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1.2 Financial institutions
Most people have used the services of a financial institution at some stage, even if the service was simply a
basic bank account
Financial institutions may specialised in:
o Taking deposits , providing advice to corporate and government clients or offering financial contracts
such as insurance
Financial institutions are essential to the operation of the modern financial system
Financial institutions permit the flow of funds between borrowers and lenders by facilitating financial
transactions
Institutions may be categorised by differences in the sources and uses of funds
o Depository financial institutions
o Investments banks and merchant banks
o Contractual savings institutions
o Unit trusts
Depository financial institutions
o Mainly attract the savings of depositors through on- demand deposit and tem deposit accounts; eg.
Commercial banks , building societies and credit cooperatives
o Mainly provide loans to borrowers in household and business sectors
o Eg. Banks , earn money from interest rates
Investment banks and merchant banks
o Mainly provide off-balance sheet (OBS)( not shown on the balance sheet) advisory services to
support corporate and government clients eg. Advice on mergers and acquisitions , portfolio
restructuring, finance and risk management
o May also provide some loans to clients but are more likely to advise on raising funds directly in
capital markets.
o Do not make money from interest rates but instead use the advisory fee
Contractual saving institutions
o The liabilities of these institutions are contracts that require, in return for periodic payments to the
institution, the institution to make payments to the contract holders if a specified event occurs eg.
Life and general insurance companies and superannuation funds
o The large pool of funds is then used to purchase both primary and secondary market securities
o Payouts are made for insurance claims and to retirees.
Unit Trusts
o Formed under a trust deed and controlled and managed by a trustee
o Funds raised by selling units to the public ; investors purchase units in the trust
o Funds are pooled and invested by fund managers in a range of asset classes specified in the trust
deed
o Types of unit trusts include equity , property , fixed interest and mortgage trusts
o Trustee- like a contract
Equity
o Ownership interest in an asset
o Residual claim on earnings and assets
Dividend
Liquidation
o Types
Ordinary share
Hybrid ( or quasi- equity ) security
Preference shares- might have some minimum periodic interest payment
Convertible notes
1.3 Financial Instruments
Debt
o
Matching principle
o Short-term assets should be funded with short term ( money market ) liabilities eg. seasonal
inventory needs funded by overdraft
o Longer term assets should be funded with equity or longer term ( capital market) liabilities eg.:
Equipment funded by debentures
Lack of adherence to this principle accentuated effects of frozen money markets with the
sub- prime market collapse
Primary market transactions
o The issue of new financial instrument to raise funds to purchase goods , services or assets by:
Business
Governments
Individuals
o Funds are obtained by the issuer
o Direct finance
Secondary market transaction
o The buying and selling of existing financial securities
No new funds raised and therefore no direct impact on original issuer of security
Transfer of ownership from one saver to another saver
Provides liquidity , which facilitates the restructuring of portfolios and securities owners
Direct finance
o Users of funds obtain finance through primary market via direct relationship with providers ( savers0
o Advantages
Avoids costs of intermediation
Increases access to diverse range of markets
Greater flexibility in range of securities users can issue for different financing needs
o Disadvantages
Matching of preferences
Liquidity and marketability of a security
Search and transaction costs
Assessment of risk , especially default risk
Intermediated financial flow markets
o A financing arrangement involving two separate contractual agreements whereby the saver provides
funds to an intermediary and the intermediary provides funding to the ultimate user of the funds
o Advantages
Asset transformation
Maturity transformation
Credit risk diversification and transformation
Liquidity transformation
Economies of scale
Wholesale markets
o Direct financial flow transactions between institutional investors and borrowers
Involves larger transactions
Retail markets
o Transactions conducted primarily with financial intermediaries by the household and small- to
medium- sized business sectors
Involves smaller transactions
Money Markets
o Wholesale markets in which short-term securities are issued and traded
o For short term
Capital markets
o Markets in which longer term securities are issued and traded with original term to maturity in
excess of one year
Summary
The Financial system is composed of financial institutions, instruments and markets facilitating transactions
for goods and services and financial transactions
Financial instruments may be equity , debt or hybrid
Financial markets may be classified according to:
o Primary and secondary transactions
o Direct and intermediated flows wholesale and retail markets
o Money markets and capital markets
o Financial institutions
Commercial banks
Main activities
Liability management
o Deposit base and other funding sources are managed to meet loan demand
Borrow directly from domestic and international capital markets
Provision of other financial services
Off-balance- sheet (OBS) business
Importance of banks (again):
o Asset transformation
o Maturity transformation
o Credit risk diversification & transformation
o Liquidity transformation
o Economies of scale
Source of Funds
Sources of funds appear in the balance sheet as either liabilities or shareholders funds
Banks offer a range of deposit and investment products with different mixes of liquidity, return, maturity
and cash flow structure to attract the savings of surplus entities
Current account deposits
o Funds held in a cheque account
o Highly liquid be able to with drawl how much you want
o May be interest or non-interest bearing
Term Deposits
o Funds lodged in an account for a predetermined period at a specified interest rate
Term: one month to five years
Loss of liquidity owing to fixed maturity
Higher interest rate than current or call accounts
Generally fixed interest rate ( banks do penalties if you do withdrawl)
Negotiable certificates of deposit (CDs)
o Issued by a bank in its own name
o Issued at a discount to face value
o Highly negotiable security
o Short term (30 to 180 days)
Debt liabilities
o Medium- to longer term debt instruments issued by a bank
Debenture ( like a loan)
Unsecured note
Foreign currency liabilities
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o
Debt instruments issued into the international capital markets that are denominated in a foreign
currency
Allows diversification of funding sources into international markets
Facilitates matching of foreign exchange denominated assets
Meets demand of corporate customers for foreign exchange products
Loan Capital and shareholders equity
o Sources of funds that have characteristics of both debt and equity (e.g. subordinated debentures
and subordinated notes)
Subordinated means the holder of the security has a claim on interest payments or the
assets of the issuer, after all other creditors have been paid (excluding ordinary shareholders)
Use of Funds
The GFC has focussed attention on the regulation of the financial system
A number of financial institutions collapsed during the crisis
The amount of leverage on the balance sheets of these institutions was a primary factor contributing to their
weakness (high leverage- more risky)
Debate concerning bank regulation and prudential supervision has concentrated on how regulators can
maintain a stable financial system
The business activities of financial institutions will inevitably involve the need to write-off of abnormal
business losses
The capital held by financial institutions serves as the buffer against such losses
If capital is inadequate, a financial institution may face insolvency. This has significant implications for the
stability of the financial system
The capital adequacy standards set down in Basel II and III define the minimum capital adequacy ( hold a
minimum amount of capital) for a bank
The standards are designed to promote stability within the financial system
Functions of capital
o Source of equity funds
o Demonstrates shareholder commitment
o Provides funding for growth and source of future profits
o Write-off periodic abnormal business losses
Development of international capital adequacy standards
o Basel I (1988)
o Basel II (2008)
o Basel III (2010)
Basel II mainly focuses on:
o Credit risk of banks assets and OBS business
o Market risks of banks trading activities
Market risk risk of losses resulting from changes in market rates in exchange rates, interest rates, equities
and commodities
o General market risk changes in the overall market for exchange rates, interest rates, equities, and
commodities ( overall market- effects every player in the market)
o Specific market risk changes in the value of a security due to issuer-specific factors
o Two approaches to market risk capital requirements
Internal modelrequires a statistical probability model that measures financial risk
exposures, i.e. value at risk (VaR)
Standardised approach
Pillar 2 Supervisory review of capital adequacy
Intended to ensure banks have sufficient capital to support all risks and encourage improved risk
management policies and practices in identifying, measuring and managing risk exposures such as:
o risks incompletely/not captured in Pillar 1 and factors external to the bank, such as a changing
business cycle
o additional risk management practices such as education/ training; internal responsibilities,
delegation and exposure limits; increased provisions and reserves; and improved internal controls
and reporting practices
Four key principles of supervisory review
Pillar 3 Market discipline
Aim is to develop disclosure requirements that allow the market to assess information on the capital
adequacy of an institution, i.e. increase the transparency of an institutions risk exposure, risk management
and capital adequacy
Prudential supervisors to determine minimum disclosure requirements and frequency
Basel II recommends a range of qualitative and quantitative information disclosure relating to principal parts
of Pillars I and II
Basel III was developed in 2010.
