Analysis of Financial Markets - 2-2

Introduction to
Financial Markets
and Institutions
Financial Systems/Crises
Financial Markets
n Financial markets do not work well when we have a financial crisis
n Financial markets are important because they promote efficient resource

allocation and economic growth (Finance/Growth literature)
n King, R. G., & Levine, R. (1993). Finance and growth: Schumpeter might
be right. The quarterly journal of economics, 108(3), 717-737.
n Adjasi, C. K., & Biekpe, N. B. (2006). Stock market development and

economic growth: The case of selected African countries. African
Development Review, 18(1), 144-161.
History of Financial Crises
n https://www.youtube.com/watch?v=bx_LWm
6_6tA
n http://www.economist.com/news/essays/2160
0451-finance-not-merely-prone-crises-it-
shaped-them-five-historical-crises-show-how-
aspects-today-s-fina
Overview of Financial System
n Financial system has five components:

l Money – as a medium of exchange and store of
wealth
l Financial instruments – to transfer resources and risk
l Financial markets – allow trading in financial
instruments
l Financial institutions – provide services, including
access to financial markets
l Central banks – monitor and stabilise the economy
Financial Instruments
n Financial instrument
l Is the legal obligation of one party to transfer
something of value, usually money, to another
party at some future date, under certain
conditions, e.g. stocks, loans, insurance
l Uses of financial instruments include:

u Act as a means of payment
u Store of value
u Allow for the trading of risk
Characteristics of Financial Instruments
n Standardization – financial instruments are homogenous

– loans and securitized loans
n Information – summarise essential information about
issuer. Resolve problem of information asymmetry
n Akerlof, G. A. (1970). The market for" lemons":
Quality uncertainty and the market mechanism. The
quarterly journal of economics, 488-500.
n Examples of financial instruments:
l Financial instruments used as store of value include: bank
loans, bonds, mortgages, stocks
l Financial instruments used to transfer risk include: insurance
contracts, futures contracts, options, swaps
Overview of Financial Markets
Financial Market: a market in which financial

assets (securities) such as stocks and bonds
can be purchased or sold
n Financial markets provide for financial intermediation--
financial savings (Surplus Units) to investment (Deficit
Units)
n Financial markets provide payments system
n Financial markets provide means to manage risk
n Financial markets pool and communicate information
about the issuers of financial instrument, summarising in
the form of price
Role of Financial Intermediaries
n Providing maturity intermediation

n Pooling savings
n Reducing risk through diversification
n Reducing costs of contracting and
information processing
n Providing a payments mechanism
n Providing liquidity
Services of Financial Institutions
n Transforming financial assets

l Deposits represent assets to customers but a liability of the financial
institution. These liabilities are transformed into loans
n Exchanging financial assets on behalf of customers
l Brokerage function
n Exchanging financial assets for own account
l Dealer function
n Assisting in the creation of financial assets
l Underwriting function
n Providing investment advice
n Managing portfolios
Function of Financial Markets
1. Allows transfers of funds from
person or business without
investment opportunities to one
who has them
2. Improves economic efficiency
Role of Financial Intermediaries
n Transfer of funds from savers to investors –

Types of Investments
l Direct Investment
u For example, purchasing a portfolio of stocks
and bonds, investing in loans.
l Indirect Investment
u For example, purchasing an equity claim issued
by an investment company, loan granted by a
bank.
Overview of Financial Markets
n Broad Classifications of Financial Markets
Money versus Capital Markets
Primary versus Secondary Markets
Organized versus Over-the-Counter Markets

Money vs. Capital Markets
n Money n Capital
l Short-Term, < 1 l Long-Term, >1Yr
Year l Range of Issuer
l High Quality Quality
Issuers l Debt and Equity
l Debt Only l Secondary Market
l Primary Market Focus
Focus l Financing
l Liquidity Market- Investment--Higher
-Low Returns Returns
Primary vs. Secondary Markets
n PRIMARY n SECONDARY
l New Issue of l Trading Previously
Securities Issued Securities
l Exchange of l No New Funds for

Funds for Issuer
Financial Claim
l Funds for l Provides Liquidity

Borrower; an IOU for Seller
for Lender
Organized vs. Over-the-Counter
Markets
n Organized n OTC
l Visible l Wired Network of
Marketplace Dealers
l Members Trade l No Central,

Physical Location
l Securities Listed
l All Securities
l GSE, NYSE Traded off the
Exchanges
Securities Traded in Financial Markets
n Money Market Securities

l Debt securities Only
n Capital market securities

l Debt and equity securities
n Derivative Securities
l Financial contracts whose value is derived from the
values of underlying assets
l Used for hedging (risk reduction) and speculation
(risk seeking)
Debt vs. Equity Securities
Debt Securities: Contractual obligations of

Debtor (borrower) to Creditor (lender)
u Investor receives interest
u Capital gain/loss when sold
u Maturity date
Debt vs. Equity Securities
Equity Securities: Claim with ownership

rights and responsibilities
u Investor receives dividends if declared
u Capital gain/loss when sold
u No maturity date—need market to sell
Valuation of Securities
n Value a function of:

l Future cash flows
l When cash flows are received
l Risk of cash flows
n Present value of cash flows discounted at the
market required rate of return
n Value determined by market demand/supply
n Value changes with new information
Investor Assessment of New Information
Economic Conditions
Industry
Conditions Impact of Evaluation Investor
Future Cash of Security Decision to
Flows Pricing Trade
Firm Specific
Information
Financial Market Efficiency
n Security prices reflect available information
n New information is quickly included in

security prices
n Investors balance liquidity, risk, and return

needs
The Role of Govt. in Financial Markets
n Government acts as financial intermediary

through its:
l Direct lending – provide credit on more
favourable terms
l Guarantees – guarantee the payment of
principal and interest in whole or in part, in
the event that the borrower defaults
l Sponsored enterprises – govt. may sometimes
provide capital for the formation of these
firms
Financial Market Regulation
n To Maintain Financial Market Stability

u Prevent market crashes – using Central
Bank’s discount window
u Prevent Inflation--Monetary policy
u Prevent Excessive Risk Taking by
Financial Institutions
n To Promote Efficiency
u High level of competition
u Efficient payments mechanism
u Low cost risk management contracts
n To Provide Consumer Protection

n Provide adequate disclosure
n Set rules for business conduct
n To Pursue Social Policies

u Transfer income and wealth
u Allocate saving to socially desirable areas
n To restrict Foreign Activities in Domestic

market
n To Control Level of Economic Activity

Forms of Regulation
n Disclosure Regulation
n Financial Activity Regulation
n Regulation of Financial Institutions
n Regulation of Foreign Participants
n Banking and Monetary Regulation
Reading Assignment – The Role of the
Government in Financial Markets
n Stiglitz, J. E. (1993). The role of the state in
financial markets. The World Bank Economic
Review, 7(suppl 1), 19-52.
Financial Repression –
Reading/Presentation
n What is financial repression?
l McKinnon and Shaw (1973) hypothesis on
financial repression.
l http://www.investopedia.com/terms/f/financial-
repression.asp
Financial Market Globalization
n Increased international funds flow

l Increased disclosure of information
l Reduced transaction costs
l Reduced foreign regulation on capital flows
l Increased privatization
Results: Increased financial integration--
capital flows to highest expected risk-
adjusted return
Reading Assignment
n Agbloyor, E. K., Abor, J. Y., Adjasi, C. K. D., & Yawson, A.

(2014). Private capital flows and economic growth in Africa:
The role of domestic financial markets. Journal of
International Financial Markets, Institutions and Money, 30,
137-152.
Types of Depository Financial
Institutions
Types of Depository Financial Institutions
Credit
Savings
Unions
Institutions
Commercial
Banks
Types of Non-depository Financial
Institutions
n Insurance companies
n Mutual funds
n Pension funds
n Securities/Investment companies
n Finance companies
Role of Nondepository Financial
Institutions
n Focused on capital market
n Longer-term, higher risk intermediation
n Less focus on liquidity
n Less regulation
n Greater focus on equity investments
Trends in Financial Institutions
n Rapid growth of mutual funds and pension

funds
n Increased consolidation of financial
institutions via mergers
n Increased competition between financial
Institutions
n Growth of financial conglomerates
The Economics of
Financial
Intermediation and
Innovation
Financial Intermediaries
n Financial intermediaries obtain funds by

issuing financial claims against themselves
to market participants, then investing those
funds.
n They may fall into three categories:

l Depository institutions
l Contractual savings institutions
l Investment intermediaries
Depository Institutions
n They are financial intermediaries that

accept deposits from individuals and
institutions and make loans.
n They include:
l Commercial banks
l Savings and Loans Associations
l Mutual Savings/Savings Banks
l Credits Unions
Contractual Savings Institutions
n They are financial intermediaries that

acquire funds at periodic intervals on a
contractual basis. Can predict the benefits
to be paid over a period.
n They include:
l Life Insurance companies
l Fire & Casualty Insurance companies
l Pension & Govt. Retirement Funds
Investment Intermediaries
n These financial intermediaries include:

l Finance companies
l Mutual Funds
Asset/Liability Management for FIs
n Spread and Non-Spread Businesses
l Mensah, S., & Abor, J. Y. (2014). Agency conflict and bank interest spreads in Ghana. African
Development Review, 26(4), 549-560.
l Spread businesses
u Banks and Insurance companies
l Non-Spread businesses
u Pension funds
u Mutual funds – excluding open-ended funds
n Nature of Liabilities
l Amount of cash outlay
l Timing of cash outlay
n Liquidity Concerns
l Profitable but illiquid FIs can easily collapse
n Regulations and Taxation

Nature of Liabilities of FIs
Type Amount Timing Example
Type I Known Known Fixed deposits, GICs
Type II Known Uncertain Life Insurance
Type III Uncertain Known Floating rate instruments
Type IV Uncertain Uncertain Automobile, home insurance

