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the financial markets, I am referring both to a unifying aspect within each
market segment and across them.
We are most certainly at a crucial juncture of the markets today. Recent
lessons have shown us that a new market dialogue is required. The generic
labels commonly used within finance today do not convey the same mean-
ing and value that they did years ago. A blanket reference to a bond versus
an equity ought no longer to evoke a sense of the former being a safer invest-
ment than the latter; just the opposite may be true in today™s highly engi-
neered marketplace. Unfortunately, the new kind of dialogue that financial
professionals must now practice does not fit the easy classifications that
suited the marketplace for decades if not centuries. It is not nearly enough

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xii PREFACE




ng




Ch
eri


Chapter 1




ap
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Products Chapter 2
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5,
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Cash Flows




Ri
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sk
an




Ma
Fin




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Bonds Spot
4,




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Currencies Options
ter




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Forwards &
Equities
Futures
Chapter 3
Credit
Products Cash Flows


Issuers


Chapter 6, Market Environment

FIGURE P.1 High-level overview of chapters and topics.


to state that credit is a factor that permeates all markets, or that legal con-
siderations are key when determining what happens in the event of a
default. What is now absolutely essential is a clear understanding of the inter-
relationships among these (and many other) market dynamics and how the
use of such tools as probability theory and historical experience can help to
guide informed and prudent decision making.
The world of finance is not necessarily a more complex place today, but
it is most certainly a different place. A large step toward understanding the
new order is to embrace the notion of how similar financial products truly
are rather than to perpetuate outlived delineations of how they are so dif-
ferent. The dialogue in support of this evolution does not require a new, dif-
ferent vocabulary; rather we must use our existing vocabulary in a richer
and more meaningful way to portray more accurately a relevant perspective
of a security™s risk and reward profile. Terms like “duration” and “beta”




TLFeBOOK
xiii
Preface


have been around for a long time and are commonly used, though they are
woefully insufficient now as stand-alone concepts; they are much more valu-
able to investors when seen in broader context alongside other financial mea-
sures. This text shows why and presents new ways that long-standing
metrics of risk and return can be combined to assist with divining creative
and meaningful market insights.
Figure P.1 presents the layout of the entire book within a single diagram.
The concepts of products (bonds, equities, and currencies), cash flows (spot,
forwards and futures, and options), and credit (products, cash flows, and
issuers) are intended to represent more specific or micro-oriented consider-
ations for investors. Conversely, the concepts of financial engineering (prod-
uct creation, portfolio construction, and strategy development), risk
management (quantifying risk, allocating risk, and managing risk), and mar-
ket environment (tax, legal and regulatory, and investors) are intended to
represent more general or macro-oriented considerations. While the micro-
topics are presented pictorially as self-contained triangles to suggest that
these are the building blocks of finance, the macrotopics are presented
around the perimeter of the triangle to suggest that these are broader and
more encompassing concepts. Two of the three topics in Chapter 3 are the
titles of Chapters 1 and 2. The significance of this is twofold: It highlights
the interrelated nature of markets, and it points out that credit is an
extremely important aspect of the market at large.
Let™s begin!




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1 Head



Acknowledgments

A work of this type typically is successful only because of the support and
assistance of a variety of individuals, and for me this is one of the most
rewarding aspects of engaging in a project such as this. The sacrifices asked
of immediate family, in particular, are usually great, and I am most grateful
to my wife, Aly, and my sons, Max, Jack, and Nicholas, for indulging their
husband and father in this latest work. Another dimension of this book is
that during the time of its writing I had the good fortune to live and work
on two continents and with global responsibilities. These experiences pro-
vided considerable food for thought, and I am grateful for that. I also want
to thank the anonymous reviewers of this text, though I fully accept any
errors as being completely my own. Finally, for their assistance with prepar-
ing this book, I want to thank Elena Baladron and Thomas Cooper.




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Introduction

This text presents, for the first time, a single unified approach to building
bridges across fundamental financial relationships. The top layer of this new
methodology is comprised of products, cash flows, and credit. Products are
financial securities including equities, bonds, and currencies. “Cash flow”
refers to the structure of a security and denotes if the asset is a spot, for-
ward or future, or option. Credit is a factor that winds its way through all
of the above. As recent market events readily attest, understanding credit
risk is paramount to successful investing.
While laying the fundamental groundwork, the text examines implica-
tions for investment-making decisions and develops a framework for how
investors and portfolio managers can evaluate market opportunities. Specific
trading strategies are presented, including detailed suggestions on how port-
folio managers can build optimal portfolios.
In short, this text provides a simple yet powerful introduction to iden-
tifying value in any financial product. While primarily intended for profes-
sional portfolio managers, individual investors and students of the financial
markets also will find the text to be of value. Key financial terms are high-
lighted in italics throughout the book for easy reference and identification.
While one obvious benefit of specialized texts is that they offer an in-
depth view of particular classes of financial products, an obvious short-
coming is that readers gain little or no appreciation for hybrid securities or
alternative investments. Is a preferred stock an equity by virtue of its credit
rating and the fact that it pays dividends, or is it a bond owing to its fixed
maturity date and its maturity value of par? With the rapid pace of finan-
cial innovation, convenient labels simply do not apply, and this is especially
the case today with credit derivatives. Thus, by virtue of its focus on the
dynamics of processes and interrelationships as opposed to more definitional
and static concepts, this text provides a financial toolbox that is equipped
to build or deconstruct any financial product that may evolve. To reinforce
this, each chapter builds on the previous one, and key concepts are contin-
uously reinforced.
Each chapter begins with a reference to a triangle of three themes that
will be explored within the chapter. A convenient property of any triangle
is that it has three points. Accordingly, if we were to label these three points
as A, B, and C respectively, point A is always one step away from either B
or C. The same can be said for point B relative to points A and C, or for
point C relative to A and B. This is a useful consideration because it sup-

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ports the notion that while I may refer to three distinguishable niches of the
marketplace (as with equities, bonds, and currencies), I wish also to stress
how the three particular niches are also related”that they are always just
one step away from one another.
Chapter 1 provides fundamental working definitions of what is meant
precisely by equities, bonds, and currencies.
Chapter 2 presents cash flows”the way that a product is structured. The
three basic cash flow types are spot, forwards and futures, and options.
Chapter 3 presents credit. In its most fundamental form, credit risk is
the uncertainty that a counterparty cannot or will not honor its promise to
provide a good, service, or payment, and in a timely fashion. The chapter
examines credit risk from the perspective of products, cash flows, and issuers.
Chapter 4 demonstrates intra- and interrelationships among the trian-
gles presented in previous chapters and in a product creation context and
shows how hybrids can be analyzed. Indeed, with the new building block
foundation, the text demonstrates how straightforward it can be to construct
or decompose any security. Also presented are ideas on how to construct and
trade optimal portfolios relative to various strategies including indexation.
Chapter 5 continues the presentation of the unifying methodology in the

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