Aims to enhance the risk coverage of the Basel II framework by enhancing capital adequacy requirements
Three principal aims:
o Boost the banking sectors ability to absorb shocks arising from financial and economic stress
o Improve risk management and governance
o Strengthen banks transparency and disclosure
Examples:
o Increase minimum Tier 1 capital to 6% (4% in Basel II) of risk-weighted assets by 2015.
o Increase minimum Common Equity Tier 1 capital to 4.5% (2% in Basel II) of RWA by 2015.
o Improve the quality of capital (e.g. tighter definition of Common Equity Tier 1 capital to include only
common stocks, retained earnings, and other comprehensive income).
o Minimum liquidity coverage ratio to ensure banks have sufficient high-quality liquid assets for
expected net cash outflows.
Share Market
o A formal exchange facilitating the issue, buying and selling of equity securities
Publicly listed corporation
o A company whose shares are quoted and traded on a formal stock exchange
Ordinary share
o The principal form of equity issued by a corporation, which bestows a claim to residual cash flows
and ownership and voting rights
The corporation differs from other business forms
o Ownership claims are widespread and easily transferable
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o
o
Owners (shareholders) do not affect the day- to day affairs of the company
Shareholders liability is limited to:
The issue price of shares of a limited liability company
Advantages of the corporate form
o Can obtain large amounts of finance at a relatively cheap cost
o The liquidity of securities facilitates investor diversification and encourages investment in corporate
securities (becomes less risky)
o Separation of ownership and control facilitates:
Appointment of specialised management
Greater effectiveness in the planning and implementation of strategic decisions
o Perpetual succession the corporate form is unaffected by changes in management or ownership
o The Corporate form is suited to large scale operations
Disadvantages of the corporate form
o Main disadvantage arises from the separation of ownership and control
Conflict of interest between owners (principals) and managers (agents) known as the agency
problem
Management may try to run business of their own benefit, rather than that of shareholders,
ie. Maximise shareholder value (share price)
o Factors moderating conflict of interest between owners and managers
Investors ability to sell shares in a corporation, causing the share price to fall
Dismissal from the board at AGM by shareholders
Threat of takeover and loss of employment
Use of performance incentives, such as share options
A stock exchange facilitates the efficient and orderly sale of new financial securities
o New floats/ initial public offerings (IPOs)
Initial listing of a corporation on the stock exchange
o Rights issue
Issue of additional shares to existing shareholders on a pro- rata basis
o Placements
Issue of new shares to selected institutional investors
o Dividend reinvestment plans
Reinvestment of dividends into corporation for additional shares
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o
The units in these funds are bought and sold on the stock exchange in the same way as shares in
corporations.
The stock exchange provides a market for trading equity related derivative products
o A derivative is a financial security that derives its price from an underlying commodity (eg. Gold) or
financial instrument (eg. BHP shares)
o Derivative products are described as:
Exchanged- traded contracts: standardised financial contracts traded on a formal exchange
Over the counter contracts : non-standardised contracts negotiated between writer and
buyer
o Derivatives serve as a:
Risk management tool (hedge)
Speculative instrument
Private equity is an alternative funding source for companies unable or not wanting to access equity capital
through a public issue
Source of funds
o Superannuation funds and life insurance offices
Use of funds
o Start-ups , business expansion, recovery finance for distressed companies , management buyouts
o Aim is generally to:
Improve profitability sufficiently to realise value through an IPO
Break up business to achieve return on investment
NPV
The difference between the present value of cash flows associated with an investment and the cost of the
investment
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IRR
The financing decision concerns the capital structure used to fund the firms business activities
The financial objective of a corporation is to maximise return, subject to an acceptable level of risk
Returns are generated from the net cash expected cash flows derived from:
o Business risk
o Financial risk
Business risk
The level of business risk depends upon the type of operations of the business, i.e:
o Industry sector that influences the level of fixed versus variable operating costs
Also affected by:
o Sectoral growth rates
o Market share
o Aggressiveness of competitors
o Competence of management and workforce
Financial risk
Exposure to factors that impact on the value of assets, liabilities and cash flows
The level of financial risk of a company is borne by the security holders (debt and equity)
Financial risk categories
o Interest rate risk
Risk of adverse movements in interest rates
o Foreign exchange risk
Risk of adverse movements in exchange rates
o Liquidity risk
Risk of insufficient cash in the short term
Financial risk and the debt to equity ratio (D/E)
o D/E is the ratio of funds borrowed (debt) to funds contributed by shareholders (equity)
o D/E indicates the risk of being unable to meet interest due and principal repayments associate with
use of debt. i.e. risk of insolvency
o Earnings per shares (EPS) is the net return on a companys shares expressed in cents per share (CPS)
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If the cost of debt is less than the return achieved, issuing more debt will benefit
shareholders on account of higher EPS
However, high debt levels increase a companys level of financial risk and, thus, the risk of
insolvency
What is the appropriate D/E ratio?
o Although there is no agreed ideal D/E ratio, factors influencing the D/E ratio in practice are:
Industry norms
Historical levels of firms ratio
Limit imposed by lenders through loan covenants, ie. Restrictions placed on a borrower
specified in a loan contract
Managements assessment of the firms capacity to service debt.
