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Financial Engineering
Principles
A Unified Theory for Financial
Product Analysis and Valuation


Perry H. Beaumont, PhD




John Wiley & Sons, Inc.




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Financial Engineering
Principles




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Financial Engineering
Principles
A Unified Theory for Financial
Product Analysis and Valuation


Perry H. Beaumont, PhD




John Wiley & Sons, Inc.




TLFeBOOK
Copyright © 2004 by Perry H. Beaumont, Ph.D. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.

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accuracy or completeness of the contents of this book and specifically disclaim any implied war-
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Library of Congress Cataloging-in-Publication Data
Beaumont, Perry H., 1961-
Financial engineering principles: a unified theory for financial
product analysis and valuation / Perry H. Beaumont.
p. cm. ” (Wiley finance series)
Published simultaneously in Canada.
ISBN 0-471-46358-2 (cloth)
1. Financial engineering. I. Title. II. Series.
HG176.7.B42 2003
658.15™224”dc21 2003011338

Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1




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For my wife, Alexandra, with love and devotion




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Equities Bonds


Currencies




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Contents




FOREWORD IX

PREFACE XI

INTRODUCTION XVII


PART ONE
Products, Cash Flows, and Credits 1
CHAPTER 1
Products 3

CHAPTER 2
Cash Flows 15

CHAPTER 3
Credit 73

PART TWO
Financial Engineering, Risk Management, and Market Environment 111
CHAPTER 4
Financial Engineering 113

CHAPTER 5
Risk Management 171

CHAPTER 6
Market Environment 241

INDEX 271



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Foreword

Casting aside the traditional notion of financial products grouped within dis-
tinct, relatively isolated asset classes, Beaumont insightfully uncovers com-
mon characteristics that allow the practitioner to better understand
interrelationships between bonds, equities, and currencies. Importantly, the
author drafts a hands-on roadmap to help investors manage these asset man-
agement building blocks within an integrated portfolio context.
Moving aggressively away from “box thinking,” the author creatively
develops an applied geometry of self-contained triangles to accent the essen-
tial functional qualities of various product or cash flow categories. Macro-
topics are then added around the perimeter of these triangles to illustrate
common traits or themes that the author pulls together to help weave the
complex fabric of financial engineering.
The text and the entire Appendix for Chapter 4 are peppered with prac-
tical examples that give Financial Engineering Principles a “real world” fla-
vor. In this way, professionals and laypersons alike have access to a virtual
Global Positioning System to safely and swiftly navigate the most challeng-
ing of financial straits, even as the market environment changes, strategic
courses are recalibrated, and new investment vehicles evolve.
Particularly timely, in a global financial arena marked by periods of
excessive volatility and widespread uncertainty, Beaumont devotes an entire
chapter to strategies and instruments that can help the portfolio manager
better quantify, allocate, and manage (or hedge) critical investment risks. By
employing a fresh cross-market approach, the author draws not just on prod-
uct-related risk drivers, but also on cash flow and credit interrelationships
to develop a richer, more powerful approach to risk management.
Financial Engineering Principles combines the best of a well-crafted
“practitioner™s guide” with an invaluable “reference work” to give readers
a financial engineering tool that will undoubtedly become one of the most
used tools in their investment management tool chest.
Gilbert A. Benz
Executive Director
Investment Solutions
UBS, Zurich, Switzerland




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Preface

After nearly 20 years in the financial industry, and with assignments that
have taken me to every corner of the globe, it is only now that I feel this
book could be written.
In my first text, Fixed Income and Synthetic Assets, the idea was to trek
from the front of the yield curve to the back and provide ideas for how a
properly equipped financial toolbox could help identify trading strategies and
perhaps even assist with creating new financial products in the world of fixed
income.
Here my goal is to introduce a unifying theory among the various fac-
tors that make up the world of finance. The three fundamental factors to
this unified theory are products, cash flows, and credit. With a solid ground-
ing in these first principles, we will show how any financial security can be
better understood by financial professionals, students, or individual investors
who desire to go beyond more basic financial concepts.
After having spent years teaching about the financial markets, I continue
to find it disheartening that some students feel that global markets are far
more disparate than they are similar and shy away from thinking in a more
eclectic and encompassing way about the world. There are many common
elements across markets, and the potential insights to risk and reward that
can be gained from a more unified approach are simply tremendous.
While one overall goal of the book is to highlight the unifying aspect of
my approach to these key financial markets, the chapters can be quite
instructive on a stand-alone basis. By this I mean that a reader who is pri-
marily interested in bonds will not have to read any chapters beyond those
within the bond sections to fully capture the essence of that product type.
To this end, it bears emphasizing that when I refer to a unifying theory of

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