Financial institutions, instruments and markets [9. ed.] 9781760422943, 1760422940

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This new edition, while maintaining its accessible approach and style, encourages students to understand, anticipate and challenge the complex and global nature of finance today.

KEY FEATURES ▶ Currency Contemporary, reliable and authoritative commentary on modern and topical financial

systems, including discussion on ethics and the global financial crisis ▶ New financial case studies With the right balance of local and international examples, students can

understand the global nature of financial institutions through real-world cases ▶ Examples Integrated worked examples and short in-chapter exercises assist student learning by

bridging the gap between theory and application ▶ Pedagogical features An easy-to-read layout includes tagged learning objectives, chapter summaries

and extended learning sections that provide additional resources for self-assessment and study

Financial Institutions Instruments & Markets 9TH EDITION

9e VINEY • PHILLIPS

Connect is proven to deliver better results. Content integrates seamlessly with enhanced digital tools to create a personalised learning experience that provides precisely what you need, when you need it. Maximise your learning with SmartBook, the first and only adaptive reading experience designed to change the way you read and learn. It creates a personalised reading experience by highlighting the most impactful concepts you need to learn at that moment in time. To learn more about McGraw-Hill SmartBook® visit www.mheducation.com.au/student-smartbook

Financial Institutions, Instruments & Markets

Now in its ninth edition, Financial Institutions, Instruments and Markets continues to be one of the market leaders in financial institutions management. With a wellrespected author team at the helm, it is a comprehensive resource for all students wanting to learn about the modern financial system, as well as those preparing for a career in finance.

CHRISTOPHER VINEY PETER PHILLIPS

www.mhhe.com/au/viney9e

spine: 26mm

FINANCIAL ABBREVIATIONS ABS ACCC ADI ADR AFMA AFR AGPS ANZ AOFM APRA ARBL ASIC ASX ATM AWOTE BAB BBSW BIS CAR CBA CBOT CD CDI CDS CEDEL CEO CGS CHESS CLICK XT/ITS CME CMT CP CPI CRA CUFS EBIT ECP EDI EDR EFIC EFTPOS EMU EPS ERM ESA ETP EU EUR FDA FEC Fed FRA FRN FTSE FX G-10 GDP GDR GICS GNE HPY IBSA IMF IPO IRR IWT L/C LBO LEPO

Australian Bureau of Statistics Australian Competition and Consumer Commission Authorised deposit-taking institution American depositary receipt Australian Financial Markets Association Australian Financial Review Australian Government Printing Service ANZ Banking Group Australian Office of Financial Management Australian Prudential Regulation Authority Assets repriced before liabilities Australian Securities and Investments Commission Australian Securities Exchange Automatic teller machine Average weekly ordinary time earnings Bank accepted bill Bank bill swap rate Bank for International Settlements Capital adequacy requirement Commonwealth Bank of Australia Chicago Board of Trade Certificate of deposit CHESS depositary interest Credit default swap Centrale de Livraison des Valeurs Mobilières Chief executive officer Commonwealth Government Securities ASX Clearing House Electronic Sub-register System ASX securities electronic trading system Chicago Mercantile Exchange Cash management trust Commercial paper Consumer price index Credit rating agency CHESS Units of Foreign Securities Earnings before interest and tax Eurocommercial paper Electronic data interchange Euro depositary receipt Export Finance and Insurance Corporation Electronic funds transfer at point of sale European Monetary Union Earnings per share Exchange rate mechanism (European Union) Exchange settlement account Eligible termination payment European Union Euro Fully drawn advance Forward exchange contract Federal Reserve Bank (USA) Forward rate agreement Floating rate note Financial Times Stock Exchange Foreign exchange Group of ten central banks Gross domestic product Global depositary receipt Global industry classification standard Gross national expenditure Holding period yield International Banks and Securities Association International Monetary Fund Initial public offering Internal rate of return Interest withholding tax Letter of credit Leveraged buy-out Low exercise price option

WORLD CURRENCIES LIBID LIBOR LIFFE LIMEAN LME LSE M&A MA MBO MSCI MTN NAB NASDAQ NBFI NCD NGF NIC NIF NPV NTA NYSE OBS OBU OECD OPEC OTC P/E PLC P-note PPP PSBR PV PVCF QIB RBA RBL RBNZ repos RITS ROE ROI RTGS S&P SEC SFE SGC SIBOR SIS SMART SME SOMA SPAN SPI SPV SSP SWIFT T-bill TLC T-note TWI UK USA USCP USSR VaR WBC

London interbank bid rate London interbank offered rate London International Financial Futures Exchange London interbank mean rate London Metals Exchange London Stock Exchange Merger and acquisition Moving average Management buy-out Morgan Stanley Capital International index Medium-term note National Australia Bank National Association of Securities Dealers Automated Quotation System Non-bank financial institution Negotiable certificate of deposit National Guarantee Fund Newly industrialising country Euronote issuance facility Net present value Net tangible assets New York Stock Exchange Off-balance sheet Offshore banking unit Organisation for Economic Cooperation and Development Organization of Petroleum Exporting Countries Over-the-counter Price to earnings ratio Publicly listed corporation Promissory note Purchasing power parity Public sector borrowing requirement Present value Present value of cash flows Qualified institutional buyers Reserve Bank of Australia Reasonable benefit limit Reserve Bank of New Zealand Repurchase agreements Reserve Bank Information and Transfer System Return on equity Return on investment Real-time gross settlement Standard and Poor’s Credit Rating Agency Securities and Exchange Commission (USA) Sydney Futures Exchange Superannuation guarantee charge Singapore interbank offered rate Superannuation Industry (Supervision) Act Specific, measurable, achievable, realistic, timely Small- and medium-sized enterprise Surveillance of Market Activity system (ASX) Standard portfolio analysis of risk hare price index Special-purpose vehicle Special service provider Society for Worldwide Interbank Financial Telecommunications Treasury bill Transferable loan certificate Treasury note Trade-weighted index United Kingdom United States of America United States commercial paper Union of Soviet Socialist Republics Value at risk Westpac Banking Corporation

ARS AUD BRL CAD CLP RMB

CZK DKK EUR

HKD HUF INR IDR ILS JPY MYR MXN NZD NOK PKR PHP PLN RUB SAR SGD ZAR KRW LKR SEK CHF TWD THB TRY UAE GBP USD VND

spine: 26mm

Argentina Australia Brazil Canada Chile China, People’s Republic of • CNY (traded on-shore) • CNH (traded off-shore) Czech Republic Denmark European monetary union • Austria • Belgium • Cyprus • Estonia • Finland • France • Germany • Greece • Ireland • Italy • Latvia • Lithuania • Luxembourg • Malta • The Netherlands • Portugal • Slovakia • Slovenia • Spain

Argentine peso Australian dollar Brazilian real Canadian dollar Chilean peso Chinese renminbi (yuan)

Hong Kong Hungary India Indonesia Israel Japan Malaysia Mexico New Zealand Norway Pakistan Philippines Poland Russia Saudi Arabia Singapore South Africa South Korea Sri Lanka Sweden Switzerland Taiwan Thailand Turkey United Arab Emirates United Kingdom United States of America Vietnam

Hong Kong dollar Hungarian forint Indian rupee Indonesian rupiah Israeli shekel Japanese yen Malaysian ringgit Mexican peso New Zealand dollar Norwegian krone Pakistani rupee Philippine peso Polish złoty Russian rouble Saudi riyal Singapore dollar South African rand South Korean won Sri Lankan rupee Swedish krona Swiss franc New Taiwan dollar Thai baht Turkish lira Emirati dirham British pound US dollar Vietnamese dong

Czech koruna Danish krone Euro

FINANCIAL ABBREVIATIONS ABS ACCC ADI ADR AFMA AFR AGPS ANZ AOFM APRA ARBL ASIC ASX ATM AWOTE BAB BBSW BIS CAR CBA CBOT CD CDI CDS CEDEL CEO CGS CHESS CLICK XT/ITS CME CMT CP CPI CRA CUFS EBIT ECP EDI EDR EFIC EFTPOS EMU EPS ERM ESA ETP EU EUR FDA FEC Fed FRA FRN FTSE FX G-10 GDP GDR GICS GNE HPY IBSA IMF IPO IRR IWT L/C LBO LEPO

Australian Bureau of Statistics Australian Competition and Consumer Commission Authorised deposit-taking institution American depositary receipt Australian Financial Markets Association Australian Financial Review Australian Government Printing Service ANZ Banking Group Australian Office of Financial Management Australian Prudential Regulation Authority Assets repriced before liabilities Australian Securities and Investments Commission Australian Securities Exchange Automatic teller machine Average weekly ordinary time earnings Bank accepted bill Bank bill swap rate Bank for International Settlements Capital adequacy requirement Commonwealth Bank of Australia Chicago Board of Trade Certificate of deposit CHESS depositary interest Credit default swap Centrale de Livraison des Valeurs Mobilières Chief executive officer Commonwealth Government Securities ASX Clearing House Electronic Sub-register System ASX securities electronic trading system Chicago Mercantile Exchange Cash management trust Commercial paper Consumer price index Credit rating agency CHESS Units of Foreign Securities Earnings before interest and tax Eurocommercial paper Electronic data interchange Euro depositary receipt Export Finance and Insurance Corporation Electronic funds transfer at point of sale European Monetary Union Earnings per share Exchange rate mechanism (European Union) Exchange settlement account Eligible termination payment European Union Euro Fully drawn advance Forward exchange contract Federal Reserve Bank (USA) Forward rate agreement Floating rate note Financial Times Stock Exchange Foreign exchange Group of ten central banks Gross domestic product Global depositary receipt Global industry classification standard Gross national expenditure Holding period yield International Banks and Securities Association International Monetary Fund Initial public offering Internal rate of return Interest withholding tax Letter of credit Leveraged buy-out Low exercise price option

WORLD CURRENCIES LIBID LIBOR LIFFE LIMEAN LME LSE M&A MA MBO MSCI MTN NAB NASDAQ NBFI NCD NGF NIC NIF NPV NTA NYSE OBS OBU OECD OPEC OTC P/E PLC P-note PPP PSBR PV PVCF QIB RBA RBL RBNZ repos RITS ROE ROI RTGS S&P SEC SFE SGC SIBOR SIS SMART SME SOMA SPAN SPI SPV SSP SWIFT T-bill TLC T-note TWI UK USA USCP USSR VaR WBC

London interbank bid rate London interbank offered rate London International Financial Futures Exchange London interbank mean rate London Metals Exchange London Stock Exchange Merger and acquisition Moving average Management buy-out Morgan Stanley Capital International index Medium-term note National Australia Bank National Association of Securities Dealers Automated Quotation System Non-bank financial institution Negotiable certificate of deposit National Guarantee Fund Newly industrialising country Euronote issuance facility Net present value Net tangible assets New York Stock Exchange Off-balance sheet Offshore banking unit Organisation for Economic Cooperation and Development Organization of Petroleum Exporting Countries Over-the-counter Price to earnings ratio Publicly listed corporation Promissory note Purchasing power parity Public sector borrowing requirement Present value Present value of cash flows Qualified institutional buyers Reserve Bank of Australia Reasonable benefit limit Reserve Bank of New Zealand Repurchase agreements Reserve Bank Information and Transfer System Return on equity Return on investment Real-time gross settlement Standard and Poor’s Credit Rating Agency Securities and Exchange Commission (USA) Sydney Futures Exchange Superannuation guarantee charge Singapore interbank offered rate Superannuation Industry (Supervision) Act Specific, measurable, achievable, realistic, timely Small- and medium-sized enterprise Surveillance of Market Activity system (ASX) Standard portfolio analysis of risk hare price index Special-purpose vehicle Special service provider Society for Worldwide Interbank Financial Telecommunications Treasury bill Transferable loan certificate Treasury note Trade-weighted index United Kingdom United States of America United States commercial paper Union of Soviet Socialist Republics Value at risk Westpac Banking Corporation

ARS AUD BRL CAD CLP RMB

CZK DKK EUR

HKD HUF INR IDR ILS JPY MYR MXN NZD NOK PKR PHP PLN RUB SAR SGD ZAR KRW LKR SEK CHF TWD THB TRY UAE GBP USD VND

spine: 26mm

Argentina Australia Brazil Canada Chile China, People’s Republic of • CNY (traded on-shore) • CNH (traded off-shore) Czech Republic Denmark European monetary union • Austria • Belgium • Cyprus • Estonia • Finland • France • Germany • Greece • Ireland • Italy • Latvia • Lithuania • Luxembourg • Malta • The Netherlands • Portugal • Slovakia • Slovenia • Spain

Argentine peso Australian dollar Brazilian real Canadian dollar Chilean peso Chinese renminbi (yuan)

Hong Kong Hungary India Indonesia Israel Japan Malaysia Mexico New Zealand Norway Pakistan Philippines Poland Russia Saudi Arabia Singapore South Africa South Korea Sri Lanka Sweden Switzerland Taiwan Thailand Turkey United Arab Emirates United Kingdom United States of America Vietnam

Hong Kong dollar Hungarian forint Indian rupee Indonesian rupiah Israeli shekel Japanese yen Malaysian ringgit Mexican peso New Zealand dollar Norwegian krone Pakistani rupee Philippine peso Polish złoty Russian rouble Saudi riyal Singapore dollar South African rand South Korean won Sri Lankan rupee Swedish krona Swiss franc New Taiwan dollar Thai baht Turkish lira Emirati dirham British pound US dollar Vietnamese dong

Czech koruna Danish krone Euro

Financial Institutions Instruments & Markets

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ASSURANCE OF LEARNING Many educational institutions today are focused on the notion of assurance of learning, an important element of some accreditation standards. This ninth edition of Financial Institutions, Instruments and Markets is specifically created to support assurance of learning initiatives designed to draw on and expand key knowledge and skill sets required by graduates such as: communication, initiative and enterprise, self-management, life-long learning, problem solving, technology, teamwork, planning and organising.1 Chapter learning objectives and pedagogical features throughout the text are developed to directly relate to the learning outcomes for your course which may assist instructors in making the collection and presentation of assurance of learning data easier.

AACSB STATEMENT McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Financial Institutions, Instruments and Markets 9e has sought to recognise the curriculum guidelines detailed in the AACSB standards for business accreditation. A variety of pedagogical features in chapters are designed to draw on the general knowledge and skill guidelines found in the AACSB standards: communication abilities, use of information technology, ethical understanding, reflective thinking, critical analysis and diversity and multicultural understanding.2 The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school and the faculty. While Financial Institutions, Instruments and Markets 9e and the teaching package make no claim of specific AACSB qualification or evaluation, we have geared pedagogical features and online assessment tools towards some of the general knowledge and skills areas.

1 DEST 2002, Employability skills for the future, Department of Education, Science and Training, Commonwealth of Australia, www.employmentdirections.net.au/docs/employabilityframework.doc. 2 AACSB International 2008, Eligibility procedures and accreditation standards for business accreditation, www.aacsb.edu.

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Financial Institutions Instruments & Markets 9TH EDITION

CHRISTOPHER VINEY PETER PHILLIPS

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Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Additional owners of copyright are acknowledged in on-page credits. Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their apologies should any infringement have occurred. Reproduction and communication for educational purposes The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work, whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes provided that the institution (or the body that administers it) has sent a Statutory Educational notice to Copyright Agency and been granted a licence. For details of statutory educational and other copyright licences contact: Copyright Agency, 66 Goulburn Street, Sydney NSW 2000. Telephone: (02) 9394 7600. Website: www. copyright.com.au Reproduction and communication for other purposes Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Act, no part of this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a database or retrieval system, without the written permission of McGraw-Hill Education (Australia) Pty Ltd, including, but not limited to, any network or other electronic storage. Enquiries should be made to the publisher via www.mheducation. com.au or marked for the attention of the permissions editor at the address below. National Library of Australia Cataloguing-in-Publication Data

Authors: Title: ISBN:

Christopher Viney, Peter Phillips Financial Institutions, Instruments and Markets 9e 9781760422943

Published in Australia by McGraw-Hill Education (Australia) Pty Ltd Level 33, 680 George Street, Sydney NSW 2000 Portfolio lead: Jillian Gibbs Content developer: Anne Harmer Senior production editor: Claire Linsdell Copyeditor: Julie Wicks Proofreader: Annabel Adair Cover design: Simon Rattray Internal design: David Rosemeyer Typeset in NimbusRomDOT 10.5/13 by SPi Global Printed in Singapore on 70 gsm matt art by Markono Print Media Pte Ltd

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BRIEF CONTENTS PART 1

FINANCIAL INSTITUTIONS  ...............................................................................................................................

1

Chapter 1

A modern financial system: an overview..........................................................................................................3

Chapter 2

Commercial banks..................................................................................................................................................41

Chapter 3

Non-bank financial institutions............................................................................................................................87

PART 2

EQUITY MARKETS  ...............................................................................................................................................129

Chapter 4

The share market and the corporation..............................................................................................................132

Chapter 5

Corporations issuing equity in the share market............................................................................................161

Chapter 6

Investors in the share market...............................................................................................................................191

Chapter 7

Forecasting share price movements..................................................................................................................222

PART 3

THE CORPORATE DEBT MARKET  ..................................................................................................................257

Chapter 8

Mathematics of finance: an introduction to basic concepts and calculations.........................................259

Chapter 9

Short-term debt.......................................................................................................................................................287

Chapter 10

Medium- to long-term debt...................................................................................................................................315

Chapter 11

International debt markets....................................................................................................................................347

PART 4

GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND INTEREST RATES  .......385

Chapter 12

Government debt, monetary policy and the payments system..................................................................388

Chapter 13

An introduction to interest rate determination and forecasting..................................................................417

Chapter 14

Interest rate risk measurement............................................................................................................................453

PART 5

THE FOREIGN EXCHANGE MARKET  .............................................................................................................483

Chapter 15

Foreign exchange: the structure and operation of the FX market.............................................................485

Chapter 16

Foreign exchange: factors that influence the exchange rate......................................................................513

Chapter 17

Foreign exchange: risk identification and management...............................................................................538

PART 6

DERIVATIVE MARKETS AND RISK MANAGEMENT  ..................................................................................563

Chapter 18

An introduction to risk management and derivatives....................................................................................565

Chapter 19

Futures contracts and forward rate agreements............................................................................................594

Chapter 20

Options......................................................................................................................................................................626

Chapter 21

Interest rate swaps, cross-currency swaps and credit default swaps.......................................................663

v

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CONTENTS Preface�������������������������������������������������������������������������������� xx

Text at a glance��������������������������������������������������������������� xxv

About the authors������������������������������������������������������������ xxi

Connect�������������������������������������������������������������������������� xxviii

Acknowledgments������������������������������������������������������������ xxi

Exploring finance on the web���������������������������������������� xxx

Highlights of the ninth edition��������������������������������������� xxii

Careers in finance��������������������������������������������������������� xxxii

PART 1 CHAPTER 1

1FINANCIAL INSTITUTIONS

1

A MODERN FINANCIAL SYSTEM: AN OVERVIEW  1.1

3

Theory and facts in finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.2

The financial system and financial institutions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1.3

Financial instruments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 1.3.1 Equity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 1.3.2 Debt  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 1.3.3 Derivatives  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1.4

Financial markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.4.1 Matching principle  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.4.2 Primary and secondary market transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.4.3 Direct finance and intermediated finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 1.4.4 Wholesale and retail markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 1.4.5 Money markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 1.4.6 Capital markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.5



CHAPTER 2

Flow of funds, market relationships and stability  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Case study: The next global financial crisis?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extended learning A: The global financial crisis of 2008  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extended learning B: The impact of the Asian financial crisis on the financial system  . . . . . . . . . . . Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30 32 35 38 39

COMMERCIAL BANKS

41

2.1

The main activities of commercial banking  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

2.2

Sources of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 2.2.1 Current account deposits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 2.2.2 Call or demand deposits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 2.2.3 Term deposits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 2.2.4 Negotiable certificates of deposit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 2.2.5 Bill acceptance liabilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 2.2.6 Debt liabilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 2.2.7 Foreign currency liabilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 2.2.8 Loan capital and shareholders’ equity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

vi

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2.3

Uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 2.3.1 Personal and housing finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 2.3.2 Commercial lending  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 2.3.3 Lending to government  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 2.3.4 Other bank assets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

2.4

Off-balance-sheet business  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 2.4.1 Direct credit substitutes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 2.4.2 Trade- and performance-related items  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 2.4.3 Commitments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 2.4.4 Foreign exchange contracts, interest rate contracts and other market-rate-related contracts  ����������������������������������������������������������������������������������������������54 2.4.5 Volume of off-balance-sheet business  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

2.5

Regulation and prudential supervision of commercial banks  . . . . . . . . . . . . . . . . . . . . . . . . 56

2.6

A background to the capital adequacy standards  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

2.7

The Basel accords: evolution from Basel I to Basel III  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 2.7.1 Minimum capital adequacy requirement  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 2.7.2 The definition of capital  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 2.7.3 Basel III structural framework  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 2.7.4 Basel III and bank liquidity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

2.8

Liquidity management and other supervisory controls  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 2.8.1 Other regulatory and supervisory controls  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70



CHAPTER 3

Case study: Basel III reforms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Summary  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extended learning A: The standardised approach to credit risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extended learning B: Business continuity risk management  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extended learning C: Corporate governance and ethics  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72 74 77 82 84 85

NON-BANK FINANCIAL INSTITUTIONS

87

3.1

Investment banks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 3.1.1 Sources of funds and uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 3.1.2 Off-balance-sheet business  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

3.2

Managed funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 3.2.1 Structure of the managed funds sector  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 3.2.2 Sources and uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 3.2.3 Capital guaranteed funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 3.2.4 Capital stable funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 3.2.5 Balanced growth funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 3.2.6 Managed growth or capital growth funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

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3.3

Cash management trusts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

3.4

Public unit trusts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

3.5

Superannuation funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 3.5.1 Sources of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 3.5.2 Defined benefit funds and accumulation funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 3.5.3 Regulation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

3.6

Life insurance offices  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 3.6.1 Life insurance policies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

3.7

General insurance offices  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

3.8

Hedge funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

3.9

Finance companies and general financiers  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

3.7.1 General insurance policies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

3.9.1 Sources of funds and uses of funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 3.9.2 Sector structure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 3.10

Building societies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

3.11

Credit unions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

3.12

Export finance corporations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116



Case study: The hedge fund sector  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 Extended learning: Project finance and structured finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

PART 2 CHAPTER 4

EQUITY MARKETS THE SHARE MARKET AND THE CORPORATION

4.1

129 132

The nature of a corporation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 4.1.1 Advantages of the corporate form of business organisation  . . . . . . . . . . . . . . . . . . . . 135 4.1.2 Disadvantages of the corporate form of business organisation  . . . . . . . . . . . . . . . . . 135

4.2

The stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

4.3

The primary market role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

4.4

The secondary market role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

4.5

The managed product and derivative product roles of a stock exchange  . . . . . . . . . . . 141 4.5.1 Exchange traded funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 4.5.2 Contracts for difference  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 4.5.3 Real estate investment trusts (REIT)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 4.5.4 Infrastructure funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 4.5.5 Options  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 4.5.6 Warrants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 4.5.7 Futures contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

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4.6

The interest rate market role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

4.7

The trading and settlement roles of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

4.8

The information role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

4.9

The regulatory role of a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

4.10

The private equity market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153



Case study: Development of industrial scale blockchain in Australia  . . . . . . . . . . . . . . . . . . . . . . . 154 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

CHAPTER 5

CORPORATIONS ISSUING EQUITY IN THE SHARE MARKET

5.1

161

The investment decision: capital budgeting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 5.1.1 Net present value  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 5.1.2 Internal rate of return  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

5.2

The financing decision: equity, debt and risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 5.2.1 Financial risk and the debt-to-equity ratio  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 5.2.2 What is the appropriate debt-to-equity ratio?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

5.3

Initial public offering  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 5.3.1 Ordinary shares: limited liability companies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 5.3.2 Ordinary shares: no liability companies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

5.4

Listing a business on a stock exchange  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

5.5

Equity-funding alternatives for listed companies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 5.5.1 Rights issue or share purchase plan  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 5.5.2 Placements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 5.5.3 Takeover issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 5.5.4 Dividend reinvestment schemes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 5.5.5 Preference shares  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 5.5.6 Convertible notes and other quasi-equity securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . 178



Case study: Covenant-lite loans—risk implications  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181 Extended learning: Australian Securities Exchange (ASX) listing rule requirements  . . . . . . . . . . . 183 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

CHAPTER 6

INVESTORS IN THE SHARE MARKET

191

6.1

Share-market investment  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

6.2

Buying and selling shares  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

6.3 Taxation  6.4

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

Financial performance indicators  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 6.4.1 Capital structure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 6.4.2 Liquidity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

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6.4.3 Debt servicing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 6.4.4 Profitability  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 6.4.5 Share price  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 6.4.6 Risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 6.5

Pricing of shares  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206 6.5.1 Estimating the price of a share  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 6.5.2 Cum-dividend and ex-dividend share prices  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 6.5.3 Bonus share issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 6.5.4 Share splits  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 6.5.5 Pro-rata rights issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

6.6



Stock-market indices and published share information  . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

Case study: Private equity firms, angel investors and exit strategies  . . . . . . . . . . . . . . . . . . . . . . . 215 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221

CHAPTER 7

FORECASTING SHARE PRICE MOVEMENTS

7.1

222

Fundamental analysis: the top-down approach  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 7.1.1 International economies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 7.1.2 The rate of growth of an economy  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 7.1.3 Exchange rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226 7.1.4 Interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 7.1.5 The balance of payments current account  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 7.1.6 Inflationary pressures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228 7.1.7 Wages growth  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 7.1.8 Understanding the interrelationships of economic fundamentals  . . . . . . . . . . . . . . . 229

7.2

Fundamental analysis: the bottom-up approach  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

7.3

Technical analysis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 7.3.1 Moving-averages models  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 7.3.2 Charting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

7.4

Electronic trading  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

7.5

The random walk, efficient market and behavioural finance hypotheses  . . . . . . . . . . . . 242 7.5.1 The random walk hypothesis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 7.5.2 The efficient market hypothesis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 7.5.3 The behavioural finance hypothesis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245



Case study: The effects of scandals on the market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

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PART 3

THE CORPORATE DEBT MARKET

CHAPTER 8

MATHEMATICS OF FINANCE: AN INTRODUCTION TO BASIC CONCEPTS AND CALCULATIONS

8.1

257 259

Simple interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 8.1.1 Simple interest accumulation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262 8.1.2 Present value with simple interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263 8.1.3 Calculation of yields  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 8.1.4 Holding period yield  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

8.2

Compound interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 8.2.1 Compound interest accumulation (future value)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 8.2.2 Present value with compound interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 8.2.3 Present value of an annuity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 8.2.4 Accumulated value of an annuity (future value)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276 8.2.5 Effective rates of interest  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277



Case study: The retirement dream  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286

CHAPTER 9

SHORT-TERM DEBT 

287

9.1

Trade credit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

9.2

Bank overdrafts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290

9.3

Commercial bills  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292 9.3.1 Features of commercial bills  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292 9.3.2 The flow of funds and bill financing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294 9.3.3 Establishing a bill financing facility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 9.3.4 Advantages of commercial bill financing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296

9.4

Calculations: discount securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 9.4.1 Calculating the price where the yield is known  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 9.4.2 Calculating the face value where the issue price and yield are known  . . . . . . . . . . . 299 9.4.3 Calculating the yield  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299 9.4.4 Calculating the price where the discount rate is known  . . . . . . . . . . . . . . . . . . . . . . . . 300 9.4.5 Calculating the discount rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

9.5

Promissory notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302 9.5.1 Establishing a P-note issue program  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 9.5.2 Underwritten P-note issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304 9.5.3 Non-underwritten issues  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

9.6

Negotiable certificates of deposit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

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9.7

Inventory finance, accounts receivable financing and factoring  . . . . . . . . . . . . . . . . . . . . 306 9.7.1 Inventory finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 9.7.2 Accounts receivable financing and factoring  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306



Case study: The demise of LIBOR?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314

CHAPTER 10

MEDIUM- TO LONG-TERM DEBT 

10.1

315

Term loans or fully drawn advances  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 10.1.1 Term loan structures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 10.1.2 Loan covenants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 10.1.3 Calculating the instalment on a term loan  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320

10.2

Mortgage finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 10.2.1 Calculating the instalment on a mortgage loan  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323 10.2.2 Securitisation and mortgage finance  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324

10.3

The bond market: debentures, unsecured notes and subordinated debt  . . . . . . . . . . . . 325 10.3.1 Debentures and unsecured notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 10.3.2 Issuing debentures and notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 10.3.3 Subordinated debt  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

10.4

Calculations: fixed-interest securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 10.4.1 Bond price/yield relationship  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 10.4.2 Price of a fixed-interest bond at a coupon date  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 10.4.3 Price of a fixed-interest bond between coupon dates  . . . . . . . . . . . . . . . . . . . . . . . . 332

10.5 Leasing 

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

10.5.1 Types of leases  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 10.5.2 Lease structures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336

Case study: The Kangaroo bonds and blockchain bond-i’s  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 Extended learning: Securitisation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

CHAPTER 11

INTERNATIONAL DEBT MARKETS

347

11.1

The euromarkets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349

11.2

Eurocurrency market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 11.2.1 Short-term bank advances  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 11.2.2 Eurocurrency standby facilities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 11.2.3 Medium- to long-term eurocurrency bank loans  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

11.3

Euronote market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354 11.3.1 Euronote issuance facility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

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11.3.2 Eurocommercial paper  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356 11.3.3 Calculating the price of an NIF and an ECP  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356 11.4

Eurobond market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 11.4.1 Euro medium-term notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 11.4.2 Eurobonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358 11.4.3 Issue and trading of eurobonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 11.4.4 Types of eurobonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361 11.4.5 Calculating the price of fixed-interest euromarket securities  . . . . . . . . . . . . . . . . . . 362

11.5

Markets in the USA  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364 11.5.1 Commercial paper  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364 11.5.2 US foreign bonds (Yankee bonds)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365 11.5.3 American depositary receipts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366

11.6



Credit rating agencies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

Case study: Supervision of rating agencies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 Extended learning A: Novation, subparticipation and transferable loan certificates  . . . . . . . . . . . 375 Extended learning B: Convertible bonds and warrants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376 Extended learning C: US medium-term notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377 Extended learning D: Standard & Poor’s credit rating definitions  . . . . . . . . . . . . . . . . . . . . . . . . . . . 379 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383

PART 4 CHAPTER 12

GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND INTEREST RATES GOVERNMENT DEBT, MONETARY POLICY AND THE PAYMENTS SYSTEM

12.1

385 388

The Commonwealth Government borrowing requirement  . . . . . . . . . . . . . . . . . . . . . . . . . 390 12.1.1 The borrowing requirement: full financial year  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390 12.1.2 The borrowing requirement: within the financial year  . . . . . . . . . . . . . . . . . . . . . . . . 391

12.2

Commonwealth Government securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 12.2.1 Treasury bonds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392 12.2.2 Treasury notes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396

12.3

State government securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399

12.4

Monetary policy  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 12.4.1 Open market operations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403 12.4.2 Impacts on financial system liquidity  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404

12.5

The payments system  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406 12.5.1 Exchange settlement accounts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407 12.5.2 Real-time gross settlement  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408 12.5.3 Repurchase agreements (repos)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409



Case study: The new payments platform (NPP) in Australia and the risk of fraud  . . . . . . . . . . . . . 410 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411

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Extended learning: Fixed-coupon Treasury bonds: price calculation using the Australian Office of Financial Management (AOFM) formula  . . . . . . . . . . . . . . . . . . . . . . . . . 413 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416 CHAPTER 13

AN INTRODUCTION TO INTEREST RATE DETERMINATION AND FORECASTING

417

13.1

The macroeconomic context of interest rate determination  . . . . . . . . . . . . . . . . . . . . . . . 419

13.2

The loanable funds approach to interest rate determination  . . . . . . . . . . . . . . . . . . . . . . . 423 13.2.1 The demand for loanable funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425 13.2.2 The supply of loanable funds  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426 13.2.3 Equilibrium in the loanable funds market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427 13.2.4 Loanable funds—an expected increase in the level of economic activity  . . . . . . . . 428 13.2.5 Inflationary expectations in the loanable funds approach  . . . . . . . . . . . . . . . . . . . . . 429

13.3

The term structure of interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431 13.3.1 The expectations theory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433 13.3.2 The segmented markets theory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435 13.3.3 The expectations approach versus the segmented markets approach  . . . . . . . . . 437 13.3.4 The liquidity premium theory  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438

13.4



The risk structure of interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441

Case study: The Reserve Bank’s balancing act  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445 Extended learning: The yield curve and expectations theory calculations  . . . . . . . . . . . . . . . . . . . 447 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452

CHAPTER 14

INTEREST RATE RISK MEASUREMENT

453

14.1

Interest rate risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

14.2

Exposure management systems  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456 14.2.1 Forecasting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457 14.2.2 Strategies and techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457 14.2.3 Management reporting  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458

14.3

Assets re-priced before liabilities principle  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459

14.4

Pricing financial securities  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460 14.4.1 Discount security pricing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460 14.4.2 Fixed-interest security pricing  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461

14.5

Re-pricing gap analysis  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462

14.6 Duration 

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464

14.7 Convexity  14.8

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470

Interest rate risk management techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473 14.8.1 Internal techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474 14.8.2 External techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475

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Case study: APRA and bear as risk management regimes in Australia  . . . . . . . . . . . . . . . . . . . . . . 476 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482

PART 5 CHAPTER 15

THE FOREIGN EXCHANGE MARKET FOREIGN EXCHANGE: THE STRUCTURE AND OPERATION OF THE FX MARKET

483 485

15.1

Exchange rate regimes  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487

15.2

Foreign exchange market participants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488 15.2.1 Foreign exchange dealers and brokers  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 15.2.2 Central banks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 15.2.3 Firms conducting international trade transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 15.2.4 Investors and borrowers in the international money markets and capital markets  ��������������������������������������������������������������������������������������������������������� 490 15.2.5 Speculative transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490 15.2.6 Arbitrage transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491

15.3

The operation of the FX market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492

15.4

Spot and forward transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493

15.5

Spot market quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 15.5.1 Asking for a quotation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 15.5.2 Two-way quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495 15.5.3 Transposing spot quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497 15.5.4 Calculating cross-rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497

15.6

Forward market quotations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 15.6.1 Forward points and forward exchange contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 15.6.2 Some real-world complications  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502

15.7



Economic and Monetary Union of the EU and the FX markets  . . . . . . . . . . . . . . . . . . . . . 505

Case study: Fixed exchange rates and currency misalignments  . . . . . . . . . . . . . . . . . . . . . . . . . . . 506 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

CHAPTER 16

FOREIGN EXCHANGE: FACTORS THAT INFLUENCE THE EXCHANGE RATE

16.1

513

The FX markets and an equilibrium exchange rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 16.1.1 Demand for a currency  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 16.1.2 Supply of a currency  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 16.1.3 Equilibrium exchange rate  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517

16.2

Factors that influence exchange rate movements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518 16.2.1 Relative inflation rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518 16.2.2 Relative national income growth rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520

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16.2.3 Relative interest rates  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521 16.2.4 Exchange rate expectations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524 16.2.5 Central bank or government intervention  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525 16.3



Measuring exchange rate sensitivity to changes in economic variables  . . . . . . . . . . . . . 528

Case study: Terrorist attacks and FX movements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531 Extended learning: Purchasing power parity   . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537

CHAPTER 17

FOREIGN EXCHANGE: RISK IDENTIFICATION AND MANAGEMENT

538

17.1

Foreign exchange risk policy formulation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540 17.1.1 Foreign exchange objectives  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541 17.1.2 Management structure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541 17.1.3 Authorisations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542 17.1.4 Exposure reporting systems  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543 17.1.5 Communications  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543 17.1.6 Performance evaluation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543 17.1.7 Audit and review procedures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544

17.2

Measuring transaction exposure  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545 17.2.1 Net cash flows  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546 17.2.2 Transaction exposures: currency variability  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548 17.2.3 Transaction exposures: currency correlations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549

17.3

Risk management: market-based hedging techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551 17.3.1 Forward exchange contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551 17.3.2 Money-market hedge to cover FX risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553

17.4

Risk management: internal hedging techniques  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555 17.4.1 Invoicing in the home currency  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555 17.4.2 Creating a natural hedge  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555 17.4.3 Currency diversification  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556 17.4.4 Leading and lagging FX transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556 17.4.5 Mark-ups  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557 17.4.6 Counter-trade and currency offsets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557



Case study: FX risk management: Do companies hedge or speculate?  . . . . . . . . . . . . . . . . . . . . . 558 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562

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PART 6 CHAPTER 18

DERIVATIVE MARKETS AND RISK MANAGEMENT AN INTRODUCTION TO RISK MANAGEMENT AND DERIVATIVES

563 565

18.1

Understanding risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567 18.1.1 Operational risks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567 18.1.2 Financial risks  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568

18.2

The risk management process  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570 18.2.1 Identify operational and financial risk exposures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570 18.2.2 Analyse the impact of the risk exposures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571 18.2.3 Assess the attitude of the organisation to each identified risk exposure  . . . . . . . . 571 18.2.4 Select appropriate risk management strategies and products  . . . . . . . . . . . . . . . . 572 18.2.5 Establish related risk and product controls  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572 18.2.6 Implement the risk management strategy  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572 18.2.7 Monitor, report, review and audit  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 573

18.3

Futures contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

18.4

Forward contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576 18.4.1 Forward rate agreements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576 18.4.2 Forward foreign exchange contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578

18.5

Option contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579 18.5.1 Call option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580 18.5.2 Put option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581

18.6

Swap contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582 18.6.1 Interest rate swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583 18.6.2 Cross-currency swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584



Case study: Regulatory reforms and the ‘clearing’ of derivatives  . . . . . . . . . . . . . . . . . . . . . . . . . . . 586 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593

CHAPTER 19

FUTURES CONTRACTS AND FORWARD RATE AGREEMENTS

594

19.1

Hedging using futures contracts  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596

19.2

Main features of a futures transaction  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597 19.2.1 Orders and agreement to trade  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598 19.2.2 Margin requirements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599 19.2.3 Closing out of a contract  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 19.2.4 Contract delivery  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600

19.3

Futures market instruments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601

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19.4

Futures market participants  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603 19.4.1 Hedgers  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603 19.4.2 Speculators  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603 19.4.3 Traders  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604 19.4.4 Arbitrageurs  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604

19.5

Hedging: risk management using futures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605 19.5.1 Hedging the cost of funds (borrowing hedge)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605 19.5.2 Hedging the yield on funds (investment hedge)  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607 19.5.3 Hedging a foreign currency transaction  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608 19.5.4 Hedging the value of a share portfolio  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609 19.5.5 Hedging against volatility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610

19.6

Risks in using futures contracts for hedging  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612 19.6.1 Standard contract size  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612 19.6.2 Margin payments  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613 19.6.3 Basis risk  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614 19.6.4 Cross-commodity hedging  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614

19.7

Forward rate agreements  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615 19.7.1 Using an FRA for a borrowing hedge  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617



Case study: SPI futures market acts as a market-maker facilitating price discovery in the S&P/ASX 200 Index  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625

CHAPTER 20

OPTIONS

626

20.1

The nature of options  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628

20.2

Option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629 20.2.1 Call option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629 20.2.2 Put option profit and loss payoff profiles  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632 20.2.3 Covered and naked options  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634

20.3

The organisation of the market  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636 20.3.1 International options markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636 20.3.2 The Australian options markets  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637

20.4

Factors affecting an option contract premium  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641 20.4.1 Intrinsic value  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641 20.4.2 Time value  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642 20.4.3 Price volatility  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642 20.4.4 Interest rate levels  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 644 20.4.5 Cap, floor and collar: an options cost-minimisation strategy  . . . . . . . . . . . . . . . . . . . 644

20.5

Option risk management strategies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645 20.5.1 Single-option strategies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645 20.5.2 Combined-options strategies  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648

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Contents



Case study: The Black–Scholes option pricing model: The equation that can end the world?  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662

CHAPTER 21

INTEREST RATE SWAPS, CROSS-CURRENCY SWAPS AND CREDIT DEFAULT SWAPS

663

21.1

Interest rate swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 666

21.2

Rationale for the existence of interest rate swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670 21.2.1 Lowering the net cost of funds (comparative advantage)  . . . . . . . . . . . . . . . . . . . . . 670 21.2.2 Gaining access to otherwise inaccessible debt markets  . . . . . . . . . . . . . . . . . . . . . . 671 21.2.3 Hedging interest rate risk exposures  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671 21.2.4 Lock in profit margins on business transactions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672

21.3

Cross-currency swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673

21.4

Rationale for the existence of currency swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676

21.5

Credit default swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 678

21.6

Credit and settlements risk associated with swaps  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681



Case study: Naked credit default swaps: Two perspectives  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683 Master before you move on  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 Questions  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687 Key terms  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 690 Glossary  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691 Index  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712

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PREFACE This book has achieved remarkable acceptance by academics and their students in a significant number of tertiary institutions throughout Australia, New Zealand and Asia, and by professionals within the financial services industry. In this ninth edition, we present once more a finance text for you that is authoritative and scholarly, and which at the same time highlights the dynamic, exciting and global nature of financial institutions, instruments and markets. As the global financial crisis and its aftermath fades into history, attention has turned to the financial services industry itself, its culture and its values. In 2018, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in Australia highlighted many areas of concern and highlighted the importance of strong governance, codes of conduct and ethics within financial services firms. The findings of the Royal Commission will continue to shape public opinion and trust in financial institutions for many years to come. New graduates in finance, as well as their professors, are not powerless to ensure that this trust is restored sooner rather than later. As the ninth edition was being finalised, financial markets in the United States were tentatively testing and retreating from new highs against a backdrop of stronger economic activity and rising interest rates. In Australia, the challenge of returning interest rates to more ‘normal’ levels without causing a major disruption to the housing market remained perhaps the most significant challenge confronting the Reserve Bank of Australia. Although political uncertainty has swept through Europe and the United States, it is important to recognise that innovation, technological and otherwise, continues at pace. New companies with new products and new ideas are forever emerging and will seek capital from the world’s debt and equity markets to fund their first (or next) steps. In the financial markets, as for most aspects of life, we can never wait for the clouds of uncertainty to lift before trying to make our way. One thing is certain, change will occur. As students of the financial system you must keep yourself informed about the structure and operation of financial institutions, instruments and markets. Importantly, you must think about and anticipate future directions and change. Despite the continuous change that financial markets undergo, there are a set of stable, underlying principles that govern decision-making across all markets and instruments. It is worth keeping in mind, then, that a sound knowledge of the basics can take you much further than you might think. With that said, we encourage you to accept every opportunity that comes your way and we wish you the best of success. Christopher Viney and Peter J Phillips

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ABOUT THE AUTHORS CHRISTOPHER VINEY brings to this book a wealth of industry experience and academic knowledge associated with the international financial markets. His appreciation of the nature of both the theoretic and the applied functions and operations of the global financial system is reflected in the clear and interesting presentation of issues in such a way that the reader is motivated to learn. Prior to moving into academia Chris spent 27 years in the commercial banking industry including retail banking, corporate lending, risk management, personnel, property, policy and administration. His academic career included appointments at Monash University and Deakin University, Melbourne, Australia. He has taught in the areas of financial markets, financial institutions management, corporate finance, treasury management and personal financial planning. Chris has also taught in Singapore, Malaysia, Thailand, Indonesia and New Zealand. He has received university awards for contributions to the internationalisation of teaching and learning programs. As the director of the finance international study programs at Monash and Deakin Universities, Chris has taken select groups of students overseas as part of their tertiary studies. He has also published research papers on the capital markets, operational risk management, bureau de change, money laundering and education and training. Following the passing of Michael McGrath with the first edition of the text, Chris has guided the evolution of future editions of the book and it has now become a principal learning and reference source for undergraduate students, postgraduate students and industry practitioners alike. Peter Phillips joined Chris ahead of the seventh edition and has been Chris’s co-author since 2011.

PETER PHILLIPS has been teaching economics and finance at the University of Southern Queensland (USQ) in Toowoomba, Australia, since 1998. Presently, he is an Associate Professor in Finance at USQ. He has taught in the areas of financial markets and institutions, portfolio management and corporate finance as well as several economics courses, including macroeconomics and econometrics. In 2003 Peter completed a PhD at USQ in financial economics. Since then he has published a number of papers on the topic of Self Managed Superannuation Funds (SMSFs) in which he and his co-authors explore various aspects of the portfolios chosen by SMSF investors.

Acknowledgments The challenge of maintaining the currency and relevancy of a book with the scope of financial institutions, instruments and markets is enormous. This daunting task is tackled at many levels. At one level we are most appreciative of those users of the book, including academics, practitioners and students, who provide ongoing feedback in the form of comment, suggestion and discussion. We value your contributions immensely. The quality of the production of the book is also dependent on the expertise and hard work of the people at McGrawHill Education (Australia). As authors, we have been very fortunate to have the dedicated editorial support of Jillian Gibbs. We would also like to acknowledge and thank the team at McGraw-Hill, including Anne Harmer, Claire Linsdell, Marisa Rey Bulen and Bethany Ng. We would like to thank our case study contributor, Jaison Parackel Johnny (University of Southern QueenslandToowoomba). We would also like to thank Michael Baker (Flinders University), Sisira Colombage (Federation University Australia) and David Spiers (Federation University Australia) for their detailed reviews of the material during development.

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HIGHLIGHTS OF THE NINTH EDITION C HAPTER 1  A modern financial system: an overview introduces the financial institutions, financial instruments and financial markets that comprise domestic and global financial systems and explains why a stable financial system is important for economic growth provides a concise context that assists the reader to understand the relationships of the material in the following chapters discussion moves away from the global financial crisis and broadens to describe how theories and ideas operate in the discipline of finance. The framework is simple: risk and reward, supply and demand extended learning—the global financial crisis extended learning—the impact of the Asian financial crisis on the financial system case study—the current possibilities of future financial crises

C HAPTER 2  Commercial banks contains a detailed discussion on the commercial bank, including its role, products, off-balance-sheet business, regulation and supervision provides a concise explanation of the capital adequacy and liquidity standards that apply to banks under Basel III shifts the focus to Basel III, which was finalised in 2017, but which will take several more years to fully implement. Basel II is out, Basel III is in outlines aspects of the regulatory response to the global financial crisis extended learning—the standardised approach to credit risk extended learning—business continuity risk management extended learning—corporate governance and ethics case study—Australian banking’s prompt response to the new Basel requirements

C HAPTER 3  Non-bank financial institutions a current examination of investment banks, managed funds, superannuation funds, cash management trusts, public unit trusts, life and general insurance offices, hedge funds, finance companies, building societies, credit unions and export finance corporations extended learning—project finance and structured finance case study—hedge fund managers, regulation, and current hedge fund trends

C HAPTER 4  The share market and the corporation new approach focusing on Basel III considers the management structure of a publicly listed corporation discusses the important roles of a stock exchange in facilitating the listing of a corporation’s shares on the exchange (primary market role) and the ongoing trading

of existing shares (secondary market role) on the share market examines the managed products and derivative products offered by a stock exchange, including exchange traded funds, contracts for difference, real estate investment trusts, infrastructure funds, options, warrants and futures contracts examines the interest rate market role, the trading and settlements roles, the information role and the regulatory roles of a stock exchange case study—industrial-scale blockchain in Australia

C HAPTER 5  Corporations issuing equity in the share market introduces the capital budgeting investment decision process; funding issues related to debt and equity; initial public offerings, stock exchange listing rules and alternative forms of equity issues extended learning—current Australian Securities Exchange (ASX) listing requirements case study—covenant-lite loans and their risk implications

C HAPTER 6  Investors in the share market considers the role of the investor in the share market; risks associated with buying and selling shares discusses taxation; financial performance indicators and the pricing of shares introduces share market indices and the interpretation of share market information case study—private equity firms, angel investors and exit strategies

C HAPTER 7  Forecasting share price movements examines fundamental analysis and technical analysis approaches to share price forecasting updated consideration of the impact of electronic trading and technology on share prices introduces the random walk hypothesis and the efficient markets hypothesis (EMH) within the context of forecasting share price movements introduces behavioural finance as an alternative theoretical framework to the EMH for understanding share price movements case study—the effects of scandal on the market

C HAPTER 8  Mathematics of finance: an introduction to basic concepts and calculations introduces the principles of mathematical calculations that underpin financial market instruments, including simple interest, compound interest, present value, future value, yield, annuities and effective rates of interest case study—the 4% rule and considering the feasibility of early retirement

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C HAPTER 9  Short-term debt examines the main sources and types of short-term intermediated and direct finance available to a business corporation, including trade credit, bank overdrafts, commercial bills, promissory notes, negotiable certificates of deposit, inventory finance, accounts receivable financing and factoring thoughtful analysis of the role of short-term debt in the GFC calculation of prices and yields on discount securities case study—the demise of the London Interbank Offer Rate (LIBOR) and the rise of the Bank Bill Swap Rate (BBSW) in the Australian economy

C HAPTER 10  Medium- to long-term debt identifies the main types of longer-term debt available to a corporation, including term loans, fully drawn advances, mortgage finance, debentures, unsecured notes, subordinated debt and leasing calculation of prices and yields on fixed-interest securities extended learning—securitisation case study—Kangaroo bond markets and the development of the blockchain bond

C HAPTER 11  International debt markets explores the structure of the international debt markets, in particular the euromarkets (eurocurrency, euronote and eurobond markets) and the US money and capital markets. examines the main generic products offered in the international debt markets considers the important role of credit rating agencies in the international debt markets extended learning—novation, subparticipation and transferable loan certificates extended learning—convertible bonds and warrants extended learning—US medium-term notes extended learning—Standard & Poor’s credit rating definitions case study—the triggering role played by credit agencies in the GFC, and how they operate in Australia today

C HAPTER 12  Government debt, monetary policy and the payments system examines why governments issue short-term and longerterm debt securities, the types of securities and the pricing of those securities. It also considers the purpose and implementation of monetary policy; the operation of the payments system, exchange settlement accounts, real-time gross settlement and repurchase agreements bolstered by an updated treatment of the GFC and aftermath extended learning—fixed-coupon Treasury bonds: price calculation using the Australian Office of Financial Management (AOFM) formula case study—the New Payments Platform (NPP) in Australia and the consequent rising risk of fraud

C HAPTER 13  An introduction to interest rate determination and forecasting examines the macroeconomic context and the loanable funds approach to interest rate determination and the impact of changes in related variables considers the term structure and risk structure of interest rates within the context of the expectations theory, the segmented markets theory and the liquidity premium theory extended learning—the yield curve and expectations theory calculations case study—the RBA’s decision to hold interest rates in Australia until 2020

C HAPTER 14  Interest rate risk measurement identifies methods used to measure interest rate risk and introduces an exposure management system examines interest rate risk measurement models, including re-pricing gap analysis, duration and convexity considers internal and external interest rate risk management techniques case study—APRA and BEAR as risk management regimes in Australia

C HAPTER 15  Foreign exchange: the structure and operation of the FX market examines the structure, participants, operation and conventions in the global FX markets discusses and calculates spot and forward FX quotations considers the impact of the Economic and Monetary Union of the European Union (EMU) case study—fixed exchange rates and currency misalignments

C HAPTER 16  Foreign exchange: factors that influence the exchange rate introduces different exchange rate regimes used by various nation-states in the context of a floating exchange rate, considers factors that affect the determination of an equilibrium exchange rate, including relative inflation rates, national income growth rates, interest rates, expectations and central bank intervention considers the application of regression analysis in the measurement of exchange rate sensitivity extended learning—purchasing power parity case study—the relationship between terrorist attacks and FX movements

C HAPTER 17  Foreign exchange: risk identification and management recognises FX risk and presents an organisational FX risk policy structure discusses the measurement of transaction FX exposures xxiii

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Highlights of the ninth edition

examines internal and external market-based hedging techniques using derivative products case study—do companies hedge or speculate in FX risk management?

C HAPTER 18  An introduction to risk management and derivatives introduces the fundamentals of understanding risk and risk management provides a concise introduction to generic derivative products and markets, in particular futures, forwards, option and swap contracts case study—regulatory reforms and the ‘clearing’ of derivatives in global banking

C HAPTER 19  Futures contracts and forward rate agreements examines the purpose, structure and operation of a futures market, including structuring and calculating risk management strategies considers forward rate agreement contracts and the use of an FRA to manage interest rate risk exposures

case study—defining the SPI futures price contract on the S&P/ASX 200 Index, and its strengths and vulnerabilities in the current market

C HAPTER 20  Options examines the purpose, structure and operation of options markets introduces option contract strategies that may be applied in a wide range of risk exposure scenarios case study—the Black-Scholes option-pricing model

C HAPTER 21  Interest rate swaps, cross-currency swaps and credit default swaps examines the purpose of interest rate swaps (including facilitating speculation) and considers the construction of a swap to manage an interest rate risk exposure in the context of international markets, considers the construction of a currency swap to manage both an interest rate exposure and an FX risk exposure introduces the credit default swap and discusses the structure of, and parties to, a CDS case study—two perspectives on naked credit details swaps

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TEXT AT A GLANCE PART INTRODUCTIONS A short overview of the material that is covered in the following chapters is provided. They are a helpful introduction to how the key concepts, institutions or instruments work together and show how they fit within the larger picture.

PART Four

CHAPTER 12

Government debt, monetary policy and the payments system

Government debt, monetary policy, the payments system and interest rates

CHAPTER OPENERS Each chapter begins with a short overview of the information contained in the chapter, providing not only an introduction to the chapter, but also a useful study reference.

CHAPTER OUTLINE

Government debt, monetary policy and the payments system

12.2

Commonwealth Government securities

12.3

State government securities

12.4

Monetary policy

12.5

The payments system

An introduction to interest rate determination and forecasting

CHAPTER 14

Consider the reasons for the existence of government debt markets and the government borrowing requirement.

LO 12.2

Outline features of the main debt instruments issued by the Commonwealth Government, that is, the Treasury bond and the Treasury note, and describe the issuance process, participants and complete relevant calculations.

LO 12.3

Describe the purpose and structure of state government central borrowing authorities.

LO 12.4

Outline the monetary policy techniques currently employed by the Reserve Bank through which it influences the level of interest rates in Australia, including open market operations and the impacts on system liquidity.

LO 12.5

Describe the purpose and operation of the payments system, including exchange settlement accounts, real-time gross settlement and repurchase agreements.

11/27/1804:39PM

Commonwealth government the central government of australia

Budget deficit

Describe the purpose and structure of state government central borrowing authorities.

LO 12.4

Outline the monetary policy techniques currently employed by the Reserve Bank through which it influences the level of interest rates in Australia, including open market operations and the impacts on system liquidity.

LO 12.5

Describe the purpose and operation of the payments system, including exchange settlement accounts, real-time gross settlement and repurchase agreements.

Calculate the price of a bond using the AOFM formula.

Untitled-4 388

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Chapter 12 Government debt, monetary policy and the payments system

ThesystemusedinAustraliafortheprimarymarketissueofTreasurybondsisknownasthetender system.Thefederaltreasurerhasthepowertodecideonthetimingofeachtender,andonthematurities, coupons and quantities of bonds to be marketed. This is currently managed through the Australian Office of Financial Management (AOFM). Withthetendersystem,theAOFMisconfidentthatinvestorswillalwayspurchaseanyTreasury bondsonoffer.Thebondsareofferedwithafixedinterestrate,butatenderwillbelodgedtobuythe bondsintermsoftheyieldtomaturity.Thatis,aninvestorwilloffertobuyatapremium,oradiscount, tothefacevalue. For example, if an issue is announced carrying a coupon of 5.75 per cent per annum but an investorrequiresarateof6.00percentperannum,underthetendersystemtheserieswillstillbefully subscribed.Buyerswillputinatenderwiththeirbidpricebeingsufficientlybelowthefacevalueofthe bondsothattheexisting5.75percentfixed-couponpayments,plusthecapitalgainatmaturity,will returnaneffectiveyieldof6.00percentonthepurchaseprice.Thatis,theinvestorwillbuythebond Partforlessthanthefacevaluetoday,receivetheperiodicfixed-couponpaymentsandfinallyreceivethe 4 Government debt, monetary policy, the payments system and interest rates facevalueofthebondatthematuritydate. ThecurrentproceduresinvolvedinbiddingforbondsareavailableonthewebsiteoftheAOFMat continued www.aofm.gov.au.Fixed-couponTreasurybondbidconditionsincludethefollowing.

Tender system investors bid a price on government securities, thus setting the yield; allocated in order of lowest yields

Australian Office of Financial Management (AOFM) a body established to manage commonwealth government debt issues

• BidsmayonlybesubmittedelectronicallybyregisteredbiddersthroughtheAOFMtendersystem. of same-day funds are surplus balances in banks’ exchange settlement accounts, • Sources TheAOFMtendersystemisaccessedviatheelectronicYieldbrokerDEBTSSystem. Reserve Bank payments for market operations or repurchase arrangements with the Reserve Bank. CASE•• Theminimumbidmustbeforafacevalueof$1million,andthereafterinmultiplesof$1million. STUDY Found at the end of every chapter, each Bidsaretobemadeintermsofyieldtomaturityuptothreedecimalplaces,notintermsofprice.

financial news case study central bank requires high-value transactions in the payments system to be settled by real• The time gross settlement (RTGS); that is, funds must be available in a bank’s exchange settlement contains excerpts from financial articles that provide real-world examples of • account immediately. The purpose is to reduce settlement risk and systemic risk. support RTGS, the Reserve Bank provides an intra-dayThey liquidity facility for same-day funds or • To concepts discussed within the chapter. are followed by related discussion an overnight liquidity facility, known as a repurchase agreements (repo). • • Reservethe Bank willopportunity provide a repo based on underlying eligible securities. An intra-day • The questions providing for self-assessment and putting into practice repo must be unwound by the end of the day. Table 12.1 Treasury bond series tender: bids and allotments what has been learned. The yield is calculated using the formula specified in the prospectus (see the Extended learning sectionattheendofthechapter). Bidsareacceptedinascendingorder;thatis,thelowest-yieldbid,whichcorrespondstothehighest price,isacceptedfirstandthequantityofthatbidisallotted.Thenthesecondlowestofthetendered yieldsisacceptedandsoon,untiltheissueisfullysubscribed.ThisisillustratedinTable12.1. Biddersmaysubmitmultiplebids,atdifferentyields,fortheonebondseries. TreasurybondpurchasesaresettledusingtheAustraclearsettlementsystem.

