Read an Excerpt
THE COMPLETE GUIDE TO CAPITAL MARKETS FOR QUANTITATIVE PROFESSIONALS
By ALEX KUZNETSOV
McGraw-Hill
Copyright © 2007 The McGraw-Hill Companies
All right reserved.
ISBN: 978-0-07-170952-1
Chapter One
Financial Markets
Over the last few years, I have had the opportunity to interview many bright young people who were applying for quantitative Wall Street positions. Overall, I have been very impressed with their intelligence, drive, and technical skills, but all of them had one glaring gap in their knowledge: they had no idea of how the financial industry works. The pattern was repeated with such predictability that I stopped asking them whether they knew anything about how Wall Street works and instead started asking them to explain why they—a very smart group if I ever saw one—were going to interviews on Wall Street without bothering to find out what it was that they were getting into. According to what they told me, it is very difficult to get a clear idea of what the financial industry does and how it is put together just by reading books and going to economics classes—these sources left them with the vague notion that Wall Street is the place where lots of money is being made, plus perhaps a couple of canned definitions, but no real understanding of the issues. One of my interviewees asked me if I could answer the questions I was asking him when I started working on Wall Street, and I had to admit that I could not. I felt guilty about this at first, but then I realized that I am still right to ask the questions about industry organization because life itself will ask them once they start working on Wall Street in almost any role—and if they know the answers, much of what is going on around them at work will begin to make sense. I am therefore starting this book with an attempt to explain how the financial industry works. This is what Part 1 of the book is about.
Before we can examine the way the financial industry operates today, however, it is important to discuss why it exists in the first place, and how and why it took its present form. Therefore, in this opening chapter, we discuss the "why" questions about the financial industry and financial markets, while the next chapter will focus on the "how." Finally, the last chapter of Part 1 will take a look inside one of the industry players to see how it is put together. That's the plan, and let us now delve into the first part of it: figuring out why Wall Street is there.
The short answer to the question of why the financial markets exist is that, given that capital is the lifeblood of capitalism, there needs to be some type of "cardiovascular system" that carries it around the capitalist economy. At any given time, there are people and organizations (companies, governments, and individuals) that want money—to invest in a new factory, to build a highway, to pay for prescription drugs for seniors, to buy a house, and so on. At the same time, there are people and organizations that have money to invest—a family saving for college, an insurance company sitting on a pool of premiums, a social security trust fund. The first group is willing and able to pay the second group for the use of its capital; the question is, how do they find each other? This is exactly where the financial markets come in.
Note that these two groups of people have existed in every society from the beginning of history. Suppose that in medieval Europe, a king wanted to wage another costly war, and city merchants had money. They would ultimately find each other, and the king would be off to his war, and the merchants (if they and the king were lucky) would grow somewhat richer from its spoils. A society does not have to be capitalist to have capital and the need to invest it. However, back then, "ultimately" could be a long time, and the amounts of money that kings could raise by arranging loans from individual merchants were minuscule by modern standards, so the process of raising money for projects was quite inefficient (as it still is in much of today's world). So both groups kept trying different ways of putting capital to work, and that effort went on for many centuries and continues today. The modern financial system is the result of that long effort.
Interestingly, despite this long and varied history, humanity has been able to come up with only three logically distinct ways of moving money and other forms of capital from those who have it to those who want to use it. These are, in order of historical appearance, theft, debt, and equity. We do not discuss theft in this book, as it is covered extensively elsewhere and is not (supposed to be) part of the financial system whose workings we are trying to understand, so we proceed with the briefest of overviews of the evolution of the other two modes of capital transfer: debt and equity.
THE HISTORY OF DEBT MARKETS
The concept of debt predates recorded history. People would borrow a tool from a neighbor in prehistoric societies, just as they do today. They also borrowed living things that could multiply, such as seed or farm animals, and it is only natural that when people borrowed such things, they could return, say at harvest time, something more than they originally took, which gave rise to lending with interest. The earliest recorded laws—those of Hammurabi, dating from about 1800 BC—not only recognized but attempted to regulate such loans by imposing a 33? percent per annum limit on interest on loans of grain. By that time, it had already become common to lend money (rather than seed and livestock) for interest.
