Investors of all types need to make a return on their money. This return money can come from a yield or capital gain or both. The amount of return required by the investors depends on the level of risk that they perceive they are taking. Even using this basic framework, there is a vast variety of financial instruments that can be created to serve the needs of companies and their investors. Investors can again be individual or institutional. While the type of investor does not guarantee as to their risk appetite, there are a host of other factors that create the differences in investment strategies of these two main classes of investors. The main factor is the difference between the volume of investors and the corresponding volume of money they can invest at one go. Needles to say, the number of individual investors far exceeds the number of institutional investors.
However, institutional investors put in comparatively a much larger amount of money on the market. Also the experience of the individual and the institutional investors, the tax relieves they get from the government while investing in a particular financial instrument are all important criteria in the selection of the financial instrument portfolio. The increasing sophistication of financial instruments and complexity of investment strategies created a widening gap between average investors and the traders and professionals who usually are formally trained. This paper specifically deals with the issue of sophistication of financial instruments and whether it has made the investment by the individual investors easier.
According to Frank J Fabozzi and Franco Modigliani “New financial instruments are not created simply because someone on the Wall Street believes that it would be fun to introduce and instrument with more bells and whistles than existing instruments. The demand for new instruments is driven by the needs of borrowers and investors based on their asset/liability management situation, regulatory constraints, if any, financial accounting and tax considerations” (Gastineau and Kritzman, 1999:1) Regardless of the motivation of the creation of new financial instruments, one thing stands out clearly that new financial instruments are created and are here to stay, and also that this creation of instruments makes the process of investments more difficult and complex than ever before. Appreciating the risk that each instrument carries individually as well as in combination with other financial instruments is a task for which corporate institutions have employed multiple experts. But individual investors usually cannot afford to do the same. In addition, the tax commission has strict and unrelenting rules regarding how individuals can be taxed, and so they cannot avail the benefits of many financial instruments such as warrants. This means that the creation of such instruments does not really mean any benefit for the individual investor. The aim of the present study is to research all the major financial instruments, and assess whether any of such instruments have any benefits for the individual investors. If so, then which are there instruments and what are their exact benefits.
Chapter 1 – Introduction
Research background: Important terms and their meanings
The term “financial instrument” is defined by International Financial Reporting Standards, particularly the IAS 32 and IAS 39, as “a contract giving rise to financial asset or equity and a financial liability or equity of other entity” (Chorafas, 2006:86). According to FASB, a financial instrument can be one of the following (Rezaee, 2001:137):
· An ownership interest in an entity
· A contractual obligation of one entity to deliver a financial instrument to a second entity and a corresponding contractor’s right of the second entity to receive that financial instrument in exchange for no consideration other than release from obligation
· A contractual; obligation of one entity to exchange financial instruments with a second entity and a contractual right of the second entity to require an exchange of financial instruments with the first entity.
Both the definitions given above are fairly similar in content, though it is clear that the definition of a financial instrument given by FASB is a fairly broad one. Hence, to clarify this definition, FASB has also provided multiple examples of the type of financial instruments as well as items that are and are not considered as financial instruments.
Financial instruments comprise the full range of financial contracts made between various institutional units. The instruments can actually be thought of as a bundle of financial attributes such as amount, term currency, reprising intervals, base rate, credit risk, tax benefits etc. The new technologies such as caps, floors, options, futures etc. are used to unbundled and repackage these attributes. Financial instruments i.e. assets are intangible assets. This means that the typical benefit or value of such assets is a claim for future cash. The entity, mostly institutions, that has agreed to made future cash payments is called the issuer of the financial instrument, while the owner of the financial instrument is referred to as the investor (Fabozzi, 2002:1). Traditionally, a financial instrument was priced by comparing it to other instruments of the same name and the same structure trading in the same market. Today, it is common to price an instrument by comparing it to pieces or packages of other type of instruments in many different markets that in combination product the same financial result i.e. the same bindle of financial attributes.
Financial instruments are usually divided into two types:
Underlying or Primary Instruments – This type of financial instruments includes the following types of securities: bank accounts, bonds, stock (Shiryaev, 1999:5).
Derivative or secondary Instruments – These are hybrids constructed on the basis of underlying or more elementary instruments. Derivative financial instruments include: options, futures contracts, warrants, swaps, combinations, spreads etc. (Shiryaev, 1999:5)
Financial instruments can also be classified on the basis of the type of claim that the holder has on the issuer. There are two types of instruments according to this classification:
Debt instrument – This type of claim is for a fixed dollar amount and includes such instruments like a vehicle loan, the US Treasury bond, or a government bond like that of the French government. The debt instruments require fixed payments (Fabozzi, 2002:1).
Equity instrument – In contrast to a debt instrument, an equity instrument obligates the issuer of the financial instrument to pay the holder an amount based on earnings, if any, after the holders of debt instruments have been paid. Example of such an instrument is common stock, partnership share in a business etc (Fabozzi, 2002:1).
Combination instrument – Some securities fall under both the above categories in terms of their attributes. For instance, preferred stock is an equity instrument that entitles the investor to receive a fixed amount. However, the payment is contingent and is dues only after payments to debt instrument holders are made. Yet another example is the convertible bond, which allows the investor to convert debt into equity under certain circumstances (Fabozzi, 2002:1).
A financial market is a place where financial instruments are exchanged. In primary financial markets, the newly issued financial instruments are exchanged for money as money saved during the current period is transferred to those who wish to borrow. In addition there are also secondary financial markets where the debt and equity financial instruments are exchanged for money. For example, the current owner of a debt or an equity instrument is able to sell the financial claim that it owns to another entity. The money market is a financial market that consists of financial instruments that mature in one year or less while in case of capital markets, the maturity financial instruments issued or traded exceeds one year (Salvatore and Diulio, 1996:158).
