FMGT6259 - Financial Markets

Lesson 1 - Introduction and Overview of Financial Markets

The Financial System
• The financial system, mainly the financial markets together with commercial bank and
other institutions, can be compared to a mosaic. The individual pieces seem to be different
and distinct when they are set apart. However, when they are joined together, they
represent a comprehensive and dynamic system. This system is influenced largely by
monetary policy, and monetary policy is communicated through the financial system to the
economy and inflation. The recent financial crisis and the Great Recession sufficiently
demonstrated the economy's need for a highly effective financial system. Disruptions in
certain areas of the financial market spread throughout the financial system and led to the
most catastrophic economic downturn and job loss since the Great Depression of the
1930s.
• Financial markets, institutions, and monetary regulations all touch our lives in numerous
ways. You have possibly been able to go to school because of a student loan or money that
your parents earned, saved, and invested while you were growing. When you last purchase
jeans in a clothing store and pay it with cash in your wallet or maybe a check, a debit card,
or probably thru a credit card. Even the car that you are driving was purchased by having
an auto loan. Your home where you live today, you are like to go to the market or an
institution to purchase it, but you will need a mortgage to make it happen. You could also
be looking for an apartment, and the owner of that unit or property goes into a mortgage to
buy the building.
• Financial markets refer mainly to any marketplace where securities exchange occurs,
including the bond market, the stock market, the derivatives market, the forex market, and
other financial securities. Financial markets are very important to the smooth operation of
capitalist economies. The financial markets are places where a surplus of funds is moved
towards those who have a deficit and need funds. Those are intermediaries that direct funds
from savers or lenders towards sellers or borrowers.
• In business and finance, the term ‘market’ refers to a place where potential buyers and
sellers get together to trade goods and services, as well as the transactions between them.
Prices in financial markets are transparent, and rules are set pertaining to costs, fees, and
even trading regulations.
• The financial market mostly refers to the stock exchanges and commodity exchanges. They
can be physical places, like the London Stock Exchange, the New York Stock Exchange
(NYSE), the Philippine Stock Exchange (PSE), or an electronic platform or a system like
Nasdaq. These markets are where the corporations and governments generate funds or
cash, companies reduce risks, and investors aim to raise money. Some financial markets
are very discriminating, like exclusive groups, and only allow participants with a certain
limited amount of money, knowledge of markets, or certain professions.
• Financial markets exist virtually in every country in the world. Some can be very small,
with fewer participants, while others are enormous, like the Forex markets that trade
trillions of dollars each day.
• Financial markets play a vital role in enabling the smooth operation of capitalist economies
by allocating resources and handles liquidity for enterprises. The financial markets enable
an easy time for buyers and sellers to trade their financial securities. Financial markets
create securities products that deliver a return for those who have excess funds like
investors or lenders and make these funds available to those who need additional cash to
the borrowers.
• The financial market is a large one, and the stock market is only one aspect of it. Buying
and selling a variety of financial products, such as bonds, shares, currencies, and
derivatives, is how financial markets are completed. To ensure that market prices are
established efficiently and appropriately, financial markets rely heavily on clear
information. Because of numerous macroeconomic variables such as taxation, market
prices of securities may not reflect their true value.
• Some financial markets are small and have little activity, but others, such aa the New York
Stock Exchange (NYSE), move trillions of dollars’ worth of assets every day. The equities
market, sometimes known as the stock market, is a financial market where investors can
purchase and sell shares in publicly traded corporations. New stock issues, known as initial
public offerings or lPOs, are sold on the major stock market. Any subsequent stock trading
takes place in the secondary market, which is where investors buy and sell assets they
already hold.
 • The OECD’s Interim Economic Outlook, published in early March 2020, stated that the
coronavirus outbreak has already slowed China’s economic growth, and that subsequent
outbreaks in other countries will have reduced economic growth prospects. Since then, the
coronavirus’s rapid expansion across countries has prompted several governments to take
extraordinary measures to combat the fatal outbreak. While these steps are important to
combat the virus, they have caused many firms to temporarily close due to broad travel and
mobility restrictions, financial market turbulence, a loss of confidence, and increased
uncertainty. According to this perspective, the shutdowns might result in substantial drops
in output in many economies, with consumer spending potentially falling by one-third.
Changes of this size would far overshadow the global financial crisis’s economic
downturn.
• The economic impact of COVID-19's global spread has increased market risk aversion to
levels not seen since the global financial crisis. The stock market has dropped 30%,
implied volatility in equities and oil has reached crisis levels, and credit spreads on non-
investment grade debt have expanded dramatically as investors seek to avoid risk. Despite
the extensive and comprehensive financial changes agreed upon by G20 financial
authorities in the post-crisis era, global financial markets are experiencing increased
volatility.