30

2

6.40

35

35

3

6.50

25

25

6.60

30

10

4

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Yield Competitive bids Allotment: Allotment: Reserve (% p.a.) ($ millions) competitive ($ millions) Bank ($ millions)

6.30 CASE STUDY 30

THE NEW PAYMENTS PLATFORM (NPP) IN AUSTRALIA AND THE RISK OF FRAUD

In Chapter 12 we examined the establishment of a new payments platform in Australia that enables 5 6.65 25 nil quick payments. The basic structure of NPP includes a network to connect participants, a switch that Weighted average yield 6.42messages between participants and an addressing 20 transfers service with a simpler payment address such as a phone number or an email 100 address. Totals 145 20

The government must manage its financial position, including the timing of its cash flows and the platform financing of capital expenditures. The matching principle (discussed in Chapter 1) alsoThe applies to is equipped with a faster payment service that enables real-time handling and settlement Table 12.1 illustrates hypothetical bond tender where the government issues $120the million of a transactions, regardless of size. The platform uses ISO of 20022 standard for electronic data government; that is, the government funds any shortfall in short-term liquidity requirements with Weighted average Treasurybonds.TwentymilliondollarsoftheissueisallocatedtotheReserveBankattheweighted interchange data than most of the other the issue of short-term debt securities, and any shortfall in its long-term capital expenditures and between financial institutions with the capability to convey more issue yield average issue yieldannouncedfortherelevanttender.Theremaining$100millionisallottedaccording messaging formats (NPP Australia, 2018). Financial institutions and customers are expected to reap the the average of the commitmentswiththeissueoflong-termdebtsecurities. tothebidsthatarereceived.Intheexample,theAOFMreceivescompetitivebidsfromfiveparties proportional yields bid benefits of the new platform; however, critics argue that the number of fraudulent transactions will rise. Aliquidityshortfallmayoccurifthereisamismatchbetweenthetimingofgovernmentintra-year totalling$145million,andthesehavebeenarrangedinascendingorderinthetable.Thefirstbidder

on a bond issue

expendituresandthereceiptofrevenues.Acapitalexpenditureshortfalloccurswhenabudgetisin It is notable that most credit card frauds take place online or over the telephone and involve stealing 393 deficit,thatis,whencapitalexpendituresaregreaterthantaxandotherincomereceipts.Ifnecessary, details (card numbers, names etc), not the plastic card itself. According to the Australian Payments Network, almost 85 per cent of thefts involving credit cards occurred when the details were theAustraliangovernmentissuestwomainformsofdebtsecurity:theshort-termTreasurynoteandthe compromised. longer-termTreasurybond. Thissectionexamines,first,theCommonwealth Government’slong-term(orfull-year)borrowing Untitled-4 393 The NPP enables instant transfer of money, and such transfers are deemed11/27/1805:36PM to be irreversible. Each requirements,and,second,thegovernment’sshort-termliquidityrequirements(thosethatexistwithin financial institution could impose limits on the upper value of transfers, however, these are expected afinancialyear). to be higher than credit card limits and similar to limits on transfers using BSB numbers. According to

12.1.1 occurs when a government’s expenditures exceed its revenues over a fiscal year

Outline features of the main debt instruments issued by the Commonwealth Government, that is, the Treasury bond and the Treasury note, and describe the issuance process, participants and complete relevant calculations.

LO 12.3

Primary market transactions

Part 4 Government debt, monetary policy, the payments system and interest rates

Consider the reasons for the existence of government debt markets and the government borrowing requirement.

Consider the reasons for the existence of government debt markets and the government borrowing requirement.

LO 12.2

KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term or concept is highlighted in the text at its first appearance, and the definition is provided in the corresponding margin. A boxed list of these key terms appears at the end of each chapter and each entry is followed by the page on which it first appeared. All of the key terms, with their definitions, appear in the glossary.

1

LEARNING OBJECTIVE 12.1

LO 12.1

CHAPTER SNAPSHOT This brief outline at the beginning of every chapter launches the reader into the content, providing a helpful overview of what is to come and placing the ideas in their broader context.

Bid

12.1

The payments system

LO 12.6

Calculate the price of a bond using the AOFM formula.

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Monetary policy

12.5

Extended learning

Extended learning LO 12.6

State government securities

12.4

Interest rate risk measurement

Learning objectives LO 12.1

Commonwealth Government securities

12.3

CHAPTER 13

LEARNING OBJECTIVES These numbered points clearly outline what each reader should know and be able to do by the end of the chapter. They will also assist in exam revision. Each learning objective notes the numbered section in which the CHAPTER 12 learning objective appears in Government the chapter. debt, They are directly monetary policy and linked to the end-of-chapter the payments system summary, which systematically CHAPTERthrough OUTLINE works each learning objective. The Commonwealth Government borrowing requirement

The Commonwealth Government borrowing requirement

12.2

Learning objectives

CHAPTER 12

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12.1

12.1

critics, this is a potential problem.

The borrowing requirement: full financial year Online fraud has almost doubled in the UK since a faster payment system was adopted. The system had

a payment limit of £100 000 in 2010 and £250 000 in 2015. In 2017, there was a notable case known Aborrowingrequirementariseswhenagovernment’sexpendituresexceeditsrevenuesinanyparticular as the ‘Friday afternoon fraud’, where a group of fraudsters hacked into the emails between solicitors period.Overafullfinancialyearthissituationgivesrisetoabudget deficit.AscanbeseeninFigure12.1, and their home-buying clients on the day money was to be transferred. the Commonwealth Government’s financial position has changed quite significantly throughout the The fraudsters impersonated the solicitor and communicated to the clients that the payment details had last10years. been changed and that the payments should be made to a different account. By the time the victims realised, the money had been transferred (Worthington, 2018). Earlier, the banks had up to three days Figure 12.1 Commonwealth Government budget outcomes ($ billions) to stop a transfer when a scam was detected, but with the transition to faster payments there was less time to detect and stop fraudulent transactions such as these (Yeates, 2018). 30

26.7

28.1

20 14.2 10 –14.5

2017–18

2015–16

2014–15

2013–14

–18.2 –33.2

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–37.4 –40.4

2016–17

–47.0 –23.5

2011–12

2010–11

2009–10

2008–09

2007–08

2006–07

2005–06

–10

–44.5 –52.0

2012–13

–56.5 –31.3

0

There is reason to be optimistic that advances in security will outpace the ingenuity of fraudsters. Traditional security measures, like passwords, are on the decline. Knowledge-based passwords are often compromised. Australian banks are planning to introduce biometrics, including voice recognition, facial recognition and fingerprints. Last year, ANZ added a voice-ID function to its banking app that allows customers to carry out high volume transactions without a PIN or a password. HSBC also experienced success in detecting fraud by implementing biometrics. Approximately $7 million of attempted fraud

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Text at a glance

REFLECTION POINTS Located after every major section within each chapter, the reflection points highlight the most significant material covered and provide regular onlytomeettherepaymentsontheborrowedfunds,thelessorsgenerallyrelyontaxdeductionsfrom summaries. They are a useful tool for revision, helping thedepreciationoftheequipmentandfromtheinterestpaidtothedebtpartiestoearntheirreturn. Sinceleveragedleasingcanbequitecomplexandmayinvolvequiteafewpartiestothearrangement, itiscommonforthearrangementstobehandledbyalease manager.Theleasemanagerstructures, students to identify areas that require further study. negotiatesandplacestheleasetransaction,andmanagesthetransactionforthelifeofthelease. Chapter 10 Medium- to long-term debt

Lease manager

the arranger and ongoing manager of a leveraged lease that brings together the lessor, debt parties and the lessee

MASTER BEFORE YOU MOVE ON These chapter summaries comprehensively review the topics covered in each chapter and are linked directly to the learning objectives, listing each learning objective and a summary of the relevant material. Part 1 Financial institutions

Master before you move on

Reflection points

• • • • • • • •

A lease is a contract whereby the owner of an asset (the lessor) allows another party (the lessee) to use that asset for an agreed period in return for lease payments. Major providers of lease finance are banks and finance companies.

LEARNING OBJECTIVE 1.1 Understand the basic frameworks that underlie the facts that characterise financial institutions, financial instruments and financial markets.

Advantages of lease financing are that it does not use up lines of credit, it provides 100.00 per cent financing, payments can be matched with revenue generation, payments are generally tax deductible, it may not breach existing loan covenants and assets can be leased for the actual periods they are needed.

• • • •

An operating lease is a full-service lease where an asset is leased for a relatively short period, then returned to the lessor. The lessor maintains and insures the asset and leases it again and again. A finance lease is a long-term net lease where an asset is leased once. The lessee maintains and insures the asset and makes periodic lease payments. The lessee is required to make a lump-sum residual payment at the completion of the lease contract.

•

Sale and lease-back occurs when the original owner of an asset sells the asset and then enters into an arrangement to lease back the asset.

The interconnected global financial system traces its origins to the introduction of money and the development of local markets to trade goods. Money is a medium of exchange that facilitates transactions for goods and services. With wealth being accumulated in the form of money, specialised markets developed to enable the efficient transfer of funds from savers (surplus entities) to users of funds (deficit entities). Financial instruments incorporate attributes of risk, return (yield), liquidity and time-pattern of cash flows. Savers are able to satisfy their own personal preferences by choosing various combinations of these attributes. By encouraging savings, and allocating savings to the most efficient users, the financial system has an important role to play in the economic development and growth of a country. The real economy and the financial system are connected.

A cross-border lease occurs when parties to a lease extend into another country; it involves foreign exchange risk.

LEARNING OBJECTIVE 1.2

A direct finance lease involves two parties, the lessor and the lessee. The lessor retains ownership of the asset and may also seek additional guarantees to support the lease contract.

Explain the functions of a modern financial system and categorise the main types of financial institutions, including depository financial institutions, investment banks, contractual savings institutions, finance companies and unit trusts.

A leveraged finance lease is an arrangement whereby the lessor borrows to fund the purchase of an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease manager will be responsible for the management of the contract.

• • • •

CASE STUDY

• •

THE KANGAROO BONDS AND BLOCKCHAIN BOND-I’s Kangaroo bonds or Matilda bonds are Australian dollar-denominated bonds issued by non-Australian issuers after complying with local laws and regulations. They represent the largest share of the Australian domestic bond market after Australian Government Securities (AGS) and semi-government securities (Semis) (Bergmann & Nitschke, 2018). The bond issuers are major banks and financial institutions of high credit quality who participate in the Australian foreign exchange and derivative markets. The experience of these firms in the Australian bond market also helps other countries develop their domestic bond markets (Batten, Hogan & Szilagyi, 2008).

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Advantages of lease financing are that it does not use up lines of credit, it provides 100.00 per cent financing, payments can be matched with revenue generation, payments are generally tax deductible, it may not breach existing loan covenants and assets can be leased for the actual periods they are needed.

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CHAPTER TEN REVIEW

A company normally enters a foreign market to gain access to better interest rates. Kangaroo bonds are normally issued when interest rates in Australia are low relative to the domestic rate of the foreign Chapter 10 Medium- to long-term debt corporation. This will help to lower the interest expense and cost of borrowing for the issuer. These bonds, which are denominated in the local currency, form an attractive investment opportunity for

• • •

operating lease is a full-service lease where an asset is leased for a relatively short period EXTENDED LEARNING The extended learning sections • An and then returned to the lessor. The lessor maintains and insures the asset and leases it again and again. provide an additional resource for self-assessment and lease is a long-term net lease where an asset is leased once. The lessee maintains • Aandfinance insures the asset and makes periodic lease payments. The lessee is required to make a a variety of activities designed to address the more lump-sum residual payment at the completion of the lease contract. and lease-back occurs when the original owner of an asset sells the asset and then enters • Sale into an arrangement to lease of back the asset.chapter. These sections are complex aspects the cross-border lease occurs when parties to a lease extend into another country; it involves • Aforeign exchange risk. accompanied by extended learning questions which test direct finance lease involves two parties, the lessor and the lessee. The lessor retains • Aownership of the asset and may also seek additional guarantees to support the lease contract. students’ understanding of the material. A leveraged finance lease is an arrangement whereby the lessor borrows to fund the purchase • of an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease manager will be responsible for the management of the contract.

Extended learning

A financial system encourages accumulated savings that are then available for investment within an economy. A modern financial system comprises financial institutions, instruments and markets that provide a wide range of financial products and services. A range of different financial institutions has evolved to meet the needs of financial market participants and to support economic growth. Depository institutions, such as commercial banks, building societies and credit unions, specialise in gathering savings in the form of deposits and using those funds to provide loans to customers. Investment banks tend to specialise in the provision of advisory services to clients (e.g. merger and acquisition advice). Contractual savings institutions, such as insurance offices and superannuation funds, enter into contracts in which they receive funds on the undertaking that they will pay a policyholder, or member of a fund, a specified sum when a nominated event occurs. Finance companies sell debt instruments directly to surplus entities and then use those funds to provide loans and lease financing to borrowers. Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and invested in asset classes specified within the trust deed. Commercial banks dominate in terms of their share of the assets of financial institutions.

LEARNING OBJECTIVE 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity, debt, hybrids and derivatives.

• • 30

Financial instruments are central to any financial relationship between two parties. Where the saver acquires an ownership claim on the deficit entity, the financial instrument is referred to as equity.

END OF CHAPTER QUESTIONS A number of different question types are included to test student recall and understanding of the material covered in the chapter.

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The Essay questions provide the opportunity to put the concepts that have been learned into practice, highlighting students’ ability to analyse and evaluate the material. Part 1 Financial institutions

LEARNING OBJECTIVE 10.6 Understand the detailed process of financial asset securitisation.

• Is there a large budget deficit and a lot of government debt outstanding?

Securitisation

The Extended learning questions relate to the • • in-depth extended learning sections and require • • students to • demonstrate a deeper understanding of • the concepts • and theories presented in the chapter. Is there loose monetary policy and high inflation?

Financial institutions and corporations accumulate financial assets and other entitlements, such as accounts receivable, mortgage-backed housing loans, credit card receivables and utility rates, which generate future cash flows over time. There are no secondary markets which specifically trade in individual assets such as these, so the process of securitisation has evolved to allow the sale of these types of non-liquid financial assets that have specified future cash flows associated with them. For example, housing loans have future cash flows attached in the form of periodic interest payments and principal repayment.

Is the domestic economy in, or at risk of, a recession? Is there a large current account deficit?

Is there a large amount of foreign debt?

Is there an asset price boom (especially credit driven) occurring?

Are there a lot of bad debts in the banking system, or is there a poor system of bank supervision? Has there been a lot of unhedged foreign currency borrowing?

Securitisation is a form of financing in which the cash flows associated with existing financial assets are used to service funding raised through the issue of asset-backed securities. For example, the securitisation of mortgage loans involves the bundling together of a group of mortgage loans with similar characteristics, such as term to maturity. The loan originator (e.g. bank) then sells the bundle of mortgage loans to the trustee of a special-purpose vehicle (SPV). In order to be able to pay for the purchase of the mortgage assets from the loan originator, the trustee of the SPV raises the funds by issuing new securities to investors, particularly institutional investors.

there poor accounting standards, few disclosure requirements or ambiguous bankruptcy • Are procedures?

These 12 points form a strong starting point for financial crisis analysis. However, you should be aware that all of the factors will not always be evident, and that the existence of some factors does not by itself imply an imminent crisis situation. Also, as with past financial crises, each future crisis will have its own particular set of defining characteristics.

Institutional investors are attracted to this type of investment because, in theory, the level of risk is relatively low because the securities issued by the SPV trustee are supported by the cash flows and mortgages associated with the loans purchased from the originator. As the owner of the mortgage loans, the trustee receives the future loan instalments paid by the housing loan borrowers. The trustee uses these future cash flows to pay interest on the new securities issued to institutional investors and repays those securities on maturity.

Questions

The diagrammatic representation of the securitisation process is shown in Figure 10A.1, and may be summarised as follows:

Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question.

•

Essay questions

1

Financial assets (e.g. housing mortgage loans) accumulate and are funded on the balance sheet by a loan originator, such as a commercial bank. 341

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2

Describe the flow of funds that characterises any financial system. (LO 1.1)

3

Explain why an investor should consider the time-pattern of cash flows and the variability of the cash flows associated with a multi-period investment, rather than simply assessing the investment on the basis of the total cash flows received. (LO 1.1)

4

Risk preferences shape the decisions that people and businesses make when under conditions characterised by risk and uncertainty. Outline the three ways in which economists categorise decision makers and explain how each type of decision maker will choose differently when confronted with a risky choice. (LO 1.2)

5

Identify and discuss three changes in the distribution of assets among the financial institutions that have occurred during the period of the global financial crisis and Australia’s recovery from it (2008 to 2018). The information required is presented in Table 1.1. (LO 1.2)

6

Financial instruments may be categorised as equity, debt or derivatives. Discuss each category. In your answer, make sure you explain the differences between debt, equity and derivatives.  (LO 1.3)

7

During the GFC, the funding of longer-term assets with short-term borrowing was identified as a point of weakness in the operations of financial institutions. Discuss this statement with reference to the matching principle. (LO 1.4)

8

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The concepts of risk, reward, supply and demand underlie the complexity of financial instruments. How could we use these concepts, for example, to explain the rate of return expected by a shareholder in Telstra and the price at which Telstra shares change hands on the stock market? (LO 1.1)

(a) What are the differences between primary market and secondary market financial transactions? (b) Why is the existence of well-developed secondary markets important to the functioning of the primary markets within the financial system? (LO 1.4)

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Text at a glance

EXPLORING FINANCE ON THE WEB This updated resource provides a comprehensive list of useful finance websites including central banks, financial institutions, government sites, exchanges and markets. It also provides online learning tools such as financial newspapers and magazines, currency converters, background reading and suggested databases.

CAREERS IN FINANCE Introduces students to the enormous career opportunities that exist in both local and international economics. A list of web addresses of select employers of finance graduates is a source of organisation-specific career information. A useful guide to preparing online applications is also presented.

EXPLORING FINANCE ON THE WEB

CAREERS IN FINANCE A career in finance can be established in any country, economic sector, industry sector, business or government and the range of career opportunities is enormous. For example, commercial banking provides an enormous range of options including retail finance, corporate lending, international banking, treasury and information technology, to name but a few. Investment banking also offers specialist finance opportunities including mergers and acquisitions, project finance, securitisation, underwriting and venture capital. For those interested in portfolio management, there are many fund managers, including superannuation funds, operating in Australia. And those people interested in working directly with clients might find that personal financial planning is another career opportunity to explore. Small, medium and large businesses all require people skilled in finance to manage their assets, liabilities and cash flows. Government departments and authorities also require finance graduates to assist with the financing of capital or recurrent expenditures. Finance is global and there are possibilities for working in a range of developing and advanced financial markets. During your studies you may find certain areas of finance that particularly excite and interest you. Research the types of organisations that provide career opportunities in your areas of interest; understand the structure and culture of the organisations and carefully consider the organisation’s guidelines for graduate employment. Most large employers include a link to this information on their website. Some examples include: ANZ Banking Group – www.anz.com.au/about-us/careers Commonwealth Bank – www.commbank.com.au/about-us/careers.html National Bank of Australia – www.nab.com.au/about-us/careers Westpac Banking Corporation – www.westpac.com.au/about-westpac/careers Goldman Sachs – www.goldmansachs.com/careers Macquarie Bank – www.macquarie.com.au/careers Reserve Bank of Australia – www.rba.gov.au/careers Australian Prudential Regulation Authority – www.apra.gov.au/aboutAPRA/workingatAPRA Department of Treasury – www.treasury.gov.au/About-Treasury/recruitmentandcareers Telstra Corporation – www.telstra.com.au/careers BHP Billiton Limited – www.bhpbilliton.com/careers KPMG – www.kpmg.com/au/en/careers Ernst & Young – www.ey.com/au/en/careers

The following websites have been selected as useful and interesting sources of information relevant to financial institutions, instruments and markets. As you continue your search of the internet you will find many more sites; this is just the beginning! See your library’s subject page on finance/economics/business where there will be listings of search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources available to use/borrow, often with their call numbers and the general call numbers to look for your subject. These pages may also list significant journals in your field as well as databases and newspapers.

BACKGROUND READING

FINANCE GLOSSARIES

Both Yahoo! and Google provide good entry points for the latest news, facts and figures as well as providing a gateway to other resources. Yahoo! has a specific Australian and New Zealand site, www.yahoo.com.au/ finance. Google Finance has an international site, www. google.com/finance.

This text includes a glossary of the main financial market words referred to in the book. As you extend your understanding of the financial system further, www. investorwords.com provides online access to over 6000 words and 20 000 links. It is the biggest financial glossary on the web.

DATABASES This is a list of some of the suggested databases your library may have access to that contain finance articles and information. If your institution does not have access to all the databases you may be able to get access through another institution, so check with your library about borrowing rights at other universities. Proquest: Academic research library Covers finance, has full text articles. Connect4: Annual report collections Business provides full text annual reports from various Australian companies including some company financial statements. APA Full Text (Australian Public Affairs full text) Lists a large range of Australian periodicals with some access to full text. Proquest: Banking Information Sources International database, full text article access. Covers banking and industry and the financial services industry.

Expanded Academic ASAP Full text articles available, international. Factiva Full text available, covers most Fairfax publications including Business Review Weekly, The Australian Financial Review and The Age. Science Direct Full text, international. Includes access to journals such as Journal of Financial Markets, Journal of International Money and Finance and Journal of Banking and Finance. You can find these databases by selecting your subject (finance, business, economics) and searching the library subject pages for relevant journal listings. Alternatively, look them up in alphabetical order through the online library catalogue to check for access. You may need a password when accessing them off campus.

Tips for online applications Before you start •

WORLD CURRENCIES http://en.wikipedia.org/wiki/List_of_circulating_currencies This site has a comprehensive list of the majority member states of the United Nations with their ISO-4217 currency codes and abbreviations listed. www.xe.com/currencyconverter provides a convenient foreign exchange currency converter.

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Allow yourself plenty of time as each application can take between two and four hours at a minimum! Read the application instructions carefully, to determine whether you: – have the appropriate/minimum software and hardware to undertake this process – have the option of downloading a copy of the application form to assist you in preparing all relevant information and in filling out the form – have to fill out the form in one sitting, or whether you have the option of saving, exiting out and returning to the form when you are ready

• •

•

know what information you will be required to include in the application form (course/unit details, results etc.) so you can have this handy when you are completing the forms – know whether additional information (cover letters, etc.) can be attached if desired. Obtain a copy of your academic transcript. Collect all the information you require, for example course/unit details. Also have electronic access to your résumé to cut and paste into the application form. If you need to use computer labs or library computers, book ahead of time.

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GLOSSARY This useful list of definitions contains all of the key terms and concepts as they appear in the margin notes.

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Glossary acceptance a bank puts its name on a bill issued by a third party; bank accepts primary liability to repay the face value of the bill at maturity acceptor a bank that puts its name on the face of a bill and takes primary liability to repay the holder at maturity

arbitrage simultaneously taking advantage of buy and sell price differences between markets arbitrageur a party that simultaneously conducts buy and sell transactions in two or more markets in order to take advantage of price differentials between markets

accounting ratios measures of a company’s financial and management performance, strength and efficiency

ARBL gap a positive ARBL gap exists when assets are re-priced before liabilities, and a negative ARBL gap exists when liabilities are re-priced before assets

accounts receivable an asset on the balance sheet representing amounts due to the business

ascending triangles form an uptrend characterised by increasing bottoms and horizontal tops

accounts receivable financing a loan obtained by a firm using current accounts receivable debtors as security to support the loan

ask price the price at which an FX dealer will sell the base currency

accumulation index measures changes in share prices, plus the reinvestment of dividends received active ETFs a type of ETF that deploys strategies designed to outperform a market index active FX strategy hedging techniques are continually adjusted in response to forecast changes in exchange rates active investment a portfolio structure based on share analysis, new information and risk/return preferences

FINANCIAL ABBREVIATIONS This comprehensive list covers all the major financial abbreviations used both in the text and in the financial world, providing a quick, easy-to-use reference point. It is helpfully located on the inside front cover to make looking up terms easy.

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asset management a bank restricts growth in its lending to the level of funds available from its depositor base asset portfolio a combination of assets, each comprising attributes of return, risk, liquidity and timing of cash flows asset transformation the ability of financial intermediaries to provide a range of products that meet customers’ portfolio preferences

age pension a limited regular income stream paid by a government to older retired persons

assets re-priced before liabilities (ARBL) a risk management principle that ensures net margins and profitability are protected

agency problem the conflict of interest that may exist between shareholders and management of a corporation

assets test minimum level of assets to be held by an entity seeking listing on a stock exchange

agent bank conducts the ongoing administration role of an established syndicated loan facility

ASX Trade the electronic securities trading platform used by the ASX to facilitate trading in equity securities listed on the ASX

WORLD CURRENCIES Located on the inside back ASX Trade24 the electronic securities trading platformcover used by the ASX to facilitate trading in futures, options and contracts for difference listed on the ASX lists the for ease of reference, this handy, updated table at-the-money the physical market price and the option American-type options options that can be exercised price arecountries, the same at any time up to the expiration currencies of alldatethe world’sexercise major as well as Austraclear an electronic clearing house for a range amortised loan a loan that is progressively repaid of financial instruments, including Treasury bonds by regularcommon equal instalments that comprise interest their abbreviations. payments and part-principal repayment American depositary receipt (ADR) a security (depositary share) issued by a US depositary bank that is supported by shares held of a foreign listed company

amortised loan instalments regular and equal loan instalments that comprise the current interest payment due, plus part repayment of the loan principal outstanding annuity a series of cash flows of equal amount, equally spaced over time annuity due periodic cash flows that occur at the beginning of each period

Australian Office of Financial Management (AOFM) a body established to manage Commonwealth Government debt issues Australian Securities and Investments Commission (ASIC) the regulatory body responsible for the supervision of the Corporations Act in Australia

authorised deposit-taking institution (ADI) financial institution authorised by APRA to accept retail deposits in Australia 691

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EXPLORING FINANCE ON THE WEB The following websites have been selected as useful and interesting sources of information relevant to financial institutions, instruments and markets. As you continue your search of the internet you will find many more sites; this is just the beginning! See your library’s subject page on finance/economics/business where there will be listings of search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources available to use/borrow, often with their call numbers and the general call numbers to look for your subject. These pages may also list significant journals in your field as well as databases and newspapers.

BACKGROUND READING

FINANCE GLOSSARIES

Both Yahoo! and Google provide good entry points for the latest news, facts and figures as well as providing a gateway to other resources. Yahoo! has a specific Australian and New Zealand site, www.yahoo.com.au/finance. Google Finance has an international site, www.google.com/finance.

This text includes a glossary of the main financial market words referred to in the book. As you extend your understanding of the financial system further, www.investorwords.com provides online access to over 6000 words and 20 000 links. It is the biggest financial glossary on the web.

DATABASES This is a list of some of the suggested databases your library may have access to that contain finance articles and information. If your institution does not have access to all the databases you may be able to get access through another institution, so check with your library about borrowing rights at other universities. Proquest: Academic research library Covers finance, has full text articles. Connect4: Annual Report Collection Business provides full text annual reports from various Australian companies including some company financial statements. APA Full Text (Australian Public Affairs full text) Lists a large range of Australian periodicals with some access to full text. Proquest: Banking Information Sources International database, full text article access. Covers banking and industry and the financial services industry.

Expanded Academic ASAP Full text articles available, international. Factiva Full text available, publications include Business Review Weekly, The Australian Financial Review and The Age. Science Direct Full text, international. Includes access to journals such as Journal of Financial Markets, Journal of International Money and Finance and Journal of Banking and Finance. You can find these databases by selecting your subject (finance, business, economics) and searching the library subject pages for relevant journal listings. Alternatively, look them up in alphabetical order through the online library catalogue to check for access. You may need a password when accessing them off campus.

WORLD CURRENCIES http://en.wikipedia.org/wiki/List_of_circulating_currencies This site has a comprehensive list of the majority member states of the United Nations with their ISO-4217 currency codes and abbreviations listed. www.xe.com/currencyconverter provides a convenient foreign exchange currency converter.

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Exploring finance on the web

FINANCE MEDIA Although not all of these may be available from your library (either in hard copy or through online access with a password) it is worth investigating the possibilities of interlibrary loans. Ask your subject librarian for information about accessing the catalogues of other libraries. Wall Street Journal http://online.wsj.com/public/asia The Wall Street Journal has great information available online without subscription.

MSN Money www.money.msn.com A useful site that has good coverage of financial events in the ‘news’ section including video clips. The Financial Times www.ft.com/home/uk Online access to full text articles from either the UK, US or Asian editions of the paper. Fortune Magazine http:www.fortune.com Fortune Magazine home, access to full text articles.

AUSTRALIAN AND INTERNATIONAL

INFORMATION PROVIDERS

INSTITUTIONS AND AUTHORITIES

Bloomberg – www.bloomberg.com Dow Jones – www.dowjones.com Thomson-Reuters – www.reuters.com

The Reserve Bank of Australia website www.rba.gov.au/links provides direct link access to the websites of:



central banks EMEAP members other international organisations Australian government departments and ­authorities Australian legislation Australian financial sector organisations

AUSTRALIAN MAJOR BANKS ANZ Banking Group – www.anz.com.au Commonwealth Bank of Australia – www.commbank.com.au National Australia Bank – www.nab.com.au Westpac Banking Corporation – www.westpac.com.au

SELECT INTERNATIONAL FINANCIAL INSTITUTIONS Allianz – www.allianz.com Citibank – www.citibank.com Credit Suisse – www.credit-suisse.com Goldman Sachs – www.goldmansachs.com ING Bank – www.ing.com JPMorgan Chase & Co – www.jpmorgan.com UBS Investment Bank – www.ubs.com

CREDIT RATING AGENCIES Fitch Ratings – www.fitchibca.com Moody’s Investors Service – www.moodys.com Standard & Poor’s – www.standardandpoors.com

EXCHANGES AND MARKETS Australian Securities Exchange – www.asx.com.au New Zealand Stock Exchange – www.nzx.com CME Group (Chicago Board of Trade and Chicago Mercantile Exchange) – www.cmegroup.com Hong Kong Exchange – www.hkex.com.hk Euronext (formerly London International Financial Futures Exchange) – www.euronext.com London Metal Exchange – www.lme.com London Stock Exchange – www.londonstockexchange.com Lloyds of London – www.lloyds.com NASDAQ – www.nasdaq.com New York Stock Exchange – www.nyse.com Shanghai Stock Exchange – http://english.sse.com.cn/ Singapore Exchange – www.sgx.com ASX Trade24 (Futures) – www.asx.com.au Tokyo Stock Exchange – www.jpx.co.jp/english/

CLEARING, SETTLEMENTS AND CUSTODIAN SERVICES Austraclear – www.asx.com.au Clearstream – www.clearstream.com Euroclear – www.euroclear.com Reserve Bank Information and Transfer System – www.rba. gov.au/payments-and-infrastructure/rits/ SWIFT – www.swift.com

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CAREERS IN FINANCE A career in finance can be established in any country, economic sector, industry sector, business or government and the range of career opportunities is enormous. For example, commercial banking provides an wide range of options including retail finance, corporate lending, international banking, treasury and information technology, to name but a few. Investment banking also offers specialist finance opportunities including mergers and acquisitions, project finance, securitisation, underwriting and venture capital. For those interested in portfolio management, there are many fund managers, including superannuation funds, operating in Australia. And those people interested in working directly with clients might find that personal financial planning is another career opportunity to explore. Small, medium and large businesses all require people skilled in finance to manage their assets, liabilities and cash flows. Government departments and authorities also require finance graduates to assist with the financing of capital or recurrent expenditures. Finance is global and there are possibilities for working in a range of developing and advanced financial markets. During your studies you may find certain areas of finance that particularly excite and interest you. Research the types of organisations that provide career opportunities in your areas of interest; understand the structure and culture of the organisations and carefully consider the organisation’s guidelines for graduate employment. Most large employers include a link to this information on their website. Some examples include: ANZ Banking Group – www.anz.com.au/about-us/careers Commonwealth Bank – www.commbank.com.au/about-us/careers.html National Bank of Australia – www.nab.com.au/about-us/careers Westpac Banking Corporation – www.westpac.com.au/about-westpac/careers Goldman Sachs – www.goldmansachs.com/careers Macquarie Bank – www.macquarie.com.au/careers Reserve Bank of Australia – www.rba.gov.au/careers Australian Prudential Regulation Authority – www.apra.gov.au/aboutAPRA/workingatAPRA Department of Treasury – www.treasury.gov.au/About-Treasury/recruitmentandcareers Telstra Corporation – www.telstra.com.au/careers BHP Billiton Limited – www.bhpbilliton.com/careers KPMG – www.kpmg.com/au/en/careers Ernst & Young – www.ey.com/au/en/careers

TIPS FOR ONLINE APPLICATIONS Before you start •

Allow yourself plenty of time as each application can take between two and four hours at a minimum! Read the application instructions carefully, to determine whether you:





–  have the appropriate/minimum software and hardware to undertake this process – have the option of downloading a copy of the application form to assist you in preparing all relevant information and in filling out the form – have to fill out the form in one sitting, or whether you have the option of saving, exiting out and returning to the form when you are ready







• •

•

–  know what information you will be required to include in the application form (course/unit details, results etc.) so you can have this handy when you are completing the forms –  know whether additional information (cover letters, etc.) can be attached if desired. Obtain a copy of your academic transcript. Collect all the information you require, for example course/unit details. Also have electronic access to your résumé to cut and paste into the application form. If you need to use computer labs or library computers, book ahead of time.

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Careers in finance

Working on the application •

• • • •

•

•

•

Print out the application form to use as a draft. Complete responses offline and cut and paste into the application. Remember to fill out all the fields. Save regularly as you progress through the application form if possible. Proofread your applications—not all online application forms have spell checks. Leave plenty of time to submit the applications electronically. Typically, employer websites experience a huge rush towards the application deadlines. You may experience delays or be unable to submit due to technical problems if sites are overloaded. Make sure your email address and mobile phone numbers are correct! All too often students record these inaccurately—it is vital that you are contactable, particularly if employers wish to schedule you for testing/interviews. If they can’t reach you, they won’t bother trying again, given the numbers of applications they will be processing. If you don’t receive acknowledgment, or you are unsure whether your application has been received, contact the relevant recruitment coordinator to confirm receipt of your application. If you are having any problems with the technology or have questions regarding the form, contact the graduate recruiter in that organisation as soon as possible.

•

•

Print out a copy of the application for your records (and make a note of any contact you have with the organisation)—it will help if and when you are invited to an interview. In addition to proofreading, reread your application before you hit the ‘send’ button. Does it present you in the best possible way? You will not get another chance to revise it!

Distinguish yourself from other applicants Employers advise that the best way to make your application stand out are the simple things: • Fill out all the fields. • Proper business language should be used as you would for a paper-based application. Just because it is an online form doesn’t mean that you should use more informal or text language, or insert symbols, for example smiley faces. • Check your spelling, or get others to check it for you—spell checks don’t pick up everything. • Answers to in-depth questions should be carefully thought out and tailored to each employer, not a generic cut-and-paste answer. Use proper paragraphs, not just a list of dot points. These tips may seem obvious, but you’d be amazed at the number of applications which are not successful because they haven’t followed this advice!

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PART One

Financial institutions CHAPTER 1 A modern financial system: an overview

CHAPTER 2 Commercial banks

CHAPTER 3 Non-bank financial institutions

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Financial institutions This textbook discusses the structure, functions and operations of a modern financial system. You are going to learn about financial institutions, financial instruments and financial markets. Although institutions, instruments and markets are fundamentally alike, they may be differentiated by size, terminology, the level of government regulation and prudential supervision. Despite this complexity, underlying all of the instruments that are traded on the world’s financial markets are some basic ideas: risk and reward, supply and demand. Internationalisation of the financial markets has, in part, occurred because of the development of sophisticated technology-based information systems and product delivery systems. This has allowed new products and markets to evolve, and an enormous increase in the volume and speed of the flow of funds through the international financial markets. As will be seen, the combination of globalisation, deregulation, technology and competition has encouraged enormous innovation and change within financial institutions, instruments and markets. Think of a financial system as a number of financial institutions and markets through which funds move between lenders and borrowers. The institutions and markets that facilitate this flow of funds develop the financial instruments and techniques that encourage savings and investment. The financial system also provides the framework through which central banks and prudential regulators influence the operations of participants in the financial system. Most importantly, a central bank, through its monetary policy initiatives, affects the level of interest rates, economic activity and business performance. A financial system is essential in facilitating economic growth and future productive capacity in a country. The provision of finance to business allows economic growth to occur, which should lead to increased productivity, increased employment and a higher standard of living. A modern, sound and efficient financial system encourages the accumulation of savings that are then available for investment in productive capital within an economy. Chapter 1 presents an overview of a modern financial system and provides a context for the more detailed studies that occur throughout the textbook. It introduces the main categories of financial institutions, discusses the functions of financial markets and provides an overview of the types of instruments that are created within the markets. At the end of Chapter 1, two extended learning sections are provided: ‘Globalisation of the financial markets’ and ‘The impact of the Asian financial crisis on the financial system’. Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks. Commercial banks are the largest financial institutions providing savings, lending and a wide range of other financial services for their customers. The assets, liabilities and off-balance-sheet business of commercial banks are analysed in detail. At the end of the chapter, three extended learning sections are provided: ‘The standardised approach to credit risk’, ‘Business continuity risk management’ and ‘Corporate governance and ethics’. Chapter 3 extends the discussion of financial institutions further and looks at the operations and significance of other types of financial institutions. In particular the chapter considers investment banks, managed funds, superannuation funds, cash management trusts, public unit trusts, life insurance offices, general insurance offices, hedge funds, finance companies, general financiers, building societies, credit unions and export finance corporations. At the end of the chapter, an extended learning section is provided: ‘Project finance and structured finance’.

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CHAPTER 1

A modern financial system: an overview CHAPTER OUTLINE 1.1 Theory and facts in finance 1.2 The financial system and financial institutions 1.3 Financial instruments 1.4 Financial markets 1.5 Flow of funds, market relationships and stability

Learning objectives LO 1.1

Understand the basic frameworks that underlie the facts that characterise financial institutions, financial instruments and financial markets.

LO 1.2

Explain the functions of a modern financial system and categorise the main types of financial institutions, including depository financial institutions, investment banks, contractual savings institutions, finance companies and unit trusts.

LO 1.3

Define the main classes of financial instruments that are issued into the financial system, that is, equity, debt, hybrids and derivatives.

LO 1.4

Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary markets, direct finance and intermediated finance.

LO 1.5

Distinguish between various financial market structures, including wholesale markets and retail markets, and money markets and capital markets.

LO 1.6

Analyse the flow of funds through the financial system and the economy, and briefly discuss the importance of ‘stability’ in relation to the flow of funds.

Extended learning LO 1.7

Appreciate the impact of the global financial crisis (GFC) on the world’s financial system and economy.

LO 1.8

Appreciate the effects, consequences and relevance of the Asian financial crisis.

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Part 1 Financial institutions

CHAPTER SNAPSHOT Financial institutions, instruments and markets cannot be separated from the ideas that have been developed in financial economics about risk, reward, supply and demand, arbitrage and the time value of money. Ideas originating in university departments of finance and economics have shaped, and in some cases created, the institutions, instruments and markets that we observe in the world today. Our very observation of them occurs through the lens of modern finance theory.

INTRODUCTION To say that finance can seem like a complex subject is, to some people, an enormous understatement. Though it’s not something that we will have to worry greatly about for now, finance theorists, like economists of certain schools, have come to rely more and more upon mathematics to express their essential ideas. This is a rhetorical choice that need not deter us, though it may delay us, from developing a deep understanding and appreciation of those ideas. The great philosopher of science, Karl Popper, argued that all facts are theory-laden. It is not possible to describe a set of facts or series of data without drawing on some theory or other. Often, the theory will be hidden from view and the person who is drawing upon its ideas will be doing so subconsciously. If traced to their ultimate source, however, we shall find that the ideas, though not necessarily the practices, that prevail in the business and financial worlds find their origins in the modern finance theories and economics that were developed in universities, mainly in America, during the twentieth century. As you read through this book, which is about financial institutions, financial instruments and financial markets, you will come across a great many facts. A full appreciation of why these facts are facts and, more to the point, a full understanding of their implications for us necessarily requires that they be viewed from some theoretical perspective or other. While we cannot cover in a few pages the results of a half-century of economic thought, we can provide a simple framework that will bring out a good deal of the meaning of the facts that we present. This simple framework is: risk, reward, supply and demand.

1.1 LEARNING OBJECTIVE 1.1 Understand the basic frameworks that underlie the facts that characterise financial institutions, financial instruments and financial markets.

Theory and facts in finance

The primary challenge that a study of finance presents is its language. There are many new words to learn and those words are used to convey new ideas. New words and new ideas all at once. If we were to name four pieces of finance and economics that can help us organise our thoughts and make it easier to understand how financial institutions, instruments and markets work, they would be: (1) risk and reward; (2) supply and demand; (3) no arbitrage; and (4) the time value of money. The returns that investors expect to earn are positively related to the risk they must bear. We might speak of shareholder returns, bond yields, interest rates or cash flows from a project. These are just different names for the returns that can be earned by bearing some degree (perhaps zero) of risk. When the risk is perceived to be greater, the returns that investors demand will be higher. Whatever we might call them, the rewards from investing depend on the risk that the investor must bear. All investment returns follow the same rules. If the risk is greater, the expected return is higher. Later in the book, we introduce some financial instruments that appear rather strange and mysterious. Of course, they also have some special language that is used to describe them. However, whether we are talking about shares, bonds, options, futures or swaps, the price of these instruments

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Chapter 1  A modern financial system: an overview

depends ultimately on supply and demand. When the supply of a particular futures or options contract goes up while demand remains the same (or falls), the price must decline, and vice versa. It can be helpful to remember that, ultimately, supply and demand are fundamental determinants of the market prices for everything. Working alongside supply and demand is a rule that we might call ‘no arbitrage’. More generally, we might say there are no free lunches. A trader cannot buy a financial instrument in one market at a low price while simultaneously selling that same thing at a higher price in a different market. If this were possible, the trader could earn infinite returns at zero risk. That would contradict the risk–reward trade-off. Of course, traders look for such opportunities all the time. Their buying and selling activities are the reason why such opportunities do not emerge or do not exist for very long when they do. ‘No arbitrage’ helps us to understand that prices are just statements that must be consistent with each other. Two different prices for the same thing is not a mystery. It is just an inconsistent statement that will quickly be corrected. Finally, have you ever wondered what interest is and why it exists? Interest is just the reward for waiting. The difference in value between wine that is in a cellar now and the same wine in 10 years’ time is interest. The difference in value between saplings planted now and fully grown oak trees in 30 years’ time is interest. How much extra value an investor demands depends on his or her impatience to consume now rather than later. This impatience determines the pure time value of money. This is the interest rate on completely risk-free investments. The pure time value of money is positive because people are generally impatient to consume now and must be rewarded for waiting. If they weren’t, no wine would ever be stored and no commercial forests would ever be planted. All of the rates of return that we observe on the financial markets consist of the pure time value of money, plus a premium for risk, plus a premium for inflation. This is the case for every rate of return we observe. Whether it is a shareholder’s return, a bondholder’s bond yield or a conservative investor’s term deposit rate, the return is a sum of the pure time value of money, a premium for risk and a premium for inflation. The risk premium may, of course, be zero for risk-free investments. These simple rules underpin the now vast interconnections of the world’s financial markets. This global financial system grew from relatively humble beginnings. Its development began the moment that people first started to use money. The use of money has many advantages. For one, it makes it easier for individuals to save their surplus earnings. Saving may be defined as deferring consumption into the future. The funds saved by surplus units—those savers with current excess funds—can be put to use by those whose current demand for goods and services is greater than their current available funds. Such users of funds are called borrowers or deficit units. Just as the exchange of goods and services can be carried out more efficiently through organised markets, so too can the exchange of money or value between surplus units and deficit units. Financial institutions and markets facilitate financial transactions between the providers of funds and the users of funds. When a financial transaction takes place, it establishes a claim to future cash flows. This is recorded by the creation of a financial asset on the balance sheet of the saver. The financial asset is represented by a financial instrument that states how much has been borrowed, and when and how much is to be repaid by the borrower. For example, if you invested money in a term deposit with a bank, the bank would issue a term deposit receipt to you. This is a financial instrument. The receipt would specify how much you had invested, the rate of interest to be paid, when interest payments are due and when the amount invested would be repaid by the bank. The interest payments and principal repayment are claims to future cash flows. Buyers of financial instruments are lenders that have excess funds today and want to invest and transfer that purchasing power to the future. The sellers of the instruments are those deficit units that are short of funds today, but expect to have a surplus amount in the future that will enable the repayment of the current borrowing. A principal role of financial institutions and markets is to bring together providers of funds (savers) with users of funds (borrowers). The flow of funds and the relationship between savers and borrowers, and the place of the financial markets in the flow, are shown in Figure 1.1. Like our fundamental ideas 5

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Part 1 Financial institutions

of risk, reward, supply and demand, it is possible to use this idea of a ‘flow of funds’ to cut through the complexity of the financial markets in its entirety. Financial markets are processes that facilitate the flow of funds between lenders and borrowers. Regardless of how many facts you are presented with throughout this book, these basic frameworks can always be drawn upon to remind us that the picture, beneath the surface at least, is a simple one.

Figure 1.1  Financial markets and flow of funds relationship Suppliers of funds: ■

surplus (savings) units

Users of funds: ■

deficit units

are

are

Lenders: ■ ■ ■ ■

Borrowers:

householders companies governments rest of world

■ ■ ■ ■

who receive funds

who supply funds and

householders companies governments rest of world

Financial markets

receive financial instruments

and issue financial instruments

REFLECTION POINTS

financial system encourages savings, provides funds for investment and facilitates • Atransactions for goods and services. The financial system and the financial markets are inextricably connected with the real economy. seemingly complex, financial institutions, instruments and markets adhere to • Although some simple rules and can be understood by drawing on basic frameworks of finance and economics. modern financial system began humbly when people first started using money. Economic • The and financial transactions are valued in money terms. Money is a universally acceptable medium of exchange and a store of value. Money, most importantly of all, has a time value.

1.2 LEARNING OBJECTIVE 1.2 Explain the functions of a modern financial system and categorise the main types of financial institutions, including depository financial institutions, investment banks, contractual savings institutions, finance companies and unit trusts.

The financial system and financial institutions

A financial system comprises a range of financial institutions, financial instruments and financial markets which interact to facilitate the flow of funds through the financial system. Overseeing the financial system, and sometimes taking a direct role, is the central bank and the prudential supervisor. The decision to save allows surplus units to transfer some of today’s income to the future, when it can be used for consumption. Therefore, savings allow consumption in the future to be independent of future levels of earned income. Surplus entities invest their savings through the purchase of financial instruments that are expected to improve their overall wealth. The expectation of the saver is to earn a positive rate of return. However, there are other factors that savers should consider, otherwise all savers would only purchase financial instruments that offered the highest rate of return. Providers of funds should consider their own particular needs when they purchase or invest in assets. This will affect the expected rate of return. It is useful to think of an asset,

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Chapter 1  A modern financial system: an overview

whether it is a real asset such as an investment property or a financial asset such as a bank term deposit, as being a package of four main attributes:

• return or yield • risk • liquidity • time-pattern of cash flows. With a real asset such as an investment in a residential unit, return is the regular rental or lease payments received, plus any increase in the value of the property over time (capital gain). Risk relates to uncertainty and probabilities, such as the failure of the tenant to make rental payments or the possibility that the property may burn down. The liquidity of the residential unit is the ease with which it can be sold. Finally, the time-pattern of the cash flows will vary depending on the frequency of the rental payments, the cost of maintenance and the payment of other expenses such as insurance and rates. In the case of a financial asset such as the purchase of shares in a corporation, return consists of the dividends received and the capital gains or losses made through movements in the share price on the stock exchange. Note that a dividend is the portion of corporation profits periodically paid to the shareholder; a stock exchange is where corporation shares are bought and sold. Risk is measured by the variability of the expected returns and, in the extreme, the possibility that the corporation may fail. The liquidity of the shares relates to the ease with which they can be sold on the stock exchange at the current market price. Finally, the time-pattern of the cash flows expected from the shares depends on the profitability and dividend policy of the corporation. Typically, a profitable corporation will pay dividends to shareholders twice a year. It is reasonable to assume that the average person likes return and liquidity, dislikes risk and prefers reliable cash flows. Fortunately, the preferences of savers with regard to these four attributes are not identical. If they were, all savers would seek to place all of their savings with very few borrowers. Since preferences are not identical, financial institutions and markets provide an enormous range of investment opportunities that have different levels of return, risk, liquidity and timing of cash flows. Individuals and businesses may be categorised as being risk averse, risk neutral or risk takers. More risk-averse individuals will accept lower expected returns for bearing lower levels of risk. If the level of risk increases, they expect to be compensated with higher expected returns. It is usual to assume that individuals and businesses are risk averse to some degree. They do not avoid risk entirely, but they do demand a higher return for bearing higher risk. Furthermore, savers will accept various levels of liquidity or different timings of cash flows associated with financial instruments. Participants in the financial markets are therefore able to alter the composition of their financial asset portfolio by changing their preferences in relation to the four attributes of return (yield), risk, liquidity and the timing of cash flows. An asset portfolio is the list of assets held by a saver. A major function of the financial system is to facilitate portfolio structuring and restructuring through the buying and selling of a wide range of financial instruments. Financial institutions and markets provide the potential suppliers of funds with the combinations of risk, return, liquidity and cash-flow patterns that best suit each saver’s particular portfolio needs. To support decisions taken by both the providers of funds and the users of funds, the financial system is also a provider of financial and economic information to market participants. Information affects price and investment decisions; therefore, the provision of timely and accurate information is essential for an efficient financial system. If a financial system is successful in creating a range of financial instruments that possess different combinations of the four attributes valued by savers, this will encourage an increased flow of savings. By encouraging savings, the financial system is important to economic growth, as the savings are available for investment capital that can be used for the improvement of the productive capacity of an economy. Not only can it be expected that a well-functioning financial system will increase the flow of savings, but it can also be argued that an efficient financial system should ensure that savings are

Financial system comprises a range of financial institutions, instruments and markets; overseen by central bank; supervised by prudential regulator

Financial instruments issued by a party raising funds, acknowledging a financial commitment and entitling the holder to specified future cash flows

Flow of funds movement of funds through a financial system

Surplus units savers or providers of funds; funds are available for lending or investment

Rate of return the financial benefit gained from investment of savings; expressed in percentage terms

Return or yield the total financial benefit received (interest and capital gain) from an investment; expressed as a percentage

Risk the possibility or probability that an actual outcome will vary from the expected outcome; uncertainty

Liquidity access to cash and other sources of funds to meet dayto-day expenses and commitments

Time-pattern of cash flows the frequency of periodic cash flows (interest and principal) associated with a financial instrument

Asset portfolio a combination of assets, each comprising attributes of return, risk, liquidity and timing of cash flows

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Part 1 Financial institutions Portfolio structuring the buying and selling of assets and liabilities to best meet current savings, investment and funding needs

Monetary policy actions of a central bank that influence the level of interest rates in order to achieve economic outcomes; primary target is inflation

more likely to be directed to the most efficient users of those funds. This outcome further enhances the rate of economic growth. Since typical savers will seek to maximise their return, subject to their preferred level of risk, liquidity and the time-pattern of cash flows, they should be expected to invest their funds with users that show a high probability of meeting those expectations, such as by investing in corporations that use funds to produce goods and services that are in demand in the marketplace. Another important function of a financial system is its role in the implementation of monetary policy. Monetary policy relates to the actions of a central bank that are taken to influence the level of interest rates in the financial system. The current monetary policy stance of central banks in developed countries is to maintain the level of inflation within a specified level. Inflation is the increase in the price for goods and services within an economy. By targeting the level of inflation, a central bank seeks to achieve a range of economic objectives, such as increased employment and the stability of the exchange rate of the currency.

REFLECTION POINTS

financial system comprises financial institutions, financial instruments and financial markets. • AOverseeing a financial system are the central bank and prudential supervisor. financial asset incorporates four main attributes: return, risk, liquidity and time-pattern of cash • Aflows. wide range of financial products available in a financial system facilitates portfolio • The structuring. financial system provides economic and financial information to the markets; that information • Ashould be timely and accurate. efficient financial system rapidly absorbs and reflects new information into the price of • An financial instruments. efficient financial system encourages savings and allocates those savings to the most • An efficient users of funds. central bank uses the financial system to implement monetary policy in order to target the • The level of inflation and achieve certain economic objectives.

Inflation an increase in prices of goods and services over time; measured by the consumer price index (CPI)

Depository financial institutions accept deposits and provide loans to customers (e.g. commercial banks, credit unions)

Investment banks specialist providers of financial and advisory services to corporations, high-networth individuals and government

Most of you have carried out transactions with one or more financial institutions. For example, you may have opened a deposit account with your local bank, applied for a loan from that bank or obtained a credit card facility. Also, you may have entered into an insurance contract for motor vehicle insurance, medical insurance, travel insurance or life insurance with an insurance office. There is a very wide range of financial institutions operating in the financial system. While some institutions offer similar products and services, typically institutions tend to specialise in areas where they have greater expertise. We will discuss the different types of institutions in detail in Chapters 2 and  3. In this chapter, we simply classify financial institutions into five categories based on the differences between the institutions’ sources of funds and uses of funds. 1 Depository financial institutions obtain a large proportion of their funds from deposits lodged by savers. Examples include deposits placed in demand deposit accounts or term deposit accounts with commercial banks, building societies and credit cooperatives. A principal business of these institutions is the provision of loans to borrowers in the household and business sectors. 2 Investment banks generally focus on the provision of advisory services for their corporate and government clients. This includes advising clients on mergers and acquisitions, portfolio restructuring and financial risk management. These institutions may provide some loans to clients but are more likely to advise and assist a client to raise funds directly from the capital markets.

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3 Contractual savings institutions are financial institutions such as life insurance offices, general insurers and superannuation funds. Their liabilities are mainly contracts which specify that, in return for periodic payments made to the institution, the institution will make specified payouts to the holder of the contract if and when an event specified in the contract occurs. The periodic cash receipts received by these institutions provide them with a large pool of funds that they invest. Payouts made by these institutions include payments for claims made on an insurance policy, or payment to a superannuation fund member on their retirement from the workforce.

Contractual savings institutions

4 Finance companies and general financiers raise funds by issuing financial instruments such as commercial paper, medium-term notes and bonds in the money markets and the capital markets. They use those funds to make loans and provide lease finance to their customers in the household sector and the business sector.

borrow funds directly from markets to provide loans and lease finance to customers

5 Unit trusts are formed under a trust deed and are controlled and managed by a trustee or responsible entity. Unit trusts attract funds by inviting the public to purchase units in a trust. The funds obtained from the sale of units are pooled and then invested by funds managers in asset classes specified in the trust deed. Trusts generally specialise in certain categories of investments, including equity trusts, property trusts, fixed-interest trusts and mortgage trusts.

offer financial contracts such as insurance and superannuation; large investors

Finance companies and general financiers

Unit trusts investors buy units issued by the trust; pooled funds invested (e.g. equity trusts and property trusts)

Table 1.1 shows the total assets of the various Australian financial institutions in June 1990, June 2008 and March 2018. The Australian financial system has rapidly evolved over this period in response to significant changes that have occurred, including regulatory change, internationalisation of the financial markets and the application of technology to the development of new financial products and information systems. As can be seen, there has been an enormous growth in assets held within the financial system. This is not restricted to the Australian market, as international markets have also shown considerable growth.

Table 1.1 Assets of financial institutions, Australia ($ billions) Financial institution

1990

% total assets

Reserve Bank

  24.9

 3.4

Commercial banks

325.8

Building societies

% total assets

2018

% total assets

93.7

  2.2

   183.4

2.36

43.8

2 239.5

52.0

4 224.4

54.49

  22.9

  3.1

21.7

  0.5

    12.1

0.0015

Credit unions

    8.7

  1.2

41.6

1.0

    37.1

0.0047

Money-market corporations

  53.6

  7.2

113.5

  2.6

    30.9

0.0039

Finance companies and general financiers

55.5

  7.5

130.7

  3.0

  153.7

1.98

Life insurance offices

85.3

11.5

184.8

  4.3

  176.1

2.27

Superannuation funds

80.8

10.8

752.2

17.5

2 208.2

28.48

Cash management trusts

4.7

  0.6

46.2

1.1

    35.5

4.57

Common funds

7.0

  0.9

11.6

0.3

9.7

0.0012

Friendly societies

8.1

  1.1

4.1

0.1

5.6

0.0007

Public unit trusts

27.7

  3.7

272.1

6.3

  326.7

4.21

General insurance offices

32.5

  4.4

130.0

3.0

216.6

2.79

5.7

  0.8

263.9

6.1

132.7

1.71

Securitisation vehicles Total

743.2

2008

4 305.6

7 752.7 

SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.

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Some generalisations that emerge from Table 1.1 include:

• Total assets of the financial institutions increased more than tenfold over the period, to $7752.7 billion.