Definitions of different Financial Instruments – There are several different types of financial instruments. The figure below shows the main divisions of the financial instruments that are popular in the market. These are described individually after that.
Fig 1-1 Classification of Financial Instruments (Cvitanić and Zapatero, 2004:4)
Preferred Stock – Preferred stock somewhat like common stock is an equity or share in the earnings and assets of the corporation. However it is much different from the common stock. For a start, a preferred stockholder has priority over the common stockholder for dividends, however these dividends are predetermined. Also unlike common stock, almost all the preferred stocks are callable at the option of the corporation at a specified price (Walmsley, 1998:20).
Bonds – A classical bond bears a fixed rate of interest and matures on a date fixed at the time of the issue. The price of the bond at any given time is the present value of the future cash flows of the bind (Walmsley, 1998:15-16).
Convertibles – Convertibles are a rather specialized market because they are relative complex to value as compared with other traditional instruments and they are generally used only in a few countries (Walmsley, 1998:19).
Equities – Equities are usually considered to be one of the simplest forms of security. The owing of stock also gives certain rights to the investor like the right to name board of directors and the right to dividend (Walmsley, 1998:21).
Warrants – Warrants are another classical financial instruments which is actually a kind of an option. A warrant gives the holder the privilege of buying a specified number of shares of the underlying common stock at a specified exercise price, and is usually issued by an entity as an accompaniment to a bond or an equity issue (Walmsley, 1998:21).
Forward contracts – A forward contract is usually a bilateral contract between two parties and none else is involved. These two parties rely on each other to complete the bargain. Hence, they may have credit risk on each other of one of the parties fails to complete in case of adverse market conditions (Walmsley, 1998:54).
Futures contracts – A futures contract resembles a forward in that it is a contract for future delivery. However the contract is for a standardized amount and the counterparty to the contract is normally the clearing division of the exchange or an independent clearinghouse, cutting out the two parties’ credit risk on each other (Walmsley, 1998:54).
Options – An option gives the owner a right, but not a requirement or obligation, to buy or sell an asset by the end of a specified period, which is usually known as call-period (Walmsley, 1998:54).
Swaps – Swaps are a very broad instrument category. Practically every cash flow sequence generates a swap. In essence swap is an agreement between two parties, called counterparties, to exchange a sequence of cash flows in the same of different currencies. Participants in the swap market may have various motivations from speculation and arbitrage to hedging, however basically the swap market’s purpose is for businesses to shape and manage the interest rate and foreign currency risk inherent in their commercial operations (Kolb and Overdahl, 2007:659). There are five basic kinds of swaps:
Interest rate swaps: Most swaps are interest related given the Libor and yield curve exposures on corporate and bank balance sheets. Such swaps involve exchanging cash flows generated by different interest rates. Interest swaps have become a fundamental instrument in world financial markets (Neftci, 2004:113).
Foreign currency swaps: A currency swap calls for the two counterparties to exchange currencies at the outset of the swap and to make a series of interest payments for the currency is received. The exchanged cash flows are in different currencies (Neftci, 2004:113).
Equity swaps: This category of swaps involves the exchange of returns from an equity or equity index against the return from another asset often against Libor-based cash flows. In an equity swaps, parties exchange two sequences of cash flows: one generated by dividends and capital gains or losses and other depending on a money market instrument (Neftci, 2004:113).
Commodity swaps: A commodity swap is designed to operate similarly to an interest swap in that one party agrees to pay a fixed price for the agreed notional quantity of the commodity while the other party agrees to pay whatever is the market value of the commodity on the payment date (Neftci, 2004:113).
Credit swaps: This is an important class of swaps which also follows the same principle as other swaps. The credit default swap is the main tool for swapping credit. This is a privately negotiated, over-the-counter derivative designed to transfer credit risk from one counter party to another. Credit swaps enable financial institutions and corporations to manage credit risks (Neftci, 2004:113).
Hedgers: Hedgers are traditionally defined as investors holding fixed portfolios of underlying or primitive assets that they do not or cannot trade because of regulatory constraints or the presence of prohibitive transaction and/or information costs (Neftci, 2004:104). They thus enter the futures or forward market to hedge the risks associated with their portfolios.
Aims and Objectives of the Research
Financial market participants come in all types and sizes according to their investment horizons, which can be short or long; according to their risk tolerance which can be low or high. Investors selling funds in the financial market fall into three broad categories: traders, institutional investors and individual investors. A great variety exists in these three groups. Traders are often speculative in their dealing, though their risk tolerances can still vary widely. Institutional investors too have different risk tolerances and time horizons for investments. Institutional investors include mutual funds, investing companies, banking and non-banking companies, insurance corporations etc. they usually engage professional fund managers to carry out extensive analysis and evaluation of different investment opportunities. Individual investors often take a long-term view, but don’t always do that and they invest in high-risk growth stocks or lower-risk income securities (Fabozzi, 2002:14). While individual investors are large in number, in general, their investable resources are comparatively smaller. Also they generally lack the skill to cary out extensive evaluation and analysis before investing. With the growth of technology, the individual investors too are gaining a strong foothold in the financial market, though the analysis that they perform is still rudimentary. As can be seen there are many types of financial instruments available in addition to the traditional instruments. Looking at the increasing volume of individual investors, it becomes imperative to understand whether these financial investors are beneficial only to corporate investors or individual investors too can benefit from them.
