From turbo options to toxic waste

This comprehensive guide to financial markets should prove a useful reference source for all those involved in the industry – though at times it does risk getting bogged down with detail.

What do crawling pegs, Eurokiwis, Farmer Macs, haircuts, inverse floaters, red herrings, toxic waste and turbo options all have in common? They are all financial terms or instruments referred to and explained in Marc Levinson’s Guide to Financial Markets. Levinson’s guide contains a huge amount of information on global financial markets. It is basically a history book, dictionary and elementary textbook on financial instruments and markets all rolled into one. The extensive 20-page index serves to illustrate the amount of research that went into compiling this text.

In his introductory remarks, Levinson, a former finance and economics editor of The Economist, writes: “This book explains the purposes different financial markets serve and clarifies the way they work. It cannot tell you whether your investment portfolio is likely to rise or fall in value. But it may help you understand how its value is determined, and how the different securities in it are created and traded.”

The opening chapter provides a suitable exposition for the guide by explaining the rationale and need for financial markets. This is accompanied by a brief history of how markets have evolved. The remaining chapters are devoted to individual asset classes or instruments, including money markets, bonds, asset-backed securities, equities, derivatives and options.

Condensing such a vast topic into 250 pages is a difficult challenge and Levinson has, in the main, succeeded. His method of introducing a topic area, providing a brief history, explaining fundamental characteristics and summarising current relevance is certainly logical. And Levinson’s considerable knowledge of financial markets provides the reader with an informed and generally balanced insight into the subject matter.

The book is littered with informative tables, historical data and useful anecdotes, enabling the reader to gauge the significance of each subject discussed in the overall context of global and regional markets. However, given the amount of material covered, it is unsurprising that at some points the balance of the book does not feel quite right. While the chapter on commodities and futures markets provides the reader with an informative and comprehensive summary of the topic, the section on securitisation struggles to tick all the right boxes.

Asset-backed securities are a more popular asset class in America than in other major developed countries but are beginning to attract more interest, particularly in Britain and Europe. They are not particularly complex financial instruments but Levinson’s description of how they work is overly laborious. A simple example of how a mortgage-backed security is constructed and the various payments from the different parties involved, perhaps with the aid of a diagram, would have enabled the reader to better get to grips with these securities.

In addition, while reference to the main types of asset-backed securities is certainly helpful, does such a text really benefit from having entire sections devoted to describing, in turn, the history, structure and importance of Fannie Maes, Ginnie Maes, Freddie Macs and Farmer Macs (all US agency securities)?

As a preface to the chapter on equity markets, Levinson gives a run-down of the different ways that a company can raise capital to fund its business needs. Bank loans, bonds and asset-backed securities are all mentioned in addition to issuing equity. Levinson explains the balancing act that companies must face when looking to raise capital and that the debt-to-equity ratio must be managed carefully. The risks of underleveraging or overleveraging clearly have to be assessed.

But one important consideration that Levinson glosses over is the relative cost of raising different types of capital, including the cost of servicing debt and equity borrowings. Certain economic conditions are more conducive to issuing equity rather than debt and these are important considerations that companies must address when financing their business needs.

The section on options and derivatives works well as an introduction to the topic area. Options are a complicated subject and a reader with no previous knowledge of how they are structured would probably not want to be confronted with a sequence of obscure mathematical equations. While Levinson avoids this approach, the inclusion of a few graphs could have helped better explain some of the features of options and the factors affecting their value, rather than relying solely on text.

While a small number of formulae are used to explain certain financial terms in the guide, Levinson does well to steer clear of the intricacies of financial equations. The book is, after all, a guide to financial markets, rather than a textbook on the theory of financial securities. Indeed, with only a few exceptions, it is highly accessible to just about anyone with an interest in the subject matter. Financial journalists, investment advisers and fund managers could all find Levinson’s guide extremely useful, even if it is just to brush up on their high-level knowledge of the markets.

And for those of you who were wondering:

A crawling peg is a type of exchange rate mechanism.

Eurokiwis are bonds denominated in New Zealand dollars but issued outside of the country.

Farmer Macs are mortgage-backed securities issued by the Federal Agricultural Mortgage Credit Corporation in America.

The haircut of a repurchase agreement (or repo) is the difference between the market value of securities and the amount the investor lends.

An inverse floater is an interest-bearing note with an interest rate defined by subtracting an index from a fixed rate – for example, 10% less six-month Libor.

A red herring is a prospectus circulated prior to the end of the registration period during the flotation process of an American company.

Toxic waste is a term for the longest-term tranche of a collateralised mortgage obligation.

A turbo option comprises the purchase of either two put or two call options with different strike prices.

To order a copy of The Economist Guide to Financial Markets call 01730 233870 or visit www.fundstrategy.co.uk/bookshop.

Marc Levinson. The Economist Guide to Financial Markets: Fourth Edition. London: Profile Books 2005.