Initial public offering (IPO) is an offer to investors of ordinary shares in a newly listed company on a stock
exchange
o New share issuer must meet listing requirements
o The promoter appoints advisers (stockbroker, merchant bank, other specialists) and possibly
underwriters
o Underwriters
Ensure a company raises the full amount of the issue
Assist with advice on the structure , price , timing and marketing of the issue and allocation
of securities
A company seeking to have its securities quoted on a stock exchange (ie. To join the official list ) must
comply with listing rules, which are additional to the corporations legislation obligations
A non-complying listed company can be suspended from quotation or delisted
Listing rule principles embrace the interests of listed entities, maintain investor protection, and maintain the
reputation and integrity of the market
Takeover issues
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Acquiring company issues additional ordinary shares to owners of target company in settlement of the
transaction
Alleviates need for owners of acquiring company to inject cash for the purchase of the company
Preference shares
Classed as hybrid securities ie. They have characteristic of both debt and equity
Fixed dividend rates are set at issue date
Rank ahead or ordinary shareholders in the payment of dividends and liquidation
Summary
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Week 4 - Equity Markets II
Share-market investment
Investors buy shares to receive returns from dividends and capital gains (losses)
Other factors encouraging investment in securities quoted on a stock exchange (SX)
o Depth of the market
Overall capitalisation of corporations listed on an SX
o Liquidity of the market
Volume of trading relative to the size of the market
o Efficient price discovery
Speed and efficiency with which new information is reflected in the current share price
Two types of risk impact on security returns
1. Systematic risk
Factors that generally impact on share prices in the market; e.g. economic growth, and changes in
interest rates and exchange rates
2. Unsystematic risk
Factors that impact specifically on the share price of a corporation; e.g. resignation of the CEO,
technology failure, board problems
Diversified Investment Portfolio
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Taxation
Potential investors are concerned with the future level of a companys performance
Companys performance affects both the profitability of the company and the variability of the cash flows
Indicators of company performance
o Capital structure
o Liquidity
o Debt servicing
o Profitability
o Share price
o Risk
Capital structure
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Indicates firms longer term financial viability/stability; a higher ratio indicates less reliance
on external funding
Liquidity
Debt Servicing
Profitability
Share Price
Represents investors view of the present value of future net cash flows of a firm
Share price performance indicators
Price to earnings ratio (P/E)
o Share price divided by earnings per share
o A higher P/E indicates more growth in future net cash flows
share price to net tangible assets ratio (P/NTA)
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o
Measures the theoretical premium or discount at which a firms share price is trading relative to its
NTA
Risk
Variability (uncertainty) of the share price
Two components
1. Systematic risk (often referred to as beta)
Arises from factors affecting the whole market, e.g. state of the domestic economy and world economy
2. Non-systematic risk
Arises from firm-specific factors, e.g. management competence, labour productivity, financial and
operational risks
Can be eliminated in a well-diversified portfolio
Pricing of Shares
(D0)
Valuing a share with constant dividend growth (g)
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Newspapers and financial journals provide share-market information to varying degrees of detail; e.g.
Australian Financial Review
Summary
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Fundamental analysis
Considers macro and micro factors that impact upon cash flows and future share prices of various industry
sectors and firms
o Macro factors include interest rates, economic growth, business investment
o Micro factors are firm-specific and relate to managements impact on company performance
Top-down approach
Economic growth
The higher the growth rate in the rest of the world, the greater the demand for Australian exports
Sectors benefitting from international growth determined by source of the growth
Growth can be driven by:
o increased consumer demand
o increased business investment in equipment
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Flip side of growth
Currency
Affect the domestic currency profit of exporters that quote their products in foreign currency prices
o A strengthening Australian dollar (AUD) makes these firms worse off because the AUD value of their
exports is lower
o The strength of the AUD over the past few years has led to calls for assistance from the
manufacturing industry, for example
Exchange rates also affect firms indirectly
o E.g. devaluation of currency increases cost of imports, thereby increasing inflation
Interest Rates
Balance of payments
If current account is in deficit (i.e. total international payments exceed total international receipts):
o some export income is diverted to service debt
o need to borrow foreign currency to service debt
Indirect effect on firms profitability
o Government may increase interest rates to slow economic growth and control the debt
Inflation
Bottom- Up approach
Following identification of the best economies and industry sectors for investment using the top-down
approach, the bottom-up approach can be used to identify the best companies within these
Bottom-up approach considers micro factors using ratios and other measures of a firms financial
characteristics and performance
Considers factors such as:
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o
Accounting ratios that assess a companys capital structure, liquidity, debt servicing, profitability,
share price and risk (see Chapter 6), observing the trend and making comparisons with firms in the
same industry
Additional information on key management changes, corporate governance and strategic direction
Comparing Companies
Technical analysis
Explains and forecasts share price movements based on past price behaviour
Assumes markets are dominated at certain times by mass psychology, from which regular patterns emerge
Two main forecasting models
o Moving averages (MA)
o Charting
Moving Averages
Charting
Trend lines
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Continuation patterns
Sideways share trading that does not normally signal a change in trend
Two types
1. Trianglescomposed of a series of price fluctuations, each smaller than its predecessor Symmetrical triangle
(no change in trend); ascending triangle (uptrend); descending triangle (downtrend)
2. Pennants and flagsformed during a sharp rise in prices (the pole); then trading volume reduces and
increases suddenly to take prices sharply higher
Reversal patterns
Occur after a major market move
Result in a head and shoulders pattern
Three successive rallies and reactions, the second rally being stronger than the first and third rallies
I.
II.
III.
Even where techniques have no apparent underlying validity, if they are followed by enough participants
they may impact on share price behaviour at times
More likely to forecast successfully when share prices move out of a range explained by economic and
financial fundamentals
Ethics
Ethics is black or white , no grey area
Ethics
o A set of guiding moral principles or values
Ethical Behaviour
o Refers to behaviour that conforms to those values
Both terms are often used to imply
o good ethics and good behaviour
So what happened?
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Aligning interests to gain trust
Global survey by CFA Institute and Edelman Berland in 2013 revealed that trust among institutional and
retail investors has eroded.
o 48% said they do not trust financial services investors do what is right
o Only 15% has great deal of trust in investment management industry
When it comes to the attributes that investors value the most:
o 35% said acting in the best interest of the client
o 17% - ability to achieve high returns and commitment to ethical conduct
o Only 7% - amount / structure of fees
Investors have moved beyond just good performance and are more interested in trustworthy behaviours
Restoring Trust
A crisis of Culture
Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other participants
in the global capital markets.
Place the integrity of the investment profession and the interests of clients above my own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional
activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on
ourselves and the profession.
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve my professional competence and strive to maintain and improve the competence of
other investment professionals.
I.
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II.
III.
IV.
V.
VI.
VII.
Applicable Law
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Avoid situations that could cause or be perceived to cause a loss of independence or objectivity in recommending
investments or taking investment action.
Maintain your professional integrity by remaining independent and objective at all times.
Avoid compromising your own or anothers independence and objectivity.
Ways in which your independence and objectivity may be compromised or perceived to be compromised
include the receipt of:
o Gifts
o Invitations to lavish events
o Tickets
o Favours
o Job referrals
o Additional compensation
I (C) Misrepresentation
Must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or
other professional activities.