The present research aims to study “The use of financial market instruments in the US stock market”. The actual research question is; “Are the financial market instruments only beneficial for the large corporations or are they also beneficial for individual investors?”
Providing an answer to this question constitutes the objective of the present research.
Structure of the Paper
The dissertation is divided into chapters starting with the literature review where the each of the financial market instruments is discussed including their advantages & disadvantages and previously conducted researched would be discussed, that provides a foundation for the dissertation. The next chapter describes the methodology of the research in detail and the methods used for analyzing the observations. Since the data used is secondary data, the researches analyzed have already been conducted. Hence, the advantages and disadvantages of this data will also be discussed in detail. The chapter after this will present the use of all the main financial market instruments in the US stock exchange, including the effect that these financial instruments have had on their financial performance. In addition to this, the use of financial market instruments by individual investors and how it affects their returns will also be discussed with examples. The next chapter would present the comparison of the use of financial market instruments in the US stock market to the UK stock market, which will be done for both large corporations as well as individual investors. This chapter will be followed by the finding of the present research, where the results of the analysis of the effect of various financial instruments will be analyzed using both quantitative and qualitative means. This chapter will attempt to answer the research question and with proper evidence. The final chapter will present the results and conclusions based on the complete research.
Chapter 2 – Literature Review
A financial instrument is cash, evidence of ownership in equity or debt, a bilateral or multilateral contract that meets obligations and rights. A derivative financial instrument is a security or contract whose value is determined from the value of a specified or underlying asset, liability or index: the underlier. Many derivatives are bilateral agreements, but others are traded in exchanges. The ratio of the former to latter varies between 33 percent and 50 percent. Derivative trades are called off-balance-sheet because in the early 1980s, the Federal Reserve permitted banks to write these contracts off-balance-sheet. At the time, these trades were exceptions and carried little weight in terms of a firm’s financial results. Today, however, trading in derivatives represents roughly two thirds of the credit line assigned to counterparties (Chorafas, 1995:8).
Financial engineering employs quantitative techniques to further our understanding and use of financial markets, instruments, and strategies. The past three decades have witnessed an explosive growth in this area, spurred by advances in fundamental research on financial theories and algorithms, the development of new markets and instruments, and the wide availability of powerful computing technology. Financial flows excluding financial derivatives increased the value of U.S. investments abroad by $1,289.9 billion in 2007, up slightly from $1,251.7 billion in 2006. Valuation adjustments excluding financial derivatives increased the value of U.S. investments abroad by $923.2 billion. Financial flows and valuation adjustments for U.S. holdings of financial derivatives with gross positive fair value increased the value of U.S. investments abroad by $1,045.6 billion (Nguyen, 2008:1). The corresponding details are shown in figure below.
Fig – 2.1 US Net International Investment position at yearend (Nguyen., 2008:1)
Integral to the risk profile of a fund is the portfolio composition and the inclusion of derivatives in the portfolio could theoretically allow managers to quickly adjust fund risk and expected payoffs. Investment in derivatives provides an opportunity to hedge risks or to engage in speculative, higher-risk activities. Hence, the inclusion of derivatives in the fund portfolio allows a fund manager to adjust the risk of the fund portfolio with a relatively small initial outlay. Risk-shifting behaviour is potentially less costly for derivative users and, therefore, likely to be more evident within this group of fund managers (Benson, Faff and Nowland, 2007:280). It is often seen that prohibitive dissemination expense and competitive safeguarding of proprietary information prevent firms from conveying sufficient data to shareholders for them to manage their portions of the firm’s foreign exchange or FX exposures.
There is empirical support for a relation between underinvestment and derivatives use. Numerous empirical studies (e.g., Hagelin, 2003; Gay and Nam, 1998; Dolde, 1995; and Nance, Smith, and Smithson, 1993) have shown that firms with richer investment opportunities are more likely to hedge. Empirical evidence on cost of financial distress and derivatives use is mixed, in part because many proxies for financial distress interact with firm value in multiple ways. Nance, Smith, and Smithson (1993), for example, find no evidence of relations between hedging and high leverage, low liquid assets, or small firm size, while Mian’s (1996) results are mixed. But Geczy, Minton, and Schrand (1997) indicate significant relations with the hypothesized signs for leverage and liquidity. Fehle and Tsyplakov (2005) find a non-monotonic relation between financial distress and derivatives use. They show that the firms in extreme low and extreme high financial distress do not initiate hedging, while firms between these extremes initiate and dynamically adjust hedges. Because there is no tabular database available on derivatives use, researchers often survey some population of firms, using an instrument designed to elicit information on hedging activities (Dolde et al. 2003:5).
Over the last decade derivative financial instruments have become a key component in firms’ capital structures and financial management decisions. However, the huge derivatives losses experienced by Proctor and Gamble, Gibson Greetings, the Orange County Investment Pool, and Barings PLC have generated concerns about how best to measure, evaluate, and disclose the risks associated with these instruments. As a result, managers, creditors, shareholders, and regulators have become increasingly interested in obtaining information about the nature of firms’ derivatives portfolios (Bishop, 1996; Loomis, 1995). The disclosure stage of the FASB’s financial instruments project is intended to provide information about the extent, nature, and terms of financial instruments with off-balance sheet credit or market risk. Three new disclosure standards were generated by this stage of the project: SFAS No. 105 (effective for fiscal years ending after June 15, 1990), SFAS No. 107 (effective for fiscal years ending after December 15, 1992), and SFAS No. 119 (effective for fiscal years ending after December 15, 1994). These standards do not change the underlying accounting for derivative financial instruments, but do require firms possessing off-balance sheet financial instruments with risk of accounting loss to disclose the notional amounts, fair values, and other information related to their derivatives activities (Duchac, 1993:23).