• Commercial banks account for the largest share of the assets of financial institutions, at 54.49 per cent. However, this figure does not fully represent the full extent of commercial banks’ influence, as these institutions also participate in a range of activities that are not recorded directly on the banks’ balance sheets (e.g. their managed funds activities).

• The importance of building societies significantly declined as changes in regulation allowed most of the larger societies to become commercial banks.

• The activity of finance companies contracted as the impact of financial deregulation, greater

competition and the absorption of some finance companies into their parent banks took effect.

• The percentage of life insurance offices’ share of total assets declined over the period. However, this was offset by significant increases in their managed funds activities, particularly superannuation products.

• The percentage share of superannuation assets increased to 28.48 per cent. Factors influencing

this growth were an ageing population saving for retirement, the introduction of compulsory superannuation and the introduction of taxation incentives for superannuation savings.

Securitisation non-liquid assets are sold into a trust; the trustee issues new securities; cash flows from the original securities are used to repay the new securities

• Securitisation vehicles showed enormous relative growth up until the onset of the GFC. The

ensuing severe tightening of the availability of credit in the capital markets—resulting, in part, from problems with securitised assets that were backed by sub-prime mortgage assets—has seen new securitisation issues subsequently almost disappear and the percentage share of securitised assets decline to just 1.71 per cent. Securitisation is discussed in the extended learning section at the end of Chapter 10, but can be briefly described as a process whereby an organisation, such as a bank, sells existing balance-sheet assets, such as housing loans, thereby generating new cash flows.

REFLECTION POINTS

institutions may be classified into five categories based on their sources of funds and • Financial uses of funds. financial institutions, such as commercial banks, gather savings from depositors and • Depository provide loans to customers. (Commercial banks also provide a wide range of other financial services.) banks do not have a depositor base; they specialise in the provision of advisory • Investment services to clients (e.g. merger and acquisition advice). savings institutions, such as insurance offices and superannuation funds, • Contractual gather savings from the sale of insurance contracts and from superannuation contributions respectively, and make payouts on the occurrence of specified events (e.g. a car accident or retirement from the workforce). companies raise funds directly from the money markets and capital markets, and • Finance provide loans and lease finance to customers. trusts sell units in a trust and invest those funds in assets specified in the trust deed; for • Unit example, an equity trust would invest in certain types of shares.

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1.3

Financial instruments

When a user of funds obtains finance from the provider of funds, the user must prepare a legal document that clearly defines the contractual arrangement. This document is known as a financial instrument: it acknowledges a financial commitment and represents an entitlement to future cash flows. The financial instrument becomes a financial asset on the balance sheet of the provider of funds. If the financial asset represents debt that will be repaid, then it also appears as a liability on the balance sheet of the borrower; however, if it represents equity, it will appear as part of shareholder funds. For example, if a bank customer deposits funds in a term deposit, the bank will acknowledge this deposit and issue a receipt that will specify the amount of funds provided, the maturity date when the funds will be repaid, the rate of interest to be paid and the timing of interest payments. The terms and conditions specified in a financial security can vary significantly. For example, a loan agreement may include an interest rate that is fixed for the term of the loan, while another loan may have a variable rate of interest that can change on certain dates. One loan may require monthly payments of interest and principal, while another loan may require half-yearly interest payments with principal only repaid at maturity. Savers, as the providers of funds, will purchase financial assets that have attributes of risk, return, liquidity and cash flows that meet their particular needs. In the financial markets, the saver is said to buy the ‘paper’ of the issuer. Financial instruments may be divided into three broad categories: equity (including hybrid instruments), debt and derivatives. These three categories reflect the nature and main characteristics of financial instruments.

1.3.1

LEARNING OBJECTIVE 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity, debt, hybrids and derivatives.

E QUITY

Equity can take a number of forms. For example, if you buy a new car by paying a deposit from your own funds and borrowing the remainder from a bank, your equity in the car is the amount of the deposit paid. As you progressively repay the loan to the bank, your level of equity in the car will increase. Equity can therefore be described as an ownership interest in an asset. Within the context of the discussions in this text, equity in a business corporation is represented through the ownership of shares issued by a corporation. The principal form of equity issued by a corporation is an ordinary share or common stock. As we will discuss in detail in Part 2, larger corporations list their shares on the stock exchange. Ordinary shares have no maturity date; they continue for the life of the corporation. However, as the shares are listed on the stock exchange, they may be sold to other investors at the current market price. An ordinary shareholder is entitled to share in the profits of the business. Shareholders generally receive a portion of the profits of the company in the form of dividend payments. (This is discussed in Part 2.) The value of a corporation’s shares may increase over time, representing a capital gain. In the event of the failure of a corporation, however, shareholders are entitled to the residual value of the assets of the corporation (if any remain), but only after the claims of all other creditors and security holders have been paid. The owners of ordinary shares have the right to vote at general meetings, in particular for the election of members of the board of directors of the company. Another form of equity is known as a hybrid security. A hybrid security may be described as having the characteristics of both equity and debt (see below). Preference shares are an example of hybrid securities. Preference shares, while being a form of equity finance, have many characteristics in common with debt instruments. For example, the holders are entitled to receive a specified fixed dividend for a defined period, similar to a fixed-interest payment. The fixed dividend must be paid before any dividend is made to ordinary shareholders. Preference shareholders also rank ahead of ordinary shareholders in their claim on the assets of the corporation should the company be wound up or placed into liquidation.

Equity the sum of the financial interest an investor has in an asset; an ownership position

Ordinary share or common stock the principal form of equity issued by a corporation; bestows certain rights to the shareholder

Dividend that part of a corporation’s profit that is distributed to shareholders

Hybrid security a financial instrument that incorporates the characteristics of both debt and equity (e.g. preference shares)

Liquidation the legal process of winding up the affairs of a company in financial distress

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The issue of hybrid securities, or quasi-equity instruments, has become an increasingly important means by which corporations raise additional equity funding. These instruments are discussed in detail in Chapter 5. The equity markets are discussed in much more detail in Part 2.

1.3.2

Debt instruments specify conditions of a loan agreement: issuer/ borrower, amount, return, timing of cash flows, maturity date; debt must be repaid

Secured debt a debt instrument that provides the lender with a claim over specified assets if the borrower defaults

Negotiable debt instrument a debt instrument that can be sold by the original lender through a financial market

Derivative instrument a synthetic security that derives its price from a physical market commodity or security; mainly used to manage risk exposures

Futures contract an exchange-traded agreement to buy or sell a specific commodity or financial instrument at a specific price at a predetermined future date

D EBT

A debt is a loan that must be repaid. Debt instruments represent a contractual claim against an issuer, and require the borrower to make specified payments, such as periodic interest payments and principal repayments, over a defined period. The types of debt instruments issued by a corporation include debentures, unsecured notes, term loans, commercial bills, promissory notes, overdrafts and mortgage loans. These types of debt instruments are discussed in detail in Part 3 of the text. However, when we discuss the financial markets later in this chapter, we will introduce the money markets and the capital markets. Debentures and unsecured notes are longer-term debt instruments issued into the capital markets, while commercial bills and promissory notes are short-term instruments issued into the money markets. Term loans, mortgage loans and overdrafts are generally provided by financial institutions. Government debt instruments are Treasury bonds and Treasury notes (T-notes); these are examined in Part 4. Debt instruments entitle the holder to a claim (ahead of equity holders) to the income stream produced by the borrower and to the assets of the borrower if the borrower defaults on loan repayments. Debt can be divided into two subcategories on the basis of the nature of the loan contract: secured debt and unsecured debt. A secured debt contract will specify the assets of the borrower, or a third party, pledged as security or collateral. If the borrower defaults on the loan, the lender is entitled to take possession of those assets to recover the amount owing. In other cases, a loan may be made on an unsecured basis. Another subdivision of debt is based on the transferability of ownership of the instrument. Negotiable debt instruments are those that can easily be sold and transferred from one owner to another. Commercial bills are an example of negotiable debt instruments that can be sold in the money markets (Chapter 9). Non-negotiable instruments are instruments that cannot be transferred from one party to another. A term loan obtained through a bank is generally non-negotiable. Corporate debt is discussed in Part 3 and government debt in Part 4.

1.3.3

D ERIVATIVES

A third class of instrument has become significant in the financial markets: the derivative instrument. Derivative contracts are primarily used to manage an exposure to an identified risk. For example, a borrower might be concerned that interest rates on existing debt funding may rise in the future. The borrower can accept this forecast risk, or seek to reduce that risk exposure by locking in an interest rate today. One way the borrower can lock in an interest rate is through the use of derivative contracts. There is a wide range of derivative contracts for the management of risk exposure related to commodities (such as gold and oil) and financial instruments (such as interest-rate-sensitive debt, currencies and equities). Therefore, financial derivatives may be used to manage risk exposures related to both equity and debt. There are four basic types of derivative contracts: futures, forwards, options and swaps: 1 A futures contract is a contract to buy (or sell) a specified amount of a commodity or financial instrument at a price determined today for delivery or payment at a future date. Futures contracts are standardised contracts that are traded through a futures exchange. Futures contracts are discussed in Chapters 18 and 19.

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2 A forward contract is similar to a futures contract but is typically more flexible and is negotiated over the counter with a commercial bank or investment bank. A forward foreign exchange contract establishes a foreign currency exchange rate that will apply at a specified date. A forward rate agreement is used to lock in an interest rate today that will apply at a specified date. Forward contracts are discussed in Chapters 17, 18 and 19. 3 An option contract gives the buyer of the option the right—but not an obligation—to buy (or sell) the designated asset at a specified date or within a specified period during the life of the contract, at a predetermined price. The fact that the buyer is not obliged to proceed with the contract is valuable, and therefore the buyer must pay a premium to the writer of the option. Option contracts are discussed in Chapters 18 and 20. 4 A swap contract is an arrangement to exchange specified future cash flows. With an interest rate swap there is an exchange (swap) of future interest payments based on a notional principal amount. A currency swap is denominated in a foreign currency and fixes the exchange rate at which the initial and final principal amounts are swapped. Ongoing interest payments are also swapped at the same exchange rate. Swap contracts are discussed in Chapters 18 and 21. Derivative instruments are different from equity and debt in that they do not provide actual funds for the issuer. Funds need to be raised in either the equity or debt markets. Risks associated with equity or debt issues may be managed using derivative contracts. For example, an investor might be concerned that the value of shares held in an investment portfolio might fall. The investor might enter into a derivative contract that gives the investor the option to sell shares at a specified date at a price that is agreed today. If the share price does fall, the investor will exercise the option and sell at the agreed higher price.

Forward contract an over-the-counter agreement that locks in a price (interest rate or exchange rate) that will apply at a future date

Option contract the right, but not the obligation, to buy or sell a commodity or security at a predetermined exercise price; the option buyer pays a premium to the option writer

Swap contract an agreement between two parties to swap future cash flows; interest rate swaps and currency swaps

REFLECTION POINTS

principal form of equity issued by a publicly listed corporation is the ordinary share or • The common stock. shares entitle the shareholder to share in the profits of the company, either through • Ordinary the receipt of dividends or through capital gains, and provide certain voting rights. hybrid security, such as a preference share, incorporates the characteristics of both debt and • Aequity. basic characteristic of debt is that it must be repaid. The debt holder is entitled to receive • The cash flows specified in the debt instrument (e.g. interest payments and principal repayment). Debt may be secured or unsecured. derivative contract is designed to facilitate the management of risk (e.g. interest rate risk). • ATypes of derivative products are futures, forwards, options and swaps.

1.4

Financial markets

We now introduce the third component of a financial system, being the financial markets. You gained a basic understanding of the financial institutions and instruments earlier in the chapter; now, once you understand the structure of the financial markets, you should have a good grasp of the integrated functions of the markets and the importance of the financial system to economic growth within a country. In this chapter, we begin by categorising the markets according to the types of transactions

LEARNING OBJECTIVE 1.4 Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary markets, direct finance and intermediated finance.

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that occur within each market. Later in the textbook we will discuss in detail the institutions and instruments that prevail in each of the financial markets. This section considers:

• the matching principle • primary and secondary markets • direct and intermediated financial flow markets • wholesale and retail markets • money markets • capital markets. 1.4.1 Matching principle short-term assets should be funded with short-term liabilities; longer-term assets should be funded with longer-term liabilities and equity

Overdraft facility a fluctuating credit facility provided by a bank; allows a business operating account to go into debit up to an agreed limit

Bonds a long-term debt instrument issued directly into the capital markets that pays the bondholder periodic interest coupons and the principal is repaid at maturity

The matching principle is one of the fundamental reasons for the existence of a wide range of financial instruments and markets. The principle contends that short-term assets such as working capital and inventories should be funded with short-term liabilities. For example, if a company is purchasing stock (asset) that will remain in the company for just a short period of time before the product is sold, the company should need only a short-term loan (liability) to fund the purchase of the stock. An example of a short-term loan that can be used for this purpose is an overdraft facility (see Chapter 9). The matching principle goes on to state that longer-term assets should be funded with equity and long-term liabilities. For example, a company may purchase a new factory and manufacturing equipment, and it is expected that these assets will generate income for the next 10 years. To fund the purchase, the company should issue equity and/or long-term debt such as bonds (see Chapter 10). The money markets and capital markets trade short-term and long-term financial instruments respectively, and therefore allow borrowers to apply the matching principle in relation to funding. A borrower is able to match the cash flows associated with a source of funds (liabilities) closely with the cash flows generated from the use of funds over the life of a particular asset. While the matching principle may be regarded as a fundamental principle of finance, it is interesting to note how often this principle is disregarded. For example, at the onset of the GFC, short-term finance available through the money markets virtually ceased as a result of uncertainty in relation to risk deriving from the so-called sub-prime market collapse. Quite a number of financial institutions had been funding longer-term instruments with short-term finance in the money markets. When this source of finance was suddenly no longer available, the institutions experienced a significant liquidity problem and some institutions failed or were taken over. They forgot the fundamentals!

1.4.2

Primary market transaction the issue of a new financial instrument; funds are obtained by the issuer

Money a commodity that is universally accepted as a medium of exchange

M ATCHING PRINCIPLE

P RIMARY AND SECONDARY MARKET TRANSACTIONS

The concept of primary markets and secondary markets is quite simple, but their role in ensuring the efficiency of the financial markets is very important indeed. A primary market transaction occurs when businesses, governments and individuals issue financial instruments in the money markets and capital markets. For example, when a corporation issues additional ordinary shares to raise equity funding for a proposed investment project, it is conducting a primary market transaction in the capital markets. Similarly, if the government sells new long-term bonds in order to finance spending on capital works, health or education, this is a primary market transaction. Individuals who borrow money from a bank to finance the purchase of a house are also participating in a primary market transaction. The distinguishing characteristic of a primary market transaction is that it creates a new financial instrument. Primary market flows and relationships are illustrated in Figure 1.2.

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Figure 1.2  Primary market transactions Suppliers of funds

supply funds

(surplus units)

Users of funds (deficit units)

Issue ‘new’ financial instruments (debt or equity) to the suppliers of funds

Use funds to acquire goods, services or assets

In contrast, secondary market transactions involve transactions with existing financial instruments. Instruments traded in the secondary markets are those that were initially created in primary market transactions. For example, consider an investor who buys shares (equity) issued by a corporation. These primary market flows are shown in Figure 1.2. If the holder of those shares now decides to sell them, the sale of the shares is regarded as a secondary market transaction. Figure 1.3 illustrates the flows involved in secondary market transactions.

Secondary market transaction the buying and selling of existing financial securities; transfer of ownership; no new funds raised by issuer

Figure 1.3  Secondary market transactions Surplus entity 1 Holders of previously issued financial instruments

sell marketable securities to

Surplus entity 2 Surplus entity n

and receive market value

Secondary market transactions have no direct impact on the amount of funding raised or available to the company that was the initial issuer of a financial instrument; that is, the company receives no extra funds from the secondary market transaction. A secondary market transaction is simply a transfer of ownership from one party to another party. However, the existence of well-developed secondary markets has important impacts on the marketability of new primary market financial instruments or securities. Secondary market transactions help overcome two potential obstacles that may stand in the way of savers providing funds for the financing of long-term capital investment. These are the savers’ preferences for liquidity and their aversion to risk. Without an active secondary market, purchasers of new-issue instruments would be required to hold those long-term instruments until they mature. In the case of equity, the problem would be even greater as there is generally no maturity date. A deep and liquid secondary market solves this problem by providing markets where these instruments can be bought and sold. A deep and liquid secondary market is one where there are many buyers and sellers in the market. Economic growth (and the benefits, such as increased employment, that flow to the community from that growth) is critically reliant on the existence of strong primary markets. Primary market transactions allow corporations and governments to raise new funding that leads to increased capital and productive investment. Secondary markets, while not directly involved in the process of channelling funds from savers to users of funds, encourage both savings and investment because they enhance the marketability and liquidity of primary-issue instruments, thus making them more attractive to savers. 15

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Securities financial assets that are traded in a formal secondary market (e.g. stock exchange)

It will be useful to introduce and explain some market terminology at this stage. A financial asset has already been defined as an entitlement to future cash flows. A financial instrument is the more general term used in the markets to describe instruments where there is no organised secondary market where that instrument can be traded. The market also describes a number of financial instruments as securities. A security is the term used to describe a financial asset that can be traded in an organised secondary market such as a stock exchange or a futures exchange. An example of a financial instrument is a bank term deposit, and an example of a security is an ordinary share in a publicly listed company. Both are financial assets.

1.4.3

D IRECT FINANCE AND INTERMEDIATED FINANCE

The issue of new financial instruments generates a flow of funds through the primary markets from the provider of funds to the user of those funds. This flow can occur in two ways:

• The funds may flow through a direct relationship from the provider of funds to the user of funds. • The flow of funds may occur through a financial intermediary such as a bank. Within the financial markets, each form of financial flow is an important source of finance.

Direct finance Direct finance funding obtained directly from the money markets and capital markets

When funds are raised in the primary markets using direct finance, the contractual agreement is between the provider of funds and the user of funds. The funds are not provided by a financial institution. The relationships that exist between savers and the users of funds in the provision of direct finance are shown in Figure 1.4.

Figure 1.4  Direct financial flows Suppliers of funds

provide funds

(surplus units)

Users of funds (deficit units)

Brokers and dealers Financial instruments

Broker an agent who carries out the instructions of a client

Dealer makes a market in a security by quoting both buy (bid) and sell (offer) prices

Credit rating the assessment by a credit rating agency of the creditworthiness of an obligor to a financial obligation

The ‘brokers and dealers’ included in Figure 1.4 may act as agents through which the instructions of the providers of funds and users of the funds are carried out. The broker does not provide the finance, but receives a fee or commission for arranging the transaction between the two parties. The broker has no rights to the benefits that may flow from the purchase of the security. It is not necessary for a broker or dealer to be involved at all in the transaction. An investor seeking to purchase shares in a company will generally arrange the transaction through a stockbroker. The stockbroker acts only as an agent to the transaction and, on behalf of a client, facilitates the direct purchase or sale of shares by accessing the electronic share trading systems of the stock exchange. Examples of direct financing include share issues, corporate bonds and government securities. These securities are discussed further in various chapters of the text.

The benefits and disadvantages of direct finance Direct finance is generally available only to corporations and government authorities that have established a good credit rating. A credit rating is an assessment of the creditworthiness of an issuer of

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paper. As the contractual relationship in direct finance is directly between the provider of funds and the issuer of paper, the risk that the issuer may default is an important consideration. Therefore, borrowers that do not have an established good credit rating generally are not able to borrow direct. The credit rating process is discussed in Chapter 11. The main advantages of direct finance are as follows:

• It removes the cost of a financial intermediary. If a borrower obtains a loan from a financial

institution, the borrower will pay a profit margin to the intermediary. Should a corporation or government authority have an investment-grade credit rating (e.g. Standard & Poor’s BBB and above), it may well be able to raise funds directly from the domestic or international markets at a lower total cost than borrowing through a bank.

• It allows a borrower to diversify funding sources by accessing both the domestic and international money and capital markets. This reduces the risk of exposure to a single funding source or market.

• It enables greater flexibility in the types of funding instruments used to meet different financing

needs. More sophisticated funding strategies may be used to raise funds. For example, a corporation may obtain a US dollar (USD) loan in the international capital markets and then use USD export income to repay the loan.

• An

organisation may enhance its international profile by carrying out transactions in the international financial markets. An increased profile in the financial markets may be beneficial in establishing a reputation in the markets for the firm’s goods and services.

There are some disadvantages that may, at times, be associated with direct financing. These include: • There can be a problem of matching the preferences of lenders and borrowers. For example, a lender may have a certain amount of funds available for investment, but this amount may not be sufficient for the needs of the borrower, who would then need to seek out and enter into funding arrangements with additional suppliers of funds. There may also be a mismatch in the maturity structure of the funding as the borrower may need to borrow for a longer period than the risk-averse investor is willing to lend.

• The liquidity and marketability of a direct finance instrument may be of concern. How easy is it for

the holder of an instrument issued by direct finance to sell at a later date? Is there a deep and liquid secondary market in that instrument? Not all financial instruments have an active secondary market through which they may be sold.

• The search and transaction costs associated with a direct issue can be quite high. These might include

advisory fees, the cost of preparing a prospectus, legal fees, taxation advice, accounting advice and specific expert advice (such as a geologist’s report). On very large direct finance transactions the fees and costs may run into millions of dollars.

• It can be difficult to assess the level of risk of investment in a direct issue, particularly default risk. Accounting and reporting standards may vary between nation-states, and information about an issuer may be limited to the prospectus and the issuer’s credit rating.

Intermediated finance The critical difference between direct and intermediated finance can be found in the relationships that exist between the saver, the intermediary and the user of funds. With intermediated finance, as illustrated in Figure 1.5, the intermediary has an active role in the relationship. The intermediary, in providing finance to deficit units, acquires the ownership of the financial instrument that is created as part of the transaction. It also obtains the rights to the benefits and risks associated with the ownership of that asset. The benefits include the receipt of interest payments and the repayment of principal. On the other hand, a significant risk accepted by the intermediary is default or credit risk—that is, the risk that the borrower may not make all loan repayments.

Default risk the risk that a borrower may not meet financial commitments such as loan repayments when they are due

Intermediated finance financial transaction conducted with a financial intermediary (e.g. bank deposits and bank loans); separate contractual agreements

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Figure 1.5  Intermediated financial flows Suppliers of funds

funds

(surplus units)

Intermediaries

Financial instrument

funds

Users of funds (deficit units)

Financial instrument

In order to be able to provide loans to its customers, an intermediary obtains its funding from savers. Savers receive financial instruments issued by the intermediary, such as a term deposit receipt issued by a bank. A contractual agreement then exists between the saver and the intermediary in relation to the term deposit. The intermediary creates a separate contractual agreement with the borrower (the ultimate user of funds). The saver has no claim on the income or assets of the ultimate borrower. Those entitlements reside with the bank as the intermediary. The saver only has a claim for the payment of interest and the return of principal at maturity from the bank. On the other hand, under a separate loan contract, the intermediary relies on the borrower for repayment of the loan. Failure of the bank to recover the funds from the borrower does not change the contractual relationship the bank has with its depositor.

The benefits of financial intermediation Very often the portfolio preferences of savers and borrowers differ. For example, a risk-averse lender may be prepared to receive a lower rate of return in exchange for maintaining funds at call. On the other hand, a borrower may be prepared to pay a higher rate of return, but may want to have the funds available for a number of years. It is likely that many savers and borrowers would find it difficult to meet their investment and funding needs if only direct finance was possible. An intermediary is able to resolve this problem and satisfy the preferences of both parties, and at the same time make a profit. An intermediary is able to transform short-term deposit funds into longerterm loan funds. An essential economic role of an intermediary is to resolve the conflicting preferences of surplus units and deficit units, and thus encourage both savings and productive capital investment. In carrying out the role of offering instruments with varying financial attributes (risk, return, liquidity, timing of cash flows), intermediaries perform a range of functions that are important to both savers and borrowers. These are:

• asset transformation • maturity transformation • credit risk diversification and transformation • liquidity transformation • economies of scale. Asset transformation Asset transformation the ability of financial intermediaries to provide a range of products that meet customers’ portfolio preferences

Financial intermediaries engage in asset transformation by offering their customers a wide range of financial products on both sides of the balance sheet, including deposit, investment and loan products. Without intermediation, surplus units that could generate only small levels of savings would not have any incentive to save; and users of funds, such as individuals and small businesses, would find the cost of obtaining loans too great to be worthwhile. Intermediaries specialise in the gathering of savings and can achieve economies of scale in their operations. They can profitably receive small amounts from many savers, pool them into larger amounts and make them available as loans to borrowers. Financial intermediaries provide a range of deposit products which meet the varying preferences and need of their customers. These include demand deposit accounts, current accounts, term deposits

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and cash management trusts. At the same time, financial intermediaries provide a range of loan products, including overdraft facilities, term loans, mortgage loans and credit card facilities.

Maturity transformation Most frequently, savers prefer great liquidity in their financial assets, while borrowers tend to prefer a longer-term commitment in the funds they borrow. By managing the deposits they receive, intermediaries are able to make loans of a longer-term nature while satisfying savers’ preferences for shorter-term savings. This is referred to as maturity transformation. Banks provide a good example of the maturity transformation function of intermediaries. The deposits they receive are generally quite short term in nature (typically less than five years), yet a large proportion of their lending is for home loans that frequently have a maturity of 30 years. The banks therefore have a mismatch between the terms to maturity of a large proportion of their sources of funds and their loan liabilities. Financial intermediaries are able to perform such extremes of maturity transformation for two reasons. First, it is unlikely that all savers would choose to withdraw their deposits at the same time. Deposit withdrawals during any particular period are generally more or less matched by new deposits. Second, and more importantly, financial intermediaries that engage in maturity transformation rely on liability management. Should a bank’s deposit base (liabilities) begin to decline below the level necessary to fund their forecast loan portfolio (assets), then the bank may adjust the interest rates that it offers in order to attract the necessary additional deposits. More probably, the bank will issue further securities (liabilities) directly into the money or capital markets to raise the additional funds required.

Maturity transformation financial intermediaries offer products with a range of terms to maturity

Liability management when banks actively manage their sources of funds (liabilities) in order to meet future loan demands (assets)

Credit risk diversification and transformation Credit risk transformation occurs through the contractual agreements of intermediation. A saver has an agreement with the financial intermediary, and therefore the credit risk exposure of the saver is limited to the risk of the intermediary defaulting. The financial intermediary has a separate loan agreement with the borrower and is exposed to the credit risk of the borrower. Financial intermediaries have two advantages over most individual savers in managing investments. First, intermediaries specialise in making loans and therefore develop an expertise in assessing the risk of potential borrowers. This expertise comes from the technical skills of the employees and systems in assessing and monitoring loan applications, and also from the information that is acquired through prior dealings with the borrower.

Credit risk transformation a saver’s credit risk exposure is limited to the intermediary; the intermediary is exposed to the credit risk of the ultimate borrower

Liquidity transformation Savers generally prefer more, rather than less, liquidity in their investments. One reason for this is that the timing of a saver’s income and expenditure flows will not perfectly coincide. There are times when income is higher than expenditure and savings are available for investment purposes. On the other hand, there are times when expenditure exceeds income. In order to try and manage this timing problem, savers will tend to hold at least some of their financial assets in a very liquid form that can easily be converted to cash. Liquidity transformation is measured by the ability to convert financial assets into cash at something close to the current market price of the financial instrument. However, liquidity has another dimension: the transaction costs associated with acquiring and disposing of the financial asset. Transaction costs can often be quite high. However, a financial intermediary may have the capacity to lower transaction fees by spreading fixed costs across a large number of transactions. The time involved in carrying out a transaction may also be an important component of the total transaction cost. Many intermediaries provide highly liquid accounts in which individuals may store some of their wealth. For example, a demand (at-call) account with a bank represents complete liquidity. The depositor has the right to withdraw funds without notice. There is zero risk that the value of the asset, when it is converted into cash, will be less than the value of the deposit in the demand account. In addition, the transaction costs associated with converting the credit balance into cash are limited to

Liquidity transformation measured by the ability of a saver to convert a financial instrument into cash

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transaction fees imposed by the bank. Intermediaries such as commercial banks can offer highly liquid assets to savers, which the ultimate users of funds would be most unlikely to be able to do. Banks have further extended liquidity arrangements by adopting systems such as electronic networks: automatic teller machines (ATMs) and electronic funds transfer at point of sale (EFTPOS) arrangements.

Economies of scale Economies of scale financial and operational benefits gained from organisational size, expertise and volume of business

Financial intermediaries gain considerable economies of scale due to their size and the volume of business transacted, and therefore have the resources to develop cost-efficient distribution systems. Banks maintain extensive branch networks as their primary distribution mechanism. At the same time they also provide extensive technology-based distribution systems such as ATMs, EFTPOS, telephone banking and internet banking. The cost of the sophisticated computer and communication systems required to support such distribution networks is spread over the millions of transactions processed. Intermediaries also obtain cost advantages through effective knowledge management and the accumulation of financial, economic and legal expertise. For example, a bank will typically use standardised documentation for its deposit and lending products. The bank knows that these documents will comply with regulatory and legal requirements. Other cost advantages include a reduction in search costs for both savers and borrowers; that is, savers do not need to investigate the creditworthiness of the ultimate borrower. The intermediary will have that data available before making a loan decision. In a competitive market, financial intermediaries should pass on efficiency gains in the form of reduced interest margins and fees.

1.4.4 LEARNING OBJECTIVE 1.5 Distinguish between various financial market structures, including wholesale markets and retail markets, and money markets and capital markets.

Wholesale market direct financial flow transactions between institutional investors and borrowers

Retail market financial transactions conducted with financial intermediaries mainly by individuals and small to medium-sized businesses

W HOLESALE AND RETAIL MARKETS

Direct financial transactions between institutional investors and borrowers are described as wholesale market transactions. Institutional investors include commercial banks, insurance offices, superannuation funds, investment banks, fund managers, finance companies, building societies, credit unions, government authorities and large corporations. Transactions conducted in the wholesale markets typically range from the tens of thousands of dollars to the millions of dollars. For example, a portfolio manager may purchase a $50 000 wholesale managed fund for a client while a financial institution might sell $10 million worth of commercial bills into the money market. The cost of wholesale funds is determined by a range of factors, such as the level of liquidity (surplus funds) within the financial system, future interest rate expectations and the maturity structure of investment opportunities. For example, large amounts of short-term funds are invested overnight in the money markets. Generally, wholesale investors are able to accumulate large quantities of surplus funds and use their market power and investment skills to obtain higher returns than would normally be available in the retail market. At the same time, wholesale market borrowers are able to use their good credit standing in the markets to obtain access to those funds. The retail market, on the other hand, comprises transactions primarily of individuals and small to medium-sized businesses. Transactions are principally conducted with financial intermediaries. Market participants are price takers; that is, the financial intermediary is able to set both deposit and lending rates of interest. Retail market participants are not totally excluded from the wholesale markets. They are able to gain indirect access to the wholesale markets through managed investment products such as cash management accounts and unit trusts. These are discussed in Chapter 3.

1.4.5

M ONEY MARKETS

The financial markets may be categorised according to the characteristics of the financial instruments that are traded in the markets. Within the debt and equity markets, the two main market classifications are the money markets and the capital markets. The money markets and the capital markets include 20

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a number of submarkets (see below). Other markets, such as the foreign exchange market and the derivatives market, also form part of the financial system. Money market transactions involve wholesale short-term-to-maturity securities of less than 12 months. As discussed below, medium- to long-term-to-maturity transactions are referred to as capital-market transactions. Figure 1.6 depicts the structure of the money markets and the capital markets. You will note that each market incorporates primary and secondary markets within both the domestic and the international markets.

Money markets wholesale markets in which short-term securities are issued and traded

Figure 1.6  Structure of the money and capital markets

Financial markets

Money markets

Primary money markets

Secondary money markets

Capital markets

Primary capital markets

(maturities to one year)

(residual maturities to one year)

(new shares and longterm debt issues)

Domestic short-term money markets

International short-term money markets

Domestic capital markets

Secondary capital markets (trading in existing securities)

International capital markets

The money markets bring together institutional investors that have a surplus of funds and those with a short-term shortage of funds. The money markets are attractive to institutional investors for short-term financing arrangements as the markets are (normally) highly liquid and the securities issued in the market are standardised and have well-developed secondary markets. The money markets allow institutional investors, such as commercial banks, insurance offices, superannuation funds, investment banks, funds managers, finance companies, other finance institutions, government authorities and large corporations to manage their short-term financing needs. For example, a large retail sales store may accumulate surplus funds from sales. In order to gain a return, the store needs to invest the surplus funds. However, the store may need to use the funds in a few days to buy more stock. The store knows that it is able to purchase short-term securities in the money markets today that can easily be sold again in a few days when the cash is needed. From the point of view of borrowers, one of the principal functions of the money markets is to enable them to bridge the mismatch between their cash expenditures and their cash receipts. A large corporation may need to raise short-term funds to cover its forecast working-capital requirements over the next three months. The corporation could borrow the funds from a bank, but it may also find that it is able to borrow at a lower yield by issuing short-term securities directly into the money markets. The securities issued may be repaid as the company generates income from its products or services. The money markets have no specific trading location. Money-market transactions are conducted from the business offices of the market participants using computer networks. The money markets

Institutional investors participants in the wholesale markets (e.g. funds managers, insurance offices, banks)

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operate both as primary markets in which new securities are issued and as secondary markets in which existing securities are bought and sold. The major money-market participants and securities issued and traded are listed in Figure 1.7.

Figure 1.7  Money-market participants and instruments Market participants

Money-market instruments

Central bank

Exchange settlement account funds

Commercial banks

Treasury notes

Superannuation funds Investment banks and merchant banks

Government bonds (less than 12 months to maturity)

Finance companies

Commercial bills

Insurance offices

Promissory notes (commercial paper)

Funds managers (including unit trusts)

Deposits (11 am and 24-hour call)

Building societies and credit unions

Negotiable certificates of deposit

Cash management trusts

Interbank loans

Corporations

Repurchase agreements (repos)

Money-market submarkets As indicated in Figure 1.7, the money markets comprise a number of submarkets, including:

• central bank: system liquidity and monetary policy • interbank market • bills market • commercial paper market • negotiable certificates of deposit market. Central bank: system liquidity and monetary policy Central banks use the money markets to carry out transactions that will maintain, or change, the amount of liquidity that is available within the financial system. The amount of daily liquidity in the financial system is affected mainly by government budget surpluses or deficits, official foreign exchange transactions and net sales of government securities. The amount of liquidity in the financial system directly impacts on interest rates in the market. The central bank implements its monetary policy by targeting the cash rate, hence the central bank carries out money-market transactions so that the cash rate remains at its target level. For example, in Australia the central bank is the Reserve Bank of Australia. The Reserve Bank deals regularly, usually daily, in the money markets for the purpose of managing the supply of liquid funds (cash) available to the financial system. The Reserve Bank deals in (buys and sells) Commonwealth Government Securities (CGS) and certain other specified securities of up to one year to maturity, and in repurchase agreements (repos). The Reserve Bank conducts these market operations with members of the Reserve Bank Information and Transfer System (RITS), principally commercial banks and other institutions that participate in the wholesale market for CGS. RITS is an electronic settlement system. Furthermore, the Reserve Bank is responsible for the implementation of monetary policy. Briefly, the main monetary policy objective is to maintain an economic environment whereby inflation remains within a desired range of 2.00 per cent to 3.00 per cent over time. To achieve this, the Reserve Bank seeks 22

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to influence the level of interest rates by targeting the cash rate in the money markets. In an efficient market, it is expected that if the cash rate changes, then this will flow through over time to changes in other interest rates. Changes in interest rates will then impact on economic activity and the level of inflation. System liquidity and monetary policy issues are discussed in Chapter 12.

Interbank market The interbank market facilitates the management of the short-term liquidity needs of the commercial banks. Banks carry out transactions on behalf of their customers and also on their own behalf. Settlement of transactions between the banks occurs through the payments system. In order to effect settlement, each member of the payments system is required to maintain an exchange settlement account with the central bank. An important role of the interbank market is the lending of surplus exchange settlement account funds. These cleared settlement funds are known as same-day funds and are required by the banks to maintain their exchange settlement accounts in credit. The introduction of real-time gross settlement for the clearance of large-value transactions has increased the profile of the interbank market. The operation of the payments system is discussed in Chapter 12.

Interbank market the lending and borrowing of very short-term funds by banks operating in the payments system

Bills market Bills of exchange are short-term discount securities. A discount security is issued today with a face value that is payable at the maturity date. A discount security does not pay interest, but is sold to investors at a price less than the face value. Therefore, the holders of these securities obtain their return on investment from the difference between the price that they pay for the security and the price for which they sell it, or the face value if held to maturity. For example, if a borrower issues a bill with a face value of $1 million, payable in 90 days, and sells the bill today for $980 000, then the return to the investor will be $20 000 if the bill is held to the maturity date. The issuer of the bill has effectively borrowed $980 000 for 90 days at a cost of $20 000. The commercial bills market is the largest component of the money markets, and involves the trading of bank bills and non-bank bills. There is an active secondary market in commercial bills. This allows market participants to manage their maturity preferences. For example, an investor can buy a 90day bill but sell it after seven days. The same bill might be sold several times during its short 90-day life. Commercial bills are discussed in Chapter 9.

Discount securities short-term securities issued with a face value payable at maturity; they do not pay interest; they are sold today at a discount to the face value

Bills market an active money market for the issue and trading of bills of exchange (discount securities)

Commercial paper market Another important segment of the money markets is the issue and trading of promissory notes. It is a market convention to refer to promissory notes as commercial paper. A promissory note is a discount security (similar to a commercial bill). It is issued with a face value that is payable at maturity. As the promissory note does not pay interest, it is sold today for less than the face value. Refer to the example given in the bills market (above). The strength of this market tends to fluctuate with the overall performance of the economy. As promissory notes are often issued on an unsecured basis, only corporations with a good credit rating are able to issue into the market. However, a segment of the market comprises the issue of secured commercial paper supported by asset-backed securities. As mentioned above, this segment of the commercial paper market virtually ceased to operate as a result of the credit crisis associated with the GFC. This occurred because a portion of the asset-backed securities turned out to be sub-prime securities with a high risk of default. Promissory notes (commercial paper) are discussed in Chapter 9.

Commercial paper promissory notes (discount securities) issued into the money market by corporations with a good credit rating

Negotiable certificates of deposit market Negotiable certificates of deposit, more commonly referred to as CDs, are short-term discount securities issued by banks. An example of a discount security is given in the bills market (above). The CD segment of the money markets is a source of liquidity funding for the banks. As a result of increased levels of funds under management, the CD market has become an increasingly important source of liquidity funding, giving the banks flexibility to manage the short-term maturity structure of their balance sheets.

Negotiable certificate of deposit a discount security issued by a bank

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1.4.6 Capital markets markets for longerterm funding; includes equity, corporate debt and government debt, and is supported by the foreign exchange and derivatives markets

C APITAL MARKETS

Capital markets channel savings to finance the longer-term investment plans of businesses, individuals and governments. Therefore, financial instruments are defined as capital-market instruments if they have an original term to maturity in excess of one year. Capital-market instruments include both debt instruments and equity, and encompass both the domestic and international markets. The capital markets are extremely large and offer a wide range of products to meet the needs of both lenders and borrowers. For example, loans may be obtained through direct or intermediated finance for periods ranging up to 30 years. Loans may be secured or unsecured, have a fixed interest rate or a variable interest rate, and different repayment structures and timing of cash flows. The development of domestic capital markets is extremely important for economic growth as they provide the long-term funds necessary for productive investment. Further, the international capital markets offer enormous opportunities for investing and borrowing funds in a range of countries, markets and currencies. We will explore the diverse nature of the capital markets by looking at the following markets:

• equity market • corporate debt market • government debt market • foreign exchange market • derivatives market. Equity market Equity markets facilitate the issue of financial securities that represent an ownership interest in an asset (e.g. stock market)

The principal characteristic of the equity market is that the provider of equity finance obtains an ownership interest in an asset. Within the context of a corporation, the main form of security issued is the ordinary share, sometimes referred to as common stock. The shareholder has an entitlement to participate in the profits of the business, by way of receiving either dividend payments or capital gains (losses) in the value of the shareholding. From the perspective of the business, equity provides a source of long-term funding that does not have to be repaid. Equity is available to:

• finance physical infrastructure such as buildings and equipment • provide creditor confidence in dealing with the firm • ensure the availability of funds to absorb abnormal losses • improve the liquidity of the business. This text focuses mainly on equity issued by publicly listed corporations on a stock exchange. Chapter 4 considers the share market and the corporation, Chapter 5 explores a range of issues that a corporation needs to consider when issuing equity, Chapter 6 examines equity financing from the point of view of an investor and Chapter 7 provides a detailed analysis of share prices. As you can see, there is a lot to learn about the equity markets. However, it is easy to become addicted to the stock market, particularly if you become an investor.

Corporate debt market Longer-term debt is an important source of funding for the growth of business corporations. Capitalmarket debt represents a financial commitment that typically requires periodic interest payments to be made during the term of the debt arrangement, and repayment of principal (amount borrowed). The principal may be amortised—that is, repaid in periodic instalments over the period of the loan—or repaid in a lump sum at the maturity date. 24

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Medium-to-longer-term debt instruments issued into the corporate debt market include:

• term loans: provided by commercial and investment banks • commercial property finance: loans secured by a registered mortgage over the business property being financed • debentures: a corporate bond, where security is given in the form of a charge over the assets of the borrower • unsecured notes: a corporate bond with no security attached • subordinated debt: where the claims of the debt holder are subordinated against other debt lenders • lease arrangements: periodic lease payments made in return for borrowing an asset • securitisation: the sale of existing assets, such as mortgage loans, to generate new funds. These capital market products are discussed in Chapter 10. With the deregulation of the financial system, the international capital markets are also an important source of funding for corporations with good credit ratings. Chapter 11 examines offshore funding, focusing on the euromarkets and the US markets and the various instruments available within those markets. While the types of products offered in the international markets are fundamentally the same as those listed above, the main variable is the currency in which they are issued. For example, a euromarket instrument is issued by a borrower into another country, and the instrument is denominated in a currency other than the currency of the country in which it is issued. An example might be an Australian company issuing corporate bonds into the Singapore market that are denominated in USD (borrowing USD).

Government debt market Governments also need to budget with regard to their cash flows and capital expenditures. A government may budget for a surplus, a deficit or be in balance. If a budget is in deficit, the government will need to borrow funds to cover the forecast deficit. If a budget is in surplus, the excess funds can be used to repay existing government debt. Governments fund budget deficits through long-term borrowings in both the domestic and the international capital markets. If a government has a short-term liquidity funding need due to a mismatch of cash inflows from taxation and cash outflows to meet commitments such as pension payments, this may be managed by issuing short-term securities. For example, if the Australian government has a short-term funding need, it will issue Treasury notes. It issues Treasury bonds to raise longer-term funds. The Reserve Bank acts as banker to the government and therefore issues government securities as required to meet the government’s funding needs. Treasury notes are discount securities issued in the money market with maturities up to six months. Treasury bonds are issued in Australia with maturities ranging up to 10 years. They are mainly issued as fixed-interest securities for which half-yearly interest payments are made for the term of the bond and the principal is repaid at maturity. The bonds may be issued at a discount or premium over face value, depending on the yield of the fixed-interest coupon relative to the issue tender price. The bonds are sold periodically by tender to members of RITS. Government funding is discussed in Chapter 12. The extent of government borrowing has an impact on the private sector. If the government increases its borrowing in the market, it will crowd out or reduce the amount of funds available to corporate borrowers.

Foreign exchange market The foreign exchange market forms an important component of the capital markets, especially since the floating of exchange rates by the majority of nation-states and the deregulation of the financial systems of the major economies of the world.

Corporate debt markets facilitate the issue and trading of debt securities issued by corporations (e.g. discount securities, bonds)

Euromarket instruments financial transactions conducted in a foreign country in a currency other than the currency of that country

Government debt government borrowing for short-term liquidity needs, or longerterm budget capital expenditures (T-notes, Treasury bonds)

Crowding out government borrowing that reduces the net amount of funds available for other lending in the financial system

Foreign exchange markets markets that facilitate the buying and selling of foreign currencies

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Corporations, financial institutions and governments all access funds in the international capital markets, which provide a range of funding instruments and a diversity of funding sources that otherwise may not be available within domestic capital markets. Financial instruments issued in the international capital markets are usually denominated in a foreign currency. Therefore, interest payments and principal repayments related to international debt commitments require the borrower to purchase the necessary foreign currency in order to make those periodic payments. The foreign exchange market facilitates the buying and selling of foreign currencies necessary for the conduct of international capital-market transactions. The exchange rate is the price of one currency against another. Foreign exchange risk is the risk that the exchange rate between currencies will change. Other issues that have an impact on the exchange rate—and therefore the cost of funding in the international capital markets—are relative inflation, relative interest rates, relative national income growth, government intervention and exchange rate expectations. The foreign exchange market is discussed in Part 5.

Derivatives market Derivatives markets markets in synthetic risk management products: futures, forwards, options, swaps

Within the context of the capital markets, the derivatives market provides a range of risk management products that are available to borrowers to manage risks associated with capital-market transactions. The principal risks to be managed include interest rate risk, foreign exchange risk and price risk. For example, a borrower with an existing loan that has a variable interest rate might be concerned that the rate will increase in the future. The borrower might use a derivative product to manage that risk. The same principles apply for the risk that the exchange rate might change or that share prices may rise or fall. Derivative products available to manage these risks are discussed in detail in Part 6. They include futures contracts, forward rate agreements, forward foreign exchange contracts, options, interest rate swaps and currency swaps. A brief introduction to the different types of derivative contracts was given in Section 1.3.3. The derivatives market, through the provision of a range of risk management products, supports and encourages capital-market transactions. Risk management through the use of derivative contracts is a complex area of finance and will represent a challenging part of your later learning.

REFLECTION POINTS

matching principle contends that short-term assets should be financed by short-term • The liabilities, and longer-term assets financed with longer-term liabilities and shareholder funds. the context of financial markets, primary markets are those markets where new financial • Within instruments are issued.

• Secondary markets are those markets where existing securities are bought and sold. finance occurs when a provider of funds contracts with a user of funds. Benefits can • Direct include lower cost of funds, access to diverse funding sources and greater financing flexibility. Disadvantages involve matching funding preferences, liquidity and marketability of instruments issued, search and transaction costs and risk assessment. finance occurs when the provider of funds contracts with a financial intermediary, • Intermediated such as a commercial bank, and the financial intermediary contracts separately with the user of funds (borrower). Benefits include asset transformation, maturity transformation, credit risk diversification and transformation, liquidity transformation and economies of scale. market transactions are large direct transactions carried out by institutional • Wholesale investors. Retail market transactions are usually greater in number but smaller in size, and are typically carried out with a financial institution by individuals and small to medium-sized businesses. 26

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markets are direct finance wholesale markets for the issue of discount securities • Money such as bills of exchange, promissory notes (commercial paper) and negotiable certificates of deposit. These short-term markets allow participants to manage their day-to-day liquidity requirements. capital markets provide long-term finance, including equity, corporate debt and • The government debt. The capital markets are supported by the foreign exchange market and the derivatives markets.

1.5

Flow of funds, market relationships and stability

A principal function of the financial system is to facilitate the flow of funds between suppliers of funds and users of funds. The flow of funds to deficit units involves the creation of financial instruments that are exchanged for money in the primary markets. The flow may be direct—that is, directly between the lender and the user. Alternatively, the flow can be indirect—that is, intermediated by financial institutions. With intermediated flows, financial institutions gather together the savings of surplus units and provide loans from the pooled savings to deficit units. For a number of financial instruments issued in the primary markets there are secondary markets in which those securities are traded. Transactions in the secondary markets do not provide additional funding for the issuer, but rather they involve a flow of funds and a change of ownership between the two parties concerned. A function of the secondary markets is to add marketability and liquidity to primary market securities. In particular, this allows the holders of securities to restructure their portfolios by buying and selling at current market prices. Most importantly, secondary market liquidity makes the issue of new primary market securities much easier and reduces the returns that savers would otherwise require if those securities were less liquid. The discussion to date on the flow of funds relationships in the financial system has referred to two major categories: the ultimate savers or surplus units, and the ultimate borrowers or deficit units. We should now consider sectorial flows of funds in terms of the saving and borrowing patterns of the key sectors of an economy. The domestic economy can be divided into four sectors:

• business corporations • financial corporations • government • household sector.

LEARNING OBJECTIVE 1.6 Analyse the flow of funds through the financial system and the economy, and briefly discuss the importance of ‘stability’ in relation to the flow of funds.

Deficit units borrowers or users of funds

Sectorial flow of funds the flow of funds between surplus and deficit sectors in an economy; the business, financial, government, household and rest-ofthe-world sectors

To these four sectors, the rest-of-the-world sector is added. This sector may be both a source of surplus funds flowing into the domestic economy and an outward investment destination for surplus funds within an economy. Net borrowing and net lending of the major sectors of the economy vary between countries. The flow of funds between sectors also varies from year to year, depending on factors such as government budgetary actions, the level of economic activity and the state of the business cycle. As a broad generalisation, the business sector will, on average, be a deficit sector. Most business enterprises need to borrow in order to fund their business activities. The financial corporations sector also tends to be a deficit sector; financial institutions fund the growth in their balance sheets by borrowing in the capital markets. The government sector may fluctuate between being a deficit sector and a surplus sector, depending on budget policy objectives, while the household sector is typically a surplus sector—that is, a net saver of funds. 27

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Part 1 Financial institutions Fiscal policy the management of annual revenues and expenditures of a government

Compulsory superannuation employers must contribute minimum specified amounts into retirement savings for employees (Australia)

World Bank created along with the International Monetary Fund (IMF), the World Bank is an organisation of 189 member countries tasked with reducing poverty in developing countries

International Monetary Fund (IMF) an organisation of 189 countries, created in 1945, to foster financial stability, trade and economic growth

A country that has a stable political environment and a domestic economy that is strong and offers good growth potential would expect to attract savings from overseas investors. Deregulation of the global capital markets has allowed the rest-of-the-world sector to become more sensitive to sudden shifts in the flow of funds, as investors are able to move funds from one market to another quite quickly and with relative ease. A country’s government can impact the flow of funds between sectors by making policy decisions that change its own deficit or surplus unit status. The most directly relevant policy is the government’s fiscal policy. However, policy decisions on issues such as compulsory superannuation have an impact on the levels of savings within the economy. Government policy decisions regarding guarantees on bank deposits and bank borrowings, designed to increase confidence in the financial system, are also important in shaping the flow of funds. Worldwide, a set of global institutions can play a role in shaping and managing the flow of funds across geographical boundaries. This can be particularly important in times of crisis. For example, the World Bank and the International Monetary Fund (IMF) can play an important role in shaping the flow of funds into and out of developing economies. As we shall soon see, the Bank for International Settlements (BIS) has played a leading role in shaping banking regulations across the world. Changes to these regulations, by requiring banks to hold more capital, for instance, shape the flow of funds globally as well as within domestic economies. The remainder of Part 1 is devoted to an examination of the main financial institutions. The role of commercial banks in the flow of funds, and explanations for their importance in the financial system, are considered in Chapter 2. The main non-bank financial institutions are examined in Chapter 3.

REFLECTION POINTS

financial system facilitates the efficient flow of funds from providers of funds to users • Aofmodern funds. strong financial system will encourage savings and investment, which should lead to • Aeconomic growth. flow of funds in a domestic economy can be divided into four sectors: business • The corporations, financial corporations, government and households. An additional sector is the rest-of-the-world sector. sector may be a surplus sector or a deficit sector, depending on whether it is a net provider of • Afunds or a net user of funds.

CASE STUDY THE NEXT GLOBAL FINANCIAL CRISIS? The sub-prime lending crisis which originated from the US housing market and spread to insurance and other sectors of the US economy became a world economic crisis (Dewatripont, 2010) in 2008, resulting in massive unemployment after the loss of 8.7 million jobs worldwide (including 250 000 in Australia) and a significant decline in world economic output (Claessens, 2014). Nations have adopted various strategies and lending policies to ensure that the crisis is not repeated. Despite this, more than 10 years after the GFC, concerns have been raised about the seeds of a new crisis being sown in different corners of the world. Bill Gates, when asked on the possibility for the outbreak of another financial crisis, has stated that there exists a high possibility. This opinion is also held by Gates’ friend, Berkshire Hathaway founder 28

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and well-known investor Warren Buffett (Frank, 2018). A growing number of experts, including Steve Eisman, have also raised some alarms about a future crisis. Eisman predicted the GFC and influenced the character played by Steve Carell in the Oscar-winning movie The Big Short. Eisman has predicted a crisis to start in Italy, where banks have a high number of non-performing loans (NPLs). These loans are to companies and households who have fallen behind in making repayments. The books of Italian banks hold about €360 billion in NPLs, which have been written down to about 50.00 per cent of their original value. The real problem is that they are not worth even that amount. When financiers buy NPLs from Italian banks, they value them at only 20.00 per cent of the book value. That is, only 10.00 per cent of the original value of the loans. Compared to Italy, Eisman sees the US economy as being in a safer position because the issue of subprime mortgages has been reduced following strong regulatory actions after 2008. He feels that the European regulators are more lenient than US regulators and that this represents a risk to the European economy (Collinson, 2018). Another potential area for concern is the Chinese banking sector, where banks have enjoyed lending growth over the past few decades that resulted in the creation of largely unregulated shadow banks or credit unions who lend to property developers. These loans are funded in various ways, including by ‘asset management products’, all of which have certain question marks regarding their levels of risk. A collapse of one of these funding streams could lead to a financial crisis in China (David, 2018; John, 2017). References Chung, F 2018, ‘Bill Gates says another US financial crisis a certainty’, News.com.au, 2 March, viewed 15 October 2018, https://www.news.com.au/finance/economy/world-economy/bill-gates-says-anotherfinancial-crisis-a-certainty/news-story/364c28ad0c20696f399553d51900fe77 Claessens, S 2014, Financial crises: Causes, consequences, and policy responses, International Monetary Fund, Washington, District of Columbia. Collinson, P 2018, ’The Big Short: is the next financial crisis on its way?’, The Guardian, 19 November, viewed 15 October 2018, http://www.theguardian.com/money/2016/nov/19/big-short-financial-crashsteve-eisman-italy-banks-risk Dewatripont, M, Rochet, J and Tirole, J 2010, Balancing the banks: global lessons from the financial crisis, Princeton University Press, Princeton and Oxford. Mauldin, J 2017, ’One Of These 3 Black Swans Will Likely Trigger A Global Recession By End Of 2018’, Forbes, 27 July, viewed 15 October 2018, http://www.forbes.com/sites/johnmauldin/2017/07/27/oneof-these-3-black-swans-will-likely-trigger-a-global-recession-by-the-end-of-2018#4cda7aef1875 Taylor, D 2017, ’Australia has the capacity to ride the wave, should a financial crisis make its way to our shores’, ABC News, 16 March, viewed 15 October 2018, http://www.abc.net.au/news/2017-03-15/ david-taylor-can-australia-survive-another-financial-crisis/8353074

Discussion points

• • •

In the words of Steve Eisman, the ‘US economic system is in a safer seat when compared with Europe’. Why? According to Steve Eisman, what are the concerns with the Italian banking sector that could trigger a crisis? Describe how the Australian economy is set to deal with crisis situations, especially in light of a financial threat from China.

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Master before you move on LEARNING OBJECTIVE 1.1 Understand the basic frameworks that underlie the facts that characterise financial institutions, financial instruments and financial markets. interconnected global financial system traces its origins to the introduction of money and • The the development of local markets to trade goods. • Money is a medium of exchange that facilitates transactions for goods and services. wealth being accumulated in the form of money, specialised markets developed to enable • With the efficient transfer of funds from savers (surplus entities) to users of funds (deficit entities). instruments incorporate attributes of risk, return (yield), liquidity and time-pattern • Financial of cash flows. Savers are able to satisfy their own personal preferences by choosing various combinations of these attributes.

encouraging savings, and allocating savings to the most efficient users, the financial system • By has an important role to play in the economic development and growth of a country. The real economy and the financial system are connected.

LEARNING OBJECTIVE 1.2 Explain the functions of a modern financial system and categorise the main types of financial institutions, including depository financial institutions, investment banks, contractual savings institutions, finance companies and unit trusts. financial system encourages accumulated savings that are then available for investment • Awithin an economy. modern financial system comprises financial institutions, instruments and markets that provide • Aa wide range of financial products and services. range of different financial institutions has evolved to meet the needs of financial market • Aparticipants and to support economic growth. institutions, such as commercial banks, building societies and credit unions, • Depository specialise in gathering savings in the form of deposits and using those funds to provide loans to customers.

banks tend to specialise in the provision of advisory services to clients (e.g. merger • Investment and acquisition advice). savings institutions, such as insurance offices and superannuation funds, enter into • Contractual contracts in which they receive funds on the undertaking that they will pay a policyholder, or member of a fund, a specified sum when a nominated event occurs.

companies sell debt instruments directly to surplus entities and then use those funds to • Finance provide loans and lease financing to borrowers. trusts sell units in a trust. The accumulated funds in the trust are pooled and invested in • Unit asset classes specified within the trust deed. • Commercial banks dominate in terms of their share of the assets of financial institutions.

LEARNING OBJECTIVE 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity, debt, hybrids and derivatives.

• Financial instruments are central to any financial relationship between two parties. the saver acquires an ownership claim on the deficit entity, the financial instrument is • Where referred to as equity. 30

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LEARNING OBJECTIVE 1.4 Discuss the nature of the flow of funds between savers and borrowers, including primary markets, secondary markets, direct finance and intermediated finance. markets and instruments allow borrowers to meet the requirements of the matching • Financial principle; that is, short-term assets should be funded by short-term liabilities, and longer-term assets should be funded by longer-term liabilities and equity.