A misrepresentation is any untrue statement or omission of a fact or any statement that is otherwise false or
misleading
To avoid misrepresentation, consider the following action items:
o Be honest about your professional credentials and your firms performance
o Exercise care and due diligence when relying on third-party information
o Disclose the use of external managers
o Be forthcoming with the risk and unpredictability of investments
o Acknowledge sources of ideas and materials that are not yours
I (D) Misconduct
Avoid dishonest, fraudulent, or deceitful conduct that reflects adversely on your professional reputation, integrity, or
competence.
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Deal with clients fairly with respect to investment recommendations and actions.
Recommend policies and procedures that will help to ensure that investment recommendations or changes
in prior recommendations are disseminated to clients fairly and objectively.
Recommend policies and procedures to ensure that all individual and institutional clients are treated in a fair
and impartial manner when taking investment actions.
Some suggested actions for fair dealing compliance
o Limit the number of people involved.
o Shorten the time frame between decision and dissemination.
o Publish guidelines for pre-dissemination behaviour.
o Disseminate investment recommendations simultaneously.
o Maintain a list of clients and their holdings.
o Develop and document trade allocation procedures.
In an advisory relationship, make reasonable inquiry of your client situation to make suitable investment
recommendations.
Document the clients needs, circumstances, and investment objectives in an investment policy statement.
o Client identification
o Investor objectives
o Investor constraints
o Performance measurement benchmarks
o Review and update the investment policy statement regularly.
o Document attempts to carry out the review if circumstances prevent it.
o Develop test procedures for choosing investments that include
an analysis of the impact on the portfolios diversification.
a comparison of the investment risks with the clients assessed risk tolerance.
the fit of an investment with the required investment strategy.
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presenting the performance of the weighted composite of similar portfolios rather than
using a single representative account,
including terminated accounts as part of performance history with a clear indication of when
the accounts were terminated,
including disclosures that fully explain the performance results being reported, and
maintaining the data and records used to calculate the performance being presented.
Short-term debt is a financing arrangement for a period of less than one year with various characteristics to
suit borrowers particular needs
o Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds
Matching principle
o Short-term assets should be funded with short-term liabilities
o The importance of this principle was highlighted by the GFC
A supplier provides goods or services to a purchaser with an arrangement for payment at a later date
Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days)
Borrow money from the bank if the interest rate is lower than the rate of trade credit
From providers perspective
o Advantages include increased sales
o Disadvantages include costs of discount and increased discount period, increased total credit period
and accounts receivable, increased collection and bad debt costs
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Example
A ice cream stand may sign an agreement, under which the distributor agrees to provide ice cream stock under the
terms "Net 60" with a ten percent discount on payment within 30 days, and a 20% discount on payment within 10
days. This means that the operator has 60 days to pay the invoice in full.
If sales are good within the first week, the operator may be able to send a cheque for all or part of the invoice, and
make an extra 20% on the ice cream sold.
However, if sales are slow, leading to a month of low cash flow, then the operator may decide to pay within 30 days,
obtaining a 10% discount, or use the money another 30 days and pay the full invoice amount within 60 days.
The opportunity cost of the purchaser forgoing the discount on an invoice (1/7, n/30) is:
Opportunity cost
% discount
365
99.0 23
0.160298 or 16.03% p.a.
Wal-Mart in the United states relies more on trade credit than bank borrowing
Its trade credit is 8 times the amount of capital invested by shareholders.
Bank Overdrafts
Commercial Bills
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33
Calculations considered
o
Calculating yield
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Example 3: A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with a
face value of $500 000. Having approached two prospective discounters, the company has been quoted yields of
9.52% per annum and 9.48% per annum. Which quote should the company accept, and what amount will the
company raise?
$500 000 365
$496 118.04
365 (0.0952 30)
or
$500 000 365
$496 134.23
365 (0.0948 30)
365 (
yield
days to maturity)
100
]
365
Example 4: A company needs to raise additional funding of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank has agreed to
discount the bill at a yield of 8.75%. At what face value will the initial bill be drawn?
365 (0.0875 60)
]
365
$507 191.78
Calculating yield
Yield
buy price
days to maturity
Promissory Notes
Also called P-notes or commercial paper, they are discount securities, issued in the money market with a
face value payable at maturity but sold today by the issuer for less than face value
Typically available to companies with an excellent credit reputation because:
o there is no acceptor or endorser
o they are unsecured instruments
Calculationsuse discount securities formulae
Issue programs
o Usually arranged by major commercial banks and money market corporations
o Standardised documentation
o Revolving facility
o Most P-notes are issued for 90 days
By tender, tap issuance or dealer bids
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Short-term discount security issued by banks to manage their liabilities and liquidity
Maturities range up to 180 days
Issued to institutional investors in the wholesale money market
The short-term money market has an active secondary market in CDs
Calculationsuse discount securities formulae
Inventory finance
Most common form is floor plan finance
Particularly designed for the needs of motor vehicle dealers to finance their inventory of vehicles
o Bailment commonfinance company holds title to dealerships stock- to promote the financial
companies
Dealer is expected to promote financiers financial products
Accounts receivable financing
o A loan to a business secured against its accounts receivable (debtors)
o Mainly supplied by finance companies
o Lending company takes charge of a companys accounts receivable; however, the borrowing
company is still responsible for the debtor book and bad debts
Factoring
o Company sells its accounts receivable to a factoring company
Converting a future cash flow (receivables) into a current cash flow
o Factoring provides immediate cash to the vendor; plus it removes administration costs of accounts
receivable
o Main providers of factor finance are the finance companies
o Factor is responsible for collection of receivables
Notification basis: vendor is required to notify its (accounts receivables) customers that payment is to be
made to the factor
Recourse arrangement
o Factor has a claim against the vendor if a receivable is not paid
Non-recourse arrangement
o Factor has no claim against vendor company
Term loan
o
A loan advanced for a specific period (three to 15 years), usually for a known purpose; e.g.
purchasing land, premises, plant and equipment
A term loan where the full amount is provided at the start of the loan
Provided by:
o
to a lesser degree, investment banks, merchant banks, insurance offices and credit unions
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o
o
o
Loan instalments commence after a specified period related to project cash flows and the
debt is amortised over the remaining term of the loan
Interest may be fixed (for a specified period of time; e.g. two years) or variable
Interest rate charged on term loan is based on:
an indicator rate (e.g. BBSW or a banks own prime lending rate) and is also influenced by:
credit risk of borrowerrisk that borrower may default on loan commitment, giving
rise to a risk premium
Loan covenants
o Restrict the business and financial activities of the borrowing firm ( dont want the firm to get more
risky)
Positive covenant
Negative covenant
Restricts the activities and financial structure of borrower; e.g. maximum D/E ratio,
minimum working-capital ratio, unaudited periodic financial statements
o Breach of covenant results in default of the loan contract entitling lender to act
Calculating the loan instalment- ordinary annuity
where :
1 (1 i )n
[
]
i
R the instalmentamount
A the loan amount (present value)
i the current nominalinterest rate per period expressedas a decimal
n the number of compounding periods.