It is well known that forward prices and futures prices will diverge if interest rates are stochastic. In case of a stochastic interest rates, it is found that in contrast to conventional wisdom according to which the difference between hedging through forward contracts and futures is immaterial, it turns out that the minimum variance hedge ratio using forwards comprises two terms instead of one only when using futures. The magnitude of the difference between the two hedge ratios may be important under some plausible assumptions. This result is due to the presence of additional interest rate risk that bears on the profit-and-loss statement associated with the forward position (Lioui, Poncet, 2005:1). One of the characteristics of the futures markets is that there are no bid and ask prices available to the public. This creates a challenge for researchers examining and analyzing the spread behavior in futures markets (Sahin and Sarajoti, 2005:11)
Chapter 3 – Research Methodology
Overview of the Chapter
In this chapter, the methods used for gathering the data to be analyzed for the research would be discussed. In addition to this, the methods for analyzing the data will also be discussed. The chapter starts with the methods of data gathering, which mentions the different types of data: primary and secondary. This research predominantly relies on secondary data that has been taken from previously conducted researches. The advantages and disadvantages of the data will be discussed next including the various quality issues related to secondary data. The next section deals with the methods used for data analysis. The qualitative and quantitative methods of data analysis are discussed in this section. The research relies on both the types of analysis to achieve the results, and a description of both these methods is pertinent to the research report. The next section of the chapter will discuss the various issues associated with the analysis of the secondary data in general and the data used for this dissertation in particular.
The collection, organization, and presentation of data are basic background material especially for any statistics based research. There are two sources of data: primary and secondary. “Primary data are the data collected specifically for the study in question and may be collected from methods such as personal investigation or mail questionnaires. In contrast secondary data were not originally collected for the specific purpose of study at hand, but rather or a different purpose” (Lee et al., 1998:14). A sample or a census may be taken from primary or secondary data. “A census contains information on all members of population whereas a sample contains observations from a subset of it” (Lee et al., 1998:15). This thesis uses secondary data for the purpose of analysis.
Secondary Data & Types
This research uses secondary data to study the effects of financial instruments on corporations and individual investors. This data being inexpensive to obtain and easier to find, and hence was used as the sole source of information to assist in the decision making of the present research. First the financial information was collected for various organizations and individual investors; these were compared for coming to the appropriate conclusions. The first step followed while searching for the data was to ascertain if and where was the data available. The research done at the time of literature review helped to gather such resources, since a complete detailed study regarding financial instruments was done. This included coming across the works, theories and studies done by previous researchers and their corresponding evaluations regarding various issues regarding the different types of financial instruments and their effects. The initial search for secondary data was the local University library where books, journals and periodicals were sought. The study was enhanced by the use of the University Library web archives, which proved invaluable for providing an abundance of academic articles and journals.
Documentary secondary data – There is a great deal of information already published, which can be used without the researchers needing to collect data themselves. This is called documentary evidence. This type of data has been usually collected for a purpose other than evaluation of a particular project. Such material may not have been previously accessed for research purposes, and was not created specifically for such purpose. Hence, in such cases it is necessary to identify any biases or other factors that might limit the utility of some secondary sources (Sim and Wright, 2000:60). Various forms of documentary data can be used for exploratory studies. This may be collected from a number of sources, and can be classified in terms of whether they were collected for formal or informal purposes, and whether they were intended for public or private consumption. Although documentary sources are usually textual, the term is also sometimes applied to oral narratives and certain non-textual objects, such as works of art. In case of exiting studies or datasets, a re-analysis is carried out often after they have been synthesized or aggregated. Documentary data is often historical i.e. they were created before the time at which the research is taking place (Sim and Wright, 2000:61)
Survey based secondary data – Survey data is the published or at least accessible results of survey in the form of quantitative, mainly questionnaire-based study done by other researchers. A national census is a good example of such a research. There are multiple sources of such type of data such as academic archives, government agencies, public opinion research centers, and any other organization that stores such type of data (Quinton and Smallbone, 2006:68-69). The best part of such a data is that the sample in this case is fairly large and in many cases it has been carefully selected to represent the population.
Advantages and Disadvantages of secondary data
The major advantages of secondary data are savings in time and savings in money. In addition to this, some of the available data is only in the form of secondary data. Also secondary data provides flexibility and great variety. Finally the amount of data available by secondary analysis is immense, which provides an opportunity for a greater depth of research by the analyst, which primary data cannot provide (Wren, Stevens and Loudon, 2002:65). A major disadvantage of secondary data is that the data may not be as recent as desired. In addition, since the data is meant for some other purpose, the relevance may also be less than ideal for the questions proposed by the current research. The accuracy of the data is also not known since it is not directly collected by the researcher; hence authenticity of the data is always in question. The quality of data is similarly a moot point and the researcher must be extremely careful about the reputation and capability of the collecting agency, or at least the credentials of the past researcher (Wren, Stevens and Loudon, 2002:66).