• These difficulties are also distinct from prior financial crises. Understanding present
market instabilities, the path to market impurity, and policy consequences necessitates a
cautious examination of the post-crisis changes in global market structure and financial
intermediation.
Overview of Financial Institutions
• Consider a world without financial institutions to have a better understanding of the
economic role they play in financial markets. Suppliers of funds, such as households that
save more than they earn and consume less than they earn, would have a basic choice in
such a world. They might keep their money as an asset or invest it in securities issued by
fund users such as entrepreneurs and businesses.
• In actuality, fund users issue financial claims, such as stock and debt securities, to bridge
the gap between their internal savings, such as retained earnings, and investment
expenditures.
• It has been demonstrated throughout history that a solid financial system is an essential
component of a developing and prosperous economy. Financial markets and institutions
must be dynamic and successful in order for businesses to raise capital to finance capital
expenditures and investors to save for future usage.
• Changing technology and enhanced communications have increased cross-border
transactions, expanded their scope, and improved the global financial system’s efficiency
over the last few decades. Companies raise cash all over the world on a regular basis to
fund projects all over the world.
• It is critical to remember that trust is the most fundamental foundation of well-functioning
markets and institutions. An investor who deposits money in a bank, buys stocks through
an online brokerage account, or contacts a broker to get a mutual fund places his money
and faith in the hands of the financial institutions that advise him and provide transaction
services. Similarly, when businesses contact commercial or investment banks for cash,
they want the banks to supply them with funds on the most favorable conditions possible,
as well as objective and solid counsel.
• While ever-changing technology and globalization have enabled a variety of financial
transactions, the financial industry has been rocked by a series of corporate frauds and
scandals in recent years, prompting many to question whether some institutions are serving
their own or their clients' interests.
• Individuals and small firms, as well as economies with less developed financial markets
and institutions, use direct cash transfers more frequently. While enterprises in more
developed economies may use direct transfers on occasion, they normally find it more
economical to engage the help of one or more financial institutions when obtaining funds.
• A group of extremely efficient financial intermediaries has emerged in highly developed
countries. Their original functions were often rather specific, but many of them have now
broadened to the point where they now service a wide range of markets. As a result, the
distinctions between institutions have begun to blur. There is still a distinction and
institutional identity; the descriptions of the key categories of financial institutions are
provided below:
◦ Investment Banking
▪ These are firms that assist enterprises in developing securities with qualities that are
now appealing to investors, then purchase and resell these securities to savers.
Despite the fact that the securities are sold twice, this is really just one primary
market transaction, with the investment banker acting as a conduit to help savers
and corporations transfer capital. Morgan Stanley, Merrill Lynch, Credit Suisse
Group, and Goldman Sachs are examples of firms that provide a variety of services
to investors and businesses looking to raise finance.
◦ Commercial Banks
▪ Are financial institutions that manage checking accounts when the Federal Reserve
or other central banks change the money supply. Other institutions now provide
checking services and have a substantial impact on the money supply. Commercial
banks also provide a diverse range of services, such as stock brokerage, insurance,
and even mutual funds. Examples of this are J.P. Morgan Chase, Banco de Oro
(BDO), Bank of Philippine Islands (BPI), and Metrobank.
▪ Financial Services
• Are enormous organizations, which are sometimes referred to as conglomerates,
because they integrate several diverse financial institutions into a single entity.
Citigroup, American Express, Fidelity, and Prudential are examples of financial
services companies that began in one area but have since diversified to
encompass the majority of the financial spectrum.
▪ Savings and Loan Associations (S&Ls or SLAs)
 • These institutions used to service individual savers as well as residential and
commercial mortgage borrowers, encouraging small savers to deposit money
and then lending it to individuals and other borrowers. When short-term interest
rates offered on savings accounts rose significantly above the returns gained on
the existing loan portfolio held by SLAs in the 1980s, commercial real estate
suffered a severe recession, resulting in high mortgage default rates, the SLA
business faced major issues. Many SLAS were compelled to combine with
larger institutions or close their doors as a result of the events.
▪ Mutual Savings Banks
• They are similar to SLA's; they primarily operate in America, accepting savings
primarily from individuals, and lending mostly on a long- term basis to home
buyers and consumers.
▪ Credit Unions
• Credit unions are cooperative organizations whose members are expected to
share a similar bond, such as working for the same company. Only other
members can borrow from the members' savings, which are typically used for
auto purchases, home improvement loans, and home loans. Individual borrowers
will find credit unions to be the most cost-effective source of funds.
▪ Pension Funds
• Pension funds are retirement plans funded by companies or government agencies
for their workers and administered primarily by the trust departments of
commercial banks or by life insurance companies. Pension funds invest
primarily in stocks, bonds, mortgages, and real estate.
▪ Insurance Firms
• Life insurance firms collect savings in the form of annual premiums, invest them
in stocks, bonds, real estate, and mortgages, and then pay out to the beneficiaries
of the insured parties. Today, life insurance companies provide a variety of tax-
deferred savings plans designed to give participants rewards when they retire.
▪ Mutual Funds
• Mutual funds are businesses that collect money from depositors and invest it in
stocks, long-term bonds, or short-term debt instruments issued by businesses or
government entities. These groups pool funds and thereby diversify risks,
lowering hazards. They also benefit from economies of scale when it comes to
assessing securities, portfolio management, and buying and selling assets.
 • Various funds are designed to satisfy the goals of various types of savers. As a result, there
are bond funds for individuals seeking safety, stock funds for those ready to take large
risks in exchange for bigger returns, and yet more funds that serve as interest- bearing
checking accounts (money market funds). There are thousands of mutual funds available,
each with its own set of goals and objectives. In recent years, mutual funds have developed
at a faster rate than most other organizations, owing in part to a shift in how companies
plan for their employees' retirement. "Come work for us, and when you retire, we will
provide you with retirement income based on the salary you earned during the last five
years before you retired," most firms said until the 1980s. The corporation was then in
charge of putting money aside each year to ensure that it had enough money to pay the
agreed-upon retirement benefits.
• That scenario is fast changing. "Come work for us, and we'll give you some money each
payday that you may invest for your future retirement," new employees are likely to be
told today. You won't be able to use the funds until you retire (without incurring a
significant tax penalty), but if you invest correctly, you'll be able to retire comfortably.”
Most workers realize they don't know enough about investing to make sensible decisions,
so they entrust their retirement assets to a mutual fund. As a result, mutual funds are
rapidly expanding.
• Publications like Value Line Investment Survey and Morningstar Mutual Funds, which are
available in most libraries and on the Internet, provide excellent information on the various
funds' objectives and past performance.
Hedge Funds
• Hedge funds are similar to mutual funds in that they accept money from depositors and
invest it in a variety of securities, but there are a few key distinctions The Securities and
Exchange Commission (SEC) registers and regulates mutual funds, whereas hedge funds
are essentially unregulated. The fact that mutual funds are primarily aimed at small
investors explains the discrepancy in regulation. Hedge funds, on the other hand, often
need substantial minimum contributions (sometimes exceeding $1 million) and are
effectively promoted to institutions and high-net- worth individuals.
• Hedge fund managers employ a variety of tactics. For example, a hedge fund manager who
believes the disparity between corporate and Treasury bond rates is too wide can buy
corporate bonds while selling Treasury bonds at the same time.
 • The portfolio is "hedged” in this scenario against general interest rate fluctuations, but it
will do well if the spread between these assets narrows. Similarly, hedge fund managers
may profit from perceived inaccurate stock market valuations, such as when a stock’s
market and intrinsic values diverge.
• Hedge funds frequently demand high fees, which are typically a predetermined amount
plus 15 to 20% of the fund's capital gains. In recent years, the average hedge fund has
performed admirably. Citigroup believes that the typical hedge fund has generated an
annual return of 11.9 percent since 1990, according to a recent analysis. The broader stock
market returned 10.5 percent annually over the same time span, but mutual fund returns
were even lower at 9.2 percent. Due to the stock market's prior performance in recent
years, a growing number of investors have turned to hedge funds.
• Between 1999 and 2004, the amount of money they managed more than doubled, reaching
almost $800 billion. However, the same BusinessWeek article that highlighted these funds’
outstanding growth and relative performance also warned that their returns were exhibiting
symptoms of weakening and that they were not without danger.
Functions of Financial Markets
• Determination of Price
◦ In the financial market, an asset’s price is determined by its demand and supply. The
funds are supplied by the investors, while the industries require the finances. As a
result, the interaction between the fund provider and individuals in need, as well as
other market forces, has a role in determining the price.
◦ The prices at which financial instruments are traded in the financial market are
governed by demand and supply forces, just as repeated contact between investors
helps set the price of stocks. As a result, one of the most important activities of the
financial market is the determination of security prices.
• Savings Mobilization
◦ In order for the economy to succeed, the money that businesses, households, and
individuals have must not be idle. As a result, a financial market facilitates the
exchange of surplus money between those who have it and those who do not.
• Ensures Liquidity
◦ In the financial market, the assets that buyers and sellers trade have a lot of liquidity.
This means that investors can sell those assets rapidly and convert them to cash at any
time. Investors participate in trade for a variety of reasons, one of which is liquidity.
One of the reasons why investors are interested in trading is because of the liquidity.
 ◦ The financial market makes securities trading easier by providing liquidity on tradable
assets and making it accessible to all participants, allowing them to readily sell
securities they own and convert an asset into cash.
• Saves Time and Money
◦ Financial markets provide a forum for buyers and sellers to meet without wasting time
or exerting effort. In addition, because these markets handle so many transactions, they
can benefit from economies of scale, cutting transaction costs and fees for all
participants.
◦ With the help of the financial market, potential sellers and buyers can easily trade with
each other, saving them time, effort, and money in the process of finding other required
parties.
◦ With the help of the financial market, investors with savings can be linked with
industries that need the funds, mobilizing the savings and putting them to the most
productive uses.
◦ Different types of information are required by the various traders, while market trading
requires time and effort. The financial market provides different information to the
traders who can access it without the necessity of inserting time and effort.
Importance of Financial Market
• Financial markets offer a place where participants like debtors and investors will have fair
and proper usage irrespective of their size.
• They provide companies, individuals, and government agencies with access to capital.
• Financial markets help in lowering the unemployment rate because of the many job
opportunities it offers.
• It helps enable an open and regulated system for the companies to acquire large amounts of
capital from the market for its work.
• Using the savings of potential investors provides a medium that flows in the economy. This
will lead to capital formation in the economy.
• It also helps in saving time and efforts, most especially the hard-earned money of the
participants, because the traders don’t have to spend their money to find the potential
sellers or the buyers of the security.
Classification of Financial Markets
• Financial Markets refers to a marketplace for the development and trading of financial
assets such as stocks, bonds, debentures, and commodities. Financial markets act as a
conduit between fund seekers, such as individuals, enterprises, and governments, and fund
providers, such as investors, Individuals, and households. It encourages parties to
exchange funds and aid in the distribution of the country's scarce resources.
• Financial Markets can be classified into four categories:
◦ By Nature of Claim
◦ By Maturity of Claim
◦ By Timing of Delivery
◦ By Organizational Structure
• By Nature of Claim
◦ Markets are classified according to the sort of claim investors have on the assets of the
company in which they have invested. There are two types of claims in general: fixed
claims and residual claims. There are two types of markets depending on the nature of
the claim.
▪ Debt Market
• The debt market refers to the exchange of debt instruments like debentures and
bonds between investors. These instruments have fixed claims on the entity’s
assets; their claim on the assets is limited to a specified amount. These
instruments generally have a coupon rate, also known as interest, that remains
constant over time.
 ▪ Equity Market
• The equity instruments are traded in this type of market. Equity, as the name
implies, refers to the owner's capital in the business and thus has the residual
claim, implying that whatever remains in the business after paying off fixed
liabilities belongs to equity owners, regardless of the face value of the shares
owned by them.
• By Maturity of Claim
◦ When making an investment, it is crucial to keep in mind the time period because the
quantity of money invested is determined by the investment's time horizon. The rick
profile of an investment is also influenced by the time period. When compared to an
investment with a longer time period, a shorter time period was associated with lower
risk.
◦ There are two types of market based on the maturity of claim:
▪ Money Market
• Short-term funds are traded on the money market, where investors who want to
invest for at least a year join into a transaction. Treasury bills, commercial paper,
and certificates of deposit are examples of monetary assets traded in this market.
All of these instruments have a one-year maturation period.
• Because these securities have a short maturity period, they have a lower risk and
provide investors with a practical return rate in the form of interest.
▪ Capital Market
• The phrase “capital market" refers to a market where medium - to long-term
instruments are traded. This is the market where money is exchanged in a
dynamic manner. It lets businesses to raise funds through equity capital and
preferred share capital, as well as allowing investors to invest in the company’s
equity share capital and share in its earnings.
• This market has two verticals:
◦ Primary Market
▪ The term "primary market" refers to the market where a corporation first
lists a security or when an already listed company issues a new security.
In most cases, this market involves the corporation and its shareholders
interacting with one another.
 ▪ The sum paid by shareholders for the primary issue is received by the
corporation. The Initial Public Offering (IPO) and the Further Public
Offer (FPO) are the two main forms of primary market products (FPO).
◦ Secondary Market
▪ Once a corporation is listed on a stock exchange, its shares become
available for trading amongst investors. The secondary market, or more
generally known as the stock market, is the market that permits trading.
▪ Simply said, it is a regulated market in which securities are traded
between participants or investors. Individuals, businesses, and merchant
bankers, among others, could be investors. The receipts or payments for
such exchanges are handled between investors without the involvement of
the company, hence secondary market transactions have no impact on the
company's cash flow condition.
• By Timing of Delivery
◦ Aside from the characteristics listed above, another aspect divides the markets into two
parts: the period of security delivery. In the secondary market, or stock market, this
concept is widely accepted. There are two sorts of markets based on delivery timing:
▪ Cash Market
• The transactions in this market are made in real time, and the complete amount
of investment must be paid by the investors, either with their own money or with
borrowed capital, known as margin, which is authorized on the account’s current
holdings.
▪ Futures Market
• The settlement of a security or commodity takes place at a later period in this
market. The majority of market transactions are settled on a cash basis rather
than a delivery basis. The total amount of assets does not have to be paid in
order to make trades in the futures market. Instead, a margin of up to a specific
percent of the asset's value is sufficient to trade it.
• By Organizational Structure
◦ The market structure also serves as a foundation for its category, such as how market
transactions are carried out. Based on organizational structure, there are two types of
markets:
▪ Exchange-Traded Market
 • A controlled market that follows pre-determined and specified protocols is
known as an exchange-traded market. In this market, neither the buyer nor the
seller knows each other. Transactions are entered into with the assistance of
intermediaries, who are responsible for ensuring that transactions between
buyers and sellers are completed. In such a market, standard products are traded;
there is no need for customized or modified products.
▪ Over-the-Counter Market
• This market is decentralized, and this allows customers to trade in customized
products based on the requirement.
• In this case, the buyers and sellers interact with each other. Mainly, over-the-
counter market transactions involve transactions for hedging of foreign currency
exposure and exposure to commodities. These transactions occur over-the-
counter as different entities have different maturity dates for debt, which
normally doesn't coincide with exchange-traded contracts’ settlement dates.
• Over time, the financial markets have achieved importance in fulfilling the
capital requirements for companies and providing investment opportunities to
the investors in the country. Financial markets provide high liquidity, transparent
pricing, and investor protection from malpractices and frauds.
Introduction to Financial Risk
• Individuals, organizations, and governments are all subject to financial risk. Risk refers to
the possibility of losing money on an investment or of the government or a firm being
unable to repay debts owed to various financial institutions.
• Risk also encompasses a variety of elements that may impact the desired outcomes of
operations or produce unfavorable outcomes that have ramifications for business,
investors, and the entire market. A person’s financial risk is the loss of an investment or the
inability to repay a debt. Corporate financial risk can arise from a variety of sources,
including business operations, credit risk (such as the inability to repay loans), and market
risk (such as when a company loses consumers due to upgrades, competitor inventions, or
changes in consumption habits). In the government, financial risk refers to the
government’s incapacity to control inflation, as well as defaulting bonds and other debt
instruments.
• Types of Financial Risk
◦ Market Risk
 ▪ Market risk occurs out of upgrades or innovation in technology, change in prices, or
even change in customers’ consumption patterns affecting business revenues.
▪ The market risk is composed of systematic and unsystematic risk which results in a
loss of investment. A systematic risk includes the decline or recession, changes in
interest rates, natural disasters that cannot be avoided. While the unsystematic risks
are those, which can be managed or avoided through a change in operations,
strategy, and planning.
◦ Credit Risk
▪ The credit risk means the inability of a borrower to repay the debt according to
contractual obligations. Defaulting in repayment of debt will influence business
reputation in the market, borrow from other financial institutions, and lose investor
confidence. While in the case of the government, the credit risk can have vast
effects on the entirety of the economy and world, since defaulting the bonds and
inability to control the inflation will affect countries’ status, social stability, business
transaction, and relations with other countries.
◦ Operational Risk
▪ The operational risk can result from decisions from the management influencing
business output or providing undesirable results. Mostly, operational risk does not
mean complete disappointment but the reduction in output capacity, which a change
in a decision can manage, maintenance, and upgrade of technology.
◦ Liquidity Risk
▪ Due to a failure to sell assets swiftly in a market, an individual or business can
fulfill its short-term financial obligations with little or minor loss. Lack of
purchasers, market circumstances, and other factors can all contribute to an inability
to sell assets or investments for cash in a timely manner. Liquidity risk can be
mitigated by diversifying short-term asset investments and keeping enough cash in
the business to meet short-term obligations.
• Advantages of Financial Risk
◦ Growth
▪ Risk is an important component of any organization, especially when it comes to
growth and expansion into new markets. It's possible that businesses will need to
borrow money. Though the financial risk appears to be a burden for the firm, it is
necessary to accept such a risk if a company is able to perform and earn higher
revenues through growth and expansion.
 ▪ Tax Planning
• Most companies use losses for tax deduction purposes, which can be distributed
over multiple years. A reduction in tax obligations and risk management can turn
financial risk into a long-term advantage.
▪ Alert for Investors and Management
• Financial risk is an indicator for investors and management to take certain
precautions to avoid further damage.
▪ Valuation Assessment
• Financial risk in particular enterprises or projects aids in the evaluation of
revenue via the risk-to-reward ratio, which typically indicates whether a firm or
project is worthwhile. Financial risk may be examined using numerous ratios,
making the role of risk in the organization much easier to comprehend.
• Disadvantages of Financial Risk
◦ Can Create Catastrophic Result
▪ Financial risk in the government leads to defaulted bonds and other debt obligations
from finance institutions, which can harm the country as well as the global economy
in the long run. A crisis has had an impact on European Union countries that invest
in Greece through bonds, particularly in Greece.
◦ Cannot be Controlled
▪ Financial risk arising from global causes such as natural disasters, wars in various
regions of the world, interest rate changes, and changes in government policies that
are beyond the control of a company operating in a specific market.
◦ Long-Term Effects
▪ If a financial risk is not managed promptly and effectively, it can harm financial
institutions and their reputation, affecting the entire organization and causing a loss
of confidence among investors and lenders. Overcoming such setbacks can be
extremely difficult for a company.
 ◦ Individual finances, businesses, and governments all face financial risk. Risk is not
always a bad thing; in fact, if used and managed appropriately, it may be a sign of
progress. Financial leverage measures such as interest coverage ratios, debt to asset
ratios, and debt to equity ratios are used in business to determine the amount of debt a
company has. Financial risk can be very beneficial if accepted in conjunction with
revenue development and business expansion, but if not managed effectively, it can
lead to serious problems, including business bankruptcy and losses for investors and
lenders.
◦ Financial Risk must be continuously managed in the case of the government in order to
avoid future negative impacts on the country and economy in particular. Individual
financial risk might be forgotten in investment, or accumulated financial debt can be a
warning sign for the future. With good management tactics, such a risk can be turned
into a bargain and deflected.
The Globalisation of Financial Markets
• The advancement of technology has made it feasible to connect computer machines in a
very effective manner. As a result, cross-border financial transactions have grown simpler
and safer, thereby removing the barrier posed by distance, which can be dictated by
geography or a variety of other factors. Furthermore, financial markets have become a
source for a diverse range of fast expanding financial products, most commonly referred to
as derivatives instruments, particularly in the previous two decades. Lenders and
borrowers can customize their risk exposures and alter them over time with these products.
With derivative products, borrowers and lenders can consequently mitigate some of the
problems associated with irregularities of information in financial markets, which are
particularly severe in the international context.
• Global markets are a venue in which the rule of one price applies, in the sense that it will
be possible to buy or sell products for a similar price regardless of geographical location
and local circumstances. When products are bought and sold outside state boundaries,
price differentials may stay as long as costs are specifically associated with cross-border
exchange compared to exchange within national boundaries. Therefore, the process of
internationalization of financial markets is just a step towards global financial markets.
This dissimilarity between globalization and internationalization seems to apply to
financial markets as well as to markets for goods and non-financial services. Over the
current decades, financial markets have achieved a clear cross-border orientation, but,
overall, it can be claimed that they are still not truly global.
• Cross-border financial flows might limit the worldwide positioning of financial markets.
Bordo, Eichengreen, and Kim (1998) believe that the absolute value of the current account
balance over GDP, averaged across a number of nations, is a good predictor of cross-
border financial movements. They show that this indicator has risen steadily since the mid-
1960s, but that it remains well below the levels reached between the mid-1870s and 1914.
Furthermore, the levels of this index in highly developed countries were more steady prior
to 1914 than in recent years. These findings show that, while net financial flows are
increasing, they are neither as large or as unpredictable as they were during the previous
World War. According to Flandreau and Riviere (1999), when the time series and cross-
sectional dimensions are taken into consideration in econometric study, this analysis of
advances in current account balances can be enhanced even further. The findings of
Flandreau and Riviere confirm that, when assessed in terms of net current account
balances, the degree of financial integration has increased in recent years but has stayed
below levels seen before 1914.
• The Benefits and Risks Associated with the Globalization of Financial Markets, and
What are the implications for Monetary Policy
◦ There has been a steady increase in cross-border financial flows around the world in
recent years. To begin with, a variety of financial organizations, including banks and
institutional investors, have broadened their geographic scope. They operated as an
intermediary in this process, facilitating the transfer of monies from lenders to
borrowers across national borders. Second, as securities markets have matured, a clear
cross-border tendency has emerged. Newly issued securities are frequently
manufactured and sold to the public in order to boost demand from overseas investors.
◦ These changes matched the gradual elimination of cross-border financial barriers, as
well as the substantial liberalization of national financial markets. As a result, the
number of borrowing and lending options available to economic agents around the
world has increased. The range of financial options available for financing current
account deficits and recycling current account surpluses has significantly increased.
 ◦ Both technological advancements and financial progress play a vital role in the
evolving internationalization of financial markets seen in recent years. Information
systems have improved their ability to compute and store more data more quickly over
the last few decades. Telecommunications networks have grown in complexity and
capacity, while more reliable data exchange methods have emerged. Obstfeld (1994)
offers a succinct summary of the economic benefits associated with financial market
globalization, writing "In theory, individuals gain the ability to smooth consumption by
borrowing or diversifying abroad, while world savings are directed to the world's most
productive investment opportunities." Globally integrated financial markets allow more
flexible ways of financing current account deficits and recycling current account
surpluses, according to one practical aspect of the theory. Furthermore, the free play of
market mechanisms should ensure that borrowers and lenders do not accept
unintentionally high risks.
◦ Additional advantages of financial market globalization include the faster
dissemination of technical advancements, financial innovation, and, more broadly,
financial performance to different parts of the world.
◦ Technological advancements in payment, settlement, and trading systems, as well as
financial information systems, can be made available to all market participants
promptly in a global financial market. Various significant financial institutions, for
example, provided new techniques of computation they had created to quantify their
market risk exposures and, later, their credit risk exposures for free or at a low cost in
the 1990s. This contributed to the fairly rapid diffusion of new risk measuring
technology among numerous financial institutions, particularly those in the eurozone,
that sought to improve their risk assessment systems.
Implications for Monetary Policy
• Financial markets that operate efficiently can only be regarded useful to the economy if the
international financial system is founded on the free functioning of market forces.
Monetary policy can contribute to financial market efficiency in two ways, both of which
contribute to medium-term economic growth.
• Primarily, monetary policy will provide a solid anchor to establish opportunities about
future developments in consumer prices by decisively maintaining price stability. When
inflation is low and projected to remain low over the medium term, financial asset prices
do not need to include as much of an inflation risk premium as they would in a situation
where inflation is high or unclear. Other factors, such as credit risk, can play a larger role
in the price formation mechanism as the inflation risk premium becomes less relevant as a
predictor of financial prices.
• In the end, this leads to a more efficient use of financial resources. There are, of course,
other advantages to price stability. Price stability, in particular, helps to improve the
functioning of the price formation mechanism by minimizing relative price instability,
therefore improving the quality of price signals.
• Second, monetary policy can help to improve market efficiency by decreasing the
occurrence of surprises connected to monetary policy decisions as much possible.
Monetary policy would reduce unnecessary volatility in long-term interest rates in this
way, which would improve the quality of price formation on interest rate markets.
Surprises can be avoided by giving financial market participants and the general public
with a clear, detailed, and honest statement of the central bank's monetary policy strategy.
• It is also beneficial to disclose the central bank's analysis of economic events on a regular
basis so that the public may learn more about the central bank’s views on price stability
• Monetary policy faces two major issues as a result of the globalization of financial
markets.
◦ One challenge is that monetary policy should consider the speed with which
information is disseminated around the world when communicating with the public.
Because of the increased speed with which information is transmitted, reactions to
monetary policy decisions can be quick and widespread. As a result, decisions must be
explained in a straightforward manner as soon as possible after they are made.
 ◦ The second difficulty is that monetary policy should take structural changes in the
economy into account as a result of financial market globalization. Financial
integration must be regarded alongside economic integration arising from growing
cross-border commerce in product and services, as Okina, Shirakawa, and Shiratsuka
(1999) point out, however the two integration types may not necessarily progress at the
same rate. In any event, as the economy becomes more internationalized, economic
interdependence will grow. With the growth of more international markets, the
importance of numerous economic variables for assessing price stability concerns will
shift. Furthermore, the transmission of the monetary policy stance to the economy may
vary and become more complex in the process.
• Globalization is a still-developing process that will lead to a world in which countries and
economic areas grow increasingly interdependent. The development of the globalization
process has led to the perception that central banks are becoming increasingly ineffectual
in some cases. As has been demonstrated, the increasing globalization of financial market
poses two distinct difficulties to monetary policy.
◦ First, monetary policy decisions can elicit swift and extensive reactions.
◦ Second, monetary policy should take into consideration structural changes in the
economy, such as increased interdependence between economies.
• These issues necessitate the central bank’s clear and forthright communication, as well as a
powerful and all-encompassing monetary policy framework capable of dealing with
structural economic change. It is critical that monetary policy pursues its core goal of
maintaining price stability in the setting of globalized financial markets. This is the most
effective long-term contribution that monetary policy can make to economic growth, as
well as the most efficient and stable financial markets.
• Apart from monetary policy, the interdependence of economies has ramifications in other
areas of economic policy. Overall, economic policy goals should be pursued with a
stability focus to avoid creating excessive uncertainty, especially in financial markets. To
avoid the consequence of rapid adjustments that market forces might impose on unsound
or unpredictable policies, fiscal and tax policy must be implemented sensibly and with a
forward-looking focus.
• Globalization offers up access to borrowing, lending, and investing in financial markets all
around the world. It also plays an important role in policy enforcement. Our economies
will reap the full benefits of globalization of financial markets while controlling the risks
associated with it if monetary and economic policy pursues stability-oriented objectives.
Lesson 2 - Central Banking and Monetary Policy
Central Banks
• Central banks are government-run agencies tasked with overseeing and controlling
commercial banking, money in circulation, interest rates, and currencies. The concept of
central banking has been around for millennia, with the earliest institutions opening in
China around a millennium ago, along with the first paper money issuance. The central
bank institution has progressed and grown over the years and decades of its existence to
reach the current stage of modern banking systems.
• Central banks are among the most important and carefully watched policy-making
institutions in the world. They usually bear primary responsibility for accomplishing
macroeconomic goals through monetary policy.
• Central banks are also the financial system’s first line of defense against financial
turbulence and turmoil. Central banks, unlike other public institutions, have the ability to
create an unlimited amount of money either by issuing currency or, more importantly, by
crediting commercial bank accounts held with them. The central banks are the lifeblood of
a country's financial system, providing final settlement for the vast majority of financial
and non-financial transactions that occur every day.
• According to the International Monetary Fund (IMF), central banks play a crucial role in
maintaining economic and financial stability. They use monetary policy to keep inflation
low and stable. Central banks have stretched their arms to deal with financial stability
threats and unpredictable exchange rates during the global financial crisis. To achieve their
goals, central banks require a complete policy framework. The efficiency of central bank
policies is improved by operational methods that are tailored to each country's
circumstances.
• Aside from these responsibilities, most central banks are responsible for overseeing
commercial banks and other major financial institutions. Central banks also provide a wide
range of financial services to financial institutions, commercial banks, governments, and,
on occasion, other central banks.
• According to Samuelson, "Every central banks serves a single purpose. Its goal is to
maintain control over the economy, money supply, and credit." "The core definition of a
central bank is a banking system in which a single bank has either a total or residuary
monopoly of note issue," Vera Smith stated.
 • In addition, "a central bank may be characterized as an entity responsible with overseeing
the increase and contraction of the volume of money in the interest of general public
welfare," according to Kent.
• "A Central Bank is the bank in any country to which has been given the function of
managing the volume of currency and credit in that country," according to the Bank of
International Settlements.
Origins of Central Banks
• In 1668, the Riksbank of Sweden was established, which was the first central bank. Later,
the most prominent of the central banks, the Bank of England, was established; it was
known as the Old Lady of Threadneedle Street and was commissioned in 1694 as a private
bank to function as the government’s bank and to help the government with its financing,
particularly during times of war. In time, it happens to be a bankers’ bank, a bank to other
banks. The other commercial banks held balances with the Bank of England, and the bank
provided liquidity to them during times of pressure. This unique function came to be
known as the lender of last resort function.
• As we know of it today, monetary policy was not fully considered during this period and
came to be added to the list of central bank functions much later. In the early days of
central banking, the monetary system was a commodity gold standard. The amount of
money in circulation and interest rates were ruled by the workings of the gold standard.
• There was limited coverage for the central bank’s monetary authority to chase a goal apart
from the stability of the value of its currency in connection to gold. Chasing central banks'
goals today, price stability and, in some cases, high levels of employment were not fully
projected and would have required leaving this fixed-exchange-rate regime. Meanwhile,
central banks were introduced in other countries globally. For example, the Banque de
France was established in 1800, and the Bank of Japan in 1882 was created. Central banks
were found to be beneficial for holding the government's funds and helping the
Government issuing and servicing its debt. The United States, on the other hand, was a
latecomer to central banking. The Federal Reserve, the Fed, was not created until 1913 and
did not operate until 1914. Nonetheless, the Fed has become the leading central bank in the
world over the century since its establishment.
Major Functions of Central Banks
• The central bank does not transact directly with the general public. It performs its
functions through the help of various financial institutions, particularly commercial banks.
The central bank is responsible for protecting the financial stability and economic
development of a country. Aside from this, the central bank also plays a significant role in
avoiding cyclical fluctuations by directing money supply in the market. As stated by
Hawtrey, a central bank should mainly be the “lender of last resort.”
• On the other hand, economists understand that maintaining the monetary standard’s
stability is the vital function of central banking. The central bank’s functions are largely
divided into two parts: these are traditional functions and developmental functions.
• Central banks were certainly playing a vital role in building and developing a nation’s
economy. Below are the central bank's main traditional functions, if not all but common in
most countries worldwide.
◦ Bank of Issue
◦ Banker, agent and adviser to government
◦ Custodian of Cash Reserves
◦ Custodian of Foreign Balance
◦ Lender of Last Resort
◦ Clearing House
◦ Controller of Credit
◦ Protection of Depositor’s Interest
• Traditional Functions
◦ Bank of Issue
▪ In today’s world, each country's central bank has a monopoly on note issuance. The
central bank's currency notes are acknowledged as unlimited legal tender
throughout the country. In the interests of uniformity, elasticity, better control,
supervision, and simplicity, the central bank has been given exclusive control over
note-issuance. It will also deal with the possibility of individual banks over-issuing.
▪ As a result, central banks control the country's currency as well as the entire money
supply circulating throughout the economy. The central bank is required to hold
gold, silver, or other assets as collateral for the notes issued. The system for issuing
notes differs from the one used in the United States.
• People's confidence in the currency is maintained.
• The supply is adjusted to demand in the economy.
 ▪ Therefore, keeping in mind the aims of uniformity, safety, elasticity, and security,
the system of note-issue has been changing from time to time.
◦ Banker, Agent, and Adviser to the Government
▪ The Central bank, in general, performs the role of banker, agent, and adviser to the
government. The central bank acts as the government’s bank because it is more
suitable and economical to the government and because of the direct connection
between public finance and monetary affairs.
▪ It originates and receives payments on behalf of the government as its primary
banker. It provides the government with short-term loans to help it overcome
economic issues or fund projects. On behalf of the government, it issues public
loans and manages public debts. After disbursements and remittances, it maintains
the government's banking accounts and balances. It advises the government on all
monetary and economic affairs and dealings in its capacity as an adviser to the
government. Where majority exchange control is in place, the central bank also acts
as an agent for the government.
◦ Custodian of Cash Reserves
▪ All commercial banks in a country maintain a part of their cash balances as deposits
with the central bank, which may be on account of convention or legal obligation. It
can be drawn during busy seasons and payback during relaxed seasons. Some of
these balances are used for clearing purposes. Other member banks look to it for
direction, help, and guidance in a time of need.
▪ It has an impact on the member banks’ cash reserve centralization. Any nation’s
banking system benefits greatly from the concentration of currency reserves in the
central bank. If the same amount were shared across the numerous banks,
centralized cash reserves could at least serve as the foundation of a large and more
elastic lending structure.
▪ It is understandable that when bank reserves are pooled in one institution that is also
charged with safeguarding the national economic interest, such reserves can be used
to the fullest extent possible, and most effectively during periods of seasonal stress,
financial crises, or general emergencies. The centralization of cash reserves is
beneficial to the economy in terms of their use, as well as increased elasticity and
liquidity of the banking system and of the financial system as a whole.
◦ Custodian of Foreign Balances
 ▪ The management of the gold standard, or if the country is on the gold standard, is
reserved to the central bank in order to maintain exchange rate stability.
▪ Central banks have been securing gold and foreign currencies as reserve note-issue
since World War I, and achieving an unfavorable balance of payment with other
countries, if there is one. The central bank's job is to keep the government's
currency rate constant and to administer exchange controls and other restrictions
imposed by the government. As a result, it becomes a guardian of the country's
international currency reserves or foreign balances.
◦ Lender of Last Resort
▪ The central bank is also known as the lender of last resort because it can offer cash
to its member banks to help them increase their cash reserves by rediscounting first-
class bills in the event of a crisis or panic that leads to a bank run, or when there is
seasonal stress. Member banks can also make advances on the central bank’s
sanctioned short-term securities to add to their cash balances as quickly as possible.
▪ This type of facility, which allows them to convert their assets into cash at a
moment’s notice, is extremely beneficial to them and improves the banking and
credit system's economy, flexibility, and liquidity. As a result, by acting as lender of
last resort, the central bank assumes responsible for meeting all reasonable requests
for accommodation made by commercial banks during a crisis.
▪ According to De Kock, the central bank’s lending of last resort function provides
better liquidity and elasticity to the entire credit structure of the country. According
to Hawtrey, the central bank’s important role as lender of last resort is to
compensate for cash shortages among competing banks.
◦ Clearing House
▪ Central bank also serves as a clearing house for the settlement of accounts of
commercial banks. A clearing house is an organization where common claims of
banks on one another are being offset, and the payment makes a settlement of the
difference. The central bank is a bankers’ bank, holds the cash balances of
commercial banks, and as such, it becomes easy for the member banks to adjust or
settle their claims against one another through the central bank.
 ▪ For example, there are two banks that draw cheques on each other. Suppose bank A
has due to it P3,000 from bank B and has to pay P4,000 to B. At the clearinghouse,
mutual claims are offset, and bank A pays the balance of P 1,000 to B, and the
account is settled. Clearing house role of the central bank leads to a good deal of
economy in cash, and much of labor and inconvenience are evaded.
◦ Controller of Credit
▪ Controlling or adjusting commercial bank loans is widely regarded as the central
bank's most important responsibility. Commercial banks created a lot of credit,
which led to inflation in some circumstances. The most major causes of business
instabilities are the expansion or contraction of currency and credit. As a result, the
necessity for credit control is essential. It usually stems from the reality that money
and credit are crucial in determining income, output, and employment levels.
▪ The basic job of a central bank, according to most economists and bankers, is to
control and modify credit. It is the function that encompasses the most essential
piece of the puzzle, one that raises problems about central banking policy and
through which virtually all other functions are merged and made to serve a common
goal. As a result, the central bank is known as a credit controller because of the
supervision it exercises over commercial banks' deposits.
◦ Protection of Depositors Interests
▪ The central bank has to oversee the functioning of commercial banks so as to
protect the interest of the depositors and guarantee the development of banking on
sound lines. Therefore, the enterprise of banking has been acknowledged as a public
service, necessitating legislative safeguards to avoid bank failures.
▪ The legislation was enacted to allow the central bank to inspect commercial banks
in order to maintain a sound banking system, which consists of strong individual
units with sufficient financial resources operating under the right management in
accordance with banking laws and regulations, as well as public and national
interests.
• Developmental Functions
◦ This refers to the functions that are connected to the promotion of the banking system
and economic development of the country. These are not obligatory functions of the
central bank.
◦ Developing Specialized Financial Institutions
 ▪ Refers to the central bank's primary responsibilities for a country’s economic
development. The central bank established institutions to meet the credit needs of
agricultural and other rural businesses. These are referred to as specialized or
dedicated institutions since they cater to specific economic areas.
◦ Influencing Money Market and Capital Market
▪ This means that the central bank assists in the regulation of financial markets’
money market and capital market transactions in short- and long-term credit, with
the central bank insuring the country's economic growth through management of
these markets' operations.
◦ Collecting Statistical Data
▪ The central bank collects and analyzes data on the banking, currency, and foreign
exchange positions of a country. Researchers, policymakers, and economists will
find the data extremely useful. These data can be used to develop various policies
and make macro-level judgments.
Monetary Policy
• Central banks play an important role in monetary policy, ensuring price stability, low and
stable inflation, and assisting in the management of economic instability. The policy
frameworks within which central banks operate have undergone significant changes in
recent years.
• Targeting inflation became the fundamental framework for monetary policy in the late
1980s. The central banks of Canada, Europe, the United Kingdom, New Zealand, and other
nations have set an explicit inflation target. Many low-income nations are likewise shifting
away from targeting a monetary aggregate that gauges the total amount of money in
circulation and toward an inflation-targeting strategy.
• Monetary policy is implemented by central banks through adjusting the supply of money,
mostly through open market operations. A central bank, for example, could cut its money
supply by selling government bonds under a sale and repurchase arrangement and taking
money from commercial banks. Short-term interest rates are influenced by open market
operations, which in turn affect longer-term rates and total economic activity. The
monetary transmission mechanism in most nations, particularly low-income countries, is
not as successful as it is in wealthy economies. Countries must build a framework that
allows the central bank to target short-term interest rates before transitioning from
monetary to inflation targeting.
• Following the global financial crisis, central banks in major economies eased monetary
policy by lowering interest rates until short-term rates were almost zero, limiting the ability
to slash policy rates even more, for example. With the risk of deflation increasing, central
banks employ unconventional monetary measures, such as purchasing long-term bonds, to
further cut long-term rates and relax monetary conditions, particularly in the United States,
the United Kingdom. the Euro region, and Japan. Short-term rates have even gone negative
or below zero in several central banks.
• Monetary policy is also part of the central banks’ variety of tools. The term monetary
policy denotes the central bank’s activities to achieve control over the countries’ monetary
supply within the country. The central bank can make decisions based on the economy's
state, adopt an expansionary policy or a contractionary policy, whereby money supply is
influenced through multiple methods.
• In the time of economic slowdown, it is the central bank’s regular choice to consider
adopting an expansionary policy. To start with, the monetary base is expanded, and interest
rates are reduced. The purpose of the expansionary policy is that money is more widely
available to both banks and companies so that growth and development can be boosted and
sustained. The results targeted are an increase in the gross domestic product (GDP) and a
shrinking of the unemployment rate.
• At times, following the era of rapid economic expansion, the economy heats up. Before
that occurs, or in the worst-case scenario when this happens, the Fed went to the adoption
of a contractionary policy. In doing that, the central bank reduces the monetary base and
increases the main interest rates. As a result, excess capital becomes scarcer or minimal.
and a higher premium is imposed on lending. Due to the smaller scale circulation of funds,
the economy is bound to launch a slowdown. During the contraction period, the GDP is
expected to slow down, and the rate of unemployment is expected to increase.
• Foreign Exchange Regimes and Policies
◦ The selection of a monetary framework is intertwined with the selection of an exchange
rate regime. In comparison to a country with a more flexible exchange rate, a country
with a fixed exchange rate will have a smaller range for autonomous monetary policy.
Although some governments do not regulate the exchange rate, they do attempt to
manage its level, which may result in a price stability trade-off. An effective inflation-
targeting system is supported by a completely flexible exchange rate regime.
• Macro-Prudential Policy
 ◦ The global financial crisis demonstrated that countries must use dedicated finance
policies to manage financial system risks. Many central banks with a financial stability
mandate have improved their financial stability functions, particularly by adopting
macroprudential policy frameworks. To work successfully, macroprudential policy
requires strong institutional framework. Because they have the competence and
capability to examine systemic risk, central banks are well-positioned to implement
macroprudential policy. Furthermore, they are frequently self-sufficient and
autonomous. The macro-prudential mission has been delegated to the central bank or a
specific committee inside the central bank in many nations.
• Regardless of the model utilized to implement macro-prudential policy, the institutional
architecture must be strong enough to withstand criticism from the financial industry and
political forces, as well as conduct macro-prudential policy credibility and accountability.
It necessitates ensuring that policymakers are given clear objectives and the necessary
legislative authority, as well as encouraging cooperation among other supervisory and
regulatory bodies. To operationalize this new policy role by mapping an analysis of
systemic risks into macro-prudential policy action, a specific policy framework or process
is required.
• Effect of Monetary Policy on Output and Prices
◦ Macroeconomists generally believe that central bank monetary policy affects the price
level or the rate of inflation in the long run but does nothing to enhance output or
employment. The amount of labor and capital in the economy, resource productivity,
and the efficiency with which markets generate resources determine the latter. Other
governmental policies, such as those that help workers increase their skills or market
flexibility, will boost output and employment in the long run. The practically universal
agreement that monetary policy can influence these variables in the short and middle
terms, despite its inability to influence output and employment in the long run, is also
noteworthy.
◦ In normal conditions, an expansionary monetary policy will enhance aggregate demand
and, in the interim, push it to greater levels of output and employment, with little
influence on prices. However, the increased levels of output and employment will be
reversed, resulting in price increases. A contractionary monetary policy, on the other
hand, will limit aggregate demand, resulting in lower output and employment, but this
effect will be reversed once prices begin to relax.
• The Goal of Price Stability
◦ In light of these connections, the central bank in several nations has been tasked with
achieving a pricing goal: price stability or low inflation. Price stability is the principal
purpose of monetary policy, as stated in the central bank’s charter. The microeconomic
role of relative pricing is expected to work more efficiently in allocating resources in a
context of stable prices, and firms and people will be more motivated to save and invest
in productive initiatives, supporting a better level of overall output and well-being.
◦ Various macroeconomic goals are listed as supplementary goals of monetary policy in
other conditions, such as maintaining employment or producing production in a
sustainable manner. This enables the central bank to follow a strategy that supports the
economy while maintaining price stability. It does not, however, allow the central bank
to pursue such a strategy if it would compromise the price objective.
◦ When conversing prices in the macroeconomic context, we usually deal with indexes of
prices that are created to represent the average price of things purchased. The most
commonly monitored indexes of prices are those for the prices that consumers pay.
There are also indexes for some other types of prices, particularly the index for the
gross domestic product (GDP), which is related to the average price of a unit of GDP.
This includes the likes of consumption goods and services, investment, government and
net exports.
◦ Consumer price indexes are based primarily on expenditure patterns for what
consumers actually buy. Price watchers around the country collect each item's prices
appearing in a typical basket of goods and services purchased by households. These are
pooled with data on the share of the household budget spent on each item's weight in
the budget. Each item's price is then multiplied by its weight and each of these
computations is summed. That sum, corresponding to the average price in this period,
is then divided by the average price during a base period to get the index number. The
index number for the period in question gives the average level of prices in that period
relative to the average price in the base period. An index number of 1.23, sometimes
expressed as 123, indicates that prices are 23 percent, on average, higher than in the
base period. If the index were to increase to 1.27 in the next period, we would say that
inflation had been 3.25 percent (0.04/1.23).
 ◦ Due to food and energy prices fluctuating a great deal, the Fed and many other central
banks tend to focus on consumer price inflation measures that eliminate these volatile
components, so-called measures of core inflation. For instance, a big spike in food
prices due to a bad harvest may alter the underlying pace of price increases, especially
as the run- up in food prices likely will be reversed before long. Eliminating these
components can give a better reading of underlying inflation trends.
• Monetary Policies Affect Aggregate Demand
◦ Aggregate demand (AD) is a macroeconomic concept that depicts an economy's total
demand for goods and services. This number is frequently used as a gauge of economic
health or growth. Both fiscal and monetary policy can affect aggregate demand because
they affect the parameters that are used to calculate consumer spending on goods and
services, company capital spending, government spending on services and
infrastructure projects, exports, and imports. Multiple trilemmas are frequently the
result of it.
◦ Fiscal policy affects aggregate demand through variations in government spending and
changes in taxation. Those factors impact employment and household income, which
then impact household spending and investment.
◦ Monetary policy influences the money supply in an economy, which affects interest
rates and the inflation rate. It also impacts corporate expansion, net exports,
employment, and the cost of debt, and the relative cost of consumption versus savings,
all of which can directly or indirectly affect aggregate demand.
• The Formula for Aggregate Demand
◦ To understand how monetary policy influences aggregate demand, it's necessary to first
understand how aggregate demand (AD) is computed, which follow the same method
used to calculate GDP:
▪ AD = C + I + G + (X-M)
▪ Where:
• C = Consumer spending on goods and services
• I = Investment spending on business capital goods
• G = Government spending on public goods and services
• X = Exports
• M = Imports
 ◦ Fiscal policy regulates government spending and tax rates. Expansionary fiscal policy,
normally enacted in response to recessions or employment blows, improves
government spending in infrastructure projects, education, and unemployment benefits.
◦ Keynesian economics stated that these programs could avoid a negative shift in
aggregate demand by steadying employment among government employees and people
involved with stimulating industries. The theory is that prolonged unemployment
benefits help to stabilize the consumption and investment of individuals who become
unemployed in times of recession. This is similar to the theory that states that the
contractionary fiscal policy can be used to lessen government spending and sovereign
debt or correct out-of-control growth driven by rapid inflation and asset bubbles. In
connection to the formula for aggregate demand, the fiscal policy directly influences
the government expenditure component and indirectly impacts the consumption and
investment component.
◦ Central banks implement monetary policy by manipulating the money supply in an
economy. The money supply affects interest rates and inflation, both of which are
major determinants of employment, cost of capital, and consumption level. The
expansionary monetary policy involves a central bank either buying Treasury notes,
reducing interest rates on loans to banks, or decreasing the reserve requirement. All of
these actions improve the money supply and lead to lower interest rates.
◦ This generates incentives for banks to loan and companies to borrow. Debt-funded
business expansion can completely affect consumer spending and investment through
employment, thus increasing aggregate demand. Expansionary monetary policy also
normally makes consumption highly attractive relative to savings. Exporters take
advantage of inflation as their products become relatively cheaper for consumers in
other economies.
◦ The contractionary monetary policy is implemented to stop the exceptionally high
inflation rates or regulate expansionary policy effects. Narrowing the money supply
discourages business expansion and consumer spending and negatively affects
exporters, reducing aggregate demand.
• Central Banks Can Increase or Decrease Money Supply
 ◦ To enhance or decrease the amount of money in the financial system, central banks
employ a variety of methods. Monetary policy is the term used to describe these acts.
While the Federal Reserve Board, also known as the Fed or the central bank, has the
authority to print paper currency at its discretion in order to increase the amount of
money in the economy, this is not the method employed in the United States.
◦ The central bank, which is the governing body that manages the government reserve,
oversees all domestic monetary policy. This means they are generally held responsible
for managing inflation and managing both short-term and long-term interest rates. They
make these decisions to toughen the economy, and controlling the money supply is an
important tool they employ.
• Modifying Reserve Requirement
◦ The central bank can influence the money supply by altering reserve requirements,
which relate to the amount of money banks must retain against bank deposits. Banks
can borrow more money if reserve requirements are reduced, increasing the overall
amount of money in the economy. Similarly, the central bank can restrict the quantity
of the money supply by boosting bank reserve requirements.
• Changing Short-Term Interest Rates
◦ Changes in short-term interest rates can also be used by the central bank to alter the
money supply. The availability of money is effectively increased or decreased by
cutting or raising the discount rate that banks pay on short-term loans from the central
bank. Lower interest rates increase the money supply and boost economic activity;
nevertheless, lower interest rates feed inflation, thus the central bank must be cautious
about lowering rates too much for too long.
◦ In the years following the 2008 economic crisis, the European Central Bank kept
interest rates either at zero or below zero for a longer time, and it negatively affected
their economies and their capability to grow healthily. Although it did not sink any
countries in economic disaster, it has been considered by many to be an example of
what not to do after a large-scale economic downturn.
The Demand for Money
• People make decisions regarding how to hold their cash while selecting how much money
to keep. How much of one's wealth should be kept in cash and how much in other assets?
The answer to this issue depends on the relative costs and benefits of holding money
against other assets for a given level of wealth. The relationship between the amount of
money people wishes to have and the circumstances that affect that amount is known as the
demand for money.
• To make things easier, let's pretend there are just two ways to store wealth: cash in a
checking account or funds in a bond market mutual fund that buys long-term bonds on
behalf of its investors. A bond fund is not the same as money. Although certain money
deposits pay interest, the yield on these accounts is typically smaller than that of a bond
fund. The advantage of checking accounts is that they have a lot of liquidity and may be
simply disposed of. We can think of money demand as a curve that represents the
outcomes of trade-offs between the increased availability of money deposits and the higher
interest rates available from owning a bond fund. The cost of storing money is the gap
between the interest rates provided on money deposits and the interest returns available
from bonds.
• Interest Rates and the Demand for Money
◦ People’s amount of money to pay for transactions and satisfy preventive and
speculative demand is likely to differ with the interest rates they can earn from
alternative assets such as bonds. When interest rates rise compared to the rates earned
on money deposits, people hold less money. When interest rates are down, people hold
more money. The logic of these assumptions about the money people holds and interest
rates depend on the people's motives for holding money.
 ◦ The amount of money that households desire to keep varies depending on their income.
The interest rate, as well as various average amounts of money held, can meet their
transactional and precautionary money demands. To see why, assume a family of three
earns and spends $3,000 per month. Every day, it spends the same amount of money.
That works out to $100 each day for a month of 30 days. One option for the household
to achieve this spending would be to deposit the funds in a checking account that pays
no interest. As a result, when the month begins, the household will have 3,000 in the
checking account, 2,900 at the end of the first day, 1,500 halfway through the month,
and nothing at the end of the month. We can calculate the amount of money the
household requires by averaging the daily balances. This kind of money management,
dubbed the cash approach, offers the advantage of simplicity, but the household will not
receive any interest on its funds.
◦ Consider a different money management strategy that allows for the same spending
pattern. The household deposits $1000 in its checking account and the remaining
$2,000 in a bond fund at the start of each month. Assume the bond fund pays 1%
interest per month, or a 12.7 percent annual interest rate. The money in the checking
account is depleted after ten days, and the household withdraws $1,000 from the bond
fund for the next ten days. The remaining $1,000 from the bond fund is deposited into
the bank account on the 20th day. The household has an average daily balance of $500
with this technique, which is the amount of money it requires. Let’s call this technique
money management the bond fund approach.
Banko Sentral ng Pilipinas (BSP)
• Established on the 3rd of July 1993 based on the provisions of the 1987 Philippine
Constitution and the New Central Bank Act of 1993, the Republic of the Philippines'
central bank is the Bangko Sentral ng Pilipinas (BSP). The Philippines' Central Bank was
established on the 3rd of January 1949 and later replaced as Banko Sentral ng Pilipinas
(BSP). The BSP has fiscal and administrative independence from the Philippine
Government in accordance with its mandated responsibilities.
• Creating a Central Bank for the Philippines
◦ As early as 1933, a group of Filipinos had conceptualized a central bank for the
Philippines. It came up with the basics of a bill for establishing a central bank for the
country after a cautious study of the economic provisions of the Hare-Hawes Cutting
bill, the Philippine Independence Bill approved by the US Congress.
◦ During the Commonwealth years (1935-1941), the discussion about a Philippine central
bank that would uphold price stability and economic growth continued. The country's
monetary system then was managed by the Department of Finance and the National
Treasury. The Philippines was on the exchange standard using the US dollar, which was
supported by 100% gold reserve as the standard currency.
◦ As required by the Tydings-McDuffie Act, in 1939, the Philippine legislature enacted a
law creating a central bank. As it is a monetary law, this required the approval of the
United States president. However, President Franklin D. Roosevelt rejected it due to
strong opposition from vested interests. Following the disapproval, a second law was
passed in 1944 during the Japanese occupation, but the American liberalization forces'
arrival terminated its implementation.
◦ As President Manuel Roxas assumed office in 1946, he instructed the Finance
Secretary Miguel Cuaderno Sr. to develop a central bank charter. The founding of a
monetary authority became imperative a year after as a result of the findings of the
Joint Philippine-American Finance Commission headed by Mr. Cuaderno. The
Commission, which planned Philippine financial, monetary, and fiscal problems in
1947, suggested a shift from the dollar exchange standard to a managed currency
system. A central bank was then required to implement the proposed shift to the new
system.
◦ Instantly, the Central Bank Council, which President Manuel Roxas created to prepare
a proposed monetary authority charter, develop a draft. It was submitted to Congress in
February 1948. By June of the same year, the newly proclaimed President Elpidio
Quirino, who succeeded President Roxas, affixed his signature on Republic Act No.
265, the Central Bank Act of 1948. The establishment of the Central Bank of the
Philippines was a definite step toward national sovereignty. Over the years, changes
were introduced to make the charter more responsive to the needs of the economy. On
the 29th of November 1972, Presidential Decree No. 72 adopted the Joint IMF-CB
Banking Survey Commission’s recommendations, which made a study of the
Philippine banking system. The Commission proposed a program designed to ensure
the system's soundness and healthy growth. Its most important recommendations were
related to the Central Bank's objectives, its policy- making structures, the scope of its
authority, and procedures for dealing with problem financial institutions.
 ◦ Succeeding changes sought to improve the Central Bank’s capability, in the time of a
developing economy, to enforce banking laws and regulations and respond to emerging
central banking challenges and issues. Thus, in the 1973 Constitution, the National
Assembly was mandated to establish an independent central monetary authority. Later,
PD 1801 designated the Philippines’ Central Bank as the central monetary authority
(CMA). Years after, the 1987 Constitution adopted the CMA provisions from the 1973
Constitution that were intended to establish an independent monetary authority through
enlarged capitalization and greater private sector participation in the Monetary Board.
◦ The administration that followed President Corazon C. Aquino’s transition government
saw the turning of another chapter in Philippine central banking. In accordance with a
provision in the 1987 Constitution, President Fidel V. Ramos signed into law Republic
Act No. 7653, the New Central Bank Act, on the 14th of June 1993. The law provides
for establishing an independent monetary authority to be known as the Bangko Sentral
ng Pilipinas, with the maintenance of price stability explicitly stated as its primary
objective. This goal was only implied in the old Central Bank charter. The law also
gives the Bangko Sentral fiscal and administrative independence, which the old Central
Bank did not have. On the 3rd of July 1993, the New Central Bank Act was fully
effective.
Overview of Functions and Operations of Banko Sentral ng Pilipinas
• Objectives
◦ The BSP’s main objective is to maintain price stability beneficial to a balanced and
sustainable economic growth. The BSP also aims to promote and preserve monetary
stability and the convertibility of the national currency.
• Responsibilities
◦ The BSP provides policy guidance in the areas of money, banking, and credit. It
oversees the operations of banks and exercises regulatory powers over non-bank
financial institutions with quasi-banking functions.
◦ Under the New Central Bank Act, the BSP performs the following functions, all of
which relate to its status as the Republic’s central monetary authority.
▪ Liquidity Management
• The BSP formulates and implements monetary policy to influence money supply
consistent with its primary objective to maintain price stability.
▪ Currency Issue
 • The BSP has the exclusive power to issue the national currency. All notes and
coins issued by the BSP are fully guaranteed by the government and are
considered legal tenders for all private and public debts.
▪ Lender of Last Resort
• The BSP extends discounts, loans, and advances to banking institutions for
liquidity purposes.
▪ Financial Supervision
• The BSP supervises banks and exercises regulatory powers over non-bank
institutions performing quasi-banking functions.
▪ Management of Foreign Currency Reserves
• The BSP seeks to maintain sufficient international reserves to meet any
foreseeable net demands for foreign currencies in order to preserve the
international stability and convertibility of the Philippine peso.
▪ Determination of Exchange Rate Policy
• The BSP determines the exchange rate policy of the Philippines. Currently, the
BSP adheres to a market-oriented foreign exchange rate policy such that the role
of Bangko Sentral is principally to ensure orderly conditions in the market.
◦ As part of BSP’s other activities, the BSP functions as the banker, financial advisor and
official depository of the Philippines, its political units and instrumentalities and
government-owned and controlled corporations.
Lesson 3 - Banking Industry and Non-Banking Financial Institutions
The Meaning of Banking
• Banks are often distinguished from other forms of financial organizations by their ability to
provide deposit and lending products. Deposit products pay out money on-demand or
when a certain amount of time has passed. Deposits are bank obligations that must be
appropriately managed if the banks’ purpose is to maximize profit. They also deal with the
assets created by loans. As a result, the main activity is to function as a middleman
between depositors and borrowers. While other financial institution, such as stockbrokers,
also act as brokers between buyers and sellers of shares, the handling of deposits and the
provision of loans or credits distinguishes a bank, despite the fact that many provide other
financial services.
• To highlight the bank’s conventional intermediate function, consider Figure 1, which
shows a simple deposit and a credit market model. The interest rate I appear on the vertical
axis, while the volume of deposits/loans appears on the horizontal axis. Assume the
interest rate is determined exogenously. In this situation, the bank is confronted with an
upward- sloping deposit supply curve (S.D.). The bank’s supply of loans curve (S.L.)
indicates that the bank will give more loans as interest rates rise. In Figure 1, DL represents
loan demand, which decreases as interest rates rise. In Figure 1, I denote the market-
clearing interest rate, which is the rate that would prevail in a totally competitive market
with no expenses associated with connecting the borrower and lender. The business
volume is denoted by the letter 0B. Banks spend intermediation expenses, such as
verification, monitoring, search, and enforcement, in order to determine the
creditworthiness of prospective borrowers.
• The lender must analyze the riskiness of the borrower and impose a premium plus the risk
assessment fee. As a result, the bank pays a deposit rate of iD and charges a lending rate of
iL in order to maintain equilibrium. The total amount of deposits is 0T, and the total
amount of loans is 0T. The interest margin is equal to iL iD and is used to cover the
institution’s intermediation costs, capital costs, risk premiums levied on loans, tax
payments, and profits. The interest margin is also influenced by market structure; the more
competition there is for loans and deposits, the narrower the interest margin becomes.
• The cost of management and other transaction costs associated with the bank's savings and
loan products will also be included in the intermediation coats. Unlike individual agents,
who have a higher cost of searching for a potential lender or borrower, a bank may be able
to achieve economies of scale in these transaction costs; given the large volume of savings
and deposit products available, the associated transaction costs are either constant or
declining. In contrast to private lenders, banks value information economies of scale in
lending choices since they have access to privileged information on existing and potential
bank account borrowers.
• Because this information is rarely packaged and sold, banks use it internally to increase the
size of their loan portfolio. As a result, banks can pool a portfolio of assets with a lower
risk of default for a given expected return, similar to depositors trying to lend funds
directly. There will be a demand for a bank’s services if it can function as a middleman at
the lowest possible cost. For example, some banks have lost out on lending to huge
corporations because these companies have discovered that issuing bonds is a more cost-
effective way to generate capital.
• However, even the highest-rated companies utilize bank credits as part of their external
financing since a loan agreement signal to financial markets and suppliers that the
borrower is creditworthy (Stiglitz and Weiss, 1988).
• Banks’ second main activity is to offer liquidity to their customers. Liquidity preferences
vary among depositors, borrowers, and lenders. Customers expect to be able to withdraw
funds from their current accounts at any moment. Typically, businesses prefer to borrow
money and repay it based on the predicted returns of an investment project, which may not
be realized for several years after the initial expenditure. Depositors agree to forego current
spending in exchange for consumption at a later period when they borrow money.
• Perhaps more importantly, liquidity preferences can shift over time as a result of
unforeseen circumstances. Customers who take out term deposits with a specified maturity
term, such as three or six months, expect to be able to withdraw them at any time in
exchange for paying an interest penalty. Borrowers also expect to be able to repay or
terminate loans early or to roll over a loan subject to a satisfactory credit check. Both
parties’ liquidity demands will be met if banks can collect a significant number of
borrowers and savers. As a result, liquidity is a critical service that a bank provides to its
customers. It also distinguishes banks from other financial institutions that offer near-bank
and non-bank financial goods such as unit trusts, insurance, and real estate services. It also
explains why banks are singled out for appropriate regulation: claims on a bank function as
money; hence the services banks provide are of a “public benefit” nature.
• Banks are assumed to be involved in asset transformation or converting the value of assets
and liabilities by pooling assets and liabilities. Banks aren't the only ones who do this;
insurance companies do it as well. Similarly, mutual funds and unit trusts pool a large
variety of assets, allowing investors to benefit from the effects of diversification that they
would not be able to enjoy if they invested in the same asset portfolio. However, there is
one aspect of asset transformation that is specific to banks. They provide savings products
with a short maturity, even on an immediate basis, and engage in a loan agreement with
borrowers to be paid back at a later period. Loans are a sort of credit that isn’t offered on
the open market.
 • Non-price elements are linked with several banking services. A current account may pay
interest on the deposit and provide a direct debit card and checkbook to the customer. The
bank might charge for any of these services, but many do so by lowering the deposit rate
paid to cover the expense of these “non-price” features. In exchange for taking out a term
deposit and keeping the money in the bank for a set amount of time, such as two months or
a year, the customer receives a higher deposit rate. A penalty is charged if the customer
withdraws the money too soon. Customers may also be penalized for early redemption if
they pay off their mortgages early.