Example 1: Floppy Software Limited has approached Mega Bank to obtain a term loan to finance the purchase of
a new high-speed CD burner. The bank offers a $150 000 loan, amortised over five years at 8% per annum,
payable monthly. Calculate the monthly loan instalments.
A $150 000
Calculating the loan instalmentannuity due
0.08
i
0.006667
12
A
n 5 years 12 months 60 R
$150 000
1 (1 0.006667)60
]
0.006667
R $3041.49 per month
[
1 (1 i )n
[
](1 i )
i
37
Example 2: A business proprietor is purchasing a computer system for the business at a cost of $21 500. A
finance company has offered a term loan over seven years at a rate of 12% per annum. The loan will be repaid
by equal monthly instalments at the beginning of each month. Calculate the amount of the loan instalments.
A $21500
0.12
i
0.01
12
n 7 12 84
$21500
R
1 (1 0.01)84
[
] (1 0.01)
0.01
$21500
57.21494
$375.78 monthly instalment
Mortgage Finance
The borrower (mortgagor) conveys an interest in the land and property to the lender (mortgagee)
If the mortgagor defaults on the loan the mortgagee is entitled to foreclose on the property, i.e. take
possession of assets and realise any amount owing on the loan
Commercial banks, building societies, life insurance offices, superannuation funds, trustee
institutions, finance companies and mortgage originators
Interest rates
o
Both variable and fixed interest rate loans are available to borrowers
With fixed interest loans, interest rates reset every five years or less
With interest-only mortgage loans, interest-only period is normally a maximum of five years
Mortgagee (lender) may reduce their risk exposure to borrower default by:
o
Up to 30-year terms
requiring the mortgagor to take out mortgage insurance up to 100% of the mortgage value
38
Example 3: A company is seeking a fully amortised commercial mortgage loan of $650 000 from its bank. The
conditions attached to the loan include an interest rate of 8% per annum, payable over five years by equal
end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount.
A $650 000
0.08
0.02
4
n 5 4 20
i
R
[
$650 000
1 (1 0.02)20
]
0.02
$39 751.87 monthly instalment
Securitisation and mortgage finance
o Mortgage originators, commercial banks and other institutions use securitisation to manage their
mortgage loan portfolios
o Involves conversion of non-liquid assets into new asset-backed securities that are serviced with cash
flows from the original assets
o Original lender sells bundled mortgage loans to a special-purpose vehicle
That is, a trust set up to hold securitised assets and issue asset-backed securities like bonds,
providing investors with security and payments of interest and principal
The securitisation of mortgage finance suffered a large contraction during the GFC.
o Securitised mortgage assets in 2007: $215 billion
o Securitised mortgage assets in 2010: $112 billion
These falls were recorded in Australia despite the much lower default rates experienced on mortgages
compared to other parts of the world
Specify that the lender will receive regular interest payments (coupon) during the term of the bond
and receive repayment of the face value at maturity
Debentures:
are secured by either a fixed or floating charge over the issuers unpledged assets
have a higher claim over a companys assets (e.g. on liquidation) than unsecured note
holders
39
Subordinated debt
o More like equity than debt, i.e. quasi-equity
o Claims of debt holders are subordinated to all other company liabilities
o Agreement may specify that the debt not be presented for redemption until after a certain period
has elapsed
o May be regarded as equity in the balance sheet, improving the credit rating of the issuer
The price of a fixed-interest security is the sum of the present value of the face value and the
present value of the coupon stream
1 (1 i )n
P C[
] A(1 i )n
i
Example 4: Current AA+ corporate bond yields in the market are 8% per annum. What is the price of an
existing AA+ corporate bond with a face value of $100 000, paying 10% per annum half-yearly coupons, and
exactly six years to maturity?
A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12
1 (1 i )n
n
k
P C
A(1 i ) (1 i )
i
Yield of a bond- describes the total rate of return, coupon payment- amount of interest throughout the lifetime
of bond
Example 5: Current AA+ corporate bond yields in the market are 8% per annum. An existing AA+ corporate
bond with a face value of $100 000, paying 10% per annum half-yearly coupons, maturing 31 December
2016, would be sold on 20 May 2011 at what price?
40
Examples
Leasing
A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the right to use the
asset for an agreed period of time in return for periodic rental payments
Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to purchase the asset
Advantages of leasing for lessee over borrow and purchase alternative
o Conserves capital
o Provides 100% financing
o Matches cash flows (i.e. rental payments with income generated by the asset)
o Less likely to breach any existing loan covenants
o Rental payments are tax deductible
Advantages of leasing for lessor over a straight loan provided to a lessee
o Leasing has relatively low level of overall risk as asset can be repossessed if lessee defaults
o Leasing can be administratively cheaper than providing a loan
o Leasing is an attractive alternative source of finance to both business and government
Types of leases
o Operating lease
Short-term lease
Lessor may lease the asset to successive lessees (e.g. short-term use of equipment)
Lessee can lease asset for a short-term project
Full-service leasemaintenance and insurance of the asset is provided by the lessor
Minor penalties for lease cancellation
Obsolescence risk remains with lessor
o Finance lease
Longer term financing
Lessor finances the asset
Lessor earns a return from a single lease contract
Net leaselessee pays for maintenance and repairs, insurance, taxes and stamp duties
associated with lease
Residual amount due at end of lease period
Ownership of the asset passes to lessee on payment of the residual amount
41
o
Summary
When choosing the most appropriate source of medium- to long-term debt, a borrower should consider the
following factors:
o Fixed or variable interest rate
o Term of the financing arrangement
o Repayment schedule
o Loan covenants
o Whether secured by fixed or floating charge, or unsecured
o The merits of leasing an asset as opposed to buying an asset
42
Foreign Exchange Markets
Exchange rate regimes
FX market participants
FX markets
o Comprise all financial transactions denominated in foreign currency, currently estimated to be over
USD4.00 trillion per day
o Facilitate exchange of value from one currency to another
o Internationally adopted FX market conventions to improve market functionality
FX market participants can be classified as:
o FX dealers and brokers
o central banks
o firms conducting international trade transactions
o investors and borrowers in the international money markets and capital markets
o foreign currency speculators
o arbitrageurs
FX dealers
o Are financial institutions, typically commercial banks and investment banks, that quote two-way (i.e.
buy and sell) prices and act as principals in the FX market
o Usually licensed or authorised by the central banks of the countries in which they operate
FX brokers
o Source from another dealer (talking about wholesalers market)
o Transact almost exclusively with FX dealers; they obtain the best prices in global FX markets
matching FX dealers buy and sell orders for a fee
Why actively selling FX- these dealers speculators taking positions from their beliefs.