Methods used for analyzing the data/information
A unique aspect of qualitative research is that the analysis actually begins before data collection ends. That is to say, in qualitative research a project may be modified as it progresses. Qualitative data at the start appears unordered and phenomenological. Hence, a thorough analysis is needed to make sense of the disparate information. Otherwise subtle biases and selective attention may cloud the conclusions. Since, qualitative approach is highly individualistic and idiosyncratic; there is no single way to perform the analysis. Some researchers use the data very meticulously and in fact come up with a semi-mathematical model out from the data they have collected, other researchers are more improvisational and use the data merely as a resource (Mariampolski, 2001, p. 255). The data that is taken for the thesis, while is not qualitative in nature, does involve some aspects of analysis which is dependent on multiple factors, not all of which have a quantitative output. Hence, qualitative analysis is a part of the methodology for this thesis
Quantitative techniques attempt to eliminate the subjectiveness of the qualitative methods. Quantitative analysis allow for statistical analysis that can help verify or provide confidences in the data. They include methods such as market tests, trend analysis and exponential smoothing. The first step in the quantitative analysis process is to count and rank the responses on the basis of frequencies. The second step is to calculate percentages. The processes and concepts include raw data, frequency, measures of central tendency, normal distribution, asymmetric distribution, spread of distribution, variances, the standard deviation, inferential statistics, bivariate statistics, testing techniques, regression analysis, multivariate analysis, multiple regression, factor analysis, cluster analysis, and discriminant analysis (Nykie, 2007:102).
Chapter 4 – Analysis of the use of Financial Market Instruments
Overview of the chapter
This chapter will present an analysis of the main financial instruments used in the US stock market. The analysis will be presented per financial instrument, the descriptions of whom are already presented in the introduction chapter. Each of the financial instruments will be analyzed based on their effects on individual and corporate investors.
Derivatives Markets Overview
As described earlier, a derivative instrument is a private contract whose value derives from some underlying asset price, reference rate or index such as a stock bond, currency, or a commodity. In contrast with securities such as stocks and bonds, which are issued to raise capital, derivatives are contracts or private agreements between two parties. Thus sum of gains and losses on derivatives must be zero, for any gain made by one party; the other party must have suffered a loss of equal magnitude. At the broadest level derivatives markets can be classified by the underlying instrument as well as by the type of trading. The figure below describes the size and growth of the global derivatives market till December 2001.
Fig 4.1 – Global Derivatives Market (Jorion, 2003:106)
1. Preferred stocks – Preferred stocks in all the ways differ from bonds and other equities significantly. In case of dividends for the preferred stock, the deduction received is 70%. In case of the convertible bond market, not many companies are issuing the preferred stocks as compared to earlier. In early 2000, the number of companies issuing such options was a mere 117, as compared to 311 convertible bond issues. Out of these 118 companies 18 are micro-cap companies including 4 nano-cap companies, 38 companies are small-cap, 45 companies are medium-cap and 16 companies are large cap companies. Hence, none of the companies offer sufficient investment opportunities for the construction of diversified portfolios based on market capitalization. Thus convertible preferred stocks are usually viewed as potential additions to dedicated bond or common stock portfolios.
Fig – 4.4 US companies actively trading convertible preferred stocks
(Noddings, Christoph, and Noddings, 2001:71)
2. Bonds – The US bond market is both large and diverse and presents important investment opportunities to individual investors. The figure below the comparative size of the bond market versus the stock market in US. In fact in the year 1999, the bond market represented almost 50% of the total investments, while the stock investments accounted for 30% of the total leaving the balance of investments in bank accounts. The larger size of the bond market is due to the fact that both governments and companies issue bonds, whereas stocks are issued only by companies. Also when companies do raise cash in the capital market, their preferred form of financing is through debt (Faerber, 2001:2).
Fig – 4.3 How assets are held in USA (Faerber, 2001:2)
The bond market in US is largely run electronically and over the counter, rather on the floor of formal bond exchanges. Even the bond trading on the New York Stock Exchange, which operates the largest bond market of any stock exchange in America has declined dramatically by 70% in the period between 1992 and 2002. Traditionally, institutional investors such as financial institutions, and foreign and domestic governments dominated the purchase of bonds in US bond markets. Individual investors account for just a small fraction of the total bond volume each year. By 2003, the total outstanding bond market debt in the United States was $20.6 billion. The details of this can be seen in the figure below.
Fig – 4.4 Outstanding Bond Market Debt 2003, (O’Connor, 2004:210)
Bond market can be an internal bond or an external bond. The structure of bond market is as shown in figure below. The internal bond, also known as the national bond market, is again divided into domestic and foreign bond market. The domestic market is where issuers domiciled in the country issue bonds and where they are traded subsequently, whereas, foreign bond issuers are not domiciled in the country.
Fig – 4.4 Sectors of the Bond Market (Fabozzi, 2007:38)
3. Convertibles – In US a variety of firms issue convertible bonds. Although medium-cap and large-cap companies popularized convertible bonds and preferreds, smaller companies have increasingly used convertibles to raise capital in recent years. The figure below summarizes the data of companies having actively traded convertible bonds. In January 2000, there were 311 companies that maintained convertible bonds outstanding. Out of these companies 81 companies were in the nano and micro-cap bracket, 99 companies were in the small-cap bracket, 84 were in the medium-cap bracket i.e. between $1.25 billion and $10.5 billion, and 47 companies were in the large-cap bracket i.e. above $10.5 billion. The 230 small-cap and larger companies are among the 3000 largest US firms, the cut-off point for the Russell indexes. All but 14 of the stocks appear in the S$P stock guides although many are not ranked and 21% of bonds received investment grade rand of BBB or higher (Noddings, Christoph, and Noddings, 2001:51-53). Some of the major companies dealing in convertibles are Advanced Micro Devices, Adaptec, Cypress Semiconductor, Hewlett Packard, Ingram Micro, Johnson & Johnson, Motorola, Times Mirror, Time Warner, US Cellular, Wind River Systems, Xerox etc.