Financial Innovation
n Is the development of new products and delivery

systems, and the emergence of new kinds of financial
providers.
n Usually occurs in response to changing needs for
financial services and the availability of new
technology to support it.
n Offers a means by which market participants may
avoid govt. regulation that they find restrictive.
n Innovation changes the financial structure and
diminishes the effectiveness of current forms of
financial regulation.
Motivation for Financial Innovation
n Two extreme views why there are financial

innovations
l To endeavor to circumvent regulation and
find loopholes in tax rules
l To introduce financial instruments that are
more efficient for redistributing risks among
market participants
Causes of Financial Innovation
n Increased volatility of interest rates, inflation,

equity prices, and exchange rates
n Advances in computer and telecommunications
technology
n Greater sophistication of market participants
n Financial intermediary competition
n Incentives to circumvent regulations and tax
laws
n Changing global patterns of financial wealth
Categories of Financial Innovation by
Economic Council of Canada
n Market-broadening instruments
l Increases the liquidity of markets and the availability of funds by
attracting new investors & offering new opportunities for borrowers
n Risk-management instruments
l Makes it possible to reallocate financial risks to those who are less
averse to them, or who have offsetting exposure and thus are
presumably better able to shoulder them
n Arbitraging instruments and processes

l Allow investors to take advantage of differences in costs and returns
between markets
Categories of Financial Innovation by BIS
n Price-risk-transferring innovations
l Provide market participants with more efficient ways of dealing with
price or exchange rate risk
n Credit-risk-transferring instruments
l They make it possible to reallocate the risk of default
n Liquidity-generating innovations
l They increase the liquidity of the market, they allow borrowers to draw
upon new sources of funds, and allow market participants to
circumvent capital constraints imposed by regulators
n Credit-generating instruments
l Instruments to increase the amount of debt available to borrowers.
n Equity-generating instruments
l Instruments to increase the capital base of financial and non-financial
institutions
Asset Securitization as a Financial Innovation
n Meaning of Securitization
l Involves the collection or pooling of loans
and the sale of securities backed by those
loans
n Basic Structure of Asset Securitization

l May involve more than one institution
l Lending bank, insurance company, institution
servicing the loan, a securities firm, investors
Benefits to Issuers
n Diversification and reduced cost of

financing
n Management of regulatory capital
n Generation of servicing fee income
n Management of interest rate volatility
Other Benefits
n To Investors
l Greater liquidity
l Reduced credit risk
n To Borrowers
l Lower lending rate spreads
n Social Benefits
Money Markets
Money Market Securities
n Debt securities issued by companies and

governments that need short-term funds
n Maturity of a year or less
n Large primary market focus
n Purchased by companies and financial
institutions
n Secondary market for securities
n Treasury bills
n Commercial paper
n Negotiable certificates of deposits
n Repurchase agreements
n Banker’s acceptances
n Treasury bills
l Issued to meet the short-term needs of the
government
l Attractive to investors
u Minimal default risk—backed by Government
u Excellent liquidity for investors
n Short-term maturity
n Very good secondary market
Competitive Bidding
n Treasury bill auction (fill bids in amount

determined by Treasury borrowing needs)
l Bid process used to sell T-bills
l Bids submitted to BOG by banks by the deadline
l Bid process
u Accepts highest bids
u Accepts bids until Treasury needs generated
Noncompetitive Bidding
n Treasury bill auction—noncompetitive bids
l May be used to make sure bid is accepted
l Price is the weighted average of the accepted bids
l Investors do not know the price in advance so they
submit cheque for full par value
l After the auction, investor receives cheque from
the Treasury covering the difference between par
and the actual price
n Estimating T-bill yield

l No coupon payments
l Par or face value received at maturity
l Yield at issue is the difference between the
selling price and par value adjusted for time
l If sold prior to maturity in secondary market
u Yield based on the difference between price paid
for T-bill and selling price adjusted for time
n Calculating T-Bill Annualized Yield
SP – PP 364
YT = 
PP n
YT = The annualized yield from investing in a T-bill

SP = Selling price
PP = Purchase price
n = number of days of the investment (holding period)

n T-bill yield for a newly issued security
Par – PP 364
T-bill discount = 
Par n
T-bill discount = percent discount of the purchase price from par

Par = face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
OR
Yd = D/FV  364/T
Treasury Bills
n T-bill with 91days to maturity, 100,000 face

value with a discount of 9,000 will have an
annualized bank discount of:
n Yd = D/FV  364/T
n Yd = 9,000/100,000  364/91 = 36%
n To get the discount, D

l D = FV  Yd  T/364
n Price = FV - D
Commercial Paper
n Short-term debt instrument

n Alternative to bank loan
n Dealer placed vs. directly placed
n Used by well-known and creditworthy firms
n Mostly unsecured/Asset Backed Commercial Paper
(ABCP)
n Minimum denominations
n Not a large secondary market
n Commercial paper backed by bank lines of

credit
l Bank line used if company loses credit
rating
l Bank lends to pay off commercial paper
l Bank charges fees for guaranteed line of
credit
n Estimating commercial paper yields
Par – PP 364
YCP = 
PP n
YCP = Commercial paper yield

Par = Face value at maturity
PP = Purchase price

Negotiable Certificates of Deposit (NCD)
n Issued by large commercial banks

n Bearer instruments
n Minimum denomination
n Purchased by nonfinancial corporations or
money market funds
n Secondary markets supported by dealers in
security
n NCD placement
l Direct placement
l Use a correspondent institution specializing
in placement
l Sell to securities dealers who resell
l Sell direct to investors at a higher price
n NCD premiums
l Rate above T-bill rate to compensate for
lower liquidity and safety
n
Repurchase Agreements
n Sell a security with the agreement to repurchase
it at a specified date and price
n Borrower defaults, lender has security
n Reverse repo name for transaction from lender
n Negotiated over telecommunications network
n Dealers and brokers used or direct placement
n No secondary market
n Estimating repurchase agreement yields
SP – PP 364
Repo Rate = 
PP n
Repo Rate = Yield on the repurchase agreement

SP = Selling price
PP = Purchase price

Money Market Securities - Repos
n
Bankers Acceptance
n Have been in use since the 12th century
n A bank takes responsibility for a future payment of trade bill of exchange
n BA is like a post-dated cheque.
n Used mostly in international transactions
n Exporters send goods to a foreign destination and want payment assurance
before sending
n Bank stamps a time draft from the importer ACCEPTED and obligates the
bank to make good on the payment at a specific time
n If the exporter needs funds, the bankers acceptance can be sold in the
secondary market
n They are sold on a discounted basis like commercial paper and T Bills.
Major Participants in Money Market
n Participants
l Commercial banks
l Finance, industrial, and service companies
l Governments
l Money market mutual funds
l All other financial institutions (investing)
l Individuals
n Short-term investing for income and liquidity
n Short-term financing for short and permanent needs
n Large transaction size and telecommunication network
Valuation of Money Market Securities
n Present value of future cash flows at maturity

(zero coupon)
n Value (price) inversely related to discount
rate or yield
n Money market security prices more stable
than longer term bonds
n Yields = risk-free rate + default risk premium
Interaction Among Money Market
Yields
n Securities are close investment substitutes
n Investors trade to maintain yield differentials
l Libor and Fed- Fed rates are close substitutes
l If rates are misaligned, demand and supply forces will force an
alignment.
n T-Bill is the benchmark yield in money market
n Yield changes in T-bills quickly impacts other securities via
dealer trading
n Yield differentials determined by risk differences between
securities
n Default risk premiums vary inversely with economic
conditions
Globalization of Money Markets
n Money market rates vary by country

l Segmented markets
l Tax differences
l Estimated exchange rates
l Government barriers to capital flows
n Deregulation Improves Financial Integration

n Capital Flows To Highest Rate of Return
n Euro-commercial paper
l Issued without the backing of a banking
syndicate
l Maturity tailored to investors
l Dealers that place paper create a secondary
market
l Rates range between 50 and 100 basis points
above the LIBOR rate
n Performance of international securities

n Effective yield for international securities
has two components
l The yield earned on the investment
denominated in the currency of the
investment
l The exchange rate effect
n Performance of international securities

n Yield for an international investment
Yf SPf – PPf
=
PPf
Yf = Foreign investment’s yield
SPf = Investment’s foreign currency selling price
PPf = Investment’s foreign currency purchase
n The exchange rate effect (%▲S) measures the

percentage change in the spot during the
investment period
Ye  (1  Yf )  (1  %S )  1
l % ▲S measures the expected percent change in the
currency
u Currency appreciated, % ▲S is positive and adds to net
yield
u Currency depreciated, % ▲S is negative and reduces net
yield
Ye  (1  Yf )  (1  %S )  1
n They are financial intermediaries that accept

deposits
n Deposits represent the liabilities (debt) on the
deposit-accepting institution
n Funds raised through deposits and other funding
sources are:
l Given as loans
l Invested in securities
n Sources of income:
l Income from loans & purchase of securities
l Fee income
Asset/Liability Problem
n A DI seeks to earn a positive spread between the

assets it invests in (loans and securities) and the cost
of its funds (deposits and other sources).
n The spread is referred to as Spread Income or Margin

Income
n Spread income should allow the institution to meet

operating expenses and earn a fair profit on capital
n In generating spread income, a DI faces several risk

n Types of Risk
l Credit Risk (Default risk) – risk that a borrower
will default on a loan obligation to the DI or that
the issuer of a security that the DI holds may
default
l Regulatory Risk – risk that regulators will change

the rules to impact unfavourably on earnings
n Interest Rate Risk – arises from the fact that

interest rates change resulting in changes in the
expected returns
n DI can borrow short and lend long
n E.g. DI takes a one-year deposit at 5% and invests in a
mortgage loan for 15 years at 8% p.a
n The spread is 3% (8 – 5)
n In this case, the DI is probably expecting interest rates
to decline.
n An increase in interest rates will adversely impact the
DI.
n DI can borrow long and lend short

l DI takes a 15 year loan at 5%p.a and invests in a
one-year security at 8%
l The spread is 3% (8 – 5).
l In this case the DI is probably expecting interest
rates to rise.
l A decrease in interest rates will adversely affect
the DI
Liquidity Concerns
n DIs must also satisfy withdrawals by

depositors and provide loans to customers
n Ways to obtain funds to accommodate
withdrawals and loan demand:
l Attract additional deposits
l Use currently-owned securities as collateral
for loans from CB or other institutions
l Raise short-term funds in the money market
l Sell currently-owned securities
n Commercial Banks
n Savings and Loan Associations
n Savings Banks
n Credit Unions
Bank Services
n Individual banking involves
l Consumer lending, residential mortgage lending,
Consumer installment loans, credit card loans, brokerage
services, student loans, etc.
n Institutional banking involves loans to

l Non-financial firms, financial firms (eg insurance
companies), govt. (national, district), commercial real
estates financing, leasing, factoring .
n Global Banking
l Corporate finance, institutional banking
l Commercial real estate finance, leasing, factoring
l Capital market and foreign exchange market products and
services
Bank Income – Acting as a Dealer
n Bid-Ask spread
n Capital gains on securities and gains on
foreign currency transactions
n Spread between interest income from
holding a security and cost of funding the
purchase of the security
Sources of Bank Funds
n Deposits
l Demand Deposits
l Savings Deposits
l Time Deposits (Certificates of Deposit)
n Non-deposit Borrowing
l Central Bank Discount Window
n Other Non-deposit Borrowing
l Issuance of Debt Securities (eg. Repos and
bonds)
n Retained Earnings & Sale of Equity Securities
Bank Regulation
n Interest Rates on Deposit Accounts
n Geographical Restrictions on Branch