Financial Innovation and the Evolution of the Banking Industry

• To comprehend how the banking business has evolved through time, it is necessary to first
comprehend the evolution of financial innovation, which has shaped the entire financial
system. The financial industry, like other industries, is in business to make money by
selling its products to clients. If a detergent manufacturer sees a market need for a laundry
detergent containing fabric softener, it develops a product to meet that demand. Similarly,
financial organizations produce new goods to meet their own and their customers' needs in
order to maximize their profits; in other words, economic innovation is driven by the
desire to become or remain wealthy. As a result of this perspective on the innovation
process, the following simple analysis can be made: A shift in the financial climate will
prompt financial institutions to look for new ideas that are likely to be profitable.
• Individuals and financial institutions operating in financial markets have been confronted
with major changes in the economic environment since the 1960s. Inflation and interest
rates rose sharply and became difficult to predict, causing demand conditions in financial
markets to shift. The rapid advancement of computer technology altered the supply
situation. Financial regulations have also become more complicated. Most of the old ways
of doing business were o longer profitable for financial institutions, and the financial
services and products they supplied to the public were no longer appealing. Many financial
intermediaries discovered that they could no longer access funds via traditional financial
instruments and that without these funds, they would be out of business in a shorter
amount of time. Financial institutions had to investigate and develop new products and
services that would match client wants and be lucrative in order to survive in the new
economic environment, a process known as Financial Engineering. Necessity was the
mother of invention in this case.
• Three main categories of financial innovation are suggested by the debate of why financial
innovation occurs: responses to changes in demand conditions, responses to changes in
supply conditions, and regulatory avoidance.
• Increased interest rate volatility has been the most major factor in the economic climate
that has impacted demand for financial products in recent years. The interest rate on three-
month Treasury bill fluctuated between 1.0 percent and 3.5 percent in the 1950s, between
4.0 percent and 11.5 percent in the 1970s, and between 5 percent and over 15 percent in the
1980s. Large changes in interest rates resulted in significant capital gains or losses and
increased uncertainty regarding investment returns. Remember that interest-rate risk is the
risk associated with the uncertainty of interest-rate fluctuations and returns and that
significant interest-rate volatility, such as we witnessed in the 1970s and 1980s, results in a
higher level of interest-rate risk.
• We believe that when interest rates rise, demand for financial products and services will
rise, reducing the risk. This shift in the economic climate would prompt financial
institutions to look for profitable innovations to accommodate this new demand, which
might lead to new financial instruments that assist reduce interest-rate risk. The
advancement of adjustable-rate mortgages and financial derivatives are two examples of
financial innovations that occurred in the 1970s that support this prediction.
• Adjustable Rate Mortgages
◦ Financial institutions, like other investors, believe that lending is more appealing when
the interest-rate risk is lower. They wouldn't want to take out a mortgage with an 11
percent interest rate only to find out two months later that they could get the identical
loan with a 13 percent interest rate. To mitigate interest-rate risk, California Savings
and Loans began issuing adjustable-rate mortgages in 1975; mortgage loans with
interest rates change when a market interest rate, usually the Treasury bill rate,
increases. An adjustable-rate mortgage can have a 5% interest rate at first. This interest
rate may change in six months depending on the amount of change in, say, the six-
month Treasury bill rate, and the mortgage payment would alter. Because adjustable-
rate mortgages allow mortgage-issuing banks to earn greater interest rates on
mortgages, profits are maintained during periods when rates climb. This distinguishing
feature of adjustable-rate mortgages has prompted mortgage lenders to provide
adjustable-rate mortgages with lower initial interest rates than traditional fixed-rate
mortgages, making them popular among many families.
 ◦ Nonetheless, many households choose fixed-rate mortgages over variable-rate
mortgages because the mortgage payment on a variable-rate mortgage can grow. As a
result, both forms of mortgages are common.
• Financial Derivatives
◦ Given the high demand for interest-rate risk reduction, commodity exchanges such as
the Chicago Board of Trade realized that if they could create a product that would assist
investors and financial institutions in securing or hedging interest-rate risk, they could
profit from selling this new instrument. Futures contracts, in which the seller
undertakes to provide a standardized product to the buyer at a predetermined price on a
future date, have been around for a long time. Officials at the Chicago Board of Trade
realized that developing futures contracts in financial instruments known as financial
derivatives may be used to mitigate risk because their payoffs are connected to
previously issued securities.
◦ Improving computer and telecommunications technology has been an essential
foundation of the changes in supply conditions that encourage financial innovation.
This technology, known as Information Technology, has resulted in two outcomes. For
starters, it has reduced the cost of processing financial transactions, allowing financial
institutions to develop new financial products and services for customers. Second,
investors now have more access to information, making it easier for companies to issue
securities. Many new financial products and services have emerged as a result of rapid
advancements in information technology, which we analyze here.
• Bank Credit and Debit Cards
◦ Credit cards have been around for a long time, far before WWII. Many individual
stores (Sears, Macy’s, Goldwater’s) formalized charge accounts by providing
customers with credit cards that allowed them to shop without using cash. After WWII,
Diners Club developed a nationwide credit card that could be used in restaurants across
the country (and abroad). Similar credit card systems were launched by American
Express and Carte Blanche, but due to the enormous costs of running these programs,
cards were only granted to a restricted group of people and corporations that could
afford pricey purchases. Credit card companies profit from the loans they give to
cardholders as well as payments made by stores on credit card sales (a percentage of
the purchase price, say 5 percent).
 ◦ Loan defaults, stolen cards, and the cost of processing credit card transactions all
contribute to the costs of a credit card program. Bankers sought a piece of the lucrative
credit card sector after seeing the success of Diners Club, American Express, and Carte
Blanche. In the 19S0s, several commercial banks attempted to spread the credit card
industry to a larger market, but the cost per transaction of running these programs was
so exorbitant that their initial attempts failed.
• Electronic Banking
◦ The marvels of current computer technology have also enabled banks to reduce the cost
of bank transactions by allowing customers to deal with electronic banking (e-banking)
facilities rather than human beings. The automated teller machine (ATM), an electronic
machine that lets users get cash, make deposits, transfer funds from one account to
another, and check balances, is one type of e-banking service. The ATM has the
advantage of not requiring overtime pay and never sleeping making it ready for usage
24 hours a day. This saves the bank money on transactions while simultaneously
providing greater convenience to the consumer. Furthermore, ATMs can be placed in
locations other than a bank or its branches due to their inexpensive cost, boosting client
convenience. Due to their inexpensive cost, ATMS have sprung up all over the world,
with over 250,000 in the United States alone. Furthermore, getting foreign currency
from an ATM when traveling in Europe is now as simple as getting cash from your own
bank. Furthermore, because ATM transactions are so much cheaper for the bank than
transactions handled with human tellers, some bank charge consumers less if they use
an ATM rather than a human teller.
• Junk Bonds
◦ Prior to the invention of computers and improved telecommunications, obtaining
information about a company’s financial status in order to sell securities was difficult.
Due to the difficulties in distinguishing between bad and excellent credit risks, only
very well- established enterprises with high credit ratings were able to sell bonds. Prior
to the 1980s, firms could only raise capital by selling newly issued bonds if they had a
BAA or higher credit rating. Some companies that had run into financial difficulties,
dubbed “fallen angels,” had previously issued long-term corporate bonds with ratings
below BAA, bonds that were derisively referred to as “junk bonds.”
• Commercial Paper Market
 ◦ Large banks and enterprises issue commercial paper, which is a short-term debt
product. Since 1970, when there was $33 billion in outstanding commercial paper, the
market has grown dramatically, reaching over $1.3 trillion at the end of 2002.
Commercial paper is undeniably one of the most rapidly developing money market
vehicles today.
◦ Information technology advancements also contribute to the quick growth of the
commercial paper market. As a result of advancements in information technology, it is
now easier for investors to distinguish between bad and excellent credit risks, making it
easier for businesses to issue debt securities. This not only made it simpler for firms to
issue long- term debt securities, such as junk bonds, but it also made it easier for them
to raise capital by issuing short-term debt securities, such as commercial paper.
◦ Many businesses that used to get their short-term funding from banks now get it from
the commercial paper market.
• Securitization
◦ Securitization, one of the most important financial developments in recent decades, is
an important example of a financial innovation emerging from improvements in both
transaction and information technology. Securitization is the process of converting
otherwise illiquid financial assets into marketable capital market securities, such as
residential mortgages, auto loans, and credit card receivables, which have traditionally
been the bread and butter of banking organizations. Improved access to information, for
example, has made it easier to sell marketable capital market securities. Financial
institutions can also pool a portfolio of loans, such as mortgages, with different small
denominations, usually less than $100,000, collect interest and principal payments on
the mortgages in the bundle, and then “pass them through” (pay them out) to third
parties, thanks to low transaction costs due to advances in computer technology. The
financial institution can then offer the claims to these interests and principal payments
to third parties as securities by partitioning the loan portfolio into regular quantities.
◦ These securitized loans’ standardized or regular amounts were then turned into liquid
securities. They are appealing because they are made up of a bundle of loans, which
helps to diversify risk. By servicing the loans, collecting interest and principal
payments, and paying them out, and charging a fee to the third party for this service,
the financial institution selling the securitized loans makes money.
• Sweep Accounts
 ◦ The Sweep Account is another invention that helps banks to avoid the "tax" of reserve
requirements. Any balances in a company's checking account at the end of a business
day that exceed a particular amount are "swept out" of the account and invested in
overnight securities that pay the corporation interest. Because the "swept out" money
are no longer considered checkable deposits, they are exempt form reserve
requirements and consequently from taxation. They also have the benefit of allowing
banks to pay interest on these business checking accounts, which is otherwise
prohibited under current legislation. Because sweep accounts have become so popular,
the quantity of required reserves has decreased to the point that most financial
institutions no longer consider reserve requirements mandatory. To put it another way,
they hold greater reserves than they are required to.
Structures and Types of Banking
• Banking structures vary greatly from country to country. The country's banking structure is
frequently the product of the regulatory regulations to which it is subject. The numerous
forms of banking arrangements are defined here. The following banking arrangements do
not alter the banks’ primary functions, which include the provision of intermediation and
liquidity and, indirectly, a payment service.

• Universal Banking
◦ Universal banks provide a full range of banking and non-banking financial services
through a single legal entity. Through cross-shareholdings and shared directorships,
banks also have direct access to banking and commerce. The following are typical
financial activities.
▪ Liquidity and intermediation through deposits and loans; (e.g., payments system).
▪ Trading of financial instruments and derivatives (e.g., bonds, stocks, and
currencies).
▪ Proprietary trading, which is when a bank trades on its own behalf using its own
trading book
▪ Stockbroking
▪ Corporate advisory services (e.g., mergers and acquisitions)
▪ Investment management
▪ Insurance
 ◦ Universal banking (German Haus bank) originated in Germany, with banks like
Deutsche Bank and Dresdner offering nearly all of its services. However, German
banks may own commercial apprehensions, and a bank’s total capital must not exceed
the sum of its equity investments (in excess of 10% of the commercial firm’s capital)
plus other fixed investments. Daimler-Benz (automobiles), Allianz (the largest
insurance company), Metallgesellshaft (oil industry), Philip Holzman (construction),
and Munich Re (a huge re-insurance firm and some other German companies) are
among Deutsche Bank’s major holdings.
• Commercial and Investment Banks
◦ Commercial banking started in the United States, but it is now widely utilized
throughout the world. The Glass Steagall Act was named after the four Glass Steagall
(G.S.) sections of the Banking Act of 1933. With the exception of municipal bonds, US
government bonds, and private placements, commercial banks were barred from
underwriting securities under the G.S. Commercial banking services were not permitted
for investment banks. The Act had two goals: to deter banking industry collusion and to
avert another financial crisis like the one that occurred between 1930 and 1933.
◦ Early investment banks in the United States acquired cash for large firms and the
government by acting as underwriters for corporate and government securities and
arranging mergers and acquisitions for a fee (M&As). Modern investment banks
typically engage in a broader range of operations, including:
▪ Underwriting
▪ Mergers and acquisitions
▪ Trading - equities, fixed income (bonds), proprietary
▪ Fund management
▪ Consultancy
▪ Global custody
◦ The extension of activities helps to diversify these firms; however, that is still haunted
by problems. For instance, the likes of Lehman Brothers, Goldman Sachs, and others,
the growth of the trading side of the bank created tensions between the relatively new
traders and the banking (underwriting, M&As) side of the firm. At Lehman's, in
particular, 60% of the stock was distributed to the bankers although banking activities
contributed to less than one-third of profits.
• Merchant Banks
 ◦ The Baring is the oldest merchant bank in the United Kingdom, having been founded in
1762. Francis Baring, a former general trader, diversified into funding the import and
export of small businesses' commodities. Bills of exchange were used to fund the
project. After validating the firms’ credit standings, Baring would charge a fee to
guarantee (or “accept”) merchants’ bills of exchange. On the market, the bills were sold
at a discount.
◦ Liquidity was provided to small traders who were in desperate need. Until the early
1980s, these banks were also known as merchants “accepting houses.” They expanded
their services to include arranging loans for sovereigns and governments, underwriting
and working as mergers and acquisitions counsel.
The Biggest Banks in the World
• The world’s largest banks are listed here, based on 12-month trailing revenue. Because
some corporations outside the United States disclose profits semi-annually rather than
quarterly, the 12-month trailing statistics may be older than for companies that report
quarterly. All data is up to date as of March 30, 2020.
◦ Industrial and Commercial Bank of China Ltd. (IDCBY)
▪ The Industrial and Commercial Bank of China Ltd is the world’s largest bank in
terms of total assets under management (AUM). This organization provides credit
cards and loans and business funding and money management services to
businesses and high-net-worth individuals. The bank is a state-owned financial
organization as well as a commercial bank.
• Revenue (TTM): $123.6B
• Net Income (TTM): $45.3B
• Market Cap: $231.8B
• 1-Year Trailing Total Return: -6.9%
• Exchange: OTC
◦ JP Morgan Chase & Co. (JPM)
▪ JPMorgan Chase & Co. is a financial service holding firm that specializes in
corporate financing, wealth management, asset management, consumer and
investment banking and other services. JPMorgan Chase recently announced a plan
to raise up to $10 billion in cash from pension funds and other clients for alternative
investments such as leveraged loans and certain forms of real estate as part of its
COVID-19 response.
• Revenue (TTM): $114.6B
 • Net Income (TTM): $36.4B
• Market Cap: $280.1B
• 1-Year Trailing Total Return: -5.8%
• Exchange: NYSE
◦ Japan Post Holdings Co. Ltd. (JPHLF)
▪ Japan Post Holdings Co. Ltd. is a bank that also has interests in life insurance,
logistics, and other areas. The corporation is best-known for its Japan Post division,
which handles mail delivery and post office management in Japan, as well as its
banking arm, Japan Post Bank.
• Revenue (TTM): $112.3B
• Net Income (TTM): $4.7B
• Market Cap: $34.4B
• 1-Year Trailing Total Return: -28.3%
• Exchange: OTC
◦ China Construction Bank Corp. (CICHY)
▪ China Construction Bank Corp. is the second-largest Chinese bank on the list.
Electronic banking, credit lines, and commercial loans are among the services it
provides to businesses. Personal banking is also available through a distinct division
of China Construction Bank, which offers personal loans, savings, asset
management, and credit cards.
• Revenue (TTM): $102.2B
• Net Income (TTM): $38.7B
• Market Cap: $196.6B
• 1-Year Trailing Total Return: -3.7%
• Exchange: OTC
◦ Bank of America Corp. (BAC)
▪ Bank of America is a financial services company based in the United States that
caters to both individuals and businesses of all kinds. Aside from deposit and
checking accounts through its Consumer Banking branch, Bank of America’s global
offices provide a comprehensive range of business and wealth management
services. During the COVID-19 crisis, the company made headlines by promising to
accept mortgage deferment requests from clients. Some clients, however, claimed
that the bank’s deferral offers were misleading.
• Revenue (TTM): $91.2B
 • Net Income (TTM): $27.4B
• Market Cap: $188.5B
• 1-Year Trailing Total Return: -18.2%
• Exchange: NYSE
◦ Agricultural Bank of China Ltd. (ACGBY)
▪ Agricultural Bank of China is a state-owned bank that provides personal and
business banking services, as well as a unique set of products for agricultural
customers such as small farms and larger agricultural wholesalers.
• Revenue (TTM): $89.7B
• Net Income (TTM): $30.9B
• Market Cap: $131.5B
• 1-Year Trailing Total Return: -14.1%
• Exchange: OTC
◦ Credit Agricole S.A. (CRARY)
▪ The lone European bank on the list is Credit Agricole S.A., which is the world's
largest cooperative financial institution by AUM. The business has a long history of
serving agricultural clientele, but it currently caters to a wide range of individuals
and businesses.
• Revenue (TTM): $83.4B
• Net Income (TTM): $5.4B
• Market Cap: $22.3B
• 1-Year Trailing Total Return: -32.4%
• Exchange: OTC
◦ Wells Fargo & Co. (WFC)
▪ Wells Fargo provides a wide range of financial services to both individuals and
businesses. The corporation has recently been engulfed in a phony accounts scandal
that has harmed the consumers of a number of prominent banks, with the US
government recently fining Wells Fargo $3 billion as part of the continuing
proceedings.
• Revenue (TTM): $82B
• Net Income (TTM): $19.6B
• Market Cap: $123.8B
• 1-Year Trailing Total Return: -35.4%
• Exchange: NYSE
 ◦ Bank of China Ltd. (BACHF)
▪ The Bank of China is primarily focused on commercial banking services such as
deposits and withdrawals, as well as foreign exchange. In Hong Kong and Macau,
the bank is even permitted to print banknotes.
• Revenue (TTM): $79.4B
• Net Income (TTM): $27.2B
• Market Cap: $109.1B
• 1-Year Trailing Total Return: -12.7%
• Exchange: OTC
◦ Citigroup Inc. (C)
▪ The Citigroup is a multinational investment bank and financial services company
providing securities services, institutional financial services, global retail banking,
and among other financial services.
• Revenue (TTM): $74.3B
• Net Income (TTM): $19.4B
• Market Cap: $91.9B
• 1-Year Trailing Total Return: -25.9%
• Exchange: NYSE
The Philippine Banking System
• These recent years are significant to the Philippine banks. The asset expansion continued
on account of sustained growth in credit and investment portfolios. The asset quality and
solvency position continued to be ideal and at par with ASEAN—5 standards. During the
year, banks maintained sufficient liquidity to achieve their operational requirements and
related financing needs. With robust balance sheets and committed partnerships with
regulators to follow significant reforms, it is not new for banks to maintain profitability.
• To further broaden client reach, the growing banking environment has capitalized on
technology advancements in electronic banking, financial innovations, and ongoing
advocacies on financial inclusion. In the Philippines, there were 758 banks with 8,534
branches as of the end of 2019. Risk aversion and poor business demand slowed credit
growth in 2010, with total loans outstanding rising 8.7% to P2.79 billion from P2.567.7
billion the previous year. Core loans as a proportion of gross domestic product, or GDP,
fell to 38.7% in nominal terms from 41.4% in 2009. Real estate, agriculture, and
manufacturing-related sectors were still the “Top 3” loan destinations via external financial
intermediation and the interbank market.
• Despite concerns about the scope of banks’ intermediation and trading activities, the loan
portfolio remained active and an important revenue stream as NPL/NPA ratios fell to 3.8 %
and 3.9%, respectively, asset and loan quality improved and were better than pre-crisis
norms of about 4%.
• Due to a considerable decline in returns and other savers’ investment products, deposit
liabilities grew at a slower rate of 9.6%. In reaction to increasing inflation and the overall
erosion of the peso’s purchasing value, the majority of these deposits were still in peso and
short-term demand, negotiable order of withdrawal (NOW), and savings accounts. Despite
the peso’s 5.6% (period average) advance versus the US dollar, headline inflation (all
goods) climbed to 3.8% from 3.2% during the evaluation period, while purchasing power
decreased to P0.60 from P0.63.
• Banks were hopeful in their trading activity in 2010 after recovering from the downturn
bear performance in world trade indexes in 2008 and 2009. Due to increased trading of
derivatives and government securities, trading income increased by 47.3% to P68.2 billion
from P46.3 billion.
• There was also enough liquidity in the system, as the liquid assets-to-deposits ratio
remained at 59.7% (up from 52.7% in 2009), and the percentage of cash and due from
banks over deposit liabilities increased to 25.9% from 18.8% the year before.
• Finally, banks' capital adequacy ratios (CARs) were higher than statutory and international
criteria, at 17% consolidated and 16% solo. Similarly, all banking groups led by universal
banks improved their compliance ratio with minimum capital requirements.
• BSP Supervised Banks/Statistics
◦ The Philippine banking system is monitored and consolidated by the Banko Sentral ng
Pilipinas (BSP). Universal and commercial banks, thrift banks, rural and cooperative
banks make up the Philippine banking system.
◦ In terms of assets, universal and commercial banks are the largest group of financial
institutions in the county. Among financial institutions, they offer a greater range of
banking services. Universal banks are authorized to participate in underwriting and
other investment house tasks, as well as invest in non-allied undertakings’ equity, in
addition to the functions of a standard commercial bank.
 ◦ Savings and mortgage banks, private development banks, stock savings and loan
organizations, and microfinance thrift banks make up the thrift banking sector. Thrift
banks are involved in the collection and investment of depositors’ funds. They also
provide short-term working capital as well as medium- and long-term financing to
businesses in agriculture, services, industry, housing, diversified financial and allied
services, as well as their targeted markets and constituencies, including small and
medium-sized businesses and individuals.
◦ In rural areas, rural and cooperative banks are the most popular types of banks. The role
is to promote and build the rural economy in a systematic and efficient manner by
providing basic financial services to rural areas. Farmers can get help from rural and
cooperative banks at any stage of the agricultural process, from seedling purchase to
harvest marketing. Ownership distinguishes rural banks and cooperative banks from
one another. Cooperative banks are formed and owned by cooperatives or federations
of cooperatives, whereas rural banks are privately owned and operated.
◦ The BSP also publishes data on non-banks that perform quasi-banking tasks. This
group includes institutions that borrow cash for their own accounts from 20 or more
lenders through issuances, endorsements, or assignments with recourse or acceptance
of deposit substitutes for re-lending or purchasing receivables and other liabilities.
• Top Banks in the Philippines According to their Total Assets
 Total Assets (Amounts in
Rank Name of Bank
Million Pesos)

1 BDO UNIBANK INC. 3,174,362.84

METROPOLITAN BANK
2 2,090,788.15
& TCO

LANDBANK OF THE
3 2,071,174.28
PHILIPPINES

BANK OF THE
4 1,900,052.58
PHILIPPINE ISLANDS

PHILIPPINE NATIONAL
5 1,080,529.59
BANK

6 CHINA BANKING CORP 895,473.66

7 SECURITY BANK CORP 779,203.61

DEVELOPMENT BANK
8 762,574.42
OF THE PHILIPPINES

RIZAL COMMERCIAL
9 708,896.5
BANKING CORP

UNION BANK OF THE

10 681,854.89
PHILIPPINES

EAST WEST BANKING

11 365,708.24
CORP

12 CITIBANK N.A. 364,176.47

UNITED COCONUT
13 328,520.92
PLANTERS BANK
 ASIA UNITED BANK
14 269,252.07
CORP

HONGKONG &
15 SHANGHAI BANKING 185,051.52
CORP

PHILIPPINE TRUST
16 159,812.55
COMPANY

17 BANK OF COMMERCE 150,392.77

ROBINSONS BANK
18 125,904.47
CORP

MAYBANK PHILIPPINES
19 109,452.09
INC.