• The markets in which new debt and equity securities are issued are known as primary markets. that facilitate the sale of previously issued securities, such as a stock exchange, are • Markets called secondary markets. providing a market for the trading of existing securities, secondary markets serve the most • By important function of adding liquidity to financial instruments. an active secondary market exists for a financial instrument, the instrument is usually • Where referred to as a security. • In the primary market, surplus entities may acquire assets directly from the issuer. the flow of funds may be through a financial intermediary, in which case the surplus • Alternatively, entity establishes a financial relationship with the intermediary rather than with the ultimate borrower. flows are attractive to many savers since the intermediary provides a range of • Intermediated financial attributes that may not otherwise be available. advantages of financial intermediation include asset transformation, maturity transformation, • The credit risk diversification and transformation, liquidity transformation and economies of scale.

CHAPTER ONE REVIEW

• Where the relationship is a loan, the financial instrument is referred to as a debt instrument. financial instrument that incorporates the characteristics of both debt and equity is known as • Aa hybrid. category of instruments is derivatives (futures, forwards, swaps and options). The main • Another use of a derivative is in the management of commodity and financial risks.

LEARNING OBJECTIVE 1.5 Distinguish between various financial market structures, including wholesale markets and retail markets, and money markets and capital markets. financial markets are categorised as money markets (short-term securities) and capital • The markets (longer-term securities). in the money markets include central bank transactions, the interbank market, • Submarkets the bills market, the commercial paper market, the government securities market and the CD market.

capital markets include the equity market, the corporate debt market, the government debt • The market, the foreign exchange market and the derivatives market. the money and capital markets there are also the wholesale markets (institutional • Within investors) and the retail markets.

LEARNING OBJECTIVE 1.6 Analyse the flow of funds through the financial system and the economy, and briefly discuss the importance of ‘stability’ in relation to the flow of funds.

• Sectorial flow of funds may be observed within an economy. include the business corporations sector, the financial corporations • Sectors government sector, the household sector and the rest-of-the-world sector.

sector, the

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sectors may be net surplus sectors (providers of funds) or net deficit sectors (users of • These funds). • Factors that affect these sectors are government policy initiatives and economic performance. stable financial system is characterised by the smooth flow of funds between surplus and • Adeficit units.

Extended learning A LEARNING OBJECTIVE 1.7 Appreciate the impact of the global financial crisis (GFC) on the world’s financial system and economy.

The global financial crisis of 2008 Global financial crisis (GFC) the global financial crisis (GFC) refers to the financial crisis of 2008 that has been traced to the collapse of the housing market in the USA and the consequences of that collapse for the market for mortgage-related securities

Sub-prime mortgages loans to borrowers that, under normal credit assessment standards, would not have the capacity to repay

The global financial crisis (GFC) has been described as the most significant economic crisis since the Great Depression in the 1930s. In 2007, realisation that house prices in America had begun to fall and mortgage defaults were increasing, particularly in sub-prime mortgages which had been issued to low-income individuals who were sometimes without a documented ability to meet the monthly repayments, initiated a liquidation of trading positions in the mortgage markets that quickly evolved into a banking crisis. Uncertainty about the value of assets posted as collateral and the solvency of counterparties significantly disrupted the financing arrangements upon which financial institutions relied to fund their activities. Uncertainty about the solvency of financial institutions flowed through the financial system. Unable to fund their activities through the usual channels, some financial institutions were forced to seek equity capital injections from investors or obtain emergency funding from central banks. Some were bailed out by their sovereign government. Others were forced to sell themselves to stronger financial institutions. Many others were forced to file for bankruptcy. The effects of the crisis flowed into the ‘real’ economy. Economic growth in the USA slowed considerably. According to the Bureau of Economic Analysis (www.bea.gov), from the second half of 2008 through to the first half of 2009, the USA experienced four consecutive quarters of negative economic growth (falling gross domestic product or GDP). Contributing to this were severe declines in private investment, including back-to-back declines of 36.00 per cent and 42.00 per cent in 2009. The Bureau of Labor Statistics (www.bls.gov) recorded a steep increase in the unemployment rate in the USA, which doubled from 5.00 per cent in 2007 to just over 10.00 per cent in 2009. Amid the uncertainty and economic turmoil, financial markets continued to reel. Share markets in most of the advanced economies experienced precipitous falls and at the depths of the crisis had recorded losses of more than 50.00 per cent. The US stock market alone experienced losses in 2008 of $8 trillion. Currency markets were not immune from the volatility. The Australian dollar experienced depreciations of more than 30.00 per cent against the major currencies. During the crisis, a number of prestigious Wall Street firms lost their independence or failed completely. Bear Stearns was purchased by JPMorgan Chase & Co. for just $10 per share in March 2008, after trading at $150 per share a year earlier. In July, the mortgage broker IndyMac was placed in ‘conservatorship’ by the US government. In September, two government-chartered mortgage lenders, Freddie Mac and Fannie Mae, were similarly placed in the care of the US government. Lehman Brothers collapsed in mid-September. At the same time that Lehman Brothers tried in vain to arrange a bailout or takeover, Merrill Lynch sold itself to Bank of America to avoid a Lehman-style collapse. The Lehman Brothers’ collapse created enormous market volatility as market participants struggled to predict the effects of the investment bank’s failure on the intertwined network of trades that characterises the financial markets. Governments and central banks desperately tried to stabilise the markets. Meanwhile, other financial institutions found themselves under tremendous pressure. Washington Mutual was

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Chapter 1  A modern financial system: an overview

Banks and other financial institutions are always vulnerable to ‘runs’. These are situations where, all at once, many customers demand their money back from a financial institution. Financial institutions do not operate with 100.00 per cent reserves and cannot possibly meet all of these demands.

Federal Reserve the central bank of the USA

Before the GFC, financial institutions became more vulnerable because of maturity mismatching in their financing arrangements. Most financial institutions had become reliant on very short-term or overnight financing to finance their operations. Repurchase agreements, or ‘repos’, are very shortterm funding arrangements and financial institutions had come to rely heavily on overnight repo financing in the decade before the crisis. During the crisis, when financial institutions became wary about the solvency of their counterparties (and themselves), repo financing became either increasingly expensive or impossible to secure. Without the overnight repo markets, financial institutions did not have the capital to sustain their operations for any length of time. This was exacerbated by the redemption and withdrawal requests being received from investors and depositors. Bear Stearns, for example, found that it was unable to secure repo financing once doubts surfaced about its solvency. Although Bear Stearns had more than $18 billion in capital, this fell far short of what was required to finance its day-to-day operations. Bear Stearns was taken over by JPMorgan Chase & Co. just a few days after its repo financing evaporated. With Bear Stearns gone, the financial markets awaited the next ‘domino’ to fall.

CHAPTER ONE REVIEW

placed in receivership. Wachovia was purchased by Wells Fargo. AIG was effectively taken over by the Federal Reserve.

When the crisis hit, information about the market value of the securities traded among financial institutions and the magnitude of financial obligations of particular institutions was difficult or impossible to obtain. Collateralised debt obligations (CDOs), which are portfolios of mortgages and other loans arranged into ‘tranches’ according to levels of risk, are complex by nature because it is very difficult to determine the quality of the numerous individual loans in each of the tranches. This complexity and the absence of liquid secondary markets for the securities led to large writedowns in the estimated values of these securities when financial institutions realised that there were no buyers willing to engage in transactions at prices even close to the previously recorded selling prices. With prices falling, write-downs in the value of positions in these markets spiralled downwards. Uncertainty about which institutions held the riskiest CDO tranches contributed to financial institutions’ unwillingness to extend financing to their counterparties. To make matters even worse, buyers of CDOs had usually entered into credit default swaps (CDSs) with other financial institutions. CDSs were designed to insure their buyers against default on bonds, tranches or by institutions. As CDOs fell rapidly in value and financial institutions reeled, the large outstanding liabilities potentially facing the ‘sellers’ of CDSs and the uncertainty over how much insurance had been sold by which institutions contributed further to the spiral in valuations, balance sheet writedowns and the viability of financial institutions. Although most of the drama and many of the popular accounts of the crisis focused on Wall Street and its ‘blue-blood’ banking establishments, as time has passed the GFC came to be thought of as having two main parts. The first, which we have just described, was the initial liquidation of assets due to the trouble emanating from and engulfing the Wall Street banks. The second was what has come to be known as the eurozone crisis or the sovereign debt crisis. This second instalment of the GFC emanated from and engulfed the central banks of a number of European countries. That is, in ‘part two’ it was country or government debt, otherwise known as sovereign debt, that became ground zero as the crisis evolved. The eurozone crisis can be traced to late 2009, when the new Greek government announced that its deficit, understood by the world financial community to already be an astronomical 113.00 per cent of the country’s national income, was actually twice as large, or more than 220.00 per cent of the country’s gross domestic product. There was a very great possibility that Greece would fail to meet its obligations to investors in Greek sovereign debt (Greek government bonds). This immediately precipitated panic in the international bond markets.

Eurozone crisis or sovereign debt crisis the economic and international financial crisis that followed the GFC, which saw multiple European governments seek bailouts from the European Central Bank (ECB) and other stronger European countries

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Like any market, investors need to have confidence that they will receive the cash flows they are entitled to and the issuer of the debt, whether it is a corporation or a government, will not default on its obligations. It looked like Greece might do just that. The panic in the international bond markets led to a collapse in bond prices and a spike in the cost of borrowing for governments suspected of being in a similar position to Greece, especially Ireland, Spain, Portugal and Italy. Government services and welfare programs became the victims of harsh austerity measures. As the government sector of these economies was curtailed, national incomes fell rapidly and other economic indicators deteriorated. The economic booms in these countries had been fuelled by money coming from banks in other European countries, particularly in northern Europe. These banks held trillions of dollars in Greek, Irish, Spanish and Italian debt, which were consequently trading at substantially lower prices. The trouble had spread north and west, like a virus. This had disastrous and far-reaching economic consequences. National incomes fell precipitously in the worst affected countries and unemployment soared. Most of the Eurozone, including relatively strong economies such as France and Germany, soon found itself amid an economic malaise that only gradually abated. A number of explanations for the GFC have been proposed. These include greed, irrationality, fraud, the inherent instability of capitalism, the disproportionate size of the financial sector compared to the manufacturing or ‘real’ sector of the economy, shadow banking, lax lending standards, deregulation and free-market policies, over-reliance on badly designed mathematical models for measuring risk, inappropriate incentive structures within financial institutions, ‘captured’ ratings agencies that were too lenient in rating mortgage debt, out-of-control financial innovation and misguided government or central bank policy. There are many different points of view and strong and convincing arguments can be made for each of the possible explanations for the GFC. Whatever role each of these factors might have played, the fundamental explanation for the GFC is quite straightforward. Throughout the early 2000s, central banks, particularly the US Federal Reserve, set interest rates at very low levels. This created a boom in consumption, housing and other asset prices driven by easy credit available throughout the economic system. In the absence of increasingly intense credit expansion, sooner or later the credit-driven boom had to come to an end. The larger and longer the boom, the more catastrophic must be the ensuing recession or depression. Despite the unique circumstances of each individual case, all economic crises can be traced to this same root cause. Following the onset of the crisis, governments and central banks around the world undertook unprecedented interventions in the financial and economic systems. In the USA, for example, the federal government arranged a $700 billion bailout plan and, as we have seen, even took ownership of some financial institutions. In Australia, the federal government implemented a guarantee on deposits with banks, building societies and credit unions to prevent ‘runs’ on these institutions by their customers. As the banking crisis gave way to concerns about economic growth, governments turned their attention to fiscal stimulus to encourage economic activity and prevent recession. In Australia, the government implemented two stimulus packages totalling more than $50 billion in late 2008 and early 2009. Various factors contributed to greater stability in Australia during the crisis and a mitigation of its effects on the real economy. However, the effects of the GFC continue to be felt in most parts of the developed world and, although Australia managed to navigate the crisis better than other countries, dealing with the legacy of the GFC will present a challenge for many years to come. Australia’s stock market in 2018 had yet to reach its pre-GFC highs set back in 2007. Many lessons might be learned from the GFC. A stable financial sector is vital to the health of the overall economy. Perceived mistakes by regulators, including allowing interest rates to remain at very low levels for long periods of time as well as perceptions that the crisis was caused by a financial sector that is out of control, have sparked calls for strong regulatory reforms. Innovative financial products and securities, such as CDOs and CDSs, present a challenge to regulators. New products do not always fall within the scope of existing regulations. The incentive arrangements and governance within financial institutions are also factors that attracted the attention of critics before, during and after the GFC. Regulations that limit compensation packages

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Chapter 1  A modern financial system: an overview

With the GFC, it appears that there was a lack of understanding of who was ultimately holding risk and the impact on the markets if the ultimate risk holder failed. For example, CDOs simply moved the risk exposure from one party to another party. Everyone made money along the way, including the mortgage brokers, the banks, the credit rating agencies and the fund managers, but the risk was still in the financial system. The process of risk shifting was also often made easier by implicit or explicit guarantees given by governments, often with limited or no regulatory oversight. To ensure the soundness and stability of a financial system, governments establish legislation and regulatory authorities responsible for the prudential supervision of the financial system. The soundness and stability of the financial system and the role of financial regulation are issues that have acquired even more significance following the GFC. The GFC produced a number of regulatory and policy responses. Some of these were directed to the problem of managing the ensuing economic recession while others were directed at specific parts or activities of the financial system. The response of governments and their regulators to the GFC will be a topic of ongoing discussion for many years. Anyone who doubts that this will be the case need look no further than the recent intense focus on the role of central bankers’ responses to the collapse of the dot-com boom in 2000 in sowing the seeds for the GFC almost a decade later. The reduction of interest rates and their maintenance at very low levels following the dot-com collapse has been criticised for inflating values in the real estate market. The subsequent decline in real estate prices from these over-inflated levels is widely viewed as the proximate cause of the GFC.

CHAPTER ONE REVIEW

within the financial sector or realign incentive structures so they do not encourage large amounts of risk taking represent attractive options to those who are critical of perceived excesses within the financial sector. Finally, the way that risk is managed within financial institutions has emerged as a very prominent subject. Risk is intertwined and interrelated. The existence of one risk will change the dynamics of other risk exposures.

It would be wishful thinking to believe that another crisis will not eventually strike the financial system. If that happens any time soon, there is no doubt that the US Federal Reserve’s years of ‘quantitative easing’ (credit easing), designed to encourage economic activity by pumping billions of dollars into the financial sector following the GFC, will be heavily scrutinised. Of course, if speculative banking practices once again lie at the heart of any such event, questions will be raised about whether the response of regulators to the GFC was strong enough or whether the bailouts of so many financial institutions, directly or indirectly, sent the wrong signals to market participants and sowed the seeds for another crisis.

Extended learning B LEARNING OBJECTIVE 1.8 Appreciate the effects, consequences and relevance of the Asian financial crisis.

The impact of the Asian financial crisis on the financial system This chapter has recognised the importance of a modern, efficient and stable financial system as a critical component of sustained economic and social growth. This fundamental principle applies to nation-states, geographic regions and, ultimately, the global economy. The proposition is aptly demonstrated by the so-called Asian financial crisis that became manifest from mid-1997. While the Asian financial crisis occurred some time ago, it is an excellent learning case study that attracted renewed interest in 2014 as weakness in some emerging markets started to exhibit some worrying parallels with the Asian crisis of the late 1990s. The crisis was more than a financial crisis; it extended into a major economic and social crisis as well. Nation-states and the global financial system are periodically adversely affected by financial crises, the most recent being the so-called sub-prime market crisis in the USA, which evolved into a global credit crisis. The

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interesting, but unfortunate, observation of financial crises is that they tend to repeat themselves over time. The lessons learned from one crisis are eventually thought to be irrelevant to the current market environment. This leads to an environment where a new crisis can grow. The reality is that the fundamentals of risk management don’t change. Managers and regulators need to understand risk and who is actually holding (or exposed to) risk. Within the context of the financial system, risk needs to be identified, measured and managed. Much has been written about the Asian financial crisis. Here, only a brief analysis and discussion of events is provided. After gaining some understanding of the complexity of the factors that precipitated the crisis, and of the inevitable flow-on effects that proceeded from it, students are advised to read papers published on the topic. These include various issues of the Reserve Bank of Australia’s RBA Bulletin, the Bank for International Settlements BIS 68th Annual Report (1998) (www.bis.org) and papers published by the Federal Reserve Bank of New York (www.ny.frb.org). The 1980s and early 1990s were a period of enormous economic growth and prosperity within what was often described as the ‘tiger’ countries of Asia, in particular Hong Kong, Singapore, Malaysia, Thailand, South Korea and Indonesia. However, the late 1990s saw the ‘bubble’ burst, and the region experienced severe economic, financial and social reversals. Prior to mid-1997, Thailand maintained a fixed exchange rate regime whereby the Thai baht was pegged to a basket of currencies, predominantly the US dollar, the Japanese yen and the German deutschmark. The currency came under sustained pressure and the central bank of Thailand was unable to continue to support the fixed exchange rate. On 2 July 1997, Thailand floated its currency, and this essentially became the trigger for the Asian currency crisis, as other fixed exchange rate regimes, including the Philippine peso, the Malaysian ringgit and the Indonesian rupiah, all fell victim to the foreign exchange market. The situation rapidly evolved into a financial and economic crisis, initially encompassing Thailand, Indonesia, the Philippines and Malaysia but eventually extending to Japan, South Korea, Russia and Brazil. The contagion effects of the ever-expanding crisis were not restricted to these countries. Other countries in the region—Singapore, Hong Kong, Australia and New Zealand—all experienced negative consequential effects of the crisis, as did the majority of global economies, including the USA. In order to understand the flow-on effects of the crisis, it is important to understand the relationships that exist between risks associated with foreign exchange, interest rates, liquidity, price, credit and capital. For example, there is a statistical relationship between interest rates and exchange rates. Normally, if an exchange rate depreciates significantly, domestic interest rates will rise. The rise in interest rates will affect the profitability of the business sector, and therefore stock prices will fall. If asset price inflation has also been evident, then asset prices would be expected to fall. The combined effect so far will cause a lack of confidence in the economy and a fall in business activity. Higher interest rates and lower economic activity will lead to businesses defaulting on credit, which will place pressure on the capital ratios of financial institutions. Also, as with the Asian crisis, a large portion of a country’s debt may be denominated in unhedged foreign currencies, and depreciation of the domestic currency will result in higher real interest and principal repayments. While this is happening, liquidity in the market disappears as financial institutions and investors withdraw. All these risk factors occurred with the Asian crisis. In its 1998 annual report, the Bank for International Settlements identified the following weaknesses that were common in the Asian crisis countries: Moral hazard the taking of excessive risk in the belief that losses will be diminished by regulation or insurance

bank credit was available, which encouraged over-investment in industrial capacity • Excessive (in particular, office buildings and condominiums) and an asset price boom and bust. was no recognition of the fragility of domestic financial systems because of historic • There monetary and exchange rate stability, coupled with an extended period of economic growth. As financial risks increased in the overheated economies, lending margins actually fell.

hazard risk existed in that there was an expectation that government would always • Moral support major financial institutions. Capital ratios were also relatively low.

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that such risk did not exist in the fixed exchange rate regime. Enormous capital inflows were suddenly exposed to foreign exchange risk when currencies were floated. At the same time, external investor confidence dissipated and there were significant capital outflows, as indicated in Table 1B.1.

Table 1B.1 Net private capital flows, Asia* (USD billions) 1994

1995

1996

1997 (1st half)

1997 (2nd half)

24

38

77

62

−108

* India, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand. SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p. 133.

Central banks in the region, in an effort to support their depreciating currencies and stem capital outflows, raised overnight interest rates significantly. The effects on interest rates, stock market prices and exchange rates are shown in Table 1B.2.

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was a reliance on potentially volatile external finance, particularly short-term funding. Much • There of the external borrowing was not hedged against foreign exchange risk, as it was perceived

Table 1B.2 Interest rates and exchange rates during the crisis Interest rates— overnight rate peak

Interest rates— three-month rate peak

Stock market indices— falls between 1 January 1997 and 4 February 1998

Exchange rate depreciation*—low between July 1997 and March 1998

Hong Kong

100.0

25.0

−22.5%

0

Taiwan

−11.5

−9.8

 n.a.

−19.3

Indonesia

300.0

27.7

−76.9%

−84.3

South Korea

−27.2

25.0

−54.6%

−54.6

Malaysia

−50.0

−8.8

−65.3%

−46.3

Philippines

102.6

85.0

Singapore

−50.0

10.3

−46.9%

−21.0

Thailand

−27.4

26.0

−62.8%

−55.0

n.a.

−41.8

* Percentage change in the US dollar/local currency exchange rate since July 1997. SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p. 136.

The global financial crisis that resulted from the Asian financial crisis caused regulators, government policy makers, academics and market participants to exercise their collective minds to reconsider issues of signals, cause, effect, regulation and financial system architecture. While changes in the structure, regulation and operation of the global financial system have occurred, and will continue to occur, history indicates that change is usually a very slow process. The lessons of the Asian financial crisis have prompted the Reserve Bank (RBA Bulletin, April 1998, p. 2) to identify a list of questions to ask about a country’s financial system if there is the likelihood of a currency crisis or a wider economic crisis.

• Does the country have a fixed exchange rate and free movement of international capital? • Is the exchange rate overvalued? • Has a country with similar economic characteristics recently experienced a currency crisis?

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• Is there a large budget deficit and a lot of government debt outstanding? • Is there loose monetary policy and high inflation? • Is the domestic economy in, or at risk of, a recession? • Is there a large current account deficit? • Is there a large amount of foreign debt? • Is there an asset price boom (especially credit driven) occurring? • Are there a lot of bad debts in the banking system, or is there a poor system of bank supervision? • Has there been a lot of unhedged foreign currency borrowing? there poor accounting standards, few disclosure requirements or ambiguous bankruptcy • Are procedures? These 12 points form a strong starting point for financial crisis analysis. However, you should be aware that all of the factors will not always be evident, and that the existence of some factors does not by itself imply an imminent crisis situation. Also, as with past financial crises, each future crisis will have its own particular set of defining characteristics.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

The concepts of risk, reward, supply and demand underlie the complexity of financial instruments. How could we use these concepts, for example, to explain the rate of return expected by a shareholder in Telstra and the price at which Telstra shares change hands on the stock market? (LO 1.1)

2

Describe the flow of funds that characterises any financial system. (LO 1.1)

3

Explain why an investor should consider the time-pattern of cash flows and the variability of the cash flows associated with a multi-period investment, rather than simply assessing the investment on the basis of the total cash flows received. (LO 1.1)

4

Risk preferences shape the decisions that people and businesses make when under conditions characterised by risk and uncertainty. Outline the three ways in which economists categorise decision makers and explain how each type of decision maker will choose differently when confronted with a risky choice. (LO 1.2)

5

Identify and discuss three changes in the distribution of assets among the financial institutions that have occurred during the period of the global financial crisis and Australia’s recovery from it (2008 to 2018). The information required is presented in Table 1.1. (LO 1.2)

6

Financial instruments may be categorised as equity, debt or derivatives. Discuss each category. In your answer, make sure you explain the differences between debt, equity and derivatives.  (LO 1.3)

7

During the GFC, the funding of longer-term assets with short-term borrowing was identified as a point of weakness in the operations of financial institutions. Discuss this statement with reference to the matching principle. (LO 1.4)

8

(a)  What are the differences between primary market and secondary market financial transactions?



(b) Why is the existence of well-developed secondary markets important to the functioning of the primary markets within the financial system? (LO 1.4)

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Chapter 1  A modern financial system: an overview

Explain the meaning of the terms ‘financial assets’, ‘financial instruments’ and ‘securities’. What is the difference between these terms? Give examples of financial instruments and securities.   (LO 1.4)

10 Banks are the major providers of intermediated finance to the household and business sectors of an economy. In carrying out the intermediation process, banks perform a range of important functions. List these functions and discuss their importance for the financial system. (LO 1.4) 11 ‘The development of domestic capital markets is extremely important for economic growth as they provide the long-term funds necessary for productive investment.’ Discuss this statement using the equity market and the corporate debt market as examples. (LO 1.5) 12 Corporations often issue long-term debt instruments into the international capital markets to raise funds. Explain the relationship between the issue of paper into the international capital markets and the foreign exchange market and the derivatives market. (LO 1.5) 13 Discuss the sectorial flow of funds. In your answer, identify five sectors that are representative of the sectorial flow of funds. Why is an understanding of the sectorial flow of funds important for economic policy determination? (LO 1.6)

Extended learning questions

CHAPTER ONE REVIEW

9

14 The GFC has had a significant impact on the stability of international financial markets. Discuss the implications of the crisis for the ‘real economy’ and evaluate the regulatory responses that have been implemented in an attempt to stabilise the financial system. (LO 1.7) 15 The GFC is now thought of as having two parts or phases. Describe each part (or phase) and outline some of the measures that have been taken by governments and central banks in Australia, Europe and the USA in order to stem the effects of both phases of the crisis on their respective real economies. (LO 1.7) 16 The Asian financial crisis provided some valuable lessons about the global financial system. What are some of those lessons and why are they relevant for today’s emerging markets?  (LO 1.8)

KEY TERMS asset portfolio  7

default risk  17

finance companies and general financiers 9

asset transformation  18

deficit units  27

bills market  23

financial instruments  7

bonds 14

depository financial institutions 8

broker 16

derivative instrument  12

fiscal policy  28

capital markets  24

derivatives markets  26

flow of funds  7

commercial paper  23

direct finance  16

foreign exchange markets  25

compulsory superannuation  28

discount securities  23

forward contract  13

contractual savings institutions 9

dividend 11

futures contract  12

economies of scale  20

global financial crisis (GFC)  32

corporate debt markets  25

equity 11

government debt  25

credit rating  16

equity markets  24

hybrid security  11

credit risk transformation  19

euromarket instruments  25

inflation 8

crowding out  25

institutional investors  21

dealer 16

eurozone crisis or sovereign debt crisis  33

debt instruments  12

Federal Reserve  33

intermediated finance  17

financial system  7

interbank market  23

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International Monetary Fund 28

negotiable debt instrument  12

secondary market transaction 15

investment banks  8

negotiable certificate of deposit 23

liability management  19

option contract  13

secured debt  12

liquidation 11

securities 16

liquidity 7

ordinary share or common stock 11

liquidity transformation  19

overdraft facility  14

sub-prime mortgages  32

matching principle  14

portfolio structuring  8

surplus units  7

maturity transformation  19

primary market transaction  14

swap contract  13

monetary policy  8

rate of return  7

time-pattern of cash flows  7

money 14

retail market  20

unit trusts  9

money markets  21

return or yield  7

wholesale market  20

moral hazard  36

risk 7

World Bank  28

sectorial flow of funds  27

securitisation 10

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CHAPTER 2

Commercial banks CHAPTER OUTLINE 2.1 The main activities of commercial banking 2.2 Sources of funds 2.3 Uses of funds 2.4 Off-balance-sheet business 2.5 Regulation and prudential supervision of commercial banks 2.6 A background to the capital adequacy standards 2.7 The Basel Accords: evolution from Basel I to Basel III 2.8 Liquidity management and other supervisory controls

Learning objectives LO 2.1

Evaluate the functions and activities of commercial banks within the financial system.

LO 2.2

Identify the main sources of funds of commercial banks, including current deposits, demand deposits, term deposits, negotiable certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency liabilities and loan capital.

LO 2.3

Identify the main uses of funds by commercial banks, including personal and housing lending, commercial lending, lending to government and other bank assets.

LO 2.4

Outline the nature and importance of banks’ off-balance-sheet business, including direct credit substitutes, trade- and performance-related items, commitments and market-rate-related contracts.

LO 2.5

Consider the regulation and prudential supervision of banks.

LO 2.6

Understand the background and application of Basel III.

LO 2.7

Examine liquidity management and other supervisory controls applied by APRA in the context of Basel III.

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Extended learning LO 2.8

Understand the standardised approach to credit risk and compute the capital requirements for particular transactions.

LO 2.9

Analyse business continuity risk and construct an education and training framework for operational risk management for commercial banks.

LO 2.10

Discuss the importance of corporate governance and ethics in the context of Australian financial institutions.

CHAPTER SNAPSHOT Commercial banks take deposits and make loans. They also engage in billions of dollars of trades in instruments such as interest rate contracts and credit derivatives, much of which is recorded ‘off balance sheet’. The importance of commercial banks to the economic and financial system and the damage that can be caused by banking crises has prompted the Bank of International Settlements (BIS) to initiate a series of banking reforms known as the Basel Accords. The final version of ‘Basel III’ was released at the end of 2017.

INTRODUCTION In order to operate as a commercial bank within most developed countries, an institution generally must obtain an authority from the prudential supervisor. A list of Authorised Deposit-taking Institutions (ADIs) operating in Australia—Australian-owned banks, foreign subsidiary banks, building societies, credit unions and branches of foreign banks—can be found on the website of the Australian Prudential Regulation Authority (www.apra.gov.au). There are four major commercial banks in Australia. Commercial banks control a significant proportion of the financial assets within the financial system. As we saw in Chapter 1, commercial banks hold more than 50.00 per cent of the total assets of financial institutions in Australia. Because of the absolute size of the commercial banks and their importance as the principal institutions in the flow of funds between savers and borrowers, it is important that we understand the functions and operations of commercial banks. Perhaps one of the most interesting aspects of the operation of commercial banks is their ability to ‘create’ money and liquidity. Commercial banks can lend out much more than they accept in the form of deposits. If a bank receives a deposit of $100, it might lend out $90, which in turn is deposited in another bank that lends out $81 and so on. The initial $100 deposit grows to a much larger amount. Historically, this activity was somewhat restricted by a reserve requirement imposed by the central bank. This was the case in Australia, as for many other countries. Most people probably assume that these requirements are still in place and that they are quite stringent, if not 100.00 per cent. In fact, the requirement for commercial banks to reserve some fraction of their deposits was removed in Australia in 1988. Banks are not required to keep any fraction of their deposit liabilities in reserve. This has played no small role in commercial banks amassing 50.00 per cent of the assets held by all financial institutions. The big question is whether they can, in fact, create money without limit. The answer, fortunately, is no. Banks face the requirement to keep a certain amount of capital, including deposits, on hand. These capital requirements have become much more stringent as regulators recognised the risks that unfettered lending can impose on the whole financial and economic system. 42

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Chapter 2  Commercial banks

Following a long phase of deregulation beginning in the 1980s, a review was undertaken during the 1990s to explore Australia’s experience with financial deregulation and identify areas for improvement. This review, called the Wallis Report, recommended the establishment of APRA, which was founded in 1998. Financial regulation in the 2000s has been dominated by the Basel III capital accords and their implementation following the GFC. Arguably, these capital requirements are much more effective than reserve requirements, even in jurisdictions where reserve requirements are still enforced. The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry that was undertaken during 2018 added an additional layer of scrutiny to the governance and culture of financial institutions operating in Australia.

REFLECTION POINTS

• • •

Commercial banks are the main type of financial institution that operates within a financial system. The regulatory environment is subject to change. The majority of developed economies began reducing banking regulations in the 1980s. Following the GFC, financial regulations have been strengthened. The process of regulatory reform is ongoing.

2.1

The main activities of commercial banking

Commercial banks take deposits from customers and then invest those deposits by making loans to their customers. Although these two functions represent a large proportion of their activities, commercial banks’ activities are much more complex than this, in that they provide a full range of financial services. Commercial bank products and services include balance-sheet transactions and off-balance-sheet transactions. Briefly, balance-sheet transactions are assets (e.g. loans), liabilities (e.g. deposits) and shareholders’ funds (equity). Off-balance-sheet items are contingent liabilities; that is, they are transactions that do not appear on the balance sheet. In a highly competitive global market, banks must compete aggressively to obtain the funds necessary to provide loans and other products and services. For example, bank customers request loans from banks. The banks try to forecast future loan demand to ensure they have the funds available to meet the forecast loan demand. As the banks lend hundreds of millions of dollars in a short-term planning period, ensuring the availability of funds is a critical issue. To do this, the banks have moved from a practice known as asset management to the practice of liability management. In the highly regulated banking sector, asset management was the dominant practice. Because of regulation, banks restricted their loan activity (assets) to match the available amount of deposits they received from customers. It was not uncommon for a bank to run out of funds for lending by the end of the month. It was expected that customers would come back next month to try again to obtain a loan. Liability management developed with the removal of restrictive regulation. It is the normal practice today. Commercial banks now actively manage their sources of funds (liabilities) in order to ensure they have sufficient funds available to meet loan demand and other commitments. If loan demand is forecast to increase, banks enter the capital markets and borrow the necessary funds required to meet their forecast loan demand. Banks are no longer dependent on their deposit base for lending. They manage their liability base by borrowing directly from the domestic and international capital markets. As the major banks typically have high credit ratings, they are able to borrow substantial amounts, especially within the international capital markets.

LEARNING OBJECTIVE 2.1 Evaluate the functions and activities of commercial banks within the financial system.

Asset management a bank restricts growth in its lending to the level of funds available from its depositor base

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Part 1 Financial institutions Off-balance-sheet business transactions that represent a contingent liability and therefore are not recorded on the balance sheet

Banks also undertake a substantial volume of business that is not recorded as assets or liabilities on their balance sheets. This is referred to as off-balance-sheet business. For example, commercial banks have developed expertise in the provision of risk management products, using a range of over-the- counter and exchange-traded derivative instruments. They also provide products and services that assist their customers to carry out import and export business.

REFLECTION POINTS

• • •

A core function of commercial banks is to gather savings from depositors and investors, and use those funds in the provision of loans to customers. Commercial banks also conduct off-balance-sheet business. These are contingent liabilities such as the promise to finance future trade transactions. Banks compete in the global capital markets to raise funds in addition to their depositor base. This is known as liability management, whereby a bank borrows sufficient funds (liabilities) direct from the capital markets to meet forecast loan demand.

2.2 LEARNING OBJECTIVE 2.2 Identify the main sources of funds of commercial banks, including current deposits, demand deposits, term deposits, negotiable certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency liabilities and loan capital.

If the major part of a commercial bank’s business is the provision of loans to customers, then the first question must be: where does the bank obtain the funds that it lends? Sources of funds appear on a bank balance sheet either as liabilities that the bank will eventually repay or as equity funds provided by shareholders. In order to attract the savings of surplus entities, commercial banks offer a range of instruments with different terms to maturity, liquidity, rates of return and cash-flow attributes. The main sources of commercial bank funds considered in this section are:

• • • • • • • •

current account deposits call or demand deposits term deposits negotiable certificates of deposit bill acceptance liabilities debt liabilities foreign currency liabilities loan capital and shareholders’ equity.

2.2.1 Current account deposits liquid funds held in a cheque account; cheques drawn to purchase goods and services

Sources of funds

C URRENT ACCOUNT DEPOSITS

One of the most liquid instruments offered by a bank is a current account deposit. These funds are held in a cheque account facility. Deposits in a cheque account provide liquidity in that they can be used directly in payment for goods and services. The current account holder is able to write an order on a cheque that instructs its bank to pay funds to the named payee. For example, a plumber may need to pay a plumbing supplier for copper pipe and fittings. The plumber may write a cheque for the amount due and give the cheque to the plumbing supplier. The plumbing supplier will lodge the cheque with its bank, which will then obtain the funds from the plumber’s bank. This financial settlement occurs through the payments system and is discussed in Chapter 12. Even though current account deposits are liquid funds, they also provide a stable source of funds for the banks. This stability occurs because current account deposits can be used to pay for goods

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Chapter 2  Commercial banks

and services. The dynamics of an economy means that individuals and businesses are continually conducting transactions for goods and services and therefore current account deposits are always being maintained for this purpose, thereby creating an ongoing funding source for the banks. A business cheque account is usually referred to as its operating account. An operating account is used by a business to pay periodic expenses as they fall due. (This is discussed further in Chapter 9.) A cheque account will generally pay interest on credit funds in the account. The level of interest paid is usually quite low and reflects the highly liquid nature of current account deposits.

2.2.2

C ALL OR DEMAND DEPOSITS

Call deposits are held in accounts other than a cheque account where the funds are available on demand. These types of accounts are generally referred to as savings accounts. Call deposit account holders usually receive interest payments, but the return on funds invested is low. As with the current account, the low rate of return represents the highly liquid nature and low risk attached to this type of account. Banks typically charge transaction and account service fees on savings-type accounts. It may be argued that the lower rates of return plus the fee structures tend to discourage customers from maintaining excess funds in this type of account. Nevertheless, call or demand deposits have historically represented a stable source of funds for the banks. This stability derives from individuals’ collective desire to hold some funds in an account that can easily be used to meet forecast expenses and unexpected contingencies.

2.2.3

funds held in a savings account that can be withdrawn on demand

T ERM DEPOSITS

Term deposits are funds lodged in an account with a bank for a specified period of time. Such funds receive a fixed rate of interest for the period of the investment. The saver nominates the term to maturity at the time the funds are invested. Commercial banks typically offer term deposits that range from one month through to five years to maturity. Term deposits offer savers a higher rate of return than is available on current accounts or call deposits. The higher return compensates the saver for the loss of liquidity with this type of deposit; that is, the term deposit is fixed for the nominated period. Savers often use term deposits as an investment alternative for surplus funds that are not immediately required for consumption. The term deposit is a safe and stable investment that is particularly attractive to a conservative investor. Term deposits are popular in countries that have an ageing population. Often these investors seek secure investments that produce known income streams. History shows us that in times of volatility in the financial markets investors tend to revert to the safe haven of the bank term deposit.

2.2.4

Call deposits

Term deposits funds lodged in an account for a predetermined period and at a specified fixed interest rate

N EGOTIABLE CERTIFICATES OF DEPOSIT

Another source of short-term funding used by banks is the negotiable certificate of deposit, referred to in the market as the CD. The CD is a certificate issued by a bank undertaking to pay to the bearer the face value of the CD at the specified maturity date. A CD is different from other forms of deposit in that a bank may issue a CD directly into the money market. The CD does not include any interest payments. It is sold by the issuing bank to an investor at a discount to the face value of the certificate. The CD is therefore known as a discount security. The term to maturity of CDs typically ranges up to 180 days. For example, if the face value of a 180-day to maturity CD is $100 000, the buyer may pay $96 755.38 to the issuing bank. On maturity of the CD, the holder of the certificate will receive $100 000 on presentation of the CD to the issuer bank. Had the original owner of the CD held it until maturity, such an investment would represent a dollar return of $3244.62, which is a yield of 6.80 per cent per annum. The structure and pricing of a CD is discussed further in Chapter 9.

Negotiable certificate of deposit a discount security issued by a bank

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Part 1 Financial institutions

Negotiable security a financial instrument that can easily be sold into a deep and liquid secondary market

Another feature of the CD that distinguishes it from other, more standard types of bank deposits is that it is a negotiable security. In the money markets there is a deep and liquid secondary market in CDs. The original purchaser of a CD may sell the CD in the secondary market to any other party, at any time up to the maturity date. The subsequent owner similarly may sell the CD. At the maturity date, it is the holder of the CD who receives the face value of the security from the issuing bank. The CD is a liquid instrument, but the liquidity does not directly affect the amount of funds available to the issuing bank because the CD is only repaid at maturity. Selling the CD during its term is simply a change of ownership. Another attribute of the CD is that the yield offered on new CDs can be adjusted quickly as the banks’ funding requirements change. CDs have become important in the liability management approach of banks. Effectively, the rate of return can be changed from one transaction to another. This flexibility is not as easily achieved on the more standard bank deposits.

2.2.5 Bill of exchange a short-term moneymarket discount security; face value repayable at maturity

Acceptance a bank puts its name on a bill issued by a third party; bank accepts primary liability to repay the face value of the bill at maturity

Debenture a form of security attached to a corporate bond; a fixed and/or floating charge over the assets of the issuer

Unsecured note a corporate bond issued without any form of underlying security attached

Collateralised floating charge security attached to a loan; if the borrower defaults, the lender will take possession of the borrower’s assets

B ILL ACCEPTANCE LIABILITIES

A business may seek to raise funds through the issue of a bill of exchange. A commercial bank may take two different roles in this type of funding arrangement. First, the bank may act as acceptor to the bill and, second, the bank may discount the bill. If a bank takes on the acceptance role, then the bill of exchange is said to be a bank-accepted bill. Bank bills are discussed in detail in Chapter 9; a brief description is provided here. A bill is a discount security; that is, it is issued today and sold at a price that is less than the face value. The bill does not pay interest. The face value of the bill is repayable at the maturity date. Therefore, the return to the holder is the difference between the price at which the bill is bought and the price at which it is sold before maturity, or the face value at maturity. A business that issues a bill will sell the bill at a discount to the face value. In order to encourage an investor to buy the bill, the issuer may ask a bank also to put its name on the bill. If a bank puts its name on the bill, the bank is said to be the acceptor. The acceptor, on behalf of the issuer, will repay the face value of the bill to the holder at maturity. By acting as the acceptor, the bank increases the creditworthiness of the bill. The bank will have a separate arrangement in place to ensure that it recovers the funds from the issuer on the maturity date. The bank charges a fee for this service. The bank may also agree to discount and buy the bill from the issuer. Rather than hold the bill to maturity, the bank is most likely to sell (re-discount) the bill immediately into the money market. In this situation the bank has incurred a liability on its balance sheet because of the acceptance commitment, that is, the agreement to repay the face value to the holder at maturity. By selling the bill into the money market, the bank has been able to arrange finance for its business customer without having to use its own funds.

2.2.6

D EBT LIABILITIES

As part of their strategic management of liabilities, banks issue debt instruments into both the money markets and the capital markets. The principal domestic money-market instrument—the negotiable certificate of deposit (CD)—has been discussed above. However, the majority of banks’ assets are longer-term loans; therefore, banks must actively borrow in the capital markets in order to fund part of their lending. Medium- to long-term instruments issued by banks include debentures, unsecured notes and transferable certificates of deposit. Debentures and unsecured notes are bonds issued by corporations, including banks. Bonds pay a regular interest coupon to the holder, usually semi-annually or annually. The principal is repaid at the maturity date. The periodic interest payments may be a fixed interest rate, or based on a variable rate that may change from time to time. Debentures are bonds with a form of security attached. The security for a bank-issued debenture is usually a collateralised floating charge over the assets of the institution. An unsecured note is a bond with no security attached.

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Chapter 2  Commercial banks

Transferable certificates of deposit are long-term fixed-rate instruments typically issued with a minimum face value of $100 000 and with terms to maturity of three to five years.

2.2.7

F OREIGN CURRENCY LIABILITIES

Deregulation of the financial system opened up enormous opportunities for commercial banks to expand their activities and fund their balance sheets from international sources of funds. For example, deregulation included the floating of the exchange rate of major currencies, the opening up of the foreign exchange markets and the removal of most restrictions on the flow of capital in the international markets. The large international capital markets are an important source of foreign currency liabilities for commercial banks. Banks find it easier to raise substantial amounts of debt in the international capital markets, often at a net lower cost, than in their traditional, transaction-based depositor base. For example, the major Australian banks (National Australia Bank, Westpac Banking Corporation, Commonwealth Bank and ANZ Banking Group) periodically issue debt instruments into the international capital markets to raise amounts ranging from $500 million to $1 billion. These funds may then be used over the next three to six months to fund the demand for loans from customers. Chapter 11 will offer a more detailed study of the types of debt issued into the international capital markets, in particular those issued into the euromarkets and the US markets. International debt issues are typically denominated in a foreign currency such as the US dollar, the yen, the pound sterling or the euro. The types of debt issued are essentially the same as those issued in the domestic markets and include discount securities (Chapter 9), medium-term notes, debentures and unsecured notes (Chapter 10). Globalisation means that the banks’ major corporate clients have become more internationalised. This has increased business demand for financial services denominated in the currencies of their commercial and financial transactions. That demand provides a further reason for the banks to seek foreign currency liabilities.

2.2.8

L OAN CAPITAL AND SHAREHOLDERS’ EQUITY

Another source of funds, which has the characteristics of both debt and equity, is described as loan capital or hybrid securities. For example, a bank may issue subordinated notes. These instruments are subordinated, which means that the holder of the security will only be paid interest payments, or have the principal repaid, after the entitlements of all other creditors (but before ordinary shareholders) have been paid. Commercial banks are listed corporations; that is, the institution issues equity securities such as ordinary shares that are quoted on a stock exchange. Also, banks typically generate profits from their business activities. Some of the profits are paid to shareholders as dividends; some are kept as retained earnings, which increases shareholders’ funds. Equity is an important source of long-term funds for the commercial banks. In fact, banks are required by the bank regulator to hold minimum levels of equity (capital). Capital adequacy requirements for banks are discussed later in the chapter.

Foreign currency liabilities debt instruments issued into the international capital markets that are denominated in another currency

Euromarkets debt markets where instruments are issued into another country, but not denominated in the currency of that country

Globalisation the integration of financial institutions, instruments and markets into an international financial system

Loan capital sources of funds that have the characteristics of both debt and equity

REFLECTION POINTS

• •

Commercial banks are highly leveraged organisations; that is, a large percentage of their funds is in the form of debt liabilities that must be repaid; the remainder is different types of equity. Current account deposits are liquid funds held in a cheque account; a cheque is a written instruction to the bank to pay the specified sum to the payee shown on the cheque. Businesses use cheque accounts as their operating accounts.

continued

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Part 1 Financial institutions continued

• • • • • • •

Call or demand deposits are liquid funds held in a savings-type account. They represent a stable source of funds for banks. They typically pay a low rate of interest, and account fees may be charged. Term deposits are savings lodged for a specified period of time that pay a fixed rate of interest. The higher interest rate compensates for the loss of liquidity. Negotiable certificates of deposit are short-term discount securities issued by a bank and sold into the money market. They are issued today with a face value payable at maturity, and no interest is paid. Bill acceptance liabilities are a commitment by a bank, on behalf of the bill issuer, to pay the face value of a bank-accepted bill to the bill holder at maturity. Debt liabilities are longer-term debt instruments issued directly into the local capital markets. They include interest-paying bonds such as debentures, unsecured notes and transferable certificates of deposit. Commercial banks issue foreign-currency-denominated debt securities into the international capital markets to raise foreign currency liabilities. Loan capital includes hybrid securities issued by a bank such as subordinated notes. The main type of equity issued is ordinary shares. Shareholder funds are an important source of longterm funding.

2.3 LEARNING OBJECTIVE 2.3 Identify the main uses of funds by commercial banks, including personal and housing lending, commercial lending, lending to government and other bank assets.

Funds used by commercial banks appear as assets on their balance sheets. The majority of bank assets are financial assets that create an entitlement to future cash flows; for example, if a bank gives a customer a loan, then the amount outstanding on the loan will appear as an asset on the bank’s balance sheet. The bank is entitled to receive periodic interest payments plus repayment of the principal in accordance with the terms and conditions of the loan contract. A bank will also accumulate other assets, such as branch premises and electronic systems. In this section we categorise commercial bank assets into the following categories:

• • • •

personal and housing finance commercial lending lending to government other bank assets.

2.3.1 Housing finance the provision of longterm funds to enable the purchase of residential property

Mortgage a form of security whereby a lender registers an interest over the title of a property

Uses of funds

P ERSONAL AND HOUSING FINANCE

Banks are the principal providers of finance to individuals. The type and amount of bank lending to individuals will vary between banks, and often between countries, and will reflect the specific priorities of both lenders and borrowers. In Australia, for example, the largest form of bank lending is for owneroccupied housing. Other forms of personal finance include investment property finance, fixed-term loans, personal overdrafts and credit card finance. Housing finance, where the bank registers a mortgage over the property as security for the loan, is an attractive form of lending as the risk of default by the borrower is normally low. In theory, borrowers will always try and meet their housing loan commitments because if they don’t, the bank will take possession of the house and sell it to recover the amount owing. The sale of a house

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under these circumstances certainly will not be in the best interests of the borrower. However, these circumstances do not always hold. The GFC was precipitated by falling home values and increasing rates of default on home loans. When house prices fell below the value of their loans, homeowners, particularly in the USA, had weaker incentives to continue to meet their housing loan commitments. Instead, many borrowers simply walked away because at that time they could leave the liability with the bank. This had catastrophic effects for the value of mortgage securities and the financial system. Commercial banks have traditionally dominated the residential housing loan market. However, many new providers of housing finance have entered the market, significantly increasing competition. For example, insurance offices and superannuation funds now provide housing loan finance. Also, specialist providers of housing finance, referred to as mortgage originators, have grown in the deregulated financial market. Both mortgage originators and commercial banks often use the process of securitisation to finance their lending activities. Briefly, a lender may seek to obtain additional funds in order to provide new housing loans by selling existing housing loans. Securitisation can be described as the selling of a class of assets, such as housing loans, into a trust. The trustee, in order to raise funds to pay for the purchase of these housing loan assets, will issue new securities to investors. The securities issued by the trustee may be bonds that are secured by the housing loans held in the trust. Investors like the securities because, under normal circumstances, they are lower-risk assets. The trustee will use the interest and principal payments due from the housing loans held in the trust to pay interest and repay principal on the new securities issued. The term of a housing loan will vary quite considerably between countries. The major determinant of the term of housing loans in a country is the average cost of housing coupled with the level of interest rates. In countries where property prices are very high, the term of the housing loan will be longer. If this was not the case, individuals would not be able to afford to repay their loan commitments. For example, in Australia the average term of a housing loan is 30 years. Housing loan repayment schedules may also differ. A typical owner-occupied housing loan will require regular amortised loan instalments over the period of the loan. Each loan instalment with an amortised loan comprises an interest component and a part repayment of principal component. Banks offer housing loans with either a fixed interest rate or a variable interest rate. However, a fixed-rate loan will usually be reset every five years or less. The interest rate on variable-rate loans will move from time to time in accordance with changes in interest rates in the markets. Another significant form of housing finance is known as investment property finance. In this situation the bank provides funds to an individual investor who purchases a property for rental or leasing purposes. Again, the bank will take a registered mortgage over the property as security for the loan. Individuals borrow for a range of reasons, such as to purchase a car or travel overseas. In these circumstances, the bank may provide the borrower with a fixed-term loan. Typically, the term loan will have a term to maturity of up to five years. As with housing finance, interest rates may be fixed or variable. The bank will require some form of security, such as a guarantee, to support the loan. Housing (mortgage) finance and term loans are discussed further in Chapter 10. Banks provide personal overdraft facilities for individuals. The personal overdraft allows an individual to put a nominated account into debit from time to time up to an agreed limit. Often, individuals need to manage the mismatch in the timing of their cash flows and the personal overdraft allows them to pay expenses when they are due by putting the overdraft account into debit. The bank expects that the overdraft will be brought back into credit when the individual receives income. A more flexible alternative to a personal overdraft is a credit card facility. A credit card typically is used to conduct electronic transactions, such as using automatic teller machines (ATMs) or electronic funds transfer at point of sale (EFTPOS), by drawing on a predetermined credit limit provided by the card issuer. The bank as the credit provider will allow the card user to draw against a predetermined credit limit. Credit cards typically have high interest rates on used credit, and a range of transaction and other fees might also apply.

Mortgage originators specialist mortgage lenders that typically refinance their lending through securitisation

Amortised loan instalments regular and equal loan instalments that comprise the current interest payment due, plus part repayment of the loan principal outstanding

Investment property finance funding that enables a borrower to purchase property to rent or lease to a third party

Fixed-term loan a loan provided for a predetermined period; used to purchase specified goods or services

Credit card a card facility that provides access to funds through electronic distribution systems: ATMs, EFTPOS

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2.3.2

Reference interest rate a benchmark interest rate published daily and used for pricing variable-rate loans

BBSW the average mid-point of banks’ bid and offer rates in the bank bill secondary market

Overdraft an arrangement with a bank that allows a business to place its operating account into debit up to an agreed limit

Commercial bills a bill of exchange issued direct to raise finance for a business; a discount security; may be sold into the money market

Bank bills held bills that have been accepted and discounted by a bank and are held as a balance-sheet asset

Rollover facility an arrangement whereby a bank agrees to discount new securities over a specified period as the existing securities mature

Lease an arrangement in which the owner of an asset, the lessor, allows a lessee to use the asset in return for periodic lease payments

C OMMERCIAL LENDING

Commercial lending represents bank assets invested in the business sector plus lending to other financial institutions. Bank lending to business is essential if economic growth is to be achieved within a nationstate. Economic growth generates benefits such as increased production, higher levels of employment and better living standards within a country. In Chapter 1 we discussed the concept of direct finance and intermediated finance, and noted that only those corporations with a good credit rating are able to raise funds through direct finance. Therefore, in numeric terms, the majority of business borrowers do not have access to the direct finance markets. These firms raise funds by borrowing from financial intermediaries. Commercial banks are the principal lenders, particularly to small and medium-sized businesses. It is worth noting that larger corporations may still borrow from the commercial banks, but they are also able to borrow direct from the markets. The main type of loan provided by the banks to firms is the term loan. Typically, term loans are for maturities ranging from three to seven years. Business borrowers negotiate the terms and conditions of a loan with their bank. Conditions will include the period of the loan, the interest rate, security provided to support the loan, and the timing of interest payments and the repayment of principal. Commercial banks offer borrowers both short-term and long-term loans. Interest rates may be based on a fixed interest rate or a variable rate set to a specified reference interest rate. For example, in Australia a reference rate that is often used is the bank bill swap rate, or BBSW. The BBSW is the average mid-point of banks’ bid and offer rates in the secondary bill market and is calculated and published daily. International reference rates such as LIBOR and USCP are discussed in Chapter 11. Loan instalments may be required monthly and may include both interest and part repayment of principal outstanding. On the other hand, the borrower may be required to make only the interest payments, and the principal is repaid in one lump sum at the maturity date. Loan repayments may be deferred for a period before regular instalments commence. Term-loan financing is discussed in Chapter 10. Banks provide overdraft facilities to businesses. The main purpose of an overdraft is to enable a business to manage mismatches in the timing of its cash flows. Businesses typically need to pay out funds for expenses before they receive funds back from their business operations. An overdraft facility allows a business to place its operating account into debit up to an agreed amount. While offering flexibility to the business, it should be noted that an overdraft is repayable upon demand by the bank and therefore needs to be managed carefully. Of course, the bank charges fees and interest for this very flexible funding arrangement. The bank also expects that the firm will bring the overdraft back into credit as revenues are received by the business. Therefore, an overdraft will normally fluctuate between being in debit and being in credit. The discussion of overdraft facilities is extended in Chapter 9. Bills of exchange were discussed earlier in the chapter. Commercial bills are discount securities. We noted above that a bank may act as an acceptor to a bill issued by a client, and that the bank will often discount the bill (buy it at less than the face value). The bank will then generally sell the discounted bills into the money market, but if the bank decides to hold the bills as assets on its balance sheet, these are described as bank bills held. Commercial bills are normally drawn for terms ranging from 30 to 180 days. In order to extend the overall term of this type of short-term financing, a bank may provide a customer with a rollover facility. For example, if a business has issued 90-day bills with a two-year rollover facility, the customer is able to redraw new bills every 90 days for the next two years. When the new bills are drawn, the yield on the bills will change to reflect current rates in the market. This means the bills are re-priced every 90 days, thus protecting the bank from the risk that interest rates might change. The bank bills money market is deep and liquid. This allows banks the flexibility initially to provide funding to business borrowers by discounting bills, but with the option to sell those bills easily into the money market to generate more funds for further lending. Another important category of bank finance is leasing. A lease is an arrangement whereby the owner of an asset (the lessor) allows another party (the lessee) to use that asset subject to the terms and conditions of the lease contract. A bank, as lessor, will finance the purchase of an asset and will enter into a financial arrangement with the lessee whereby the lessee will make lease payments in return for

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the use of the asset. Essentially, the lessee is borrowing the asset rather than borrowing the funds to purchase the asset. Leasing is discussed further in Chapter 10.

2.3.3

L ENDING TO GOVERNMENT

Governments generally borrow direct from the markets. Commercial banks lend to government directly by investing in government-issued securities, such as Treasury notes, Treasury bonds and other public sector securities. Banks may also provide some loans to government agencies in the form of term loans and overdraft facilities. Governments need to manage their short-term and longer-term cash flows. Short-term funds are required to meet regular commitments such as social security benefits and the salaries of government employees. Longer-term funding is required for capital expenditures such as building hospitals and water storage facilities. If the timing of taxation and other income receipts does not cover intra-year expenses, a government may issue short-term securities such as Treasury notes (T-notes) to raise the necessary short-term funds. Longer-term budget capital expenditures will be funded through the issue of Treasury bonds. Banks purchase a proportion of these securities issued by government. Government borrowing and debt instruments are discussed further in Chapter 12. Securities issued by governments are usually regarded as having a very low level of risk and therefore yield a low rate of return. Why do banks invest in government securities when they could obtain a higher return by giving more loans to other borrowers? There are a number of reasons. Government securities:

• • • • • • • •

are an investment alternative for surplus funds that a bank is holding are a source of liquidity as they can be easily sold in the secondary markets when funds are needed for further lending

Treasury notes (T-notes) short-term discount securities issued by the government; face value payable at maturity

Treasury bonds medium- to long-term securities issued by the government; pay regular half-yearly interest, principal repaid at maturity

provide income streams and potential capital gains, whereas holding cash does not may be used as collateral to support the bank’s own borrowings in the direct finance markets may be used for a repurchase agreement with the central bank in order to raise cleared funds for payments system settlements (Chapter 12) improve the quality of the balance sheet by holding a group of assets (government paper) with lower-risk attributes enable a bank to manage the maturity structure of its balance sheet by purchasing securities with a range of maturities and cash flows allow a bank to manage its interest rate risk by buying or selling securities with different interest rate structures (fixed or variable interest rates).

Therefore, lending to government, particularly through the purchase of government securities, provides a bank with the flexibility to actively manage its overall asset portfolio, while at the same time lowering the overall levels of risk in its asset portfolio.