Fig – 4.5 US companies actively trading bonds
4. Warrants – US equity warrants allow the investors to buy shares of common stock at a specified price for a specified period of time. Warrants are capital-raising instruments usually issued by very small companies as part of an initial public offering. Exercising warrants requires the company to issue new shares of common stock which causes some dilution. Warrants typically have a starting life of three to five years. Presently there are about 200 companies having warrants that are actively trading and most of these companies have market capitalizations below $50 million. The figure below summarizes the data of these 200 companies that have actively trading warrants in January 2000. Out of these 200 companies, 136 falls under the $50 million nano-cap bracket, 4 companies fall in the micro-cap i.e. $50 to $225 million bracket, 12 companies fall in the small-cap i.e. 225 million to $1.2 billion bracket and only 8 companies are about the $1.2 billion bracket or what are commonly considered as the medium and the large cap sectors. Some of the major companies dealing in warrants are AES Corp, ALZA, Fleet Boston Financial, Texas Biotechnology, Trans World Airlines, US Energy Systems, In addition, there are nine international companies that have warrants actively trading in US; Asia Pulp & Papers, Euro909.com, Hibernia Foods, Nogo Electro-Mechanical. Oilcom, Rhone-Poulnec, T.V.G Electronics, Tramford International and Willies G-Food International.
Fig – 4.6 US companies actively trading warrants
(Noddings, Christoph, and Noddings, 2001:127)
5. Futures contracts – Futures markets developed in United States and proved so successful that they have spread to many other nations around the world. The futures industry is large and growing and was once a US monopoly thought he industry has later moved towards true international status. This process of internationalization is reshaping the futures industry today and years to come. The figure below shows the growth of trading volume on US futures exchanges.
Fig 4.7 The Growth of Trading Volume on US Futures Exchanges
6. Options – trading on options on organized exchanges in Untied States embraces a number of different underlying instruments. The different types of options are stock options, financial index options, foreign currency options, options on futures etc. Stock options and index options may be used to replicate the position in a stock or portfolio of stocks. They may be used to enhance income on a portfolio or on a stock, a way to declare a dividend by itself by and for yourself or as a way to reduce the riskiness or a stock or a portfolio or both. Options have proven to be very flexible and effective hedging tools across the spectrum of US stocks and are widely available on practically every stock that an investor may be likely to follow and ultimately invest in. Hence in US, the participation in the options markets and equity options especially has been increasing almost dramatically. In United States, options on individual stocks trade on the CBOE i.e. Chicago Board of Trade and four exchanges that principally trade stocks. These exchanges trade all options on individual stocks in United States, but they also trade options on other instruments. The figure below is divided into two panels. The first panel shows the option exchanges in the Untied States while the panel 2 lists a sample of some of the most important non-US options. The right column indicates the kind of options traded.
Fig – 4.8Principle option exchanges(Kolb, 2002:315)
The table below shows the different option volumes in United States by type of options in the Chicago Board of Exchange.
Fig – 4.9 Listed Options volumes in United States (Kolb, 2002:315)
The figure below shows the total volume options by Exchange
Fig – 4.10 Total Option Volume by Exchange (Kolb, 2002:316)
7. Swaps – While there are many different types of swaps, the two major swap types are interest rate and currency swaps. The first interest rate swap occurred between IBM and World Bank in the year 1981. Swap market has grown considerably since then. In fact by the year 2001, interest rate swaps with $57 trillion in underlying value were outstanding and currency swaps totaled another $4.3 trillion. The total swaps market exceeded a principle amount of $60 trillion, with about 93% of the swaps being interest rate swaps and the remaining 7% being currency swaps. The growth in this market has been phenomenal; in fact, it has been the most rapid for any financial product in history. The figures in the swap market exceed the US federal debt and the swap market still continues to expand rapidly (Kolb, 2002:671).
Primary determinants of Individual’s asset allocation in US
Investors’ history, current situation, and expectations for the future will shape the degree of emphasis they place on the asset allocation tradeoffs. These asset allocation tradeoffs that are shown in the figure below may cause the potential investors to purchase one broad type of assets versus another. When possible individual investors should hence think about, create, collect and regularly refer to strategic and tactical principles of asset allocation and investment strategy.
Fig – 4.11 Primary Determinants of Individual Investors’ Asset Allocation
According to the Bank of International Settlements, BIS, there is a huge concentration in the share of the five biggest global banks, in the following business lines:
· Equities Issuance 50%
· Bond Underwriting 40%
· Syndicated Loans 40%
· Derivative Financial Instruments
This over concentration, according to analysts, is the aftermath of globalization, as well as of mergers and acquisitions which have created mega companies. Usually structured products are combinations of two or more financial instruments, at least one of them being a derivative. Their time frame is usually six to seven years. The difficulty in controlling exposure comes from the fact that every structured product has its own risk profile, based on exposures characterizing its individual components, as well as design characteristics and market conditions. Under these conditions, for individual investors, risk management is a taxing enterprise, a problem that is augmented by the fact that only un very few financial institutions, those who sell the instrument really know its exposure (Chorafas, 2007:52).
Evolution of Individual’s asset allocation activity in US
There are three main phases in the evolution of individual investors’ asset allocation activity. Traditionally most of the private investors in US tended to deploy their portfolios according to overall perceived-wisdom guidelines reflecting the investment ethos of the age. In the 1930ss, one version of these guidelines specified 60% in US domestic bonds and 40% in US stocks. A representative version of this standard asset mix that prevailed for quite some time in the 1950 and 1960s is shown in the figure below. According to this it was generally recommended for individual investors to keep 60% in US stocks, 30% in US bonds and 10% in cash. Interestingly this was also the recommended asset allocation for professional asset allocation in US during that period.