- Investors and borrowers in the international markets and capital market
- They dont play a major part- in FX (the points)
Central banks
43
Exporters receive foreign currency for the sale of their goods and services
Exporters use the FX market to sell foreign currency and buy AUD
Importers use the FX market to buy foreign currency (sell AUD) for purchasing imports
Investors and borrowers in the international money markets and capital markets
Commercial bank foreign borrowings are usually converted into the home currency
o Payments of interest and principal need to be made in the denominated currency of the loan
Corporations and financial institutions investing overseas
o Need to purchase FX in order to make investments
o Dividends or interest payments received from overseas investments will be denominated in a foreign
currency
Speculative transactions
Businesses and financial institutions may attempt to anticipate future exchange rate movements to make a
profit
There is a risk involved that the exchange rate will move:
o in the opposite direction to that anticipated
o in the anticipated direction but by less than expected
o
Example : Take a risk, based on a benefit that a rate will more in a particular direction
If, today:
Spot rate: USD1= AUD0.9725
Exchange rate expected today + n days:
USD1= AUD1.0225
Then, today:
Buy USD1 at a cost of AUD0.9725
Then, at today + n days:
Sell USD1 and obtain AUD1.0225
Arbitrage transactions
Example:
Arbitrage strategy
Sell AUD1.3525 and receive USD1
44
Sell USD1 to receive SGD1.3525
Sell SGD1.3525 to receive AUD1.3703
If there is arbitrage, prices will change eventually to reach equilibrium.
Operation of the FX market
The FX market:
o is a global market, operating 24 hours a day according to business hours across the time zones
o
o
consists of a vast and highly sophisticated global network of telecommunications systems that
provide the current buy and sell rates for various currencies in dealing rooms located around the
globe
involves larger FX dealers like commercial, investment and merchant banks providing the FX function
as part of their overall Treasury operations within which they establish an FX dealing room
London- most major FX trading centre
45
o
The first currency mentioned is the price being sought (also called base currency or the unit of
quotation)
o The second currency is the terms currency
Example: USD/AUD is the price of USD1 in terms of AUD
Two-way quotations
o Example: Australian dollar/euro may be expressed as EUR/AUD1.37551.3765, usually abbreviated
to EUR/AUD1.375565
The two numbers indicate the dealers buy (bid) and sell (offer) price
A dealer quoting both bid and offer prices is a price-maker
The dealer will buy EUR1 for AUD1.3755
The dealer will sell EUR1 for AUD1.3765
Dealer buys low and sells high
Two-way quotations (cont.)
o The difference between the buy and sell price is the spread, represented in percentage terms in
Equation 15.1
1.000
1.3765
1.3755
AUD/EUR0.72650.7270
Calculating cross-rates
o All currencies are quoted against the USD
o There are two ways currencies can be quoted against the USD:
Direct quotethe USD is the base currency
Indirect quotethe USD is the terms currency and the other currency is the base currency
o When FX transactions occur between two currencies, usually where neither currency is the USD, the
cross-rate needs to be calculated
Method of cross-rate calculation depends on whether the quote is direct or indirect
USD/EUR0.725055
USD/JPY81.4050
To determine the EUR/JPY cross-rate:
81.40/0.7255 = 112.20
81.50/0.7250 = 112.41
46
EUR/JPY 112.20-41
GBP/USD1.6270-75
USD/NZD1.3292-97
To determine the GBP/NZD cross-rate:
1.6270 x 1.3292 = 2.1626
1.6275 x 1.3297 = 2.1641
GBP/NZD2.1626-41
Example 5: Crossing two indirect FX quotations:
AUD/USD0.926269
GBP/USD1.627075
To determine the AUD/GBP cross-rate:
0.9262/1.6275 = 0.5691
0.9269/1.6270 = 0.5697
AUD/GBP0.569197
Summary
47
0.963040
and six-month forward points:
0.00320.0027
Since the forward points are falling, subtract them from the spot rate to obtain the six-month forward rate
of:
0.95980.9613
Forward points and forward exchange rates (cont.)
o Equation 15.2 is a generalised formula to calculate forward points:
Summary
FX market participants include companies, dealers, central banks, investors, speculators and arbitrageurs
FX market instruments are usually either spot or forward transactions
o Involve the quotation of the dealers buy-sell prices
o Cross-rates calculations are necessary between two non-USD currencies
o Forward exchange rates are quoted as forward points either above or below the spot rate
o The euro has grown in acceptance to become a hard currency accepted in international trade
transactions
If US interest rate is 1% and AUD is 4%.- Borrow from USD for 1 year and invest in AUD for 4% in one year
Countries with a lower interest rates, should trade at a forward premium
48
o
Previous chapter:
o focused on the structure and operations of the FX markets
This chapter:
o focuses on the factors that influence the value of a currency (in a floating exchange rate regime) in
order to attempt to forecast future exchange rates with some reliability and accuracy
Relative inflation rates influence the price of and, therefore, the demand for foreign goods by residents
The change in demand for imported goods, in turn, affects the demand for foreign currency used to buy
these goods
o This view of the determination of the value of a currency is called purchasing power parity (PPP) and
is discussed in detail later
Example: increase in US rate of inflation relative to Australia
o Effect for Australian residents
US imports more expensive, decreasing demand for these goods; therefore, reducing the
supply of AUD
o Effect for US residents
Some US demand for goods and services, and assets will switch to Australian items,
increasing demand for AUD to pay for these items
o Net effect is an appreciation of the AUD
Inflation changes with PPP
Us inflation increase more than AUD
o Buying US importer decreases and demand decreases, USD decreases until AUD increases
49
Australian investors and businesses are more likely to keep their surplus funds invested in
Australia, causing a decrease in the supply of the AUD
o Net effect
AUD will appreciate
Expectations about the value of the currency during the investment period
o An analysis of the effect of interest rates on the exchange rate cannot ignore expectations about the
value of the currency during the investment period
o Table 16.1 illustrates the interaction of interest rate differentials and expected changes in the
exchange rate over the investment period on currency value
From Table 16.1 the following impact on the value of the AUD would be evident:
o Scenario 1: AUD would depreciate
The 3% benefit obtained from placing funds in the Australian money market would be more
than offset by the 5% depreciation of the AUD
o Scenario 2: AUD would appreciate
The 3% benefit obtained from placing funds in the Australian money market would be offset
only partly by the 2% depreciation of the AUD
Reason for change in nominal interest rate
o The analysis has ignored whether a change in the nominal interest rate is due to a change in the:
real rate of return; or
inflation expectations premium
Example: if nominal interest rates rise owing to an increase in the inflation expectations premium:
o the currency may not appreciate, and could depreciate because of:
the effect of inflationary expectations (PPP theory)
businesses and individuals seeking to invest cash holdings in overseas securities to avoid a
loss of value
Example: if nominal interest rates rise owing to an increase in the real rate of return:
o the currency may appreciate because of an inflow of funds from the rest of the world
Carry Trades
50
Policies by foreign and/or domestic governments may affect the relative rate of inflation, income growth or
interest rates between countries
Also, the market participants expectations that the government will alter its policy affects these variables in the
future
A central bank may also influence the currency by:
o intervening in international trade flows
o intervening in foreign investment flows
o directly intervening in the FX market
International trade flows
o Intervention aimed at increasing exports and/or reducing imports by using the following:
Subsidies to exporters, making exports more competitive
Increases demand for Australian exports and demand for AUD
Intervention on the import side