PHILIPPINE BANK OF
20 103,193.43
COMMUNICATIONS

21 MUFG BANK LTD 87,752.45

MIZUHO BANK LTD -

22 75,736.98
MANILA BRANCH

STANDARD
23 65,591.59
CHARTERED BANK

PHILIPPINE VETERANS
24 65,245.43
BANK

CTBC BANK
25 55,690.26
(PHILIPPINES) CORP

JP MORGAN CHASE
26 46,078.25
BANK NATIONAL ASSN.
 AUSTRALIA AND NEW
27 ZEALND BANKING 45,215.54
GROUP LTD

28 DEUTSCHE BANK AG 42,881.32

BDO PRIVATE BANK

29 37,698.98
INC

SUMITOMO MITSUI
30 BANKING CORP - 36,854.52
MANILA BR

31 BANK OF AMERICA N.A. 24,726.43

32 ING BANK N.V. 22,968.64

MEGA INTERNATIONAL
33 COMMERCIAL BANK 17,527.7
CO LTD

KEB HANA BANK -

34 13,565.99
MANILA BR

BANGKOK BANK
35 10,058.88
PUBLIC CO LTD

INDUSTRIAL AND
COMMERCIAL BANK
36 8,854.09
OG CHINA LTD -
MANILA BR

INDUSTRIAL BANK OF
37 7,070.36
KOREA - MANILA BR
 CIMB BANK
39 5,385,78
PHILIPPINES INC

SHINHAN BANK -
40 5,246.77
MANILA BR

UNITED OVERSEAS
41 4,443.2
BANK LTD - MANILA BR

HUA NAN
42 COMMERCIAL BANK 4,093.22
LTD - MANILA BR

FIRST COMMERCIAL
43 3,535.99
BANK LTD - MANILA BR

AL-AMANAH ISLAMIC
44 INVESTMENT BANK 777.53
OF THE PHILS

Non-Banking Financial Institutions

• A non-bank financial institution (NBFI) is a financial institution that does not have a full
banking license and is therefore unable to take deposits from the general public. NBFIs do,
however, provide alternative financial services such as group and individual investing, risk
sharing, financial advice, brokering, money transfers, and check to cash. NBFIS, like
licensed banks, are a source of consumer credit. Insurance companies, venture capitalists,
currency exchanges, microfinance groups, and pawn shops are examples of non-bank
financial institutions. These non-bank financial institutions compete with banks by
providing services that are not always appropriate to banks.
• Risk Pooling Institutions
 ◦ Insurance companies offer financial protection against a variety of hazards, including
death, disease, property damage or loss, and other losses. In the case of a loss, they
provide a hypothetical assurance of financial protection. Insurance firms are divided
into two categories: Life Insurance and General Insurance. Short-term insurance is
common; however, life insurance is a longer-term contract that ends when the insured
passes away.
◦ Life and property insurance are both available to people from all walks of life.
Insurance businesses have a high level of information efficiency due to the nature of
the sector (companies must access a profusion of information to assess the risk in each
unique instance).
◦ Life insurance firms insure against the financial loss that might result from the
insured’s untimely death. Every term, the insured will pay a set amount as an insurance
premium. Because the likelihood of mortality rises with age but premiums remain
constant, the insured overpays in the early years and underpays later. The cash value of
the insurance policy is the overpayment in the early years of the agreement.
◦ Market and social insurance are the two main types of general insurance. The danger of
losing income due to unexpected unemployment, disability, disease, or natural
calamities is covered by social insurance. Due to the unpredictability of these risks, the
ease with which the insured can conceal relevant information from the insurer, and the
presence of a moral hazard, private insurance companies frequently do not provide
social insurance, a gap in the insurance industry that is usually filled by the
government. In industrialized Western nations, where family networks and other
organic social support groups are less common, social insurance is more common.
◦ Market insurance is privatized insurance for damage or loss of property. General
insurance companies take a single premium payment. In return, the companies will
make a specified payment contingent on the event that it is being insured against.
Examples include theft, fire, damage, natural disaster, etc.
• Contractual Savings Institutions
 ◦ Individuals can invest in collective investment vehicles in a fiduciary rather than
principal role through contractual savings institutions (also known as institutional
investors). Individuals and firms pool their resources to participate in a variety of
equities, debt, and derivatives promises through collective investment vehicles.
However, the individual owns stock in the CIV as a whole, not in the specific
investments made by the CIV. Mutual funds and private pension plans are the two most
common contractual savings institutions.
◦ The two main types of mutual funds are open-end and closed-end funds. Open-end
funds generate new investments by allowing the public to buy new shares at any time.
Shareholders can liquidate their shares by selling them back to the open-end fund at the
net asset value. Closed-end funds issue a fixed number of shares in an IPO. The
shareholders capitalize on the value of their assets by selling their shares in a stock
exchange.
◦ Mutual funds can be delineated along with the nature of their investments. For
example, some funds make high-risk, high-return investments, while others focus on
tax-exempt securities. Others specialize in speculative trading (Le., hedge funds), a
specific sector, or cross-border investments.
◦ Pension funds are mutual funds that limit the investor's ability to access their
investment until after a certain date. In return, pension funds are granted large tax
breaks to incentivize the working public to set aside a percentage of their current
income for a later date when they are no longer amongst the labor force (retirement
income).
• Other Non-Bank Financial Institutions
◦ Market makers are broker-dealer institutions that quote both a buy and sell price for an
asset held in inventory. Such assets include equities, government and corporate debt,
derivatives, and foreign currencies. Once an order is received, the market maker
immediately sells from its inventory or makes a purchase to offset inventory loss. The
difference in the buying and selling quotes, or the bid-offer spread, is how the market-
maker makes a profit. Market makers improve the liquidity of any asset in their
inventory.
 ◦ Specialized sectoral financiers provide a limited range of financial services to a targeted
sector. For example, leasing companies provide financing for equipment, while real
estate financiers channel capital to prospective homeowners. Leasing companies
generally have two unique advantages over other specialized sectoral financiers. They
are somewhat insulated against the risk of default because they own the leased
equipment as part of their collateral agreement. Additionally, leasing companies enjoy
preferential tax treatment on equipment investment.
◦ Other financial service providers include brokers (both securities and mortgage),
management consultants, and financial advisors. They operate on a fee-for-service
basis. For the most part, financial service providers improve informational efficiency
for the investor. However, in the brokers’ case, they do offer a transaction service by
which an investor can liquidate existing assets.
Role of NBFIs in the Financial System
• NBFIs supplement banks in providing financial services to individuals and firms. They can
provide competition for banks in the provision of these services. While banks may offer a
set of financial services as a package deal, NBFIs unbundle these services, tailoring their
services to particular groups. Additionally, individual NBFIs may specialize in a particular
sector, gaining an informational advantage. By this unbundling, targeting and specializing,
NBFIs promote competition within the financial services industry.
• Having a multi-faceted financial system, which includes non-bank financial institutions,
can protect economies from financial shocks and recover from those shocks. NBFIs
provide multiple alternatives to transform an economy’s savings into capital investment,
which act as backup facilities should the primary form of intermediation fail.

Lesson 4 - The Financial Markets

Financial Market
• A financial market is a group of people who are looking to purchase and sell securities,
commodities, and other financial instruments and transactions. Financial markets include
capital markets, derivative markets, money markets, and currency markets. General and
specialized markets, capital markets and money markets, and primary and secondary
markets are some of the many types of financial markets.
• The phrase "financial markets" is often used in the financial industry to refer primarily to
the markets that are utilized to raise funds:
◦ For long-term finances of which capital markets are utilized
 ◦ For short-term finance with maturity up to one year of which money markets are used.
• Stock and bond markets are two forms of capital markets that issue stock and bonds,
respectively, to provide finance. In the capital markets, the distinction between main and
secondary markets is crucial. Newly created or issued securities are purchased and sold in
primary markets, usually during initial public offerings. Secondary markets are used for
asset resale, arid they provide an endless and constant marketplace for buying and selling
securities.
• While capital and money markets are the tighter definitions of economic markets, other
markets are often included in the term's broader definition. The derivatives market is a
financial market for derivatives, which are financial products derived from other assets
such as futures contracts or options. Exchange or FX markets facilitate currency
transformation and determine the relative value of international currencies.
• Role of Financial Markets in Capital Distribution
◦ One of the most important purposes of financial markets is to distribute capital,
bringing together those who have money and those who don’t. Money markets enable
the transfer of liquidity by linking those who have capital with those who need it.
Capital markets facilitate the creation of capital in particular. From the start-up stage
through expansion and even later in the firms’ life, financial markets gather cash from
investors and distribute it to businesses that utilize it to support their operations and
accomplish development. Money markets allow businesses to borrow money for a short
period of time, whereas fund markets allow businesses to obtain long-term finance to
promote development.
◦ Money market funds are typically utilized for basic operational expenditures and to
cover short periods of illiquidity. When a company borrows from the main capital
markets, it intends to use the funds to purchase additional physical capital goods, which
will allow it to expand its revenue. Financial capital is the money that entrepreneurs
and businesses use to buy the materials and equipment they need to manufacture their
products or offer their services. The investment may take many months or years to
generate enough revenue to cover its costs, therefore the financing is long-term. Shared
capital, mortgage loans, venture capital, and other forms of long-term financing are
available.
 ◦ Borrowers would have struggled to locate loans if there were no financial markets. This
process is aided by capital intermediaries such as banks. Banks take deposits from
those who have extra cash to put away. Many people are unaware that they are
considered lenders when they put money in the bank in the form of a savings account
or contribute to a pension; nevertheless, many do lend money, at least indirectly, when
they put money in the bank in the form of a savings account or contribute to a pension.
Intermediaries, such as banks, can then lend money to people who want to borrow from
this pond of deposited money. Further complex transactions than a simple bank deposit
want markets where lenders and their agents can interact with borrowers and their
agents and where existing borrowing or lending commitments can be sold on to other
parties. A classic example is the stock exchange, where a corporation can raise money
by selling ownership shares to investors, and its existing shares can be bought or sold.
• Role of Financial Markets in Providing Feedback to Management
◦ Financial markets can provide assessment or feedback to management by presenting
signals of the demand to supply funds to that business. Management often has flawed
information about its own business, especially its business value in the outside world.
One way managers try to improve their business assessment is by conducting market
research to discover customer wants, needs, or beliefs. Once that research is finished, it
can be used to determine how to market specific products to a particular customer
group.
◦ Financial markets can also provide assessment, showing how potential shareholders
view one company’s financial value compared to its competitors. For example, the
investors holding shares in multiple companies in a sector may have more information
about the prospects in that sector than one firm’s manager in that sector. In economics
and contract theory, information asymmetry deals with the study of decisions in
transactions where one party has much or better information than the other party,
creating a disproportion of power. Financial economists have realized information
asymmetry in studies of differentially learned financial market participants like the
insiders, stock analysts, investors, and others.
 ◦ These various participants can provide management feedback such as when the stock
price is up or down. That being said, the stock market is an example of a system of
frequent fluctuation. It is directed by positive and negative feedback caused by the
cognitive and emotional factors among market participants. This possibly is the product
of fundamental data-based analysis or more sentiment-based analysis. This means that
the stock market’s feedback can differ in its usefulness for managers making short-term
and long-term decisions.
Trends in Markets
• A market trend is an assumed tendency of a financial market to vary in an exceedingly
particular direction over time. These trends are categorized as secular for long-term
frames, primary for medium-term frames, and secondary for short-term frames. Traders
determine market trends using technical analysis, a framework that illustrates market
trends as predictable price tendencies when the price reaches support and resistance levels,
changes over time.
• The terms securities industry and market describe rising and defining market trends,
respectively, and might be wont to describe either the market as full or particular sectors
and securities.
• Secular Market Trend
◦ A secular market trend may be a long-term trend that lasts 5 to 25 years and comprises
of a series of primary trends. A secular market is composed of smaller bull markets and
bigger bear markets, while a secular securities industry comprises larger bull markets
and smaller bear markets. In an exceedingly secular market, the dominant trend is
“bullish” or upward-moving. From roughly 1983 to 2000, the US securities market was
regarded as being in a fairly secular market, with minor upheavals such as the stock
market crash of 1987 and the dot-com meltdown of 2000 to 2002.
◦ The prevalent tendency in the secular securities sector is “bearish,” or downward-
moving. A slump in gold from January 1980 to June 1999, concluding with the Brown
Bottom, is an example of a secular securities sector. The nominal gold price fell from a
peak of $850/oz or $30/g to a low of $253/oz or $9/g during this time and became a
component of what is now known as the Great Commodities Depression.
• Primary Market Trend
◦ A primary trend has wide-ranging support throughout the entire market and lasts for a
year or more.
• Bull Market
 ◦ A bull market is related to improving investor confidence and improved investing in
anticipation of future price increases. A bullish trend in the stock market mostly begins
before the general economy shows clear and vibrant recovery signs.
• Bear Market
◦ A bear market is defined as a long-term decline or drop in the stock market. It's a shift
from high levels of investor confidence to widespread dread and despair. “While there
is no universally acknowledged definition of a bear market,” according to The
Vanguard Group, “one commonly accepted metric is a price fall of 20% or more over at
least a two-month period.”
• Market Top
◦ A market top or market high is frequently not a dramatic event. The market has
achieved the very best point that it will for a few times A decline then follows, often
gradually initially and later, with more rapid movement. William J. O'Neil and the
company stated that since the 1950s, a market top is characterized by 3 to 5 distribution
days in a very major market index occurring within a reasonably short period of time.
• Market Bottom
◦ A market bottom is a trend reversal. the end of a market downturn and leads to the
beginning of an upward moving trend, which calls a bull market. It is very challenging
to recognize a bottom while it is happening. The upward movement following a decline
is frequently short-lived, and prices may resume their decline. This can bring a loss for
the investor who purchases stocks during a misperceived or false market bottom.
Regulated Market
• A regulated market is one that is governed and controlled by government authorities or,
less frequently, industry or labor organizations. The government is typically in charge of
market regulation, which entails deciding who may enter the market and what rates they
can charge. In a market economy, the government's principal duty is to control and monitor
the financial and economic system. Regulation restrains the freedom of market participants
or grants them special privileges. Regulations consist of rules regarding how goods and
services can be promoted; what rights consumers have to request refunds or replacements;
safety standards for products, offices, food, and drugs; alleviation of environmental and
social impacts; and the level of control a given participant is permitted to assume over a
market.
 • Standardizing weights and measures, as well as imposing punishments for theft and fraud,
were essential market laws implemented by ancient civilizations. As a result, governments
have generally enforced rules, with a few exceptions: medieval guilds were trade groups
that rigorously controlled entry to certain professions and established requirements and
standards for performing such professions. Since the beginning of the twentieth century,
labor unions have typically had a more or less formal role in market regulation.
• Examples of regulatory bodies include the Food and Drug Administration, the Securities
and Exchange Commission, and the Environmental Protection Agency. These agencies
derive their authority and their basic frameworks for regulation from legislation enacted by
Congress. They are often charged with creating the rules and regulations they enforce,
based on the idea that Congress lacks the time, resources, or expertise to write regulations
for every agency. Supporters of a certain legislation or regulatory system, on the whole,
perceive the advantages to society. Controlling mining corporations’ capacity to damage
waterways, prohibiting landowners from discriminating based on race or religion, and
allowing credit card customers to contest charges are just a few examples.
• Regulations are not always useful, and their arguments are not always simply
humanitarian. Labor unions have fought for rules that provide their members exclusive
access to specific activities on occasion. Regulations, no matter how well-intentioned, can
have unintended consequences. Local-content rules are frequently imposed in order to
promote domestic businesses. For example, a government may mandate that automobiles
and gadgets sold in the nation have a specific percentage of locally made components.
These restrictions are not always successful in fostering local production; instead, they
frequently result in legal loopholes in which components are manufactured in fully staffed
factories overseas and assembled by a few people in-country or on the illicit market.
• Some proponents of free markets argue that any regulation beyond the most basic is
inefficient, expensive, and perhaps unjust. Some believe that even small minimum salaries
increase unemployment by erecting a barrier to entrance for low-skilled and inexperienced
workers. Advocates for the minimum wage cite past examples of extremely lucrative firms
paying employees rates that could not afford even a basic standard of life, arguing that
wage regulation will decrease exploitation of vulnerable people.
Securities
• A fungible, negotiable financial instrument that retains some sort of monetary value is
referred to as a "security." It can reflect stock ownership in a publicly listed firm or
corporation, a creditor connection with a governmental body or a corporation represented
by holding that entity's bond, or ownership rights represented by an option.
• Equity Securities
◦ The Food and Drug Administration, the Securities and Exchange Commission, and the
Environmental Protection Agency are examples of regulatory agencies. Legislation
adopted by Congress provides these agencies with their power and fundamental
regulatory frameworks. They are frequently tasked with writing the rules and
regulations that they enforce, based on the assumption that Congress lacks the time,
money, or ability to do so for each agency.
◦ Equity securities granted the holder some control of the company on a pro-rata basis
through voting rights. In the event of bankruptcy, they share only in residual interest
after all liabilities and obligations have been paid out to creditors. They are sometimes
offered as payment-in-kind.
◦ Equity securities play an important role in investment analysis and portfolio
management. This asset class’s significance continues to grow on a global scale due to
the need for equity capital in developed and emerging markets, technological
innovation, and the growing complexity of electronic information exchange. Given
their outright return potential and ability to impact portfolios’ risk and return
characteristics, equity securities are vital to both individual and institutional investors.
◦ This interpretation introduces equity securities and provides an overview of global
equity markets. A detailed analysis of their historical performance reveals that equity
securities have shown average real annual returns that have only kept pace with the
inflation. The different types and characteristics of common and preferred equity kept
ties are analyzed, and the primary differences between public and private equity
preferred are drawn. A description of the main forms of equity securities listed and
traded on worldwide markets, as well as their risk and return characteristics, is
presented. Finally, the function of equity securities in generating business value is
investigated, as well as the link between a company's cost of equity, accounting return
on equity, investors' needed rate of return, and intrinsic value.
• Debt Securities
◦ A debt security is a loan that must be paid back, with terms specifying the loan's size or
amount, interest rate, maturity, or renewal date.
 ◦ Debt securities, such as corporate and government bonds, certificate of deposit (CDs),
and collateralized securities such as CDOs and CMOs, typically entitle their holders to
regular interest and principal payment regardless of the issuer's performance, as well as
any other contractual rights not including voting rights.
◦ They are normally issued for a fixed term, which the issuer can redeem. Debt securities
can be secured or backed by collateral or unsecured. If it is unsecured, it may be
contractually prioritized over other unsecured, subordinated debt in the event of
bankruptcy.
◦ Debt securities are negotiable financial instruments; this represents their legal
ownership is readily transferrable from one owner to another. One of the most common
forms of specialized securities is bonds. They are agreements between a borrower and a
lender that require the borrower to pay an agreed-upon rate of interest on the principal
over a set period of time and then repay the principal at maturity.
◦ Governments and non-government organizations can both issue bonds. They are
available in a range of sizes and forms. Fixed-rate and zero-coupon bonds are both
typical structures. Floating-rate notes, preferred shares, and mortgage-backed securities
are examples of debt securities. In contrast, a bank loan is a non-negotiable financial
instrument.
• Main Features of Debt Securities
◦ Issue Date and Issue Price
▪ Debt securities will always have an issue date and a price at which investors can
purchase them when they are initially released.
◦ Coupon Rate
▪ In addition, issuers must pay an interest rate, known as the coupon rate. The coupon
rate may be set for the duration of the security’s life, or it may change in response to
inflation and economic conditions.
◦ Maturity Date
▪ The issuer must return the principal at face value and any leftover interest on the
maturity date. The term that categorizes debt instruments is determined by the
maturity date.
▪ Short-term securities have a one-year maturity, medium-term securities have a one-
to- three-year maturity, and long-term securities have a three-year or longer
maturity. Investors want larger returns for longer investments; therefore the length
of the period will influence the price and interest rate offered to them.
 ◦ Yield-to-Maturity (YTM)
▪ Lastly, yield-to-maturity (YTM) measures the annual rate of return an investor is
expected to earn if the debt is held to maturity. It is used to compare securities with
similar maturity dates and considers the bond’s coupon payments, purchasing price,
and face value.
• Advantages of Debt Securities
◦ Return on Capital
▪ There are many benefits in selecting debt securities as a form of investment.
Initially, investors acquire debt securities to earn a return on their capital. Debt
securities, such as bonds, are intended to reward investors with interest and the
repayment of capital at maturity. The repayment of capital depends on the issuer’s
ability to fulfill their promises; failure to do so will lead to the issuer’s
consequences.
◦ Regular Stream of Income from Interest Payments
▪ Interest payments related to debt securities also give investors a regular income
stream throughout the year. They are certain, promised payments, and guaranteed at
which can assist with the investor’s cash flow needs.
◦ Means for Diversification
▪ Depending on the investor’s strategy, debt securities can also serve to diversify their
portfolio. In difference to high-risk equity, investors can use such financial
instruments to manage their portfolio risk. They can also work around the maturity
dates of multiple debt securities ranging from short-term to long-term. It enables
investors to tailor their portfolios to meet future needs.
• Hybrid Securities
◦ Hybrid securities are the combination of some of the characteristics of both debt and
equity securities. Examples of hybrid securities consist of equity warrants. It is the
options issued by the company itself that gives shareholders the right to purchase stock
within a certain period and at a specific price, convertible bonds, which are bonds that
can be converted into shares of common stock in the issuing company, and preference
shares that is company stocks whose payments of interest dividends, or other yields of
capital can be readied first over those of other stockholders.
• Trading of Securities
 ◦ Securities that are publicly traded are listed on stock exchanges, where issuers can
search for security listings and attract investors by ensuring a liquid and regulated
market. Securities are now typically traded over-the-counter (OTC) or directly among
investors online or over the phone, thanks to the rise of informal electronic trading
platforms in recent years.
◦ An initial public offering (IPO) represents a company’s first major issue of equity
securities to the public. After an IPO, any newly issued stock is called a secondary
offering while still sold in the primary market. Otherwise, securities may be offered
privately to a restricted and qualified group in what is known as a private placement, an
important distinction in terms of both company law and securities regulation. In some
cases, companies sell stock in a combination of a public and private placement.
◦ Securities are simply converted as assets from one investor to another in the secondary
market often known as the aftermarket. Shareholders can sell their assets for cash or a
profit to other investors. As a result, the secondary market supplements the primary
market. Because privately placed assets are not publicly traded and may only be
transferred among approved investors, the secondary market for them is less liquid.
• Investing in Securities
◦ The entity that makes the securities for sale is known as the issuer, and those who
purchase them are investors. Normally, securities represent an investment and a means
by which cities, companies, and other commercial businesses can raise fresh capital.
Businesses can raise a lot of funds when they go public, selling stock in an initial public
offering (IPO), for example.
◦ A city, state, or provincial government can raise funds for a particular project by
floating a municipal bond issue. Varying on an institution's market demand or pricing
structure, raising capital through securities can be a preferred substitute for financing
through a bank loan.
◦ On the other hand, acquiring securities with borrowed money, an act known as buying
on a margin is a trending investment technique. In essence, a company may deliver
property rights, in the form of cash or other securities, either at initiation or in default,
to pay its debt or other obligation to another entity. These collateral arrangements have
been growing of late, especially among institutional investors.
Derivatives
• Derivatives are financial contracts whose value is connected to the value of an underlying
asset. They are complex financial instruments that are used for different purposes: this
includes hedging and getting access to additional assets or markets.
• Derivatives aren’t new in the financial world. The first futures contracts, for example. may
be dated back to Mesopotamia in the second millennium BC. The financial instrument,
however, was not widely utilized until the 1970s. The advent of new valuation
methodologies sparked the derivatives market's rapid growth. We can no longer envision
modern finance without derivatives.

• Types of Derivatives
◦ Forwards and Futures
▪ These are financial contracts that oblige contract purchasers to acquire an asset at a
pre- determined price on a pre-determined date in the future. The essence of both
forwards and futures is basically the same. Forwards, on the other hand, are more
flexible contracts since the parties can change the underlying commodity, the
quantity of the commodity, and the transaction date. Futures, on the other hand, are
standardized contracts exchanged on exchanges.
◦ Options
▪ Options provide the buyer of the contracts with the right, but not the obligation, to
purchase or sell the underlying asset at a predetermined price. Based on the option
type, the buyer can exercise the option on the maturity date (European options) or
on any date before maturity (American options).
◦ Swaps
▪ Swaps are derivative contracts that allow the exchange of cash flows between two
parties. The swaps usually involve the exchange of a fixed cash flow for a floating
cash flow. The most popular types of swaps are interest rate swaps, commodity
swaps, and currency swaps.
• Benefits of Derivatives
◦ Hedging Risk Exposure
▪ Since the derivatives’ value is linked to the underlying asset’s value, the contracts
are primarily used for hedging risks. For example, an investor may purchase a
derivative contract whose value moves in the opposite direction to the value of an
asset the investor owns. In this way, profits in the derivative contract may offset
losses in the underlying asset.
 ◦ Underlying Asset Price Determination
▪ Derivatives are frequently used to determine the price of the underlying asset. For
example, the spot prices of the futures can serve as an approximation of a
commodity price.
◦ Market Efficiency
▪ It is considered that derivatives increase the efficiency of financial markets. By
using derivative contracts, one can replicate the payoff of the assets. Therefore, the
underlying asset prices and the associated derivative tend to be in equilibrium to
avoid arbitrage opportunities.
◦ Access to Unavailable Assets Markets
▪ Derivatives can help organizations access otherwise unavailable assets or markets.
By employing interest rate swaps, a company may obtain a more favorable interest
rate relative to the interest rates available from direct borrowing.
• Drawbacks of Derivatives
◦ Despite the benefits that derivatives offer to the financial markets, they also have some
major disadvantages. During the financial crisis of 2007-2008, the flaws had
devastating repercussions. Financial institutions and securities all around the globe
have collapsed due to the fast devaluation of mortgage-backed securities and credit-
default swaps.
◦ High Risk
▪ The high volatility of derivatives exposes them to potentially huge losses. The
sophisticated design of the contracts makes the valuation extremely complicated or
even impossible. Thus, they bear a high inherent risk.
◦ Speculative Features
▪ Derivatives are widely regarded as a tool of speculation. Due to the extremely risky
nature of derivatives and their unpredictable behavior, unreasonable speculation
may lead to huge losses.
◦ Counter-party Risk
▪ Although derivatives traded on the exchanges generally go through a thorough due
diligence process, some of the contracts traded over-the- counter do not include a
benchmark for due diligence. Thus, there is a possibility of counter-party default.