Fig – 4.12 Representative Asset allocations in 1950s and 1960s
The second phase of the asset allocation scenario began in the middle to later 1980s, inspired by the activities of certain professional investors and a small proportion of individual investors, who began to shift some of their assets into venture capital, real estate, private equity that included LBOS and oil and gas, and international developed and emerging markets equity and debt securities. A representative portfolio including this expanded range of asset classes is shown in the figure below.
Fig – 4.13 Representative Asset allocations in the mid to late 1980s
In this third phase of this evolution, individual investors are seen to have increased their exposure, generally though domestic or offshore hedge finds or other partnership structures, or as separately managed accounts to a variety of alternative-investment instruments, including what is usually knows as market-neutral or absolute-return strategies. In the equity realm, these absolute return strategies include warrant and convertible arbitrage, hedged closed-end fund and cross-ownership arbitrage, synthetic-security arbitrage, and other techniques involving derivative instruments. In the fixed-income realm, these absolute return strategies include various forms of bond arbitrage, involving futures, swap arrangements, credit risk and yield curve shape mispricings and embedded and explicit options features. The representative portfolio of these newly defined asset classes is as shown in the figure below.
Fig – 4.14 Representative Asset allocations in 1990s and continuing in the post-2000 era
Chapter 5 – Comparison of the use of Financial Market Instruments in US and UK
The US and UK stock markets are different in many ways. First of all, the US stock markets are organized on the basis of a rolling five-day settlement period. This is not true for most of the stock markets, who require settlement at fixed calendar dates such as monthly in French and Italian stock markets. The UK stock markets settled on a fixed-date, biweekly basis until recently when it moved to rolling T + 10 (Crane, 1995:56)
1. Preferred Stock – In UK, the preferred stock market is known as the preference share market. Like in the case of preferred stock, preference shares too are classified as cumulative, redeemable, participating and convertible. As a result of a tax changes introduced by the Labor government in 1997, the yields on preference shares are higher than those for common shares. However, now there is no real advantage to a UK company in raising capital in the preference share market, which may ell become illiquid in future. In contrast with the US, the instrument is more popular with non-financial corporates though banks too have been large-volume issuers (Choudhry, 2004:251). In UK the preference shares are traded in the same way as ordinary shares, that is, they are listed on the exchange. Domestic issues of preference shares can be relatively small size, and they are often issued as a part of a company financial re-structuring or through a private placement to a small group of investors (Choudhry, 2001:422).
2. Bonds – The British government bond market is called the gilt-edged market and is concentrated in the City of London. Gilt-edged securities are perceived by investors as having virtually zero risk of default, as the UK government is the guarantee. The main domestic issuers of sterling bonds other than gilts are UK companies and local authorities. Because of the low risk factor, the gilt market plays the predominant role in the UK economy. In addition to this, in 2003 a new scheme of investment known as covered bonds were introduced.. though there are still a new prospect for investors, the market has the potential to develop into a very important funding source. These covered bonds in UK are entirely composed of first-rank residential mortgages. The figure below shows the spreads of the covered bonds in UK.
Fig – 5.1 UK Structured Covered Bond Spreads (Golin, 2006:198)
3. Convertibles – UK along with France are the two most established convertible markets in Europe and together they make up 57% of the European convertible market. UK has an active domestic and Euroconvertible market. Domestic convertibles are registered and exchange traded. They trade in smaller sizes that appeal to retail investors. The typical structure of is a convertible preference that can be converted only on specific dates. These securities are in bearer form and are mainly bonds with premium redemptions and hard call protection. In 1999, there was a surge in exchangeable issues and a shift away from the sterling-dominated to US dollar and euro-dominated issues (Noddings, Christoph, and Noddings, 2001:127).
4. Warrants – The United Kingdom is unique with the type of warrants prevalent in its exchanges. British warrants are primarily issued on closed-end funds, 75% of the roughly 170 active warrants traded. These funds issued the warrants, like many start up companies in Untied States, as part of initial public offerings of the underlying security. The relative impact of the British market is easy to overstate. Many of the funds that have warrants are international or regional funds with little exposure to the domestic market. The balance of the market consists primarily of covered warrants – those issued by banks or brokerage houses against stock held in their accounts instead of by the company (Noddings, Christoph, and Noddings, 2001:46).
5. Futures – In US, the responsibility for regulating securities and futures business is vested in two separate regulatory authorities i.e. CFTC and the SEC, while in UK the regulatory authority function has been merged into a single regulatory authority, the SFA. Hence, the US exchanges have to obtain specific approval before listing new contrasts whereas the UK exchanges may enlist new contracts as they see fit. Also un US, all futures should be traded on an exchange or be exempted by CFTC, which is not a constraint in UK (Spence, 1999:115).
6. Options – In contrast with the US options, a European option allows for exercise only i.e. buy or sell the underlying call case or put case upon maturity. Options are also called traded options in UK to differentiate them from the general meaning of option as a right of first refusal. The traded options market in UK is one of the most important organized markets and began operations on the floor of the Stock exchange in April 1978. In UK there are two forms of equity options: traditional options and traded options. The former may be exercised only on a specific date and cannot be sold to anyone else, while the latter can be accessed throughout their life and are freely tradable. The London International Financial Futures and Options Exchange, LIFFE, provides a market for traded options in individual equity shares and on the FTSE 100 index (Ogilvie, 1999:19).