2.3.4

O THER BANK ASSETS

Bank lending is the core business of commercial banks and the largest allocation of their assets. However, banks accumulate a range of other assets, including receivables, shares in and loans to controlled entities, goodwill, property, plant and equipment and unrealised gains from their trading activities in derivative products. Banks are highly dependent on their information systems and product delivery systems. Therefore, they invest heavily in technology, property, plant and equipment. Nevertheless, there has been a shift away from the accumulation of physical assets, including a contraction of branch networks. The reduction in the branch networks has been offset by an increase in the use of electronic products and service delivery systems, such as phone and internet banking, ATMs and EFTPOS. Apart from direct branch closures, the divesting of physical assets has taken several other forms. For example, 51

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some banks have sold a proportion of their branch premises and entered into lease-back arrangements. Others have outsourced their computer centre operations to specialist providers. You can test your understanding of the sources and uses of funds by commercial banks by examining the balance sheet of a major bank. The notes to the accounts reveal the details of the various sources and uses of funds. Banks publish their financial statements on their websites; for example:

• • • •

Australia and New Zealand Bank Group Limited at www.anz.com.au Commonwealth Bank of Australia Limited at www.commbank.com.au National Australia Bank Limited at www.nab.com.au Westpac Banking Corporation at www.westpac.com.au

REFLECTION POINTS

• • • • • • • • • • •

The major business of commercial banks is the provision of loans to customers. Personal finance includes housing loans, term loans and credit card facilities. Housing finance is the provision of loans to purchase residential property. As security, the bank will register a mortgage over the property. Loan repayments may be amortised; that is, each loan instalment includes both interest and principal repayments. A bank may securitise part of its loan portfolio; that is, sell a group of loans into a trust in order to raise additional funds for new lending. Commercial lending is loans provided to the business sector, including overdrafts, term loans and mortgage finance. Loans may have a fixed interest rate, or a variable interest rate based on a reference rate such as the BBSW. Businesses establish overdraft facilities that allow a firm to put its operating account into debit up to an agreed limit. This fluctuating facility allows a business to manage the timing of its cash flows. Banks are providers of lease finance, whereby the bank purchases an asset that is leased to a customer. Banks mainly lend to government by purchasing government securities. These securities allow banks to invest surplus funds and manage interest rate risk and maturity risk in the asset portfolio. Banks also accumulate other assets such as physical infrastructure, for example, branches, and electronic information and product delivery systems.

2.4 LEARNING OBJECTIVE 2.4 Outline the nature and importance of banks’ off-balancesheet business, including direct credit substitutes, trade- and performance-related items, commitments and market-rate-related contracts.

Off-balance-sheet business

The focus of the previous discussion has been on the balance sheet—specifically, the acquisition and uses of funds by the commercial banks. Such an emphasis understates the role of a modern bank. It was noted at the beginning of the chapter that banks undertake a substantial volume of business that, by its nature, is not recorded as an asset or liability on the balance sheet. Such off-balance-sheet transactions represent an important source of income for the banks, and are most important in the financial life of businesses and governments. The main types of off-balance-sheet business conducted by commercial banks can be divided into four major categories:

• • • •

direct credit substitutes trade- and performance-related items commitments foreign exchange contracts, interest rate contracts and other market-rate-related contracts.

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Direct credit substitutes and trade- and performance-related items generally involve the bank in supporting or guaranteeing the obligation of a client to a third party. Normally the bank will make a payment to that third party only if a specified event occurs. Commitments relate to a bank’s contractual obligations to customers that are yet to be completed. Finally, market-rate-related contracts involve the use of derivative products to manage financial risk exposures of the bank and its customers. The large commercial banks also provide a wide range of advisory services to business and government. These advisory services include risk management advice and portfolio restructuring advice. Much more detail is provided on these types of advisory services in Chapter 3, Section 3.1.2 (‘Off-balance-sheet business’).

2.4.1

D IRECT CREDIT SUBSTITUTES

Direct credit substitutes are provided by a commercial bank to support a client’s financial obligations. In this situation, the bank does not provide the finance from its own balance sheet. The direct credit substitute effectively ensures that the client is able to raise funds direct from the markets. For example, the direct credit substitute may take the form of a stand-by letter of credit. This is an undertaking by a bank to make payment to a specified third party if the bank’s client fails to meet its financial obligation to that party. With the bank undertaking in place, the client is able to issue securities and raise funds directly in the markets, since the lender is assured that amounts due will be repaid by either the borrower or the bank that issued the letter of credit. Other examples of direct credit substitutes include guarantees, indemnities and letters of comfort issued by a bank that have the effect of guaranteeing the financial obligations of a client. For example, a bank’s client, when submitting tender documents for a major construction project, may need to provide, with the tender documents, a formal assurance that it has the financial capacity to complete the project. It would be expected that if the client wins the tender, the bank will provide finance for the project.

2.4.2

•

an undertaking provided by a bank to support the financial obligations of a client

T RADE- AND PERFORMANCE-RELATED ITEMS

Trade- and performance-related items are also guarantees made by a bank on behalf of its client, but in this case they are made to support a client’s non-financial contractual obligations. The obligations may include trade-related undertakings or contractual agreements to provide goods or services. In these circumstances, the bank provides a guarantee on behalf of its client that it will make a payment to the third party subject to the terms of the specific commercial contract. Examples of trade- and performance-related items include:

•

Direct credit substitute

Documentary letters of credit (DLCs). These are where a bank substitutes its credit standing for that of its client. The bank, on behalf of its client, will authorise payment to a named party against delivery by that party of a shipment of goods (evidenced in specified documents). For example, an exporter of goods will usually require the importer of the goods to arrange for its bank to provide a documentary letter of credit to the exporter’s bank. Once the imported goods arrive in the country, the associated documents are inspected and payment is made between the banks immediately. The DLC will be irrevocable; that is, it cannot be cancelled.

Trade- and performance-related item an undertaking provided by a bank to a third party promising payment under the terms of a specified commercial contract

Performance guarantees. These are where a bank agrees to provide financial compensation to a third party if a client does not complete the terms and conditions of a contract. For example, a client may be deemed to have failed to complete the terms of a contract if inferior components are used in a major computer system upgrade.

2.4.3

C OMMITMENTS

Commitments involve a bank in an undertaking to advance funds to a client, to underwrite debt and equity issues or to purchase assets at some future date.

Commitments the contractual financial obligations of a bank that are yet to be completed or delivered

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Examples of commitments include:

• • • • •

Outright forward purchase agreements. These are where a bank contracts to buy a specified asset, such as foreign currency, from its client at an agreed exchange rate on a specified date. Repurchase agreements. A bank sells assets, such as government securities, on the understanding that the bank will repurchase them at a specified date. Underwriting facilities. A bank guarantees a client that, subject to a range of conditions, it will cover any shortfall in funds received from a primary market issue of debt or equity securities. Loans approved but not yet drawn down. For example, a bank has agreed to provide a borrower with a loan at a future date upon completion of the loan documentation. Credit card limit approvals that have not been used by card holders. For example, a bank may authorise a credit card limit of $4000 for a client. If the client uses $1000 of the available credit, then that amount will appear on the balance sheet as an asset (loan), and the remaining $3000 credit remains as an off-balance-sheet commitment.

2.4.4

F OREIGN EXCHANGE CONTRACTS, INTEREST RATE CONTRACTS AND OTHER MARKET-RATE-RELATED CONTRACTS

Market-rate-related contracts derivative products; allow management of exposures to interest rate, foreign exchange, equity and commodity price risks

Hedging implementing strategies to protect against an identified risk exposure

Foreign exchange, interest rate and other market-rate-related contracts principally involve the use of derivative products—that is, futures, options, swaps and forward contracts. These instruments are primarily designed to facilitate hedging against risk; for example, the effects of movements in exchange rates, interest rates, equity prices and commodity prices. Derivative contracts are also bought and sold by traders in an attempt to make profits from movements in contract prices. Details of each of these instruments and their use for risk management are provided in Parts 5 and 6. Examples of foreign exchange, interest rate and other market-rate-related contracts include:

• • • • • •

Forward exchange contracts. A bank contracts to buy or sell at a future date a specified amount of a foreign currency at an exchange rate that is set today. Currency swap. A bank exchanges a principal amount and ongoing associated interest payments that are denominated in a foreign currency. Forward rate agreements. A compensation agreement between a bank and client based on a notional principal amount. One party compensates the other party if interest rates move above or below an agreed interest rate. Interest rate futures contracts. These are exchange-traded agreements to buy or sell a specific security at a specific price at a predetermined future date. Interest rate options contracts. These provide the right, but not the obligation, to buy or sell a specified financial instrument at an agreed date and price. Equity contracts. These include futures and options contracts based on specified stock prices or stock indices. These contracts lock in the equity price today that will apply at a specified future date.

2.4.5

V OLUME OF OFF-BALANCE-SHEET BUSINESS

There are two outstanding features of the banks’ off-balance-sheet business. The first is the magnitude of the notional face value of the off-balance-sheet contracts written by banks. This will vary between countries, but an examination of the volume of off-balance-sheet business within the Australian market gives a good indication of the size of the markets. In Australia, the face value of banks’ off-balance-sheet business as at December 2017 stood at $37 341 981 (million) while the total value of banks’ assets stood at $4 125 764 (million). That is, the 54

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notional value of off-balance-sheet business is nine times the value of total assets held by the banks. As described in Part 6, the notional value of many derivative products is significantly greater than the actual associated cash flows. Comparing the notional value of derivatives with the value of balancesheet assets does overstate the relationship. The second characteristic of the off-balance-sheet business is that it is mainly market-rate-related contracts. The notional values of the various types of off-balance-sheet business are shown in Table 2.1.

Table 2.1 Bank off-balance-sheet business, Australia, as at December 2017 Off-balance-sheet business type

Notional amount ($ millions)

Direct credit substitutes

46 806

Trade- and performance-related items

66 945

Commitments Interest rate contracts Foreign exchange contracts Credit derivatives Other Total

1 232 076 27 356 300 8 305 871 42 312 291 667 37 341 981

SOURCE: © Australian Prudential Regulation Authority 2018

The nature and size of market-rate-related contracts, combined with the volatility and speed at which contracts are re-priced in the market, has resulted in a number of extraordinary losses being incurred by both financial institutions and their clients. The threat to the stability of domestic and global financial systems that may result from large losses in the derivatives markets has been the subject of much discussion by regulators and prudential supervisors. One high-profile example (which has since been depicted in the movie Rogue Trader) was the loss of $1.5 billion by the UK bank Baring Brothers plc. Speculation on price movements of derivative contracts on the Singapore and Osaka exchanges by one of its traders, Nick Leeson, brought about the loss, which resulted in the eventual failure of the bank. Of course, during the GFC a number of institutions, including Lehman Brothers and Bear Stearns, collapsed as the direct or indirect result of excessive trading in mortgage-related derivatives. In the end, it is the responsibility of each bank to ensure that it establishes and documents objectives, policies and procedures in relation to its use of derivative products.

REFLECTION POINTS

• • • • •

Direct credit substitutes are provided by a bank to support a customer’s financial obligations to a third party (e.g. a letter of comfort written by the bank confirming that a customer has sufficient funding in place to proceed with a project). Trade- and performance-related items are guarantees given by a bank to support a customer’s obligations; for example, a bank will execute a documentary letter guaranteeing that it will pay for the importation of goods on behalf of its customer. Commitments are yet-to-be-completed financial agreements made by a bank to its customers (e.g. the approval to provide a loan in the future to purchase a house, or a credit limit on a credit card). Foreign exchange, interest rate and other market-rate-related contracts are typically derivative contracts, such as futures, forwards, options and swaps, used to manage risk exposures. The notional value of the off-balance-sheet business of banks is much greater than the value of balance-sheet assets. 55

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2.5 LEARNING OBJECTIVE 2.5 Consider the regulation and prudential supervision of banks.

Bank regulation constraints on banking activities through prescriptive legislation and prudential supervision

Prudential supervision the imposition and monitoring of standards designed to ensure the soundness and stability of a financial system

Regulation and prudential supervision of commercial banks

We have highlighted the essential role that the financial system plays in facilitating financial transactions that enable economic growth and prosperity. Therefore, governments and regulators have sought to maintain the stability and soundness of the financial system in order to achieve both economic objectives and social outcomes. The GFC cast a spotlight on the issue of regulation. In particular, the leverage that characterised the financial system in the years before the crisis attracted much attention. Many of the major financial institutions in the USA held assets with a value more than 30 times larger than the banks’ underlying capital reserves. This leverage was supported by short-term financing and innovative capital instruments that evaporated during the crisis. Following the crisis, the primary regulatory response has been Basel III. We will discuss this in detail in this chapter. However, concerns about the regulation of financial institutions did not just stem from the crisis. In Australia, the housing finance provided by banks and the potential for a ‘housing bubble’ raised questions about lending practices, and reports of poor treatment of customers eventually resulted in the establishment in 2018 of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Evidence heard at the Royal Commission raised additional questions about Australia’s financial regulatory frameworks. The primary purpose of this section is to consider issues arising from bank regulation and prudential supervision. This will vary between countries, but it is interesting to note that the principles and functions of bank regulation and supervision have changed in similar ways and at a similar pace in all developed economies. Much of the theory of bank regulation and supervision is the same internationally; variations exist to a degree but mostly in the detail of the application. It may be argued that a banking sector regulatory and supervisory framework should:

• • • • •

ensure a regulatory framework that is able to adjust regulation to maintain the cost effectiveness of the financial system in a dynamic environment provide a focused and accountable structure that facilitates community expectations for consumer protection and financial safety provide efficient and effective regulation of multinational financial conglomerates establish consistent regulation and competitive neutrality across the financial system contribute to effective monitoring and review with the aim of establishing more contestable, efficient and fair financial markets.

An area of concern for regulators is that of maintaining the soundness and stability of the financial system, and ensuring that savers have confidence in the institutions—in particular the  commercial banks—as safe repositories for their funds. Bank regulation no longer relies (as it once did) on heavily prescribing the asset composition of a bank’s balance sheet. Rather, it now imposes guidelines that allow the banks a wide range of options in their lending decisions, but forces those banks that adopt higherrisk lending strategies to support their activities with higher amounts of capital or shareholders’ funds. Regulation directly influences the structure, scope and scale of financial institutions, instruments and markets. The institutional framework for regulation and supervision of a financial system varies between countries. In some countries, the central bank acts as the banking sector regulator and supervisor; in other countries, the central bank has responsibility for the stability of the financial system and the soundness of the payments system, while a separate authority has responsibility for the regulation and supervision of financial institutions. Generally, other authorities will be responsible for competition law, consumer protection and corporations legislation supervision. By way of example, Australia has implemented a regulatory structure with the following features.

•

Overall responsibility for the maintenance of financial system stability, and soundness of the payments system, is the responsibility of the central bank (Reserve Bank of Australia).

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•

Prudential regulation and supervision of authorised deposit-taking institutions (i.e. commercial banks, building societies and credit unions), insurance offices, superannuation funds and friendly societies is the responsibility of the Australian Prudential Regulation Authority (APRA).

•

Regulation and supervision of market integrity and consumer protection, within the context of the Corporations Act 2001, is the responsibility of the Australian Securities and Investments Commission (ASIC).

•

Authorised deposittaking institutions financial institutions authorised by APRA to accept retail deposits in Australia

Matters of competition policy (Competition and Consumer Act 2010) are the responsibility of the Australian Competition and Consumer Commission (ACCC). Within this context, the government has implemented a  ‘four-pillars’ policy, which currently restricts mergers between the four major commercial banks in Australia.

A basic principle of APRA’s approach to bank supervision is that the primary responsibility for a bank’s sound operation rests with the bank’s own management and board of directors. However, there are some aspects of banking operations where APRA is more intrusive and has implemented prudential guidelines and standards, such as with the imposition of minimum capital requirements. In the event of a threat to the stability of the financial system, the Reserve Bank is responsible for determining whether, and how, it might provide emergency liquidity support to the financial system. The Reserve Bank, however, does not regard its balance sheet as available to support the solvency of an individual financial institution that may experience financial difficulty. Ultimately, each commercial bank must rely on the strength of its own balance sheet. Nevertheless, some depositor protection may be provided by the government. Deposit insurance, in the form of a Financial Claims Scheme (FCS), was introduced in Australia in October 2008 during the GFC. Under the FCS, $250 000 per person per institution is covered. More details are available at www.apra.gov.au.

REFLECTION POINTS

• • • • •

The important role of the financial system, in particular the commercial banks, in supporting economic growth means that each nation-state has established a regulator that sets prudential standards for the supervision of the banking sector. The GFC highlighted the importance of effective regulatory frameworks. The 2018 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry highlighted other areas for concern. The regulator may be the central bank, a specialist supervisory authority or a combination of both. In Australia, the central bank is the Reserve Bank of Australia, while the authority responsible for financial institution supervision is APRA. The ACCC is responsible for competition and consumer protection and ASIC is responsible for the Corporations Act. Government guarantees may be provided for certain bank deposits.

2.6

A background to the capital adequacy standards

According to APRA, capital is the cornerstone of a bank’s financial strength. This guides the most important prudential standard, ‘capital adequacy’. The balance sheet of a corporation, including a commercial bank, comprises a range of assets that are funded from liabilities and shareholders’ funds. Shareholders’ funds represent equity and may be referred to as capital. The main assets accumulated by commercial banks are its loans to customers. Typically, a percentage of borrowers will default on their loan repayments. Under normal circumstances, these loan losses are written off against profit in the

LEARNING OBJECTIVE 2.6 Understand the background and application of Basel III.

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relevant accounting period. However, if loan losses increase above the level of profits, then the losses must be written off against capital. They cannot be written off against liabilities because the bank must still repay its liabilities when due. Capital has a number of important functions, including:

• • • •

G-10 Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the UK and the USA

Basel II capital accord the standard that defines the minimum capital adequacy requirement for a bank

Basel III capital accord an enhanced set of capital, leverage and liquidity standards

It is the source of equity funds for a corporation. It demonstrates shareholders’ commitment to the organisation. It enables growth in a business and is a source of future profits. It is necessary in order to write off periodic abnormal business losses.

It is this last function of capital that is the basis upon which international capital adequacy standards for banks have evolved. Deregulation and globalisation of the international financial system, coupled with rapid advances in technology and the development of sophisticated financial products, created an environment in which there was the potential for instability or failure of the global financial system. Therefore, the governors of the central banks of the major industrialised countries, who meet monthly at the Bank for International Settlements (BIS) in Basel, Switzerland, established a new standing committee in 1974 which is now known as the Basel Committee on Banking Supervision. Currently, the committee’s members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the USA. However, the committee originally comprised only the senior bank regulators of the G-10 group of countries, plus Luxembourg and Switzerland. Even in the early 1970s, the committee recognised the problems involved in regulating internationally diversified banks and recommended that such banks should be treated on a globally consolidated basis but should come primarily under the regulatory powers of the home country. The committee presented a paper to the governors of the central banks in which it expressed concern about the erosion of banks’ capital bases and recommended that these should be rebuilt. The committee continued to work on the adequacy of banks’ capital and on the development of a common minimum standard of capital adequacy that international banks should maintain. The overriding purpose of the committee’s work was to develop a framework that would maintain the soundness of the international financial system and that would, at the same time, allow individual banks to make their own portfolio choices and promote a greater competitive equality between banks in the international markets. The committee’s work culminated in a document, The International Convergence of Capital Measurement and Capital Standards (Basel Committee Publication No. 4, published in July 1988). These capital adequacy requirements, currently referred to as the Basel I capital accord, were adopted by most countries that have commercial banks operating in the global financial system. The 1988 Basel I capital accord applied a standardised approach to the measurement of the capital adequacy of banks. Basel I was successful in increasing the amount of capital held by banks and therefore created a strong foundation to support the stability of the global financial system. However, over time, it became apparent that Basel I did not fully account for the diversity, sophistication or innovation of the changing financial markets. The committee conducted a major review of the capital adequacy guidelines, which culminated in the Basel II capital accord guidelines. Basel II capital adequacy guidelines were adopted by bank regulators in most major industrial countries and implemented by commercial banks. In some countries, including Australia, other regulated financial institutions were also required to meet the Basel II capital adequacy requirements. In 2010, the Basel III capital accord guidelines were released. The goal of Basel III is to make financial institutions more resilient to the economic shocks that occur periodically within an economic system that is characterised by financial institutions that do not hold reserves that match their liabilities. Basel III initially proposed enhancements to the quantity and quality of banks’ capital reserves, liquidity ratios and leverage ratios. These have been reviewed over time. The Basel III bank capital framework was finalised in December 2017.

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REFLECTION POINTS

• • • •

An international capital adequacy standard for banks was developed to strengthen the global financial system. Banks need sufficient capital to expand their business and also periodically to write off abnormal losses. The Bank for International Settlements established a permanent committee, the Basel Committee on Banking Supervision, to develop capital standards. The Basel I accord was introduced in 1988 and strengthened by the Basel II capital accord. The Basel III capital accord introduced enhanced capital requirements following the GFC. It was finalised in December 2017.

2.7

The Basel accords: evolution from Basel I to Basel III

Basel I developed a measure of capital adequacy that principally focused on the level of credit risk associated with a bank’s balance-sheet and off-balance-sheet business. Credit risk is the risk that counterparties to a transaction will default on their commitments. At the same time, bank supervisors did not wish to restrict the asset choices of banks or to stifle banks’ participation in off-balance-sheet business. An extension of the original guidelines introduced a capital requirement for market risk. Market risk is the exposure of an institution’s trading book to changes in interest rates and foreign currency exchange rates. Basel II was a major extension of Basel I and much more sensitive to different levels of risk that may exist within an institution and to the sophistication of modern risk management practice. The Basel II approach focused on:

• • • • • •

the credit risk associated with a bank’s balance-sheet and off-balance-sheet business the market risks associated with a bank’s trading activities the operational risk evident in a bank’s business operations the form and quality of capital held by a bank to support these exposures the risk identification, measurement and management processes adopted by banks transparency, through the accumulation and reporting of related information and data.

LEARNING OBJECTIVE 2.6 Understand the background and application of Basel III.

Credit risk the risk that an obligor will not make future interest payments or principal repayments when due

Market risk the exposure of a bank’s trading book to changes in interest rates and exchange rates

Basel III was primarily a response to the GFC but it has been revised and enhanced since then. The focus has remained on the capital adequacy of financial institutions. The main objective of Basel III is to increase bank liquidity and decrease bank leverage in order to support financial system stability. While the Basel capital accords are developed by the Bank for International Settlements, it is the responsibility of each country’s prudential regulator to implement the standards. We will look at the application of Basel III in Australia by APRA. You can view updates on implementation at www.apra.gov.au.

2.7.1

M INIMUM CAPITAL ADEQUACY REQUIREMENT

The Basel accords require that the ratio of a bank’s capital to its risk-weighted assets be set at some minimum level. A bank’s capital, including equity and retained earnings, forms the numerator for the capital ratio. A bank’s assets, including loans, forms the denominator. The assets are multiplied by a risk factor or ‘weight’ to reflect their inherent riskiness. More risky assets attract a higher weight, which reduces the capital ratio and requires more capital to be set aside to ensure that the capital ratio reaches 59

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the desired level. Minimum capital adequacy requirements apply to commercial banks and any other institutions specified by a country’s prudential regulator. In addition to a minimum total capital ratio to be maintained at all times, banks are required to maintain a capital conservation buffer of 2.50 per cent. To act as a further safeguard, a counter-cyclical buffer of between 0 and 2.50 per cent was also introduced to be applied when credit growth is judged to have resulted in an undesirable increase in systemic risk. In Australia, APRA will determine the level of the counter-cyclical buffer and bring it into effect when it deems it necessary to do so. Immediately following the GFC, the focus of the capital adequacy requirements was on the amount and nature of capital that would form the basis for determining a bank’s capital ratio. A distinction was made between Tier 1 and Tier 2 capital to ensure that the capital that banks set aside to meet their capital adequacy requirements contributed to financial strength in a real and meaningful way. Subsequent revisions to Basel III focused on the other half of the capital adequacy ratio. That is, the way in which a bank’s risk-weighted assets should be calculated to avoid weaknesses in the financial system emerging from dubious or inconsistent assumptions that banks might apply in developing their own internal risk models.

2.7.2 Common Equity Tier 1 capital highest quality; core capital for capital adequacy purposes

Tier 2 capital additional capital that contributes to a bank’s financial strength

T HE DEFINITION OF CAPITAL

Capital, within the context of Basel III, is measured in two tiers: Tier 1 and Tier 2. Common Equity Tier 1 capital, or CET1, consists of the highest quality capital: common shares, retained earnings and other reserves as set down by Australian Prudential Standard APS 111. APRA is phasing in a requirement that banks in Australia have a Common Equity Tier 1 capital (CET1) ratio of at least 10.50 per cent. Tier 2 capital is additional capital that contributes to a bank’s financial strength. Australian Prudential Standard APS 111 sets down the characteristics that an instrument must have to qualify as Tier 2 capital. Tier 2 capital includes subordinated debt and general loan-loss reserves.

2.7.3

B ASEL III STRUCTURAL FRAMEWORK

The Basel III capital accord framework is based on three integrated pillars:

• • •

Pillar 1: capital adequacy requirements, risk coverage and leverage ratios Pillar 2: risk management and supervision Pillar 3: the market discipline, incorporating disclosure and transparency requirements.

In the final version of Basel III, as mentioned previously, special focus was given to the methods that banks use to compute their risk-weighted assets (the denominator in the capital adequacy ratio). The mathematical models that banks use to compute the likelihood that they will suffer losses of varying magnitudes have been scrutinised very closely. Basel III, in its final version, not only ensures that banks set aside capital of appropriate quality but also ensures that the models used to compute the risk that the bank bears in carrying a particular asset are calibrated correctly. Extended learning A works through an example of the calculations involved. Pillar 1 incorporates components of credit risk, operational risk and market risk within the Basel III framework

Pillar 1: Credit risk component Pillar 1 incorporates three risk components: credit risk, operational risk and market risk. Credit risk relates to the underlying counterparty to a balance-sheet asset or an off-balance-sheet transaction. It is the risk that a counterparty is unable to meet its obligations. A bank’s risk-based capital ratio is the ratio of capital to risk-weighted assets. A bank’s assets include cash, loans and securities. The value of an asset is weighted by multiplying it by the appropriate risk weight. The safer the asset, the lower the risk weighting.

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How does a bank determine the risk weights to be applied to different types of assets? Basel III provides three alternative ways for a bank to measure credit risk: 1 the standardised approach (SA) 2 the foundation internal ratings-based approach (FIRB) 3 the advanced internal ratings-based approach (AIRB) Globally, most banks use the standardised approach for credit risk. The standardised approach to credit risk requires banks to assign each balance-sheet asset and off-balance-sheet item a risk weight that is based on an external rating published by an approved credit rating agency, or is a fixed weight specified by the prudential supervisor. This means that banks do not use their own internal models. Off-balance-sheet exposures that give rise to credit risk are first converted into so-called balance-sheet equivalents according to specified credit conversion factors prior to allocating the relevant risk weight. With regard to market-related off-balance-sheet transactions, a bank has the choice of two methods for determining the credit conversion factor: the current exposure method or the original exposure method. The current exposure method (mark-to-market) is the sum of the current credit exposure and the potential future credit exposure of a contract. The current credit exposure is defined as the sum of the positive mark-to-market value (or replacement cost) of a contract. The potential future credit exposure is determined by multiplying the notional principal amount by the relevant credit conversion factor. Each of these market-related off-balance-sheet transaction methods has its own set of credit conversion factors. The original exposure method applies a different set of credit conversion factors to the notional value of the contract. Larger commercial banks, under certain conditions, can use the internal ratings-based approach to credit risk. These banks have the information systems and expertise that enable a more sophisticated approach to the measurement and management of risk. In some cases, the bank’s estimate of the riskweighting to be applied to certain assets may be better informed than a risk-weighting determined by a prudential supervisor. However, there are obvious incentives for a bank to understate the riskiness of a particular asset. As such, Basel III places constraints on the use of internal models. There are two internal ratings-based approaches available: 1 the foundation internal ratings-based approach (FIRB) 2 the advanced internal ratings-based approach (AIRB). Under the FIRB approach, a bank must provide its own estimates of probability of default and effective maturity, but must rely on supervisory estimates for other credit risk components, including the loss given default estimates and exposure at default estimates. Under the AIRB approach, a bank must provide its own estimates of all of the credit risk components. Basel III removes the option for using AIRB to estimate the risk exposures to financial institutions. In addition, no internal models can be used at all to compute the risk for equity exposures. In Australia, APRA has decided to distinguish between authorised deposit-taking institutions that use internal models and those that use the standardised approach. In the transition to full Basel III implementation, those banks that use internal models will be required to meet a stricter capital  requirement than those banks that use a standardised approach. Those banks that are using internal models to assess their credit risk will be required to meet a capital requirement that is approximately 1.00 per cent (100 basis points) higher than banks that use the standardised approach. This is an indication of the additional scrutiny that has been directed to internal risk models since the GFC and which is reflected in the final version of Basel III.

Pillar 1: Operational risk component In recent years, banks have gained a greater understanding and awareness of operational risks that may result in the loss of business functions. The reality of disaster was particularly evident following the terrorist attacks in New York on 11 September 2001. The US financial system was severely tested as financial institutions and markets closed and struggled to recover their critical business

Standardised approach to credit risk provides risk weights to be applied to balancesheet assets and offbalance-sheet items to calculate minimum capital requirement

Current exposure method off-balance-sheet capital calculation based on the current and potential credit exposures’ mark-to-market

Original exposure method off-balance-sheet capital calculation based on the notional contract value multiplied by a credit conversion factor

Mark-to-market the revaluation of a contract based on its current quoted price on an exchange

Internal ratings-based approach to credit risk for capital calculations a bank may use some or all of its own risk measurement model factors; supervisor approval required

Operational risks exposures that may impact on the normal day-to-day business functions of an organisation

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operations. The direct and consequential operational and financial losses associated with that disaster were significant. The Bank for International Settlements categorises operational risk as:

• • • • • •

internal and external fraud employment practices and workplace safety clients, products and business practices damage to physical assets business disruption and system failures execution, delivery and process management.

The categorisation of operational risk is very wide ranging and indicates that all aspects of an organisation’s day-to-day business activities are exposed to operational risk. The Australian prudential supervisor, APRA, defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risks. The rapid advance in technology, together with globalisation of the international financial system, has increased the time sensitivity of banks to operational risk. For example, a bank’s derivatives transactions, foreign exchange trading and payments system settlements are clear examples of critical business functions that are time sensitive within very short time-frames. The loss by a bank of its critical business operations due to a disaster may severely challenge its operational and financial survival. For example, such disasters may include the loss of computer or communication systems, or severe damage from fire or earthquake. Further, operational risk contagion is an extended risk to which a country’s financial system is exposed. It is possible that contagion effects may result in instability within the global financial system. Principally, the management of operational risk requires the development and maintenance of defined strategies that will enable a bank to recover its functionality and resume critical business operations within predetermined time frames. There are three overarching objectives of operational risk management: 1 Operational objectives. These are associated with the impact on a bank of the loss of business function integrity and capability. 2 Financial impact objectives. These relate to direct losses incurred as a result of an operational risk exposure, the cost of recovering normal business operations and consequential financial losses due to reduced business effectiveness. 3 Regulatory objectives. These derive from prudential standards established by bank supervisors.

Business continuity management maintenance of strategies to ensure the continuance of critical business functions

It might be argued that the prevailing risk management regime within a bank will ensure that exposures to operational risk are identified and managed through a structured decision process. However, it became apparent to bank regulators that theoretical drivers of risk management were often impeded by operational and financial imperatives that limited the development of risk management objectives, policies and practices. For example, failures within a bank’s operational risk management process may result from a lack of understanding of this risk by the board of directors and executive management, inadequate budget allocations, poor risk management leadership and procedures, and weak or non-existent education and training programs. It is within this context that the Basel Committee on Banking Supervision incorporated an operational risk component into Pillar 1 of the capital accords. The first, and most important, requirement is that commercial banks establish and maintain a comprehensive risk management framework for operational risk. It must be clearly understood that the provision of additional capital in the capital accord will not protect a bank from operational risk. The capital will only support the survival of the institution and the stability of the financial system after an event has occurred. Business continuity management, or disaster risk management, is a significant component of operational risk management. At the end of this chapter, Extended learning B provides a business

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continuity risk management structure consisting of a disaster recovery planning process and a disaster recovery response process, and applies these processes to an education and training framework for commercial banks. This is essential reading for those responsible for the management of business continuity risk. Basel III requires banks to hold additional capital to support their exposure to operational risk. The final version of Basel III simplified the process of calculating the amount of operational risk capital that a bank would be required to set aside by setting down a single standardised measurement approach. Under this approach, a bank’s required operational risk capital is determined by the product of a ‘business indicator’ (BI) factor and an internal loss multiplier (ILM). APRA’s Prudential Standards APS 114 and 115 will be revised in line with Basel III’s new approach to operational risk. The calculation of operational risk capital under the new standardised approach is relatively simple. The BI is a measure of income that increases with the size of the bank. The ILM is inferred from the bank’s own history of losses. In its 2018 discussion paper on the revisions to the capital frameworks, APRA presents an example that explains the calculation. The Basel III framework identifies ranges of bank income: (1) up to $1 billion; (2) between $1 billion and $30 billion; and (3) greater than $30 billion, along with coefficients of 12.00, 15.00 and 18.00 per cent, respectively. For example, if a bank’s business indicator is $5 billion, then its BI factor would be $1 billion multiplied by 0.12 plus $4 billion multiplied by 0.15, or $720 million. This BI factor is then multiplied by the ILM, which will either increase or decrease the amount of capital required depending on the bank’s record of losses. Basel III allows prudential supervisors some discretion in applying the specifics of the standardised approach to calculating operational risk capital. APRA, if it decides, can disregard the ILM component. In this case, the operational risk capital that a bank in Australia must set aside will be equal to its business indicator. An important thing to note about the BI is that it increases non-linearly as the size of the financial institution increases. This reflects the belief that operational risk not only increases with the scale of the financial institution, but that it does so more than linearly. Larger banks will be required to set aside more operational risk capital than smaller banks.

Pillar 1: Market risk component Market risk is the third component of Pillar 1 and is defined as the risk of losses resulting from movements in market prices. Commercial banks that operate in the foreign exchange, interest rate, equity or commodities markets may be exposed to potentially large swings in market prices and significant consequential losses. Potential losses may arise from general market price movements and, in the case of interest rate and equity instruments, from price movements specific to particular issuers. An institution is required to divide its assets into either its banking book or its trading book. A commercial bank must hold market risk capital against interest rate risks and equity risks arising from positions held in its trading book. Also, market risk capital must be held against credit derivatives in the bank’s trading book, as well as against all foreign exchange and commodity risks. Market risk is split into two components: general market risk and specific market risk. General market risk relates to changes in the overall market for interest rates, equities, foreign exchange and commodities. Specific market risk is the risk that the value of a security will change as a result of issuerspecific factors, such as a change in the creditworthiness of the issuer. This is relevant only to interest rate and equity positions. It is the responsibility of the board of directors to ensure that an institution has documented a trading book policy statement. The institution must ensure that it has in place adequate systems to identify, measure and manage market risk. Institutions have had a choice of two approaches to calculate their market risk capital requirements: the internal model approach and the standardised approach. Basel III, and APRA’s interpretation of it, place restrictions on the use of internal models. This step has been taken to ensure that the methods used to compute risk exposures yield approximately the same results for comparable banks. When banks are permitted to use their own tailored models, the risk exposure calculations can vary considerably from bank to bank, even though the business characteristics are very similar.

General market risk for capital adequacy purposes; changes in the overall market for interest rates, equities, foreign exchange and commodities

Specific market risk the risk that the value of a security will change due to issuer-specific factors

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Part 1 Financial institutions Value at risk (VaR) a statistical probability model that measures financial risk exposures based on historic observations

The models that are used to measure risk exposure produce a measure of the value at risk (VaR) from all market risks over a period of 10 trading days. To determine the amount of capital required, the measure of VaR is multiplied by a factor set by the prudential supervisor. The factor will range from 3 to 5 according to the regulator’s view of the strength and reliability of the internal VaR model. Added to this will be a plus factor of up to 1, depending on the ex-post performance of the model in back-testing.

Value-at-risk models (VaR) VaR models endeavour to estimate maximum potential gains or losses that may be incurred on a portfolio based on a specified probability over a fixed time period. APRA requires the VaR model to include historical data observations for a minimum of one year. In times of high market volatility, APRA may also require the banks to calculate VaR over a shorter time period to take account of the increased risk associated with the volatility. The model data sets must be updated at least monthly. The regulator requires a model to apply a 99.00 per cent confidence level over a 10-day holding period. This assumption implies that, on average, trading losses from market-related contracts will exceed the VaR estimate only once in every 100 trading days. However, VaR is calculated using historic observations and therefore is not necessarily an accurate estimate of future losses, especially if an extreme event occurs that impacts upon the financial markets. The VaR model recognises the detailed structure of the balance-sheet and off-balance-sheet items and—given specific assumptions on prices, values and volatility—determines a VaR estimate. The sophistication of a VaR model used by an institution will vary, depending on the structure of its balance-sheet and off-balance-sheet items, the risk management needs of the institution, the theoretical and technical skills of its risk managers and the availability of computer hardware and software. Simple VaR models: Basis points interest rates; 100 basis points equal 1.00 per cent

• • •

estimate the sensitivity of portfolio components to small changes in prices; for example, a 1 basis point change in interest rates assume that market price movements follow a certain statistical distribution, usually a normal or log-normal distribution enable inferences to be drawn about potential losses with a given degree of statistical confidence; for example, a 99.00 per cent probability of a certain dollar amount loss. More complex VaR models:

• • •

recognise correlations between different portfolio components; that is, the model allows for market price changes that move together or offset each other account for the effects of portfolio diversification consider the liquidity of different portfolio instruments; that is, the ease or ability of an institution to liquidate (sell) securities or close out an open risk position.

VaR represents an important tool available to risk managers and boards of directors for the estimation of potential exposures to market-rate-related risks. However, VaR models are constrained by some theoretical and statistical limitations; they:

• • • • •

are based on a limited set of historical data which may not be a correct reflection of future data assume liquidity in all markets; that is, the ability of an institution to trade all components of its portfolio. This will not always be the case, particularly in times of financial stress assume that all instruments can be liquidated in one day. This is not possible. Contractual constraints also mean that some items cannot be liquidated do not include excessive intra-day price volatility; that is, unusually large short-term exchange rate or interest rate movements assume a normal distribution, when data indicate that in some markets prices may be volatile and a normal distribution is not always evident.

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These limitations were on full display during the GFC. The historical data on which VaR models were based simply did not include a housing market crisis of the proportions that precipitated the GFC. A number of financial institutions significantly underestimated the amount of potential losses that they could suffer and, in some cases, reported relatively low levels of potential losses just days before being forced into bankruptcy. Because of these limitations, and as part of good risk management practice, banks should back-test their VaR model estimates against actual outcomes. The model should be applied to a range of scenario analysis situations, and particularly must be ‘stress tested’ for extreme market conditions. Following the GFC, stress testing of financial institutions and their models attracted much attention. APRA introduced a ‘stressed Value at Risk requirement’ that came into effect in January 2012. Among other things, the stressed VaR must address illiquidity, price gapping, concentrated positions, one-way markets, non-linear products, deep out-of-the-money positions and other risks that may not be captured by VaR, including implied correlations and skew risk. For more information see APRA’s APS 116, especially Attachment C (www.apra.gov.au). Perhaps one of the defining features of Basel III is the ‘output floor’ that limits the discrepancy that can emerge between a bank’s internal models and the standardised approaches to measuring market risk. This places a limit on the incentives that exist for banks to develop models that understate market risk.

Pillar 2: Risk management and supervision The supervisory review process forms the second pillar of Basel III. The Basel Committee on Banking Supervision advises that the supervisory review process is intended to: 1 ensure that banks have sufficient capital to support all the risk exposures in their business 2 encourage banks to develop and use improved risk management policies and practices in identifying, measuring and managing risk exposures. Banks have a responsibility to ensure that they hold adequate capital to support the overall risks of the organisation beyond the core minimum requirements determined in Pillar 1. A bank’s supervisors are expected to evaluate how well the bank is actually assessing its capital needs relative to its level of risk. Under Basel III, particular emphasis is placed on the interest rate risk in the banking book (IRRBB). Basel III expands the calculations that banks must perform while placing some restrictions on the internal models that banks can use to estimate their IRRBB. APRA’s interpretation of this aspect of Basel III is found in Prudential Standard APS 117. The supervisory review process establishes a forum for dialogue between commercial banks and their supervisors. Supervisors are expected to intervene when capital assessment by a bank is seen as inadequate for its risk profile. While capital adequacy is a key foundation in the support of sound risk management, it should not be seen as the sole determinant. Pillar 2 encourages additional good risk management practice, such as:

• • • •

Interest rate risk in the banking book (IRRBB) the risk to earnings and capital arising from movements in interest rates

developing risk management policies and procedures, including education and training (e.g. see Extended learning A) applying internal responsibilities, delegations and exposure limits increasing provisions and reserves strengthening internal control and reporting procedures.

Therefore, the Pillar 2 supervisory review process seeks to encourage banks to better understand and account for:

• • •

risks that are not fully captured in Pillar 1, such as credit concentration risk; for example, lending large amounts to a single borrower, industry or within a limited geographic region those factors that are not taken into account by Pillar 1, such as interest rate risk in the banking book, business risk and strategic risk factors external to the bank, such as the effects of a changing business cycle. 65

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An essential component of the Pillar 2 supervisory review process is the assessment, by the supervisor, of compliance by the banks with the minimum standards and disclosure requirements attached to the capital accord. Supervisors are responsible for ensuring that these requirements are being met. In order to establish an international benchmark for the application of Pillar 2, the Basel Committee on Banking Supervision has identified four key principles of supervisory review. Principle 1 states: ‘Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.’ The five main features of a rigorous process are identified as: 1 board and senior management oversight 2 sound capital assessment 3 comprehensive assessment of risks 4 monitoring and reporting 5 internal control and review. Principle 2 states: ‘Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.’ To achieve these outcomes, supervisors would be expected to be involved with, or require:

• • • • •

on-site examinations and inspections off-site reviews discussions with bank management reviews of work done by external auditors periodic reporting.

Principle 3 states: ‘Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.’ Reasons why commercial banks should be required to maintain a capital buffer include:

• • • • • •

Pillar 1 requirements represent only a minimum level of capital. Banks will require additional capital in order to achieve business growth. International banks will require a higher level of capital to enhance their credit ratings. Fluctuations in capital requirements will occur as the dynamic business environment changes. Obtaining additional capital on short notice is generally more costly. Failure of a bank to maintain the minimum capital requirement may trigger legislative or supervisory corrective action. A bank may be exposed to specific risks that are not taken into account in Pillar 1, such as a large exposure to a specific industry sector.

Principle 4 states: ‘Supervisors should seek to intervene at an early stage to prevent capital falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.’ These actions may include:

• • • •

intensifying the monitoring of the bank restricting the payment of dividends requiring the bank to prepare and implement a satisfactory capital adequacy restoration plan requiring the bank to raise additional capital immediately.

Pillar 3: Market discipline Market disclosure forms the third pillar of Basel III. The purpose of Pillar 3 is to encourage market discipline by developing a set of disclosure requirements that allow market participants to assess important information relating to the capital adequacy of an institution. 66

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The Basel Committee on Banking Supervision states that such disclosures have particular relevance under the capital accord because banks are given greater discretion in assessing their capital requirements through the use of internal methodologies and models. The key word associated with Pillar 3 is transparency, whereby the objective is to make banks’ risk exposure, risk management and capital adequacy positions more transparent, or apparent, such that market discipline can reinforce the regulatory process. For example, market discipline may be reflected in a rise or fall in an institution’s share price if its risk profile is perceived to have changed. It is to be expected that institutions will provide the prudential supervisor with all material relevant to risk exposures, risk management and capital adequacy. Each nation-state supervisor will determine what information is released for public consumption. Clearly, the general release of all information would raise concerns relating to the maintenance of stability and confidence in the financial system, as well as raise issues relating to proprietary and confidential information. Prudential supervisors will determine the minimum disclosure requirements for institutions within their jurisdiction. They will also determine the frequency of various reporting requirements. The Basel Committee on Banking Supervision recommends that a range of qualitative and quantitative disclosure reports be prepared that relate to the principal parts of Pillar 1 and Pillar 2. Within the context of the Basel III capital accord, these will include reports on:

• • • • • • • • • •

the scope of the application of the capital accord within an organisation the capital structure of the institution the methodologies, approaches and assessment of capital adequacy by the institution the determination of all aspects of credit risk exposures the application of credit risk mitigation the determination of equity risk within the banking book the impact of securitisation of assets the determination of market risk exposures the measurement of operational risk the assessment of interest rate risk within the banking book (IRRBB).

2.7.4

B ASEL III AND BANK LIQUIDITY

In addition to the ‘three pillars’, Basel III sets down some liquidity standards. APRA has described these two standards as the centrepiece of Basel III. The first is a liquidity coverage ratio (LCR) that aims to ensure that financial institutions hold high quality liquid assets in sufficient volume to sustain them for a period of one month during a period of ‘acute stress’. The second is a net stable funding ratio (NSFR) that aims to foster longer-term stability by requiring financial institutions to fund their activities with stable sources of funding. The LCR is supposed to ensure that banks have a ‘buffer’ that will help them to withstand a period of acute financial stress for a period of one month. The LCR is the ratio between a financial institution’s high quality liquid assets (HQLA) and net cash outflows over a 30-day (one month) period. Banks are required to maintain a LCR of at least 100.00 per cent. HQLA may be classified as Level 1 (highest quality) and Level 2 (lower quality). A bank’s total HQLA must be at least 60.00 per cent of Level 1 (HQLA1). HQLA1 assets must, according to APRA, be unencumbered, easily converted to cash with little or no loss of value during times of market stress and be eligible for repurchase agreements with the RBA. According to APRA, the assets that will be suitable for classification as HQLA1 are cash, deposits with the RBA and marketable securities representing claims guaranteed by sovereigns, quasi-sovereigns, central banks and multilateral development banks that have undoubted liquidity during periods of stress and are assigned a zero risk weight under Basel III’s standardised approach to credit risk. HQLA2 assets, which cannot exceed 40.00 per cent of a bank’s total HQLA holdings, may comprise marketable securities representing claims on or by sovereigns, quasi-sovereigns, central banks 67

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and multilateral development banks, which are assigned a 20.00 per cent risk weight under the Basel III standardised approach, and corporate bonds issued by corporations with a credit rating of at least AA–. In effect, banks must maintain holdings of HQLA that match or exceed total net cash outflows for a period of 30 days under stressful market conditions. These quantitative requirements are complemented by several qualitative prudential requirements. Primarily, liquidity risk management is identified as the responsibility of the board of a financial institution. The board is responsible for setting the institution’s risk tolerance levels and clearly articulating this information. The board must also approve a formal funding strategy. These measures are designed to improve board oversight of liquidity risk management. APRA’s existing APS 210 prudential standards, to which we turn our attention next, incorporate these Basel III enhancements of good practice and governance.

REFLECTION POINTS

• •

Banks must maintain a minimum risk-based capital ratio. The Basel III capital accord comprises three integrated pillars:

— Pillar 1: the capital adequacy minimum requirements, risk coverage and leverage — Pillar 2: the supervisory review of capital adequacy — Pillar 3: the market discipline, incorporating disclosure and transparency requirements.

• • • • • • • • • • •

Pillar 1 is divided into three components: credit risk, operational risk and market risk. Either a standardised approach or a more advanced approach can be used to measure risk. The credit risk standardised approach requires a bank to assign each balance-sheet asset and off-balance-sheet item a risk weight. The risk weight is either based on an external credit rating or is a fixed weight specified by the bank supervisor. Off-balance-sheet items are converted to balance-sheet equivalents before applying a credit risk weight. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or external events (e.g. the failure of the computer system, employee fraud or a major fire). Basel III requires banks to hold additional capital to support their exposure to operational risk. The standardised approach to operational risk set down in Basel III simplifies the process of calculating the operational risk capital that a bank must set aside. Under Basel III, this is a function of a business indicator (BI) and internal loss multiplier (ILM). A bank is required to hold market risk capital against its trading book. Market risk is split into general market risk and specific market risk. Commercial banks have typically used an internal value-at-risk (VaR) model to measure their market risk requirement. Basel III places restrictions on the use of internal models. VaR models estimate potential gains or losses that may be incurred on a portfolio over a 10-day holding period, based on a 99.00 per cent confidence level. Pillar 2 establishes dialogue between banks and their supervisors. It also encourages good risk management practices for those risks not covered in Pillar 1. Pillar 3 aims to make banks’ risk exposure, risk management and capital adequacy positions more transparent such that market discipline can reinforce the regulatory process. Four key principles of supervisory review have been developed relating to the monitoring of a bank’s risk management processes and minimum capital levels. Basel III also introduced stricter capital requirements and enhanced liquidity requirements, including the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR).

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2.8

Liquidity management and other supervisory controls

Banks, in common with all organisations, must manage their day-to-day liquidity needs, such as paying creditors and employees. Liquidity is access to funds that enable an institution to meet its business operating commitments. For example, if a bank approves a loan to a customer, it needs to be able to provide those funds at settlement date. Should a depositor wish to withdraw funds from a demand account, the bank must be able to make those funds available. Basel III introduced two new liquidity standards to ensure that financial institutions do not find themselves short of funds. First, financial institutions must hold high quality liquid assets in sufficient volume to sustain them for one month during a period of ‘acute stress’ and, second, financial institutions will be expected to fund their activities with stable sources of funding. These reforms are warranted, given the liquidity problems to which the banking business is prone. The nature of a bank’s business means that banks have special liquidity problems that they must manage. The first problem relates to the mismatch in the terms to maturity of balance-sheet assets and liabilities and the timing of associated cash flows. The majority of banks’ sources of funds are relatively short term. For example, the longest term to maturity of a bank deposit product is typically five years. On the other hand, banks provide housing loans to their customers with a term to maturity in excess of 30 years. Banks must manage the fact that their sources of funds (liabilities) often need to be repaid sooner than their loan assets; therefore, they have a liquidity risk exposure that has to be managed. Both of the new liquidity standards aim to address this and related problems. The second liquidity problem relates to the role of banks in the payments system. This is discussed in Chapter 12, but it should be noted that banks need to have funds available for financial settlement of the millions of financial transactions carried out by their customers each day. Value settlement of these transactions occurs through the payments system. In order to obtain liquidity, a bank must hold sufficient cash or have access to sources of liquidity. Cash holdings do not provide a return on funds, therefore there is no incentive for a bank to hold excess cash. A bank will invest surplus cash in securities that it will hold in its securities portfolio. The securities held in the portfolio will provide a return on investment, but at the same time they can easily be sold into the secondary markets to convert into cash as needed. For example, a bank may hold a portfolio of government securities. There is an active secondary market in which these securities can be sold immediately, if required, to access cash for liquidity purposes. Liquid securities include cash, government securities, semi-government securities and moneymarket securities. Another liquidity contingency arrangement would be the provision of a stand-by credit facility by an international bank. In this situation, the international bank must be able to provide immediate liquidity support, subject to the stand-by credit facility terms and conditions. In Australia, APRA applies a liquidity prudential standard, APS 210 Liquidity. Under APS 210, the board of directors and management of a bank must implement and maintain a liquidity management strategy that will ensure that the institution will be able to meet its operational liquidity demands as they fall due. The liquidity management strategy must be reviewed at least annually, and a bank must immediately inform the supervisor of any concerns about current or future liquidity. APRA will review the adequacy and appropriateness of the liquidity management strategy. APRA states that a liquidity management strategy must include the following elements:

• • • • •

LEARNING OBJECTIVE 2.7 Examine liquidity management and other supervisory controls applied by APRA in the context of Basel III.

Securities portfolio financial securities held by an institution for investment and trading purposes

Liquidity management strategy an organisation’s objectives, policies and procedures as they relate to cash flows and liquidity

a liquidity management policy statement approved by the board of directors a system for measuring, assessing and reporting liquidity procedures for managing liquidity relevant to balance-sheet and off-balance-sheet activities on a group basis clearly defined managerial responsibilities and controls a formal contingency plan for dealing with a potential liquidity crisis.

Contingency plan a set of predetermined strategies to be implemented if a designated event occurs

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Prudential Standard APS 210 requires an institution’s liquidity management strategy to include regular scenario analysis of domestic and foreign currency liquidity under a range of operating conditions. The liquidity standard places great emphasis on a bank’s own internal management practices for managing liquidity. Banks are able to adopt a range of strategies to manage liquidity, including:

• • • • • • • •

setting limits on maturity mismatches between assets and liabilities holding high quality liquid assets that can easily be sold to relieve unexpected liquidity pressures diversifying liability sources to maintain a stable funding base access to wholesale markets through the issue of money-market securities, or establishing stand-by credit facilities access to foreign currency markets for liquidity, particularly to meet foreign-currency-denominated liquidity commitments intra-group liquidity, whereby liquidity surpluses and shortfalls are identified, and any regulatory or legal impediments are addressed use of assets through sales, repurchase agreements and securitisation to provide liquidity industry liquidity support arrangements through the provision of stand-by liquidity between banking institutions.

2.8.1

O THER REGULATORY AND SUPERVISORY CONTROLS

Even though the operation of the financial system is often described as being deregulated, this description is really only relative to previous periods. The capital adequacy and liquidity management requirements of banks are supervised by the bank regulator, and there is a range of other regulatory and supervisory controls with which banks must comply. The following are some of the controls placed on Australian banks, many of which are similar to those applied in other countries.

• • •

• •

Risk management systems certification. A bank is required to provide APRA with an annual attestation from the chief executive officer, endorsed by the board of directors (or relevant senior officer outside Australia in the case of foreign bank branches), of the efficacy of the bank’s risk management systems. The chief executive officer and the board will attest that risks have been identified, that systems have been designed to manage those risks and that those systems are working effectively. Business continuity management. The board and senior management of a bank must ensure that appropriate policies and procedures are in place to identify, measure and manage business continuity risk. In particular, a bank must develop, implement and maintain a business continuity plan that documents procedures and information that will enable the bank to respond to disruptions and recover critical business functions (see also Extended learning A). Audit (external auditors, on-site visits). APRA requires a commercial bank’s external auditor to inform it of the reliability of statistical data provided to APRA, and of compliance with regulatory and prudential requirements. In addition, each year external auditors are required to review a particular area of a bank’s operation that is specified by APRA. They are required to provide APRA with an analysis of the strengths and weaknesses of the risk management systems employed by the bank. APRA also conducts a program of on-site visits to banks, focusing on bank systems used to measure and manage risk. The Reserve Bank may also participate in the on-site visits. Disclosure and transparency. As discussed above in the context of Basel III, bank supervisors expect banks to improve the quality of publicly disclosed information. This assists market participants to exercise their own disciplines on banks as a complement to supervision. For example, banks are encouraged to upgrade information on asset quality and off-balance-sheet business, particularly derivatives activities. Large exposures. Banks are required to report, for the consolidated group, exposures of greater than 10.00 per cent of the group’s capital base to an individual client or client group. Further capital

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requirements may be imposed on banks with such large exposures, due to the potentially increased counterparty credit risk.

•

Foreign currency exposures. APRA requires banks to report their overnight foreign exchange positions, and may establish currency exposure limits for individual banks.

•

Subsidiaries. A further prudential requirement is the establishment of transparency between banking group subsidiaries such as funds management and securitisation entities. A bank must make a clear disclosure that such investments do not represent deposit or other liabilities of the parent bank. Any commitment of a subsidiary that creates recourse to the bank will require appropriate capital support.

•

Ownership and control. The Financial Sector (Shareholdings) Act 1998 provides that an individual, entity or group is not permitted to have an aggregate interest of 15.00 per cent or more of the nominal value of the voting shares of an institution. An exemption may be sought from the Treasurer of the Commonwealth of Australia.

The ultimate responsibility for the sound and prudent operation of a commercial bank rests with the board of directors. The board should comprise at least five directors who should be fit and proper persons, capable of exercising independent judgment and widely representative of shareholders. The chairperson and a majority of directors should be non-executive board members. The board also should have regard to its responsibilities to depositors. Scrutiny of the effectiveness of the boards of financial institutions in Australia was heightened during the 2018 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Many commentators saw this as a warning to directors to ensure that they perform their function effectively.

Non-executive board members board members who are not part of the management of a corporation or its subsidiaries

REFLECTION POINTS

• • • • •

Liquidity risk is a major risk exposure of commercial banks. Banks need to have access to funds to meet day-to-day commitments, such as repayment of deposits and loan settlements. Banks hold liquid assets, such as money-market instruments, in their securities portfolio for this purpose. These assets are easily sold in the secondary markets to raise cash as needed. Bank supervisors require banks to maintain a liquidity management strategy, including access to contingency liquidity in an extreme situation. The bank supervisor imposes a range of other prudential requirements on banks, including risk management certification, business continuity management, external audits, on-site visits, limits on large credit and foreign currency exposures, subsidiary business operations and ownership and control restrictions.

CASE STUDY BASEL III REFORMS The Basel Committee on Banking Supervision (BCBS) has agreed to a schedule for Basel III that involves gradual implementation over the next decade. The Australian Prudential Regulation Authority (APRA) has reaffirmed its expectation that ADIs will comply more quickly with the required capital ratios and expects that compliance will be achieved by January 2020. This reflects a general perception that transitioning to Basel III will be relatively smooth in Australia. This may not be the experience in other parts of the world. In May 2018, the president of the association of German public banks stated in an annual press conference that the impact of the Basel III reforms on the calculation of capital ratios will be to drag the German system back to 2015 levels. He also adds that the regulatory efforts will prove to be in vain, like an act of Sisyphus who pushes a boulder up the mountain, only to see it roll down again. 71

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In May 2018, The Financial Times reported that the CFO of Commerzbank of Germany, in talking about Basel III, suggested that ‘the devil is in the detail’ and that the rule changes are difficult to quantify. French lender Société Générale says it can assess the impact of some but not all of the new rules while Dutch bank ABN Amro states that its capital requirements might jump by more than one-third due to changes in definitions and measurement methodology as well as stricter requirements. Changes to the methodology applied to risk measurement and the acceptability of various assets that can be used to meet capital requirements have real impacts on financial institutions. In some countries, the adjustment process to Basel III may be tumultuous. References Bippart, G 2017, ‘Banks breathe a little sigh of relief as Basel III is completed’, Euromoney, 11 December, viewed 15 October 2018, http://euromoney.com Gorajek, A & Turner, G 2010, ‘Australian Bank Capital and the Regulatory Framework’, RBA Bulletin, September 2010. PricewaterhouseCoopers 2017, ‘Basel III Reforms (‘Basel IV’) Capital Floors’, viewed at http://www .PricewaterhouseCoopers.com.au Samuels, S 2018, ‘Confusion over Basel bank capital requirements fails us all’, Financial Times, 22 February, viewed at http://www.ft.com Wittkowski, B 2018, ‘Basel IV throws German banking sector back by two years—VOeB’s president’, 25 May 2018.