Lesson 5 - The Money Markets

Money Market
• The money market is a well-organized exchange market where people may lend and
borrow short-term, high-quality debt instruments with a one-year or shorter maturity. It
enables governments, banks, and other big organizations to sell short-term securities to
meet their immediate financial needs. Individual investors can also use money markets to
invest modest sums of money in a low-risk environment. Treasury bills, certificates of
deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-
backed securities and asset- backed securities are among the products traded in the money
market.
• Large corporations and enterprises with short-term cash flow needs can borrow directly
from the market through their dealer, while small firms with excess cash can borrow
through money market mutual funds. Individual investors can invest in a money market
bank account or a money market mutual fund to profit from the money market. A money
market mutual fund is an expertly managed investment vehicle that acquires money market
assets on behalf of individual investors.
• The money market is a sector of the financial market where high-liquidity financial
products with short maturities are exchanged. The money market has evolved into an
important part of the financial market for buying and selling short-term assets such as
Treasury bills and commercial papers with maturities of one year or less. Over-the-counter
trading is a wholesale procedure that takes place in the money market. It is used by the
participants as a short-term borrowing and lending mechanism.
• Money market is considered a secured market to invest in due to the high liquidity features
of securities. The risks are still present in which investors should be aware of the securities
on default such as commercial papers. The likes of financial institutions and dealers seek to
borrow or loan securities comprising the money market and it is one of their best sources
to invest in liquid assets.
• The money market is not structured like the capital markets, where securities are arranged
formally. It is a free and informal market. The money market gives a lower return to
investors, but it does provide a wide range of goods. Because of its liquidity, the money
market makes it easy to withdraw money. Money markets are also distinct from capital
markets in that they are designed for short-term securities, whereas capital markets are
utilized for long-term financing.
• A mortgage lender can make protection against the risk by entering into an agreement with
an agency or private conduit for operational, rather than mandatory, delivery of the
mortgage. For such kind of agreement, the mortgage originator effectively buys an option,
which gives the lender the right but not the obligation, to deliver the mortgage. Against
that, the private conduit charges a fee for allowing optional delivery. The money market is
one of the important components of the global financial system.
• Most money market transactions are wholesale transactions that happen between financial
institutions and companies. Commercial paper is a popular borrowing mechanism in the
wholesale market because the interest rates are relatively higher than for bank time
deposits or Treasury bills and have a wider range of maturities available, from overnight to
270 days.
• The need for money markets arises because individuals, corporations, and governments’
immediate cash needs do not essentially coincide with their receipts of cash. For example,
corporations’ daily receipts do not necessarily follow the same pattern as their daily
expenses like wages and other disbursements. Because excessive holdings of cash balances
involve a cost in the form of foregone interest, which is called opportunity cost, those
economic units with surplus cash usually keep such balances to the minimum required to
meet their daily transaction requirements.
• Therefore, holders of cash invest excess cash funds in financial securities that can be
quickly and relatively costless converted back to cash when needed with minimal risk of
loss of value over the short investment period. Money markets are highly efficient in
performing this service. They allow large amounts of capital to be transferred from
suppliers of funds to users of funds for short periods of time, both quickly and at a low cost
to the transacting parties. A money market instrument provides an investment opportunity
that offers a higher rate of interest or return than holding cash which yields zero interest,
but it is also very liquid and due to its short maturity, has relatively low default risk.
• It is important to note that money markets and money market securities or instruments
have three basic characteristics. First, money market instruments are mostly sold in large
denominations (often in units of $1 million to $10 million). The majority of the money
market participants resort to borrowing large amounts of cash to have a low transaction
cost and interest paid. The volume of these initial transactions disallows most individual
investors from investing directly in money market securities. Individuals usually invest in
money market securities indirectly through financial institutions such as money market
mutual funds or short-term funds.
• Second, money market instruments have low default risk. The risk of late or non-payment
of principal and/or interest is generally small since cash borrowed in the money markets
must be available for a faster return to the lender; money market instruments can generally
be issued only by high-quality borrowers with little risk of default.
• Lastly, money market securities must have an original maturity of one year or less. The
longer the maturity of the debt security, the greater its interest rate risk, and the higher is its
required rate of return. Provided that adverse price movements resulting from interest rate
changes are smaller for short-term securities, the short-term maturity of money market
instruments helps reduce the risk that interest rate changes will significantly influence the
security's market value and price.
• Functions of the Money Market
◦ The money market contributes to economic stability and development by providing
short- term liquidity to governments, commercial banks, arid other large businesses.
Here are the main functions of the money market.
▪ Financing Trade
• Local and international merchants in need of short-term capital might turn to the
money market for assistance. It gives the ability to discount bills of exchange,
allowing for quick payment of goods and services. Acceptance houses and
discount markets were used by international dealers. Other economic units, such
as agriculture and small-scale businesses, can also benefit from the money
market.
▪ Central Bank Policies
• The central bank is responsible for a country's monetary policy and allowing
measures in order to keep the financial system healthy and active. Using the
money market, the central bank can efficiently carry out its policy-making
duties.
• The short-term interest rates on the money market reflect the current state of the
banking industry and can help the central bank create an appropriate interest rate
policy. Similarly, interconnected money markets assist the central bank in
influencing sub-markets and achieving its monetary policy goals.
▪ Growth of Industries
 • The money market makes it simple for businesses to get short-term loans to
meet their working capital requirements. Businesses may face cash shortages
while purchasing raw supplies, paying workers, or meeting other short-term
expenditures due to the high frequency of transactions.
• They may readily lend money on a short-term basis using commercial paper and
finance bills. Although money markets do not provide long-term loans, they can
have an impact on the capital market and assist businesses in obtaining long-
term funding. The money market's interest rate serves as a benchmark for the
capital market’s interest rates.
▪ Commercial Banks Self-Sufficiency
• The money market provides a ready market for commercial banks to invest their
excess reserves and earn interest while maintaining liquidity. Bills of exchange
and other short-term investments can be readily converted to cash to enable
client withdrawals.
• Similarly, when faced with liquidity issues, they might borrow on the money
market for a limited period of time rather than borrowing from the central bank.
This has the advantage of allowing the money market to charge cheaper interest
rates on short-term loans than the central bank.
Money Market Instruments
• Several financial instruments are created for short-term lending and borrowing in the
money market; they include:
◦ Treasury Bills
▪ Treasury notes are the most secure instruments since they are issued with a
complete guarantee from the US government. The US Treasury issues them on a
regular basis to refinance maturing Treasury notes and finance the federal
government’s deficits. They are available in one-, three-, six-, or twelve-month
maturities.
▪ Treasury bills are offered at a discount to their face value, and the interest rate is the
difference between the reduced purchase price and the face value. Banks, broker-
dealers, private investors, pension funds, insurance firms, and other major
businesses all acquire them.
◦ Certificate of Deposit (CD)
 ▪ A commercial bank issues a certificate of deposit (CD), which may be acquired
through brokerage companies. It can be issued in any denomination and has a
maturity date ranging from three months to five years. Most CDs have a set
maturity date and interest rate, and withdrawals before the maturity date will result
in a penalty. A certificate of deposit, like a bank checking account, is covered by the
Federal Deposit Insurance Corporation (FDIC).
◦ Commercial Paper
▪ Commercial paper is an unsecured loan provided by major firms or corporations to
cover short-term cash flow demands such as inventory and accounts payable, as
well as working capital. It is sold at a discount with the investor profiting from the
difference between the commercial paper's price and face value.
▪ Commercial paper may only be issued by organizations with a high credit rating,
making it a secure investment. Commercial paper is issued in $100,000 and higher
denominations. Individual investors can indirectly participate in the commercial
paper market by purchasing money market funds. Commercial paper has a maturity
period ranging from one to nine months.
◦ Banker's Acceptance
▪ A banker’s acceptance is a form of short-term debt issued by a company but
guaranteed by a bank. It is generated by a drawer, providing the bearer the rights to
the money specified on its face at a specified date. It is mostly used in international
trade because of the benefits to both the drawer and the bearer. The holder of the
acceptance may choose to sell it on a secondary market, and investors can profit
from the short-term investment. The maturity date usually lies between one month
and six months from the issuing date.
◦ Repurchase Agreements
▪ A repurchase agreement (repo) is a short-term loan that allows you to sell a security
in exchange for the right to buy it back at a better price at a later date. It is widely
used by government securities dealers who sell Treasury bills to a lender and then
promise to repurchase them at a later date at a predetermined price. The Federal
Reserve buys repurchase agreements to keep the money supply and bank reserves in
check. The maturity dates of the agreements range from overnight to 30 days or
more.
◦ Money Market Funds
 ▪ The wholesale money market is restricted to companies and financial institutions
that offer and borrow in amounts ranging from $5 million to well over $1 billion per
transaction. Mutual funds offer baskets of these products to individual investors.
This type of fund's net asset value (NAV) is expected to remain constant at $1.
During the 2008 financial crisis, one fund falling below that level sparked fear in
the markets and a huge exodus from the funds, resulting in further limitations on
their access to increasingly riskier investments.
◦ Money Market Accounts
▪ A sort of savings account, money market accounts are a type of savings account.
They offer interest, but some issuers limit account users’ ability to make
unscheduled withdrawals or write checks against the account. The interest on a
money market account is usually calculated daily and credited to the account once a
month.
▪ Money market accounts, on average, provide somewhat greater interest rates than
traditional savings accounts. Since the financial crisis of 2008, the rate differential
between savings and money market accounts has decreased considerably. Money
market account’s average interest rates vary depending on the amount deposited.
The best-paying money market account with no minimum deposit earned 0.99
percent yearly interest as of August 2020.
◦ Eurodollars
▪ Eurodollars are dollar-denominated deposits held in foreign banks and are not
subject to Federal Reserve regulations. Very large deposits of Eurodollars are held
in banks in the Cayman Islands and the Bahamas. Money market funds, foreign
banks, and large businesses invest in them because they pay a slightly higher
interest rate than U.S. government debt.
Determinants of Interest Rate
• The cost of borrowing money is represented by the interest rate. To put it another way,
there's a trade-off between the service's value and the danger of lending money. In both
situations, it boosts the economy by encouraging individuals to borrow, lend, and spend.
The present interest rate, on the other hand, is always changing and different types of loans
have varying interest rates. Whether you’re a lender, a borrower, or both, it’s critical that
you understand why these variations and changes exist. They have a significant influence
on the stock markets for rare metals and silver.
• The practice of charging interest on money loans has not always been considered
appropriate. Both the Bible and Sharia law expressly forbid "Usury,“ and current Islamic
banks exist only for the purpose of profit.
• The distinctions between interest, rent, profit and capital appreciation in modern financial
markets are not obvious. The present trend and fascinating suggestion on interest taxes in
the European Union has highlighted the difficulties of arriving at legally exact definitions.
Interest is the cost of persuading individuals with money to save rather than spend it and to
invest in long-term assets rather than cash, according to economic theory. The Rates are a
reflection of the relationship between the supply of savings and demand for the fund, or the
demand for and supply of money.
• Interest rates are expressed as a percentage payable or a coupon; commonly, they are
expressed yearly; or as the present discounted value of an amount payable at a future date,
usually the maturity date. There is an inverse connection between the current interest rate
and the discounted value of assets paying interest at any given period. Bond prices, for
example, decline when yields rise.
• The distinction between "nominal" and "real" interest rates must be understood. The
nominal or "coupon" rate is subtracted from the rate at which money depreciates in value
to get a real interest rate. Because there are so many different ways to calculate inflation
rates, computing actual rates is a methodological challenge.
• Inflationary expectations, however, are one of the most vital determinants of interest rates.
Generally, investors demand a real return from their investments. Changes in the forecasts
of future inflation are therefore reflected in the current prices of assets. The effect on bonds
of varying maturity, for example, can be charted as shifts in the “yield curve.”
• Different levels of risk are also reflected in interest rates. A company with a good credit
rating, such as the European Investment Bank, will be able to draw savings at a
considerably lower rate of interest than “junk bond” issuers. Those with a high amount of
existing debt may have to pay higher borrowing rates than countries with a low risk of
default. Certainly, the assurance that “sovereign debt” will be repaid on maturity has
allowed governments to borrow at negative real rates of interest on a number of occasions.
• Short-Term Rates
◦ The rates established by Central Banks have a significant impact on money market
“overnight” (up to a week) and “short-term” (up to a year) interest rates. The European
System of Central Banks (ESCB) can utilize its monopoly cash supply authority to
establish a “floor” and “limit” for overnight and short rates (the Deposit Rate and the
Marginal Lending Rate), as well as a benchmark central rate, throughout the euro
region (the Marginal Refinancing Rate or "repo" rate).
◦ Short-term rates will be set by central banks with primary responsibility for price
stability, such as the European Central Bank (ECB), in order to avoid future inflation.
Higher current rates should encourage consumers to save rather than spend, as well as
firms to postpone capital expenditure. “Neutral” interest rates will be just high enough
to keep future inflation at bay, but not so high as to stifle economic development and
lead to job losses.
◦ There are of number of problems in implementing this theoretical model, however,
such as:
▪ Political support for the goal of price stability isn’t assured. Maintaining full
employment for example, might be an alternate goal, with interest rates kept low to
encourage investment. Alternatively, nominal rates may only be modified to keep
real rates at a certain level.
▪ Determining what “neutral” rates are at any one time is difficult if not impossible.
Using data of different precision to estimate inflationary risk is a question of
judgment. The ECB uses a “twin pillar” approach, with a 4.5 percent reference level
for annualized growth in the monetary aggregate M3 and a “broadly based
assessment of the outlook for price developments” based on a variety of other
indicators such as bond yields, consumer credit and the exchange rate, among
others.
▪ The transmission mechanisms through which Central Bank interest rates flow into
market rates are unknown. Disparities in corporate financing sources, the quantity
and structure of business and household debt, and the degree of competition in the
financial services industry cause differences between national economies and
regions. Because financial systems are now in flux as a result of monetary
unification, nothing can be learned from previous experience (the Lucas critique).
 ▪ International financial markets are increasingly influencing national economies.
Short-term capital can migrate quickly across currency regions in pursuit of greater
returns, causing domestic monetary policy to be disrupted. This can lead to conflicts
like the one that the United Kingdom encountered in September 1992, when higher
interest rates were needed to avoid a devaluation of the pound sterling and maintain
it within the European Monetary System’s Exchange Rate Mechanism lower rates to
avoid a recession. In comparison to the individual Member States' currency regions,
the euro area has a lower share of GDP that is exchanged, which has decreased, but
not eliminated, such vulnerability.
• Long-Term Rates
◦ Global financial markets’ presence ensures that real long-term interest rates tend to
move together in various economies. However, nominal long-term rates reflect
inflationary expectations in the separate economies, which in turn reflect the credibility
of domestic monetary policy. Connected to inflationary expectations are exchange-rate
expectations; however, exchange-rate movements can also take place for reasons
unconnected to inflation differentials. Economic theory in this area has a bad record of
the forecast.
◦ The outcome of short-term interest rate changes on long-term rates is not, therefore,
straightforward. An increase in short-term rates can lead to, or be contemporary with, a
rise in long rates and a fall if the markets are influenced that future inflation has been
prevented.
◦ National fiscal policies have also played a major part in determining long-term interest
rates. Where budget shortages and/or the total government debt level have been high,
the need to borrow for current spending and refinance maturing debt has forced up
long-term rates. The path of “monetization” like the printing of money to meet current
budget deficits, allowing inflation to reduce the real value of existing debt, has led to
borrowing at ever-higher rates of interest, and ever-shorter maturities, with default at
the end. For this motive, the Maastricht Treaty clauses, strengthened by the Stability
and Growth Pact, demand balanced budgets throughout the economic cycle and
outright ban monetization, preferential access to funds, and “bail-out” of failing public
entities. All euro zone members are committed to bringing their total public debt down
to 60% of GDP or less.
 ◦ The extent to which interest rate fluctuations impact the actual economy, including
investment, GDP, employment, and other factors, is also unclear. An increase in rates,
in general, has a negative effect on future GDP, and a fall in rates a positive one. But
the effects in detail rely on the structure of a particular economy and the components of
demand within it. The latest Japanese experience shows that very low rates of interest,
on their own, are not enough to revive a lagging economy.
◦ The interest rates observed in financial markets are known as nominal interest rates.
These nominal interest rates, or simply interest rates, have a direct impact on the value
(price) of most assets traded in the domestic and international money and capital
markets.
Loanable Funds Theory
• Interest rates play a vital role in the determination of the value of financial instruments. For
example, when the Fed suddenly raised interest rates in February 2010, financial markets
reacted significantly. The Dow Jones Industrial Average, which had previously posted
three consecutive days of gains in value, dropped 0.9 percent in value, the yield on
Treasury securities increased, which is the yield on two-year T-notes improved from 0.88
percent to 0.92 percent, gold prices dropped $11 to $1,112.70, and the U.S. dollar
weakened against foreign currencies (the dollar fell from $1.3613/€ to $1.3518/€).
• Given the effect a change in interest rates has on security values, financial institutions and
other financial managers spend much time and effort trying to identify factors that dictate
the level of interest rates at any moment in time and what causes interest rate movements
over time.
• One commonly used model to explain interest rates and interest rate movements is the
Loanable Funds Theory. The loanable funds theory of interest rate determination views the
level of interest rates in financial markets as resulting from factors that affect the supply,
for example, from households, and demand, for example, from corporations for loanable
funds. This is similar to how the prices for goods and services, in general, are viewed as
the result of the forces of supply and demand for those goods and services. The supply of
loanable funds is commonly used to describe funds provided to the financial markets by
net suppliers. The demand for loanable funds is used to describe the total net demand for
fund users' funds.
• The loanable funds framework categorizes financial market participants, suppliers, and
demanders of funds as consumers, businesses, governments, and foreign participants. The
loanable funds theory is a theory of interest rate determination that views equilibrium
interest rates in financial markets as a result of the supply and demand for loanable funds.
• Supply of Loanable Fund
◦ Generally, the quantity of loanable funds supplied increases as interest rates rise. Figure
below illustrates the supply curve for loanable funds. Other factors are held constant;
more funds are supplied as interest rates increase (the reward for supplying funds is
higher).
◦ The household sector, also known as the consumer sector, is the biggest supplier of
loanable funds in the United States $45.54 trillion in 2010. Households supply funds
when they have surplus income or want to transfer their asset portfolio holdings. For
instance, during high economic growth times, households may substitute part of their
cash holdings with earning assets, for example, by providing loanable funds in
exchange for holding securities. The entire quantity of loanable money from a customer
will typically rise as that consumer’s total wealth increases. Households select their
supply of loanable money based on the risk of securities investments as well as the
general level of interest rates and their total wealth.
◦ At each interest rate, fewer consumers are ready to invest because of the perceived risk
of securities investments. Furthermore, the availability of loanable cash from families is
influenced by their immediate spending demands. For example, near-term schooling or
medical expenses will deplete a household’s financial resources.
• Higher interest rates will also result in more funds being supplied by the US business
sector ($17.71 trillion from nonfinancial businesses and $43.34 trillion from financial
businesses in 2010), which frequently has excess cash or working capital that it can
invest in financial assets for a short period of time. Aside from interest rates, the
projected risk on financial assets and their enterprises' future investment needs will
have an impact on their overall availability of money.
• Some governments also provide loanable money ($18.62 trillion in 2010). Some
governments (for example. municipalities) may temporarily produce more revenue
inflows (for example, from local taxes) than they have budgeted to spend. These funds
can be lent to users of financial market funds until they are needed.
• Finally, international investors increasingly see U.S. financial markets as a substitute
for their local financial markets, with $15.63 trillion in money flowing into them in
2010. Foreign investors boost their supply of money to U.S. markets when interest rates
on U.S. financial assets are greater than equivalent securities in their home nations.
Indeed, foreign households' high savings rates (such as Japanese households) have
resulted in foreign market participants being major suppliers of funds to US. financial
markets in recent years. Like domestic suppliers of loanable funds, foreigners assess
the interest rate offered on financial securities and their total wealth, the risk on the
security, and their future expenditure needs.
• Furthermore, if financial conditions in their home countries change in relation to the
US economy and the exchange rate of their country’s currency changes against the US
dollar, international investors adjust their investment selections. During the current
financial crisis, for example, investors all over the world sought a safe refuge for their
money and poured billions of dollars into U.S. Treasury securities. The quantity of
money invested in Treasury notes was so great that the three-month Treasury bill yield
fell below zero for the first time ever, implying that investors were effectively paying
the US government to borrow money.
• Demand for Loanable Funds
◦ In general, the quantity of loanable funds demanded is higher as interest rates decrease.
The figure above also illustrates the demand curve for loanable funds. Other factors are
held constant: more funds are demanded as interest rates fall (the cost of borrowing
funds is lower). Households (though they are net suppliers of funds) also lend funds in
financial markets ($20.50 trillion in 2010). The demand for loanable funds by
households reflects the demand for financing purchases of homes (with mortgage
loans), durable goods (e.g., car loans, appliance loans), and nondurable goods (e.g.,
education loans, medical loans). Additional non-price conditions and requirements also
affect a household’s demand for loanable funds at every level of interest rates.
◦ Businesses typically issue debt and other financial instruments to finance long-term
(fixed) assets (e.g., plant and equipment) as well as short-term working capital needs
(e.g., inventory and accounts receivable) ($41.71 trillion for nonfinancial businesses
and $60.10 trillion for financial businesses in 2010). Businesses prefer to finance
investments using internally produced money (e.g., retained earnings) rather than
borrowed funds when interest rates are high (i.e., the cost of loanable funds is high).
 ◦ Furthermore, the higher the demand for loanable money, the bigger the quantity of
profitable projects accessible to firms or the better the general economic conditions.
Governments also take out a lot of loans in the market ($12.07 trillion in 2010). State
and municipal governments, for example, frequently issue debt instruments to cover
short-term gaps between operational income (e.g., taxes) and projected expenditures
(e.g., road improvements, school construction). Higher interest rates may force state
and municipal governments to delay borrowing and, as a result, capital spending,
Governments’ demand for cash fluctuates with overall economic conditions, much like
families and companies. The federal government is also a significant borrower, partially
to cover current budget deficits (expenditures exceeding revenues) and partly to cover
historical deficits. The national debt is the total of historical deficits, which in the
United States reached a new high of $14.34 trillion in 2011.
◦ Thus, the national debt and the interest payments on the national debt have to be
financed largely by additional government borrowing. Chapter 4 provides details of
how government borrowing and spending impact interest rates as well as overall
economic growth.
◦ Finally, international players (households, corporations, and governments) borrowed
$6.46 trillion in 2010 in US financial markets. Foreign borrowers search the world for
the lowest dollar funds. The business sector accounts for the majority of foreign
borrowing in US financial markets. Foreign borrowers evaluate non-price terms on
loanable money, as well as economic conditions in their home nation and the dollar's
general desirability relative to their native currency, in addition to interest charges (e.g.,
the euro or the yen).
Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift
• While we’ve hinted at the underlying causes that drive the supply and demand curves for
loanable money to fluctuate, this section officially summarizes them. The equilibrium
interest rate of a given financial instrument is then determined by variations in the supply
and demand curves for loanable funds. When the quantity of financial security provided or
desired varies at each given interest rate in reaction to a change in another element other
than the interest rate, this is known as a shift in the supply or demand curve. In either
scenario, a shift in the supply or demand curve for loanable funds causes interest rates to
shift.

• Supply of Funds
◦ We have already described the positive relationship between interest rates and loanable
funds' supply along the loanable funds supply curve. Factors that cause the supply
curve of loanable funds to shift at any given interest rate include the wealth of fund
suppliers, the risk of financial security, future spending needs, monetary policy
objectives, and economic conditions.
▪ Wealth
• As the total wealth of financial market participants (households, businesses, etc.)
increases, the absolute dollar value available for investment purposes increases.
Accordingly, the supply of loanable funds increases at every interest rate, or the
supply curve shifts down and to the right. For example, as the US. economy
grew in the mid-2000s, the total wealth of U.S. investors increased as well. On
the other hand, as the total wealth of financial market participants declines, the
absolute dollar value available for investment purposes declines. Therefore, the
supply of loanable funds drops at every interest rate, or the supply curve shifts
up and to the left. The fall in the supply of funds due to a decline in market
participants' total wealth results in the rise in the equilibrium interest rate and a
fall in the equilibrium quantity of funds loaned (traded).
▪ Risk
• As the risk of a financial security decreases (e.g., the probability that the issuer
of the security will default on promised repayments of the funds borrowed), it
becomes more attractive to suppliers of funds. Conversely, as the risk of
financial security increases, it becomes less attractive to suppliers of funds.
Accordingly, the supply of loanable funds declines at every interest rate, or the
supply curve shifts up and to the left. Holding all other factors constant, the
decrease in the supply of funds due to an increase in the financial security’s risk
increases the equilibrium interest rate and a fall in the equilibrium quantity of
funds loaned (or traded).
▪ Near-Term Spending Needs
 • When financial market participants have few near-term spending needs, the
absolute dollar value of funds available to invest increases. For example, when a
family's son or daughter moves out of the family home to live on his or her own,
the family’s current spending needs decrease, and the supply of available funds
(for investing) increases. The supply of loanable funds increases at every interest
rate, or the supply curve shifts down and to the right. The financial market,
holding all other factors constant, reacts to this increased supply of funds by
decreasing the equilibrium interest rate and increasing the equilibrium quantity
of funds traded. Conversely, when financial market participants have increased
near-term spending needs, the absolute dollar value of funds available to invest
decreases. The supply of loanable funds decreases at every interest rate, or the
supply curve shifts up and to the left. The supply curve shift creates a
disequilibrium in the financial market that increases the equilibrium interest rate
and decreases the equilibrium quantity of funds loaned (or traded).
▪ Monetary Expansion
• When monetary policy objectives are to allow the economy to expand (as was
the case in the late 2000s, during the financial crisis), the Federal Reserve
increases the supply of funds available in the financial markets. At every interest
rate, the supply of loanable funds increases, the supply curve shifts down and to
the right, and the equilibrium interest rate falls, while the equilibrium quantity of
funds traded increases. Conversely, when monetary policy objectives are to
restrict the rate of economic expansion (and thus inflation), the Federal Reserve
decreases the supply of funds available in the financial markets. At every interest
rate, the supply of loanable funds decreases, the supply curve shifts up and to the
left, and the equilibrium interest rates rises, while the equilibrium quantity of
funds loaned or traded decreases.
▪ Economic Conditions
 • Finally, as the underlying economic conditions themselves (e.g., the inflation
rate, unemployment rate, economic growth) improve in a country relative to
other countries, the flow of funds to that country increases. This reflects the
lower risk (country or sovereign risk) that the country, in the guise of its
government, will default on its obligation to repay funds borrowed. For example,
the severe economic crisis in Argentina in the early 2000s resulted in a decrease
in the country's supply of funds. An increased inflow of foreign funds to US
financial markets increases the supply of loanable funds at every interest rate,
and the supply curve shifts down and to the right. Accordingly, the equilibrium
interest rate falls, and the equilibrium quantity of funds loaned or traded
increases. Conversely, when foreign countries' economic conditions improve,
domestic and foreign investors take their funds out of domestic financial markets
(e.g., the United States) and invest abroad. Thus, the supply of funds available in
the financial markets decreases, and the equilibrium interest rate rises, while the
equilibrium quantity of funds traded decreases.
• Demand for Funds
◦ In the previous section, we learned that a firm's decision to acquire and keep capital
depends on the net present value of the capital in question, which in turn depends on
the interest rate. The lower the interest rate, the greater the amount of capital that firms
will want to acquire and hold since lower interest rates translate into more capital with
positive net present values. The desire for more capital means, in turn, a desire for more
loanable funds. Similarly, at higher interest rates, less capital will be demanded because
more of the capital in question will have negative net present values. Higher interest
rates, therefore, mean less funding demanded.
 • Thus, the demand for loanable funds is downward-sloping, like the demand for
virtually everything else, as shown in Figure 1. The lower the interest rate, the more
capital firms will demand. The more capital that firms demand, the greater the funding
that is required to finance it.

Factors Affecting Nominal Interest Rates

• Inflation
◦ The continual increase in the price level of a basket of goods and services.
• Real Interest Rate
◦ A nominal interest rate that would exist on security if no inflation were expected.
• Default Risk
◦ Risk that a security issuer will default on the security by missing interest or principal
payment.
• Liquidity Risk
◦ Risk that a security cannot be sold at a predictable price with low transaction costs at
short notice.
• Special Provisions
 ◦ Provisions (e.g., taxability, convertibility, and callability) that impact the security
holder beneficially or adversely and, as such, are reflected in the interest rates on
securities that contain such provisions.
• Term to Maturity
◦ Length of time a security has until maturity.
• Inflation
◦ The first factor to affect interest rates is the actual or expected inflation rate in the
economy. Specifically, the higher the level of actual or expected inflation, the higher
the level of interest rates will be. The intuition behind the positive relationship between
interest rates and inflation rates is that an investor who buys a financial asset must earn
a higher interest rate when inflation increases to compensate for the increased cost of
foregoing consumption of real goods and services today and buying these more highly
priced goods and services in the future. In other words, the higher the rate of inflation,
the more expensive the same basket of goods and services will be in the future.
Inflation of the general price index of goods and services (I.P.) is defined as the
(percentage) increase in the price of a standardized basket of goods and services over a
given period of time. In the United States, inflation is measured using indexes such as
the consumer price index (CPI) and the producer price index (PPI). For example, the
annual inflation rate using the CPI index between years t and t! 1 would be equal to:

• Real Interest Rates

◦ A real interest rate is the interest rate that would exist on security if no inflation were
expected over the holding period (e.g., a year) of security. The real interest rate on an
investment is the percentage change in the buying power of a dollar. As such, it
measures society’s relative time preference for consuming today rather than tomorrow.
The higher society’s preference to consume today (i.e., the higher its time value of
money or rate of time preference), the higher the real interest rate (RIR).
• Fisher Effect
◦ The relationship among the real interest rate (RIR), the expected rate of inflation
[Expected (I.P.)], described above, and the nominal interest rate (i) is often referred to
as the Fisher Effect, named for the economist Irving Fisher, who identified these
relationships early last century. The Fisher effect theorizes that nominal interest rates
observed in financial markets (e.g., the one-year Treasury bill rate) must compensate
investors for (1) any reduced purchasing power on funds lent (or principal lent) due to
inflationary price changes and (2) an additional premium above the expected rate of
inflation for forgoing present consumption (which reflects the real interest rate
discussed above). When an investor purchases a security that pays interest, the nominal
interest rate exceeds the real interest rate because of inflation.

• where RIR $ Expected (I.P.) is the inflation premium for the loss of purchasing power
on the promised nominal interest rate payments due to inflation. For small values of
RIR and Expected (I.P.) this term is negligible. Thus. the Fisher effect formula is often
written as:

• The approximation formula assumes RIR $ Expected (I.P.) is small. Thus, the nominal
interest rate will be equal to the real interest rate only when market participants expect
the inflation rate to be zero - Expected (I.P.) " 0. Similarly, nominal interest rates will
be equal to the expected inflation rate only when real interest rates are zero. Note that
we can rearrange the nominal interest rate equation to show the determinants of the real
interest rate as follows:

• Example: Calculations of Real Interest Rates

◦ The one-year Treasury bill rate in 2007 averaged 4.53%, and inflation (measured by
the consumer price index) for the year was 4.10%. If investors had expected the
same inflation rate as that actually realized (i.e., 4.10%), then according to the
Fisher effect, the real interest rate for 2007 was:
▪ 4.53% - 4.10% = 0.43%
 ◦ The one-year T-bill rate in 2009 was 0.47%, while the CPI for the year was 2.70%.
This implies a real interest rate of -2.23%; that is, the real interest rate was negative.
International Aspects of Money Markets
• Euro Money Markets
◦ Large banks in London organized the interbank Eurodollar market. This market is now
utilized by banks around the world as a source of overnight funding. The term
“Eurodollar market" is something of a contradiction because the markets have no true
physical location. Rather, the Eurodollar market is a market in which dollars held
outside the United States are traced among multinational banks, including the offices of
U.S. banks abroad, such as Citigroup’s branch in London or its subsidiary in London.
For example, a corporation in Italy requiring U.S. dollars for a foreign trade transaction
might ask Citigroup’s subsidiary in London to borrow these dollars on the Eurodollar
market. Otherwise, a Greek bank needing U.S. dollar funding may raise the required
funds by issuing a Eurodollar CD. Most Eurodollar transactions take place in London.
• London Interbank Offered Rate (LIBOR)
◦ The rate offered for sale on Eurodollar funds is commonly known as the London
Interbank Offered Rate (LIBOR). The funds traded in the Eurodollar market are mostly
used as an alternative to Fed funds as a source of overnight funding for banks. As
alternate sources of overnight funding, the LIBOR and the U.S. federal funds rate likely
to be very closely related. If rates in one of these markets like the LIBOR market
decrease relative to the other like the Fed funds market, the overnight borrowers will
borrow in the LI80R market rather than the Fed funds market. As a result, the LIBOR
will increase with this upsurge demand, and the Fed funds rate will decline with the
decrease in demand. This will make the difference between the two rates pretty small,
although not equal. The convenience of transacting in both markets makes it virtually
costless to use one market versus the other. Certainly, the LIBOR rate is mostly used by
major banks in the United States to base commercial and industrial loans.