Banking
n Permissible Activities for Commercial Banks
n Capital Requirements for Commercial Banks

Savings and Loan Associations
n Either mutually owned or have corporate stock

ownership
n Principal assets
l Mortgages
l Mortgage-backed securities
l Government securities
n Principal sources of funds
l Savings accounts
l Time deposits
n Regulation
Factors in The S&L Crisis
n Borrowing short and lending long

n Interest rate ceilings on deposits
n Volatile interest rates
n Fraudulent management activities
n High-risk strategies
Credit Unions
n Owned by members
n Principal assets
l Small consumer loans
l Residential mortgages
l Securities
n Principal source of funds
l Member deposits
Central Bank and the Creation of Money
n Tools of Monetary Policy

l Reserve Requirements
l Open Market Operations
l Discount Rate
Reserve Requirements
n Fractional Reserve Banking System

l Required reserve ratio
u Demand deposits
u Time deposits
l Total reserves
u Required reserves
u Excess reserves
Open Market Operations
n CB purchases and sales of government securities in

the open market
n CB purchases
l Increase excess reserves
l Increase new loans
l Increase money supply
n CB sales
l Decrease excess reserves
l Decrease loans
l Decrease money supply
n Repos and reverse repos
Discount Rate
n Rate charged on loans from the CB’s

discount window.
n Administratively set by the CB
n An increase in the discount rate discourages
banks from borrowing from the CB
n A decrease in the discount rate encourages
banks to borrow from the CB
Different Uses of Money
n Unit of Account
l Numeraire
n Medium of Exchange
l Currency and demand deposits
n Store of Value
l Time deposits
Monetary Aggregates
n Monetary Base: Currency in circulation

l Currency and coins plus total reserves
l High powered money
n M1 Money Supply
l Currency plus demand deposits
l Narrow money
l Functions as medium of exchange
n M2 Money Supply
l M1 plus short-term time deposits
l Functions as store of value
n M3 Money Supply
l M2 plus long-term time deposits, commercial paper, bankers acceptances.
l Functions as store of value
Monetary Aggregates
n Velocity of money
l Ratio of money supply to the economy’s income
l Velocity measures the average amount of
transactions carried by a dollar/cedi.
l Ratio not stable thus complicating monetary
policy
l If the economy’s velocity were stable, monetary
policy could achieve any desired level of income
by targeting say M1.
Money Multiplier
n Process by which changes in bank reserves

generate larger changes in the money supply.
n Size of Multiplier Influenced by:
l Reserve requirement ratio
l Public’s demand for cash
l Banks’ willingness to make loans
l Level of interest Rates
The Money Supply Process
in an Open Economy
n Foreign Exchange Market Intervention -

The CB’s purchase and sale of foreign
currencies
l Purchase of foreign currencies
u Increasesmonetary base
u Reduces value of the Ghanaian currency
l Sale of foreign currencies
u Decreases monetary base
u Increases value of the Ghanaian currency
Goals of Monetary Policy
n The CB manages the monetary supply to

achieve certain economic goals. These
include:
l Stability in the price level
l Increase employment
l Economic growth
l Stabilize interest rates
l Stabilize exchange rates
Limitations of Monetary Policy
n Credit crunch
n Lagged effects of monetary policy
l Recognition lag
l Implementation lag
l Impact lag
n Fiscal policy effects
Non-depository
Institutions
Types of Nondepository Financial
Institutions
n Insurance companies
n Investment companies
n Pension funds
n Securities companies
n Finance companies
Insurance Companies
n Insurance companies are financial

intermediaries that for a price (premium),
will make payment if certain events occur.
n They function as risk bearers.
n Two types:
l Life insurance companies
l Property and casualty insurance companies
Life Insurance Companies
n Life Insurance companies insure against

death.
n Make lump sum payment or a series of

payments to beneficiary of policy holder
upon the death of a policy holder.
n May also provide retirement benefits as

another area of business.
Types of Policies
n Policies issued by life insurance companies

can be classified as one of four types:
l Pure insurance protection against risk of
death
l A package consisting of life insurance
protection and an investment vehicle.
l Insurance against the risk of life (annuities),
primarily designed for pension programs
l Pure investment oriented vehicles (such as
guaranteed investment contracts)
Types of Policies
n Pure Insurance Protection against the risk
of death
l Provides death benefit but no cash buildup
l No investment component
l Premium remains constant for a specified
term of years
l Renewable at the end of each term, but at
higher premium
l Insurance company knows the amount of
liability to pay but does not know the date
Types of Policies
n Insurance/ Investment policies

n Has two features:
l Pays off a stated amount upon the death of the insured
l Accumulates a cash value against which the
policyholder can borrow
l Types include universal life and variable life
u A universal life policy pays dividend that is tied to market
interest rates
u With the variable life policy, benefit depends on the market
value of the investment at the time of the insured’s death.
Types of Policies
n Insurance against the risk of life

l Relies on estimates of the average length of
life of a random group
l Offers persons a fixed annuity as long as the
person lives, thus relieving the risk of
outliving the resources of the person.
Types of Policies
n Pure Investment-oriented Policies
Example is the Guaranteed Investment
Contract (GIC)
l These policies are typically purchased by
pension plans sponsors as an investment.
l A life insurance company agrees, for a
single premium, to pay the principal amount
and the predetermined annual crediting rate
over the life of the investment, all of which
is paid at the maturity date.
Investments of Life Insurance
Companies
n Mostly invest in debt obligations.
n They are the largest buyers of corporate bonds
in the US.
n They also provide direct commercial loans and
invest in private placements.
n Allocation of its funds in long term debt
obligations is a result of the nature of its
liabilities.
n Regulation also gives incentive to invest in
bonds rather than equities
Property & Casualty Insurance
n Property and casualty (P&C) insurance

companies provide a broad range of
insurance protection against:
l Loss of damage or destruction of property
l Loss or impairment of income producing
ability
l Claims for damages by third parties because
of negligence.
l Loss resulting from injury or death due to
occupational accidents
n The amount and timing of claims on P & C

insurance companies are more difficult to
predict due to the randomness of natural
catastrophes.
n Has an impact on the investment strategies

of P & C insurance companies compared to
life insurance companies.
n P&C insurance products are classified on:

l Personal lines – automobile insurance, home
owner insurance etc.
l Commercial lines – product liability
insurance, commercial property insurance
and malpractice insurance.
n The cost of the policies underwritten by a P&C
company consists of :
l Claims for losses that have been incurred and
reported during the year.
l Actuarially estimated claims on policies written
during the year that will not be paid until later years.
l P&C companies must by law establish reserves to
satisfy the actuarially estimated claims.
n Sources of revenue include:

l Premium income for policies written in the year
l Investment income.
Investments of P & C Companies
n P & C companies invest more in equities and

less in bonds than the life insurance
companies.
n P&C companies tend to hold investments in
money market instruments due to higher
uncertainty of claims.
n P & C companies are regulated to reduce
likelihood of insolvency.
Insurance Companies in Ghana –
Solvency Ratios
n All insurance companies will be expected to have a solvency
margin of at least 30% or Minimum Capital, which ever is
higher by 31 December 2008, at least 40% margin by 31
December, 2009 and at least 50% margin by 31 December
2010 and thereafter.
SOLVENCY CONTROL LEVELS

LEVEL MARGIN CORRECTIVE ACTION
GREEN If assets are 150% or more of liabilties Routine Monitoring
If assets are more than 125% of liabilities but less than

AMBER 150% thereof Restructure investments
If assets are at least equal to liabilities but less than

RED 125% of liabilities Enforcement Action/capital injection
Suspend licence with the possibility of final

BLACK if liabilities are more than assets licence withdrawal and liquidation
Prescribed Investment Mix
INVESTMENT MIX
PROPORTION OF INVESTMENT PORTOFOLIO
INVESTMENT LIFE Non-Life
Government securities,
cash and deposits At least 35% At least 35%
(excluding Statutory
Deposits)
Statutory Deposit At least 10% of minimum capital At least 10% of minimum capital
Listed Stocks 0 - 30% 0 - 30%
Unlisted stocks 0 - 20% 0 - 10%
Mutual funds 0 - 20% 0 - 20%
Investment Properties 10 - 20% 0 - 20%
Other investments
approved by the NIC 0 - 10% 0 - 10%
n In addition to the investment mix, it is required that at any point in time, the ratio
of investments to total assets should not be less than 55%. That is, at least 55% of
the total assets of the company must be in direct investments. Direct investments
are defined as assets that directly earn cash income or appreciate in value (capital
appreciation) over time.
Investment Companies
n An investment company is a financial
intermediary that sells shares in itself to the
public and uses the funds its raises to invest in a
diversified portfolio of securities.
n They therefore provide an outlet for the savings

of several investors directing their funds into
bonds, stocks and money market securities.
n There are three types:

l Closed-end funds
l Open-end funds
l Unit trusts
Closed-end funds
n Closed-end investment companies sell only a

specific number of ownership shares.
n Their capitalizations are fixed unless a new
public offering is made.
n An investor wanting to acquire closed-end shares
must find another investor who wishes to sell.
n Shares are usually traded on an exchange like
many other stocks.
n The investment company itself does not take part
in the transaction.
Open-end funds (Mutual funds)
n Mutual funds buy back or redeem their shares any

time the customer wishes and
n Sell shares in any quantities demanded
n Thus, the amount of their outstanding shares
changes continually in response to the public
demand.
n The price of each open-end company’s share is
equal to the net value of the fund. i.e. the
difference between the value of its assets and
liabilities divided by the volume of shares issued.
Open-end funds (Mutual funds) cont.
n The share price is quoted on a bid-offer

basis.
n The sales commission is referred to as load.
n The mutual fund that does not impose a sales
commission is called a no-load fund.
n There are two types: money market mutual
funds (short-term funds), equity and bond &
income funds (long-term funds)
Unit Trusts
n Is typically an unmanaged, fixed income