The individually negotiated loan described in the laws of Hammurabi—effectively a binding agreement between two specific parties outlining when the principal (the borrowed amount) was to be returned and how much interest was to be paid—has remained the most common legal form of debt ever since. This is the arrangement we enter into when we take out a personal loan at a bank today. Of course, the banks themselves went through a lot of changes before they took their present form, but the essence of the bank-lending business has not changed much in the last 3,800 years. While banks are the mainstay of personal finance in most of the developed world today, corporate entities and institutional investors, especially in the United States, the United Kingdom, and the rest of the Anglo-Saxon world, usually rely on a newer branch of finance, the capital markets, that has developed over the last 800 years. Wall Street is an offshoot from that branch, and therefore in what follows we focus on this relative novelty.
Strictly speaking, one can argue that financial markets existed much earlier than we claim here. In ancient Rome, the government of the republic outsourced tasks such as tax collection and some municipal services to semi-private entities that raised their operating capital by selling shares to the public, and people traded these shares (known as particulae, or particles) in the Roman Forum as early as the second century BC (Cicero inveighed against trading of particulae, calling it gambling). However, it is a sad fact of Western history that this Roman invention, together with a great many others, was completely forgotten after the fall of Rome and had very little effect on the formation of the modern capital markets.
The roots of modern capital markets are not in this Roman practice, but rather in the medieval trade fairs, which began to appear all over Western Europe as early as the eleventh century AD. The fairs brought together buyers and sellers of agricultural and manufactured goods from far afield by offering the merchants two advantages. The first was physical proximity. In those days, there were no payment systems that would allow you to buy, say, spices in Venice and pay for them in Lyons; the business had to be done face-to-face, and the fairs offered an opportunity to do exactly that. Second, the fairs usually negotiated exemptions from the onerous taxes and duties that crippled commerce done outside the fairs. The fairs were held periodically, typically twice a year, but by the late medieval period, some of them, most notably the Antwerp fairs, had become permanent, causing many merchants to relocate to these free-trade zones and making Antwerp one of the first true financial centers. Some merchants at the fairs traded not in goods, but rather in money—they offered loans to other merchants, as well as what we now would call foreign exchange services. These money dealers at the fairs were the first members of what has grown into the modern financial industry. There were, however, other sources driving the development of finance in those early years, and in this chapter we review two of them.
A new form of debt, called census, or rente in French, had become widespread in early medieval Europe. Census was akin to a modern mortgage—the owner of a property granted a borrower the right to use it in exchange for periodic payments. This was a convenient way for owners of land and other property (those notorious feudal barons, and very often the Church) to convert their illiquid wealth into money as the economy began to shift away from the self-sufficient feudal manor system. In fact the very word mortgage originated in those times. There was a live-gage census, where the borrower in fact repaid the loan after some (usually long) period of time and took possession of the census property, and a dead-gage, or "mort-gage," where the payments continued forever. (Of course, today's mortgage is eventually paid off and is therefore the live-gage of old; also, gage is a valid, if archaic, word that means "pledge.") The innovation here was that this form of borrowing or lending exchanged a sum of money today for income in the future; the return of the principal, if it happened at all, was a secondary issue. This is when "fixed-income" investments first began to play a noticeable role in society. The whole class of rentiers living off these rentes sprang up as the Middle Ages turned into the Renaissance. This kind of borrowing "in perpetuity" became standard procedure during this period and remained so until the early twentieth century.
These census and, in the later medieval period, annuity contracts (where payments continued for as long as the contract holder remained alive—in the United States today, this is viewed as a hot new financial product) were agreements between two parties and could not be easily transferred to another owner. The first significant change in this regard came in Venice in the thirteenth century. The government of the Venetian Republic was always hard- pressed to raise money for wars, and (as was fairly common at the time) imposed so-called forced loans on its more prominent citizens in proportion to their wealth. Today we would recognize this as taxes, for which we accept government services in return, but in those days, these prestiti were viewed as loans, with the government simply paying interest on the amount it took away (the word prestiti means "loans" in Italian). In 1262 many earlier such loans were consolidated into a single loan called monte vecchio that promised to pay 5 percent interest forever in two semiannual installments of 2&fra12; percent each. The government retained the right to pay back some or all of the borrowed amount at its discretion, as well as the right to assess more money as part of this, in today's parlance, issuance program.