Lesson 6 - The Bond Market

Fixed Income Securities
• Fixed income securities are a type of debt instrument that offers returns in the form of
daily or fixed interest payments and principal repayments when the security reaches
maturity. The instruments are provided for funding their activities by states, companies,
and other bodies. They vary from equity because they do not include a company's
ownership interest, but they confer a right of seniority in cases of bankruptcy or default
relative to equity interests.
• The term fixed income applies to interest payments received by an investor based on the
borrower’s creditworthiness and current interest rates. Generally speaking, fixed income
securities like bonds pay a higher interest the longer their maturities are, which is known as
the coupon.
• For a longer period of time, the borrower is willing to pay more interest in return for
borrowing the money. The borrower returns the borrowed money, known as the principal
or “par value,” at the end of the security's term or maturity.
• An investment that provides a return in the form of fixed periodic interest payments and
the principal's eventual return at maturity is fixed-income security. Unlike variable-income
securities, fixed-income security payments are known in advance when payments change
based on some underlying measure, such as short-term interest rates.
• Fixed-income securities are debt instruments that pay investors a fixed amount of interest
in coupon payments. Usually, interest payments are made semi-annually, while the
invested principal returns to the investor at maturity - the most common form of fixed-
income securities bonds. By issuing fixed-income products to investors, companies raise
capital.
• A bond is an investment product that is issued to finance projects and fund operations by
corporations and governments to raise funds. Corporate bonds and government bonds are
mostly comprised of bonds and may have varying maturities and face value amounts. The
face value is the amount that the lender is going to get when the bond matures. Usually,
corporate and government bonds trading on major exchanges is listed, also known as the
par value, with face values of $1,000.
• Examples of Fixed-Income Securities
◦ There are several examples of fixed income securities existing, such as bonds (both
corporate and government), Treasury Bills, money market instruments, and asset-
backed securities, and they function as follows:
▪ Bonds
 • By itself, the topic of bonds is the entire field of the study of finance or
investment. Generally speaking, they can be described as loans made by
investors to an issuer, with the guarantee of repayment of the principal amount at
the set maturity date and regular coupon payments (usually every six months),
reflecting the interest paid on loan. The purpose of such loans varies widely.
Typically, bonds are issued by governments or corporations that look for ways to
finance projects or operations.
▪ Treasury Bills
• Considered to be the safest short-term debt instrument, the U.S. federal
government issued treasury bills. These securities most commonly involve 28,
91, and 182-day (one month, three months, and six months) maturities with
maturities ranging from one to 12 months. Such instruments do not offer regular
coupons or interest payments.
• Instead, they are sold at a discount to their face value, representing the interest
rate they offer investors, with the difference between their market price and face
value. As a simple example, if a Treasury bill sells for $90 with a face value or
par value of $100, it offers around 10% interest.
▪ Money Market Instruments
• Securities such as commercial paper, banker’s acceptances, certificates of
deposit (CD), and repurchase agreements (“repo”) are used in money market
instruments. Technically, treasury bills are included in this category, but they
have their own category since they are traded in such high quantities.
▪ Asset-Backed Securities (A.B.S.)
• Asset-Backed Securities (A.B.S.) are securities with fixed income backed by
“securitized” financial assets, such as credit card receivables, auto loans, or
home-equity loans. A.B.S. is a series of such assets which have been bundled
together in the form of a single fixed-income security. Asset-backed securities
are usually an alternative for investors to invest in corporate debt.
• Risks of Investing in Fixed Income Securities
◦ Principal risks associated with fixed-income securities concern the borrower’s
vulnerability to defaulting on its debt. These risks are integrated into the interest or
coupon that the security offers, with securities with a higher risk of a default offering
higher interest rates to investors.
◦ Exchange rate risk for securities denominated in a currency other than the U.S. dollar
(such as foreign government bonds) and interest rate risk provide additional risks - the
risk that changes in interest rates can decrease fixed-income market value security held
by an investor.
◦ For example, if an investor holds a 10-year bond that pays 3% interest, then interest
rates increase, and issuing new 10-year bonds offers 4% interest. The bond the investor
holds that pays only 3% interest becomes less valuable.
◦ Even though fixed-income securities have many advantages and are often considered
safe and stable investments, there are some risks associated with them. Before investing
in fixed- income securities, investors must consider the pros and cons.
◦ Investing in fixed-income securities typically leads to low returns and sluggish
appreciation of capital or price increases. The principal amount invested can be tied up
for a long time, particularly in long-term bonds with maturities of more than ten years.
As a result, investors don't have access to the cash and may take a loss if they need the
money and cash in their bonds early. There is also the risk of lost income since fixed-
income products can often pay a lower return than equities.
◦ There is an interest rate risk for fixed-income securities, meaning that the rate paid by
the security could be lower than the overall market interest rates. If rates increase,
existing bondholders might lose out on the higher rates. For example, if interest rates
increase over the years to 4%, an investor that purchase a bond paying 2% per year
might lose out. Fixed-income securities, regardless of where interest rates change over
the bond's life, provide a fixed interest payment.
◦ It is not possible to repay bonds issued by a high-risk company, resulting on loss of
principal and interest. Since the securities are tied to the issuer's financial viability, all
bonds have credit risk or default risk associated with them. If the company or
government struggles financially, investors are at risk of default on the security. If the
country is economically or politically unstable, investing in international bonds can
increase default risk.
 ◦ Inflation erodes the return on fixed-rate bonds. Inflation in the economy is an overall
measure of rising prices. Inflation risk can be an issue since the interest rate paid on
most bonds is fixed for the bond's life if prices increase at a faster rate than the interest
rate on the bond. If a bond pays 2% and inflation rises by 4%, the bondholder loses
money when factoring in the rise in prices of goods in the economy. Ideally, investors
want fixed-income security that pays an interest rate high enough that the return beats
inflation.
• Benefits of Fixed-Income Securities
◦ Fixed-income securities provide investors with stable interest income throughout the
life of the bond. In an investment portfolio, fixed-income securities can also reduce the
overall risk and protect against volatility or wild fluctuations in the market.
Traditionally, equities are more volatile than bonds meaning their price movements can
lead to higher capital gains but also greater losses. As a result, many investors allocate a
portion of their portfolios to bonds to reduce stock volatility risk.
◦ It is necessary to note that bond prices and fixed income securities can increase and
decrease. Although fixed-income securities interest payments are steady, their prices
are not guaranteed to remain stable throughout the life of the bonds. For example, if
investors sell their securities before maturity, there could be gains or losses due to the
difference between the purchase price and the sale price. If the bond is held to maturity,
investors will receive the bond’s face value, but if it is sold beforehand, the sale price
will likely be different from the face value.
◦ However, fixed-income securities typically offer principal stability than other
investments. Corporate bonds are more likely to be repaid if a company declares
bankruptcy than other corporate investments. For example, bondholders would be
repaid before common stockholders if they face bankruptcy and must liquidate their
assets.
◦ In periods of economic uncertainty, the U.S. Treasury guarantees government fixed-
income securities and considers safe-haven investments. On the other hand, corporate
bonds are backed by the financial viability of the company. In short, corporate bonds
have a higher risk of default than government bonds. Default is a debt issuer's failure to
make good on investors or bondholders on their interest payments and principal
payments.
 ◦ Fixed-income securities are easily traded through available mutual funds and exchange-
traded funds through a broker. In their funds, mutual funds and ETFs contain a blend of
many securities, such that investors can purchase many types of bonds or equities.
The Bond Market
• The bond market is often called the debt market, fixed-income market, or credit market,
which is the collective name given to all trades and debt securities issues. In order to raise
capital to pay down debts or fund infrastructural improvements, governments typically
issue bonds. When they need to finance business expansion projects or maintain ongoing
operations, publicly traded companies issue bonds.
• The bond market is divided widely into two different silos: the primary market and the
secondary market. The primary market is frequently referred to as the “new issues” market
in which transactions strictly occur directly between the bond issuers and the bond buyers.
In essence, the primary market yields the creation of brand-new debt securities that have
not previously been offered to the public.
• In the secondary market, securities that have already been sold in the primary market are
then bought and sold at later dates. Investors can purchase these bonds from a broker, who
acts as an intermediary between the buying and selling parties. These secondary market
issues may be discussed among many other product structures in the form of pension
funds, mutual funds, and life insurance policies.
• Types of Bond Markets
◦ The general bond market can be segmented into the following bond classifications,
each with its own set of attributes.
▪ Corporate Bonds
• For a sundry of reasons, companies issue corporate bonds to raise money, such
as financing current operations, expanding product lines, or opening up new
manufacturing facilities. Corporate bonds usually describe longer-term debt
instruments that provide a maturity of at least one year.
▪ Government Bonds
• National-issued government bonds (or Treasuries) entice buyers on the agreed
maturity date certificate by paying out the face value listed on the bond while
also issuing periodic interest payments along the way. This characteristic makes
government bonds attractive to conservative investors.
▪ Municipal Bonds
 • Commonly abbreviated as “Muni” bonds, municipal bonds are locally issued by
states, cities, special-purpose districts, public utility districts, school districts,
publicly-owned airports and seaports, and other government-owned entities who
seek to raise cash to fund various projects.
▪ Mortgage-Backed Bonds
• The pledge of particular collateralized assets locks these issues, which consist of
pooled mortgages on real estate properties. They pay monthly, quarterly, or
semi- annual interest.
▪ Emerging Market Bonds
• These bonds are issued by governments and companies located in emerging
market economies, these bonds provide much greater growth opportunities and
risk than domestic or developed bond markets.
• Bond Characteristics
◦ Bearer Bonds
▪ The bonds that coupons are attached to. When they are due, the bondholder presents
the coupons to the issuer for interest payments.
◦ Registered Bonds
▪ With a registered bond, the issuer records the owner's identity information and mail
the coupon payments to the registered owner.
◦ Term Bonds
▪ Bonds in which the entire issue matures on a single date.
◦ Serial Bonds
▪ Bonds that mature on a series of dates, with each paying off a portion of the issue.
◦ Mortgage Bonds
▪ Bonds issued to finance specific projects pledged as collateral for the bond issue.
◦ Equipment Trust Certificates
▪ Bonds collateralized with tangible non-real estate property (e.g., railcars and
airplanes).
◦ Debentures
▪ Bonds backed solely by the general credit of the issuing firm and unsecured by
specific assets or collateral.
◦ Subordinated Debentures
▪ Junior unsecured debentures in their mortgage bonds rights and regular debentures.
◦ Convertible Bonds
 ▪ Bonds that may be exchanged at the discretion of the bond holder for another
security of the issuing firm.
◦ Stock Warrants
▪ Bonds that allow the bond holder to purchase common stock at a specified price up
to a specified date.
◦ Callable Bonds
▪ Bonds that allow the issuer to force the bond holder to sell the bond back to the
issuer at a price above the par value (at the call price).
◦ Sinking Fund Provisions
▪ Bonds that have a requirement that the issuer retires a certain amount of the bond
issue each year.
• Bond Valuation
◦ Bond pricing is an empirical matter in the field of financial instruments. The price of a
bond depends on several characteristics inherent in every bond issued. These
characteristics are:
▪ Coupon, or lack thereof
▪ Principal/Par Value
▪ Yield to maturity
▪ Periods to maturity
◦ Alternatively, the last missing characteristic can be solved if the bond price and all but
one of the characteristics are known.
◦ Bond valuation is a technique for determining a particular bond’s theoretical fair value.
Bond valuation includes calculating the present value of a bond's future interest
payments, also known as its cash flow, and the maturity value of the bond, also known
as its face value or par value. As the par value and interest payments of a bond are
fixed, an investor uses bond valuation to determine the return rate required to be
worthwhile for a bond investment.
◦ In order to determine its intrinsic value, since bonds are an integral part of the capital
markets, investors and analysts seek to understand how the different features of a bond
interact. Like a stock, the value of a bond determines whether it is a suitable investment
for a portfolio and hence, is an integral step in bond investing.
 ◦ In effect, bond valuation is calculating the present value of the expected future coupon
payments of the bond. The theoretical fair value of a bond is calculated by discounting
the present value of its coupon payments by an appropriate discount rate. The discount
rate used is the yield to maturity, which is the return rate that an investor would obtain
if every coupon payment from the bond is reinvested at a fixed interest rate until the
bond matures. The price of a bond, par value, coupon rate, and the time to maturity is
considered.
• Bond Pricing: Coupons
◦ A bond may not come with attached coupons. A coupon is stated as a nominal
percentage of the bond's par value (principal amount). Each coupon is redeemable per
period for that percentage. For example, a 10% coupon par bond is redeemable each
period.
◦ A bond may also come with no coupon. In this case, the bond is known as a zero-
coupon bond. Zero-coupon bonds are typically priced lower than bonds with coupons.
• Bond Pricing: Principal/Par Value
◦ Each bond must come with a par value that is repaid at maturity. Without the principal
value, a bond would have no use. The principal value is to be repaid to the lender (the
bond purchaser) by the borrower (the bond issuer). A zero-coupon bond pays no
coupons but will guarantee the principal at maturity. Zero-coupon bond purchasers earn
interest from the bond being sold at a discount to its par value.
◦ A coupon-bearing bond pays coupons each period and a coupon plus principal at
maturity. The price of a bond comprises all these payments discounted at the yield to
maturity.
• Bond Pricing: Yield to Maturity
◦ Bonds are priced to yield investors a certain return. A bond that sells at a premium will
have a yield to maturity that is lower than the coupon rate (where the price is above par
value). Alternatively, it can reverse the causality of the relationship between yield to
maturity and price. A bond could be sold at a higher price if the intended yield (market
interest rate) is lower than the coupon rate. This is because the bondholder will receive
coupon payments higher than the market interest rate, who will thus pay a premium for
the difference.
• Bond Pricing: Periods to Maturity
 ◦ Bonds will have a number of maturity periods. Usually, these are annual periods but
may also be semi-annual or quarterly. The number of periods will equal the number of
coupon payments.
• Bonds and the Time Value of Money
◦ Bonds are priced based on the time value of money. Each payment is discounted to the
current time based on the yield to maturity (market interest rate). The price of a bond is
usually found by:
▪ P(T0) = [PMT(T1)/(1+r)^1] + [PMT(T2)/(1+r)^2]...[PMT(Tn)+FV)/(1+r)^n]
▪ Where
• P(T0) = Price at Time 0
• PMT (Tn) = Coupon Payment at Time N
• FV = Future Value, Par Value, Principal Value
• R = Yield to Maturity, Market Interest Rates
• N = Number of Periods
• Bond Pricing: Main Characteristics
◦ Ceteris paribus (All else held equal)
▪ A bond with a higher coupon rate will be priced higher.
▪ A bond with a higher par value will be priced higher.
▪ A bond with a higher number of periods to maturity will be priced higher.
▪ A bond with a higher yield to maturity or market rates will be priced lower.
◦ A simpler way to note this is that bonds will be priced higher for all characteristics,
except for yield to maturity - a higher yield to maturity results in lower bond pricing.
• Bond Pricing: Other “Soft” Characteristics
◦ The empirical characteristics outlined above affect bond issues, especially in the
primary market. However, other bond characteristics can affect bond pricing, especially
in the secondary markets. These are:
▪ Creditworthiness of Issuing Firm
• Bonds are rated on the basis of the issuing firm’s creditworthiness. These ratings
range from AAA to D. Typically, bonds rated higher than A are known as
investment-grade bonds, whereas anything lower is colloquially known as junk
bonds.
• Junk bonds will require a higher yield to maturity to compensate for their higher
credit risk. Because of this, junk bonds trade at a lower price than investment-
grade bonds.
 ▪ Liquidity of Bond Trade
• Bonds which are traded more widely would be more valuable than sparsely
traded bonds. Intuitively, an investor will be wary of purchasing a bond that
would be harder to sell afterward. This drives prices of illiquid bonds down.
▪ Time to Next Payment
• Finally, a bond's “actual” price affects the next coupon payment time. This is a
more complex bond pricing theory, known as “dirty” pricing. Dirty pricing takes
the interest that accrues between coupon payments into account. A bondholder
has to wait less time before receiving his next payment as the payments get
closer. This drives higher prices steadily before it drops right after coupon
payment again.
Present Value of Payments
• A bond value is obtained by discounting the bond’s expected cash flows of the bond to the
present using a reasonable discount rate.
• Using the present value method, the bond price can be calculated. Bond valuation is the
determination of the fair price of a bond. The theoretical fair value of a bond is the present
value of the stream of cash flows it is expected to generate, as with any security or capital
investment. Therefore, a bond's value is obtained by discounting the bond's expected cash
flows to the present using an appropriate discount rate. This discount rate is also calculated
in practice by comparison to similar instruments, provided that such instruments exist. The
basic present value (P.V.) formula for a given discount rate is used to calculate the price of
a bond.
 • Where:
◦ F = Face value
◦ iF = Contractual interest rate
◦ C = F*iF = Coupon payment (periodic interest payment)
◦ N = Number of Payments
◦ i = Market interest rate, or required yield, or observed/appropriate yield to maturity
◦ M = Value at maturity, usually equals face value
◦ P = Market price of bond
• The bond price can be summarized as the sum of the present value of the par value repaid
at maturity and the present value of coupon payments. The present value of coupon
payments is the present value of an annuity of coupon payments.
• An annuity is a series of payments that are paid at fixed time intervals. The present value
of an annuity is the value of a stream of payments, discounted at various moments in the
future by the interest rate to account for the payments being made.
• The Present Value is calculated by:
◦ PVA = PMTi [1 - (1/(1+i)n)]
◦ Where
▪ i = The number of periods
▪ n = Per period interest rate
Par Value at Maturity
• Par value, for a typical bond making repayment of par value at maturity, is stated value or
face value. A typical bond allows coupon payments and final repayment of par value at
maturity at fixed intervals throughout its lifetime. Along with coupon payments, the par
value at maturity is discounted back to the time of purchase to calculate the bond price.
• The formula for calculating a bond’s price, using the basic present value (P.V.) formula for
a given discount rate, is below.
 • Where:
◦ F = Face value
◦ iF = Contractual interest rate
◦ C = F*iF = Coupon payment (periodic interest payment)
◦ N = Number of Payments
◦ i = Market interest rate, or required yield, or observed/appropriate yield to maturity
◦ M = Value at maturity, usually equals face value
◦ P = Market price of bond
• In general, the par value of a bond does not change, except for inflation-linked bonds
whose par value is adjusted for every predetermined period of time at inflation rates. Even
though the coupon interest rate is unchanged, the coupon payments for such bonds are still
adjusted accordingly.
Yield to Maturity
• Yield to maturity is the discount rate at which the sum of all future bond cash flows is
equal to the price of the bond.
• Contrary to popular belief, yield to maturity does not rely on reinvestment of dividends,
including concepts often cited in advanced financial literature. Instead, the yield to
maturity is simply the discount rate at which the sum of all future bond cash flows
(coupons and principal) is equal to the bond price. The formula for yield to maturity:
◦ Yield to Maturity (YTM) = [(Face Value/Present Value)1/Time Period] - 1
• The YTM is often given in terms of the Annual Percentage Rate (A.P.R.), but the market
convention is usually followed: the convention is to quote yields semi-annually in a
number of major markets (for example, an effective annual yield of 10.25% would be
quoted as 5.00%, because 1.05 x 1.05 = 1.1025).
 • If the yield to maturity for a bond is less than the bond’s coupon rate, then the bond’s
(clean) market value is greater than the par value (and vice versa).
◦ If a bond’s coupon rate is less than its YTM, then the bond is selling at a discount.
◦ If a bond’s coupon rate is more than its YTM, then the bond is selling at a premium.
◦ If a bond’s coupon rate is equal to its YTM, then the bond is selling at par.
• As some bonds have different characteristics, there are some variants of YTM:
◦ Yield to Call
▪ When a bond is callable (can be repurchased before maturity by the issuer), the
market often looks at the yield to call, which is the same YTM calculation but
assumes that the bond will be called, thus shortening the cash flow.
◦ Yield to Put
▪ Same as yield to call, but when the bondholder has the option to sell the bond back
to the issuer at a fixed price on the specified date.
◦ Yield to Worst
▪ When a bond is callable, puttable, exchangeable, or has other characteristics, the
yield to worst is the lowest yield of yield to maturity, yield to call, yield to put, and
others.

Lesson 7 - The Stock Market

Stock Market
• The stock market refers to public markets that exist for issuance, acquisition, and sales of
stocks that trade on or over-the-counter on the stock exchange. A stock market is a location
where investors may purchase and sell ownership of such investible assets. Stocks, also
known as equities, reflect a company's fractional ownership. A well-functioning stock
market is considered as critical to economic development because it allows businesses to
quickly access public money.
Purposes of the Stock Market - Capital and Investment Income
• Two very significant reasons serve the stock market. The first is to provide companies with
the capital they can use to fund and expand their businesses. Suppose a company issues
one million stock shares that initially sell for $10 a share. In such a scenario, it provides
the company with $10 million in financing to help it expand (minus whatever fees the
company pays for an investment bank to manage the stock offering). By issuing stock
instead of borrowing the cash needed for expansion, the firm avoids taking on debt and
paying interest on that loan.
 • The secondary purpose of the stock market is to give investors (those who purchase stocks)
the opportunity to share publicly traded companies' profits. Investors can profit in one of
two ways from stock buying. Some equities pay out dividends on a regular basis (a given
amount of money per share of stock someone owns). If the stock price rises above its
purchase price, another option for investors to earn from stock purchases is to sell them for
a profit. For example, if an investor purchases shares of a company’s stock for $10 per
share and the stock price rises to $15 per share, the investor would earn 50% on their
investment when they sell their shares.
Stock Market Securities
• There are two types of corporate stock: common stock and preferred stock. While all
public corporations issue common stock, many do not offer preferred stock. Only about
1% of the value of common stock outstanding is the market value of preferred stock
outstanding.
◦ Common Stock
▪ The fundamental ownership claim in a public or private corporation is common
stock. It is differentiated from other financial securities types by many common
stock characteristics (e.g., bonds, mortgages, preferred stock). These include:
• Discretionary dividend payments
• Residual claim status
• Limited liability
• Voting rights
▪ Further discussion of characteristics:
• Dividends
◦ While common stockholders, if the company is highly profitable, can
potentially receive unlimited dividend payments, they have no special or
guaranteed dividend rights. Rather, the payment and size of dividends are
determined by the issuing firm’s board of directors.
• Residual Claim
◦ In the event of bankruptcy, common stockholders have a residual claim for
the lowest priority claim on a corporation’s assets. Only after all senior
claims are paid, such as payments owed to creditors, such as employees of
the company, bondholders, the government (taxes), and preferred
stockholders, are common stockholders entitled to the company’s assets left.
• Limited Liability
 ◦ Limited liability feature is one of the most important characteristics of
common stock. Legally, limited liability implies that when the company’s
asset value falls to less than the value of the debt it owes, common
stockholder losses are limited to the amount of their original investment in
the company.
◦ The personal wealth of the common stockholders holding outside the
company’s ownership claims is unaffected by the corporation’s bankruptcy,
even though the company’s losses exceed its overall common stock
ownership claims. In comparison, sole proprietorship or partnership stock
interests mean that the company gets into financial difficulties and its losses
exceed the stockholders' ownership claims in the firm. The stockholders may
be liable for the company's debts from their total private wealth holdings.
This is the case of "unlimited" liability.
• Voting Rights
◦ Voting rights are a fundamental privilege assigned to common stock.
Although common stockholders do not exercise control over the firm's daily
activities (these activities are controlled by managers appointed to work in
the best interests of the firm's common stockholders and bondholders), they
indirectly exercise control over the firm's activities by appointing the Board
of Directors.
▪ Dual-Class Firms
• There are two kinds of common stock on the market, each with
separate voting rights.
▪ Cumulative Voting
• All directors up for election are voted on at the same time. Each
stockholder is given a number of votes equal to the number of shares
held multiplied by the number of directors to be chosen.
▪ Proxy
• A voting ballot sent to investors by a corporation. When a proxy is
returned to the issuing business, it permits shareholders to vote by
absentee ballot or empowers stockholders’ representatives to vote on
their behalf.
◦ Preferred Stock
▪ Preferred stock is a hybrid instrument that combines the features of a bond and a
common stock. Preferred stock is comparable to ordinary stock in that it reflects the
issuing company’s ownership stake, but unlike a bond, it makes a fixed periodic
(dividend) payment. Preferred stock is a type of equity that ranks higher than
common stock but lower than bonds.
▪ As a result, preferred stockholders are paid only after profits are made and all debt
holders have been paid (but before common stockholders are paid).
▪ Corporations choose preferred stock as a source of capital because, unlike coupon
interest on a bond issuance, dividends on preferred stock can be missed without risk
of bankruptcy proceedings. Preferred stock is also advantageous to an issuing firm’s
debt holders. The firm can utilize cash generated through a preferred stock offering
to buy assets that will provide the revenue needed to pay debtholders before
preferred shareholders can be paid.
▪ Preferred stock on the other hand, has a disadvantage for companies. The first
disadvantage is that if a preferred dividend payment is missed, prospective investors
may be hesitant to participate in the company. As a result, businesses are typically
unable to obtain fresh capital until all missed preferred stock dividend payments are
made. Furthermore, preferred stockholders must be paid a rate of return that is
commensurate with the risk they face (i.e., dividend payments may be delayed).
Preferred stock may also be more expensive for the issuing company than bonds.
▪ A second disadvantage of preferred stock from the standpoint of the issuing
business is that, unlike coupon interest paid on corporate bonds, dividends paid on
preferred stock are not tax deductible. After-tax earnings are used to pay preferred
dividends. In comparison to bonds, this boosts the cost of preferred stock for a
company's stockholders. The difference in tax treatment between debt coupon
interest and preferred stock dividends has an impact on the net profit of the
company’s common stockholders. Dividends on preferred stock are usually set
(quarterly payable) and represented as a cash amount or a percentage of the
preferred stock face or par value.
▪ Typically, preferred stockholders do not have voting rights in the firm. There could
be an exception to this rule if the issuing firm has missed a promised dividend
payment. For example, preferred stock in Pitney Bowes, Inc., except where
dividends are in arrears for six quarterly payments, has no voting rights. In this case,
one-third of the board of directors will be chosen by preferred stockholders.
 • Nonparticipating Preferred Stock
◦ Ensures that the preferred stock dividend is fixed regardless of any increase
or decrease in the issuing firm’s profits.
• Cumulative Preferred Stock
◦ Ensures that any missed dividend payments go into arrears and must be made
up before it is possible to pay any common stock dividends.
• Participating Preferred Stock
◦ Is preferred stock where actual dividends paid in any year may be greater
than the promised dividends.
• Noncumulative Preferred Stock
◦ Is preferred stock where dividend payments are never paid and do not go into
arrears.

Primary and Secondary Markets

• Before a company may issue common stock, it must be approved by a majority vote of
both the board of directors and the firm's existing common stockholders. New shares of
stock are given to current and new investors through a primary market sale once they have
been authorized with the aid of investment banks. Once issued, the stocks are traded on
secondary stock exchanges such as the NYSE or NASDAQ. The Philippine Stock
Exchange, or PSE, is the country's secondary market.

• Primary Stock Markets

◦ The primary stock markets are markets where corporations raise funds through new
issues of stocks. The new stock securities are sold to initial investors (suppliers of
funds) in exchange for funds (money) required by the issuer (user of funds).
• The investment bank can conduct firm commitment underwriting to perform a primary
market sale of stock (where the investment bank guarantees the corporation a price for
newly issued securities by buying the entire issue from the corporate issuer at a fixed
price) or best efforts underwriting to perform a primary market sale of stock (where the
underwriter does not guarantee a price to the issuer and acts more as a placing or
distribution agent for a fee).
• In a firm commitment underwriting, the investment bank buys the stock from the issuer at
a guaranteed price (called the net proceeds) and resells it to investors at a higher price
(called the gross proceeds). The difference between the gross and net proceeds (known as
the underwriter’s spread) is used to compensate the issuing investment bank for its
expenditures and risks.
• The primary market or new issues market (NIM) has no physical structure or form. The
NIM is established by all the agencies that provide the facilities and participate in selling
new issues to the investors. The NIM has three functions to perform. They are:
◦ Origination
▪ Origination is the preliminary work in connection to a company’s floatation of a
new issue. It deals with assessing the feasibility of the project, technical, economic,
and financial, as well as making all arrangements for the actual floatation of the
issue. Decisions may have to be taken on the following issues as part of the
origination work:
• Time of Floating the Issue
◦ Timing of the issue is vital to its success. To ensure proper support and
subscription to the issue, the floatation of the issue should correspond with
the buoyant mood in the investment market.
• Type of Issue
◦ At the time of origination work, the type of issue, whether equity, preference,
debentures, or convertible securities, must be properly evaluated.
• Price of the Issue
◦ The issue’s pricing is a delicate subject, as public support for a new issue is
heavily influenced by the issue's price. The issuer, not the market, determines
the price of the securities in the primary market. New issues are issued at a
discount or at a premium. Well-established firms may be able to sell their
shares at a premium during a fresh offering.
◦ Underwriting
 ▪ NIM's second function is the underwriting of the activity to provide the issuer with
a guarantee to ensure the issue is successfully marketed. An underwriter is a person
or organization who agrees to buy a certain number of shares from the stock issuing
firm in the event of a deficit in subscriptions for the new issue. Even if investors do
not have a suitable response to the new offer, the stock issuing firm can assure
complete subscription to the new issue through underwriting agreements with
several underwriters.
▪ Underwriting is the procedure by which a person or a company accepts financial
risk in exchange for a fee. The most common types of risk include loans, insurance,
and investments.
▪ The term underwriter originated from the practice of having each risk-taker write
their name for a specified premium under the total amount of risk they were
prepared to accept. While the mechanics have changed over time, today,
underwriting continues as a key function in the financial world.
▪ Underwriting includes conducting research and assessing each applicant or entity's
degree of risk before assuming that risk. This check helps set fair loan borrowing
rates, establishes appropriate premiums to cover insurance policyholders’ true cost
and creates a market for securities by accurately pricing investment risk. An
underwriter may refuse coverage if the risk is deemed too high.
◦ Distribution
▪ Besides the functions of origination and underwriting, the new issue market
performs the third function. This third function is that of the distribution of shares.
Brokers, sub-brokers and agents perform the distribution function. Using different
mass media, such as newspapers, magazines, television, radio, Internet, etc., new
issues have to be publicized. New issues are also publicized by mass mailing. The
distribution prospectus, application forms, and other literature regarding new issues
to the investing public have become a general practice.
• Syndicate
◦ The process of distributing securities through a group of investment banks.
• Initial Public Offering (IPO)
◦ The first public issue of financial instruments by a firm.
• Seasoned Offering
◦ The sale of additional securities by a firm whose securities are currently
publicly traded.
 • Preemptive Rights
◦ A privilege of existing stockholders in which new shares must be offered to
existing shareholders first in such a way that their proportional ownership in
the corporation can be maintained.
• Secondary Stock Markets
◦ The secondary stock markets, where buyers purchase and sell stocks after they have
been issued, are the marketplaces where equities are exchanged once they have been
issued. The New York Stock Exchange (NYSE) and the National Association of
Securities Dealers Automated Quotation (NASDAQ) system are two well-known
examples of stock secondary markets.
◦ A secondary stock market transaction involves the exchange of funds, generally with
the assistance of a securities broker or business serving as an intermediary between the
buyer and the stock seller. In this transfer of stocks or funds, the original issuer of the
stock is not involved. We look at the major secondary stock markets in this section, the
process by which a trade occurs, and the major stock market indexes.
◦ The secondary market can be further broken down into two specialized categories:
▪ Auction Market
• Individuals and organizations interested in trading assets gather in one location
to form an auction market and indicate the prices at which they are ready to
purchase and sell securities. The terms “bid” and “ask” are used to describe
these pricing. The notion is that by bringing all participants together and
requiring them to openly announce their pricing, an efficient market will emerge.
Thus, since the convergence of buyers and sellers would allow mutually agreed
prices to develop, the optimal price for a commodity would not need to be
pursued. The New York Stock Exchange is the greatest example of an auction
market (NYSE).
▪ Dealer Market
 • In contrast, a dealer market does not require parties to converge in a central
location. Instead, the market participants are joined through electronic networks.
The dealers keep a security inventory and then stand ready with market
participants to buy or sell. These dealers earn profits through the spread between
the prices at which they buy and sell securities. The Nasdaq, in which the
dealers, who are known as market makers, provide firm bids and ask prices at
which they are willing to buy and sell a security, is an example of a dealer
market.
• The theory is that the best possible price for investors would be provided by
competition between dealers.
Functions of a Stock Market
• Fair Dealing in Securities Transactions
◦ The stock exchange needs to ensure that all interested market participants have instant
access to data for all buy and sell orders, depending on the standard demand and supply
rules, thereby helping with the fair and transparent pricing of securities. In addition,
efficient matching of appropriate buy and sell orders should also be done.
• Efficient Price Discovery
◦ Stock markets need to support an effective price discovery mechanism that refers to
deciding the proper price of a security that is typically performed by assessing the
supply and demand of the market and other factors associated with transactions.
• Liquidity Maintenance
◦ Although the number of buyers and sellers is out of control for the stock market for a
particular financial security, it needs to ensure that anyone who is qualified and willing
to trade gets instant access to place orders that should be executed at a fair price.
• Security and Validity of Transactions
◦ While more participants are important for a market to efficiently work, the same market
needs to ensure that all participants are checked and comply with the necessary rules
and regulations, leaving no room for any of the parties to fail. Furthermore, it should
ensure that all associated entities operating on the market are also expected to comply
with the rules and work within the regulator's legal framework.
• Support All Eligible Types of Participants
 ◦ A variety of participants, including market makers, investors, traders, speculators, and
hedgers, create a marketplace. In the stock market, all these participants operate with
different roles and functions. For example, an investor can buy stocks and hold them
for several years in the long run, while a trader can enter and exit a position within
seconds.
• Investor Protection
◦ A very large number of small investors and wealthy and institutional investors are also
served by the stock market because of their small investments. These investors may
have limited financial expertise and may not be fully aware of the pitfalls of investing
in stocks and other listed instruments.
Bull and Bear Markets, and Short Selling
• Two of the most fundamental stock market trading ideas are the “bull” and “bear” markets.
The phrase “bull market” refers to a stock market in which stock values are steadily
increasing. Because the bulk of investors are stock purchasers rather than short sellers, this
is the sort of market in which most investors prosper. When stock prices are falling in
general, it is called a bear market.
• Investors can still profit even in bear markets through short selling. Short selling is the
practice of borrowing stock from a trading firm that holds shares of the stock that the
investor does not own. In the secondary market, the investor then sells the borrowed stock
shares and receives the money from that stock's sale. Suppose the stock price falls as the
investor wishes, then by purchasing a sufficient number of shares. In that case, the investor
can realize a profit to return the broker the number of shares they borrowed at a total price
lower than what they received earlier at a higher price for selling shares of the stock.
• For example, if an investor assumes that the stock of company “A” is likely to decrease
from its current price of $20 a share, the investor can put down what is known as a margin
deposit to borrow 100 shares of the stock from his broker. He then sells each of those
shares for $20, the current price, which gives him $2,000. The investor can then buy 100
shares to return to his broker for only $1,000 if the stock falls to $10 a share, leaving him
with a $1,000 profit.

Analyzing Stocks
• Analysts and investors in the stock market can look at various factors to indicate the
possible future trajectory of stock, up or down in price. Here’s a list of some of the stock
analysis variables most often viewed.
• The market capitalization or market cap of a stock is the total value of all the stock's
outstanding shares. Typically, a higher market capitalization indicates a more well-
established and financially stable business.
• Publicly traded companies are expected to provide earnings reports regularly through
exchange regulatory bodies. Market analysts carefully watch these reports, issued
periodically and annually, as a good indicator of how well a company’s business is doing.
Among the key factors analyzed from earnings reports are the earnings per share (EPS) of
the company, which reflects the company's profits as shared between all of its outstanding
stock shares.
• A number of financial ratios that are intended to indicate the financial stability,
profitability, and growth potential of a publicly traded company are most often analyzed by
analysts and investors. A few of the key financial ratios that investors and analysts consider
are the following:
◦ Price to Earnings (P/E) Ratio
▪ Ratio of a company’s stock price in relation to its EPS. A higher P/E ratio indicates
that investors are willing to pay higher prices per share for the company’s stock
because they expect the company to expand and increase the stock price.
◦ Debt to Equity Ratio
▪ This is a fundamental metric of the company’s financial stability, since it illustrates
what percentage of a company’s operations are financed by debt compared to what
percentage is financed by equity investors. It is preferable to have a lower debt to
equity ratio, indicating primary investors’ funding.
◦ Return on Equity (ROE) Ratio
▪ The return on equity (ROE) ratio is considered a good indicator of a company’s
growth potential since it shows the company’s net income compared to the total
equity investment.
◦ Profit Margin
▪ There are several profit margin ratios, including operating profit margin and net
profit margin, that investors may consider. Instead of just an absolute dollar profit
figure, the advantage of looking at the profit margin is that it illustrates the
company's percentage profitability. For example, a company may show a profit of
$2 million, but if that only translates to a profit margin of 3%, then any significant
decrease in revenues may threaten the profitability of the company.
 • Return on assets (ROA), Dividend Yield, Price to Nook (P/B) Ratio, Current Ratio, and the
Inventory Turnover Ratio are other commonly used financial ratios.

Basic Approaches to Stock Market Investing

• There is countless stock-picking method employed by analysts and investors, but virtually
all of them are one form or another of the two basic stock buying strategies for investing in
value or investing in growth.
◦ Value investors typically invest in well-established companies that have shown stable
profitability for a long period of time and can offer regular dividend income. Value
investing is more focused on risk management than growth investing is, but when they
consider the stock price to be an undervalued bargain, value investors try to buy stocks.
◦ Growth investors search out companies with extraordinarily high growth potential,
aiming to achieve maximum share price appreciation. Usually, they are less concerned
with dividend revenue and are more willing to risk investing in relatively young
companies. Growth investors also prefer technology stocks because of their high
growth potential.