security portfolio put together by a sponsor and
handled by an independent trustee.
n Number of unit certificates is fixed.
n Typically invest in bonds.
n Once the unit trust is assembled by the sponsor
(usually a brokerage firm or bond underwriter)
and turned over to a trustee, the trustee holds all
the bonds until they are redeemed by the issuer.
Unit Trusts cont.
n The only time a trustee may sell an issue in the

portfolio is when there is a dramatic decline in
the issuer’s credit quality rating.
n Unit trusts have a fixed termination date (mutual
funds and closed-end funds do not)
n The unit trust investor knows the specific
collection of bonds in the portfolio and has no
concern that the trustee will alter the portfolio
(not the case of closed-end and mutual funds)
Pension Funds
n Pension funds have become important for

several reasons:
l Income and wealth have grown steadily over
the post war II period, leaving households with
more money for long-term savings.
l Cater for financial needs for longer retirement
periods.
l Pension represent compensation to employees
upon retirement. (is free of tax liability).
Pension Funds cont.
n A pension plan is a fund that is established for the payment for
retirement benefits. The entities that establish pension plans are
called plan sponsors.
l Plan sponsors may be private business entities acting for their
employees
l National district, local entities on behalf of their employees
l Unions on behalf of their members
l Individual for themselves
l Pension funds are financed by contributions of the employer and/or
employee.
l In some plans employer contributions are matched with employees’
l Contributions are tax exempt
l Serve to reduce labour turnover
n Pension funds invest in equities, fixed income securities, real estate,

annuities etc.
Types of Pension Funds
n Types:
l Defined contribution plans
l Defined benefit plans
l Hybrid pension plan (Designer pensions)
n Defined contribution plan

l The plan sponsor is responsible only for making
specified contributions into the plan on behalf of
participants
l The amount contributed is typically either as a
percentage of the employee’s salary or a percentage
of profit
l The plan sponsor does not guarantee any certain
amount at retirement
l The payment made to participants upon retirement
depends on the growth of the plan assets.
n Defined benefit plan

l Plan sponsor agrees to make specified cedi payment to
employees at retirement.
l Retirement payment is determined by a formula that takes

into account the length of service and employee’s earnings
l Example
u Annual pmt = 2% * average of final 3 years income * years of service.
l Plan sponsor can use payments into the fund to purchase an

annuity policy from a life insurance company
l Defined benefits plans guaranteed by life insurance products

are called insured plans.
n Hybrid pension plan (Designer pensions)

l Plan sponsor contributes a certain amount
each year to the fund.
l Plan sponsor guarantees a certain level of
benefit depending on an employee's years
of service.
Managers of Pension Funds
n A plan sponsor can do one of the following with

pension assets under its control:
l Use in-house staff to manage all the pension
assets.
l Distribute pension assets to one or more money
mgt. firms to manage
l Combination of both
n In the case of a contribution pension plan, the
plan sponsor allows participants to select how to
allocate their contributions among funds
managed by a fund group.
Managers of Pension Funds cont.
n Insurance companies have subsidiaries that

manage pension funds.
n The trust departments of commercial banks
manage funds.
n Independent money management funds.
n Foreign entities are also allowed to manage
pension funds.
n Managers charge annual fees based on
percentage of the value of assets.
Pensions in Ghana
n TA Bediako Commission set up by President Kufour in July 2004.

l Workers agitating to be on CAP 30
l People in the informal sector could not contribute to SSNIT
n Pensions governed by the National Pensions Act, 2008 (Act 766) as
amended by National Pensions Amendment Act, 2014 Act 883.
n The worker contributes 5.5% of monthly basic salary.
n The employer contributes 13% of worker’s monthly basic salary.
n The minimum contribution shall be 18.5% of the approved monthly
equivalent of the national minimum daily wage.
n 2.5% is transferred to the National Health Insurance Fund for provision of
medical insurance.
n 5% is transferred to Tier 2.
n SSNIT effectively withholds 11% for the administration of Tier 1.
n The self-employed members contribute 18.5% of their declared income.
Pensions in Ghana
n The new minimum age at which a person may join the Basic National
Pension Scheme is 15 years and the maximum is 45 years.
n The 12-year annuity guarantee period under the old scheme has been
increased to 15 years.
n The Pension paid will fall between 37.5% and 60% of the average of the
three best years’ salary depending on how long he/she contributed to the
scheme at age 60.
l Every 12 months after the minimum contribution period shall lead to an
increase of 1.125% in the pension payable. Maximum is 60%.
n Those unable to contribute up to the minimum 180 months (15 years),
receive a return of their contributions accumulated at a prescribed interest
rate.
n A member can opt for early retirement between ages 55 and 59 and receive
a reduced pension.
Bond Markets
Background on Bonds
n Bonds represent long-term debt securities

l Contractual
l Promise to pay future cash flows to investors
n The issuer of the bond is obligated to pay:
l Interest (or coupon) payments periodically usually
semiannually
l Par or face value (principal) at maturity
n Primary vs. secondary market for bonds
Background on Bonds
n Bonds are classified by the ownership structure as

either;
l Bearer bonds
l Registered bonds.
n Bearer bonds require the owner to clip coupons

attached to the bonds and send to the issuer to
receive payment.
n Registered bonds require the issuer to maintain

records of who owns the bond and automatically
send coupon payments to the owners.
Background on Bonds
n Types of bonds include:

l 1. Debentures, the most common type of
corporate bond, are backed by the general credit of
the company. Unsecured bonds
l 2. Subordinated debentures, Unsecured “junior”

debt.
l 3. Mortgage bonds have real estate as collateral

for the repayment of the loan.
Background on Bonds
l 4. Serial bonds specify periodic payment of interest and

mature in successive years.
l 5. Zeros - bonds that pay only par value at maturity; no

coupons.
l 6. Junk bonds - speculative or below-investment grade

bonds; rated BB and below. High-yield bonds.
l 7. Treasury Strips – interest only and principal only

securities. Each interest payment can be traded separately.
Background on Bonds
l 8. Convertible bonds - bonds that could be converted into

shares. The conversion price is known at the time of issue.
l 9. Index-Linked bonds – are structured such that, value at

maturity is linked to a specific index, eg. a corporate issue
linked to a Stock Exchange Index, or a govt. bond linked to
the RPI.
l 10. Eurobonds - bonds denominated in one currency and

sold in another country. (Borrowing overseas).
l 11. Green bonds – bonds issued to finance investment in

clean technologies.
Background on Bonds
Bond Interest Rates
n The issuer’s cost of financing with bonds is

the coupon rate
u Determined by current market rates and
risk
u Usually fixed throughout term
u Determines periodic interest payments
Background on Bonds
Bond Yield to Maturity
n The yield to maturity (TYM) is the yield that

equates the future coupon and principal payments
with the bond price
l The YTM is the investor’s expected rate of return if
the bond is held to maturity
l The actual YTM may vary from the expected
because of risks assumed by the investors
Background on Bonds
S
n
$Ct $F
P0 = +
(1 + kb)t (1 + kb)n
t=1
YTM = Ct + (F – P0)/n
(F + P0)/2
Background on Bonds
An investor can purchase a ten-year, ¢1000

par value bond with an 8 percent annualized
coupon rate for ¢936. Determine the yield to
maturity for this bond.
N I PV PMT FV
10 –936 80 1000
Background on Bonds
An investor can purchase a ten-year, ¢1000

par value bond with an 8 percent annualized
coupon rate for ¢936. Determine the yield to
maturity for this bond.
N I PV PMT FV
10 9 –936 80 1000
Background on Bonds
Bonds by Issuers
Issuer Type of Bond

Federal Government Treasury Bonds
(U.S. Treasury)
Federal Agencies Federal Agency Bonds
State and Local Municipal Bonds
Governments
Corporations Corporate Bonds
U. S. Treasury Bonds
n Issued by the U.S. Treasury to finance federal

government expenditures
n Maturity
l Notes, < 10 Years
l Bonds, > 10 to 30 Years
n Active OTC Secondary Market
n Semiannual Interest Payments
n Benchmark Debt Security for Any Maturity
Treasury Bonds
Inflation-Indexed Bonds
l Intended for investors who seek inflation

protection with their investments
l Coupon rates less than other Treasuries
l Principal value adjusted for the U.S.
inflation rate (CPI) every 6 months
l Coupon income increases with inflation
Bonds in Ghana
Bonds in Ghana
Issuer Type of Bond
Government of Ghana GGILB, Jubilee bond,

Eurobond
Home Finance Company US dollar and sterling
denominated bonds
Corporate Bonds
n When companies want to borrow for long-term

periods they issue corporate bonds
l Usually pay semiannual interest
l Have long-term maturities
l Public offering vs. private placement
l Limited exchange, larger OTC secondary
market
l Investors seek safety of principal and steady
income
Corporate Bonds
Corporate Bond Terminology
l Indenture
u Legaldocument specifying rights and
obligations of issuer and bondholder
l Trustee
u Represents
bondholders to ensure
compliance with indenture
Corporate Bonds

l Sinking Fund Provision
u Requirement that the firm retires a certain amount or
number of bonds each year
u Protects investors with principal reduction
l Protective Covenants
u Places restrictions on the firm to protect bondholders
u Examples: limits dividends and officer salaries,
restricts additional debt
Corporate Bonds
l Call provisions: Ability to pay bonds off early

u Call premium – difference between bond’s call price
and par value
u Advantage to issuers; disadvantage to investor
l Bond collateral
u Usually consists of a mortgage on real property
u Unsecured bonds are called debentures and are
backed only by the general credit of the issuing firm
Corporate Bonds

l Low-coupon and zero-coupon bonds
u Provide investors known rate of return
u Imputed interest income taxed if not in tax-
sheltered investment plan
u Attractive to pension funds with expected
payouts
l Variable-rate bonds
l Convertible bonds
Corporate Bonds
n Junk Bonds
l Junk bonds are also called high-yield bonds or
noninvestment rated bonds
l Perceived to have high risk
l Offer high yields that contain risk premium to
compensate investors for high risk
l Popularized in the direct finance boom of the
1980s
l Secondary market supported by dealer market
Globalization of Bond Markets
n Foreign investment in dollar securities

n Foreign issuance by local firms
n Increased global investment by pension and
mutual funds
n Development of foreign security markets—
24 hour trading
n Eurobond market
Eurobond Market
l In 1960s, U.S. corporations were limited to

the amount of funds they could borrow in the
U.S. for overseas operations.
l They began to issue bonds in the Eurobond
market where bonds denominated in various
currencies were placed.
u About 75 percent are denominated in U.S. dollars
Eurobond Market
n An underwriting syndicate of investment

