Capital Market Finance: An Introduction to Primitive Assets, Derivatives, Portfolio Management and Risk

1385 Pages·2022·21.219 MB·English

by  Patrice Poncet, Roland Portait

Springer Texts in Business and Economics
Patrice Poncet
Roland Portait
Capital Market
Finance
An Introduction to Primitive Assets,
Derivatives, Portfolio Management
and Risk
Springer Texts in Business and Economics
Springer Texts in Business and Economics (STBE) delivers high-quality instruc-
tionalcontentforundergraduatesandgraduatesinallareasofBusiness/Management
Science and Economics. The series is comprised of self-contained books with a
broadandcomprehensivecoveragethataresuitableforclassaswellasforindividual
self-study. All texts are authored by established experts in their fields and offer a
solidmethodologicalbackground,oftenaccompaniedbyproblemsandexercises.
(cid:129)
Patrice Poncet Roland Portait
Capital Market Finance
An Introduction to Primitive Assets,
Derivatives, Portfolio Management
and Risk
With Contributions by Igor Toder
PatricePoncet RolandPortait
ESSECBusinessSchool ESSECBusinessSchool
CergyPontoise,France CergyPontoise,France
ISSN2192-4333 ISSN2192-4341 (electronic)
SpringerTextsinBusinessandEconomics
ISBN978-3-030-84598-8 ISBN978-3-030-84600-8 (eBook)
https://doi.org/10.1007/978-3-030-84600-8
MathematicsSubjectClassification:91G10;91G15;91G20;91G30;91G40;91G60;91G70
TranslationfromtheFrenchlanguageedition:FinancedemarchébyPatricePoncet,etal., #Éditions
Dalloz2008.PublishedbyÉditionsDalloz.AllRightsReserved.
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This book is dedicated to the dear memory of
Roland Portait (1943–2021), my long-time
friend, wonderful colleague and inspiring
co-author, whose untimely death leaves a
deep and painful void among his family and
friends.
Preface
This textbook is primarily aimed at graduate students of market finance (MBA,
MiM,andMsinbusinessschoolsandengineeringschoolsatuniversities,first-year
PhD programs in finance or economics). It is also aimed at market finance
practitioners: trading rooms, asset management firms (using quantitative tools),
actuaries in banks and insurance companies, risk management and control outlets,
andresearchteamsinmarketfinance.
Theobjectiveistomakeupfortherelativeinadequacyofmosttraditionalfinance
books and mathematical finance books. The former do not offer in general the
advanced mathematicaltechniquescurrently usedbyexpert professionals. And the
latter often focus on mathematical refinements at the expense of the economics
behind financial contracts and products, the practical use of instruments, and the
financiallogics ofmarkets; inaddition, some ofthem areofalevel inaccessible to
non-mathematicians,evenengineers.
Thisbookistheresultofmanyyearsofteachingmarketfinanceinthespecialized
programsofESSEC(marketfinancetrack,master’sinfinance),CNAM(master’sin
market finance), University of Paris 1-Panthéon-Sorbonne (master’s and PhD in
finance)andwithinthetradingroomsofSociétéGénérale,amajorFrenchbank,and
otherbankinginstitutions.
Itoffersacomprehensiveandconsistentpresentation(fromthepointofviewof
analysis and notation) of the whole of market finance. In particular, it covers all
primitive assets (equities, interest and exchange rates, indices, bank loans) except
realestate,mostvanillaandexoticderivatives(swaps,futures,options,hybrids,and
credit derivatives), portfolio theory and management, and risk appreciation and
hedging of individual positions as well as portfolios and firms’ balance sheets. It
emphasizesthemethodologicalaspects oftheanalysisoffinancial instrumentsand
of risk assessmentand management. In particular,it devotes an importantspace to
the probabilistic foundations of asset valuation and to credit and default risks, the
poorunderstandingofwhichaggravatedthe2007–2008financialcrisisoriginatedin
thesubprimecreditmarket.
Theintroductorychapter(Chap.1)isdevotedtotheeconomicroleplayedbythe
financialandbankingmarketsandtheirorganizationandfunctioning.Itisfollowed
byfourparts.
vii
viii Preface
The first part, consisting of Chaps. 2 to 8, deals with primitive assets (debt
securities, bonds, equities), the term structure of interest rates, floating rate
instruments, and vanilla swaps. It does not use complicated mathematical tools
and is accessible to undergraduate students. It is aimed at readers who are new to
market finance, the most advanced of which can access the second part almost
directly.
Thesecondpart,consistingofChaps.9to20,isdevotedtoderivatives(options
andfutures)andpresentsthemainmodels,stochasticcalculustools,andprobabilis-
tic theories on which modern methods of valuing contingent assets or claims and
financial risks are based. This part, much more technical than the previous one, is
aimed at graduate students and practitioners operating in financial markets. The
mathematicalbackgroundrequiredtoreadpartofthematerialisthatacquiredduring
the first two years of scientific studies and quantitative economics or management