Lesson 8 - The Foreign Exchange Market

The Foreign Exchange Market
• The foreign exchange market, also known as Forex, F.X., or the currency market, is an
over-the-counter (OTC) global market that defines the exchange rate for currencies all over
the world.
• Forex markets compose of financial institutions, forex dealers, commercial companies,
central banks, investment management firms, hedge funds, retail forex dealers, and
investors.
• The foreign exchange market is among the novel financial markets created to provide a
structure to the expanding world economy. Foreign exchange market is by far the largest
financial market when it comes to trading volume.
• Separate from being considered a place for the buying, selling, exchanging, and
speculation of currencies, the foreign exchange market also assists currency conversion for
international trade settlements and investments. Based on the Bank for International
Settlements (BIS) data, which central banks control, the trading in foreign exchange
markets reach $6.6 trillion per day in April 2019 on average.
Background and History of Foreign Exchange Markets
• The foreign exchange markets have been present for a certain period as international trade,
and investing have prompted the need to exchange currencies. The type of exchange rate
system utilized to achieve this exchange, however, has transformed over time. Way back
1800s, foreign exchange markets functioned under a gold standard or system. Under the
gold standard, currency providers are guaranteed to convert notes upon demand into an
equivalent amount of gold.
• Counties that adopted such a fixed exchange system, which redeemed their notes to other
countries in gold, shared a fixed-currency relationship. This resulted in gold becoming a
transferable, universal, and reliable unit of valuation. Also, the United Kingdom, which at
the time was the leading trading country internationally, had an enduring commitment to
the gold standard. But, during the 1939-1942 period, the United Kingdom exhausted much
of its gold stockpile due to the purchases of munitions and armaments from the United
States and other nations to support the fight during the World War II. The exhaustion of the
United Kingdom’s reserve led Winston Churchill, the U.K Prime Minister at the time, to a
belief that reverting to a prewar-style gold standard was unfeasible. As a result, from 1944
to 1970, the Bretton Woods Agreement came up for the exchange rate of one currency for
another to be fixed within thin bands around a stated rate with government intervention
assistance. Nevertheless, the Bretton Woods Agreement resulted in a situation in which
most currencies such as the U.S. dollar became much overvalued and others like the
German mark became very undervalued. The Smithsonian Agreement of 1971 was cited to
address this situation. Under this agreement, leading countries permitted the dollar to be
devalued, and the boundaries between which exchange rates could fluctuate were raised
from 1% to 2.25%.
• During 1972, the Interbank Foreign Exchange Market was the only venue through which
spot and forward foreign exchange transactions happen. The interbank market comprises
electronic trades between major banks worldwide, like between J.P. Morgan Chase and
HSBC. This kind of market is over the counter or OTC, and therefore it has no normal
trading hours so that currencies can be purchased or sold anywhere around the world 24
hours a day.
 • Meanwhile, in 1972, organized markets such as the International Money Market (IMM) of
the Chicago Mercantile Exchange (CME) created derivatives trading in foreign currency
futures and options. Yet, the presence of such a well-established interbank market for
foreign exchange forward contracts has hindered the growth of the futures market for
foreign exchange trading. As an example, as foreign currency trading has developed
significantly since 1972, trading in the forward market remains much larger than the
futures market based on the order of 20 times the volume per day measured by trade value.
• The main dissimilarities between the interbank foreign exchange market and organized
trading on exchanges contain the market location, the standardization of contracts, the
calibration of delivery dates, and the dissimilarities in the way contracts are settled. While
the interbank forward market is a worldwide market with no geographic limitations, the
main futures market is the IMM in Chicago. Futures market contracts trade in the major
currencies such as the euro and British pound, with contracts expiring on the third
Wednesday of March, June, September, and December. On the contrary, forward market
contracts can be entered into any currency, with maturity stated as a given number of days
to deliver the currency in the future. The futures market (the IMM of the CME) determines
the size of futures contracts on foreign currencies, and all contracts must be of these sizes.
In the forward market, the contract size is exchanged between the bank and the customer.
Lastly, less than 1% of all futures contracts are completed by the delivery of the foreign
currency. Rather, profit or loss on the futures contract is settled daily between the trader
and the exchange, and many traders sell their contracts prior to maturity. In contrast, the
foreign currency's delivery happens on the contract’s maturity in almost 90% of forwarding
contracts.
• The foreign exchange markets have become among the biggest of all financial markets,
with turnover surpassing $4 trillion per day in 2010. London remains to be the biggest
center for trading in foreign exchange (36.7% of worldwide trading); it accommodates
over twice the daily volume of New York, the second-largest market (17.9% of all trading).
Third- ranked Tokyo caters approximately one-sixth of the volume of London. Moreover,
the F.X. market is fundamentally a 24-hour market, moving from Tokyo, London, and New
York throughout the day. Therefore, variations in exchange rates and foreign exchange
trading risk exposure remain into the night even when some financial institutions’
operations are closed.

Demanders and Suppliers of Currency in Foreign Exchange Markets

 • In forex markets, demand and supply become significantly interrelated because a person or
company who demands one currency should at the same time supply another currency and
vice versa.
• Below are the groups of participants in the market:
◦ Importer or exporter of goods and services
◦ International tourist
◦ International investors buying ownership or part-ownership in a foreign company
◦ International investors making financial investments that do not involve ownership
• Entities that sell export products or services or buy imports discover that their costs for
personnel, suppliers, and investors are determined in the currency of the nation where their
production happens, but their revenues from sales are determined in the currency of the
different nation where their sales occur. So, a Philippine company exporting abroad will
earn some other currency, let say U.S. dollars but will need the Philippine peso to pay the
personnel, suppliers, and investors who are based in the Philippines. In the foreign
exchange markets, this firm will be a supplier of U.S. dollars and a demander of the
Philippine peso.
• Financial investments that breach international boundaries and involve exchanging
currency are mostly divided into two categories. The foreign direct investment (FDI) refers
to buying at least ten percent ownership in an entity in another country or opening a new
business in a foreign country. For example, in 2008, the Belgian beer-brewing company
InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this
acquisition of a U.S. firm, InBev had to supply euros, which is Belgium's currency to the
foreign exchange market and demand for U.S. dollars.
Participants of Foreign Exchange Market
• Commercial Banks or Market Makers
◦ Commercial banks usually take over the position of backing the economy of the
country by holding over the foreign currency from one period to another for providing
the future need of the country. In some cases, they are also making the short sale of
foreign currency to fulfill the need of firms to make payments. Short selling by which
they agree to sell or actually sell the foreign currency without any real capacity to sell
through or borrow the necessary currency from others.
 ◦ And later, it brings the position in equilibrium; they quote the rates for buying and
selling foreign currency. As they buy the foreign currency from the customer, the rate
they figure for buying the foreign currency is technically named Bid Rate. When they
sell the foreign currency to a customer, the rate they quote is technically known as the
Ask Rate.
• Foreign Exchange Brokers
◦ Two of the most fundamental stock market trading ideas are the “bull” and “bear”
markets. The phrase “bull market” refers to a stock market in which stock values are
steadily increasing. Because the bulk of investors are stock purchasers rather than short
sellers, this is the sort of market in which most investors prosper. When stock prices are
falling in general, it is called a “bear” market.
• Central Banks or Reserve Banks
◦ Central banks, including the Reserve Bank of India (RBI), intervene in foreign
currency markets to maintain price disequilibrium in order to protect the financial
soundness and consistency of a country’s balance of payments, domestic money supply,
interest rates, and inflation.
• Corporates and Entrepreneurs
◦ Corporations are among the forex market participants who need to pay for goods,
commodities, and services imported in foreign currency. They must, on the other hand,
convert foreign money into domestic currency in order to export goods, commodities,
and services. Conversion is also required for transactions in global financial markets,
such as loan disbursement, loan repayment, receipt and payment of yearly charges, and
so forth.
Important Functions of Foreign Exchange
• Transfer Function
◦ The primary purpose of the foreign exchange market is to facilitate the conversion of
one currency into another, and more particularly, to facilitate the transfer of buying
power between two countries. Various credit instruments, such as telegraphic transfers,
bank drafts, and foreign bills, are used to transmit purchasing power.
◦ The foreign exchange market performs the transfer function by making international
payments by clearing debts in both directions at the same time, analogous to domestic
clearings.
• Credit Function
 ◦ Another function of the foreign exchange market is to facilitate credit for both national
and international, to support foreign trade. Apparently, when foreign bills of exchange
are utilized in international payments, a credit for about 3 months until their maturity is
necessary.
• Hedging Function
◦ The third function of the foreign exchange market is to hedge foreign exchange risks.
Hedging means the dodging of a foreign exchange risk. In a free exchange market,
when the exchange rate, specifically the price of one currency in terms of another
currency, change may be a gain or loss to the party involved. Under this circumstance,
a person or an entity undertakes a potential exchange risk if there are vast amounts of
net claims or net liabilities which are to be seen in foreign money.
◦ Exchange risk as such should be evaded or minimized. For this, the exchange market
provides a channel for expected hedging or actual claims or liabilities through
forwarding contracts in exchange. A forward contract which is generally for three
months is a contract to buy or sell foreign exchange against another currency at some
fixed date in the fixture at an agreed-upon now price.
◦ No money is cleared during the contract. But the contract makes it possible to disregard
any likely changes in the exchange rate. The presence of a forward market thus makes
it possible to hedge an exchange position.
Benefits for Using the Foreign Exchange Market
• Some key factors differentiate the Forex market from others, like the stock maket.
◦ There are fewer rules, which means investors aren’t held to the strict standards or
regulations found in other markets.
◦ There are no clearing houses and no central bodies that supervise the forex market.
◦ Most investors won’t have to pay the customary fees or commissions that you would on
another market.
◦ Because the market is open 24 hours a day, you can trade at any time of day, which
means there's no cut-off time to be able to participate in the market.
◦ Finally, if you’re worried about risk and reward, you can get in and out whenever you
want and you can buy as much currency as you can afford based on your account
balance and your broker’s rules for leverage.
Foreign Exchange Rates and Transactions
 • A foreign exchange rate is the price at which one currency, such as the U.S. dollar, can be
exchanged for another currency like the Philippine Peso. An exchange rate is the value of
one nation's currency versus the currency of another nation or economic zone. For
example, how many Philippine Peso does it take to buy one U.S. dollar? As of Dec 2020,
the exchange rate is 48.10, meaning it takes P48.10to buy $1.
How the Foreign Exchange Market Works
• Money dealers will provide a unique purchasing and selling rate in the trade currency
exchange industry. Many transactions are made in or out of the local currency. The
purchasing rate is the price at which money dealers will purchase foreign currency, while
the selling rate is the price at which they will sell it. The mentioned rates will include a
margin (or profit) allowed for traders, or the margin may be repaid in the form of a
commission or in another method.
• Different rates may be charged for various types of exchanges, such as cash (typically
restricted to notes), a documented form such as traveler's checks, or electronic transfers
such as credit card purchases. Documentary transactions, such as traveler's checks, have a
higher exchange rate due to the added time and expense of clearing the document whereas
cash may be resold immediately.
Types of Exchange Rates
• One of the most crucial economic decisions a country must make is how its currency will
be valued in relation to other currencies. The way a country handles its currency in the
foreign exchange market is referred to as an exchange rate regime. The monetary policy of
a country has a strong influence on the exchange rate regime.
• Floating exchange, fixed exchange, and pegged float exchange are the three fundamental
forms of exchange regimes.

• Free Floating
◦ A free-floating exchange rate fluctuates or increases and decreases due to changes
in the foreign exchange market. A floating exchange rate, or fluctuating exchange
rate, is a type of exchange rate regime of which a currency’s value is permitted to
fluctuate according to the foreign exchange market. A currency that adopts a
floating exchange rate is known as a floating currency. The dollar is an example of a
floating currency.
 ◦ Many economists believe floating exchange rates are the optimum possible
exchange rate regime since they automatically adopt economic conditions. These
regimes enable an economy to diminish the impact of shocks and foreign business
cycles and prevent the possibility of a balance of payments crisis. But they also
stimulate volatility as the result of their dynamism.
• Fixed Exchange Rate
◦ A fixed exchange rate system, also known as a pegged exchange rate system, is a
currency system in which governments strive to maintain a consistent currency
value against a specified currency or product. A country's government determines its
worth in terms of a predetermined weight of an asset, another currency, or a basket
of currencies under a fixed exchange-rate system. A country's central bank commits
to buying and selling its currency at a set price at all times.
◦ The central bank of a currency keeps foreign currency and gold reserves to ensure
that its “pegged” value is preserved. They can sell these reserves to make up for
shortfalls in the foreign exchange market.
◦ The well-known fixed rate system is the gold standard, where a unit of currency is
pegged to a definite amount of gold. Regimes also peg to other currencies. These
countries can either select a sole currency to peg to or a “basket” comprising the
country’s major trading partners’ currencies.
• Pegged Float Exchange Rate
◦ Pegged floating currencies are tied to a band or value that is either fixed or changed
on a regular basis. These regimes are a mix of fixed and floating. Pegged float
regimes are divided into three categories:
▪ Crawling Bands
• The market value of a national currency is permitted to fluctuate within a
range specified by a band of fluctuation. This band is determined by
international agreements or by unilateral decisions by a central bank. The
bands are adjusted periodically by the country’s central bank. Generally, the
bands are adjusted in response to economic circumstances and indicators.
▪ Crawling Pegs
 • A crawling peg is an exchange rate regime that allows for progressive
depreciation or appreciation of an exchange rate. It is generally regarded as a
component of fixed exchange rate regimes. The approach is a way to fully
use the peg in fixed exchange rate regimes while maintaining flexibility in
floating exchange rate regimes. The system is set up to peg at a specific value
while also allowing it to “glide” in reaction to external market fluctuations.
In dealing with external pressure to appreciate or depreciate the exchange
rate (such as interest rate differentials or changes in foreign exchange
reserves), the system can meet frequent but moderate exchange rate changes
to ensure that the economic dislocation is minimized.
▪ Pegged with Horizontal Bands
• This system is similar to crawling bands, but the currency is allowed to
fluctuate within a larger band of greater than 1% of the currency's value.
Onshore versus Offshore
• Even within the same nation, exchange rates might fluctuate. There is an onshore rate and
an offshore rate in some cases. Typically, a better exchange rate may be found within a
country's borders versus outside its limits. A well-known example of a country with this
rate structure is China. Furthermore, the Chinese Yuan is a government-managed and
regulated currency. The Chinese government sets a daily midpoint value for the currency,
allowing the yuan to trade in a 2% range around that value.
Finding an Equilibrium Exchange Rate
• Methods to find the equilibrium exchange rate between currencies: the Balance of Payment
Method and the Asset Market Model.
• Most economies are keenly interested in the exchange rate of their currency against that of
their trading partners because it has a direct impact on trade flows. Exports are more
expensive when the local currency has a high value. This results in a trade deficit, reduced
output, and job losses. Imports might be extremely costly if the currency’s value is low,
while exports are projected to rise.
 • If goods can be easily traded across borders with no transportation costs, the Law of One
Price posits that exchange rates will change until the goods' value is the same in both
nations. Also, not all products can be traded internationally (e.g., haircuts), and there are
transportation costs, so the law does not always apply.
• The concept of Purchasing Power parity is vital for understanding the two models of
equilibrium exchange rates below:
◦ Balance of Payments Model
▪ Foreign exchange rates are said to be at an equilibrium level if they provide a steady
current account balance, according to the balance of payments model. A country
with a trade imbalance will see its foreign exchange reserves dwindle, lowering or
reducing the value of its currency. When a country’s currency is undervalued, its
exports become more appealing on the global market while imports become more
expensive. After a transition phase, imports will be forced to decrease while exports
will increase, resulting in a more balanced trade balance and currency.
◦ Asset Market Model
▪ The balance of payments approach, like purchasing power parity, focuses primarily
on physical commodities and services, ignoring the growing importance of global
financial movements. Simply said, money is used to purchase not just goods and
services, but also financial assets such as stocks and bonds to a greater extent. The
movements from financial asset transactions flowed into the capital account item of
the balance of payments, therefore balancing the current account deficit. The asset
market model has benefited from the growth in capital flows.
▪ Currency is a critical component in determining the equilibrium exchange rate in
the asset market model. Asset values are influenced mostly by people’s willingness
to hold existing quantities of assets, which is based on their expectations of the
assets’ future worth. The asset market model of exchange rate determination stresses
that the exchange rate between two currencies is the price that simply balances the
respective supply and demand for assets denominated in those currencies. These
assets are not restricted to consumables, such as groceries or cars. They include
investments, such as shares of stock that are denominated in the currency and debt
denominated in the currency.

Real versus Nominal Rates

• Real exchange rates are nominal rates adjusted for differences in price levels.
 • Currency is complicated, and its value may be calculated in a variety of ways. A currency
can be measured in terms of the products and services it can buy, or it can be assessed in
terms of other currencies. The rate at which one currency is exchanged for another is
referred to as an exchange rate between two currencies. However, multiple perspectives
can be used to comprehend that pace. The two most popular techniques of defining
exchange rates are explained here.
◦ Nominal Exchange Rate
▪ A nominal value is an economic value expressed in monetary terms (that is, in units
of a currency). It is not affected by the change of price or worth of the goods and
services that currencies can buy. Therefore, changes in the nominal value of
currency over the period can occur because of a change in the currency value or the
related prices of the goods and services that the currency is used to buy.
▪ When you go online to see the current exchange rate, it is usually expressed in
nominal terms. The nominal rate is set on the open market and is based on how
much of one currency another currency can buy.
◦ Real Exchange Rate
▪ The buying power of a currency is respect to another currency at current exchange
rates and prices is known as the real exchange rate. It is the ratio between the
number of units of a given country's currency necessary to buy a market basket of
products in another country after purchasing the other country's currency in the
foreign exchange market to the number of units required to buy the market basket
directly in the provided country. The nominal exchange rate is adjusted for price
disparities to get the real exchange rate.
▪ Purchasing Power Parity is a metric for comparing price levels (PPP). The idea of
purchasing power parity allows one to calculate what the exchange rate between
two currencies should be in order for the exchange to be equal to the buying power
of the two currencies. When utilizing the PPP rate for hypothetical currency
conversions, a given quantity of one currency has the same buying power whether it
is used directly to buy a market basket of products or converted to the other
currency and then bought with that currency.
Foreign Exchange and Foreign Exchange Market
 • Foreign exchange, also called Forex, refers to converting one country's currency into
another country’s currency. A single country’s currency is priced against another’s
currency or against a pool of currencies. The global foreign exchange market comprises
daily volumes ranging in trillions of dollars, thus making it the world’s biggest financial
market. Foreign exchange transactions are performed over the counter, and there is no
specific centralized market for the same.
• The foreign exchange market is a venue for buying, selling, exchanging, and speculating
on currencies. Foreign exchange market also makes currency conversion for investments
and international trade. The Foreign exchange markets, also termed as Forex Markets,
consists of investment management firms, central banks, commercial companies, retail
forex brokers, and investors.
• In learning about the foreign exchange market, students will gain insight into the foreign
exchange transactions in these markets. Foreign exchange transaction refers to the
purchase and sale of foreign currencies. The transactions are made with an exchange of a
specific country’s currency for another at an agreed exchange rate on a specific date.
Types of Foreign Exchange Transactions
• Foreign exchange transactions contain all conversions of currencies that a tourist may do at
an airport booth or billion-dollar payments made by financial institutions and governments.
The growth in globalization has led to a huge increase in the number of foreign exchange
transactions in recent years.
• The following are the types of foreign exchange transactions:
◦ Spot Transactions
▪ This way of transaction is the fastest way to exchange currencies. Spot transaction
refers to the exchange or settlement of the buyer and seller's currencies within two
days of the deal without a signed contract. The Spot Exchange Rate is the prevailing
exchange rate in the market.
◦ Forward Transactions
▪ Forward transactions are future transactions when the buyer and seller enter into an
agreement to purchase and sell currency after 90 days. The agreement is framed on
the basis of a fixed exchange rate for a definite date in the future. The rate at which
the deal is fixed is termed as Forward Exchange Rate.
◦ Future Transaction
 ▪ Future transactions also deal with contracts in the same manner as forward
transactions. However, in the case of future transactions, standardized contracts in
terms of features, date, and size should be followed. Whereas regular forward
transactions have the flexibility and can be customized. In future transactions, an
initial margin is fixed and kept as collateral in order to establish a future position.
◦ Swap Transaction
▪ Simultaneous lending and borrowing of two different currencies between two
investors are referred to as swap transactions. One investor borrows a currency and
repays in the form of a second currency to the second investor. Swap transactions
are made to pay off obligations without suffering a foreign exchange risk.
◦ Option Transaction
▪ The exchange of currency from one denomination to another at an agreed rate on a
specific date is an option for an investor. Every investor owns the right to convert
the currency but is not obligated to do so.
Return and Risk of Foreign Exchange Transactions
• The risk involved with a spot foreign exchange transaction is that the foreign currency’s
price may change relative to the U.S. dollar over a holding period. In addition, foreign
exchange risk is presented by adding foreign currency assets and liabilities to a firm’s
balance sheet. Like local assets and liabilities, returns result from the contractual income
from or costs paid on a security. With foreign assets and liabilities yet, returns are also
affected by changes in foreign exchange rates.
◦ Example:
▪ Suppose that on August 19, 2019, a US firm plans to purchase €3,000,000 worth of
Eurobonds from a German bank in one month's time. The German bank wants
payment in euro. Believing that the exchange rate of US dollars for euro will move
against it in the next month, the US firm will convert dollars into euro today. On
August 19, 2019, the spot exchange rate of US dollars for euro is 0.9691, or one
euro costs 0.9691 in dollars. Consequently, the US firm must convert:
• $/€ = x €3,000,000
• 0.9691 x €3,000,000 = $2,907,300
 ▪ One month after the conversion of dollars to euro, the Eurobonds purchase deal falls
through, and the US firm no longer needs the euro it purchased at $0.9691 per euro.
The spot exchange rate of the euro to the dollar has fallen or depreciated over the
month so that the value of a euro is worth only $0.9566, or the exchange rate is
$0.9566 per euro. The US dollar value of €3,000,000 is now only:
• 0.9566 x €3,000,000 = $2,869,800
▪ The depreciation of the euro relative to the dollar over the month has caused the US
firm to suffer a $37,500 ($2,907,300-$2,869,800) loss due to exchange rate
fluctuations.

Lesson 9 - The Derivatives Market

The Derivatives Market
• A derivative security is a financial instrument whose payout is linked to the payback of
another, previously issued security. Derivative instruments typically entail two parties
agreeing to swap a standard quantity of an asset or cash flow at a predetermined price and
at a future date. The value of the derivative security changes in tandem with the value of
the underlying asset being traded. Risk is bought and sold, or transferred, via derivatives.
Under normal conditions, futures trading should not have a negative impact on the
economy because it allows those who want to take risks to take more risks while allowing
people who don’t want to take risks to shift their risk to another location.
• Traders in derivative instruments, however, may suffer huge losses if the price of the
underlying asset moves drastically against them. Damages connected with off-balance-
sheet derivative instruments influenced and held by FIs were undoubtedly at the heart of
the current financial crisis.
• The place or venue where derivative securities are exchanged is known as a derivative
securities market. While derivative securities have existed for millennia, the growth of
derivative securities markets has only occurred since the 1970s. As a result, derivative
securities markets are the most recent of the financial security markets to be deemed
essential.
• Foreign currency futures contracts were the first derivatives to be traded in the present
trend. Following the Smithsonian Agreements of 1971 and 1973, the International
Monetary Market (IMM), a subsidiary of the Chicago Mercantile Exchange (CME),
established these contracts as a response to the entry of floating exchange rates between
currencies of numerous nations.
• Interest rate derivative instruments were the second trend in derivative security evolution.
Their rise was primarily due to increases in interest rate volatility in the late 1970s and
1980s, as the Federal Reserve began to focus on non-borrowed reserves rather than interest
rates. Financial institutions such as banks and savings companies had many rate-sensitive
assets and liabilities on their balance sheets. As interest rate volatility rises, the sensitivity
of these firms' net worth or equity to interest rate blows increased as well. In response, the
Chicago Board of Trade (CBT) presented, in the 1970s, numerous short-term and long-
term interest rate futures contracts, and in the 1980s, stock index futures and options.
Consequently, financial companies are the major participants in the derivative securities
markets.
• A third trend of derivative security revolutions happened in the 1990s with credit
derivatives (e.g., credit forwards, credit risk options, and credit swaps). For example, a
credit forward is a forward agreement that hedges against a rise in default risk on a loan (a
decline in the borrower’s credit quality) after the loan rate is determined and the loan is
delivered. Although the credit shield buyer hedges exposure to default risk, there is still
counterparty credit risk in the event that the seller fails to achieve its obligations under the
terms of the contract (as was the concern in September 2008 regarding AIG, an active
credit default swap seller). In March 2010, the notional value of credit derivatives held by
U.S. banks was approximately $14.36 trillion. These derivative securities have become
particularly valuable for managing the credit risk of emerging-market economies and credit
portfolio risk overall.
 • The fast growth of derivatives use by both FIs, and nonfinancial firms have been
debatable. In the 1990s and 2000s, critics charged that derivatives contracts comprise
potential losses that can materialize, mainly for banks and insurance companies that
transact heavily in these instruments. In the 1990s, a number of scandals concerning FIs,
firms, and municipalities, like the scandal in Bankers Trust and the Allied Irish Bank led to
a narrowing of the accounting (reporting) requirements for derivative contracts. Definitely,
beginning in 2000, the Financial Accounting Standards Board (FASB) mandated all
derivatives to be marked to market and required that losses and gains be immediately
transparent on FIs’ and other firms’ financial statements.
• During the late 2000s, billions of dollars in derivatives losses and the near-collapse of the
world’s financial markets prompted a need for important derivatives trading restrictions to
be enacted. Many over-the-counter derivative transactions between financial institutions
were expected to be brought under federal supervision, with securities and commodities
authorities empowered to enforce them.

Participants in the Derivatives Market

• Hedgers
◦ Hedging is when a person invests in financial markets to lessen the risk of price
volatility in exchange markets, which eliminates the risk of future price activities.
Derivatives are the most common instruments in the range of hedging. It is due to
derivatives are effective hedges in relation to their respective underlying assets.
• Speculators
◦ The most common market activity that the participants take part in the financial market
is speculation. It is a high-risk activity that investors are involved with. It includes the
purchase of any financial instrument or an asset that an investor speculates on in order
to be significantly valuable in due time. Speculation is motivated by the drive to
potentially earn lucrative profits in the future.
• Arbitrageurs
◦ Arbitrage is a very common money-making activity in financial markets that comes
into effect by taking advantage of or profiting from the market’s price volatility.
Arbitrageurs make a profit from the price difference rising in an investment of a
financial instrument such as bonds, stocks, derivatives, etc.
• Margin Traders
 ◦ In the finance industry, the margin is the guarantee deposited by an investor investing
in a financial instrument to the counterparty to shield the credit risk associated with the
investment.
Types of Derivatives Contracts
• Derivative contracts can be classified into four types:
◦ Options
▪ Options are financial derivative contracts that allow the buyer the right, but not the
duty, to purchase or sell an underlying asset at a predetermined price, often known
as the strike price, over a specific time period. Option periods in the United States
can be exercised at any time before they expire. The European options, on the other
hand, can only be used until they expire.
◦ Futures
▪ Futures contracts are consistent contracts that allow the holder of the contract to buy
or sell the particular underlying asset at an agreed price on a pre-determined date.
The parties involved in a futures contract hold the right and are under the obligation
to carry out the contract as arranged. The contracts are standardized, which means
they are traded on the exchange market.
◦ Forwards
▪ Forwards contracts are comparable to futures contracts in the sense that the holder
of the contract holds not only the right but is also under the obligation to carry out
the contract as agreed. Though, forwards contracts are over-the-counter products,
which means they are not regulated and are not assured by specific trading policies
and regulations.
▪ Since the contracts are not standardized, they are traded over the counter and not on
the exchange market. As the contracts are not covered by a regulatory body's rules
and regulations, they are customized to suit the requirements of all trading parties.
◦ Swaps
▪ Swaps are financial derivative contracts in which two holders, or contract parties,
exchange financial responsibilities. The most common swaps contracts traded by
investors are interest rate swaps. Swaps aren't traded on the stock exchange.
Because swaps contracts must be customized to meet the needs and criteria of all
parties involved, they are traded over the counter.
Forwards and Futures
• Let us compare forward and futures contracts and markets to spot contracts to demonstrate
the key nature and characteristics of these ‹contracts and marketplaces. In Figure 1 below,
we demonstrate appropriate dates for each of the three contracts that use a bond as the
underlying financial security to the derivative contract.

• Spot Contract
◦ An agreement made between a buyer and a seller at time 0 for the seller to deliver the
asset immediately and the buyer to pay for the asset immediately.
• Forward Contract
◦ An agreement between a buyer and a seller at time 0 to exchange a non-standardized
asset for cash at some future date. The asset's details and the price to be paid at the
forward contract expiration date are set at time 0. The price of the forward contract is
fixed over the life of the contract.
• Futures Contract
◦ Agreement between a buyer and seller at time 0 to exchange a standardized asset for
cash at some future date. Each contract has a standardized expiration, and transactions
occur in a centralized market. The futures contract price changes daily as the market
value of the asset underlying the futures fluctuate.
Spot Market
• A spot contract is an arrangement between a buyer and a seller at time 0, when the seller of
the asset agrees to deliver it instantly, and the buyer agrees to pay for that asset directly.
Therefore, the spot market's unique feature is the immediate and synchronized exchange of
cash for securities, or what is frequently called delivery versus payment. A spot bond quote
of $97 for a 20-year maturity bond is the price the buyer must pay the seller, per $100 of
face value, for immediate (time 0) delivery of the 20-year bond.
• Spot transactions happen because the asset buyer understands its value will rise in the
immediate future over the investor’s holding period. If the value of the asset rises as
expected, the investor can sell the asset at a higher price for a profit. For example, if the
20- year bond rises in value to $99 per $100 of face value, the investor can sell the bond
for a profit of $2 per $100 of face value.

Forward Markets
• A forward contract is a contract between a buyer and a seller at time zero to exchange a
pre- determined asset for payment at a later time. Because the future or spot price or
interest rate on an item is unknown, market participants take positions in forward
contracts. Fairly than risk that the future spot price will move against them, the asset will
become more costly to buy in the future-forward traders pay a financial institution a fee to
position a forward contract. Such a contract lets the market traders hedge the risk that
future spot prices on an asset will move against him or her by assuring a future price for
the asset today.
◦ Example:
▪ In a 3-month forward contract to deliver $100 face value of 10-year bonds, the
buyer and seller settle on a price and amount today (time 0), but the delivery (or
exchange) of the 10-year bond for cash does not occur until 3 months into the
future. If the forward price agreed to at time 0 was $98 per $100 of face value, in
three months' time, the seller delivers $100 of 10-year bonds and receives $98 from
the buyer. This is the price the buyer must pay, and the seller must accept no matter
what happens to the spot price of 10-year bonds during the three months between
the time the contract is entered into and the time the bonds are delivered for
payment (i.e., whether the spot price falls to $97 or below or rises to $99 or above).
 • Commercial banks and investment firms, and broker-dealers are the key forward market
participants, serving as both principals and agents. These financial institutions generate a
profit on the spread between the price at which they buy and sell the assets underlying the
forward contracts.
• Each forward contract is initially transacted between the financial institution and the
customer. Therefore, the details of each variable like the price, expiration, size, and
delivery date can be unique. Most forward contracts are customized contracts that are
negotiated between two parties. Therefore, there is a risk of default by both parties. If an
over-the- counter (OTC) transaction is not organized cautiously, it may pass along
accidental risks to participants, pushing them to higher frequency and severity of losses
than if they had held an equivalent cash position.