banks participates in placing the bonds
u Issuercan choose the currency in which the
bond interest and principal are denominated
u Dollar denominated most common
Mortgage Markets
Mortgage Market
n Consists of the primary market also known as the

origination market and secondary market.
n A mortgage is a long term loan which is secured

by a real estate and the loan mortgage is
amortized. i.e. the borrower pays off over time in
some combination of principal and interest
payment.
n Two types
l Residential
l Non-residential
Mortgage Market
n Mortgage origination. The original lender is

the mortgage originator.
n In most countries mortgage originators are

comm. banks and mortgage banks and thrift
institutions.
n Other private originators are the life insurance

companies and pension funds.
Mortgage Market
n The mortgage originator generates income in

several ways:
l Origination fee
l Application and processing fees
l Service fee
n Two primary factors to lending

l Payment to income ((PTI) ratio
l Loan to value (LTV) ratio
Mortgage Market
n PTI ratio is the ratio of monthly payment of the

mortgage to applicant’s monthly income.
l Measures the ability of the applicant to make monthly
payment for the mortgage and real estate tax payment.
l The lower the ratio the greater the likelihood that the
applicant will be able to meet required payment.
n LTV is the ratio of the amount of the loan to the

market value of the property.
l The lower the ratio the greater the protection for the
lender. If the applicant defaults on the payment and the
lender must repossess and sell the property.
Residential Mortgage Characteristics
Insured vs. Conventional Mortgages
l Insurance guarantees repayment in the event

of borrower default
l Limits on amounts, borrower requirements
l Borrower pays insurance premiums
Fixed Rate vs. Adjustable Mortgages

n Fixed rate loans (traditional mortgage) have a
constant, unchanging rate
l Borrower pays interest and principal in equal
installments
l Loan is fully amortized after the end of the period
l Interest rate risk can hurt lender rate of return
u If interest rates rise in the market, lender’s cost of
funds increases
u No matching increase in fixed-rate mortgage return
l Borrowers lock in their cost and have to refinance to
benefit from lower market rates
n Fixed monthly payment includes

l Interest owed first
l Balance to principal
n Interest on the declining principal balance
n Calculating monthly payment
l Principal borrowed = PV
l Number of months to maturity = years  12 = N
l Rate/12 = I
l Calculate PMT
Calculate the monthly payment for a $330,000

home. The new owner has made a $70,000
down payment and plans to finance over 30
years at the current fixed rate of 7%.
Calculate the monthly payment for a

$330,000 home. The new owner has made a
$70,000 down payment and plans to finance
over 30 years at the current fixed rate of 7%.
$330,000 – $70,000 = $260,000 PV (original

investment of the financial institution)
30 x 12 = 360 N; 7/12 = I; Calculate PMT
Calculate the monthly payment for a $330,000

new home. The new owner has made a
$70,000 down payment and plans to finance
for 30 years at the current fixed rate of 7%.
$330,000 – $70,000 = $260,000 PV (original

investment of the financial institution)
30  12 = 360 N; 7/12 = I; Calculate PMT
PMT = $1,729.79
Fixed-Rate vs. Adjustable Mortgages
n Adjustable-rate mortgages
l Rates and the size of payments can change
u Maximum allowable fluctuation over year and life of loan
u Upper and lower boundaries for rate changes
l Lenders stabilize profits as yields move with cost of
funds
l Uncertainty for borrowers whose mortgage
payments can change over time
Mortgage Maturities
n 30-year mortgage loan popular in the 1970s

n Trend shows increased popularity of 15-year
loans
l Lender has lower interest rate risk if the term or
maturity of the loan is lower
l Borrower saves on interest expense over loan’s life
but monthly payments higher
Mortgage Maturities
n Balloon payments
l Principal not paid until maturity
l Lower monthly payments
l Forces refinancing at maturity
n Amortizing mortgages
l Monthly payments consist of interest and principal
l During loan’s early years, most of the payment reflects
interest
Creative Mortgage Financing
Methods:
n Graduated-payment mortgage (GPM)
l Small initial payments
l Payments increase over time then level off
l Assumes income of borrower grows
n Growing-equity mortgage
l Like GPM low initial payments
l Unlike GPM, payments never level off but
continue to increase throughout the life of the loan
l Mortgage may be paid within a short time
Creative Mortgage Financing
n Second mortgage used in conjunction with

first or primary mortgage
l Shorter maturity typically for 2nd mortgage
l 1st mortgage paid first if default occurs so 2nd
mortgage has a higher rate
l If used by sellers, makes a home with an
assumable loan more affordable
n Shared-appreciation mortgage
l Below market interest rate but lender shares in
home’s price appreciation
Activities in the Mortgage Markets
n How the secondary market facilitates mortgage

activities
n Selling loans
l Origination, servicing and funding are separate
business activities and may be “unbundled”
l Secondary market exists for loans
n Securitization
l Pool and repackage loans for resale
l Allows resale of loans not easily sold on an
individual basis
Activities in the Mortgage Markets
n Unbundling of mortgage activities provides

for specialization in:
l Loan origination
l Loan servicing
l Loan funding
l Any combination of the above
Institutional Use of Mortgage Markets
n Mortgage companies
l Originate and quickly sell loans
l Do not maintain large portfolios
n Government agencies
n Brokerage firms
n Investment banks
n Finance companies
Valuation of Mortgages
n Market price of mortgages is present value of cash

flows
C  PRIN
n
PM  
t 1 (1  k )t
Where:
PM = Market price of a mortgage
C = Interest payment and PRIN is principal
k = Investor’s required rate of return
t = maturity
Valuation of Mortgages
n Periodic payment commonly includes

payment of interest and principal
n Required rate of return determined by risk-free
rate, credit risk and liquidity
n Risk-free interest rate components and
relationship
l + inflationary expectations
l + economic growth
l – change in the money supply
l + budget deficit
Risk from Investing in Mortgages
n Interest rate risk

l Present value of cash flows or value of
mortgage changes as interest rate changes
l Long-term fixed-rate mortgages financed by
short-term funds results in risks
l To limit exposure to interest rate risk
u Sell mortgage shortly after origination (but rate
may change in that short period of time)
u Make adjustable rate mortgages
n Prepayment risk
l Borrowers refinance if rates drop by paying
off higher rate loan and financing at a new,
lower rate
l Investor receives payoff but has to invest at
the new, lower interest rate
l Manage the risk with ARMs or by selling
loans
n Credit risk can range from default to late payments

n Factors that affect default
l Level of borrower equity
u Loan-to-value ratio often used
u Higher use of debt, more defaults
l Borrowers income level

l Borrower credit history
n Lenders try to limit exposure to credit risk-

purchasing insurance
Use of Mortgage-Backed Securities
n Securitization is an alternative to the

outright sale of a loan
n Group of mortgages held by a trustee serves
as collateral for the securities
n Institution can securitize loans to avoid
interest rate risk and credit risk while still
earning service fees
n Payments passed-through to investors can
vary over time
Globalization of Mortgage Markets
n Mortgage market activity not confined to

just one country.
n Market participants follow global economic

conditions.
Equity Markets
Background on Common Stock
l Common stock - certificate representing

equity or partial ownership in a corporation
Issued in primary market by corporations that

need long-term funds
Stock is then traded in the secondary market,

creating liquidity for investors and company
evaluation for managers
Background on Common Stock
Ownership and Voting Rights
l Owners of common stock vote on:

u Electionof board of directors
u Authorization to issue new shares
u Amendments to corporate charter
u Other major events
l Many investors assign their vote to
management via a proxy
Background on Preferred Stock
n Represents equity or ownership interest, but
usually no voting rights
n Trade voting rights for stated fixed annual
dividend
n Dividend paid before common shareholders if
dividends are declared by board of directors
n Dividend may be omitted
l Cumulative provision
l If common dividend paid, preferred dividend fixed
l Preferred stock is a less desirable source of
financing than bonds (not a tax-deductible
expense)
Private Placement of Stock
n An “enabling institution” traditionally an

investment bank, raises funds for a private
or public entity seeking these funds.
n The institution arranges for one or more

large institutional, or wholesale, investors
to buy all the shares.
Public Placement of Stock
n Stock offerings are classified as Initial public

offerings (IPOs) or Secondary offering.
n Initial public offerings
l First-time offering of shares to the public
l Two types of underwriting:
u “Bought deal”/ “fully underwritten deal” –
underwriter buys all shares at a discount.
u “Best efforts” – promises to use its facilities
and goodwill to distribute shares at best price
for a commission.
Public Placement of Stock
l Firm must provide information to public
u Registration statement to SEC
u Prospectus
u Firm is assisted by an investment banker
l Performance of IPOs
u Price generally rises on first day
u Refer to the Reader for African Experience - Osei, K. A., et al (2014),
Recent Developments in Finance: A Reader, Vol 2, Woeli Publishing.
Accra
u Longer-term performance of IPOs is poor (prices decline over time)
n Secondary stock offerings
l New stock issued by firm that already has shares outstanding
l Hire securities firm to sell its shares.
l Monitor the market prices to anticipate the price at which to sell new
shares.
Stock Secondary Markets
Stock Exchanges
l Stock Exchanges facilitate the trading of

existing stocks in the secondary market.
l Brokerage firms serve as financial
intermediaries between buyers and sellers of
stock in the secondary market.
l Brokers receive orders and pass on to the
exchange.
Organized Exchanges
l Execute secondary market transactions

l Examples: GSE, NYSE, AMEX, Midwest,
Pacific
l NYSE is largest, controlling 80 percent of
value of all organized exchanges
u Must own a seat on exchange in order to trade
u Trading resembles an auction
Over-the-Counter Market
l No trading floor or specific location
l Buy and sell orders are completed through a
telecommunications network
l Nasdaq
u Many stocks in the OTC are served by the National Association of
Securities Dealers Automated Quotations, which is an electronic
quotation system
u Firms must meet specific requirement on minimum capital, assets and
number of shareholders
u Thousands of small firms, plus high-tech giants
l Pink sheets
u Tiny firms that do not meet requirements for NASDAQ
n Trend: Consolidation of stock exchanges
n Market microstructure
l Specialists – take positions in specific stocks and stand ready
to buy or sell these stocks through TC network
l Floor brokers – execute transactions for their clients
l Market-makers – like specialists, but operate in Nasdaq
l Types of orders
u Market order – to execute transaction at the best possible
price.
u Limit order – a limit is placed on the price at which a stock
can be purchased or sold.
u Stop order – specifies that the order is not executed until
the market moves to a designated price (market order)
l Changes in technology
u Online trading
u Real-time quotes
u Company information
u Electronic Communications Networks (ECNs)
l Margin requirements
u Specify amount of borrowed versus amount in
cash
u Intended to ensure that investor’s can cover their
position if the value of their investment declines
over time.
l Purchasing stock on margin