The novelty of prestiti (and similar forced loans by other Italian cities) was the relative ease with which citizens could buy and sell these loans. They traded at the then newly built Rialto bridge. A buyer of prestiti acquired the promised stream of income in return for a lump payment to the seller. The new owner was recorded in a registry maintained by city officials, and interest payments were made based on these records. The price of this transaction was negotiated between the buyer and the seller, and the government (the ultimate borrower) had no say in it. Thus, for the first time, the concept of tradable and negotiable debt was introduced, and the first modern financial market was born. The city of Venice continued making interest payments on these obligations through thick and thin during the fourteenth century, which made the prestiti a very desirable investment throughout Europe. This investor interest made it much easier for Venice to raise money. However, people from outside Venice needed special permission to invest in the prestiti market, and it was hard to get, or, as we say today, prestigious.
This early example of tradable debt gives us an opportunity to introduce the modern concept of yield, or rate of return. The 5 percent rate on the monte vecchio is nominal yield in today's terminology—this is the rate of return that the original lenders would get on their initial investment (called the par amount). However, these loans could often be bought for far less than the par amount because of the ever-present doubts about the ability of Venice to maintain the interest payments. If you bought these loans at 50 percent of par value (or simply at 50; all bond price quotes are expressed as percentages of the par amount), then the return on your investment would be 10 percent. The ratio of nominal rate to price is called the current yield. When the price drops, the yield increases, as you are getting the same interest payments on a smaller principal investment, and vice versa. The current yield on these perpetual loans was in fact the going interest rate for lending money to the Venetian government, and in this early market it was already set by supply and demand and not by government decree. As it happened, the prestiti often traded way below par in the early fourteenth century, then rose close to par and, for a brief period, even traded above it (therefore yielding less than 5 percent) as their reputation grew.
The success of the prestiti was due not so much to their marketable nature as to the steadfastness of the Venetian government in maintaining payments. This was definitely not typical of the vast majority of other governments at the time. For the next 300 years, in most of Europe, "government" simply meant the king, and kings very often played fast and loose with their credit, frequently defaulting on their debts, jailing or banishing their creditors, and doing other unsavory things. Well-documented examples of this include the 1648 default by Louis XIV of France that ruined many of his Italian bankers, as well as the "Stop of the Exchequer" by Charles II of England in 1672 that famously did in the London goldsmiths who had financed his exploits. As a result of this unfortunate practice, lenders were forced to charge exorbitant interest on loans to kings and princes—50 to 80 percent was not uncommon, and in one instance Charles VIII of France paid 100 percent to his Genovese bankers at the end of the fifteenth century.
A decisive break from that tradition occurred in the second half of the seventeenth century in the newly formed Dutch Republic. A combination of a popular and stable government, a relatively peaceful international situation, and the frugality of the Dutch people led to a remarkable flourishing of government finance. This was perhaps the first example of a society that managed to channel the savings of its people into productive projects, either private or government-led, on a truly large scale. The debt instrument (instrument is an often-used synonym for security) of choice was the perpetual annuity, issued by provinces and municipalities. These municipal obligations were an attractive way for the prosperous Dutch population to invest its savings, given that none of these entities ever defaulted on its debt, and the amounts of money that were raised in this way were enormous by contemporary standards. This also led to a steady decline in the interest rates that government borrowers had to pay. By the end of the seventeenth century, the rate on those annuities had dropped to around 3 percent. This happy state of affairs came to be known as "Dutch finance" and was the envy of the rest of Europe.
England in particular tried hard to emulate the success of the Dutch. In 1693, William III (who was a Dutch prince himself before becoming the king of England) and his Whig government had to borrow at 14 percent to finance a war with France; they found this rate onerous and were very keen to bring it down. In the process of doing so, the English government came up with another financial innovation that endures to this day: a central bank. The Bank of England was established in 1694 and quickly took over all matters of government finance, becoming the manager and issuer of government debt as well as the manager and issuer of bank money (bank notes), which, in today's terminology, means that it was responsible for monetary policy. It also started acting as the lender of last resort that could stabilize the financial system during crises. The turbulent history of British banking, which was undergoing tremendous growth during the eighteenth and nineteenth centuries, gave the Bank of England plenty of opportunity to practice its crisis management skills, and many of the tools for managing liquidity used by today's central bankers are the product of that period. Other European nations followed suit, establishing their own central banks and otherwise stabilizing their financial systems.
(Continues...)
Excerpted from THE COMPLETE GUIDE TO CAPITAL MARKETS FOR QUANTITATIVE PROFESSIONALS by ALEX KUZNETSOV Copyright © 2007 by The McGraw-Hill Companies. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