Discussion points

• • •

Outline the positives for the Australian banking system in light of the Basel III reforms. Describe the concerns regarding Basel III from the perspective of the German banking system. What is the role of APRA in guiding the implementation of the Basel III reforms?

Master before you move on LEARNING OBJECTIVE 2.1 Evaluate the functions and activities of commercial banks within the financial system.

• • •

Commercial banks are the largest group of financial institutions within a financial system and therefore they are very important in facilitating the flow of funds between savers and borrowers. The core business of banks is often described as the gathering of savings (deposits) in order to provide loans for investment. The traditional image of banks as passive receivers of deposits through which they fund their various loans and other investments has changed since deregulation. For example, banks provide a wide range of off-balance-sheet transactions.

LEARNING OBJECTIVE 2.2 Identify the main sources of funds of commercial banks, including current deposits, demand deposits, term deposits, negotiable certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency liabilities and loan capital. 72

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Banks now actively manage their sources of funds (liabilities). They offer a diversity of products with different return, risk, liquidity and cash-flow attributes to attract new and diversified funding sources. Sources of funds include current deposits, call or demand deposits, term deposits, negotiable certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency liabilities, loan capital and shareholder equity.

LEARNING OBJECTIVE 2.3 Identify the main uses of funds by commercial banks, including personal and housing lending, commercial lending, lending to government and other bank assets.

• • • • • • •

Commercial banks now apply a liability management approach to funding growth in their balance sheets. Under this approach, a bank will (1) encourage depositors to lodge savings with the bank, and (2) borrow in the domestic and international money markets and capital markets to obtain sufficient funds to meet forecast loan demand. The use of funds is represented as assets on a bank’s balance sheet.

CHAPTER TWO REVIEW

• • •

Bank lending is categorised as personal and housing lending, commercial lending and lending to government. Personal finance is provided to individuals and includes housing loans, investment property loans, fixed-term loans, personal overdrafts and credit card finance. Banks invest in the business sector by granting commercial loans. Commercial loan assets include overdraft facilities, commercial bills held, term loans and lease finance. While banks may lend some funds directly to government, their main claim is through the purchase of government securities such as Treasury notes and Treasury bonds.

LEARNING OBJECTIVE 2.4 Outline the nature and importance of banks’ off-balance-sheet business, including direct credit substitutes, trade- and performance-related items, commitments and market-rate-related contracts.

• • • •

Viewing banks only in terms of their assets and liabilities greatly underestimates their role in the financial system. Banks also conduct significant off-balance-sheet business. The national value of off-balance-sheet business is over four times the value of the accumulated assets of the banking sector. Off-balance-sheet business is categorised as direct credit substitutes, trade- and performance-related items, commitments, and foreign exchange, interest rate and other market-rate-related contracts. Over 94.00 per cent of banks’ off-balance-sheet business is in market-rate-related contracts such as foreign exchange and interest-rate-based futures, forwards, options and swap contracts.

LEARNING OBJECTIVE 2.5 Consider the regulation and prudential supervision of banks.

• • •

One of the main influences of change in the banking sector has been the regulatory environment within which banks operate. Commercial banks are now said to operate in a deregulated market. Relative to previous regulatory periods, this is a reasonable description; however, there still remains quite a degree of regulation that affects participants in the financial markets, including the banks. Each nation-state is responsible for the regulation and supervision of its own financial system. In particular, central banks and prudential supervisors are responsible for the maintenance of financial system stability and the soundness of the payments system. 73

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LEARNING OBJECTIVE 2.6 Understand the background and application of Basel III.

• • • • • •

At the global level, the Bank for International Settlements takes an active interest in the stability of the international financial system. To this end, the Basel Committee on Banking Supervision has developed an international standard on capital adequacy for banks. Basel III was finalised in December 2017. It is based on three pillars: capital adequacy, risk management and supervision, and market discipline. Basel III also contains additional liquidity requirements. In particular, banks are required to maintain a ratio of high quality liquid assets (HQLA) to net cash outflows per month of at least 100.00 per cent. This is called the liquidity coverage ratio (LCR). Minimum capital ratios are core to Basel III. The capital ratio of a bank is the ratio of its capital (equity, retained earnings) to its risk-weighted assets (loans, securities). In order to ensure that banks set aside ‘quality’ capital, Basel III categorises capital as either Common Equity Tier 1 (CET1) capital or Tier 2 capital. Banks are required to maintain a minimum quantity of CET1 capital. In computing its capital ratio, a bank assigns risk weights to balance-sheet assets. The final version of Basel III focused on the determination of risk weights and, in particular, restrictions on the banks’ use of internal models to make the assessments.

LEARNING OBJECTIVE 2.7 Examine liquidity management and other supervisory controls applied by APRA in the context of Basel III.

•

The Australian bank regulator, APRA, applies a number of important prudential controls on commercial banks. These include liquidity management policies, risk management systems certification, business continuity management, audit (external auditors, on-site visits), disclosure and transparency, large credit exposures, foreign currency exposures, subsidiaries, and ownership and control.

Extended learning A LEARNING OBJECTIVE 2.8 Understand the standardised approach to credit risk and compute the capital requirements for particular transactions.

The standardised approach to credit risk The standardised approach to credit risk requires banks to assign each balance-sheet asset and offbalance-sheet item a risk weight. The risk weights reflect the view of regulators about credit risk on a portfolio basis. The regulator emphasises that the risk weights should not be seen as a substitute for the credit risk assessment of individual credit risk exposures. A bank has primary responsibility to ensure that adequate systems are applied to measure credit risk, and that sufficient capital is allocated to cover that risk. The risk-weighted amount of a balance-sheet asset is calculated by multiplying its current book value by the relevant risk weight. The risk weight applied may derive from an external rating grade or a risk weight specified by the regulator. An external credit assessment rating can only be obtained from regulator-approved external credit assessment institutions. For example, in Australia, APRA recognises the ratings of Standard & Poor’s Corporation, Moody’s Investors Service and Fitch Ratings. Credit rating agencies and

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Table 2.2 External long-term rating grades External rating grade

1

2

3

4

5

Standard & Poor’s Corporation

Moody’s Investors Service

Fitch Ratings

AAA

Aaa

AAA

AA+

Aa1

AA+

AA

Aa2

AA

AA−

Aa3

AA−

A+

A1

A+

A

A2

A

A−

A3

A−

BBB+

Baa1

BBB+

BBB

Baa2

BBB

BBB−

Baa3

BBB−

BB+

Ba1

BB+

BB

Ba2

BB

BB−

Ba3

BB−

B+

B1

B+

B

B2

B

B−

B3

B−

CCC+ CCC 6

CCC− CC C D

Caa1 Caa2 Caa3 Ca C

CHAPTER TWO REVIEW

the methodologies used are discussed in Chapter 11. A credit rating is the credit rating agency’s opinion of the creditworthiness of an issuer of debt or equity. Credit ratings are represented by alpha or alpha-numeric codes; for example, the long-term ratings of Standard & Poor’s range from AAA (highest) to D (lowest). APRA’s APS 112 notes the external rating grades to these published credit ratings (see Table 2.2).

CCC+ CCC CCC− CC C D

Sourced from the Federal Register of Legislation at 4 October 2018. For the latest information on Australian government law please go to https://www.legislation.gov.au.

The external rating grades (1 to 6) are given a risk weight. For example, APS 112 Capital Adequacy: Standardised Approach to Credit Risk requires that claims held in the banking book for corporate counterparties and commercial public sector entities that have the following external rating grade (as determined in Table 2.2) will need to use the relevant risk weight:

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External rating grade

Risk weight

1

 20%

2

 50%

3, 4

100%

5, 6

150%

SOURCE: Adapted from APRA Prudential Standard 112, Final, July 2019, p.24.

It should be noted that APS 112 applies different risk weights to the various external rating grades depending on the category of counterparty to a claim. Clearly, there is a direct relationship between the level of credit risk and the amount of capital required. If a bank provides a $1 million loan to a company that has an AA credit rating (external rating grade 1), the amount of capital required is the book value × the risk weight × 8.00 per cent capital adequacy requirement. That is, $1 million × 0.20 × 0.08 = $16 000. The remaining $984 000 can be funded from bank liabilities. Had the bank given a $1 million loan to a company that has a BB credit rating, the capital requirement would have been $1 million × 1.0 × 0.08 = $80 000. Therefore, there is a significant difference in the amount of capital a bank must use between the AA-rated company and the BB-rated company. Risk weights specified by the regulator may range from zero to 400.00 per cent.

loan-to-valuation ratio the percentage ratio of a loan to the bank’s valuation of the property being mortgaged

As mentioned earlier in the chapter, a large part of bank loan assets may be in the form of residential housing loans (mortgage loans). With a standard mortgage loan, the risk weight is determined relative to the loan-to-valuation ratio (LVR) and the level of mortgage insurance. The loan-to-valuation ratio is simply the amount borrowed to purchase a residential property divided by the accredited valuation of the property. For example, with a house valued at $400 000 where the buyer borrows $350 000, the LVR is 87.50 per cent. Therefore, as indicated in Table 2.3, the risk weight is 50.00 per cent with no mortgage insurance or 35.00 per cent with at least 40.00 per cent of the mortgage insured. It should be noted that Basel III proposes some changes to risk weights for residential mortgage exposures. Updates to APRA’s response can be found at: www.apra.gov.au.

Table 2.3 Risk weights for standard residential mortgages Loan-tovaluation ratio

Risk weight (no mortgage insurance)

Risk weight (at least 40% of the mortgage insured by an acceptable lender’s mortgage insurer)

0–60.00%

  35%

35%

60.01–80.00%

 35%

35%

80.01–90.00%

 50%

35%

90.01–100.00%

 75%

50%

More than 100%

100%

75%

SOURCE: Adapted from APRA Prudential Standard 112, Final, July 2019, p.18.

In the above example, assuming that the borrower has taken appropriate mortgage insurance, the capital requirement will be $350 000 × 0.35 × 0.08 = $9800. Risk weights for balance-sheet assets are to be found on the website of a nation-state’s bank supervisor. For example, the weights applied by the Australian bank supervisor, APRA, are listed in Prudential Standard APS 112, Capital Adequacy: Standardised Approach to Credit Risk at www. apra.gov.au. APRA may change some part of this risk-weighting structure in response to the final version of Basel III. 76

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1

The notional amount of the off-balance-sheet transaction is converted into a balance-sheet equivalent (the credit equivalent amount) by multiplying the amount by a specified credit conversion factor.

2

The resulting credit equivalent amount is multiplied by the risk weight applicable to the counterparty or type of asset.

Off-balance-sheet transactions are categorised as non-market-related transactions or marketrelated transactions. Non-market-related off-balance-sheet transactions are those items included in the first three types of bank off-balance-sheet business discussed earlier in the chapter, namely direct credit substitutes, trade- and performance-related items and commitments. Market-related off-balance-sheet transactions are those included in the fourth type of off-balance-sheet business, that is, foreign exchange, interest rate and other market-rate-related contracts. Again, the risk weights applied by APRA are listed in Prudential Standard APS 112. Let us consider the example of a non-market-related off-balance-sheet transaction. A company arranges for its bank to provide a $1 million documentary letter of credit to support a trade transaction. The company has a single B credit rating issued by Standard & Poor’s. Reference to the website of the bank supervisor indicates that the credit conversion factor is 20.00 per cent and that the external rating grade 5 represents a risk weight of 150.00 per cent. The capital required by the bank to support this off-balance-sheet transaction is $1 million × 0.20 × 1.50 × 0.08 = $24 000.

CHAPTER TWO REVIEW

The risk-weighted amount of an off-balance-sheet transaction that gives rise to a credit exposure is generally calculated by means of a two-step process:

Extended learning B LEARNING OBJECTIVE 2.9 Analyse business continuity risk and construct an education and training framework for operational risk management for commercial banks.

Business continuity risk management Business continuity risk management has an impact on a bank’s ability to maintain its day-to-day business operations. It relates to the risk of direct, indirect or consequential operational and financial impacts as a result of inadequate or failed internal or external processes, people, systems or events. These may result, for example, from a natural disaster such as an earthquake or a physical disaster such as a loss of computer or communication systems. Business continuity risk management may be described as a dichotomy of: 1

a disaster recovery planning process, plus

2

a disaster recovery response process.

The two processes consist of a wide range of core components. Each component has implications for, and must be incorporated in, business continuity risk management.

1. Disaster recovery planning process The core components of the disaster recovery planning process are as follows:

•

The establishment of an organisational business continuity risk management structure that is horizontally and vertically integrated throughout the bank using a top-down approach. The management structure reports to the board of directors and includes a global risk committee, a business continuity risk management group and divisional contingency planning units. The global risk committee is made up of executive managers and implements strategic policy initiatives to achieve the bank’s business continuity risk management objectives. The business continuity risk management group will develop, implement, coordinate, monitor and maintain 77

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• • •

• • •

the bank’s overall business resumption plan. Divisional contingency planning units ensure the relevancy of business continuity risk management within business units in each division of the bank. This includes planning teams, emergency response teams and recovery teams. Risk analysis and business impact analysis. These are processes of risk identification and measurement using quantitative and qualitative methodologies. The risk analysis process ensures that all risk exposures are identified and understood by the bank. This enables existing procedures to be improved and thereby lessen the potential risk exposure. The business impact analysis measures the operational and financial effects of a disruption to a business function, particularly critical business functions. Business function recovery prioritisation. When a large and diverse organisation such as a bank experiences a major disruption to business operations, it is not possible to resume all functions at the one time. This makes it necessary to establish a recovery prioritisation schedule. The business impact analysis will be used to substantiate the prioritisation of business function recovery at the divisional level, but within the constraints of the bank’s integrated business resumption plan. Development of disaster recovery strategies. Bank personnel need to be aware of the range of alternative strategies that may be put in place to maintain critical business functions. For example, in order to ensure the resumption of computer operations, a bank may build a dedicated back-up computer centre; alternatively, the bank may outsource that function to a specialist provider. To facilitate these arrangements, a bank will enter into disaster recovery service agreements and support agreements. Education and training. This is a core component of business continuity risk management. Education and training will directly affect the preparedness and capability of a bank and its people to plan for and respond to a disaster situation. A business continuity risk management education and training framework is provided later in the section. Testing of disaster recovery strategies. A bank must be absolutely confident that its disaster recovery strategies will be effective in the event of a disruption to critical business functions. Therefore, the bank must establish a structured testing program that progressively tests all components of the bank’s disaster recovery strategies. Testing should be integrated throughout the bank. Plan maintenance. This includes the ongoing monitoring, review, reporting and auditing of the bank’s business continuity risk management processes. This component will ensure that changes in a bank’s systems, products and procedures are reflected in the disaster recovery plan. Periodic auditing and review ensures that executive management and the board of directors are appropriately informed.

2. Disaster recovery response process Ultimately, the effectiveness of the disaster recovery planning process is dependent on the actions taken by bank personnel in response to a disaster situation. The core components of the disaster recovery response process include:

• • • •

Plan activation. The disaster recovery plan specifies when a disruption to normal business operations is to be declared a disaster. The disaster alert trigger point will activate notification procedures, emergency response teams and recovery strategies. Impact assessment and evaluation. Divisional recovery teams will conduct an initial analysis of the operational impact of a situation. They will report to management and advise on which recovery strategies need to be implemented, including the initial estimates of resources and time required in order to recover primary business operations. Recovery control centre. This is the location from which the disaster recovery response is managed. Key personnel will report to the centre and direct recovery operations within the context of the bank’s business resumption plan. The recovery control centre facilitates the control, command and coordination management decision processes. Communications and media liaison. The business continuity risk management group will take control of a situation and communicate with executive management. Divisional recovery planning teams must be able to communicate with their personnel. Communications will be established with the providers of recovery facilities and service and support agreements.

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Chapter 2  Commercial banks

•

Implementation of prioritised business recovery. Back-up strategies, facilities, service agreements and support agreements will be activated, but only within the constraints of priorities established in the bank’s overall business resumption plan. Performance evaluation, reporting and plan review. During the course of an event, the business continuity risk management group will monitor and evaluate recovery progress and report to executive management. When recovery is complete, it is necessary to analyse thoroughly, evaluate and review performance outcomes and, as appropriate, revise the business continuity plan.

The purpose of business continuity risk management is to ensure that a bank and its personnel are prepared to respond to an event that disrupts critical business functions and are able to recover those functions effectively. Education and training is integral to achieving these objectives.

An education and training framework for business continuity risk management The education and training framework provided below is designed to support the business continuity risk management objectives of commercial banks, and improve the capability and preparedness of institutions and their personnel to plan for, and respond to, an occurrence that may affect the continuity of critical business functions.

CHAPTER TWO REVIEW

•

Media liaison personnel will establish communications with bank supervisors, government authorities, the press, customers and other market participants.

Three business continuity risk management education and training programs have been developed: 1

Induction/awareness program

2

Contingency planning program

3

Executive program

All bank personnel and associated non-bank personnel should complete the induction/ awareness program. Participants in the contingency planning program will be specialist business continuity risk management personnel, while the board of directors and executive management, including global risk committee members and audit and compliance committee members, will complete the executive program. Each education and training program includes the rationale, participants, objectives, curriculum framework, learning outcomes and performance indicators.

Program 1: Induction/awareness The induction/awareness program should be completed by all bank personnel. A bank may also provide the program to non-bank personnel from other organisations that provide critical services to the bank. This program recognises that the effectiveness of business continuity risk management is dependent on the attitude and actions of personnel. All bank personnel must know and apply the principles of risk management and want to participate in a corporate culture and practice of active and positive disaster recovery planning and response. The induction/awareness program curriculum framework incorporates the following issues and learning outcomes. 1

What is business continuity? Why is business continuity risk management important? Participants will be able to describe examples of physical and natural disasters and identify critical business functions that may be exposed to such situations.

2

Organisation of business continuity risk management objectives, policies and procedures. Participants will be able to explain why a bank needs to maintain the continuity of its critical business functions. Participants will know how they can include business continuity risk management in their day-to-day operational practice.

3

The bank’s business continuity risk management organisational structure. Participants will be able to describe the bank’s business continuity risk management organisational structure, emphasising the roles and responsibilities of individuals within business units. 79

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4

Risk and the disaster recovery planning process. Participants will be able to give a range of examples of risk and demonstrate the practical application of the risk management process.

5

The disaster recovery response process. Participants will be able to explain through examples why a bank implements a structured and prioritised disaster recovery process.

6

How to respond in a disaster situation. Participants will know their responsibilities in an emergency, including disaster identification and reporting procedures, personnel safety, asset damage mitigation and building evacuation procedures.

7

Applying learning to practice. Participants will return to their workplace knowing they have the fundamental knowledge and skills to apply effective business continuity risk management practices in their day-to-day business operations.

Program 2: Contingency planning Although all bank personnel must incorporate business continuity risk management into their dayto-day practices, certain personnel will be responsible for core components of the disaster recovery planning and response processes. The contingency planning program will provide these personnel with the necessary specialist knowledge and skills to complete those tasks effectively. Participants include organisational business continuity risk management group members, divisional contingency planning unit members and nominated global risk committee members. The contingency planning program curriculum framework incorporates the following issues and learning outcomes. 1

Construction of a contingency plan. Participants will appreciate the benefits that will derive from contingency planning and develop a culture whereby contingency planning is incorporated into normal business operations. Participants will be able to apply effectively the bank’s standard contingency planning software and format to their business unit functions.

2

Risk analysis, business impact analysis and recovery prioritisation. Participants will be able to identify risk exposures within their work environment and review procedures to minimise such exposures. Participants will be able to apply quantitative methods and qualitative measures to determine the operational and financial impact of a disruption to business functions. Based on the risk analysis and business impact analysis, participants will be able to document a recovery prioritisation schedule.

3

Disaster recovery strategies, service agreements and support agreements. Participants will have acquired the knowledge and skills to identify, analyse, compare and evaluate recovery strategy alternatives and be able to make recommendations to management based on a cost–benefit analysis. Participants will be able to construct basic service agreements and support agreements.

4

Emergency response teams, divisional recovery teams and communications. Participants will be able to perform the responsibilities of emergency response team members in a disaster situation— that is, to ensure the safety of bank personnel, the implementation of disaster notification procedures and the initial mitigation of damage to assets. Participants will also be able to describe the roles and responsibilities of divisional recovery teams in implementing disaster recovery procedures within the context of the organisational business resumption plan and the divisional recovery plan. Participants will be able to demonstrate the application of communication procedures, including activating 24-hour contact arrangements and establishing communications with the recovery control centre, back-up facilities and service and support providers.

5

Disaster recovery plan testing. Participants will be able to develop and maintain a structured and comprehensive recovery plan testing schedule. Participants will be able to apply a range of testing methodologies, evaluate performance outcomes and report results to management.

6

Plan maintenance, monitoring and review. Participants will be able to maintain the currency of a disaster recovery plan, including the application of procedures to ensure that new products and services and changes in operational procedures are reflected in the disaster recovery planning and response processes. Participants will be able to implement the bank’s policies in relation to plan review and reporting requirements.

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The essential role of the board of directors and executive management in driving business continuity risk management is recognised in program 3. This program addresses issues that will support the board of directors and executive management in determining appropriate business continuity risk management objectives, policies, strategies and procedures. The executive program curriculum framework incorporates the following issues and learning outcomes. 1

Corporate governance and risk management. Participants will be able to critically review corporate governance risk management policies and practices and shape new strategies to improve the bank’s business continuity risk management corporate culture.

2

Business continuity and disaster risk management. Participants will be able to apply a structured risk management process to the disaster recovery planning and response processes and identify issues that must be the focus of the strategic decision maker.

3

Regulation and prudential supervision. Participants will be able to evaluate different prudential supervisor approaches to business continuity risk management. They will also be able to investigate the implications of the Basel Committee on Banking Supervision application of a capital charge for operational risk and the recording of operational risk occurrences.

4

Objectives, policies, procedures, budget and infrastructure. Participants will be able to review current business continuity risk management objectives, policies and procedures and recognise any divergence between policy and practice. Participants will also be able to identify the bank’s critical business functions, and evaluate and review disaster recovery strategies and infrastructure, budget allocations and testing programs.

5

Business continuity risk management organisational structure. Participants will be able to identify and describe the scope, roles, responsibilities, authorities, reporting structures and review procedures applicable to the business continuity risk management organisational structure. Participants will also recognise the linkages between divisional contingency planning units, the organisational business continuity risk management group and the global risk committee.

6

Global best practice. Participants will be able to investigate and evaluate global best practice in business continuity risk management, and analyse and compare the bank’s current practice. Participants will be able to develop and implement policies and strategies that will enable the implementation of best practice.

7

Disaster response: recovery control centre, communications, media liaison. Participants will be able to demonstrate leadership in responding to a disaster situation. Participants will be able to activate recovery control centre procedures, particularly the initiation of communications. They will be able to command, control and coordinate the disaster recovery process. Participants will also know their roles and responsibilities in relation to the bank’s policies and procedures for media liaison.

CHAPTER TWO REVIEW

Program 3: Executive program

Summary The business continuity risk management education and training framework for banks comprises three specific programs that are directed towards identifiable groups of bank personnel:

• • •

an induction/awareness program for all bank personnel a specialist contingency planning program an executive program for strategic policy decision makers.

The curriculum framework within each program is designed to achieve learning outcomes that will result in measurable performance indicators that reflect the business continuity risk management culture and practice that derives from the bank’s related objectives, policies and procedures. Figure 2A.1 presents the three business continuity risk management education and training programs and the curriculum framework relevant to each program. 81

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Figure 2A.1 An education and training framework for disaster risk management for banks ■ ■

Program 1 Business continuity risk management: Induction/awareness

■ ■ ■ ■ ■

■ ■

Program 2 Business continuity risk management: Contingency planning

■ ■ ■ ■

■

Program 3 Business continuity risk management: Executive

■ ■ ■ ■ ■ ■

What is a disaster? Why is disaster risk management important? Organisational disaster risk management objectives, policies and procedures Bank disaster risk management organisational structure Risk and the disaster recovery planning process The disaster recovery response process How to respond in a disaster situation Applying learning to practice

Construction of a contingency plan Risk analysis, business impact analysis and recovery prioritisation Disaster recovery strategies, service agreements and support agreements Emergency response teams, divisional recovery teams and communications Disaster recovery plan testing Plan maintenance, monitoring and review

Corporate governance and risk management Business continuity and disaster risk management Regulation and prudential supervision Objectives, policies, procedures, budget, infrastructure Disaster risk management organisational structure Global best practice Disaster response: recovery control centre, communications, media liaison

The overall success of the education and training programs will become evident through a positive change in a bank’s commitment to business continuity risk management and the corporate culture. Some of the learning outcomes and performance indicators specified for each program will be immediately measurable on completion of a program; others will be sustained over time as bank personnel progressively apply their business continuity risk management knowledge and skills to their day-to-day business practice. The objective of business continuity risk management is to establish policies and procedures that will ensure that a bank is able to maintain the continuity of its critical business functions and resume normal operations within defined time parameters in the event of a crisis. Education and training is essential in achieving this outcome.

Extended learning C LEARNING OBJECTIVE 2.10 Discuss the importance of corporate governance and ethics in the context of Australian financial institutions.

Corporate governance and ethics It would be unusual today for someone to complete a business or commerce degree without hearing the words ‘corporate governance’. The Australian Securities Exchange (ASX) defines corporate governance as: ‘The framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. It encompasses the mechanisms by which companies, and 82

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The corporate scandals of the late 1990s and early 2000s, as well as the tremendous volatility arising from the GFC, have gradually increased the prominence of corporate governance within the business and regulatory communities as the need to demonstrate good governance to regulators, customers and investors has grown. Needless to say, however, some managers and boards of directors have not been so acutely attuned to these developments. The 2018 hearings of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry once again thrust corporate culture and ethics into the spotlight. Each Australian company is responsible for developing its own appropriate governance frameworks, but the regulators have provided guidance in the form of principles and minimum standards. For Australian listed companies, the ASX has developed its Corporate Governance Principles and Recommendations to articulate the core principles of good and effective corporate governance. It contains seven principles or recommendations: 1

Lay solid foundations for management and oversight.

2

Structure the board to add value.

3

Promote ethical and responsible decision making.

4

Safeguard integrity in financial reporting.

5

Make timely and balanced disclosure.

6

Respect the rights of shareholders.

7

Recognise and manage risk.

8

Remunerate fairly and responsibly.

CHAPTER TWO REVIEW

those in control, are held to account. Corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised.’

It is a requirement of the ASX’s listing rules that each listed company discloses whether it is following the guidelines and recommendations the ASX has set down. The approach is an ‘if not, why not’ approach that aims to gradually increase governance reporting and quality, and enhance transparency for shareholders. For authorised deposit-taking institutions (ADIs), APRA oversees compliance with Prudential Standard APS 510, Governance. This prudential standard sets down the minimum standards for good governance of institutions regulated by APRA. All regulated institutions must comply. The requirements include prescriptions on board size and composition, the independence of the board and chair, and the establishment of a Board Audit Committee. These requirements are designed to ensure the prudent management of ADIs and promote a culture of good governance within ADIs. The ultimate responsibility for the prudent management of all companies, including ADIs, rests with the board of directors. A strong governance framework will help to ensure that the board functions effectively and good outcomes are obtained for all stakeholders, including shareholders. Unfortunately, in the Australian banking sector, the 2018 Royal Commission uncovered many unethical practices that should not have occurred if strong governance frameworks were in place. The failure to uphold a culture of ethical behaviour has seen the reputation of a number of banking and financial services firms tarnished and has done considerable damage to the already poor public perception of bankers and financial services providers. One of the most important issues to be discussed before the Royal Commission is the provision by a bank of financial advice on its own products. The corporate regulator, ASIC, had already identified the problems with this behaviour in a January 2018 report entitled Financial Advice: Vertically Integrated Institutions and Conflicts of Interest. The report noted that in 75.00 per cent of the customer files reviewed by ASIC, ‘...the adviser had not demonstrated compliance with the best interests duty and related obligations’. The full report can be found at: http://download.asic.gov.au/ media/4632718/rep-562-published-24-january-2018.pdf The Royal Commission came at a time when Australian banks were already facing up to other instances of poor and, in some cases, illegal behaviour. The Commonwealth Bank was facing a lawsuit brought against it by the Australian Transaction Reports and Analysis Centre (Austrac) for 83

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breaches of money laundering and terrorism financing laws. Also, as reported by The Guardian in April 2018, the Federal Court of Australia had imposed fines totalling $20 million on ANZ and NAB for attempted manipulation of the bank bill swap rate (BBSW). With the ABC running stories with titles like ‘Banking Royal Commission: Does this mean that Banks are Not an Ethical Investment?’ (May 2018), the Royal Commission provides a stark reminder to the boards of directors of financial institutions that there are real consequences for failures of governance. They might also be reminded that their behaviour reflects poorly not only on the finance industry, but on the finance discipline (i.e. the body of knowledge accumulated in finance theory and research). The responsibility is not one that should be taken lightly. Further reading: Gareth Hutchens (2018), ‘Banking Royal Commission: All You Need to Know So Far’, The Guardian, 20 April.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

‘Deregulation has changed banking practices in Australia.’ Discuss this statement with reference to banks’ asset and liability management. (LO 2.1)

2

‘Decades after the commencement of deregulation in the financial markets, the international capital markets remain a relatively unimportant source of funds for commercial banks.’ Analyse and discuss this statement. (LO 2.1)

3

A customer has approached your commercial bank seeking to invest funds for a period of six months. The customer is particularly worried about geopolitical risk following recent tensions in the Middle East and elsewhere. Explain the features of call deposits, term deposits and CDs to the customer, and provide advice on risk-reward trade-offs that might be associated with each product. (LO 2.2)

4

Discuss the four main uses of funds by commercial banks and identify the role that the purchase of government securities plays in commercial banks’ management of their asset portfolios. (LO 2.3)

5

Commercial banks are the principal providers of loan finance to the household sector. Identify five different types of loan finance that a bank offers to individuals. Briefly explain the structure and operation of each of these types of loans. (LO 2.3)

6

ABC Limited plans to purchase injection moulding equipment to manufacture its new range of plastics products. The company approaches its bank to obtain a term loan. Identify and discuss important issues that the company and the bank will need to negotiate in relation to the term loan. (LO 2.3)

7

The off-balance-sheet business of banks has expanded significantly and, in notional dollar terms, now represents over nine times the value of balance-sheet assets.



(a) Define what is meant by the off-balance-sheet business of banks.



(b) Identify the four main categories of off-balance-sheet business and use an example to explain each category. (LO 2.4)

8

Following the GFC, the off-balance-sheet activities of commercial banks attracted a great deal of attention among commentators. With reference to the size and composition of commercial banks’ off-balance-sheet activities, outline some of the possible reasons for this concern. (LO 2.4)

9

Bank regulators impose minimum capital adequacy standards on commercial banks. APRA has stressed the importance of CET1 capital. Explain what this is and why APRA places such emphasis upon it. (LO 2.5)

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11 Provide an overview and rationale for the two new liquidity standards introduced by Basel III. (LO 2.6) 12 The final version of Basel III, released in 2017, focuses more attention on the denominator of the minimum capital ratios that banks must maintain. Discuss this statement. (LO 2.7) 13 The second pillar of Basel III, risk management and supervision, addresses the management of a bank’s interest rate risk in the banking book (IRRBB). Explain what is meant by IRRBB and the new expectations regarding how it should be managed (LO 2.7)

Extended learning questions 14 The Basel III capital accord comprises a framework of three pillars. Pillar 1 established the minimum capital required by a commercial bank and incorporates three risk components: credit risk, operational risk and market risk.

(a) Define credit risk.



(b) What approaches may be used to measure the credit risk capital adequacy component of Pillar 1?



(c) Using the standardised approach to credit risk, explain how a commercial bank will use this method to calculate its minimum capital requirement. (LO 2.8)

CHAPTER TWO REVIEW

10 Basel III simplifies the process of computing the amount of operational risk capital that a bank must set aside. Briefly explain the process. (LO 2.6)

15 Commercial banks are exposed to the very real risk that at some point their critical business operations could fail. Business continuity risk management may be said to incorporate a disaster recovery planning process and a disaster recovery response process.

(a) Define business continuity risk management.



(b) Identify and briefly explain the core components of a disaster recovery planning process.



(c) Identify and briefly explain the core components of a disaster recovery response process. (LO 2.9)

16 An essential element of business continuity risk management is education and training.

(a) Why is education and training important in the context of business continuity risk management?



(b) Identify three discrete education and training programs that a bank should provide.



(c) Briefly discuss what issues should be incorporated in each of the three education and training programs. (LO 2.9)

17 (a) Discuss the nature of corporate governance and its relationship with ethics. (LO 2.10)

(b) Discuss the importance of corporate governance and ethics for Australian ADIs, both in terms of complying with regulations and effectively meeting the expectations of stakeholders. (LO 2.10)

KEY TERMS acceptance 46

bank bills held  50

BBSW 50

amortised loan instalments  49

bank regulation  56

bill of exchange  46

asset management  43

Basel II capital accord  58

authorised deposit-taking institutions 57

Basel III capital accord  58

business continuity management 62

basis points  64

call deposits  45

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collateralised floating charge  46 commercial bills  50 commitments 53 Common Equity Tier 1 capital 60

internal ratings-based approach to credit risk  61

operational risks  61

interest rate risk in the banking book (IRRBB)  65

overdraft 50

investment property finance  49

contingency plan  69

lease 50

credit card  49

liquidity management strategy 69

credit risk  59 current account deposits  44 current exposure method  61 debenture 46 direct credit substitute  53 euromarkets 47 fixed-term loan  49 foreign currency liabilities  47 G-10 58 general market risk  63 globalisation 47

loan capital 47 loan-to-valuation ratio  76 market risk  59 market-rate-related contracts  54 mark-to-market 61 mortgage 48 mortgage originators  49 negotiable certificate of deposit 45 negotiable security  46

hedging 54

non-executive board members 71

housing finance  48

off-balance-sheet business  44

original exposure method  61 Pillar 1  60 prudential supervision  56 reference interest rate  50 rollover facility  50 securities portfolio  69 securitisation 000 specific market risk  63 standardised approach to credit risk 61 term deposits  45 Tier 2 capital  60 trade- and performance-related item 53 Treasury bonds  51 Treasury notes (T-notes)  51 unsecured note  46 value at risk (VaR)  64

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CHAPTER 3

Non-bank financial institutions CHAPTER OUTLINE 3.1 Investment banks 3.2 Managed funds 3.3 Cash management trusts 3.4 Public unit trusts 3.5 Superannuation funds 3.6 Life insurance offices 3.7 General insurance offices 3.8 Hedge funds 3.9 Finance companies and general financiers 3.10 Building societies 3.11 Credit unions 3.12 Export finance corporations

Learning objectives LO 3.1

Describe the roles of investment banks, with an emphasis on the nature of their off-balance-sheet business, in particular mergers and acquisitions.

LO 3.2

Explain the structure, roles and operation of managed funds and identify factors that have influenced their rapid growth.

LO 3.3

Discuss the purpose and operation of cash management trusts and public unit trusts.

LO 3.4

Describe the nature and roles of superannuation funds, including the primary sources of superannuation funds and the different types of fund.

LO 3.5

Define life insurance offices and general insurance offices, and explain the main types of insurance policies offered by each type of insurer.

LO 3.6

Discuss hedge funds, including their structure, investors, investment strategies and risk.

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LO 3.7

Explain the principal functions of finance companies and general financiers, and the changes that have had an impact on finance company business.

LO 3.8

Outline the roles and relative importance of building societies and credit unions, and analyse the significant changes that have occurred in these sectors.

LO 3.9

Describe the unique role of export finance corporations.

Extended learning LO 3.10

Understand project finance and structured finance, and the related roles of investment banks.

CHAPTER SNAPSHOT Operating alongside commercial banks are a range of non-bank financial institutions. These include superannuation funds and other funds management operations, insurance companies, investment banks and hedge funds. The tools and strategies that are deployed within these operations draw heavily on modern finance theory and mathematics, especially in the hedge fund world. The seeming complexity of the strategies, however, should not lead us to overlook the role that fundamental concepts such as risk and reward and supply and demand play in determining whether or not these institutions are successful.

INTRODUCTION In this chapter the focus moves away from the commercial banks to the wide range of other financial institutions that operate in a modern financial system. For convenience, the market refers to the collective group of financial institutions other than the commercial banks as ‘non-bank financial institutions’. The institutions examined in this chapter are:

• investment banks • managed funds • superannuation funds • cash management trusts • public unit trusts • life insurance and general insurance offices • hedge funds • finance companies and general financiers • building societies • credit unions • export finance corporations. Why do so many different financial institutions exist? In a deregulated and competitive market it might be argued that the financial strength and enormous size and expertise of commercial banks would create an environment in which other non-bank financial institutions would struggle to compete. In part this may be true. For example, in Australia there has been a significant reduction in the building society sector since the commercial banks were largely deregulated in the 1980s. With increased competition between commercial banks and building societies, the building societies responded by merging with other institutions and many changed to become commercial banks. 88

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However, other financial institutions have thrived by specialising within segments of the financial markets. For example, investment banks have used their particular expertise to expand their off-balancesheet business, including providing financial advice to corporate clients on areas such as mergers and acquisitions. As the insurance business of life insurance offices has declined, these institutions have moved into, and taken a prominent position in, superannuation and managed funds products. To meet the retirement savings needs of an ageing population, there has been an enormous expansion in managed funds, in particular superannuation and public unit trusts. The financial system as a whole is constantly evolving. Non-bank financial institutions have developed in response to the different regulatory environments that have existed from time to time, and to the changing preferences of market participants. The chapter opens with an examination of the exciting world of investment banking, in particular the investment banks’ off-balance-sheet activities.

REFLECTION POINTS

range of non-bank financial institutions can compete within a modern financial system • A(e.g.wideinvestment banks, life insurance and general insurance offices, superannuation funds, finance companies, building societies, credit unions, cash management trusts and unit trusts). financial institutions tend to specialise in areas of the financial markets in which • Non-bank they have a particular strength or expertise; for example, investment banks specialise in the provision of financial advisory services.

3.1

Investment banks

Investment banks have always been regarded as financial innovators, at the leading edge of the financial system. Today, these institutions continue to specialise in sophisticated areas of finance that are both challenging and exciting. Investment banks grew strongly in the USA, in particular as specialist facilitators of financial transactions rather than providers of finance. Investment banks established a reputation as financial innovators and were often responsible for the development of new financial products and services that met the changing needs of market participants. Investment banks are organised around risk taking, risk measurement and operational controls. The activities that take place within an investment bank are normally described as front office (including trading, investment banking, research and investment management); middle office (including risk measurement, risk management and reporting); and back office (accounting, bookkeeping, audit and compliance). These features and other aspects of investment banking are discussed in the context of the GFC by Mark Williams in his book Uncontrolled Risk (2010). As Williams points out, the relative power and prestige of the activities, especially risk taking versus risk management, depends critically on organisational culture. A culture of risk taking will place proportionally more power and prestige in the hands of front office personnel and make it more difficult for the middle office to ensure that risks are being managed appropriately. This may generate substantial profits when markets are moving in the right direction, but leave an investment bank particularly vulnerable when market conditions change. The relative size and importance of investment banks is significant, especially within the major financial centres of London and New York. Outside these two financial centres, these banks often selectively focus on other jurisdictions, such as Asia, Australia, South America, Western Europe and Eastern Europe.

3.1.1

Sources of funds and uses of funds

Investment banks provide financial services to their corporate clients, high-net-worth individuals and government clients.

LEARNING OBJECTIVE 3.1 Describe the roles of investment banks, with an emphasis on the nature of their offbalance-sheet business, in particular mergers and acquisitions.

Front office the name given to those activities within an investment bank that involve client relations, especially trading, investment banking, research and investment management

Middle office the name given to those activities within an investment bank that do not involve client relations but may complement or monitor front office activities; risk measurement and reporting are examples

Back office the name given to those functions within an investment bank that are most removed from client relations; accounting and compliance are examples

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Unlike commercial banks, these institutions do not have a depositor base from which to acquire assets. Their liabilities or sources of funds are usually raised through the issue of securities into the international money markets and capital markets. Under normal market conditions, the high-profile reputation of many of the investment banks affords them easy access to the international capital markets. Investment banks will provide some limited lending to clients, but usually on a short-term basis. They tend to sell any loans into the secondary markets rather than hold them on their balance sheet. They are primarily focused on advisory services; for example, they will advise their clients on all aspects of raising funds directly from the money and capital markets. In fact, the relative size of financial assets held by investment banks has diminished over time. For example, in Australia the financial assets held by investment banks represent less than 1.00 per cent of the total assets of financial institutions. However, this figure completely misrepresents the importance of the investment banks. The decline in asset share does not indicate the demise of these institutions; rather, it shows the significant change that has occurred in their functions and operations. They now mainly focus their activities on specialist off-balance-sheet advisory services.

3.1.2

Off-balance-sheet business

Investment banks have established a reputation as financial innovators. Much of that financial innovation has been in the development of sophisticated off-balance-sheet products and advisory services. Therefore, the principal income of these banks is fee income associated with their off-balance-sheet activities. Examples of their off-balance-sheet business include: 1 Operating as foreign exchange dealers. Within a global market, importers, exporters, investors, borrowers, central banks, speculators and arbitrageurs conduct a range of transactions that are written or denominated in a foreign currency. Investment banks that operate as foreign exchange dealers quote both bid (buy) and offer (sell) prices on all major currencies. As we will discuss in Chapter 15, the foreign exchange markets are enormous, and at times quite volatile. 2 Advising clients on how, where and when to raise funds in the domestic and international capital markets. Investment banks understand the global financial markets and how to access funds in those markets. They provide advice and expertise on the types and structures of securities that can be issued, interest rate risk and exchange rate risk, and the preparation of documentation, including legal, accounting, taxation and regulatory matters, associated with a securities issue.

Underwriter an institution that supports the issue of securities by a client and agrees to buy any securities not bought by investors

3 Acting as the underwriter of new share and debt issues. In order to ensure funds are raised from an equity or debt issue, the issuing corporation may pay a fee and enter into an underwriting agreement with an investment bank, whereby the underwriter agrees, subject to the terms of the contract, to purchase any securities that are not purchased by investors. By having an underwriting agreement in place, the issuer is confident that they will raise the total funds they need for their business operations. 4 The placement of new issues with institutional investors. A corporate client may wish to raise additional debt or equity by issuing new securities. One relatively simple way to do this is to offer the securities to institutional investors. Investment banks have a large corporate client list and also have access to institutional investors such as funds managers. They are able to approach these investors and offer them the opportunity to purchase large parcels of securities to be issued by clients. Placements are discussed in Chapter 5. 5 Providing advice to corporate clients on balance-sheet restructuring. A balance sheet is dynamic in that a corporation should always be considering the most effective funding of its assets. This will change, for example, as the asset structure of the business changes, as interest rates are forecast to move, as the economy or business cycle is expected to shift or as the exchange rate changes. An investment bank will provide a client with advice on all these issues and assist the client to issue new securities in order to restructure the balance sheet.

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6 Evaluating and advising a corporate client on mergers and acquisitions. See the section on mergers and acquisitions below. 7 Conducting feasibility studies and advising clients on project finance and structured finance undertakings. Project finance is long-term finance for projects such as building a tollway or a power station. The financing of the project is based on the future expected cash flows that will be generated by the project once it has been built. As the project will only generate cash flows once it is completed, and often has only limited asset value before completion, this is a specialist area of high-risk lending (refer to the Extended learning section at the end of this chapter for a detailed discussion on project finance and structured finance). 8 Identifying client risk exposures and advising on risk management strategies. Corporations and governments are exposed to a wide range of financial and operational risks. Risks that may affect the value of assets, liabilities or shareholder funds, or cash flows generated by the business, include interest rate, foreign exchange, liquidity, credit, investment, fraud and disaster risk exposures. Investment banks have the expertise to provide sophisticated solutions that allow the identification, measurement and management of risk exposures. Risk management strategies often involve the use of complex financial products, such as derivatives. 9 Advising on, and partial provision of, venture capital. Venture capital, also known as risk capital, is funding provided for new start-up businesses where there is a high level of risk attached to the future success of the business but the potential for high returns. The size of the funding requirement, plus the high level of associated risk, means that funding is often provided by a group or syndicate of investors. An investment bank may take on the role of lead manager of a syndicate and bring together a large group of other investment and commercial banks who will all provide funding for the project. This list of off-balance-sheet business carried out by investment banks demonstrates that they operate in the more innovative and exciting areas of the financial markets. Many of the types of offbalance-sheet business conducted by investment banks, including advisory services, foreign exchange, underwriting, equity and debt issues, risk management and derivatives, are discussed in various parts of this text. At this stage one important function that is carried out by investment banks, mergers and acquisitions, is considered.

Mergers and acquisitions Advising corporate clients on mergers and acquisitions—in which one company gains control over another—is a significant fee-generating service provided by investment banks. There seems to be a direct correlation between sustained economic growth and the level of merger and acquisition activity. Interestingly, in recent years investment banking deals have been dominated by spin-offs, whereby a company breaks itself into pieces and the pieces become separately listed public companies. In this process, previous mergers and acquisitions are undone or divisions that have grown to a substantial size within the company are spun off to begin an independent existence. When companies cannot find buyers willing to pay a desirable price for the division that it wishes to sell, the company spins off the division and becomes two separate companies: parent and child. Often, the combined market value of the two new entities exceeds the market value of the parent company before the spin-off. This provides an incentive for companies to investigate the possibility and for investment banks to initiate deals. Mergers, acquisitions and spin-offs are important examples of the balance-sheet restructuring facilitated by investment banks. Typically, merger and acquisition strategies are categorised as horizontal, vertical or conglomerate takeovers. For example, if a toy manufacturer purchases another toy manufacturer, the acquisition may be described as a horizontal takeover. A horizontal takeover occurs when the target company conducts the same type of business as the takeover company.

Merger and acquisition takeover company seeking to gain control over a target company

Spin-off a situation where a part of a company is separated from the whole and begins an existence as an independent company

Horizontal takeover when two companies involved in a merger and acquisition are in the same business

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Part 1 Financial institutions Vertical takeover when the target company in a merger and acquisition operates in a business related to that of the takeover company

Conglomerate takeover when the business of a merger and acquisition target company is unrelated to the existing business of the takeover company

Hostile takeover when the target company rejects the merger and acquisition proposal of the takeover company

A vertical takeover occurs when the takeover company acquires a company that normally operates within a related business area (e.g. a toy manufacturer purchases an electronic components supplier). A conglomerate takeover is said to occur when the takeover company diversifies its business activities by acquiring a company that operates in a business area unrelated to the existing business of the takeover company (e.g. a toy manufacturer purchases a media company). A company interested in pursuing a merger or acquisition will seek the services of an investment bank in its efforts to complete the transaction. The target of the acquisition may also seek the services of an investment bank to advise the company on how best to resist what it might see as a hostile takeover. A hostile takeover is one in which the actions of the takeover company are actively resisted by the board of directors of the target company. Investment banks generate significant fee income from their mergers and acquisitions business. They are not, therefore, passive players in the market; that is, they do not wait until they are commissioned by a client on either side of a merger transaction. Rather, investment banks actively seek out, analyse and evaluate potential takeover opportunities for clients, then approach the client and try to sell them the takeover idea. There should be value added in a merger. That is, the value of the merged entity should be greater than the sum of the two original companies on a stand-alone basis. This additional value could be gained from synergies that may be present in the merger. Synergy benefits may be achievable from:

• Economies of scale. For example, a company might gain operating advantages from a better use

of productive capacity and a lowering of the overall cost of production. Financial gains can also be made from reductions in overhead expenses associated with administrative and management structures within the merged business.

• Finance advantages. A merged corporation should be able to leverage its larger balance sheet; that is, the

merged company may have a greater capacity to extend its debt funding. The enhanced reputation of the larger organisation may enable it to access new debt markets, particularly the international capital markets, and at a lower average cost of funds. The merged corporation will seek to maximise potential tax advantages that may be available; for example, through the possible offsetting of capital losses.

• Competitive growth opportunities. A takeover company can achieve immediate growth by acquiring the

existing business operations of another company. The cost of acquisition is typically more certain, and much quicker, than the cost of internally generated growth. For example, it may be easier for a business to purchase a company that has the production facilities it requires rather than build new facilities.

• Business diversification. A corporation may extend its business operations into the international

markets through acquisition. Another firm may diversify its business functions through a conglomerate takeover. In either situation, the takeover company will diversify its sources of revenue and will try to protect itself from a downturn in a single economic market that might occur from time to time.

In advising a corporate client on a merger and acquisition opportunity, an investment bank must consider the economic, legal, accounting and taxation implications of the proposal, often across a number of jurisdictions. For example, anti-trust or competition regulations can vary quite significantly between countries. Although most major countries apply international accounting standards, variations do exist. This is noticeable in the stringent regulatory reporting requirements of the Securities and Exchange Commission (SEC) in the USA. Taxation regimes also vary between nation-states, particularly in relation to the treatment of tax issues arising from merger and acquisition activity. A brief description of a range of issues that an investment bank would bring to the attention of a corporate client when considering a merger and acquisition proposition is provided below.

• Analysis of the target company. Is the company a strategic fit? Issues to consider include the company’s size, geographic position, business mix, operational capacity, financial strength and availability for takeover.

• Valuation of the company. Quantitative models will be used that incorporate net asset values (liquidation value), net present values of incremental cash flows and future earning power. The value of the combined entity should be greater than its pre-merger parts.

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• Establishment of contacts. Confidentiality is essential if a successful merger is to be achieved at a

reasonable price. If the market becomes aware of a potential merger, the price of the target company will be pushed higher on expectation of a takeover premium. Contacts need to be established with the investment bank and senior representatives of the target company.

• Transaction structures. Principally, this will include the development and evaluation of acquisition

and purchase methods. For example, should the deal involve a cash offer, a share offer, an asset swap or a combination thereof? Other transaction issues include legal, taxation and accounting structures, and future organisational and management structures.

• Negotiation. Negotiation skills are essential when a dominant company is making a takeover bid for a target company. If negotiations are conducted properly, there will be no perceived winners or losers. Negotiators must resist taking positions, and should separate people from the business issues; that is, the takeover should not be about personalities and personal gain, but rather about benefiting the business.

• Due diligence. This involves the detailed and careful analysis of the financial and operational

condition of the target company. Clearly, information gained in the due diligence process will determine whether a proposal should proceed and at what offer price.

• Nature of the takeover. If an offer is made, will it be resisted by the board of directors of the target

company? If so, what are the strategic, financial and operational implications of proceeding with a hostile takeover? If an unsolicited friendly merger is possible, what concessions will need to be made?

• Communication with the market. This includes regulatory communication requirements to keep the

market informed, plus strategic communication with the media and specific market participants such as investment analysts.

• Project management and integration. Development of a merger and acquisition proposal will, at times,

be influenced by issues of speed versus accuracy of information, confidentiality versus transparency of information provided to stakeholders, and the robustness versus the efficiency of the transaction structure.

The merger and acquisition advisory role of an investment bank provides enormous opportunities for the institution to offer a range of further services to its corporate client. Once it has advised on a merger proposal, the investment bank will seek to facilitate the transaction on behalf of the client. Other additional services may include providing advice and facilitating funding requirements for debt and equity, underwriting arrangements, balance-sheet restructuring and risk management. All these functions are discussed in detail in other parts of this textbook.

Reflection points

banks are providers of innovative financial products and services to corporations, • Investment high-net-worth individuals and government. institutions do not have a depositor base; they raise funds in the international financial • These markets. banks provide some lending products to clients, but are more likely to assist a client • Investment to borrow directly from the money and capital markets. structure of investment banks is characterised by a division of activities among front-office, • The middle-office and back-office employees. The front-office activities are the most prominent activities within an investment bank and usually involve direct relations with clients. banks specialise in the provision of off-balance-sheet products and advisory • Investment services, such as: continued

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— operating as foreign exchange dealers, quoting bid and offer prices on a range of currencies — advising clients on how to raise funds in the local and international capital markets — acting as underwriters and assisting clients with the placement of new equity and debt issues — advising clients on balance-sheet restructuring, having regard to the forecast business environment — evaluating and advising on corporate mergers and acquisitions, and spin-offs — conducting feasibility studies and advising clients on project finance and structured finance — providing risk management advice, products and services — advising clients on accessing venture capital within the capital markets. merger and acquisition is a situation in which one company seeks to take over another • Acompany. The merger may be friendly or hostile, and strategically may be a horizontal takeover, a vertical takeover or a conglomerate takeover. spin-off is a situation where an independent company is formed from a part of the existing • Acompany. For example, a division that manufactures and sells one of the company’s products may be spun off to form an independent company (for example, Wesfarmers’ decision to spin off Coles). merger will seek to achieve synergy benefits such as economies of scale, finance • The advantages, competitive growth opportunities and business diversification.

LEARNING OBJECTIVE 3.2 Explain the structure, roles and operation of managed funds and identify factors that have influenced their rapid growth.

investment bank would assist a client with analysis and valuation of the target company, and • An provides expertise in relation to contracts, transaction structures, negotiation, due diligence, communication with the market, project management and integration.

3.2

Managed funds

Managed funds investment vehicles through which the pooled savings of individuals are invested

Mutual funds managed funds that are established under a corporate structure; investors purchase shares in the fund

Trust fund managed funds established under a trust deed; managed by a trustee or responsible entity

Trust deed document detailing the sources, uses and disbursement of funds in a trust

Responsible entity the trustee and manager of a trust in Australia

Over time, there has been an amazing growth in the managed funds industry on an international scale. For example, growth in the amount of funds invested in mutual funds in the USA has had a significant impact on the flow of funds into the US domestic capital market and other international capital markets. In the USA, a mutual fund is established under a corporate legal structure; that is, a fund will be operated by an investment company. Investors purchase shares issued by the investment company, and funds managed by the mutual funds are invested using professional fund managers. An alternative structure, used in countries such as the UK and Australia, is a trust fund. In this situation, managed funds are established under a trust deed. A trust deed specifies the parameters under which the trust will operate. The investor in the trust obtains a beneficial right to the assets of the fund and an entitlement to share in the income and capital gains (losses) derived from the fund. Traditionally, managed funds have maintained a dual protective structure for investors by separating the roles and responsibilities of the custodian or trustee and the fund manager. For example, a mutual fund is required to use the services of a mutual fund custodian. A mutual fund custodian is a commercial bank or trust company that provides safekeeping of the fund’s investment securities, and controls cash flows to and from shareholders. With a trust fund, the fund is controlled by a trustee, within the constraints of the trust deed. For example, in Australia a trust must have a responsible entity. The responsible entity is both the trustee and the manager of the trust fund, and is responsible for all aspects of its operation, including the appointment of professional fund managers and the administration and safe custody of the trust’s assets.

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Managed funds use the services and skills of professional investment managers or fund managers. The fund managers seek to maximise the return they can achieve on investment portfolios and therefore move very large volumes of investment funds around the globe, as if they were playing a game of monopoly. The driving forces behind the growth of managed funds have been:

• deregulation of the flow of funds in the international capital markets • a more affluent population • an ageing population where individuals are enthusiastically saving for their retirement from the workforce

• more highly educated investors with increased financial knowledge, which leads them to seek more diverse and sophisticated investment opportunities.

3.2.1

Structure of the managed funds sector

Managed funds provide a range of investment structures and opportunities for an investor. Managed funds gather the savings of individuals and then invest the accumulated amount of funds in various asset classes in the domestic and international money markets and capital markets. The main categories of managed funds are:

• Cash management trusts (see Section 3.3) • Public unit trusts (see Section 3.4) • Superannuation funds (see Section 3.5) • Statutory funds of life offices (see Section 3.6) • Hedge funds (see Section 3.8) • Common funds. These are operated by trustee companies. They combine the funds of beneficiaries into an investment pool and invest those funds in specified asset classes. Common funds are different from unit trusts in that they do not issue units to investors. Solicitor firms often offer mortgage trusts through a common fund.

• Friendly societies. A mutual organisation that provides investment and other services, such as

insurance, sickness and unemployment benefits, to its members. Friendly societies’ investment products include the issue of bonds that invest in a range of asset classes, such as cash, fixed-interest trusts, equity and property.

3.2.2

Sources and uses of funds

A managed fund is not a financial intermediary, but rather provides direct access to a wide range of investment opportunities, including the wholesale investment markets. Wholesale markets were discussed in Chapter 1. Managed funds derive their funding from the specific contractual commitments of investors. These may be in the form of either periodic payments into the fund (e.g. superannuation) or, alternatively, a single payment or premium (e.g. an insurance policy). A large managed fund will typically allocate a portion of its total asset portfolio to several professional fund managers. This is both a risk management and a performance management strategy. Risk is diversified between a number of fund managers; therefore, if one manager experiences a poor investment return for the fund, other managers should offset that poor performance. Similarly, each 95

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fund manager will have a competitive incentive to achieve higher returns; otherwise the services of the fund manager may be dispensed with. Each professional fund manager will:

• invest in asset types authorised under the trust deed for the particular fund. For example, a fund may be authorised to invest in commercial property

• balance investments within their portion of the fund. For example, a fund manager will usually maintain a diversified portfolio of assets (such as shares) within the asset class authorised in the trust deed

• reinvest income and any capital gains in the fund • restructure the asset portfolio based on forecast changes in the financial markets and the economy. For example, an expectation that interest rates might change may cause the fund manager to sell assets that could adversely be affected by an interest rate change

• provide financial advice to the fund trustee • periodically report to the fund trustee. Table 3.1 demonstrates the remarkable growth that has occurred in managed funds in Australia. Managed funds have increased from $345 billion in March 1995 to $3171 billion at the end of 2017.