u Borrow a portion of the funds from broker
u Usually margin limit is 50%
u Margin is the amount of equity an investor provides
u Magnifies returns (both good and bad)
l Short sales
u Borrow stock and sell
u Repay stock loan, hopefully at a lower price
u Investor able to have potential profit from decline
in stock price
The Ghana Stock Exchange
n Public company limited by guarantee

n The exchange aims to convert into a public
limited liability company (demutualization).
n Licensed Dealing Members (LDMs) act
through Authorized Dealing Officers (ADOs)
n Located on the Firth Floor of the Cedi House
n Trading is usually off the floor of the
exchange
n Traders meet on designated dates on the floor
Regulation of Trading on Ghana Stock
Exchange
n The GSE is a self-regulatory body.
n Allowed
under the SIL (amended) to make rules for its
members and its operations
n Subject to the approval of SEC
n The GSE Rules Book contains all rules, some include;
nGSE Listing, 1990 (LI 1509)
nGSE Membership Regulation, 1991 (LI 1510),
nContinuous Trading Rules
nSecurities Clearing and Settlement House Rules,
n Rules on Takeovers etc.
GSE Online
n Stock Prices
l http://www.gse.com.gh/index1.php?linkid=5&subl
inkid=12
n Market cap, no. of shares, dividend yield, PE
ratio
l http://www.gse.com.gh/index1.php?linkid=46
n Information on the GSE Indexs
l http://www.gse.com.gh/index1.php?linkid=23&ad
ate=04%2F01%2F2011&archiveid=453&page=1
Stock Quotation
n Stock Quotation
l 52-week price range (high/low and YTD%
change)
l Stock symbol
l Dividend annualized and dividend yield
l Price-earnings ratio
l Volume in round lots
l Previous day’s price close and net daily
change
Stock Indexes
n Dow Jones Industrial Average

l Price-weighted average
l 30 large U.S. firms
n Standard and Poor’s (S&P) 500
l Value-weighted
l 500 large U.S. firms
n New York Stock Exchange Indexes
n Other Stock Indexes
l Amex, NASDAQ
Stock Indexes in Ghana
n The key market indices in Ghana include:

l GSE All-Share Index
l Databank Stock Index
l Databank Stock Average
l Gold Coast Liquidity Index
l Gold Dollar Index
l Gold Coast Brewery Index
l Gold Coast Finance Index
Stock Indexes
n Investing in stock indexes

l Indexing – a strategy where portfolio managers
invest a portion of their funds in a set of stocks
whose performance should mirror a specific stock
index.
l Has become very popular
u Lower transactions costs
u Studies find that actively-managed funds do not
outperform stock indexes
n Examples of publicly traded stock indexes
l SPDRs (Standard & Poor’s Depository Receipt)
l Diamonds
Investor Trading Decisions
n Stock value = proportional value of total

company
n Investor return = dividend yield + capital
gain/loss
n New information translated into trading
decisions impacting supply/demand for shares
n New equilibrium price established until new
information appears
Investor Monitoring of Firms in the Stock
Market
n Shareholder vrs managers (agency problems)
n Institutional and individual investors
n Shareholder activism
u An investor who is dissatisfied with the way managers
are running a firm has three choices:
Sell
Do Nothing
Flush!
Shareholder Activism
Investor Monitoring of Firms in the Stock
Market
n Types of shareholder activism
l Communication with the firm
u Effort to place pressure on management
u Institutional investors
n e.g. request a seat on BOD
l Proxy contest
u In an attempt to change composition of BOD
u Is a more formal effort than communication
l Shareholder lawsuits
Corporate Monitoring of Firms
in the Stock Market
n Market for corporate control
l Stock price declines due to poor management
l Subject to possible takeover
n Barriers to market for corporate control
l Shark Repellent - Amendments to a company charter made to
forestall takeover attempts.
l Poison Pills – special rights awarded to shareholders or
specific managers upon specified events
l Golden Parachutes – specifies compensation to managers in
the event that they lose their jobs or there is a change in the
control of the firm.
l White Knight - friendly potential acquirer sought by a target
company threatened by an unwelcome suitor.
Corporate Monitoring of Their Own
Stock in the Stock Market
n Stock repurchases
l Dividend alternative or undervalued stock
l Excessive cash relative to +NPV investments
n Leveraged buyouts (LBO)
l If managers believe the stock price undervalued,
they may buy the outstanding shares with
borrowed funds
n Stock offerings
l Signals overvalued shares
Pricing Efficiency of the Stock Market
n Weak form efficiency – the price of the security

reflects the past price and trading history of the
security.
n Semi-strong form efficiency – means the price of

the security fully reflects all public information.
n Strong form efficiency – price of the security

reflects all information whether it is publicly
available or known to only insiders such as the
firm’s managers or directors.
The Ghana Alternative Exchange (GAX)
n The issuer shall be a public limited liability company incorporated under the
Companies Act, 1963 (Act 179).
n Companies considering listing on the GAX must have minimum capital of

GH¢250,000 (US$146,600), lower than the GH¢1million required for the main
market.
n They must also have a minimum of 20 shareholders, compared with 100 for the
main bourse.
n The reporting requirements are lower. Companies on the main exchange have to
present their financial reports quarterly. This has been reduced to twice a year for
those on the GAX.
n The public float of the company must constitute a minimum of 25% of the total
number of issued shares
The Ghana Alternative Exchange (GAX)
n The company should have operated for at least one year, and have published or
filed accounts for at least one financial year. A start-up may be listed if it submits a
3 year business plan that clearly demonstrates the viability of the applicant. In
terms of profitability, the company need not have recorded historic profits but must
have the potential to make profit at least after its third year of listing.
n On the main exchange, the company should have published accounts for at least
three full years and must have positive pre-tax profits when taken in aggregate over
the three years.
n At least 50% of the Board of an applicant should be composed of non-executive

directors and at least 1 or approximately 25% of the total should be independent.
n Though listing and application fees are waived, a GAX listed company must pay
an annual fee of GHS 2000.
Incentives Provided by Stock Exchange for
the GAX
n Companies listed on the GAX will be able to access
the SME Listing Support Fund -- which will be used
to assist companies meet their listing expenses. The
fund has been set up with an initial GHS 1million
contribution from the African Development Bank,
the GSE and the Venture Capital Trust Fund.
n Also due to the requirement that issues be

underwritten by a Sponsor there is no probability of
an initial public offering (IPO) failure.
Methods of Listing Securities on the GAX
n Introduction
l An introduction is suitable where a company does not need to raise
capital and has the minimum number of 20 shareholders.
n Public offer
l An offer to the public may be an offer for subscription or an offer for
sale.
l In an offer for subscription, members of the public are invited to
subscribe for un-issued shares and the proceeds accrue to the company.
l In an offer for sale, existing shareholders invite subscribers to purchase
their shares and therefore the proceeds accrue to the sellers.
l Public offers require the publication of a prospectus, which must be
approved by the Securities and Exchange Commission and registered
with the Registrar of Companies.
Methods of Listing Securities on the GAX
n Private placement
l A private placement is an offer of shares to
selected parties where shares are “placed” or
offered to subscribers by the company as the result
of private negotiations.
Some Companies Listed on the GAX
Number Name of Company Date of Listing Issued Shares (Millions) Amount Raised (Millions)
1Samba Foods May-15 5.9754353 4.30232616
2Intravenous Infusion Ltd Dec-15 226.621246 20.39592583
3Meridian Marshalls Holding Company Jul-15 96.084166 10.56925826
4Hords Ltd Aug-15 114.947561 11.4947561

Bonds listed on the GAX
Bonds Listed on the GAX
Globalization of Stock Markets
n Stock markets are becoming globalized

l Firms in need of funds can tap foreign markets
l Investors can purchase foreign stocks
n Barriers to international stock trading have decreased
l Reduction in transaction costs
l Reduction in information costs
l Reduction in exchange rate risk
n Foreign stock offerings in the United States
n International placement process
n Global stock exchange characteristics
n Emerging stock markets
Globalization of Stock Markets
n Methods used to invest in foreign shares

l Direct purchases
l American Depository Receipts (ADRs)
l International mutual funds
l World equity benchmark shares (WEBS)
The Level and Structure
of Interest Rates
Interest Rates
n An interest rate is the price paid by a

borrower to a lender for the use of resources
that will be used during some time period
then returned.
l Real rate
l Risk-free rate
l Short-term rate
Interest Rates
n Real rate – rate that would prevail in the

economy if the avg prices for goods and
services were expected to remain constant
during the loan’s life
n Risk-free rate – rate on a loan whose borrower

will not default on any obligation
n Short-term rate - rate on a loan that has one year

to maturity
Theories of Interest Rates
n Fisher’s Classical Approach

n Loanable Funds Theory
n Keynes’ Liquidity Preference Theory
Fisher’s Classical Approach
n Proposed by Irving Fisher

n Irving Fisher analyses the determination of
the level of interest rate in an economy by
inquiring why people save and why others
borrow
n No premium for default risk
Fisher’s Classical Approach
n Supply of Savings
l Marginal rate of time preference (high time preference –
want to consume more today – higher discount rate)
l Income
l Reward for saving
n Demand for Borrowed Resources
l Marginal productivity of capital
l Rate of interest
n Equilibrium Rate of Interest
Fisher’s Law
n Nominal Rate of Interest (i) – number of
monetary units to be paid per unit borrowed
n Real Rate of Interest (r) –growth in the power to
consume over the life of a loan.
n Premium for Expected Inflation (p)
n No inflation, i = r
n Fisher’s Law
n (1 + i) = (1 + r)(1 + p)
n or
n i=r+p
The Loanable Funds Theory
n Fisher ignored power of govt, and

investments in cash balances
n LFT - Proposes that the general level of
interest rate is determined by the complex
interaction of two forces:
l Demand for and Supply of Funds by Firms,
Governments, and Households
The Loanable Funds Theory
n Demand for and Supply of Funds by Firms,