Chapter 6 – Analysis of Results
1. Preferred stock versus individual stocks – In United States, individual investors do not generally own much preferred stock due to a special tax feature of the preferred stock. Any corporation that owns preferred stock in another corporation pays taxes on 15% of the dividend payment. However, individual investors who are preferred stockholders do not enjoy this same advantage, thy pay taxes on the full dividend payment. Because of this tax advantage most preferred stock in the Untied States is held by other corporations and not by individual investors. For this reason common stock is prevalent in the US financial system than preferred stocks among individual investors.
2. Bonds – The greatest advantage of all types of international bonds for individual investors is that interest income on them is exempt from withholding taxes at the source. Investors must report their interest income to their national authorities but both tax evasion and tax avoidance are extremely widespread. However, the bonds are more attractive to official institutions as they are not liable for tax on this. Private institutions legally avoid tax by being in tax-haven countries (Kim, 2002:270).
3. Warrants – Stock warrants are purchased in the open market from individual investors or from an issuing corporation. The warrants are issued either separately or from an issuing corporation. When issued with other securities warrants are used as an attracting device to lure potential investors by making the securities more attractive. Investors can detach the warrants and sell them or if they choose exercise them. In case of corporates, employers and officers are offered stocks under the stock option plan, which are similar to warrants. An example of stock option is given in figure below for Elmo electronics corporation
Fig – 6.1 Footnote Disclosure relating to stock option plan of Elmo Electronic Corporation (Friedlob, Plewa and Plewa, 2006:114)
4. Futures – Futures refer to buying or selling a specific amount of a commodity, financial issue or stock index at a specific price on a specific future data. Most futures fall under the category of grains, precious metals, industrial metals, food, meats, oils, woods, and fibers. The financial group includes government T-bills and bonds plus foreign currencies. Usually it is considered to be best for the individual investors if they do not participate in the futures market. This is because, commodity futures are extremely volatile and much more speculative than most common stock. In fact for an individual investor it is almost considered to be a gamble. However, well-read and experienced investor with sufficiently large risk appetites can definitely think of futures as an investment option. Also there are a very small number of futures than can be traded hence speculators must also be thorough in their analysis. Also it is always best if the proportion of investment finds committed to futures is limited, something like 5% of the entire capital in any one futures position. The figure below shows the statement of fiduciary net assets for the State of Delaware in the year 2004.
Fig – 6.2 Fiduciary Funds for the State of Delaware
(Friedlob, Plewa and Plewa, 2006:301)
Chapter 7 – Results and Conclusions
Individual investors are different from other types of investors in many ways. First is of course the amount of money they can invest, second is their mortality which is not an issue with corporations, and third is the tax allocation. Many institutional investors such as endowments and banks are tax exempted, and corporates too enjoy lots of tax benefits. In addition, the responsibilities held by individual investors is way too personal to just let goo and look at the bottom line, as in case of corporate investors. Finally individual investors, while do have some idea of their balance sheet regarding their assets and responsibilities, do not really put them down on paper in terms of requirements and long term responsibilities – which is a common facet of corporate entities. However, individual investors – their choices and aspirations vary according to many aspects such as age, financial stability, the country they live in, their personal values etc. For instance, a little more than 2 year ago, individual investors in America would have preferred stocks over government bonds, as opposed to their counterparts in UK who still swear by gilt edged securities. However, post the financial crunch period and the present uncertainty, stock market confidence has reduced way too much and while people are waiting for the market to come back to normal, government bonds are gaining their preferred status. Contrary to this professional and mainly corporate investors do not like bonds at all, because of higher risk appetite and requirement of higher returns.
Many spokespersons for institutional investors, underwriters and the various exchanges have extolled derivative instruments’ benefits in reducing risk. However, many people do argue that derivative instruments may have increased market risk for individual investors, confused them, and contributed to an erosion of their confidence in the markets. Derivative instruments have also been accused for adding to the market volatility, particularly in cases where futures and options contracts on stock indices expire don the same day and precipitated frantic buying and selling of stocks. In addition, derivative instruments serve mainly to allow greater leverage to short term speculators and arbitragers and collectively contain redundancy. Many analysts also argue that the more derivative an investment vehicle, the further it takes the market away from the basic purpose of financial markets i.e. capital formation, and the market becomes closer to speculation with the result that the financial system is weakened and the industrial sector is starved.
Individual investors, because of the small volume of shares they are interested are not actually given preferred status while choosing stocks, and hence only a few quantity of shares are available for individual investors, despite it being a public market. Also institutional investors are privy to better information than individual investors, who rely mostly on hearsay and prospectus. The balance sheets and charts shown in this research, even if was freely available, would not prompt most investors to read though them, much less analyze and choose that as a basis for scientific and rational investment. Instead the going is either instinctive or with the flow, or at times risky if the situation is unique enough. Also while companies might be willing to share their financial sheets with other companies, because of some agreements or under a legal bond, the same is not true for individual investors. Because of legal liabilities of many kinds, the companies are usually reluctant to share their information with the public in general (D’Arista, 1994:27).
Institutional investors also enjoy several privileges which are not given to individual investors. An example is that if individual investors sell their shares immediately after issue, there is a high chance that they would be penalized, while institutional investors are allowed to flip their shares. Hence, many individual investors do not actually take advantage of the different types of finds that are available on the market, at least not directly. The mere intention and provision of several options for the investments is hence not enough. The laws of investment and taxation must also be considered carefully if business are actually interested in having the individual investors on the financial instrument market.
The last part is probably an answer on its own. Wall Street does not really prefer individual investors at all. In a panicky situation they are probably the most fickle and hence giving power to them would be tantamount to giving power to a large number of uncaring individuals who are really interested in profits at a reduced margin – which is probably the opposite of the interest of the corporate investors, even though venture capitalists can still be considered to be a minor exception to the rule.
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