Tariffscharge levied on imports increasing their prices
Quotasrestriction on the amount imported
Embargoprohibition on import of specified goods or services
Summary
Demand and supply determine the value of a currency in a floating exchange rate regime
Factors influencing the demand and/or supply of a currency
o Relative inflation rates (PPP)
o Relative national income growth rates
o Relative interest rates
o Exchange rate expectations
o Central bank or government intervention
In most developed economies monetary policy actions are directed at influencing interest rates
By understanding what motivates a central bank in its implementation of interest rates policy:
51
o financial market participants can anticipate changes in a governments interest rate policy
o lenders and borrowers can make better-informed decisions
A central bank may increase interest rates if there is:
o inflation above target range
o excessive growth in GDP
o a large deficit in the balance of payments
o rapid growth in credit and debt levels
o excessive downward pressure on FX markets
An increase in interest rates (i.e. tightening of monetary policy) will:
o eventually increase long-term rates
o slow consumer spending
reducing inflation and demand for imports
o decrease the size of the current account
o possibly attract foreign investment, causing the domestic currency to appreciate
Three effects of changes in interest rates
1. Liquidity effect
The effect of the RBAs market operations on the money supply and system liquidity
o E.g. RBA increases rates (i.e. tightens monetary policy) by selling CGSs
2. Income effect
A flow-on effect from the liquidity effect
If interest rates rise, economic activity will slow, allowing rates to ease
o Increased rates reduce spending levels and income levels
3. Inflation effect
As the rate of growth in economic activity slows, demand for loans also slows
This results in an easing of the rate of inflation
52
o
The loanable funds (LF) approach is the preferred way of explaining and forecasting interest rates because it
is:
o preferred by financial market analysts
o a conceptually simplistic model
Alternatively, macroeconomics uses demand and supply of money to explain rates
The loanable funds (LF) approach
o LF are the funds available in the financial system for lending
o Assumes a downward-sloping demand curve and an upward-sloping supply curve in the loanable
funds market; i.e.:
as interest rates rise demand falls
as interest rates rise supply increases
Demand for loanable funds
o Two sectors
1. Business demand for funds (B)
o Short-term working capital
o Longer-term capital investment
2. Government demand for funds (G)
o Finance budget deficits and intra-year liquidity
o Demand for loanable funds (B + G)
53
With less saving the supply will shift more to the left.
Yield is the total return on an investment, comprising interest received and any capital gain (or loss)
Yield curve is a graph, at a point in time, of yields on an identical security with different terms to maturity
54
1. EXPECTATIONS THEORY
The current short-term interest rate and expectations about future short-term interest rates are used to
explain the shape and changes in shape of the yield curve
Longer term rates will be equal to the average of the short-term rates expected over the period
The theory is based on assumptions, e.g.:
o Large number of investors with reasonably homogenous expectations
o No transactions costs and no impediments to interest rates moving to their competitive equilibrium
levels
o Investors aim to maximise returns and view all bonds as perfect substitutes regardless of term to
maturity
Example: The rate on a one-year instrument is 7% per annum. The investor expects to obtain 9% per annum
on a one-year investment starting in one years time. What is the current twoyear rate?
55
Assumes that securities in different maturity ranges are viewed by market participants as imperfect
substitutes (i.e. investors will operate within some preferred maturity range)
o Rejects two assumptions of the expectations theory
o Preferences of participants are motivated by reducing the risk of their portfolios; i.e. minimising
exposure to fluctuations in prices and yields
The shape and slope of the yield curve are determined by the relative demand and supply of securities along
the maturity spectrum
56
If the central bank increases the average maturity of bonds by purchasing short-term bonds and selling longterm bonds
o Segmented markets theory suggests:
short-term yields decrease and long-term yields increase
although financial system liquidity is unchanged, economic activity is affected because areas
of expenditure sensitive to:
short-term interest rates will expand
long-term interest rates will contract
Expectations theory suggests:
o no effect on expectations about future short-term interest rates, and therefore no effect on the
economy
The emphasis of the segmented markets theory on risk management denies the existence of investors
seeking:
o arbitrage opportunities
without their participation, the extreme segmentation theory would facilitate discontinuities
in the yield curve
o speculative profit
speculators trading actions are dictated by expectations
3. LIQUIDITY PREMIUM THEORY
Assumes investors prefer shorter term instruments, which have greater liquidity and less maturity and
interest rate risk and, therefore, require compensation for investing longer term
This compensation is called liquidity premium
The liquidity premium can be included in the expectations theory equation
57
Default risk is the risk that the borrower (i.e. issuer) will fail to meet its interest payment obligations
Commonwealth government bonds are assumed to have zero default risk
o As they are risk-free, they offer a risk-free rate of return
Some borrowers may have greater risk of default (i.e. state government or private sector firms)
Investors will require compensation for bearing the extra default risk
58
Changes in monetary policy interest rate settings are likely to affect the state of the economy, which in turn
affects interest rates generally
o This occurs through the liquidity effect, income effect and inflation effect
Leading, coincident and lagging economic indicators assist in assessing the direction of the economy, likely
future monetary policy actions and the effect on interest rates
A more disciplined approach to forming a view on future interest rates is provided by the loanable funds
theory
The term structure of interest rates is represented by a yield curve, which may be normal, inverse, humped
or flat
The expectations, segmented markets and liquidity preference theories describe how a yield curve obtains
its shape
The risk structure of interest rates reflects the level of credit risk, over time, of a particular debt issue
Futures contracts and FRAs are called derivatives because they derive their price from an underlying physical
market product
Two main types of derivative contracts
o Commodity (e.g. gold, wheat and cattle)
o Financial (e.g. shares, government securities and money market instruments)
Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of
changes in interest rates, exchange rates and share prices
Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to
another party
A futures contract is the right to buy or sell a specific item at a specified future date at a price determined
today
The change in the market price of a commodity or security is offset by a profit or loss on the futures
contract
Example: Farmer Joes 10 tonne wheat crop will be harvested and ready for sale in 3 months time. What is
the risk that he needs to protect against?
Futures contract is an agreement to buy or sell a specified asset at a specified time in the future.
Buy Futures/Long position = Agreement to buy an asset in the future
Sell Futures/Short position = Agreement to sell an asset in the future?
59
Reasons for the second contract- may not meet the conditions, dont have to go give wheat
Q. In relation to the wheat future hedge undertaken by Farmer Joe, who might have taken the other side of the short
position? Would their futures position be profit or loss?
- People who expect the price to be higher than 300 in the future, there will be a loss.
- A hedge fund- type of speculator
- Bakery- opposite, they worry that wheat prices will rise, Aim to eliminate price volatility
Q. What would happen to Farmers Joes futures position if the price of wheat inface rose during the hedging period?
What would happen to his position in the physical wheat?