Governments, and Households
l Changes in the money supply
l Government deficits
l Changes in preferences by households
l New investment opportunities for firms
The Liquidity Preference Theory
n Developed by John Keynes

n Analyses the equilibrium level of interest
rate through the interaction of the supply of
money and the public’s aggregate demand
for holding money.
n Assumes people hold wealth in two forms:
l money,
l bonds
The Liquidity Preference Theory
n Demand for Money Balances

l Transactions demand
l Precautionary demand
l Speculative demand
n Supply of Money – under the control of CB
Changes in the Supply for Money and Interest
Rates
n Liquidity Effect
l Increase in money supply will lead to a decrease in interest
rate.
n Income Effect
l Increase in money supply is economically expansionary.
n Price Expectations Effect
l Increase in money supply depending on the strength of the
economy will lead to expectation of a rising level of prices.
Increase in prices will lead to increased demand for money
and consequently increase interest rates
n Net Effect:
l The interest rate may rise, fall, or remain unchanged
depending on the net effect of changes in desired liquidity,
income, and price expectations.
Determinants of the Structure of Interest Rates
n The Base Interest Rate

n Risk Premiums Are Determined By:
l Issuer Type
l Credit risk
l Term to maturity
l Embedded options
l Taxability of interest
l Liquidity
Factors Affecting Security Yields
n Risk-averse investors demand higher yields

for added riskiness
n Risk is associated with variability of returns
n Increased riskiness generates lower security
prices or higher investor required rates of
return
Estimating the Appropriate Yield
n The appropriate yield to be offered on a

debt security is based on the risk-free rate
for the corresponding maturity plus
adjustments to capture various security
characteristics
Yn = Rf,n + DP + LP + TA + CALLP + COND

Estimating the Appropriate Yield
Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury
(risk-free) security
DP = default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount
Types of Issuers
n Treasury Market Sector

n Corporate Market Sector
l Utilities
l Industrials
l Finance
l Banks
n Intermarket and intramarket Sector
Default risk
n Benchmark—risk-free treasury securities

for given maturity
n Default risk premium = risky security yield
– treasury security yield of same maturity
n Default risk premium = market expected
default loss rate
n Rating agencies set default risk ratings
n Anticipated or actual ratings changes
impact security prices and yields
Default or Credit Risk
n Rating Companies
l Moody’s, S&P, Fitch, Duff & Phelps
n Credit Ratings
l Investment grade
l Non-investment grade
n Credit Spread
Term to Maturity
n The volatility of a bond’s price is influenced

by its maturity.
n The longer the maturity of a bond, the greater
its price sensitivity to a change in market
yields.
n Maturity spread or yield curve spread
Embedded Options
n Special Provisions
l Call Feature: enables borrower to buy back the
bonds before maturity at a specified price
u Call features are exercised when interest rates
have declined
u Investors demand higher yield on callable
bonds, especially when rates are expected to fall
in the future
Embedded Options
n Special provisions
l Convertible bonds
u Convertibility feature allows investors to
convert the bond into a specified number
of common stock shares
u Investors will accept a lower yield for
convertible bonds because investor
returns include expected return on equity
participation
Embedded Options
n Call option
l benefits issuer
l increases required return on Treasuries
n Put Option
l benefits bondholder
n Conversion option
l benefits bondholder
l reduces required return on bonds
Tax Status
n Tax status of income or gain on security

impacts the security yield
n Investors concerned with after-tax return or
yield
n Investors require higher yields for higher
taxed securities
Tax Status
Yat = Ybt(1 – T)
Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Tax Status
n Example: a taxable security that offers a

before-tax yield of 14 percent. The investor’s
tax rate is 20 percent. Calculate the after-tax
yield.
Yat = 14%(1 – 0.2)
= 11.2%
n The fully taxable pre-tax equivalent corporate
bond for a 11.2% municipal bond is:
Ybt = 11.2%/(1 – .2) = 14%
Liquidity
n The greater the expected liquidity of a

security issue, the lower the required yield.
n The size of the issue is an important factor
that affects its liquidity.
Liquidity
n The Liquidity of a security affects the

yield/price of the security
n A liquid investment is easily converted to
cash at minimum transactions cost
n Investors pay more (lower yield) for liquid
investment
n Liquidity is associated with short-term, low
default risk, marketable securities
The Yield Curve
n Term to maturity
l Interest rates typically vary by maturity.
l The term structure of interest rates defines
the relationship between maturity and yield.
u The Yield Curve is the plot of current
interest yields versus time to maturity.
Yield Curve
Yield
%
Time to Maturity
An upward-sloping yield curve indicates that Treasury

Securities with longer maturities offer higher annual yields
Yield Curve Shapes
Normal Level or Flat Inverted

The Term Structure of Interest Rates
Theories Explaining Shape of Yield Curve
l Pure Expectations Theory

l Liquidity Premium Theory
l Segmented Markets Theory
n Pure Expectations Theory

l Long-term rates are average of current short-
term and expected future short-term rates
l Yield curve slope reflects market expectations
of future interest rates
l Investors select maturity based on expectations
n Pure Expectations Theory

l Assumes investor has no maturity
preferences and transaction costs are low
l Long-term rates are averages of current
short rates and expected short rates
u Forward rate: market’s forecast of the future
interest rate
Forward Interest Rates
n
n Liquidity Premium Theory

l Investors prefer short-term, more liquid,
securities
l Long-term securities and associated risks
are desirable only with increased yields
l Explains upward-sloping yield curve
l When combined with the expectations
theory, yield curves could still be used to
interpret interest rate expectations
n Segmented Markets Theory

l Choice of investment influenced by forecasted
cash needs.
l Theory explaining segmented, broken yield
curves
l Assumes investors have maturity preference
boundaries, e.g., short-term vs. long-term
maturities
l Explains why rates and prices vary
significantly between certain maturities
Derivatives Markets
Derivatives
n A derivative is a financial instrument whose value

depends on – is derived from – the value of some
other financial instrument, called the underlying
asset.
n Contingent claims.
n Example: forwards, futures, options, and swaps

Functions of Derivatives
n Allow banks to manage the mismatch in the

maturity structure of assets and liabilities.
n Hedge against risk.
n Used as a form of investment (speculators).

Forwards
n A forward contract is an agreement between a

buyer and a seller to exchange a commodity or
financial instrument for a specified amount of
cash on a prearranged future date.
n Forward contracts are used on a variety of
underlying assets such as:
l Currencies
l Commodities
l Interest rates
Forwards
n In a forward:
l Contract is negotiated directly by the seller and the
buyer.
l Terms of the contract can be “tailored”
l Neither party can walk away unilaterally from the
contract.
l Possible default risk borne by individual parties.
l Default controlled by collateral.
Futures
n Futures contract is a forward contract that has

been standardised and sold through an
organised exchange
n A futures contract specifies that the seller –
who has the short position – will deliver some
quantity of a commodity or financial
instrument to the buyer – who has the long
position – on a specific date.
Futures
n In a futures contract:
l Buyers and sellers deal through the organised
exchange, not directly
l Contract terms are standardised
l Either party can reverse its position at anytime by
closing out its contract
l Default risk borne by exchange, not by individual
parties
l “Margin accounts” are used to reduce default risk
Margin Accounts and Marking to Market
n Margin Accounts
l Clearing House requires both parties to futures
contract to place a deposit with it.
l Margin deposits guarantee that when the contract
comes due, the parties will be able to meet their
obligations.
n Marking to Market
l Apart from the initial deposit, the Clearing House also
posts daily gains and losses on the contract to the
margin account of the parties involved.
l
l
Options
n An option is financial security that gives the

holder the right to buy or sell specified quantity
of a specified asset at a specified price on or
before a specified date.
n Options are agreements between two parties
l Seller – option writer
l Buyer – option holder
There are two basic options:
Call option – right to buy – “call away”
Put option – right to sell.
Options
n Specified price – strike or exercise price.

n Specified date – maturity date or expiration
date.
n Buyer = holder = long position
n Seller = writer = short position
Call Options
n In the money – when the option is profitable

for the holder. Price of stock is above the strike
price
n At the money – when price is equal to strike
price
n Out of the money – when the option holder is
incurring a loss. Price is below strike price.
Put Options
n In the money – option’s strike price is above

the price of stock.
n At the money – when price is equal to strike
price
n Out of the money – price of stock is above
strike price
American and European Options
n American option
l Can be exercised on any date from the time they are written
until the day they expire
l Holder has three choices prior to the expiration date.
u Hold the option
u Sell the option
u Exercise the option
n European option
l Can be exercised only on the day they expire
l Holder has two choices on a date prior to expiration
u Hold the option
u Sell the option
Options as Financial Insurance
n Option provides financial insurance
l Holder has right, not obligation, to participate in specified
date.
l Right will be exercised only if it is in the holder’s interest to
do so.
l Holder can profit, but lose from exercise decision.
n The writer of the position provides this insurance to
the holder
l The writer is obligated to take part in the trade if the holder
should so decide.
n In exchange, writer receives a fee called the option
price or the option premium.
Pricing Options
n An option has two parts:
l The value of the option if it is exercised
immediately (intrinsic value).
l The fee paid for the option’s potential benefits
(option premium).
n Option Price = intrinsic value + option

premium
Swaps
n A swap, in general, is an agreement to
exchange cash flows at specified future time
according to specified rules.
n The most common kind of swap is the plain
vanilla, fixed-for-floating interest rate swap:
l One counterparty pays the fixed payments in
exchange for receiving floating payments
according to some pre-specified index (LIBOR)
l Principals not exchanged.
n Other kinds of swaps also exist
Swaps
n A swap is based on an exchange by one party
of a particular benefit, which it enjoys in one
market for a corresponding benefit available to
another party in a different market.
n Originally, swaps were agreements between
companies that had equal but opposite
requirements.
n In principle, a swap is the simultaneous buying
or selling of a similar underlying assets that
give both parties a benefit they wouldn’t have
had without the transaction.
Objectives of Swaps
n Hedging of interest rate risk, foreign exchange
risk, commodity price risk, equity investment
risk etc.
n Speculation (assumption of risk in expectation
of profit).
n Lowering funding costs (overcoming market
imperfection or regulation), flexibility etc.
Standard (Plain Vanilla) Type of Swaps
n Interest rate swaps (eg fixed rate for floating
rate)
n Commodity swaps
n Equity swaps
n Currency swaps
n Credit risk swaps
SWAPS
Example (vanilla/annually settled)
XYZ ABC
fixed rate 10% 11.5%
floating rate libor + .25 libor + .50
Q: if libor = 7%, what swap can be made and what is the profit
(assume $1mil face value loans)
A:
XYZ borrows $1mil @ 10% fixed
ABC borrows $1mil @ 7.5% floating
XYZ pays floating @ 7.25% to ABC
ABC pays fixed @ 10.50% to XYZ
SWAPS
Example - cont
Benefit to XYZ Net position
floating +7.25 -7.25 0
fixed +10.50 -10.00 +.50
Net gain +.50%
Benefit ABC Net Position