Table 3.1 Managed funds, Australia ($ million, December 1995, 2010 and 2017) 1995

2010

2017

124 183

241 013

242 070

91 330

206 771

192 812

155 992

1 087 458

2 520 130

44 217

308 534

356 033

Cash management trusts

7 455

39 313

35 695

Common funds

4 884

10 005

10 776

Friendly societies

8 300

6 252

7 263

Total of all funds

345 031

1 692 575

3 171 967

Statutory funds of life offices Statutory funds (superannuation) Superannuation funds Public unit trusts

SOURCE: © Commonwealth of Australia

There are a number of different types of managed funds. These types of funds are defined by the nature of the assets held in the fund:

• capital guaranteed funds • capital stable funds • balanced growth funds • managed growth or capital growth funds. Managed funds offer members a choice of investment strategies to meet their particular risk and liquidity preferences. For example, it might be reasonable for a person nearing retirement to want to minimise risk exposure and adopt a conservative investment strategy in order to protect their funds. On the other hand, a young person may wish to take a more aggressive risk strategy to try and maximise the return over the longer term. Therefore, managed funds may be categorised by the investment risk profile of the different types of funds on offer. In some cases, however, there may be a marked difference between what the fund is called and the nature of the risks that are borne by investors. 96

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3.2.3

Capital guaranteed funds

A capital guaranteed fund aims to provide investors with positive returns while protecting their investment from downside losses. Despite being ‘capital guaranteed’, the investor’s capital is at risk and the Australian Securities and Investments Commission (ASIC) has undertaken an analysis of these products to determine whether the terms used to describe the funds are subject to misinterpretation by investors. The structure of these products can be quite complex, and can involve sophisticated derivatives investments and dynamic hedging strategies layered on top of investments in low-risk assets such as bonds. During periods of market volatility, there is the risk of capital losses and investors may not always achieve the outcome they expected, particularly if they fail to understand the nature of the product in which they have invested. Sometimes, products such as insurance or savings annuities are advertised as capital guaranteed or capital protected. These are not to be confused with a capital guarantee fund offering the type of product described above.

3.2.4

Capital stable fund the capital invested exhibits low variability because the fund invests mainly in lowrisk securities

Balanced growth funds

A balanced growth fund aims at delivering a longer-term income stream and some capital appreciation or growth. The investment strategies of this type of fund are more aggressive than for a capital stable fund, with assets diversified across a greater risk spectrum. Their portfolios include money-market instruments, some government securities, property and a relatively high proportion of domestic and foreign equities. On average, the assets of the balanced growth funds are subject to greater market fluctuations. An investor in this type of fund typically has a longer-term investment horizon, or is willing to accept a higher level of investment risk.

3.2.6

a fund that offers the potential of positive returns while putting in place strategies to protect investors’ capital from downside losses

Capital stable funds

A capital stable fund aims to at least secure contributors’ investment, but the fund does not provide an explicit or implicit capital guarantee. Capital stable funds will invest in defensive assets that have low volatility and lower expected returns. A small portion of the portfolio may be invested in riskier assets such as shares.

3.2.5

Capital guaranteed fund

Balanced growth fund investments target longer-term income streams supported by limited capital growth

Managed growth or capital growth funds

A managed growth fund is designed to maximise the return from capital growth; that is, funds managers are looking for an appreciation in the value of assets held in an investment portfolio. The proportion of equity in a managed growth fund portfolio is considerably higher than it is in the balanced growth funds, and the equity segment also includes a greater range of risk securities. While the risk of the portfolio is higher than for any of the other types of funds, managed growth funds provide the opportunity of potentially higher returns. Investors in managed growth funds will generally have a higher propensity to accept risk and will usually have a longer-term investment horizon. Now that we understand the purpose and function of managed funds, we will look at the following:

Managed growth fund invests to obtain greater return through capital growth; lower income streams

• cash management trusts • public unit trusts • superannuation funds • life insurance and general insurance offices. 97

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REFLECTION POINTS

funds include cash management trusts, public unit trusts, superannuation funds, • Managed statutory funds of life insurance offices, common funds and friendly societies. market deregulation, ageing populations, a more affluent population and more highly • Financial educated investors have driven growth in this sector. funds accumulate savings (e.g. superannuation contributions or investors buying units • Managed in a trust). The funds are invested using professional fund managers. managers invest funds in authorised assets, balance their portfolios, reinvest income and • Fund capital gains, provide advice and periodically report to the fund. of managed funds are categorised by their investment risk profile, being capital stable • Types funds, balanced growth funds, managed or capital growth funds.

3.3 LEARNING OBJECTIVE 3.3 Discuss the purpose and operation of cash management trusts and public unit trusts.

Cash management trust (CMT) invests the accumulated savings of individuals mainly in wholesale money-market securities

Cash management trusts

A cash management trust (CMT) is a mutual investment fund, often managed by a financial intermediary within the terms of a specific trust deed. The trust deed sets out the rules under which the CMT is to be managed, including the manager’s responsibility for the day-to-day operation of the trust, and provides for a trustee to be responsible for the supervision of the trust. The deed also specifies the maximum management fees that may be charged. The CMT deed defines the types of assets in which the trust may invest. The assets are generally restricted to short-term money-market instruments. Some funds specialise in short-term-to-maturity government and semi-government securities, while others have a broader portfolio, including bills of exchange, promissory notes and certificates of deposit (these securities are discussed in Chapter 9). Table 3.2 shows the main types of investments held by cash management trusts in Australia.

Table 3.2 Cash management trusts (Australia): Assets as at December 2017 $ million Cash and deposits Bills of exchange

26 310 0

Other assets

9 385

Total assets

35 695

SOURCE: © Commonwealth of Australia

Cash management trusts provide a high degree of liquidity for the investor. Investments are primarily in bank deposits and money-market securities. It is to be expected that the weighted average maturity of investments held in a CMT will be measured in days. The money markets provide a range of short-term investment opportunities; however, the money markets are essentially a wholesale market—that is, most transactions are high value and are carried out by institutional investors such as fund managers. The CMT provides an opportunity for the smaller individual investor to obtain indirect access to money-market investments. The CMT gathers the savings of investors and invests those accumulated savings in money-market securities. A significant growth area in the use of the CMT has been within the stockbroking industry. With the introduction of electronic settlement arrangements for the sale and purchase of securities traded on 98

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a stock exchange, the CMT has generally been adopted as the account through which settlement occurs. Investors hold surplus funds in a CMT with their stockbroker in anticipation of conducting future transactions on the stock exchange. Also, when a shareholder sells shares, the funds will be credited to the CMT held with the stockbroker. Typical features attached to a CMT held with a stockbroker include:

• no entry, exit or account-keeping fees • 24-hour electronic access • personalised cheque book • free periodical payment service • direct crediting of dividends and unit trust distributions. REFLECTION POINTS

cash management trust (CMT) typically invests the majority of its funds in money-market • Asecurities such as bills and commercial paper.

• A CMT provides retail investors with access to the wholesale money markets. • Funds invested in a CMT are very liquid and normally can be withdrawn on 24 hours’ notice. quite often provide CMT accounts for their clients to enable the value settlement • Stockbrokers of share trading transactions. 3.4

Public unit trusts

A public unit trust is an investment fund established under a trust deed whereby the trust sells units in the trust to investors. The trustee, known as the responsible entity, is responsible for the management of the trust and the investment of the pooled funds of the unit holders in accordance with the specified asset classes listed in the trust deed. The trustee will normally appoint several fund managers who will be authorised to invest funds on behalf of the trust. The trust will also specify how unit holders may sell their units in the trust. The four main types of public unit trusts are defined by the assets accumulated in the fund:

• property trusts • equity trusts • mortgage trusts • fixed-interest trusts. Property trusts invest in industrial, commercial, retail and residential property. A particular trust may invest only in residential rental properties, while another may invest in shopping centres, another in hotels and another in central business district properties. The potential investment choices are quite wide, and the nature of the unit trust, whereby investors purchase a limited number of units in the trust, means that the investors gain access to investment opportunities that they may not be able to afford to purchase direct from the market. For example, an individual person generally cannot afford to buy a shopping centre complex; however, individuals are able to buy units in a trust that invests in shopping centres. Similarly, an equity trust may invest in different equity markets, including the local share market or any number of international share markets. The fund may invest in particular industry sectors, such as stocks in the banking sector or the mining sector. One fund may invest only in industrial stocks, while another may invest in resource stocks. Funds will generally specify if they are income or growth funds. Income funds invest in stocks that produce higher dividend returns, while growth funds seek to achieve greater capital gains in the value of the portfolio. Equity trusts are particularly useful for investors wishing to gain access to the international share markets. Generally, an individual investor will not have the same level of knowledge about the international share markets as they may have about their local share market. The trustee of an equity trust will appoint fund managers who have an intimate knowledge of particular international markets.

LEARNING OBJECTIVE 3.3 Discuss the purpose and operation of cash management trusts and public unit trusts.

Public unit trust investors purchase units in a trust; the pooled funds are invested in asset classes specified in the trust deed

Property trusts invest in different types of property specified in the trust deed; includes industrial, commercial and retail property

Equity trust invests in different types of shares listed on stock exchanges (e.g. industrial, resources, emerging markets)

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Part 1 Financial institutions Mortgage trust invests in mortgages registered as loan securities over land

Fixed-interest trust invests in a range of debt securities such as government and corporate bonds

Listed trust the units of a trust are listed and traded on a stock exchange

Unlisted trust to sell units, a unit holder must sell them back to the trustee after giving the required notice

Mortgage trusts invest in mortgages issued by borrowers. A mortgage is a registered security taken by a lender over the land of a borrower. The majority of mortgages will be ‘first mortgages’, where the mortgagee has first claim over the title to the land in the event that the mortgagor defaults on the loan. Fixed-interest trusts invest in a range of bonds issued by governments or corporations. For example, a fund may purchase Treasury bonds issued by the government or debentures issued by listed corporations. These instruments are discussed in Chapters 12 and 10 respectively. The funds may also invest in securities issued in the domestic capital markets and the international capital markets. There has been an enormous growth in public unit trusts. Table 3.3 compares the situation in Australia in 1995 and 2017. The amount invested in public unit trusts has increased from about $40 billion to approximately $350 billion. Table 3.3 categorises property and equity unit trusts as listed trusts and unlisted trusts. With a listed trust, the units of the trust are listed and traded on a stock exchange. A unit holder who wishes to sell units held in a listed trust simply sells them through their stockbroker on the stock exchange at the current market price. With an unlisted trust, a unit holder who wishes to dispose of units held in a trust is required to sell them back to the trustee, after giving the required notice of intention to sell under the terms of the trust deed. With the unlisted trust, it is possible that the trustee may not be able to obtain enough liquidity to buy back the units, particularly in a volatile falling market.

Table 3.3 Public unit trusts (Australia): Assets as at December 2017 ($ million) Type of trust

1995

2017

17 000

183 037

2 129

7 273

1 079

 55 362

•  unlisted

16 571

 88 264

Mortgage trusts

 1 904

194

Other trusts (including fixed-interest trusts)

 5 534

  21 903

44 217

356 033

Property trusts •  listed •  unlisted Equity trusts •  listed

Total SOURCE: © Commonwealth of Australia

The distinction between listed and unlisted trusts is important. For example, this was highlighted in Australia during the late 1980s when, in an environment of falling property prices, the valuations of most property trusts were marked down. This caused a significant demand for withdrawals by unit holders who wanted to exit the trusts before they experienced further write-downs. The unlisted trusts were generally unable to meet the demand for a large number of simultaneous withdrawal requests as, quite reasonably, the trusts did not hold cash reserves to the extent of the withdrawal demand. Many trusts began to impose a withdrawal notice period, which had the effect of stopping immediate withdrawals. It also served to signal to investors what should have been obvious all the time: that unlisted property trusts should not be seen as highly liquid investments. As a result of that experience, a majority of property trusts are now listed on the stock exchange. With a listed trust, the market determines the value of the units issued by a trust. The listed unit trust is not involved with trading in existing units and therefore is not exposed to the demand for liquidity that may be necessary for an unlisted trust. It is interesting to compare the use of listed property trusts against the proportion of listed equity trusts in Table 3.3. The value of listed equity trusts is relatively small. This reflects the liquidity characteristics of the underlying assets. Because property typically is not a liquid asset, it is desirable to list the units on 100

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a stock exchange, thus creating a more liquid financial security. On the other hand, shares held by equity trusts are generally highly liquid and therefore it is not as necessary to list the equity trust itself. The growth in public unit trusts over the past two decades is not surprising. Professionally managed public unit trusts represent an attractive investment option for an ageing population, as well as the growing number of more educated, affluent investors.

REFLECTION POINTS

• A public unit trust is formed under a trust deed. trustee, known as the responsible entity, manages the trust and ensures the pooled funds • The are invested according to the terms of the trust deed. • The trust deed specifies the types of assets in which the trust will invest. trust will invest in specified types of property, such as residential property, hotels • Aandproperty shopping centres. equity trust will invest in specified shares listed on local or international stock exchanges, • An such as industrial or emerging market shares. • A mortgage trust will invest in mortgages registered over land and the property thereon. • A fixed-interest trust will invest in debt securities such as government bonds or corporate bonds. a listed trust, the units are listed on a stock exchange and may be sold by the unit holder • With through the exchange at the current market price. an unlisted trust, a unit holder must sell their units back to the trustee. The trust needs • With sufficient liquidity to meet this demand. 3.5

Superannuation funds

In the international markets, financial institutions and financial instruments are sometimes referred to by different names, even though they are very similar. Superannuation funds, pension funds and provident funds are terms used in different countries to describe essentially the same type of institution. For example, the market convention in the USA is to use the term pension fund, while in Singapore the market might refer to the Central Provident Fund. In Australia, the convention is to describe the institution as a superannuation fund. Superannuation refers to specific savings accumulated by individuals in order to maintain their lifestyle after retirement from work. When people leave the workforce they typically no longer receive the regular income streams that have been a pattern of their working lives. This is a significant and often traumatic change that should be planned for over an extended period prior to retirement. Depending on the age at retirement, an individual may reasonably expect to live more than 30 years in retirement. In some countries individuals must fund their own retirement, while in other countries, such as Australia, age pension entitlements are available from the government. However, these entitlements are restrictive and generally are not sufficient to allow an individual to live in the manner to which they may have been accustomed. With many countries experiencing an ageing population, it is probable that governments may provide less support for retirees into the future. Therefore, superannuation savings will be essential for younger people currently in the workforce. For most individuals the secret to accumulating sufficient retirement funds is progressive longterm savings. However, for young people entering the workforce, retirement seems a long way off and thus saving for retirement is not seen as a priority. Therefore, many countries have introduced different compulsory superannuation savings schemes. While compulsory-superannuation-type schemes are an excellent government policy decision, most schemes will not provide sufficient retirement incomes to fund existing lifestyles. Additional savings will be required.

LEARNING OBJECTIVE 3.4 Describe the nature and roles of superannuation funds, including the primary sources of superannuation funds and the different types of fund.

Superannuation savings accumulated by an individual to fund their retirement from the workforce

Age pension a limited regular income stream paid by a government to older retired persons

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Superannuation funds gather long-term savings and are increasingly important in providing a significant proportion of funds that are available within the financial system for investment within an economy. Such long-term investment facilitates economic growth, which in turn leads to positive economic and social outcomes such as a higher standard of living and higher levels of employment. Using Australia as an example, Table 3.4 shows the contribution of superannuation savings. Superannuation assets of around $1700 billion represent a significant and growing level of savings within the context of a small, open economy such as Australia.

Table 3.4 Superannuation assets and entities (Australia) as at December 2017 Superannuation fund classification Entities with more than four members Pooled superannuation trusts

Assets ($ billion) 1 696.4

207

147.1

39

2.1

2 079

Small APRA funds Self-managed superannuation funds

721

Balance of life office statutory funds

592 658

56.1 2 614.5

Total

Number of entities

595 014

SOURCE: © Australian Prudential Regulation Authority [2018]

In Table 3.4, APRA classifies superannuation funds as:

• Entities with more than four members: regulated superannuation entities with more than four members. • Pooled superannuation trusts (PSTs): trusts in which regulated superannuation funds, approved deposit funds and other PSTs invest.

• Small APRA funds: superannuation entities regulated by APRA with less than five members. • Self-managed superannuation funds: superannuation funds regulated by the Australian Taxation Office that have fewer than five members, all of whom are trustees.

• Balance of life office statutory funds: assets held for superannuation or retirement purposes in statutory funds of life insurance companies. The balance of life office funds includes annuities and assets backing non-policyholder liabilities. These products are regulated under the Life Insurance Act 1995.

3.5.1

Sources of funds

Superannuation funds accept and manage contributions from their members. As superannuation represents long-term savings for retirement, the majority of fund members make regular periodic contributions to their superannuation fund over an extended working life. The superannuation funds invest the accumulated contributions. Income derived from investing those contributions is also added to the superannuation savings. Although APRA does not separate retail, corporate, industry and public sector superannuation funds, we find it useful to segment regulated superannuation entities with more than four members based on their sources of funds. We therefore consider the following groups of superannuation funds and sources of funds within the superannuation system:

• corporate funds, industry funds and public sector superannuation funds • compulsory superannuation funds • retail superannuation funds • self-managed superannuation funds • rollover funds. 102

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Corporate funds, industry funds and public sector superannuation funds A corporate superannuation fund provides benefits to employees of a particular corporation. Industry superannuation funds had their origins in providing benefits to employees working within a particular industry and public sector superannuation funds provide benefits to government employees. These superannuation funds may be contributory or non-contributory. With a contributory fund, both the employer and the employee make specified contributions to the fund. With a non-contributory fund, only the employer makes payments into the fund on behalf of the employees. Often, government employers do not make direct contributions to public sector superannuation funds, but rather meet ongoing superannuation commitments from future taxation receipts. For example, universities in Australia offer contributory superannuation schemes whereby the university (employer) contributes the equivalent of 17.00 per cent of an academic’s salary, and the academic contributes a further 7.00 per cent from their salary. On the other hand, a corporation is more likely to offer a non-contributory scheme, with the corporation only contributing the required 9.50 per cent compulsory contribution.

Corporate superannuation fund

Compulsory superannuation funds

a governmentsponsored fund established for the benefit of government employees

In many countries around the world the average age of the population is increasing. An ageing population presents a twofold problem:

an employer contributes to a fund established for the benefit of an employee; employee may also contribute to the fund

Industry superannuation fund similar to a corporate fund, but the fund is established for all employees in a specific industry

Public sector superannuation fund

1 More people will be retiring from the workforce in the near future, and improved living standards mean that they will live much longer than in the past. These people will require access to funds in order to maintain a reasonable lifestyle. 2 Many governments have traditionally provided support for the aged from taxation receipts. However, as the aged leave the workforce, the proportion of the total population still actively working and contributing to the tax base will fall. At the same time there will be increased demand for aged support services such as hospitals and nursing homes. At some time in the future governments may not be able to fund directly all the necessary services. A number of countries have implemented compulsory superannuation schemes in an attempt to deal with this problem in the longer term. Compulsory superannuation schemes differ considerably between countries; for example, in Singapore the current scheme requires employers to contribute the equivalent of 20.00 per cent of an employee’s earnings and employees a further 16.00 per cent. In Australia, the current compulsory superannuation scheme is known as the superannuation guarantee charge (SGC). The scheme was implemented on 1 July 1992 and phased in over a 10-year period; it is designed to encourage an increase in the level of retirement savings and gradually to reduce the burden of an ageing population on the social security system, by ensuring that employers provide a required level of superannuation support to their employees. Employers who pay the required level of superannuation into a complying superannuation scheme do not need to pay the SGC to the Australian Taxation Office. The SGC is therefore a penalty taxation charge made on employers who do not contribute to their employees’ superannuation. From 1 July 2002, employer contributions on behalf of employees were set at the equivalent of 9.00 per cent of an employee’s wages or salary. This has had an ongoing impact on the flow of funds through the financial system and on the amount of funds available for capital investment. As shown in Table 3.4, total superannuation funds are currently more than $2 trillion. However, for a number of years there has been debate about the adequacy of the 9.00 per cent SGC. In late 2011, the government introduced the Superannuation Guarantee (Administration) Amendment Bill. The amendments to the legislation proposed the gradual increase in the SGC from 9.00 per cent to 12.00 per cent by 2019. In 2014, the government opted to slow the growth of this change by keeping the SGC constant at 9.50 per cent for the years between 2014 and 2021. Only after 2021 would the increase resume, finally reaching 12.00 per cent in 2025 or six years later than originally proposed. In Australia, the government has also introduced taxation incentives that make it attractive for individuals to contribute additional funds into superannuation. For example, contributions and

Superannuation guarantee charge (SGC) the compulsory superannuation scheme operating in Australia

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earnings of a superannuation fund are taxed at a concessional 15.00 per cent taxation rate. When a superannuation fund member reaches age 60 and the fund operates in pension mode, earnings and withdrawals are tax free. Perhaps the greatest incentive to the large numerical increase in private superannuation funds is the concern that compulsory superannuation will not be sufficient to fund a comfortable lifestyle in retirement; additional savings are required.

Retail superannuation funds Retail superannuation funds are operated by financial institutions and membership is open. Anyone can join a retail superannuation fund. These funds are run ‘for-profit’ by the financial institutions who charge a fee on capital invested and take a percentage of the investment earnings. This distinguishes them from industry funds, which are often run on a ‘not-for-profit’ basis on behalf of the fund’s members. Retail funds are a popular choice for many individuals and account for around one-fifth of Australia’s superannuation savings. Individuals seeking to exercise their freedom of choice in the superannuation sector may transition out of an industry or corporate fund and into a retail fund or a self-managed superannuation fund. Their superannuation contributions and those of their employer will now be directed to the retail fund or the self-managed fund.

Self-managed superannuation funds Approximately 30.00 per cent of Australia’s superannuation savings are managed in self-managed superannuation funds (SMSFs). These funds are regulated by the Australian Taxation Office (ATO), which also collects and publishes statistics that provide an overview of some of the more interesting characteristics. The most eye-catching fact about self-managed superannuation is the large amount of money that resides in SMSFs. This is more than $700 billion and a substantial proportion, more than $150 billion, is invested in cash. This has proven to be a useful buffer against financial crises and stock-market crashes but one might question whether the portfolios are, on average, too conservative. Although there has been substantial growth in the SMSF sector, an overly conservative asset allocation may lead us to expect SMSFs to make up a smaller and smaller percentage of the total superannuation savings over time if the earnings in other fund types compound faster during market uptrends than SMSFs, despite SMSFs being competitive at protecting the invested capital during periods of crisis through substantial cash allocations. SMSF investors are not completely averse to risk. More than $200 billion is invested in shares listed on the ASX and a further $20 billion is invested in listed trusts. In fact, despite presumably being set up to afford the investor more control over the investment decisions, SMSFs invest approximately $100 billion in listed and unlisted trusts and other managed investments. About $110 billion is invested in residential and non-residential property. Collectables, government bonds and other debt securities and overseas-based investments do not figure prominently in the asset allocations of SMSFs. The aggregated picture reflected by the ATO’s statistics and confirmed by academic research is that SMSFs invest predominantly in shares and cash, with most of the remainder of the portfolios allocated to managed investments and property. Most SMSF trustees are the trustees of their own superannuation funds and are middle-aged or  older. Less than one-fifth of the almost 600 000 SMSFs are managed by people aged 44 or less. Half of the trustees are over 55. This tends to explain the somewhat conservative asset allocation profile that characterises the SMSF sector. Investors who are closer to retirement must take steps to protect their retirement savings. This is particularly the case for those individuals who are on lower-to-medium incomes. The taxable income of approximately one-quarter of SMSF members is less than $20 000. More than half of SMSF members report taxable income of less than $60 000. Of course, these figures reflect the age distribution of SMSF members, many of whom are possibly already in some form of retirement from the workforce. SMSFs have enjoyed an uncontroversial existence. There has been no major scandal associated with SMSFs and some might be willing to conclude that this is adequate demonstration that people are capable of looking after their own affairs when their retirement incomes are at stake. This being 104

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said, SMSFs do present both regulatory and policy issues. The portfolios are conservative but some evidence suggests that they are not well managed. In particular, there is evidence to suggest that the equity component of SMSF portfolios contains too few investments in too few industrial sectors to be considered well diversified. As a consequence, SMSFs may be exposed to individual company-specific risks that could be avoided by better managing the portfolios’ diversification. SMSFs also represent a significant potential customer base for the financial services industry. The portfolio management of SMSFs and innovations in the products that are specifically offered to SMSF trustees are two areas that may present challenges to regulators and policy makers.

Rollover funds An individual who changes jobs or retires early may need to retain accumulated superannuation entitlements in a prescribed superannuation arrangement. Such prescribed arrangements are set by the government to ensure that individuals retain their superannuation savings until retirement age, and also to ensure the continuation of the concessional taxation environment for superannuation funds. The vehicle through which these benefits may be preserved is called a rollover fund. For example, in Australia an individual who moves from one job to another may roll over their existing superannuation as an eligible termination payment (ETP). An ETP includes a payout from a superannuation fund if a person withdraws from that fund, plus other amounts directly related to a person’s termination of employment, such as a financial inducement paid for early retirement and retrenchment benefits.

3.5.2

Defined benefit funds and accumulation funds

Superannuation funds offer members a choice of investment strategies to meet their particular risk and liquidity preferences. For example, it might be reasonable for a person nearing retirement to want to minimise risk exposure and adopt a conservative investment strategy in order to protect their accumulated superannuation balances. On the other hand, a young person may wish to take a more aggressive risk strategy to try and maximise the return over the long term. The different types of managed funds were discussed in Section 3.2 and included capital stable funds, balanced growth funds and managed growth funds. The net amount of funds paid to a fund member is also dependent upon the type of superannuation fund. Superannuation funds are described as either defined benefit funds or accumulation funds. A defined benefit fund is a superannuation fund that may be offered by an employer to employees. As the name implies, a defined benefit scheme is one in which the amount of the benefit paid to a member on retirement is calculated based on a formula stated at the time the member joins the fund. The final superannuation payout is normally calculated on the basis of the specified factor times the employee’s average salary over the final year, or few years, of employment, multiplied by the number of years of fund membership. Should the performance of the investments in the defined benefit fund not be sufficient to meet the defined payout, the employer must make good the shortfall. With this type of fund the investment risk falls directly on the employer. In recent years many employers have transferred this risk exposure by encouraging employees to move to, or only offering, accumulation funds (also known as defined contribution schemes). An defined contribution fund gathers in the contributions of the employer and the employee and invests those funds on behalf of the superannuation fund member. At retirement, the total amount of superannuation funds available to the member is the accumulated sum of contributions plus investment earnings, minus expenses and taxes. There is no defined payout; the amount received depends totally on the investment performance of the fund. In other words, the investment risk lies with the fund member. Defined contribution schemes are the predominant type of superannuation fund today.

Rollover fund holds existing eligible termination payments within the regulated superannuation environment

Eligible termination payment (ETP) superannuation funds due on termination of employment, plus related redundancy payments

Defined benefit fund the amount of superannuation paid to an employee on retirement is based on a defined formula

Defined contribution fund the amount of superannuation funds available at retirement consists of past contributions plus earnings, less taxes and expenses

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3.5.3

Regulation

By the early 1990s, the Commonwealth Government had developed a retirement income policy to address a range of issues, including low levels of national savings, an ageing population and declining labour participation rates. Legislative initiatives were implemented to raise retirement savings and reduce future dependence on social security age pensions. In 1992, the current compulsory superannuation arrangements were implemented (these were discussed above). The Superannuation Industry (Supervision) Act 1993 (Cwlth) (SIS) and the Income Tax Assessment Act 1936 are the two principal pieces of legislation that directly affect the operation of superannuation funds. The SIS is the governing legislation for the regulation of complying superannuation funds that receive concessional taxation treatment. APRA has responsibility for the prudential supervision of superannuation funds, while ASIC has an associated responsibility for market integrity and consumer protection, which includes superannuation products. Superannuation funds are trusts established under a trust deed. The trustee is the responsible entity and as such has a fiduciary duty of care to ensure that the fund is managed for the benefit of its members. The Superannuation Industry (Supervision) Act establishes an overarching test that must be applied to superannuation investments: the sole purpose test. The sole purpose test requires a superannuation fund to invest in a range of assets that seek to achieve the member’s established risk and liquidity preferences. The purpose is to provide the member with funds for retirement. The concessional taxation treatment of complying superannuation funds relates primarily to a 15.00 per cent tax rate applied to fund contributions, earnings and realised capital gains. There are, however, limitations on the amount an individual can contribute to a superannuation fund annually. Superannuation fund members can withdraw their superannuation funds as a pension, or in a lump sum, tax free once they reach age 60.

REFLECTION POINTS

funds, provident funds or pension funds accumulate retirement savings of • Superannuation individuals. funds may be classified as corporate funds, industry funds, public sector funds, • Superannuation retail funds, small regulated funds and self-managed funds. savings come from a number of sources, including employer contributions, • Superannuation employee contributions, compulsory superannuation contributions, personal contributions and eligible rollover funds. countries are experiencing a demographic shift to an ageing population. Some have • Many introduced compulsory superannuation schemes to ensure people fund at least part of their own retirement. Australia, employers are required to pay the equivalent of 9.50 per cent of an employee’s • Inwage or salary into a superannuation fund in the employee’s name. fund may be a defined benefit fund or a defined contribution fund. At retirement, a defined • Abenefit fund pays a lump sum or pension based on a predetermined formula, whereas a defined contribution fund pays the accumulated contributions and earnings of the fund, less expenses and taxes. funds in Australia are supervised by APRA. A concessional taxation rate of • Superannuation 15.00 per cent applies to contributions and earnings of a fund. Funds may be withdrawn tax free after age 60. 106

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3.6

Life insurance offices

Life insurance offices are contractual savings institutions. The liabilities of insurance offices are defined by contracts in which, in return for the payment of specified periodic cash flows, the policyholder will be entitled to a determinable benefit following the occurrence of a specified future event or condition. The main contract offered by a life insurance office is described as an insurance policy. The cost of an insurance policy is the premium paid. The premium is usually paid annually until the policy matures or is terminated. Typically, in return for payment of the premium, a policyholder or a beneficiary will receive a payment upon death or disablement, or at a nominated maturity date, subject to the terms and conditions of the insurance policy. From an economic point of view, insurance premiums represent a form of savings. The accumulated savings derived from the premium payments received by a life office are invested in a wide range of asset classes. The return received on those investments is used to make payment to an insured policyholder or beneficiary if an event specified in the insurance policy occurs. For example, a specified event may be the death of the insured. Life insurance offices are also providers of superannuation or retirement savings products, and therefore accumulate and invest the superannuation savings of individuals. In Australia, superannuation represents over 87.00 per cent of the assets of life insurance offices’ statutory funds. Statutory funds are funds established within a life insurance office that hold, and therefore separate, the assets backing policyholder liabilities from the other assets of the life insurance office. The inflow of funds to a life insurance office is typically regular, relatively predictable and long term. This gives the life insurance offices, in aggregate, a very stable source of funds. Their payment flows to policyholders and superannuation fund members can be reasonably well predicted on an actuarial basis and generally are not subject to erratic, seasonal fluctuations. Therefore, life insurance offices are able to invest a large proportion of their funds in long-term securities. For example, as indicated in Table 3.5, life insurance offices in Australia are large investors in equities, unit trusts, longterm securities and property, in both the domestic and international markets, with over $240 billion in total funds invested.

LEARNING OBJECTIVE 3.5 Define life insurance offices and general insurance offices, and explain the main types of insurance policies offered by each type of insurer.

Premium the amount paid by the buyer of a contract, such as an option or an insurance policy

Policyholder the person who takes out an insurance policy that covers a defined risk event

Beneficiary the party who is entitled to receive payment under the terms of an insurance policy

Table 3.5 Life insurance offices (Australia): Statutory funds as at December 2017 Statutory funds

$ millions

Cash and short-term investments

14 552

Long-term securities

21 243

Equities and unit trusts Land and buildings

180 275 81

Overseas assets

14 742

Other assets

11 178  

Total assets

242 071

SOURCE: © Commonwealth of Australia

Each country has its own legislative and regulatory supervision requirements for life insurance offices. In Australia, the prudential supervisor of life insurance offices is the Australian Prudential Regulation Authority (APRA). As the prudential supervisor of insurance offices, APRA regulates them in the same manner as it does the commercial banks, particularly with regard to capital 107

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adequacy requirements and liquidity management (discussed in Chapter 2). The principal legislation is the Life Insurance Act 1995 (Cwlth). This legislation covers the licensing and control of life insurance offices.

3.6.1

Life insurance policies

As the name implies, a life insurance policy provides a named beneficiary with a financial payment in the event of the death of the policyholder. Alternatively, the policyholder may receive payment if some other defined event occurs, such as a permanent disability. As discussed below, some life insurance policies also make a payment if the policyholder survives to a nominated age, such as 65 years. In a competitive market, each life insurance office offers a range of different policies that will incorporate a selection of terms and conditions. The basic insurance policy products offered by a life insurance office include:

• whole-of-life policy • term-life policy • total and permanent disablement policy • trauma policy • income protection policy • business overheads insurance policy. Whole-of-life policy Whole-of-life policy a life insurance policy that incorporates a risk component and an investment component, thus accumulating bonuses and a surrender value

Investment component allows periodic bonuses to accumulate on a whole-of-life insurance policy

Risk component the cost of the actual life insurance cover as determined by an actuary

Term-life policy life insurance cover for a fixed amount and a predetermined period

The whole-of-life policy is a long-term life insurance policy. The policy will pay the sum insured, plus bonuses, on the death of the policyholder. The whole-of-life policy incorporates a special feature—an investment component—that affects the amount paid on the death of the policyholder. The life insurance office invests the periodic premiums paid by the policyholder. The returns on investment will, typically, be higher than the risk component of the policy and therefore a surplus is accumulated in the life insurance office statutory fund. The surplus is returned to the policyholder in the form of bonuses that are attached to the policy. Therefore, the policy will pay both the sum insured and the total bonuses attached to the policy. Should the policyholder get into financial difficulty and not be able to pay the premiums on the policy, the accumulated bonuses may be used to offset the outstanding premium payments due. A whole-of-life policy, over time, acquires a surrender value—that is, an amount that will be paid if the policy is cancelled by the policyholder.

Term-life policy The term-life policy pays a specified benefit to a nominated beneficiary on the death of the insured, if that death occurs during the term of the policy. The term-life policy is for a predetermined period and does not include an investment component. The term-life policy is often more attractive than the whole-of-life policy. It allows the policyholder to obtain financial protection for the nominated beneficiary over that period in the policyholder’s life when personal debt commitments are high. For example, a married couple with children may have outstanding debts on their house and car, and are planning to send their children to private schools. If the main income earner died during this period, the surviving family members may experience severe financial hardship. The amount of insurance cover taken with a term-life policy should be at least sufficient to cover these and any other forecast debt exposures. Premium payments are made by the policyholder to the life office during the term of the policy. The policy may require regular, periodic fixed premium payments for the term of the policy. Alternatively, the premiums may be stepped over time, whereby the premium increases progressively during the term of the policy. This form of premium reflects more closely the increasing level of risk of death over time.

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A feature that is available with a term-life policy is the indexation of the sum insured. Generally, the  policyholder is given the option to increase the amount of life cover each year during the term of the policy. A prospective policyholder should clearly understand exclusions that are incorporated in a termlife policy. For example, cover will not be extended to the insured in the event of suicide occurring within a specified period from the commencement of the policy. Also, a policyholder is required to advise the insurer of any pre-existing health and physical conditions and may be required to undergo a medical examination. The insurer may not cover those conditions. Similarly, if the policyholder dies as a result of an undeclared pre-existing condition, coverage may be excluded. If a policyholder is injured or dies as a result of a riot, a terrorist act or war, the cover may be limited or unavailable.

Total and permanent disablement insurance Total and permanent disablement insurance is often taken as an extension to a life insurance policy. It would seem prudent and logical to cover the situation in which death does not occur but serious injury results. This is quite often the case, for example, in a car accident. The injury suffered may be such that the policyholder is no longer able to work. A total and permanent disablement policy will pay a specified amount, either as a lump sum or as an annuity, if an injury causes total and permanent disablement to the policyholder. Therefore, the definition of a total and permanent disablement is critical in determining whether an insurance claim will be paid or not. The definition is, at best, very restrictive. Before taking this type of insurance, one should be aware of the limitations associated with disablement insurance. The restrictiveness of a policy will vary between insurers. It is necessary to read a policy proposal very carefully. In general terms, a total and permanent disablement will be determined within the constraints of either:

Total and permanent disablement insurance insurance policy covering loss of limbs or total inability to resume an occupation

Annuity a series of cash flows of equal amount, equally spaced over time

• the total and permanent loss of the use of a combination of two of the following: hands, feet and/or eyes; or

• total and permanent disablement resulting from an injury, accident or illness whereby the insured is unable to carry out the normal functions of their usual occupation. This measure will usually be subject to a range of conditions.

Trauma insurance Another type of insurance policy that can be attached to a life policy is trauma insurance. With trauma insurance, the life insurance office will make a lump-sum payment to the insured in the event of a specified trauma occurring. Examples of trauma events include cancer, heart attack, HIV, major body parts failure and terminal disease or illness. Again, as with all insurance, the extent of coverage of a policy, definitions of events and terms and conditions need to be examined with great care. For example, at what point is a heart attack a trauma event under a policy?

Trauma insurance a lump-sum payment made if a specified trauma event, such as a stroke, occurs

Income protection insurance Serious injury, illness or redundancy may result in an individual being unable to work for an extended period of time. Income protection insurance offers a periodic payment of an amount up to 75.00 per cent of average pretax income, for a predetermined period. The amount paid will be offset by any other related payments received, such as workers’ compensation, and will be confined to the length of time specified in the policy. Again, this type of policy will vary between insurers. Given the nature of this type of policy, a policyholder must ensure that a policy includes a guarantee of policy renewal by the life insurance office.

Business overheads insurance An extension of an income protection policy may be necessary where an individual runs their own business. Business overheads insurance provides coverage for strictly defined, normal day-to-day operating expenses such as telephones, electricity, insurance premiums, bank interest and fees, office cleaning and administrative personnel.

Income protection insurance payment of a limited income stream if the insured is unable to work in the event of illness or accident

Business overheads insurance coverage of specified day-to-day operating expenses in the event of business disruption

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REFLECTION POINTS

insurance offices are contractual savings institutions; that is, their liabilities are defined by • Life insurance contracts that provide a determinable payout if a specified event occurs. The cost of the policy is the periodic premium paid. insurance offices are large investors in the financial markets, particularly in longer-term • Life debt and equity securities. whole-of-life policy is a long-term life insurance policy that pays a beneficiary the sum • Ainsured, plus bonuses derived from an investment component, on the death of the policyholder. The policy may accrue a surrender value. term-life policy also pays the sum insured but does not incorporate an investment • Acomponent. This is a fixed-term policy that is used to cover that period of a person’s life when they have high personal debt commitments. insurance offices provide a range of other insurance policies, including total and permanent • Life disablement, trauma, income protection and business overheads insurances. Policyholders need to understand the policy exclusions and limitations.

3.7 LEARNING OBJECTIVE 3.5 Define life insurance offices and general insurance offices, and explain the main types of insurance policies offered by each type of insurer

General insurance offices

General insurance policies cover specified risks and provide a promise to pay the insured a predetermined amount in the event that the peril that is insured against occurs. These funds include medical insurance, motor vehicle insurance, travel insurance, public liability insurance and house and contents insurance. Since insurance premiums are paid in advance, general insurers have substantial amounts of funds to invest. However, because of the uncertain nature of the risks that are underwritten in general insurance policies, claims are less predictable than those of life insurance offices. Thus, general insurers tend to invest a larger proportion of their assets in shorter-term, highly marketable securities. They will typically invest significant amounts in money-market assets such as bills of exchange, commercial paper and certificates of deposit. These are very liquid assets that can easily be sold should the insurance company need to raise cash to meet claims against insurance policies.

3.7.1

General insurance policies

General insurance offices provide a wide range of risk insurance products. Policies offer protection to individuals in the retail market and to businesses in the commercial market. This section considers two of the principal insurance policy types:

• house and contents insurance • motor vehicle insurance. House and contents insurance

Co-insurance clause if an asset is underinsured, the policy will cover only the proportional value insured

House insurance provides financial protection to the insured in the event of loss or damage to a residential property. Typically, a policy will provide insurance cover up to a specified amount. The insured must ensure that the amount of the cover is sufficient to replace or rebuild the property covered in the policy. Under-insurance is a significant issue. Policies generally incorporate a co-insurance clause, which means that the general insurance office will pay a claim only up to the proportional insurance coverage. For example, if a house is insured for $400 000 but the replacement cost is determined to be $500 000, then under a co-insurance clause the house is covered for only 80.00 per cent of any loss.

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If an event occurs that is covered under the policy that causes, say, $100 000 damage to the property, the general insurance office will pay only $80 000. The policyholder is said to have self-insured for the remaining 20.00 per cent of the damage. Under-insurance can therefore be very expensive. The range of events covered under a policy varies between insurers. The following is a list of perils that an insurer may include in house and contents insurance policies:

• fire or explosion • natural disasters such as lightning strike, flood and earthquake • malicious acts, riots, civil commotion • theft by persons other than residents • external impact • storm and water damage. Contents insurance policies usually provide new-for-old replacement value. Specified items and items over a certain value may need to be listed in a schedule attached to the policy. For example, valuable paintings or antiques may need to be catalogued and listed on the schedule. Expert written valuations of the items will usually be required. House insurance policies typically incorporate public liability insurance coverage up to a specified amount. Public liability insurance covers injury or death to a third party visiting the named property that may result from negligence on the part of the property owner or occupier. For example, if, in the dark, a visitor to a house falls down steps leading from the house, and if it can be shown that the lighting was defective, the visitor may have a claim against the property owner.

Motor vehicle insurance Accidents do happen, particularly when it comes to road transport. The owner or driver of a vehicle has the choice of a number of motor vehicle insurance policies, each providing a different level of cover. The highest level of cover is provided by a comprehensive insurance policy. A comprehensive motor vehicle policy covers damage to the named vehicle, as well as damage to any third-party vehicles and property. Motor vehicles are generally covered for market value, although it is possible to negotiate a higher cover if necessary. A lesser level of cover is available with a third-party, fire and theft policy. With this type of policy, the named vehicle is covered only for damage or loss associated with fire or theft of the vehicle. Damage to any third-party vehicles and property is covered. A third-party policy only covers damage or loss to a third-party vehicle or property, but does not cover the vehicle of the insured. The cost, or premium, for the above motor vehicle insurance policies reduces as the level of coverage or protection reduces. Also, the more expensive the vehicle owned, the more prudent it is to take higher insurance cover. Finally, within the Australian market there is compulsory third-party insurance. All vehicle owners must pay for this insurance cover when they pay their annual vehicle registration. The policy covers any legal liability for bodily injury caused by a motor vehicle accident. The cover varies between states; some require proof of driver negligence, while others are on a no-fault basis.

Public liability insurance covers injury or death of a third party due to negligence of a property owner or occupier

Comprehensive insurance policy covers damage to the insured vehicle, plus third-party vehicle or property damage

Third-party, fire and theft policy policy covers only fire or theft of the insured vehicle, plus third-party vehicle or property damage

Third-party policy policy covers only third-party vehicle or property damage

Compulsory thirdparty insurance covers legal liability for bodily injury resulting from a motor vehicle accident

REFLECTION POINTS

insurance provides financial protection against an insured event (e.g. travel or medical • General insurance). and contents insurance protects against loss or damage to a residential property, up • House to a specified amount, caused by a range of perils specified in the policy, such as fire, flood or theft. The policy will include a co-insurance clause. The policy should also include public liability insurance, which covers negligent injury to third parties. continued

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vehicle insurance includes (1) comprehensive insurance, which covers damage to the • Motor named vehicle, plus damage to third-party vehicles or property, (2) third-party fire and theft, which covers damage to the named vehicle from fire or theft, plus damage to third-party vehicles or property, and (3) third-party policy, which does not cover the named vehicle, but covers damage to third-party vehicles and property.

3.8 LEARNING OBJECTIVE 3.6 Discuss hedge funds, including their structure, investors, investment strategies and risk.

Hedge funds invest in exotic financial products mainly for high-networth individuals and institutional investors

Hedge funds

A hedge fund typically uses so-called sophisticated investment strategies and exotic investment products to try and achieve higher returns on investments. Therefore, a hedge fund investment is generally regarded as a higher-risk asset in an investment portfolio. Hedge funds will tend to specialise in different types of financial instruments. These include equity, foreign exchange, bonds, commodities and derivatives. The hedge fund sector is generally divided into (1) single-manager hedge funds and (2) fund of funds. The main difference is that the fund of funds invests in a number of single-manager funds; that is, the fund of funds attempts to diversify its fund investments across a number of funds. Hedge funds may be offered and managed by individual managers or financial institutions, particularly investment banks. Individual managers usually have a very high profile and an established reputation in the financial markets. Similarly, investment banks employ individuals with specialist skills, but offer the extra protection of operational transparency; that is, they keep investors informed. Hedge funds use their reputation to attract funds, as investors perceive the manager (individual or investment bank) to have superior skills, particularly in relation to sophisticated investment strategies and the use of exotic investment products. Hedge funds obtain their funds from institutional investors, high-net-worth individuals and retail investors. In particular, superannuation funds and life insurance offices are a major source of institutional funds. Institutional investors seek to manage the risk and return structure of their investment portfolios by adding hedge fund investments to a portfolio. Retail investors may invest in hedge funds in some countries, such as Australia, but are excluded from this type of investment in the USA. If a hedge fund makes an offer to retail investors in Australia, the fund must meet the same regulatory requirements that are applicable to any other type of retail fund, such as an equity unit trust. A hedge fund may choose to list on a stock exchange. This will provide a secondary market that will allow a hedge fund investor to buy and sell units in the fund. As such, a listed fund may be much more liquid in that the price of the units in the hedge fund will move with current market valuations. An expectation of investors is that hedge funds will achieve positive returns in both an upward- and a downward-moving market. This is in contrast to the traditional funds management outcome where a portfolio, on average, increases with an upward-moving market, but decreases with a downward-moving market. While this expectation is possible, clearly it will be dependent on the skills of the hedge fund manager to outperform the market. A hedge fund may seek to leverage investment opportunities by borrowing large amounts of debt, over and above the funds lodged by the hedge fund investors. Also, a typical hedge fund will leverage a position by using derivative products. Derivative products—such as options, forward and futures contracts—may be bought or sold to take either a short or a long position in the equity market or the foreign exchange market. For example, a hedge fund that takes a short position will either sell forward shares, or use a derivative such as an option or futures contract that it forecasts will fall in price. Alternatively, the fund may buy shares it forecasts will rise in price by using either borrowed funds or

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derivative products. Note that with a derivative product, the fund may only need to pay a premium for an option contract, or a deposit margin for a futures contract; that is, the full value of the shares does not need to be paid during the term of the contract. If the share price moves up or down as forecast, the fund will take a profit and not have to pay the full amount at all. (The operation of derivative contracts is discussed in detail in Part 6.) In the above examples, the profit potential to the hedge fund is multiplied by the high level of leverage taken. Of course, the level of risk is also much higher.

REFLECTION POINTS

hedge fund seeks to achieve above-average returns using sophisticated investment • Astrategies and exotic investment products. are often highly leveraged by using borrowed funds or derivative products, and are • Funds invested in equities, foreign exchange, bonds, commodities and derivatives. funds or fund of funds may be managed by a high-profile individual or a • Single-manager financial institution such as an investment bank. fund investors may be institutional investors, high-net-worth individuals or retail • Hedge investors.

• Hedge funds should be regarded as a higher-risk investment. 3.9

Finance companies and general financiers

Finance companies and general financiers borrow funds in the domestic and international financial markets in order to provide loans to their customers. They do not accept deposits from the general public. Finance companies emerged largely in response to regulatory constraints that existed in the previously highly regulated banking sector, where interest rate ceilings and lending directives were often imposed on commercial banks by regulators. Constraints placed on banks created an opportunity for the development of institutions that could conduct business outside the regulated banking sector. In order to circumvent regulatory ceilings placed on bank deposit and lending interest rates, and constraints on their ability to lend to higher-risk borrowers, the banks took a major role in the ownership and funding of finance companies.

3.9.1

LEARNING OBJECTIVE 3.7 Explain the principal functions of finance companies and general financiers, and the changes that have had an impact on finance company business.

Sources of funds and uses of funds

There is a direct correlation between the rise and fall in the relative importance of finance companies and general financiers and the process of deregulation of the banking sector. For example, in Australia in 1955 these institutions represented only 3.00 per cent of the total assets of financial institutions, but by 1980 their market share had risen to 13.00 per cent. However, with the deregulation of the interest rate and portfolio restrictions on commercial banks, the finance companies’ share of total assets declined continuously, and in 2017 stood at less than 2.00 per cent. The main sources of funds of these institutions are from borrowings from related corporations, loans from banks and borrowing direct from the domestic and international money markets and capital 113

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markets. The high level of funding obtained from related corporations derives from the fact that a number of finance companies are subsidiaries of a parent company. For example, as mentioned above, many finance companies are subsidiaries of commercial banks. Other finance companies have parent companies that are manufacturers, such as motor vehicle manufacturers. In both instances, the parent company may provide a large amount of the funds required by the finance company from its own balance sheet. Another significant source of funds has been the increased use of offshore funding following deregulation of capital flows in the international markets and the floating of the exchange rates of major currencies. On the asset side of the balance sheet, the main categories of business of the finance companies and general financiers are:

• loans to individuals • instalment credit to finance retail sales by retail stores • lease financing • loans to business, including bills finance, term loans, wholesale financing or floor plan financing, factoring and accounts receivable financing.

These lending products are discussed in detail in Chapters 9 and 10.

3.9.2

Sector structure

Clearly, the finance company and general financier sectors of the market have experienced considerable change. There has been an enormous contraction in finance companies in particular. Participants in the market can be classified into one of three broad categories: 1 diversified finance companies that provide a wide range of lending products 2 manufacturer-affiliated companies whose business is almost exclusively involved with the financing of the sale of the parent manufacturers’ products; for example, motor vehicles 3 niche specialists, which tend to be relatively small independent companies that have developed an expertise in one aspect of lending, such as lease financing (see Chapter 10). Examples of finance companies that operate in Australia include:

• ESANDA: owned by the Australia and New Zealand Banking Group; a leading provider of vehicle and equipment finance solutions and fixed-interest investments.

• MyFord Finance: owned by Ford Motor Company; mainly provides financing for products of the parent company.

• RACV Finance Limited: a vehicle roadside service organisation that has diversified into the provision of financial products.

A full list of registered financial corporations operating in Australia may be found at www.apra.gov.au.

REFLECTION POINTS

institutions borrow funds in the local and international money and capital markets and • These use those funds to provide loans and lease financing mainly to individuals and small and medium-sized businesses. finance company sector has contracted as commercial banks have become more • The competitive in the deregulated environment. number of finance companies specialise in niche areas of the market, such as motor vehicle • Afinancing and lease financing. 114

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3.10

Building societies

Building societies are an example of a niche financial institution that evolved to meet a specific market need during the period of heavy regulation of commercial banks. This type of institution is not found in all countries; rather, it is found in certain countries where there is a large demand for finance to buy residential property and the demand is not able to be fully met by the banking sector. The main activities of building societies are to accept deposits from individuals and to provide mortgage finance primarily for owner-occupied housing; that is, building societies gather in savings from their depositors and provide loans to their customers to purchase residential property. In Australia as at December 2017, the building society sector held $12.1 billion in balance-sheet assets. Over 80.00 per cent of liabilities required to fund the balance sheet came from deposits from customers. Residential lending represented 73.00 per cent of total assets. However, since 2007 there has been a significant decline in the number of building societies operating in Australia (from 14 to 4). This is due to consolidation within the sector and the fact that many building societies have re-branded themselves as mutual banks. It is interesting to consider the changes that have occurred in the building society sector in Australia, as it demonstrates the direct impact of changing regulation on the structure of the financial system. Originally, the growth of building societies resulted from portfolio and interest rate restrictions imposed by the Reserve Bank on the activities of savings (commercial) banks, which were the major providers of residential mortgage finance. Building societies were not regulated by the Reserve Bank and were able to offer—and charge—more market-related interest rates than could the commercial banks. The market rates paid on deposits by the building societies increased their liability base, thus providing more available funds for mortgage lending. With the progressive deregulation of product and interest rate controls over the banks, building societies came under greater competitive pressure and lost substantial market share. Their responses to the increased competition from the banks include the following:

LEARNING OBJECTIVE 3.8 Outline the roles and relative importance of building societies and credit unions, and analyse the significant changes that have occurred in these sectors.

Building societies authorised deposittaking institutions that primarily give loans to customers to buy residential property

• Smaller building societies merged with a view to rationalising administrative and other costs. • Improved technology was adopted with the aim of reducing costs and improving services to customers. • Diversifying the products and services offered to members, such as an increase in lending to small businesses, credit card facilities and personal term loans.

• The most important response of many building societies was to seek regulatory approval and become

a commercial bank. This final response has had a significant impact on the building society sector and is largely responsible for the overall decline in total assets of the sector. The largest building societies progressively converted to banks, and now form a large proportion of the regional bank sector in Australia. A number of other building societies that converted to banks have subsequently been taken over by larger commercial banks.

Building societies are authorised deposit-taking institutions (ADI) and as such are regulated and supervised by APRA. Essentially, APRA applies the same prudential and reporting standards to the building societies as to the commercial banks. These requirements were discussed in Chapter 2—in particular, the capital adequacy and liquidity management requirements.

REFLECTION POINTS

• Building societies accept deposits from customers and provide personal finance to individual borrowers, particularly housing finance, but also term loans and credit card finance. • In Australia, the building society sector contracted significantly as the banking sector •

was deregulated. Many building societies merged and eventually converted into commercial banks. Building societies are authorised deposit-taking institutions that are regulated by APRA.

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3.11 LEARNING OBJECTIVE 3.8 Outline the roles and relative importance of building societies and credit unions, and analyse the significant changes that have occurred in these sectors.

Credit unions authorised deposittaking institutions that accept retail deposits and provide loans to members

Common bond of association members are drawn together from a common background of work, industry or community

Credit unions

Credit unions provide deposit and loan products for their members. The strength of credit unions derives mainly from a common bond of association of its members. The common bond of association may be based in employment, industry or the community. For example, the Shell Employees’ Credit Union is an employer-based credit union; the Maroondah Credit Union is a community-based credit union; and the Industries Mutual Credit Union is an industry-based institution. Credit unions obtain the majority of their funds from deposits lodged by their members. To a limited extent, they supplement their deposit base by borrowing from other credit unions, or issuing promissory notes and other securities into the financial markets. Many credit unions are able to attract deposits inexpensively through automatic customer payroll deductions. This is an arrangement whereby an employee authorises an employer to forward part of their salary each pay day to an account held with a nominated credit union. On the asset side of their balance sheets, credit unions provide loans to members for residential housing, personal term loans, credit card facilities and limited commercial lending to small businesses. Another attraction offered to members is an automatic bill payment facility against the member’s credit balance. The credit union sector in Australia has more than $38 billion in assets (December 2017). Like building societies, the 10 years up to 2017 saw a significant decline in the number of credit unions operating in Australia. This was due to consolidation in the sector and to the re-branding of credit unions as banks. In 2007, there were 141 credit unions in Australia. At the end of 2017, there were 54. Over the same period, the number of domestic banks in Australia increased from 9 to 28. Credit cooperatives are authorised deposit-taking institutions and as such are regulated and supervised by APRA. The regulator applies the same prudential and reporting standards to credit unions as to banks and building societies. These requirements were discussed in Chapter 2—in particular, the capital adequacy and liquidity management requirements.

REFLECTION POINTS

• Credit unions accept deposits from their members and provide loans to those members, including housing loans, term loans and credit card finance. • Members of a credit union tend to have a common bond of association. This may be based • LEARNING OBJECTIVE 3.9 Describe the unique role of export finance corporations.

Export finance corporations government authorities that provide finance and insurance support and services to exporters

on the members’ employer, the industry in which they work or the community in which they live. In Australia, credit unions are authorised deposit-taking institutions and are regulated by APRA.

3.12

Export finance corporations

Nation-states generally support economic growth by encouraging increased exports of goods and services. Many countries have therefore established export finance corporations. These organisations are government authorities that provide financial support and services to exporting corporations in a nation-state. In Australia, the official export credit agency is the Export Finance and Insurance Corporation (EFIC). The role of EFIC is to facilitate and encourage Australian export trade through the provision of trade insurance and other trade-related financial services and products. EFIC is constituted under

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the Export Finance and Insurance Corporation Act 1991 (Cwlth). Through its charter, EFIC encourages Australian international trade by:

• insuring Australian suppliers of goods and services against non-payment • guaranteeing trade finance for the purchase of Australian goods and services • insuring Australian firms that invest in enterprises overseas against the political risks associated with such investments

• lending directly to overseas borrowers in support of particular classes of capital goods and services transactions

• indemnifying financial transactions of insurers that provide bonds or guarantees to overseas buyers, and providing performance bonds in support of Australian export contracts

• insuring Australian suppliers of goods and services against the unfair calling of such bonds or guarantees.