Futures Markets
• A futures contract is generally traded on an organized exchange such as the ICE
(Intercontinental Exchange) Futures U.S. Like a forward contract, a futures contract is an
agreement between a buyer and a seller at time 0 to exchange a standardized, pre-specified
asset for cash at some later date. Thus, a futures contract is the same as a forward contract.
One difference between forwards and futures is that forward contracts are bilateral
contracts subject to counterparty default risk, but the default risk on futures is significantly
reduced by the futures exchange, ensuring to underwrite counterparties against a credit or
default risk.
• Another dissimilarity relates to the contact’s price, which is a forward contract is fixed
over the life of the contract (e.g., $98 per $100 of face value for three months to be paid on
the expiration of the forward contract), while a futures contract is marked to market daily.
This means that the contract's price is adjusted each day as the price of the asset underlying
the futures contract fluctuates and as the contract nearing expiration. Thus, actual daily
cash settlements occur between the buyer and seller in reaction to these price changes.
◦ Marked to Market
▪ Describes the prices on outstanding futures contracts adjusted each day to reflect
current futures market conditions.
◦ Open-Outcry Auction
▪ Method of futures trading where traders face each other and "cry out" their offer to
buy or sell a stated number of futures contracts at a stated price.
 • Only members of futures exchanges are allowed to trade on futures exchanges. The
public's trades are placed with a floor broker. A floor broker may trade with another floor
broker or a professional trader when an order is made. Professional traders trade for their
own accounts, comparable to professionals on the stock exchanges. Position traders, day
traders, and scalpers are all terms used to describe professional traders. Position traders
enter the futures market with the anticipation of the underlying assets’ prices moving in the
direction they expect. Day traders typically open a position and close it before the end of
the day. Scalpers trade for relatively short periods of time, often only minutes, in the hopes
of profiting from this type of aggressive trading.
• Scalpers are not obligated to supply liquidity to futures markets, but they do so in the
hopes of making a profit. Scalpers make money based on the bid-ask spread and the
amount of time they hold a position. Scalper transactions that last longer than three
minutes, on average, result in losses for scalpers, according to research. As a result, the
requirement for a scalper’s position to be turned around quickly enhances futures market
liquidity and is thus important.
• Futures transactions, like stock trades, can be placed as market orders (instructing the floor
broker to transact at the best price available) or limit orders (instructing the floor broker to
transact at a specified price). The order may be for a buy of the futures contract, in which
case the futures holder would take a long position in the contract, or for a sell of the futures
contract, in which case the futures holder would take a short position in the contract.

Margin Requirements on Futures Contracts

 • When clients seek a transaction, brokerage houses ask them to post just a fraction of the
value of the futures (and option) contracts, known as an initial margin. The margin amount
varies depending on the kind of transaction and the number of futures contracts traded
(e.g., 5% of the value of the underlying asset). Each exchange establishes its own
minimum margin requirements. The customer receives a margin call if losses on their
futures position occur (when their account is marked to market at the end of the trading
day) and the quantity of money in the margin account falls below a certain threshold
(called the maintenance margin).
• A margin call necessitates the consumer depositing extra cash into his or her margin
account in order to restore the balance to its original level. In most cases, the maintenance
margin is roughly 75% of the initial margin. The broker closes out (sells) the customer's
future position if the margin is not maintained. The consumer has the option to withdraw
any cash received beyond the original margin from his or her account. Brokerage
companies are in charge of making sure their clients meet the required margin
requirements.
◦ Example: The Impact of Marking to Market and Margin Requirements on Futures
Investments
▪ Suppose an investor has a $1 million long position in T-bond futures. The investor's
broker requires a maintenance margin of 4%, or $40,000 ($1m x .04), which is the
amount currently in the investor's account. Suppose also that the value of the futures
contracts drops by $50,000 to $950,000.
▪ The investor will now be required to hold $38,000 ($950,000 x .04) in his account
(or he has a $2,000 surplus). Further, because futures contracts are marked to
market, the investor's broker will make a margin call to the investor requiring him to
immediately send a check for $50,000 less $2,000, or $48,000, leaving him with an
account balance of $38,000 at his broker for the $950,000 T-bond futures position.
Thus, as stated above, the marking to the market feature of futures contracts can
lead to unexpected cash outflows for a future investor.

Options Market
• An option is a contract that gives the holder the right, but not the obligation, to buy or sell
an underlying asset at a pre-determined price for a specified time period. Options are
categorized as either call options or put options.
• The Chicago Board of Options Exchange (CBOE) opened in 1973. It was the first
exchange dedicated solely to the trading of stock options. In 1982, financial futures options
contracts (options on financial futures contracts, e.g., Treasury bond futures contracts)
started trading. Options markets have developed rapidly since the mid-1980s.
• The trading process for options is comparable to that for futures contracts. An investor
keen to take an option position calls his or her broker and places an order to buy or sell a
stated number of call or put option contracts with a specified expiration date and exercise
price. The broker leads this order to its representative on the appropriate exchange for
execution. Most trading on the largest exchanges such as the CBOE happens in trading
pits, where traders for each delivery date on an option contract informally group together.
Like futures contracts, options trading mostly occurs using an open-outcry auction method.
◦ Call Options
▪ A call option gives the purchaser (or buyer) the right to buy underlying security
(e.g., a stock) at a pre-determined price called the exercise or strike price (X). In
exchange, the call option buyer must pay the writer (or seller) an up-front fee
known as a call premium (C). This premium is an instant negative cash flow for the
buyer of the call option. Though, he/she possibly stands to generate a profit should
the underlying stock's price be higher than the exercise price (by an amount
exceeding the premium). If the price of the underlying stock is higher than X (the
option is referred to as "in the money"), the buyer can exercise the option, buying
the stock at X and selling it instantly in the stock market at the current market price,
higher than X. If the price of the underlying stock is less than X (the option is
referred to as "out of the money"), the buyer of the call will not exercise the option
(i.e., buy the stock at X when its market value is less than X). If this is the case, the
option will expire without being exercised when it matures. When the underlying
stock price is precisely identical to X when the option expires, the same thing
happens (the option is referred to as "at the money"). For the option, the call buyer
pays a cost C (the call premium), and no additional cash flows are generated.
◦ Put Options
 ▪ A put option gives the option buyer the right to sell underlying security (e.g., a
stock) at a pre- specified price to the writer of the put option. In return, the buyer of
the put option should pay the writer (or seller) the put premium (P). If the
underlying stock’s price is less than the exercise price (X) (the put option is “in the
money”), the buyer will buy the underlying stock in the stock market at less than X
and instantly sell it at X by exercising the put option. If the price of the underlying
stock is greater than X (the put option is “out of the money”), the buyer of the put
option would not exercise the option (i.e., selling the stock at X when its market
value is more than X). If this is the case, when the option matures, the option
expires unexercised. This is also true if the underlying stock price is exactly equal to
X when the option expires (the put option is trading “at the money”). The put option
buyer incurs a cost (P) for the option, and no other cash flows result.

Swaps Markets
• A swap is a contract between two parties (called counterparties) to trade specified periodic
cash flows in the future based on some underlying instrument or price (e.g., a fixed or
floating rate on a bond or note). Like forward, futures, and options contracts, swaps allow
firms to handle better their interest rate, foreign exchange, and credit risks. Though, swaps
also can result in large losses.
• At the center of the financial crisis from 2008 to 2009, derivative securities, mostly credit
swaps, were held by financial institutions. Especially in the late 2000s, financial
institutions such as Lehman Brothers and AIG had written and also (in the case of AIG)
insured billions of dollars of credit default swap (CDS) contracts. When the mortgages
underlying these contracts fell extremely in value, credit swap writers found themselves
incapable of making good on their promised payments to the swap holders. The result was
a substantial increase in risk and a decrease in profits for the FIs that had purchased these
swap contracts. To prevent an immense collapse of the financial system, the federal
government had to step in and bail out several of these financial institutions.
• The asset or instrument underlying the swap may vary, but the basic principle of a swap
agreement is the same in that it includes the trading parties restructuring their asset or
liability cash flows in a chosen direction.
• Swap transactions are generally diverse in terms of maturities, indexes used to determine
payments, and timing of payments - there is no standardized contract. Swap dealers
(usually an FI performing this brokerage activity) exist to serve the function of taking the
opposite side of each transaction in order to keep the swap market liquid by locating or
matching counterparties or, in many cases, taking one side of the swap themselves. In a
direct swap between two counterparties, each party must find another party having a mirror
image financing requirement. For example, a financial institution in need of swapping
fixed-rate payments, made quarterly for the next ten years, on $25 million in liabilities
must find a counterparty in need of swapping $25 million in floating-rate payments made
quarterly for the next ten years.
• Without swap dealers, the search costs of finding such counterparties to a swap can be
significant. A further advantage of swap dealers is that they generally guarantee swap
payments over the life of the contract. If one of the counterparties defaults on a direct
swap, the other counterparty is no longer adequately hedged against risk and may have to
replace the defaulted swap with a new swap at less favorable terms (replacement risk). By
booking a swap with a swap dealer, a default by a counterparty will not affect the other
counterparty.

• Interest Rate Swaps

◦ By far, the largest segment of the swap market comprises interest rate swaps.
Conceptually, an interest rate swap is a succession of forward contracts on interest rates
arranged by two parties.
 ◦ In a swap contract, the swap buyer agrees to make a number of fixed interest rate
payments based on a principal contractual amount (called the notional principal) on
periodic settlement dates to the swap seller. The swap seller, in turn, agrees to make
floating-rate payments, tied to some interest rate, to the swap buyer on the same
periodic settlement dates. In undertaking this transaction, the fixed-rate payer’s party
seeks to transform the variable- rate nature of its liabilities into fixed-rate liabilities to
match its assets’ fixed returns better.

• Currency Swaps
◦ Interest rate swaps are long-term contracts that can be used to hedge interest rate risk
exposure. This section considers a simple example of how currency swaps can be used
to immunize or hedge against exchange rate risk when firms mismatch the currencies of
their assets and liabilities.
• Credit Swaps
◦ In recent years, the fastest-growing types of swaps have been those developed to allow
better financial institutions to hedge their credit risk, so-called credit swaps or credit
default swaps. In 2000, commercial banks’ total notional principal for outstanding
credit derivative contracts was $426 billion. By March 2008, this amount had risen to
$16.44 trillion before falling to $13.44 trillion in 2009 during the financial crisis. Of
this 2009 amount, $13.30 trillion was credit swaps.
 ◦ Two types of credit swaps are total return swaps and pure credit swaps. A total return
swap involves swapping an obligation to pay interest at a specified fixed or floating
rate for payments representing the total return on a loan (interest and principal value
changes) of a specified amount. While total return swaps can be used to hedge credit
risk exposure, they contain an element of interest rate risk as well as credit risk. For
example, if the base rate on the loan changes, the net cash flows on the total return
swap also will change - even though the credit risks of the underlying loans have not
changed.
Definition of Terms
• Floor Broker
◦ Exchange members who place trades from the public.
• Professional Traders
◦ Exchange members who trade for their own account.
• Position Traders
◦ Exchange members who take a position in the futures market based on their
expectations about the future direction of the prices of the underlying assets.
• Day Traders
◦ Exchange members who take a position within a day and liquidate it before the day's
end.
• Scalpers
◦ Exchange members who take positions for very short periods of time, sometimes only
minutes, in an attempt to profit from this active trading.
• Long Position
◦ A purchase of a futures contract.
• Short Position
◦ A sale of futures contract.
• Clearinghouse
◦ The unit that oversees trading on the exchange and guarantees all trades made by the
exchange traders.

Lesson 10 - Risk Management in Financial Institutions

Risk Management
 • The primary objective of the financial institution’s management is to increase the rims
returns for its shareholders. This mostly happens, however, at the exchange of increased
risk. Regulators’ assessment of a depository institution’s overall safety and reliability (DI)
is summarized in the CAMELS rating assigned to the DI. This module overviews the
various risks facing financial institutions: credit risk, liquidity risk, interest rate risk,
market risk, off- balance-sheet risk, foreign exchange risk, country or sovereign risk,
technology risk operational risk, and insolvency risk.
• The effective management of these risks is vital to an FI’s performance. Certainly, it can be
reasoned that the main business of FIs is to manage these risks. In general, FI managers
must dedicate significant time to understanding and dealing with the various risks to which
their FIs are exposed. By the end of this module, you will have a basic understanding of
the variety and complications of the risks facing managers of present FIs.
• Because of some financial institutions’ huge size, overexposure to risk can lead financial
institutions to failure and affect millions of people. By understanding the risks posed to
banks, governments can impose better regulations to promote prudent management and
decision-making. The ability of a bank to handle risk also affects investors’ decisions.
Even if a bank can generate huge revenues, poor risk management can lower profits due to
losses on loans. Value investors are most likely to invest in a bank that has the capability to
provide profits and is not at an excessive risk of losing money.

Risks Faced by Financial Institutions

• Credit Risk
◦ The risk that promised cash flows from loans and securities held by FIs may not be
paid in full.
• Liquidity Risk
◦ The risk that a sudden and unexpected increase in liability withdrawals may require an
FI to liquidate assets in a very short period of time and at low prices.
• Interest Rate Risk
◦ The risk incurred by an FI when the maturities of its assets and liabilities are
mismatched, and interest rates are volatile.
• Market Risk
◦ The risk incurred in trading assets and liabilities due to changes in interest rates,
exchange rates, and other asset prices.
• Off-Balance-Sheet Risk
 ◦ The risk incurred by an FIs the result of its activities related to contingent assets and
liabilities.
• Foreign Exchange Risk
◦ The risk that exchange rate changes can affect the value of an FI's assets and liabilities
denominated in foreign currencies.
• Country or Sovereign Risk
◦ The risk that repayments by foreign borrowers may be interrupted because of
interference from foreign governments or other political entities.
• Technology Risk
◦ The risk incurred by an FI when its technological investments do not produce
anticipated cost savings.
• Operational Risk
◦ The risk that existing technology or support systems may malfunction, that fraud
impacts the FIs activities may occur, and/or that external shocks such as hurricane and
floods may occur.
• Insolvency Risk
◦ The risk that an FI may not have enough capital to offset a sudden decline in the value
of its assets relative to its liabilities.
Credit Risk
• Credit risk occurs because of the possibility that assured cash flows on financial claims
held by businesses, such as loans and bonds, will not be paid in full. Almost all types of
financial institutions face this risk. Nevertheless, in general, financial institutions that avail
loans or buy bonds with long maturities are more exposed than are financial institutions
that make loans or buy bonds with short maturities. For example, depository institutions
and life insurers are more exposed to credit risk than money market mutual funds and
property like casualty insurers since depository institutions and life insurers tend to hold
longer maturity assets in their portfolios than mutual funds property-casualty insurers. For
example, commercial and investment banks incurred billions of dollars of losses in the
mid- and late 2000s as a result of credit risk on subprime mortgages and mortgage-backed
securities. If the principal on all financial claims held by Fl’s were settled in full on
maturity and interest payments were made on their guaranteed payment dates, Fl’s would
always receive back the original principal lent plus an interest return; that is, they would
face minimal to nothing credit risk. Should a borrower defaults but, both the principal
loaned, and the interest payments expected to be received are at risk.
• A lot of financial claims issued by individuals or businesses and held by Fl’s promise a
limited or fixed upside return (principal and interest payments to the lender) with a high
possibility, but they also may result in a huge downside risk (loss of loan principal and
promised interest) with a quite lesser probability. Some examples of financial claims
issued with these return-risk trade-offs are fixed-coupon bonds issued by corporations and
bank loans. In both cases, an FI holding these claims as assets earns the coupon on the
bond or the interest promised on the loan if no borrower default occurs. In the event of
default, however, the FI earns zero interest on the asset and may well lose all or part of the
principal lent, a subject on its ability to lay claim to some of the borrower’s assets through
legal bankruptcy and insolvency proceedings.
• Credit risk is the largest and most common risk for banks. It appears when borrowers or
counterparties fail to meet contractual obligations. An example is when borrowers fail or
default on a principal or interest payment of a loan. Defaults can occur on mortgages,
credit cards, and fixed-income securities. Failure to meet obligational contracts can also
happen in areas such as derivatives and guarantees provided.
• While banks and other financial institutions may not be fully protected from credit risk due
to their business model's nature, they can minimize their exposure in several ways. Since
the decline in an industry or issuer is frequently unpredictable, banks lower their exposure
via diversification.
• By doing so, during a credit recession, banks are less likely to be overexposed to a
category with huge losses. To lessen their risk exposure, they can loan money to people
with good credit records, transact with high-quality counterparties, or own collateral to
back up the loans.
◦ Example: Impact of Credit Risk on an FI's Value of Equity
▪ Consider financial institutions with the following balance sheet:
 • Suppose that the managers of the FI recognize that $5 million of its $80 million is
loans id doubtful to be repaid due to an increase in credit repayment difficulties of
its borrowers. Eventually, the FI's managers must answer by charging off or writing
down these loans' value on the FI's balance sheet. This means that the value of loans
falls from $80 million to $75 million, an economic loss that must be charged off
against the stockholders' equity capital or net worth (i.e., equity capital falls from
$10 million to $5 million). Thus, both sides of the balance sheet shrink by the
amount of the loss:

• Despite losses due to credit risk increase, financial institutions continue to give loans
readily. This is because the FI charges a rate of interest on a loan that pays off the loan risk.
Thus, a significant component in the credit risk management process is its pricing. The
potential loss a financial institution can experience from lending suggests that FIs need to
gather information about borrowers whose assets are in their portfolios and monitor those
borrowers over time. Consequently, managerial (monitoring) efficiency and credit risk
management strategies directly influence the loan portfolio's returns and risks.

Liquidity Risk
• Liquidity risk occurs when a financial institution’s liability holders, such as depositors or
insurance policyholders, demand instant cash for the financial claims they hold with the
financial institutions or when holders of off-balance-sheet loan commitments (or credit
lines) quickly exercise their right to borrow (draw down their loan commitments). For
example, when liability holders demand cash instantly - that is, “put” their financial claim
back to the FI, the FI must either liquidate assets or borrow supplementary funds to meet
the demand for the withdrawal of funds. The most liquid asset of all is cash, which
financial institutions can use directly to meet liability holders’ demands to withdraw cash.
Even though Fl’s limit their cash asset holdings because cash earns no interest, low cash
holdings are mostly not a problem.
• Daily withdrawals by liability holders are mostly predictable, and large banks can normally
expect to borrow additional funds to meet any unexpected shortfalls of cash in the money
and financial markets.
• Liquidity risk also means the ability of a financial institution to access cash to meet
funding obligations. Obligations include enabling clients to take out their deposits. The
failure to provide cash in a timely manner to clients can result in a domino effect. If bank
delays providing cash for a few of their customer for a day, other depositors may haste to
take out their deposits as they lose confidence in the bank. This further lowers the bank’s
ability to deliver funds and leads to a bank run.
• Reasons that banks face liquidity problems include dependence on short-term sources of
funds, having a balance sheet concentrated in fixed assets, and loss of confidence in the
bank on the part of customers. Mishandling of asset-liability duration can also cause
funding difficulties. This happens when a bank has many short-term liabilities and not
enough short- term assets.
• Short-term liabilities are customer deposits or short-term guaranteed investment contracts
(GICs) that the bank is obligated to pay out to customers. If all or the majority of a bank’s
assets are tied up in long-term loans or investments, the bank may suffer from a
discrepancy in asset-liability duration. Regulations exist to reduce liquidity problems. They
include a requirement for banks to possess enough liquid assets to survive for a period of
time even without outside funds’ inflow.
◦ Example: Impact of Liquidity Risk on an FI's Equity Value
▪ Consider the simple FI balance sheet. Before deposit withdrawals, the FI has $10
million in cash assets and $90 million in non-liquid assets (such as small businesses
loans). These assets were funded with $90 million in deposits and $10 million in
owner's equity. Suppose that depositor's unexpectedly withdraw $15 million in
deposits (perhaps due to the release of negative news about the profits of the FI),
and the FI receives no new deposits to replace them. To meet these deposit
withdrawals, the FI first uses the $10 million it has in cash assets and then seeks to
sell some of its non-liquid assets to raise an additional $5 million in cash.
 ▪ Assume that the FI cannot borrow any more funds in the short-term money markets,
and because it cannot wait to get better prices for its assets in the future (as it needs
the cash now to meet immediate depositor withdrawals) the FI has to sell any non-
liquid assets at 50 cents on the dollar. Thus, to cover the remaining $5 million in
deposit withdrawals, the FI mus sell $10 million in non-liquid assets, incurring a
loss of $5 million from those assets' face value. The FI must then write off any such
losses against its capital or equity funds. Since its capital was only $10 million
before the deposit withdrawal, the loss on the fire-sale of assets of $5 million leaves
the FI with $5 million.

Interest Rate Risk

• The main securities that Fl’s acquire often have maturity characteristics unique from the
secondary securities that FIs sell. In mismatching the maturities of its assets and liabilities
as part of its asset transformation function, an FI potentially exposes itself to interest rate
risk.
◦ Example: Impact of an Interest Rate Increase on an FI's Profit when the Maturity of
Assets Exceeds the Maturity of Liabilities
▪ Consider an FI that issues $100 million of liabilities with one-year to maturity to
finance the purchase of $10 million of assets with a two-year maturity.
 ◦ Suppose that the cost of funds (liabilities) for the FI is 9% in Year 1 and the interest
return on the assets is 10% per year. Over the first year, the FI can lock in a profit
spread of 1% times $100 million by borrowing short-term (for one year) and
lending long-term (for two years). Thus, its profit is $1 million (.01x100m). Its
profit for the second year, however, is uncertain. If the level of interest rates does
not change, the FI can refinance its liabilities at 9% and lock in a 1% or $1 million
profit for the second year as well. The risk always exists, however, that interest rates
will change between years 1 and 2. If interest rates rise and the FI can borrow new
one-year liabilities at only 11% in the second year, its profit spread in the second
year is actually negative; that is, -1%, or the FI loses $1 million. The positive spread
earned in the first year by the FI from holding assets with a longer maturity than its
liabilities is offset by a negative spread in the second year. Note that if interest rates
were to rise by more than 2% in the second year, the Fi would stand to make losses
over the two-year period as a whole. As a result, when an FI holds longer-term
assets relative to liabilities, it potentially exposes itself to refinancing risk.
• Example: Impact of an Interest Rate Decrease on an FI's Profit When the Maturity of
Liabilities Exceeds the Maturity of Assets
◦ An alternative balance sheet structure would have the FI borrowing $100 million for
a longer-term than the $100 million of assets in which it invests. This is shown as
follows:
 ▪ In this case, the FI is also exposed to an interest rate risk by holding shorter-term
assets relative to liabilities, it faces uncertainty about the interest rate at which it can
reinvest funds in the second year. As before, suppose that the cost of funds for the
FI is 9% per year over the two years and the interest rate on assets is 10% in the first
year. Over the first year, the FI can lock in a profit spread of 1%, or $1 million. If
the second-year interest rates on $100 million invested in new one-year assets
decrease to 8%, the FI's profit spread is -1%, or the FI loses $1 million. The positive
spread earned in the first year by the FI from holding assets with a shorter maturity
than its liabilities is offset by a negative spread in the second year. Thus, the FI is
exposed to reinvestment risk by holding shorter-term assets relative to liabilities, it
faces uncertainty about the interest rate at which it can reinvest funds borrowed over
a longer period. In recent years, good examples of this exposure are banks operating
in the Euromarkets that have borrowed fixed-rate deposits while investing in
floating-rate loans - loans whose interest rates are changed or adjusted frequently.
• In addition to a possible refinancing or reinvestment outcome, financial institutions
experience price risk or market value uncertainty when interest rates fluctuate. Recall that
an asset or liability's economic or fair market value is theoretically equal to the present
value of the current and future cash flows on that asset or liability. Therefore, increasing
interest rates increase the discount rate on future asset (liability) cash flows and lessens the
market price or present value of that asset or liability.
• On the other hand, falling interest rates improve the cash flows’ present value from assets
and liabilities. Likewise, mismatching maturities by holding longer term assets than
liabilities states that when interest rates rise, the Fl's assets' economic or present value falls
by a longer-term than do its liabilities. This exposes the Fl to the risk of economic loss and
possibly to the risk of insolvency.
Market Risk
• Market risk arises when Fl’s actively transact assets and liabilities (and derivatives) instead
of holding them for a longer-term investment, funding, or hedging purposes. Market risk is
directly related to interest rate and foreign exchange risk in that as these risks fluctuate, the
overall risk of the FI is affected. However, market risk adds another dimension of risk,
which is the trading activity. Market risk is the additional risk incurred by an FI when the
interest rate and foreign exchange risks are combined with an active trading strategy,
particularly one that involves short trading periods such as a day.
 • Theoretically, a financial institution’s trading portfolio can be distinguished from its
investment portfolio on the basis of time horizon and liquidity. The trading portfolio
comprises assets, liabilities, and derivative contracts that can be quickly acquired or sold
on structured financial markets. The investment portfolio (for banks, the “banking book”)
contains assets and liabilities that are fairly illiquid and held for longer periods.
• The financial market crisis demonstrates trading or market risk, the risk that when an FI
takes an open or unhedged long (buy) or short (sell) position in bonds, equities,
commodities, and derivatives, prices may change in a direction opposite to that expected.
As a result, as the volatility of asset prices rises, financial institutions' market risks that
adopt open trading positions increase. This needs Fl management (and regulators) to
establish controls or limits on positions taken by traders and develop models to determine
the market risk exposure of an FI daily.
Off-Balance-Sheet Risk
• One of the most remarkable trends involving present financial institutions has been the
growth in their off-balance sheet (OBS) activities and, thus, their off-balance-sheet risks.
The off-balance-sheet risk is the risk incurred by an FI as the result of activities associated
with contingent assets and liabilities.
• While all Fl’s, to some level, are involved in off-balance-sheet activities, most attention
has been drawn to the activities of banks, particularly large banks that invest largely in off-
balance-sheet assets and liabilities, mainly derivative securities. Off-balance-sheet
activities have not been much of a concern to smaller depository institutions and many
insurers. An off-balance-sheet activity, by definition, does not appear on an Fl’s current
balance sheet since it does not involve holding a current primary claim (asset) or the
issuance of a current secondary claim (liability). Instead, off-balance-sheet activities
influence an Fl's balance sheet’s future shape since they engage in the creation of
contingent assets and liabilities that give sense to their potential placement in the future on
the balance sheet. As such, accountants place them “below the bottom line” on an FI’s
balance sheet.
• Another example of an off-balance-sheet activity is the issuance of standby letters of credit
guarantees by insurance companies and banks to back the issuance of municipal bonds.
Foreign Exchange Risk
 • Fl’s have progressively recognized that both direct foreign investment and foreign
portfolio investment can extend the operational and financial benefits presented from
purely domestic investments. To the extent that the gains on domestic and foreign
investments are imperfectly correlated, Fl’s can lessen the risk through domestic-foreign
activity investment diversification.
• Foreign exchange risk is the risk that arises, and a fall in the exchange rate can directly
influence the value of an FI’s assets and liabilities denominated in foreign currencies.
• Foreign exchange risk occurs when a company is involved in financial transactions
denominated in a currency other than the currency where that company is located. Any
movement of the base currency or the depreciation/appreciation of the denominated
currency will have an impact on the cash flows emanating from that transaction. Investors
are also affected by the foreign exchange risk, trade in international markets, and
companies engaged in import/exporting products or services to various countries.
• Closed trade earnings, whether it is a profit or loss, will be denominated in the foreign
currency and must be converted back to the investor's base currency. Movement in the
exchange rate could badly affect this conversion resulting in a lower-than-expected
amount.
Technology and Operational Risk
• Technology and operational risks are closely related and, in recent years, have led to great
concern for the managers of financial institutions and regulators alike. The Bank for
International Settlements (BIS), the principal organization of central banks in the major
economies of the world, describes operational risk (inclusive of technological risk) as “the
risk of loss resulting from inadequate or failed internal processes, people, and systems or
from external events.” Several Fls add reputational risk and strategic risk (e.g., due to a
failed merger) as part of a wider definition of operational risk.
 • Technology risk rises when technological investments do not produce the anticipated cost
savings in the form of either economy of scale or economies of scope. Diseconomies of
scale, for example, occur because of excess capacity, redundant technology, and/or
organizational and bureaucratic inefficiencies that become worse as an Fl grows in size.
Diseconomies of scope arise when an Fl fails to generate perceived synergies or cost
savings through major new technological investments. Technological risk can result in
major losses in an FI's competitive efficiency and eventually result in its long-term failure.
Likewise, gains from technological investments can provide performance superior to FI’s
rivals as well as enables it to develop new and innovative products enhancing its long-term
survival chances.
• Operational risk is partly related to technology risk and can arise when existing technology
malfunctions or “back-office” support systems break down. For example, in February
2005, Bank of America announced that it had lost computer backup tapes containing
personal information such as names and Social Security numbers on about 1.2 million
federal government employee charge cards as the tapes were being transported to a data
storage facility for safekeeping. Bank of America could not rule out the possibility of
unauthorized purchases using the lost data, but it said the account numbers, names,
addresses, and other tape contents were not easily accessible without highly sophisticated
equipment and technological expertise. The biggest known theft of credit card numbers
was exposed in May 2007, when, over a two-year period, as many as 200 million card
numbers were stolen from TJX Company - parent company to such retail stores as
Marshalls and TJ Maxx. The retailer’s wireless network reportedly had less security than
most home networks. Even though such computer and data problems are uncommon, the
incidence can cause major dislocations for the FIs involved and potentially disrupt the
financial system in general.
Insolvency Risk
• Insolvency risk is a consequence or an outcome of one or more of the risks described
above: interest rate, market, credit, off-balance-sheet, technological, foreign exchange,
sovereign, and liquidity. Technically, insolvency occurs when the capital or equity
resources of an FI's owners are driven to, or near to, zero due to losses incurred as the
result of one or more of the risks described above.
 • In general, the more equity capital to borrowed funds an FI has, the lower its leverage - the
better able it is to endure losses due to risk exposures such as adverse liquidity changes,
unexpected credit losses, and so on. Thus, both the management and regulators of Fls focus
on an Fl’s capital (and its “adequacy”) as a key measure of its ability to continue solvent
and grow in the face of a multitude of risk exposures.
Definition of Terms
• Firm-Specific Credit Risk
◦ The risk of default for the borrowing firm associated with the specific types of project
risk taken by that firm.
• Systematic Credit Risk
◦ The risk of default associated with general economy-wide or macro conditions
affecting all borrowers.
• Interest Rate Risk
◦ The risk incurred by an FI when the maturities of its assets and liabilities are
mismatched, and interest rates are volatile.
• Refinancing Risk
◦ Type of interest rate risk in that the cost of refinancing can be more than the return
earned on asset investments.
• Letter of Credit
◦ A credit guarantee issued by an FI for a fee on which payment is contingent on some
future event occurring, most notably the default of the agent that purchases the letter of
credit.
• Operational Risk
◦ The risk that existing technology or support systems may malfunction or break down.
• Technology Risk
◦ the risk incurred by an FI when its technological investments do not produce
anticipated cost savings.
• Insolvency Risk
◦ The risk that an FI may not have enough capital to counter a sudden decline in the
value of its assets relative to its liabilities.