floating +7.25 - 7.50 -.25
fixed -10.50 + 11.50 +1.00
net gain +.75%
SWAPS
Example - cont
Settlement date
ABC pmt 10.50 x 1mil = 105,000
XYZ pmt 7.25 x 1mil = 72,500
net cash pmt by ABC = 32,500
if libor rises to 9%
settlement date
ABC pmt 10.50 x 1mil = 105,000
XYZ pmt 9.25 x 1mil = 92,500
net cash pmt by ABC = 12,500
Interest rate swap example
n Company A can access financial market:
l LIBOR + 3/8%
l Fixed Eurobond 11 ½%
n Company B can access financial market:
l LIBOR + 1 1/8%
l Fixed Eurobond (if at all) 13%
n How can a swap reduce financing cost and
possible risk?
n Assume A and B on a fixed rate of 12 5/8%
Foreign Exchange Market
Foreign Exchange Market
n The foreign exchange market allows currencies to be

exchanged in order to facilitate international trade or
financial transactions.
n Nominal exchange rate – the rate at which one can
exchange the currency of one country for the
currency of another country.
n Real exchange rate – the rate at which one can
exchange the goods and services from one country
for goods and services from another country.
l Real exchange rate = dollar price of domestics goods
dollar price of foreign goods
Foreign Rates in the Long-Run
n The Law of One Price is based on the concept of

arbitrage
l dollar price of domestic goods = dollar price of foreign
goods
n The Law of One Price fails almost all the time due to:
l Transport cost
l High tariffs
l Differences in technical specifications
l Differences in tastes
Foreign Rates in the Short-Run
n To explain the short-run changes in nominal

exchange rates, we turn to an analysis of the
supply of and demand for currencies.
n Equilibrium in the Market for Dollars.
n Shifts in the supply of and demand for dollars

n Increased supply leads to a fall in the value of

the dollar. Increase in dollar supply is caused
by:
l Increase in American preference for foreign goods
l Increase in US real GDP
l Increase in real interest rate on foreign bonds
l Increase in American wealth
l Reduction in riskiness of foreign investment
l Expected depreciation of the dollar
n Increased demand leads to a rise in the value

of the dollar. Increase in dollar demand is
caused by:
l Increase in foreign preference for American goods
l Increase in foreign real GDP
l Increase in real interest rate on US bonds
l Increase in foreign wealth
l Reduction in riskiness of US investment
l Expected future dollar appreciation
Government Policy and Foreign
Exchange Intervention
n Govt. officials can intervene in the foreign
exchange market in several ways:
l Adopt fixed exchange rate – maintain fixed
exchange rate at all times.
l Foreign exchange intervention – buy and sell
currency in an attempt to offset demand and supply.
Foreign Exchange Transactions
n There is no specific building or location where

traders exchange currencies.
n Trading also occurs around the clock.
n The market for immediate exchange is known
as the spot market.
n The forward market enables an MNC to lock
in the exchange rate at which it will buy or sell
a certain quantity of currency on a specified
future date.
n Hundreds of banks facilitate foreign exchange

transactions, though the top 20 handle about
50% of the transactions.
n At any point in time, arbitrage ensures that
exchange rates are similar across banks.
n Trading between banks occurs in the interbank
market. Within this market, foreign exchange
brokerage firms sometimes act as middlemen.
n The following attributes of banks are

important to foreign exchange customers:
l competitiveness of quote
l special relationship between the bank and its
customer
l speed of execution
l advice about current market conditions
l forecasting advice
n Banks provide foreign exchange services for a

fee: the bank’s bid (buy) quote for a foreign
currency will be less than its ask (sell) quote.
This is the bid/ask spread.
n bid/ask % spread = ask rate – bid rate
ask rate
n Example: Suppose bid price for £ = $1.52,
ask price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%
n Assume you have $1,000 and plan to travel

from the United States to the United Kingdom.
The bank’s bid rate for the British pound is
$1.52 and its ask rate is $1.60.
l How much pounds will your money convert into.
l Assume at the last minute you cancel your trip,
how much in dollars will you have lost. What
accounts for this loss?
n Bid = $1.52
n Ask = $ 1.60
n $1.60 = ₤1
n $1,000 = x
n X = $1000 * ₤1
$1.60
n X = ₤625
n $1.52 = ₤1
n X = ₤ 625
n X = ₤625 *$1.52
₤1
n X = $950
n You will have lost $50. This is due to the
bank’s bid/ask spread (charge/profit).
n The bid/ask spread is normally larger for those

currencies that are less frequently traded.
n The spread is also larger for “retail”

transactions than for “wholesale” transactions
between banks or large corporations.
Interpreting Foreign
Exchange Quotations
n Exchange rate quotations for widely traded
currencies are frequently listed in the news
media on a daily basis.
n Forward rates may be quoted too.
n The quotations normally reflect the ask prices

for large transactions.
Exchange Quotations
n Direct quotations represent the value of a
foreign currency in cedis
n Indirect quotations represent the number of

units of a foreign currency per cedi.
n The same currency may also be used by more

than one country.
Exchange Quotations
n A cross exchange rate reflects the amount of
one foreign currency per unit of another
foreign currency.
n Value of 1 unit of currency A in units of
currency B = value of currency A in $
value of currency B in $
Exchange Quotations
n
Fixed Exchange-Rate Regimes
n The system for establishing exchange rates has

evolved over time.
l From 1876 to 1913, each currency was convertible
into gold at a specified rate, as dictated by the gold
standard.
l This was followed by a period of instability, as
World War I began and the Great Depression
followed.
Exchange-Rate Pegs and the Bretton
Woods System
l In 1944, a group of 44 countries agreed to form the

Bretton Woods System
l The 1944 Bretton Woods Agreement called for
fixed currency exchange rates.
l Each country pegged it’s exchange rate to the US
dollar.
l By 1971, the U.S. dollar appeared to be
overvalued. The Smithsonian Agreement devalued
the U.S. dollar and widened the boundaries for
exchange rate fluctuations from ±1% to ±2%.
Exchange-Rate Pegs and the Bretton
Woods System
l Even then, governments still had difficulties

maintaining exchange rates within the stated
boundaries. In 1973, the official boundaries for the
more widely traded currencies were eliminated
and the floating exchange rate system came into
effect.
Hard Pegs: Currency Boards and
Dollarization
n Two important hard pegs include:
l Currency boards
l Dollarization
Dollarization
n Currency boards
l The central bank commits to holding enough
foreign currency assets to back domestic currency
liabilities at a fixed rate.
l Somewhere between 10 and 20 currency boards
operate in the world.
l The best known one is the Hong Kong Monetary
Authority
l Argentina decided to adopt currency boards in
1991 to end triple-digit inflation. After 3 years,
inflation dropped to 4%; by 1998 it was nearly
zero.
Dollarization
n One major problem with currency boards is that, by
giving up the ability to control the size of its balance
sheet, the central bank loses its role as the lender of
last resort to the domestic banking system.
Dollarization
n Dollarization
l One country formally adopts the currency of
another country for use in all its financial
transactions, completely eliminating its own
monetary policy.
l Need not be based on the dollar.
l Monaco adopted the French franc in 1865 and uses
the euro today.
l Ecuador, El Salvador.
l Panama has been dollarized since 1904.
Dollarization
n Benefits of dollarization include:
l With no exchange, there is no risk of an exchange rate
crises.
l Integration into the world markets – increasing trade and
investment
l By rejecting the possibility of inflationary finance, a
country can reduce the risk premium it must pay on
loans and generally strengthen its financial institutions.
l The benefits of dollarization is balanced against the loss
of revenue that comes from issuing currency
u what is called seignorage.
l Dollarization is not the same as monetary union.

Analysis of Financial Markets - 2-2

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Analysis of Financial Markets - 2-2

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Introduction to

n Financial markets do not work well when we have a financial crisis

n Financial markets are important because they promote efficient resource

n Adjasi, C. K., & Biekpe, N. B. (2006). Stock market development and

n Financial system has five components:

l Uses of financial instruments include:

n Standardization – financial instruments are homogenous

Financial Market: a market in which financial

n Providing maturity intermediation

n Transforming financial assets

n Transfer of funds from savers to investors –

n Broad Classifications of Financial Markets

Money versus Capital Markets

Primary versus Secondary Markets

Organized versus Over-the-Counter Markets

l Exchange of l No New Funds for

l Funds for l Provides Liquidity

l Members Trade l No Central,

n Money Market Securities

n Capital market securities

Debt Securities: Contractual obligations of

Equity Securities: Claim with ownership

n Value a function of:

n Security prices reflect available information

n New information is quickly included in

n Investors balance liquidity, risk, and return

n Government acts as financial intermediary

n To Maintain Financial Market Stability

n To Provide Consumer Protection

n To Pursue Social Policies

n To restrict Foreign Activities in Domestic

n To Control Level of Economic Activity

n Increased international funds flow

n Agbloyor, E. K., Abor, J. Y., Adjasi, C. K. D., & Yawson, A.

Types of Depository Financial Institutions

n Rapid growth of mutual funds and pension

n Financial intermediaries obtain funds by

n They may fall into three categories:

n They are financial intermediaries that

n They are financial intermediaries that

n These financial intermediaries include:

n Regulations and Taxation

Type Amount Timing Example

Type I Known Known Fixed deposits, GICs

Type II Known Uncertain Life Insurance

Type III Uncertain Known Floating rate instruments

Type IV Uncertain Uncertain Automobile, home insurance

n Is the development of new products and delivery

n Two extreme views why there are financial

n Increased volatility of interest rates, inflation,

n Arbitraging instruments and processes

n Basic Structure of Asset Securitization

n Diversification and reduced cost of

n Debt securities issued by companies and

n Treasury bill auction (fill bids in amount

n Estimating T-bill yield

n Calculating T-Bill Annualized Yield

YT = The annualized yield from investing in a T-bill

n = number of days of the investment (holding period)

n T-bill yield for a newly issued security

T-bill discount = percent discount of the purchase price from par

n T-bill with 91days to maturity, 100,000 face

n To get the discount, D

n Short-term debt instrument