Understanding Bubbles and Crashes 549
Representativeness and Narrow Framing 549Overconfidence 550Familiarity and Celebrity Stocks 551
Investor Overreaction 552The Crash 553Post-Keynesian Perspectives on Stock Market Bubbles and Crashes 554Buying on Margin and the Liquidity Theory of Asset Prices 555Types of Trade 557Monetary Imbalance and Extrapolative Expectations 559A Behavioural Model of the Dot.com Bubble and Crash 559
J y EXHIBIT 27.1 :A Behavioural Model of the Dot.com Bubble and Crash
Portfolio Insurance 561Research Using Experimental Markets 561Complexity Theory as an Explanation of Bubbles and Crashes 562Catastrophe Theory as an Explanation of Crashes and Surges 564Price Bubbles and Banking Crises 565
J y EXHIBIT 27.2: The run on the Northern Rock Bank in August 2001
CHAPTER 28 - Stock index futures 571Financial Futures 571
Example of Hedging with Futures 572Speculation and Arbitrage 572The Margin System 574Closing Out 574Futures Funds 575Contracts for Difference (CFDs) and 130/30 Funds 576
J y EXHIBIT 28.1:130/30 Funds
Equity Swaps 578
CHAPTER 29 - Stock index futures prices 581Arbitrage Pricing 581The Role of Hedgers and Speculators 587
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DETAILED CONTENTS
The Role of Risk and Noise Traders 589Futures Prices and Expected Future Spot Prices 592
CHAPTER 30 - Hedging with stock index futures 594
The Nature of Hedging 594Sources of Hedge Imperfection 597Hedge Ratios 597What Index Level is 'Guaranteed' by Futures? 601
CHAPTER 31 - Stock options 607
Call Options 607The Profit/Loss Profile at Expiry 609The Profit/Loss Profile Prior to Expiry 610
Determinants of the Option Price (Premium) 611Put Options 611
The Profit/ Loss Profile at Expiry 612The Profit/Loss Profile Prior to Expiry 613
Writing Options 614Market Practices and Terms 616Boundary Conditions 618
CHAPTER 32 - Speculation with stock options 622
The Effects of Gearing 622Volatility Trading and the Collapse of Barings Bank 625Other Volatility Trading Strategies 627
CHAPTER 33 - Hedging with options 632Hedging the Value of a Shareholding 632
Long Versus Short Option Positions 633Hedging Anticipated Purchases 637Switching between Stocks without Trading in Stocks 639Vertical Spreads 643Option Cylinders 645Crash Options 645
CHAPTER 34 - Structured products 647Options Funds (Guaranteed Equity Funds) 648
The Nature of Options Funds 648The Fiduciary Call Approach 648The Protective Put Approach 649Break-Even Points 653
I EXHIBIT 34.1: Close UK Escalator 100 Fund and Close UK Escalator 95 Fund
Options Funds as Disaster Insurance 656Use of Exotic Options and Option Combinations 658
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DETAILED CONTENTS
Jti) EXHIBIT 34.2: Family Safety Net Stockmarket Unit Trust
High Yield Funds (Covered Call Funds/Precipice Bonds/Scarps) 661Bonds with Variable Principals (Structured Notes) 665CoUateralised Debt Obligations (CDOs) and the Sub-Prime Mortgage Crisis 667
CHAPTER 35 -Warrants, convertibles, and split-caps 669Warrants 669
Covered Warrants 670The Capital Fulcrum Point 670
Convertibles 670Split-Capital Investment Trusts 673Shares and Bonds as Options 677
CHAPTER 36 - Option pricing and the Black-Scholes model 680
Option Prices as the Costs of Replication 680The Determinants of Option Prices 680The Black-Scholes Option Pricing Model 684Early Exercise 688
CHAPTER 37 -Variations on the basic Black-Scholes optionpricing model 690European-style Call Options on Dividend Paying Stocks 690American-style Call Options on Dividend Paying Stocks (Black's Approximation) 694European-style Call Options on Stock Indices 695The Greeks 699Pricing American-style Options 702Vahjing Options on Bonds 702Put-Call Parity and the Pricing of Put Options 703
Implied Stock Prices, Observed Stock Prices, and Stock Price Bubbles 706Reliability of the Black- Scholes Model 707
Implied Volatility 707Volatility Smiles and Volatility Smirks 708
CHAPTER 38 -The binomial option pricing model 711The One-Period Binomial Model 712Multi-Period Models 712Illustration of the Application of the One-Period Model 714Illustration of the Application of the Two-Period Model 715Illustration of the Pricing of an American-style Option 718The Binomial Model and the Assumptions of the Black-Scholes Model 722Real Options and Company Valuation 723
CHAPTER 39 - Currency forwards, futures, swaps, and options 729
International Money Market Investments 729Currency Forwards and Currency Futures 730
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DETAILED CONTENTS
Comparing Currency Forwards and Currency Futures 730Pricing Currency Forwards and Futures 732
Interest Rate Parity 732Covered Interest Arbitrage 732Synthetics and the Pricing of Forward Contracts 735The Significance of Bid-Offer Spreads 735
Hedging Currency Risk with Futures 738The 'Guaranteed' Exchange Rate 743
Currency Swaps 744Currency Options as Hedging Instruments 745Zero-Cost Options 746Delta Hedging with Options 746
CHAPTER 40 - Bond prices and redemption yields 751
Discount Models 751Valuing Coupon Streams as Annuities 755Consols and PIBs 756Accrued Interest and Rebate Interest 756Bond Price Convexity 757Bond Equivalent Yields, Effective AnnualYields, and Realised CompoundYields 758Horizon Return (Holding-Period Return) 760Index-Linked Gilt Redemption Yields 761
CHAPTER 41 - Duration and risk 763The Measurement of Bond Price Volatility (Duration) 763
A Formula for Calculating Macaulay's Duration 766Money Duration (Price Value of a Basis Point) 767The Behaviour of Macaulay's Duration 770Portfolio Immunisation 772Inverse Floaters and Floating Rate Notes 775Bond Index (Tracker) Funds 776Interest Rate Anticipation 777
CHAPTER 42 - Bond price convexity 779The Problem of Convexity 779The Value of Convexity 782Construction of Bond Portfolios 783Callable Bonds 783
CHAPTER 43 - Bond futures 785
Bonds 785Futures Contracts 785Hedging the Value of a Portfolio 786
Delivery, Price Factors, Invoice Amounts, and the Cheapest-to-Deliver Bond 789
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DETAILED CONTENTS
Hedge Ratios 789Bond Portfolio Immunisation 792Adjusting Portfolio Duration with Futures 793
Determination of Bond Futures Prices 793Arbitrage Pricing 793The Role of Implicit Options 796Implied Repos 797
Basis Risk 798Synthetic Bond Portfolios 798Credit Derivatives 8 01
CHAPTER 44 - Yield curves and interest rate futures 804Yield Curves 804Construction of Bond Portfolios 808Forward Interest Rates and Expected Future Interest Rates 809The Forward Yield Curve 812Short-Term Interest Rate Futures 813Determination of Futures Prices 813Hedging the Yield Curve with Futures 814
Straddles 816Butterfly Spreads 817
A Generic Hedge Ratio 818Forward Rate Agreements (FRAs) 818
CHAPTER 45 - Interest rate swaps 820Hedging Interest Rate Risk 820Warehousing 822Floating Rate Notes (FRNs) 823Swap Pricing 823Credit Default Swaps 824
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