. 3
( 60 .)


context of risk management and considers risk: quantifying, allocating, and
managing it.
Chapter 6 presents the market environment, by which is meant the more
macro-influences of market dynamics. Three fundamental macro-influences
include tax, legal and regulatory, and investor considerations.
Many senior institutional investors and those with considerable market
experience traditionally have viewed the bond, equity, and currency markets
as rather distinct and generally differentiated asset classes. Indeed, it would
not be too difficult at all to assemble a list of how these asset types are
unique. For example, the stock market is generally an exchange-traded or
listed market (including the New York Stock Exchange, NYSE), while the
currency market is generally an unlisted or over-the-counter (OTC) market,
(meaning not on an exchange), while bonds are more OTC than not,
although this situation is changing rapidly. Another point of distinction is
that over long periods of time (several years), equities generally have sported
superior returns relative to bonds, although also with a greater level of risk.
In this context, risk is a reference to the variability of returns. That is, the
returns of equities may be more variable year-to-year relative to bonds, but
over a long period of time the return on equities tends to be greater.
However, similarities among the big three products (equities, bonds, and
currencies) are much more dominating and persuasive than any differences.
But before listing these similarities, it is worthwhile to list the three points


of conventional wisdom that places these asset types into three very differ-
ent spheres.

1. Stemming largely from their different risk-reward profiles, market pro-
fessionals who actively trade within these three asset classes generally
tend to specialize. Accordingly, equity trading often is protected and iso-
lated from bond trading, and vice versa; currencies also are typically seen
as being in their own world.
2. If only from a pure marketing perspective, if asset classes are “packaged”
differently and are marketed as truly unique and individual products, it
is perhaps easy to understand why the firms that sell these products (as
well as many that buy them) are keener to accept differences than sim-
3. Some powerful ideas within portfolio theory suggest that meaningful
diversification can allow for appreciable return enhancement opportu-
nities while also reducing risk profiles. With this particular orientation,
the drive to carve out separate and distinct asset classes becomes more

To avoid misunderstanding, I must emphasize that I do not mean to sug-
gest that equities, bonds, and currencies are identical or even virtually so.
However, I do wish to show how these broad asset classes are interrelated
and to indicate that while they typically have different characteristics in dif-
ferent market environments, the big three are best understood as being more
like one another than unlike. That is, the big three have many things in com-
mon, and a pedigogical approach that embraces these commonalities has the-
oretical and practical value.
Consider the following example. Typically, interest rate risk is perceived
to be dominant among bonds while price risk is perceived to be the purview
of equities. But consider the risk profile of a long-dated stock option. This
instrument type actually trades on the Chicago Board of Options Exchange
and is known as a LEAP (for long-term equity anticipation securities). As
any knowledgeable LEAP trader will readily state, interest rate risk is quite
easily a LEAP™s single greatest vulnerability among the key market variables
that are used to value an option. Why? Since an option can be seen as a lever-
aged play on the market, and since leverage means financing, the cost of that
financing is measured by an interest rate. The longer the time that a strat-
egy is leveraged, the greater the overall contribution that is being made by
the relevant financing rate. Indeed, in some instances, an option need not
have a final expiration much beyond six months to have a situation where,
all else being equal, the price value of the LEAP responds more to an incre-


mental change in the finance rate than an incremental change in the LEAP™s
underlying equity price. In other words, for certain longer-dated stock
options, the greatest risk at a particular point in time may be the risk asso-
ciated with financing rather than the underlying equity. Thus, the dominant
risk of an equity future may not be an equity price risk but an interest rate
risk: the dominant risk of bonds. Some LEAP traders actually buy or sell
Eurodollar interest rate futures in combination with their equity option
trades so as to help minimize any unwanted interest rate (financing risk)
exposure. More on this later.
Without question, global financial markets do encompass much more
than equities, bonds, and currencies. To name but a few other key market
segments, there are also precious metals and commodities of every shape,
size, color, and taste. By choosing to focus primarily on equities, bonds, and
foreign exchange, this text highlights the commonality among these three
markets; I do not mean to understate the depth and breadth of other finan-
cial markets. Indeed, Chapter 5 attempts to link the unified approach to these
other markets. The underlying principles for the big three are applicable to
every type of financial product.
Why focus on equities, bonds, and currencies? They are well-established
markets, they are very much intertwined with one another, and collectively
they comprise the overwhelming portion of global trading volume. Investors
do themselves a disservice if they attempt to define the relative value of a
particular corporate bond to the exclusion of balance sheet and income state-
ment implications of that firm™s equity outlook, and vice versa. And certainly
both equity and bond investors are well advised to monitor the currency pro-
file of their investments consistently. Even for locally based portfolio man-
agers who are interested solely in locally denominated products (as with a
U.S.-domiciled investor interested only in U.S.-dollar-denominated securi-
ties), the proliferation of venues to hedge away the currency component of
a given security provides the ability to embrace a global investment outlook.
With an American Depository Receipt (ADR), for example, a U.S.-based
investor can purchase a U.S.-dollar-denominated equity listed with a U.S.
equity exchange but with the equity issuer actually domiciled outside of the
United States.
As an overlay to the analysis of key financial products, the text devotes
considerable attention to credit issues and the ways that certain uses of cap-
ital can have profound implications. The notion of symmetry across a firm™s
capital structure and associated financial instruments is not necessarily a new
idea, although it has become increasingly deserving of new and creative
insights. In an important paper written in 1958 entitled “The Cost of
Capital, Corporate Finance, and the Theory of Investment,” Franco
Modigliani and Merton Miller first suggested, among other propositions,