- loss (future), profit for physical market
It would be difficult to find a counter party to match your requirements if the market expected to fall
Information
The current spot price of wheat is $300/tonne.
3 month wheat futures are trading at $300/tonne.
After 3 months the spot price of wheat falls to $250 per tonne.
Who might have taken the other side of Farmer Joes Futures position? What happens to their profit/loss in
the futures market?
What if the entire market expected wheat prices to fall?
What if the price of wheat in fact rose during the hedging period?
60
61
1.Hedgers
(borrowing hedge same as selling a bill)- you worry about interest rates will go up
Attempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share prices
Take the opposite position to the underlying, exposed transaction
Example:
o An exporter has USD receivable in 90 days. To protect against falls in USD over the next three
months, the exporter enters into a futures contract to sell USD
2. Speculators
3. Traders
4. Arbitragers
Simultaneously buy and sell to take advantage of price differentials between markets
Attempt to make profit without taking any risk
Example:
o Differentials between the futures contract price and the physical spot price of the underlying
commodity
Futures contracts may be used to manage identified financial risk exposures such as:
o Hedging the cost of funds (borrowing hedge)
o Hedging the yield on funds (investment hedge)
o Hedging a foreign currency transaction
o Hedging the value of a share portfolio
62
HEDGING THE COST OF FUNDS (BORROWING HEDGE)
The risks of using the futures markets for hedging include the problems of:
o standard contract size
o margin risk
o basis risk
o cross-commodity hedging
Standard contract size
o Owing to contract size the physical market exposure may not exactly match the futures market
exposure, making a perfect hedge impossible
o Table 19.6
63
Margin payments
o Initial margin required when entering into a futures contract
o Further cash required if prices move adversely (i.e. margin calls)
o Opportunity costs associated with margin requirements
Basis risk
o Two types of basis risk
Initial basis
The difference between the price in the physical market and the futures market at
commencement of a hedging strategy
Final basis
The difference between the price in the physical market and the futures market at
completion of a hedging strategy
(when you close out early?)
o A perfect hedge requires zero initial and final basis risk
Cross-commodity hedging
o Use of a commodity or financial instrument to hedge a risk associated with another commodity or
financial instrument
Often necessary as futures contracts are available for few commodities or instruments
o Selection of a futures contract that has price movements that are highly correlated with the price of
the commodity or instrument to be hedged
When hedging share portfolio- risk is that share price will fall
- Future market- you can take a short position
Choose which country if there is no future contracts available in that country- choose country with highest stock
market correlation.
FORWARD RATE AGREEMENTS (FRAS)
64
Pay FRA the dealer the difference = for a company dealer normally a bank
65
Summary
A futures contract
o An agreement between two parties to buy or sell a specified commodity or instrument at a specified
date in the future, at a price specified today
o May be used as a hedging strategy by opening a position today that requires a closing transaction that is
the reverse of the exposed transaction in the physical market
o Limitations include margin calls, imperfect hedging owing to basis risk, and availability
OPTIONS MARKETS
- allows to speculate
- enter in position today- cost- there is a premium-one of the main differences between futures contract and dont
have to go through with options
- asymmetry pay off- it depends on price of the underlying asset.
THE NATURE OF OPTIONS
Options differ from futures because they provide asymmetric cover against price movements
66
Options limit the effects of adverse price movements without reducing profits from favourable price movements
Options involve the payment of a premium by the buyer to the seller (writer)
An option gives the buyer the right, but not the obligation, to buy or sell a specified commodity or financial
instrument at a predetermined price (exercise or strike price), on or before a specified date (expiration date) An
option will be exercised only if it is in the buyers best interests
Types of options
o Call options
Give the option buyer the right to buy the commodity or instrument at the exercise price
o Put options
Give the buyer the right to sell the commodity or instrument at the exercise price
( if think price will increase- long call option, if decrease- long put option)
67
68
o
o
Unlike the case with futures, the risk of loss for a buyer of an option contract is limited to the
premium
However, sellers (writers) of options have potentially unlimited risk and may be subject to margin
requirements unless they write a covered option
I.e. the writer of an option holds the underlying asset or provides a financial guarantee
The writer of a call option has written a covered option if the writer either:
owns sufficient of the underlying asset to satisfy the option contract if exercised; or
is also the holder of a call option on the same asset, but with a lower exercise price
The writer of a put option has written a covered option if the writer is also the holder of a put option
on the same asset, but with a higher exercise price
69
1.Intrinsic value
The market price of the underlying asset relative to the exercise price
The greater the intrinsic value, the greater the premium, i.e. positive relationship
Options with an intrinsic value
o Positive are in the money and the buyer is able to exercise contract at a profit
o Negative are out of the money and the buyer will not exercise
o Zero are at the money
70
2.Time value
The longer the time to expiry, the greater the possibility that the option will be able to be exercised for a
profit (in the money); i.e. positive relationship
If the spot price moves adversely, the loss is limited to the premium
3.Price volatility
The greater the volatility of the spot price, the greater the chance of exercising the option for a profit, or a
loss
The option will be exercised only if the price moves favourably
The greater the spot price volatility, the greater the option premium; i.e. positive relationship
4.Interest rates
Single-option strategies
o Example: long asset (i.e. bought) and bearish (negative) about future asset price
Strategy
Limit downside risk by writing (selling) a call option, i.e. short call
Figure 20.5 and Table 20.4 in the textbook illustrate the profit profile of this strategy
o Example: short asset (i.e. sold) and bullish (positive) about future asset price
Strategy
Buy a call in the underlying asset (i.e. take a long-call position)
Figure 20.6 and Table 20.5 in the textbook illustrate the profit profile of this strategy
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Combined-options strategies
o Example: expectation of increased price volatility, with no trend
Strategy
Hold (buy) a put option
Hold (buy) a call option with common exercise price
Long straddle provides positive pay-off for both large upward and downward price
movements
If prices remain unchanged, individual makes loss equal to sum of premiums
Figure 20.11 in the textbook illustrates the profit profile
o Example: expectation of increased volatility, without trend, with stagnation
Strategy
Hold (buy) call option with out-of-the-money exercise price
Hold (buy) put option with out-of-the-money exercise price
With long strangle loss is decreased if price remains unchanged, compared with
long straddle
Figure 20.12 in the textbook illustrates the profit profile
o Example: expectation of asset price stability
Strategy
Take opposite position to long straddle and long strangle
Strategy I: Short straddle
o Sell call and put options with same exercise price
Strategy II: Short strangle
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CONCLUSION
The potential gains and losses to buyers and sellers of futures contracts are different from those of options
o Options provide one-sided price protection that is not available through futures
o The option buyer limits losses and allows profits to accumulate
However, the premium may be quite high
Summary
The holder of an option (long party) has the right to buy (call) or sell (put) the commodity at a specified
exercise price
The writer (seller) is the short party
ASX trades standardised options, unlike over-the-counter market
The premium paid to buy an option is affected by its intrinsic value, time value, price volatility, and interest
rates
A broad array of option strategies may be adopted by hedgers and speculators