studies (analysis, differential and integral calculus, linear algebra, and probability
theory). These developments are signaled by one star (*) or, rarely, two stars (**).
This is also the case for books referenced at the end of each chapter. Readers
equipped with this mathematical background will find in the book all the
complements concerning stochastic calculus and probabilistic theories, necessary
andsufficientforanin-depthunderstandingofmodernmarketfinance.
The third part, including Chaps. 21 to 25, is devoted to portfolio theory and
management. After a presentation of the standard portfolio theory (Markowitz,
capital asset pricing model, and arbitrage pricing theory), various techniques of
strategicandtacticalassetallocation(benchmarking,portfolioinsurance,alternative
investment,etc.)arediscussed.
Finally,thefourthpart,consistingofChaps.26to30,dealswithriskmanagement
with particular attentiontoanalytical methods (simulations, value-at-risk, expected
shortfall,valueadjustments),creditrisk(theoreticalandempiricalanalysisofcoun-
terparty and default risks, credit VaR, credit derivatives), and new regulation
regardingfinancialinstitutionsandbanks.
CergyPontoise,France PatricePoncet
RolandPortait
Main Abbreviations and Notations
Despite our efforts, because of the variety of themes covered in this book and its
length and technicality, we could not prevent certain symbolsfrom having distinct
meanings in different chapters. Although we always define our notations before
usingthemandthecontextinprincipleremovesanyambiguity,thefollowinglistof
keynotationsandabbreviationsmayproveuseful.
General conventions: an underlined variable (x) denotes a vector (or sequence),
matrices are written in bold (X), a ' denotes the derivative of a function or the
transpose of a vector or matrix, and [X]+ means max[X, 0]. The reading of more
technicalparagraphsequippedwithoneortwostarscanbeomittedorpostponed.
AAO Absenceofarbitrageopportunity,noarbitrage
ABS Asset-backedsecurity
α “abnormal” return rate (in asset pricing and portfolio management), or
recoveryrateofadebtinstrumentintheeventofdefault(increditrisk
analysis)
BS Black–Scholes(formulaof,ormodelof)
BSM Black–Scholes–Merton(modelof).Alternativename:Gaussianevalua-
tionmodel
B (t) Price on date t of a zero-coupon bond delivering $1 or €1 on date
T
T(duration:T-t)
bθ(t) Discountfactororpriceondatetofazero-couponbonddelivering$1or
€1ondatet+θ(duration:θ).Wehave:B (t)¼b (t).
T T-t
β Betaofastock(sensitivitytoastockmarketindex)or,moregenerally,
theslopeofalinearregression
C Usuallythepriceofacall,sometimesacoupon,sometimesaCap
CDO Collateralizeddebtobligation
CDS Creditdefaultswap
CIR Cox–Ingersoll–Ross(modelof)
CRR Cox–Ross–Rubinstein(modelof).Alternativename:binomialmodel
D,d Ingeneral,timetomaturity(duration),orMacaulayduration
δ Thedelta(sensitivity)ofanoption
DD distancetodefault
ix
x MainAbbreviationsandNotations
E mathematicalexpectation(EQ,EQT,E*,ERN,iftheprobabilitymeasure
isspecified)
ES Expectedshortfall(alternatively:conditionalVaRortailVaR)
F Acashflow;thepriceofafloor;aforwardorfuturesprice;adistribution
function
F Acashflowsequence(vector):
F (t) ForwardorfuturespriceondatetformaturityT(lessprecisenotation:F
T
(t))
Φ (t) Forwardpricewhenitisdistinguishedfromthefuturespricedenotedby
T
F (t)
T
f (t) Forwardrateprevailingattrelativetotheperiod(T,T+D)
T,D
f (t) Instantaneousforwardrate(limitofthepreviousonewhenDtendsto0)
T
γ(t) Probabilityofsurvivalatt(incaseofriskofdefault)
Γ,θ,ρ,ν Thevariousother“Greek”parametersofanoption(gamma,theta,rho,
vega,respectively)
H(t) Valueattoftheoptimalgrowth(logarithmic)portfolio
k Often a fixed interest rate (nominal rate of a fixed income instrument,
fixedrateofaswap,...)
K Exerciseprice(strike)ofanoption
λ Market price of risk, Lagrange multiplier, intensity of a jump process,
hazardrate,scalar
L Lossindefaultriskanalysis,Lagrangian
μ Oftenanexpectationoramean
N(μ,σ2) Normal(Gaussian)distributionofmeanμandvarianceσ2
N(x) Distributionfunctionofareducedcentered(standard)normalvariable
P Historicalprobability
P Usuallythepriceofaput
p Probabilityofdefault
d
PDE Partialdifferentialequation
Q Risk-neutral probability measure (denoted also by RN and sometimes
by*)
Q Forward-neutralprobabilitymeasurerelativetomaturityT(denotedalso
T
byFN-T)
r Generically means a rate. In general, our notation does not distinguish
between proportional, compounded, discrete, and continuous rates.
From Chap. 6 on, it is a zero-coupon rate, with yields to maturity of
bulletbondsbeingdenotedbyy.Also,rrepresentsarisk-freerateandr
(t)theinstantaneousrisk-freerateondatet.
rθ Ingeneralazero-couponrateofdurationθ
R,R Oftenarandomreturn(chaptersonportfoliotheory)
i
ρ Often a correlation coefficient; also the sensitivity of an option to
interestratevariations;exceptionallyaninterestrate
S Sometimes the sensitivity of an interest rate instrument to interest rate
variations
s,sθ Oftenaspread(differencebetweenrates,margin,...)