that the financial instrument used by a firm to finance an investment is irrel-
evant to the question of whether the instrument is worthwhile; issuing debt
to finance an acquisition, for example, will not make it a more profitable
investment than issuing equity.1 While the “M&M propositions” came under
much attack when first introduced (notably for what were decried as unrea-
sonable assumptions underlying the propositions), in 1990 Miller received
the Nobel Prize in economics, largely due to his work in the area of capital
structure, and Modigliani received the same prize in 1985.
It has been said that a useful way of thinking about the various (per-
haps even heroic) assumptions2 underlying the M&M propositions is that
they at least contribute to a framework for analysis. If the framework argues
for a particular type of symmetry between bonds and equities, asymmetries
may be exposed in the process of questioning key assumptions. The same
spirit of questioning ought also to be encouraged to better understand any
practical or theoretical framework. Thus, students and practitioners of
finance must question how existing financial relationships differ (or not)
from theoretical contexts and explore the implications. In essence, such
exploration is the mission of this text, which provides an innovative way to
think about market linkages and synergies and sketches a practical blueprint
that both students and practitioners can use for a variety of applications.

Franco Modigliani and Merton Miller, “The Cost of Capital, Corporate Finance,

and the Theory of Investment,” American Economic Review; December 1958, pp.
2Within the theoretical context of presenting their ideas, Miller and Modigliani

assumed that companies don™t pay taxes and that all market participants have
access to the same information. In actuality, companies certainly do pay taxes, and
in most instances worldwide there is a tax advantage with debt offerings over
equity offerings.


Cash Flows,
and Credit



Bonds Equities


his chapter provides working definitions for bond, equity, and currency,
T and discusses similarities and differences between bonds and equities.


Perhaps the most basic definition of a bond1 is that it is a financial instru-
ment with a predetermined life span that embodies a promise to provide one
or more cash flows. The life span of the security is generally announced at
the time it is first launched into the market, and the longest maturities tend
to be limited to about 30 years.2

A bond typically is viewed as a fixed income instrument with more than 10 years
to maturity, while a note typically is viewed as a fixed income security with 10
years or less to maturity. Fixed income securities with a year or less to maturity are
typically referred to as money market instruments. In this text, all fixed income
products are referred to as bonds.
From time to time so-called century bonds are issued with a life span of 100 years.



Cash flows generally consist of periodic coupons and a final payment
of principal. Coupons typically are defined as fixed and regularly paid
amounts of money, and usually are set in relation to a percent of the prin-
cipal amount. For example, if the coupon of a bond is set at 8 percent and
is paid twice a year over five years, and if the principal of the bond is val-
ued at $1,000, then every six months the investor will receive $40.

$1,000 8%/2 $40

A bond issuer is the entity selling the bonds to investors. The issuer then
has the opportunity to use the money received to finance various aspects of
its business, and the investor has the opportunity to earn a rate of return on
the money lent. In sum, the issuer has incurred a debt that is owed to the
investor. If the issuer becomes unable to pay back the investor (as with a
bankruptcy), the bond investor generally is protected by law to have a pri-
ority ranking relative to an equity investor in the same company. Priority
ranking means that a bondholder will be given preference over an equity
holder if a company™s assets are sold off to make good on its obligations to
investors. Chapter 3 presents more information on bankruptcy.


Perhaps the most basic definition of equity is that it™s a financial instrument
without a predetermined life span. An equity may or may not pay cash flows
called dividends. Dividends typically are paid on a quarterly basis and usu-
ally are paid on a per-share basis. For example, if a dividend of 34 cents per
share is declared, then every shareholder receives 34 cents per share. Unlike
a bond, an equity gives an investor the right to vote on various matters per-
taining to the issuer. This right stems from the fact that a shareholder actu-
ally owns a portion of the issuing company. However, unlike a bondholder,
a shareholder does not enjoy a preferential ranking in the event of a bank-
With the benefit of these working definitions for bonds and equities, let


. 3
( 60 .)