There is a continual demand for export credit. This is particularly true for the export of capital and semi-capital goods, where the terms of payment and financing facilities can be just as important as price. To be successful in international markets, exporters need access to payments insurance, guarantees and bonding, and loan facilities that compete with those available to overseas competitors. Exporters wishing to compete successfully in overseas markets sometimes need to offer deferred payment terms; however, this increases the risk exposure to non-payment. EFIC provides protection against this risk. Where applicable, EFIC makes loans for export sales of capital equipment and services at concessional rates of interest. An EFIC loan is usually made to the buyer or to its financier in the buyer’s country. For government and public sector buyers in countries that are recipients of Australian aid, mixed credits may be made available—that is, EFIC finance combined with aid funds.

REFLECTION POINTS

finance corporations typically encourage export trade through the provision of trade • Export insurance and financial services and products to corporations. finance corporations are often able to provide exporters with innovative trade finance • Export solutions that may not be available through other financial institutions. Australia, the official export credit agency is the Export Finance and Insurance Corporation • In(EFIC).

CASE STUDY THE HEDGE FUND SECTOR In Chapter 3, we discussed different types of managed funds, among which are the famously secretive hedge funds. The first hedge fund manager, Alfred Winslow Jones, started a business with $100 000 and began generating extraordinary profits through the 1950s and 1960s (Mallaby, 2010). Ever since, the industry has captured interest and generated curiosity. The annual rich list of top hedge fund earners published by Institutional Investors features four hedge fund managers who made more than $1 billion in 2017, with other top hedge managers 117

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earning more than 65 times the median pay of CEOs from the top 100 US companies (Frank, 2018). Investors are often mesmerised by these figures and take a plunge into the sector, relying on the stature and profile of these managers, which are often enhanced by the complexities of hedge fund strategies. The role of regulators has always been crucial in determining the development of the industry. The scant regulation was one of the main elements that paved the way for the development of the industry. According to industry estimates in 2008, the hedge fund industry’s assets under management had grown to $2.5 trillion, actually performing well during the GFC. Regulatory bodies have moved to tighten their hold over the sector due to fears that a collapsing fund may damage the entire financial system. Frauds and Ponzi schemes that emerged after the GFC, such as the Madoff investment scandal in late 2008, prompted further regulatory attention (Cumming, 2010). Apart from the regulatory changes, the acceptability of exchange-traded funds and index funds proved detrimental to the hedge sector. In the words of Jack Bogle, investor and founder of Vanguard, ‘In hedge fund investments, people have been paying very high fees for poor performance, which resulted in disenchantment, especially among institutional investors’. The dissatisfied customers were lured into the Exchange Traded Fund (ETF) industry which offered better returns with lower fees (Chris, 2017). Despite the fact that the hedge fund sector is glorified by the large incomes earned by its most prominent fund managers, the overall trend is not positive, with the withdrawal of major investors including major pension funds such as Calpers. The legendary investor Warren Buffett, who has always been a strong critic of hedge fund managers and their promises of outperforming the market, made a bet with the fund manager Protégé Partners in 2007 that his S&P 500 index fund would beat a basket of hedge funds. Buffett’s index fund earned 7.10 per cent per annum over 10 years, beating a return of 2.20 per cent per annum earned by the basket of hedge funds, winning a million dollar bet (to be donated to charity) in 2017 (Akin, 2018). References: Cumming, D & Dai, N 2010, ‘Hedge fund regulation and misreported returns: Hedge fund regulation and misreported returns’, European Financial Management, 16(5), 829-857. doi:10.1111/j.1468036X.2010.00576. Frank, R 2018, ‘These hedge fund managers made more than $3 million a day last year’, CNBC, https:// www.cnbc.com/2018/05/30/these-hedge-fund-managers-made-more-than-3-million-a-day-last-year. html Mallaby, S 2010, More money than God: Hedge funds and the making of the new elite, Bloomsbury, UK. Newlands, C 2017, ‘Jack Bogle: ETFs have beaten hedge funds’, Financial Times, 4 March, https://www. ft.com/content/68123fe6-ff68-11e6-96f8-3700c5664d30 Oyedele, A 2018, ‘Warren Buffett has won his $US1 million bet he made against the hedge fund industry 10 years ago’, Business Insider Australia, 3 January, viewed 15 October 2018, https:// www.businessinsider.com.au/warren-buffett-wins-million-dollar-bet-against-hedge-funds-20181?r=US&IR=T

Discussion points

• • •

Highlight the reasons behind the success of hedge funds at the time of the sub-prime mortgage crisis. What are the aspects that necessitated strong regulatory involvement in the hedge fund industry? What are the factors that are causing a downturn for the hedge fund industry?

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LEARNING OBJECTIVE 3.1 Describe the roles of investment banks, with an emphasis on the nature of their off-balance-sheet business, in particular mergers and acquisitions. wide range of non-bank financial institutions has evolved within the financial system in • Aresponse to changing market regulation and to meet particular needs of market participants. banks play an extremely important role in the provision of innovative products and • Investment advisory services to corporations, high-net-worth individuals and government. structure of investment banks is characterised by a division of activities between front • The office (trading, investment banking, investment management, research), middle office (risk measurement, risk management) and back office (accounting, audit, compliance).

banks raise funds in the capital markets, but are less inclined to provide intermediated • Investment finance for their clients; rather, they advise their clients and assist them in obtaining funds directly from the domestic and international money markets and capital markets.

banks specialise in the provision of off-balance-sheet products and advisory • Investment services, including operating as foreign exchange dealers, advising clients on how to raise

CHAPTER THREE REVIEW

Master before you move on

funds in the capital markets, acting as underwriters and assisting clients with the placement of new equity and debt issues, advising clients on balance-sheet restructuring, evaluating and advising on corporate mergers and acquisitions, identifying and advising on potential spin-offs, advising clients on project finance and structured finance, providing risk management services and advising clients on venture capital.

investment bank may advise a corporation on all aspects of a merger and acquisition • An proposal. This is a situation in which one company seeks to take over another company. The

merger may be friendly or hostile, and strategically may be a horizontal takeover, a vertical takeover or a conglomerate takeover. The merger will seek to achieve synergy benefits, such as economies of scale, finance advantages, competitive growth opportunities and business diversification.

LEARNING OBJECTIVE 3.2 Explain the structure, roles and operation of managed funds and identify factors that have influenced their rapid growth. funds are a significant and growing sector of the financial markets due, in part, to • Managed deregulation, ageing populations, a more affluent population and more highly educated investors. main types of managed funds are cash management trusts, public unit trusts, superannuation • The funds, statutory funds of life offices, common funds and friendly societies. funds may be categorised by their investment risk profile, being capital stable funds, • Managed balanced growth funds or managed or capital growth funds.

LEARNING OBJECTIVE 3.3 Discuss the purpose and operation of cash management trusts and public unit trusts. management trusts are highly liquid funds that allow individual retail investors to access • Cash the wholesale money markets. unit trusts allow investors to purchase units in a trust that is controlled by a trustee under • Public the terms of a trust deed. The trustee (responsible entity) arranges for the pooled funds of the trust to be invested by selected fund managers in specified asset classes.

• Public unit trusts include property trusts, equity trusts, mortgage trusts and fixed-interest trusts. • Unit trusts may be listed on the stock exchange or they may be unlisted. 119

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LEARNING OBJECTIVE 3.4 Describe the nature and roles of superannuation funds, including the primary sources of superannuation funds and the different types of fund.

• Superannuation funds facilitate savings by individuals for their future retirement. of superannuation funds include corporate funds, industry funds, public sector funds, • Types retail funds, small regulated funds and self-managed funds. of superannuation savings include employer contributions, employee contributions, • Sources compulsory superannuation contributions, personal contributions and eligible rollover funds. • Many countries are experiencing a demographic shift to an ageing population. countries have introduced compulsory superannuation schemes to ensure people fund at • Some least part of their own retirement. employers must contribute the equivalent of 9.50 per cent of an employee’s wage • InintoAustralia, a superannuation account in the name of the employee. The superannuation funds receive concessional taxation treatment.

defined benefit scheme pays a superannuation amount on retirement based on a defined • Aformula, while a defined contribution fund pays the accumulated balance. • APRA is the prudential supervisor of most superannuation funds.

LEARNING OBJECTIVE 3.5 Define life insurance offices and general insurance offices, and explain the main types of insurance policies offered by each type of insurer. insurance offices are contractual savings institutions. They generate funds primarily from • Life the receipt of premiums paid for insurance policies written. • Life insurance offices are also major providers of superannuation savings products. insurance policies include an insurance risk component and an investment • Whole-of-life component. The policy will accumulate a surrender value over time. term-life policy provides life insurance cover for a specified period. If the policyholder dies • Aduring that period, a predetermined amount is paid to the named beneficiary. insurance policies include total and permanent disablement insurance, trauma • Related insurance, income protection insurance and business overheads insurance. • The regulator of life insurance offices is APRA. • General insurance offices also generate funds from premiums paid on insurance policies. • General insurance policies include house and contents insurance. • Policyholders need to be aware of the co-insurance clause and the amount of public liability cover. vehicle insurance includes comprehensive, third-party fire and theft, third party only and • Motor compulsory third-party insurance.

LEARNING OBJECTIVE 3.6 Discuss hedge funds, including their structure, investors, investment strategies and risk. fund seeks to achieve above-average returns using sophisticated investment strategies • Aandhedge exotic derivative investment products; as such, they are higher-risk investments. funds are often highly leveraged by using borrowed funds or derivative products; they • Hedge invest in equities, foreign exchange, bonds, commodities and derivatives. funds, or fund of funds, may be managed by a high-profile individual or a • Single-manager financial institution such as an investment bank. • Hedge fund investors may be institutional investors, high-net-worth individuals or retail investors. 120

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CHAPTER THREE REVIEW

LEARNING OBJECTIVE 3.7 Explain the principal functions of finance companies and general financiers, and the changes that have had an impact on finance company business. companies provide loans to individuals and businesses, including lease finance, floor • Finance plan financing and factoring. • Deregulation of commercial banks has resulted in a significant decline in finance companies. finance companies are now operated by manufacturers, such as car companies, to finance • Many sales of their product.

LEARNING OBJECTIVE 3.8 Outline the roles and relative importance of building societies and credit unions, and analyse the significant changes that have occurred in these sectors. majority of building society funds are deposits from customers. Residential housing is the • The main form of lending. unions’ funds are sourced primarily from deposits of members. Housing loans, personal • Credit loans and credit card finance are available to their members. defining characteristic of a credit union is the common bond of association of its members, • Ausually based on employment, industry or community.

LEARNING OBJECTIVE 3.9 Describe the unique role of export finance corporations. agencies play an important role in providing financial services to the corporate • Government sector to support the export of goods and services. official Australian agency is the Export Finance and Insurance Corporation (EFIC), which • The provides trade insurance and trade-related financial services and products.

Extended learning LEARNING OBJECTIVE 3.10 Understand project finance and structured finance, and the related roles of investment banks.

Project finance and structured finance Project finance Project finance is an interesting and complex area of finance. Project finance supports economic growth within a country in that it enables important developments and infrastructure projects to proceed. Such projects include the building of power stations, toll roads and tunnels, the extraction of minerals, heavy industry and processing plants, tourist resorts and casinos. Investment banks have developed expertise in the provision of advisory services for their corporate and government clients on the structuring and financing of major projects. The possible finance and ownership structures and the range of risks associated with project finance are quite extensive. This extended learning section will give you an understanding of the main features of project finance and structured finance.

Project finance financing large projects where loan repayments are based on the future cash flows of the completed project

Distinguishing features The key difference between project finance and most other forms of lending is that, with project finance, the lenders determine their participation primarily on the basis of the expected future cash 121

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Part 1 Financial institutions

flows and assets of the project. There is only a secondary reliance on the balance sheets and financial positions of the project sponsors. Figure 3A.1 provides a simplified conceptual framework that diagrammatically represents a basic project finance structure. As indicated in Figure 3A.1, a corporation or syndicate of corporations that implements a project is known as the project sponsor.

Figure 3A.1  Conceptual project finance structure Comp

Sponsors Equity

letion

guara

ntees

Dividends Debt

Project company

Syndicate lenders Loans repayments

Cash flows

Project

Project sponsors the originators and equity providers of a project

Contractors, suppliers, buyers

Project sponsors, as the project originators, take an equity position in the project. For example, the sponsors may form a project company to build, own and operate the project. The sponsors will inject equity into the project company by buying shares in the company. The remainder of the funding for the project will come from loans provided by a syndicate of lenders. The debt will eventually be repaid from the future cash flows that the completed project will generate. Within the context of the simple structure in Figure 3A.1, a number of acronyms have evolved which describe different structures that may be used in project finance. These include ‘build, own, operate and transfer’ (BOOT) structures, ‘build, own and operate’ (BOO) structures and ‘build, operate, lease and transfer’ (BOLT) structures. A BOOT structure may be a project such as a toll road; a project company builds the road and operates the toll road for a specified number of years, at which date the road is transferred back to the government. A BOO structure may be used for a project such as a power station; the project company builds the station and continues to operate the station for the productive life of the facility. A BOLT structure will include capital leasing arrangements. A number of projects are completed in partnerships between the public sector and the private sector. These are referred to as ‘public-private partnership’ structures. Characteristics that distinguish project financing from more traditional methods include the following: project company is established as a separate legal entity, and it relies very heavily on • The debt financing. Project financing generally provides up to 75.00 per cent of the total capital

requirements. The remainder of the funding consists of equity and subordinated debt contributed by the project sponsors.

• The debt of the project company is separate from the project sponsors’ other business obligations. lenders’ security is usually limited to the assets of the project company, and does not include • The the assets of the project sponsors. However, sponsors generally provide various completion and performance guarantees.

from related third parties are sought as credit support for the project. Support • Commitments may be in the form of specific performance guarantees. Third parties may include suppliers, intending purchasers of the project’s output and government authorities. 122

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Chapter 3  Non-bank financial institutions

The recourse provisions are important, because they specify the rights of the lenders from project commencement up to the time when the project is built and begins to generate positive cash flows. Under non-recourse lending, lenders are totally dependent on the project’s future cash flows for interest payments and the eventual repayment of the debt. During the total life of the loan the lenders have no recourse to other repayment sources, including the project’s sponsors. Nonrecourse lending is most unlikely to be provided by banks. In so far as it is available, it has been from major corporate investors. Where bank finance is involved, it is almost always limited recourse lending. While the particular recourse arrangements vary widely, lenders typically have very tightly defined and restricted access to the sponsors for loan repayments prior to project completion. Once the project is complete, the lenders have recourse only to the project’s cash flows and assets.

Non-recourse lending the lender is totally reliant on future project cash flows for loan repayments

Limited recourse lending

Completion is said to occur when construction is finished, the project is operational and specified cash-flow levels are achieved. For example, with a toll road, completion is said to occur when the road has been built, is open for public use and is generating a required level of revenue from vehicle tolls.

lenders have certain claims on the assets of the project sponsors if project cash flows fail to achieve specified levels

Participants

Project completion

Projects are typically very large and extend over many years before completion. Often they require hundreds of millions of dollars in finance. Given their size, most project undertakings are jointly owned and controlled. Some of the advantages of joint ownership include:

point at which a project is built and is generating a prescribed level of cash flows

project development risk is shared between the joint owners. This is particularly important • The where the sponsors have provided completion guarantees to the project lenders. ventures between parties bring different sets of skills to the project. These include both • Joint specialist operational skills and specialist financial skills. project size may well require a greater financial and managerial capability than can be • The provided by a single sponsor. Greater sponsor expertise and commitment will encourage project

CHAPTER THREE REVIEW

finance loans are generally for a considerably longer term than is usually available • Project through finance provided by banks and other intermediaries. • Debt is on a ‘limited recourse’ or ‘non-recourse’ basis.

lenders. In addition to the project sponsors, the investment banks are essential in that they will facilitate syndicated loans, partly through bill acceptance facilities, term loans and overdraft facilities. More importantly, the investment banks will assist the project company with the issue of debt securities directly to the capital markets. The size of a project will normally require a syndicate of lenders, whereby several financial institutions form a syndicate to share the risk of providing project finance. The syndicate of banks will use the standing of the banks in the financial markets to access funds in the domestic and international capital markets. Syndicates are also able to raise loans in currencies that match the currencies that will be earned once the project cash flows are positive. This minimises the foreign exchange (FX) risk exposure of the project’s earnings. (Chapter 17 discusses FX risk exposure and its management.) Where the development and operation of a project involves the leasing of assets, lessor partnerships form another party to the project. The key suppliers of equipment to the project may also be important providers of funds. Indeed, the availability and terms of funding associated with a lease may determine the ultimate choice of equipment used for the project. Project finance is a highly specialised task. Both financial and technical expertise is required by the lending syndicate to assess the potential productive capacity of the project and the length of the development period before a positive cash flow can be expected, and to establish appropriate guarantees from other participating parties. In order to achieve this, the syndicate of investment banks will bring together the specialist engineers, environmentalists, marketing consultants, financial consultants, auditors, accountants, taxation experts and legal counsel necessary when drafting the project ownership agreements and loan documentation.

Syndicated loan the provision of loan funds by a group of financiers for a single project

Leasing the borrowing of an asset in return for lease payments, rather than borrowing the funds to purchase the asset

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Structured finance Structured finance funding provided for major infrastructure projects

Structured finance is the term applied by the market to complex infrastructure funding arrangements; essentially, it is a specialist area of project finance. However, there are a number of characteristics of structured finance that tend to differentiate it from other forms of project finance. These include: provides the essential major connectors for economic capital and activity, such as • Infrastructure power, water and roads. supports economic growth and activity within an economy; for example, railway • Infrastructure networks efficiently carry goods from suppliers to markets. • Facilities such as hospitals are maintained for the public good. • Infrastructure projects tend to represent natural monopolies (e.g. the reticulation of water). projects are capital intensive (e.g. the construction of a water storage dam or an electricity • The generating plant). In the past, governments have primarily been responsible for infrastructure development and finance. However, in recent years a change in political ideology has seen an enormous increase in private sector infrastructure developments. Factors that have influenced private sector infrastructure finance include:

current preference of governments to maintain budget surpluses, resulting in fiscal • the constraints being imposed on the ability of governments to fund large infrastructure projects granting of tax concessions to qualified infrastructure projects in order to encourage private • the sector investment initiatives to create market competition within economic sectors that were previously • policy monopolised by government • the privatisation of existing government authorities and enterprises.

The above initiatives have encouraged new infrastructure projects, often referred to as greenfield projects. Infrastructure projects often retain a monopoly position within the market, and also retain very stable and predictable cash flows. For example, retail electricity users will continue to buy similar quantities of electricity regardless of the supplier. Embedded options specific performance guarantees included in a project contract

Consumer price index a measure of changes in the price of a basket of goods and services

Subordinated junior debt claims of these security holders are subordinated after all other creditors

Infrastructure projects may well incorporate embedded options; that is, government may legislate or contract to provide various guarantees such as revenue streams, anti-competition advantages and periods of monopolistic advantage. However, government may also restrict commodity price rises for a specified period of time; for instance, product price rises may be limited to movements in the consumer price index. Project and structured financing incorporate equity and debt funding techniques. These were introduced in Chapter 1 and will be discussed in greater detail in later chapters. Equity includes ordinary shares and hybrids such as preference shares and convertible notes. Debt ranges from bank overdrafts to commercial paper facilities, medium-term note issues and longer-term bond issues. Debt contains different priority rankings, from senior debt to subordinated junior debt, and incorporates different interest rate structures, such as fixed and variable rates, and repayment structures. Debt may also be denominated in a number of major currencies. The role of the investment bank is to advise on funding structures and participate in syndicated lending and underwriting agreements. Risks associated with project finance For providers of debt finance, particular importance is attached to the project reaching the completion stage. It is at that point that the limited recourse provisions expire, and both limited recourse and non-recourse lenders become dependent on the project’s future income stream for repayment of their loans. As a result, lenders must carefully assess the risks associated with achieving project completion, and the subsequent risk that may adversely impact upon the project’s income streams, such that they may not be sufficient to provide for the repayment of debt.

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Chapter 3  Non-bank financial institutions

For example, in the case of a resource development project, one of the risks that must be taken into account is the amount of recoverable resources. Will they be sufficient to cover commitments to the debt providers, particularly if resource prices fall? To cover themselves against this risk, debt providers typically seek an assurance that the proven reserves that are accessible under current technologies are well in excess of those necessary to meet the debt-servicing requirements. A 2:1 ratio of accessible reserves to necessary sales is not uncommon. In projects where the object is the development of infrastructure, such as the development of electricity-generating facilities, usage and revenue guarantees may be sought from the relevant government authorities. Given the significance of completion, lenders will typically seek non-completion covenants from the project sponsors. The forms of the covenants are varied and may include some of the following. from the sponsors that they will repurchase the debt, or convert it on specified terms • Guarantees into obligations of the sponsoring corporations, if the completion conditions are not achieved. from the sponsors that they will provide the appropriate management expertise and • Guarantees additional funding (including equity funding) to ensure that the completion conditions will be met. from the sponsors that they will meet any working capital shortfall during the • Guarantees development phase.

The definition of completion is also of significance. From the lenders’ point of view, the preferred definition of completion would include a benchmark for performance criteria. The performance criteria may include the performance of the project at design specification standards for a specified period following the physical completion of the project, or the attainment of a predetermined cash flow or a minimum level of sales.

Non-completion covenants specific loan conditions enforceable against project sponsors if a project is not completed

CHAPTER THREE REVIEW

There are a host of risks that can be identified. Most of them are also relevant to the assessment of the risk of a borrower seeking any loan. However, the risks are more critical in the case of project finance because the project (the borrower) often has no other assets that can be secured by the lenders. As a result, it is likely that, when quantifying the risks, the lenders will be more conservative in their calculations than they would be if they were assessing the risk for the purposes of making a secured loan.

Working capital finance required by a firm to fund its day-to-day operations

In addition to these risks, the debt providers must also calculate the risks associated with the management of the project beyond completion, the impact of future changes in the regulatory environment and financial risks such as the impact of changes in interest rates and exchange rates. The complexity and sophistication of project financing should now be evident. Managers of corporations typically are not experienced in these aspects of finance and therefore seek the expertise and advice of investment banks. Fees earned on a project by an investment bank may run into millions of dollars.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points that you raise in relation to each question. 1

The ‘middle office’ is a less glamorous part of an investment bank but serves some of the most important functions. Discuss this statement. (LO 3.1)

2

A number of the advisory services investment banks provide for their corporate clients are defined as off-balance-sheet business. One service is placing new issues with institutional investors. Outline the nature of this service and explain why it might be sought after by large corporations. (LO 3.1)

3

Hostile takeovers rose to prominence during the 1980s and remain a part of the mergers and acquisitions landscape. Explain the rationale for a hostile takeover and discuss the roles that investment banks may play in both ‘offence’ and ‘defence’. (LO 3.1) 125

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4

Typically, an investment bank will act on behalf of a company involved in a merger and acquisition. What are the main areas to which the investment bank will draw the client’s attention? (LO 3.1)

5

Managed funds are often categorised by the type of investments purchased by the fund. These include capital stable funds, balanced growth funds and managed capital growth funds. For each of these funds, discuss the types of investments the fund might accumulate and explain the purpose of the investment strategies. (LO 3.2)

6

Provide an overview of the changing nature of public unit trusts between 1995 and 2017. (LO 3.3)

7

Identify and discuss three classes of assets in which public unit trusts may invest funds. Extend your discussion by distinguishing between listed and unlisted trusts. (LO 3.3)

8

Superannuation savings for retirement is a growth area and represents a significant proportion of the assets accumulated in the financial system.

(a) Why has there been such growth in superannuation savings?

(b) Self-managed superannuation funds (SMSFs) are a popular choice among investors. Outline the size of the SMSF sector relative to other parts of the superannuation industry and list some reasons that may explain the popularity of SMSFs. (LO 3.4)

9

One of the functions of a life insurance office is the writing of life insurance policies for individuals.



(a) How does the life insurance office derive income from this function?



(b) Describe the basic characteristics of the two main types of life insurance policies.



(c) Briefly describe one other type of related insurance policy that an individual may purchase. (LO 3.5)

10 In recent years in Australia and in other parts of the world, households have suffered significant damage to their property as a result of floods and storms. Many households found, to their dismay, that their policies did not cover them for some types of damage. The clauses that are embedded within insurance policies are of obvious importance. Outline the consequences that may result from a combination of under-insuring property while overlooking the presence of a co-insurance clause. (LO 3.5) 11 You have purchased a motor vehicle and been advised that you should consider insuring the vehicle. You contact an insurance office and receive advice on three forms of cover that are available.

(a) Explain the three different levels of motor vehicle cover that you can choose from.



(b) If the vehicle that you purchased is valued at $45 000, which level of insurance might you decide to take? Why? (LO 3.5)

12 A friend has suggested that you should consider investing in an equity hedge fund because the fund may achieve returns higher than the share market.

(a) Describe how a hedge fund is structured, including the manager, investors and types of investment.



(b) Explain how a hedge fund may use leverage strategies to achieve higher returns. Give an example. (LO 3.6)

13 Because hedge funds are usually only accessible to high-net-worth individuals, hedge funds should not be regulated. Discuss this statement. (LO 3.7) 14 Building societies are no longer as significant as they once were. What are some of the main reasons for this decline? (LO 3.8)

Extended learning questions 15 Project finance is largely based on forecast future cash flows. (a) Draw a diagram showing the flow of funds that occurs in a basic project finance structure. Referring to your diagram, explain the nature of project financing, why this type of funding

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Chapter 3  Non-bank financial institutions



(b) A form of project finance is described as structured finance. Identify some of the factors that have influenced the growth in structured finance. What are the characteristics of structured finance that tend to differentiate it from other forms of project finance? (LO 3.10)

KEY TERMS age pension  101

export finance corporations  116

public liability insurance  111

annuity 109

fixed-interest trust  100

back office  89

front office  89

public sector superannuation fund 103

balanced growth fund  97

hedge funds  112

public unit trust  99

beneficiary 107

horizontal takeover  91

responsible entity  94

building societies  115

hostile takeover  92

risk component  108

business overheads insurance 109

income protection insurance 109

rollover fund  105

capital guaranteed fund  97

industry superannuation fund 103

structured finance  124

cash management trust (CMT) 98

investment component  108

superannuation 101

leasing 123

co-insurance clause  110

limited recourse lending  123

superannuation guarantee charge (SGC)  103

common bond of association 116

listed trust  100

syndicated loan  123

managed funds  94

term-life policy  108

comprehensive insurance  111

managed growth fund  97

compulsory third-party insurance 111

merger and acquisition  91

third-party fire and theft policy 111

middle office  89

third-party policy  111

mortgage trust  100

total and permanent disablement insurance  109

capital stable fund  97

conglomerate takeover  92 consumer price index  124 corporate superannuation fund 103 credit unions  116 defined benefit fund  105 defined contribution fund  105 eligible termination payment (ETP) 105

mutual funds  94 non-completion covenants  125 non-recourse lending  123 policyholder 107 premium 107 project completion  123 project finance  121

embedded options  124

project sponsors  122

equity trust  99

property trusts  99

spin-off 91

CHAPTER THREE REVIEW

structure is established, the major participants and the guarantees that the lenders will request from the project sponsors to support their loans.

subordinated junior debt  124

trauma insurance  109 trust deed  94 trust fund  94 underwriter 90 unlisted trust  100 vertical takeover  92 whole-of-life policy  108 working capital  125

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PART TWO

Equity markets CHAPTER 4 The share market and the corporation

CHAPTER 5 Corporations issuing equity in the share market

CHAPTER 6 Investors in the share market

CHAPTER 7 Forecasting share price movements

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Equity markets The prices of shares and other securities traded in the domestic and international share markets are always changing and are, from time to time, quite volatile. The following have all raised public awareness of sharemarket price volatility: the great bull run of the mid-1980s, followed by the stock-market crash of October 1987; the subsequent extended period of growth (particularly in technology stocks); the negative flow-on effects of the Asian financial crisis from mid-1997; the collapse of the technology stock market; another period of recovery and growth; the effect of the 11 September 2001 terrorist attacks in the USA, and the subsequent strong recovery; the significant fall in share prices due to the initial global financial crisis (GFC) in 2007–08; the extension of the GFC into a sovereign debt crisis that stretched well into 2011–12; and, finally, the monetary stimulus-backed recovery in US stock prices to new record highs. Nevertheless, investor participation in share-market investments has increased in many countries. Important factors that have led to this increase include:

• globalisation of the financial markets • a reduction in regulations restricting the flow of investment funds into the international markets • greater understanding of investment opportunities as a result of, among other things, higher education • • • •

levels and access to financial advice an ageing population saving for retirement increased savings levels, such as the implementation of compulsory superannuation savings in some countries the evolution of new risk management products and strategies, including the use of derivatives privatisation of government enterprises; for example, in Australia a number of large government-owned enterprises such as the Commonwealth Bank of Australia, Telstra Corporation and Qantas Airways have been sold and their shares listed on the stock exchange. In 2014, privatisation once again emerged on the political agenda with proposals to privatise Medibank Private and other state-owned assets.

The performance of the local and global share markets is reported daily in the press, on radio and in television news broadcasts and specialised business programs. Some of the general features of the share market and its role in the financial system were introduced in Part 1. The purpose of Part 2 is to examine the share market in more detail. While the fundamental purpose of a share market is the same worldwide, there may be operational differences between countries. In order to study the share market, it is necessary at times to look specifically at a modern and efficient market to focus on a particular issue. When this is necessary, the Australian share market and the operation of the Australian Securities Exchange will be considered. If you need to find out particular details relating to the stock exchange of another country, simply refer to its website, where you will find a wealth of information. The distinguishing feature of equity, in particular shares or stock, is that the provider of equity finance to a business obtains a share in its ownership. This text focuses on the type of corporation known as a publicly listed corporation, that is, a company whose shares are listed on a stock exchange. Private companies and other business forms are not considered. As a part-owner of a public corporation, the shareholder has the right to participate in the profits of the business (should there be any) but receives no guaranteed income stream. Why then are individuals and institutions prepared to provide equity funding? This issue is taken up in Chapter 4, which explores the advantages that accrue to publicly listed companies or corporations.

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Chapter 4 examines the operation of a stock exchange as a primary market and as a secondary market for securities issued through the exchange. In facilitating its primary market and secondary market functions, a stock exchange enables the offering of a range of securities, including equity, interest rate and hybrid or derivative products. Importantly, stock exchanges facilitate the flow of information that is essential in an efficient marketplace. This flow of information is crucial to both investors and companies issuing securities. Finally, in order to maintain integrity and fairness in the market, a stock exchange will monitor the behaviour of market participants and also ensure compliance with the regulatory requirements of the nation-state supervisor. Following the general discussion of the share market and the corporation in Chapter 4, the remaining chapters in Part 2 examine the equity markets, first from the point of view of companies seeking to raise funds in the equity markets and, second, from the point of view of investors. Chapter 5 explores the stock exchange rules that apply to a company seeking to be listed as a public company on a stock exchange. The chapter also considers various forms of equity funding that may be available to companies. A distinction is drawn between those companies that are raising equity through the share market for the first time and those that have already issued shares and are issuing additional shares to obtain more equity in order to expand the business. The latter group of companies has a wider range of equity funding alternatives. Chapter 6 examines companies listed on a stock exchange from a potential investor’s point of view. It examines major indicators of the financial structures, risk and profitability of listed companies. The chapter also analyses issues that affect the price of shares. Chapter 6 concludes with a discussion on sharemarket indices. Chapter 7 discusses techniques employed by market analysts and fund managers in their selection of particular shares for inclusion in an investment portfolio. The chapter examines the fundamental analysis and technical analysis approaches that may be used in the share investment decision process. Within the context of fundamental analysis, macro and micro factors are identified that will have an impact on share values. Two technical analysis forecasting models are considered: moving-averages models and charting. The chapter also provides a discussion on market efficiency and considers the implications for investors of various tests of the efficiency of a share market.

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CHAPTER 4

The share market and the corporation CHAPTER OUTLINE 4.1 The nature of a corporation 4.2 The stock exchange 4.3 The primary market role of a stock exchange 4.4 The secondary market role of a stock exchange 4.5 The managed product and derivative product roles of a stock exchange 4.6 The interest rate market role of a stock exchange 4.7 The trading and settlement roles of a stock exchange 4.8 The information role of a stock exchange 4.9 The regulatory role of a stock exchange 4.10 The private equity market

Learning objectives LO 4.1

Understand the structure of a corporation and identify advantages and disadvantages of being a publicly listed corporation.

LO 4.2

Consider the origins and purpose of a stock exchange.

LO 4.3

Understand the primary market role of a stock exchange through which corporations raise new funding.

LO 4.4

Discuss the secondary market role of a stock exchange through which existing securities are bought and sold.

LO 4.5

Examine the managed product (exchange traded funds, contracts for difference, real estate investment trusts and infrastructure funds) and derivative product (options, warrants and futures contracts) roles of a stock exchange.

LO 4.6

Examine the interest rate market role of a stock exchange.

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Chapter 4  The share market and the corporation

LO 4.7

Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for sharemarket transactions by the Australian Securities Exchange (ASX).

LO 4.8

Recognise the importance of information flows to the efficiency and integrity of stock exchanges.

LO 4.9

Identify the principal regulators that affect the behaviour of participants in the Australian share market.

LO 4.10

Explain the structure and purpose of the private equity market.

CHAPTER SNAPSHOT The equity markets represent one of the main hunting grounds for institutions such superannuation funds, investment banks and hedge funds. With more than $1.5 trillion of equity capital on the Australian Securities Exchange (ASX) alone, these institutions find both trading and financial services provision opportunities in abundance. The ASX oversees and provides the framework for the almost continuous auction that takes place in determining the market price for securities such as shares in companies and units in managed funds and real estate investment trusts.

INTRODUCTION A stock exchange is a place where a range of listed financial assets is bought and sold. The share market refers to that part of a stock exchange where companies are listed on the exchange and are known as public corporations. The shares of listed public corporations are issued and traded through the share market. The financial systems of countries with developed economies will include at least one stock exchange on which public corporations list their ordinary shares, or common stock, plus other securities such as preference shares, some debt securities and derivative products. The best-known stock exchange is probably the New York Stock Exchange (NYSE). Another exchange in the USA, the NASDAQ, lists mainly technology stocks. In Australia, the principal stock exchange is the Australian Securities Exchange (ASX). A publicly listed corporation is a legal entity formed under the provisions of the corporations legislation of a nation-state and listed on a formal stock exchange. Listing on a stock exchange requires the corporation to comply with the rules of that exchange as well as the Corporations Act 2001. A corporation usually lists its shares on the exchange of its home country, although some large multinational corporations may choose to list on their home exchange and an international stock exchange such as the London Stock Exchange and/or the NYSE. Dual listing is discussed further in Chapter 5. The main class of financial asset quoted and traded on a stock exchange is the ordinary share, or common stock. In some countries, such as the USA, it is the convention to use the term ‘common stock’, while in other countries, such as Australia, the term ‘ordinary share’ is used. Both terms refer to the main type of equity issued by a publicly listed company. A share represents a financial claim to a fraction of the assets of the corporation given by the accounting equation Equity = Assets − Liabilities; that is, a shareholder may benefit from the net profits of the organisation after all other claims have been paid as this represents the increase in the value of equity. The fractional benefit will relate to the number of shares that the shareholder has purchased in the company. Other claims include those of employees (wages and salaries), debt holders (interest and principal), suppliers of business inputs (cost of goods and services used) and taxes. 133

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Part 2 Equity markets

Corporation a legal entity formed under corporations legislation; main source of equity is ordinary shares

Shares have an additional dimension that distinguishes them from other financial claims. As equity, they represent a share in the ownership of the corporation, and provide the shareholder with a right to vote in the affairs of the corporation. In particular, a shareholder has the right to vote for the board of directors of the company. The shareholder can also vote on resolutions put to a general meeting of the company. The relationships between the rights of shareholders, the board of directors and the managers of a company give some insight into the nature of a corporation.

REFLECTION POINTS

exchange is a formal market within a nation-state that lists a range of securities issued • Abystock publicly listed corporations; the largest component of a stock exchange is its share market. Publicly listed corporation a company whose shares are listed and quoted on a stock exchange

• A publicly listed corporation is a company whose shares are listed on a stock exchange. • The ordinary share, or common stock, is the main type of equity security issued by a corporation. share is a financial asset; that is, a security that entitles a shareholder to share in the net • Aprofits of the company and to vote for the board of directors, and any resolutions put by the board to shareholders at general meetings.

4.1 LEARNING OBJECTIVE 4.1 Understand the structure of a corporation and identify advantages and disadvantages of being a publicly listed corporation.

Objectives and policies what a company intends to achieve and how that will be achieved

Board of directors elected by shareholders; determine the objectives and policies of the corporation

Limited liability company the claims of creditors against shareholders are limited to the issue price of their fully paid shares

No liability company shareholders may decide not to pay calls on partly paid shares, but will forfeit such shares

The nature of a corporation

A corporation is a company that is a legal entity established under the corporations legislation of a nation-state. The shares of a publicly listed corporation are listed on a stock exchange and the main source of equity funding, the ordinary share, is quoted in the share market. There are a number of features that distinguish a corporation.

• Ownership is generally widely dispersed among a large number of shareholders and shares issued

by a company can be readily bought and sold in the share market without directly affecting the continuing existence of the business.

• Shareholders, as owners of a company, do not have a right to participate directly in the ­day-to-day

operation and management of the business. The objectives and policies of a corporation are determined by a board of directors, the members of which are elected at a general meeting of shareholders. Directors have a legal responsibility to ensure that the corporation operates in the best interests of the shareholders. The board of directors appoints an executive management group that is responsible for achieving the specified objectives and policies of the organisation through the management of the day-to-day financial and operational affairs of the company. Executive management is responsible to the board of directors. The board of directors reports to shareholders.

• The liability of shareholders for the debts of the business is limited. If a sole proprietorship, a

partnership or an unlimited company fails to meet its obligations to creditors, the creditors have a legal right to take possession of the personal assets of the owners in order to recover any amount owing. The rights of creditors against shareholders in a publicly listed company (i.e. a limited liability company or a no liability company) are significantly less. These are defined more fully in Chapter 5, but, by way of summary, in the event that a publicly listed company is liquidated, the following applies: — The liability of shareholders in a limited liability company is limited to the issue price of the share. Providing the shareholder has paid the full issue price of the share (i.e. there is no uncalled amount due on the share), the shareholder cannot be required to make any further payment to the company or its creditors. — With a no liability company, where the shareholder has purchased partly paid shares, there is no legal requirement for the shareholder to meet a future call for payment of any unpaid amount; however, in that event the shareholder would forfeit their partly paid shares in the company.

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4.1.1

Advantages of the corporate form of business organisation

A publicly listed corporation has important advantages over other forms of business organisation. They include the following:

• Large amounts of equity funding can normally be obtained more easily, through access to a wide

pool of investors in the market. These investors are willing to purchase shares because the stock exchange provides an active secondary market for the sale of those shares. It is said that the share market is normally deep and liquid; that is, there are usually buyers willing to purchase shares at the current market price.

• Shareholders can reduce the risks of share ownership by holding a diversified portfolio of share

Share market a formal exchange that facilitates the issue, buying and selling of equity securities

investments. The ability of shareholders to spread risk through diversification, and also readily to transfer ownership by buying and selling share holdings in a deep and liquid market, reduces risk and therefore enables listed corporations to raise capital on more favourable terms.

• The separation of ownership (shareholders) and control (managers) of a business means that

the corporation can appoint specialised and skilled personnel to run the business. For example, a business may employ personnel with specialist skills in manufacturing, engineering, marketing, accounting, risk management and taxation. The same option is often not available to a sole proprietorship or a partnership, where the owners are also the managers.

• The corporation as a legal entity allows for the continuation of the business. A change in shareholders,

that is, the ability to trade a corporation’s shares, enables ownership to change without significant disruption to the firm’s day-to-day operations. The corporation has the potential to exist indefinitely. This legal right is known as the right of perpetual succession.

• The corporate form is almost essential for large-scale undertakings. Generally, only publicly listed

corporations, with a credit rating, have access to the wider range of equity and debt sources of funds that are available in the capital markets. Listed corporations attract investors from both the local and international markets.

Right of perpetual succession a corporation continues to operate regardless of changes in ownership

• The separation of ownership and control allows a corporation to plan and implement strategic decisions more effectively over both short-term and longer-term planning periods.

4.1.2

Disadvantages of the corporate form of business organisation

The above advantages available to the corporation are clearly significant and explain why the majority of large business organisations become publicly listed corporations. However, there are some potential disadvantages that cannot be ignored. The main problem that may be associated with a publicly listed company relates to the separation of ownership and control. This may seem strange, since separation has also been identified as an advantage of the corporate form. It is, however, possible for separation to be both an advantage and a disadvantage. Since the managers who control the day-to-day operation of the business do not own the company, they will not necessarily have a strong incentive to act in the best interests of the shareholders. Managers may be tempted to run the business for their own personal benefit rather than for the benefit of the shareholders. This conflict of interest between owners (principals) and managers (agents) is known as the agency problem. In theory, an efficient share market should minimise the concern about conflicts between the interests of owners and the interests of managers. Owners can express their satisfaction, or

Agency problem the conflict of interest that may exist between shareholders and management of a corporation

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Share options the remuneration of a manager may include an option to purchase shares in the company at a specified price

Corporate governance policy and practice that define the relationship between shareholders, the board and management

dissatisfaction, with the performance of management through the purchase or sale of shares. When management pursues a course that is not in the interests of the owners, it is argued that shareholders will eventually begin to sell their shares and the share price will fall. If share prices in similar firms are not falling, the share market will be signalling that the corporation’s owners are not satisfied with management’s performance. This is clearly not in the interests of the managers, since such a public judgment lowers the managers’ reputations and reduces their employability elsewhere. Should the share price fall sufficiently, another corporation may buy the lower-priced shares and assume control of the company. The threat of takeover and the consequent loss of control by the current management group should serve to discipline managers and encourage them to act in a manner consistent with maximising shareholder value. However, it may be argued that managers are mobile and may implement a short-term maximisation strategy knowing that they will move to another more lucrative job before the adverse impact of their current strategies becomes evident. One typical strategy used by many corporations in an attempt to align the interests of shareholders with those of management is to incorporate performance incentives such as share options in the management compensation package. A share option scheme may allow managers to obtain the right to buy shares in the company at a discounted price. Managers with share options have a strong incentive to manage the company so that the share price increases, thereby increasing the value of their share options as well. Recent history demonstrates that the agency problem still exists in corporations. In order to deal with this problem, boards of directors, and regulators, have moved towards more rigorous corporate governance requirements. Corporate governance relates to the relationships between the shareholders, the board of directors and management. A company must implement corporate governance processes that put policies and procedures in place to ensure that accountability and transparency become an integral part of the corporate culture. Clear responsibility and reporting structures need to be established to facilitate the long-term survival of the organisation and the maximisation of shareholder value.

REFLECTION POINTS

of the board of directors of a corporation are elected by shareholders at a general • Members meeting. board determines the objectives and policies of the firm, and appoints executive managers, • The who are responsible for managing the day-to-day business operations and for reporting back to the board. a limited liability company, the liability of a shareholder is limited to the fully paid issue • With price of the shares. a no liability company, a shareholder holding any partly paid shares cannot be forced to • With make further payment, but may instead forfeit the shares. of the corporate form of business include access to a large pool of equity funds • Advantages through the stock market, the separation of ownership (shareholders) and control (managers), the continuity of business operations, the ability to conduct large-scale operations and the opportunity for investors to hold a diversified share portfolio. disadvantage of the corporate form is the agency problem, whereby managers may • Atrypotential to run the business for their own benefit rather than for the shareholders’ benefit. board of directors should establish strong corporate governance practices to ensure • The accountability and transparency.

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4.2

The stock exchange

The origins of the modern stock exchange can be traced back to as long ago as 1553 with the establishment in England of the Muscovy Company. The company was established to find the north-east trade route to China and the Orient. The venture was a ‘joint stock’ company. A number of merchants and suppliers of capital became part-owners of the venture, and jointly shared the risks and the returns of the venture. Another feature which shares in the Muscovy Company had in common with the shares of today was that they were freely transferable. By the end of the seventeenth century there was substantial dealing in the shares of about 140 joint stock companies in London. The merchants who owned shares (or their agents) met in the coffee houses of London to carry out their transactions. These coffee-house markets gradually evolved into formal stock exchanges, as rules were developed to govern share transactions and the behaviour of businesses seeking to raise funds through the sale of shares. Indeed, the London Stock Exchange, believed to be the world’s first stock exchange, was opened in 1700 in Jonathon’s Coffee House near Change Alley in London. Today, stock exchanges compete within an international market that is characterised by the rapid and continuous flow of information to the markets within a regulatory environment that allows capital to move almost instantaneously around the world. In a globalised market, the principal functions of a modern and efficient stock exchange are:

LEARNING OBJECTIVE 4.2 Consider the origins and purpose of a stock exchange.

• establishment of markets in a range of financial securities • provision of a securities trading system • operation of a clearing and settlements system • regulation and monitoring of the integrity of the exchange’s markets • provision of a well-informed market, to secure the confidence of all participants. The remainder of this chapter will consider the role of a modern and efficient stock exchange. We will focus on the primary market role, the secondary market role, the managed products and derivative products roles, the interest rate market role, the trading and settlements role, the information role and the regulatory role of a stock exchange. Where necessary, we will refer to the operations of the ASX, as it is regarded internationally as a modern and efficient stock exchange. The ASX is the principal stock exchange in Australia. The ASX, until 2016, held a monopoly position when the Australian government legislated to allow competition in the Australian market. To date, two exchanges are operating in competition with the ASX. These are the National Stock Exchange of Australia (NSX) and Chi-X Australia. It is common practice in the markets to use the terms share market, stock market and stock exchange interchangeably. Market participants refer to the main equity security issued by listed corporations as shares or stock, hence the use of the terms share market and stock market. A deep and liquid share market is important to a corporation. The development of the stock exchange was necessary to facilitate the formation of the publicly listed corporation and the creation of a deep and liquid share market. Stock exchanges have facilitated the rise in the importance of the corporation as the dominant business form in developed economies. The stock exchange provides the primary market through which new share capital is issued by a listed corporation, and also provides the market structure through which the ownership of existing shares can be bought and sold by investors. While the principal security quoted on a stock exchange is an equity instrument, other securities are also quoted. These are typically government bonds, corporate bonds and hybrid securities. A further role of a stock exchange is the provision of derivative products that enable investors to (1) purchase equity-based securities rather than purchasing ordinary shares directly, (2) manage risk exposures associated with their investment portfolios or (3) synthetically restructure or leverage their portfolios. A principal determinant of an efficient market is the speed at which new information flows to the market, and the speed at which that information is absorbed and then reflected in share prices. A stock

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exchange facilitates this rapid flow of information to all market participants. Other determinants of an efficient market are the securities trading system and the transaction settlement system, that is, the procedures for buying and selling shares, and the transfer of ownership and funds associated with those transactions. The final role addressed in this chapter is the regulatory role of an exchange. Market confidence in the integrity of the share market is essential and must be maintained. The stock exchange plays a very important role in prescribing and monitoring the activities of market participants.

REFLECTION POINTS Primary market the issue of new financial securities such as ordinary shares

World Federation of Exchanges trade association representing 64 publicly regulated stock, futures and options exchanges

• The origin of stock exchanges dates back to 1553 in England. stock exchanges compete within the international markets, where there are continuous • Today, flows of information. stock exchange facilitates the listing of corporations and price quotations, for the buying and • Aselling of listed securities.

• An exchange operates a securities trading system and a transaction settlement system. • Stock exchanges, and regulators, seek to maintain the efficiency and integrity of the market. 4.3

LEARNING OBJECTIVE 4.3 Understand the primary market role of a stock exchange through which corporations raise new funding.

New float or initial public offering (IPO) the initial listing of the securities of a corporation on a stock exchange

Rights issue the issue of additional shares to existing shareholders on a prorata basis

The primary market role of a stock exchange

The primary market role of a stock exchange is to ensure the efficient and orderly sale of new-issue securities, and includes all of the support facilities that are required to enable this to happen. Although the focus of Part 2 is on equity markets and equity securities, major stock exchanges also list fixedinterest debt instruments and units in listed trusts. The fixed-interest debt securities may be Treasury bonds issued by government or corporate bonds, such as debentures issued by corporations. Units in a public unit trust are issued by the trustee and are quoted and traded on the stock exchange. (See Chapter 3 for a discussion of unit trusts.) Also, a stock exchange may list a range of derivative products (Section 4.5). Table 4.1 provides data on the number of listed companies, new listings, market capitalisation, new capital issues, the level of the S&P/ASX200 index and the World Federation of Exchanges ranking for the principal stock exchange in Australia, the Australian Securities Exchange (ASX).

Table 4.1 The ASX market statistics as at 8 May 2018 Number of listed companies

2 279

Domestic market capitalisation

$1.9 trillion

World Federation of Exchanges ranking

16th

SOURCE: ASX Limited, ASIC, 2018.

Placement additional ordinary shares are sold by a corporation to selected institutional investors

Dividend reinvestment scheme allows shareholders to reinvest dividends by buying additional shares in the company

In May 2018, there were 2 279 companies listed on the ASX. The market capitalisation of the share market—that is, the current value of shares issued—was $1.9 trillion, with 60 new listings since January 2017. New companies listed on a stock exchange are referred to as a new float or an initial public offering (IPO); almost $3 billion in initial capital was raised in the first four months of 2018. Equity capital issued included ordinary shares issued with IPOs, rights issues, placements and dividend reinvestment schemes. A rights issue is the issue of additional shares to existing shareholders on a pro-rata basis of, say, one additional share for every five shares held. Placements are the issue of new shares to selected institutional investors such as fund managers. Dividend reinvestment schemes

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give shareholders the opportunity to reinvest dividend receipts back into the company by buying additional shares in the company. Rights issues, placements and dividend reinvestment schemes are discussed in Chapter 5. The main participants involved in the primary issue of equity securities are illustrated in Figure 4.1. In a central position in the figure are corporations, which receive the proceeds from the issue of new equity. The stock exchange is the institutional structure that facilitates the listing of the shares. With an offer to issue new shares to the public, the application form must be attached to the issue prospectus.

Prospectus document prepared by a company stating the terms and conditions of an issue of securities to the public

Figure 4.1  Participants in a primary market issue of shares Advisers

Underwriters

Sub-underwriters

Corporations

Purchase unsold shares

Stock exchange

Brokers

Flow of ownership rights

Flow of funds

Individuals

Institutions

Rest of world Key Flow of ownership rights Flow of funds

Investors in new-issue shares can be individuals, institutional investors such as insurance companies, superannuation funds, unit trust funds managers, other corporations and overseas investors. Other groups, such as investment banks, involved in the primary issue of shares are the advisers to the corporation, and the underwriters and sub-underwriters of the share-selling program. The roles of these groups are discussed in Chapter 5.

REFLECTION POINTS

primary market role of a stock exchange relates to the issue of new securities by listed • The corporations or other entities.

• The listing of a new company is known as a float or an initial public offering (IPO). continued

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Part 2 Equity markets continued

• The main form of equity issued by a corporation is the ordinary share (common stock). market issues of ordinary shares raise equity capital for corporations. Equity capital is • Primary typically used to enable a firm to grow. • Shareholders may receive dividends and/or capital gains (or losses). corporations may issue additional equity through rights issues, placements and • Existing dividend reinvestment schemes. • A stock exchange may also list debt instruments, units in public trusts and derivative products. • An issue of equity or debt to the public requires the preparation of a prospectus. companies were listed on the ASX as at May 2018. The ASX was ranked 16th globally • 2 279 by the World Federation of Exchanges. 4.4 LEARNING OBJECTIVE 4.4 Discuss the secondary market role of a stock exchange through which existing securities are bought and sold.

The secondary market role of a stock exchange

Secondary market transactions in a stock exchange involve the buying and selling of existing financial securities, principally ordinary shares. The participants associated with secondary market transactions in existing shares are shown in Figure 4.2. We noted in Figure 4.1 that ownership of shares flows to individuals, institutions and the rest of the world. If any of these shareholders decide to sell their shares, they will carry out a secondary market transaction.

Figure 4.2  Participants in a secondary market share transaction

Individuals

Individuals Transfer of ownership

Institutions

Brokers

Stock exchange

Brokers

Institutions

Transfer of funds Rest of world Sellers of existing shares

Rest of world Buyers of existing shares

As indicated in Figure 4.2, a shareholder will normally issue a sell order to a stockbroker. The stockbroker will enter the order into the stock exchange securities trading system. Another broker will have entered a buy order on behalf of another client. The stock exchange securities trading system will match the orders and facilitate the sale of the shares, transfer of ownership and payment for the purchase. It is important to recognise that the corporation whose shares are being traded does not feature in the flow of funds. Secondary market transactions have no direct impact on the cash flows of the corporation. 140

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The corporation receives the proceeds of the primary market issue, but the flow of funds associated with the secondary market trade in existing shares is between the buyer and the seller of the shares; that is, in the secondary market there is a transfer of ownership and a settlement of value for that transfer. This does not mean that the price behaviour of the corporation’s shares in the secondary market, and the secondary market itself, are of no consequence to the corporation. The existence of a welldeveloped secondary market is of great significance to a corporation that may be seeking to raise new equity finance in the future. The relationship between the primary and secondary markets is extremely important. Corporations normally seek to raise additional equity in order to expand the business. Equity funding and therefore economic growth come from companies raising funds in the primary market. The existence of an active, liquid and well-organised secondary market in existing shares encourages investors to buy new shares issued in the primary markets. In Part 1 it was argued that savers can be assumed to have a preference for more, rather than less, liquidity in the various forms in which their savings may be invested. Liquidity in the share market means that participants can buy and sell shares without unduly disturbing current market prices of the shares that are being traded. The standard measure of market liquidity is the ratio of the value of turnover to market capitalisation, where market capitalisation is calculated by multiplying the number of shares on issue by the current market prices. The depth and liquidity of a share market are important to investors and corporations alike. Corporations are able to raise equity at a lower cost and investors are able actively to manage and lower their risk exposures. Stock exchanges in many countries have entered into memorandums of understanding and established reciprocal arrangements with international stock exchanges in order to increase their market liquidity. For example, there is a longstanding arrangement between the Singapore Exchange (SGX) and the ASX.

Market liquidity the ratio of the value of share turnover to market capitalisation

Market capitalisation the number of shares issued by listed corporations multiplied by current share prices

REFLECTION POINTS

secondary market role provides a market structure for the buying and selling of existing • The listed securities. and sell orders are lodged through a stockbroker that has access to the exchange’s trading • Buy and settlement platforms. market transactions do not raise additional equity for the original issuing • Secondary corporation—they are a transfer of ownership for value. liquidity is the ratio of turnover to market capitalisation. A deep and liquid market • Market encourages investors.

• Market capitalisation is the number of issued shares multiplied by the share price. 4.5

The managed product and derivative product roles of a stock exchange

In support of their primary and secondary market roles relating to the issue of ordinary shares and hybrid securities, stock exchanges may provide a market for the trade of specific equity-based managed products and derivative products. These products derive their value from the value of an underlying security or group of securities listed on a stock exchange. The underlying securities trade in the socalled physical market, being the stock exchange. Equity-based managed products provide investors with the opportunity to gain a diversified exposure to a market, or a market sector, through a single investment product rather than directly purchasing all the individual securities represented in the basket of securities held in the managed product. For example, an investor is able to buy an exchange traded fund (ETF) which is based on 20 major stocks listed on the ASX and representing the main sectors in the Australian equity market.

Derivative a risk management product that derives its value from an underlying commodity or instrument

Physical market a market in which a commodity or financial instrument is issued or traded

LEARNING OBJECTIVE 4.5 Examine the managed product (exchange traded funds, contracts for difference, real estate investment trusts and infrastructure funds) and derivative product (options, warrants and futures contracts) roles of a stock exchange.

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Exchange traded contracts standardised financial contract traded on a formal exchange

Over-the-counter contracts non-standardised contract negotiated between a writer and a buyer

Hedge implement a strategy that manages or protects against an identified risk exposure

Exchange traded funds (ETFs) units sold in a managed investment scheme that tracks the performance of a specified stock exchange index, foreign currencies or commodities

Exchange traded products (ETPs) group of products that includes ETFs, managed funds and structured products

The value of the ETF is based on the value of the underlying shares held by the fund and the value moves as the market value of the underlying shares moves. In the case of an equity-related derivative product, the price of the derivative will be directly correlated with the price of the corresponding equity security quoted on the stock exchange. For example, on the ASX, an investor may buy an option contract (derivative) that provides the right to purchase 100 Crown Resorts Limited shares at a certain price, on or by a predetermined date. The price of the option will be based on the current price of Crown on the share market (physical market). The value of the option contract will change over time as the price of the share changes on the share market. The derivative products available through a stock exchange are described as exchange traded contracts. The main feature of an exchange-traded contract is the standard terms and conditions of each contract. For example, an exchange-traded contract is based on a standard product, for a fixed amount and will mature on a predetermined date. Alternatively, over-the-counter contracts that are available from other financial institutions and fund managers are not standardised across a market, and terms and conditions are negotiated between the writer and the buyer of a contract. It should be noted that the types of contracts traded, and the standard terms and conditions of those contracts, will vary between stock exchanges in different countries. Why do stock exchanges offer a range of managed products and derivative products? The managed products allow investors to invest in asset classes that otherwise may be complex to manage or difficult to access directly. For example, the exchange-traded contracts offered by the ASX give individual investors the opportunity to access a broad range of international shares within a single product listed on the exchange. Other products provide access to the real estate markets and the infrastructure markets. Derivative products, in part, give investors the opportunity to manage, or hedge, a risk exposure in their investment portfolio. For example, an investor might be exposed to the risk that share prices may fall in the future. The investor might consider using a derivative product that gives the right to sell those shares at a future date, but at a price that is set in the contract today. In entering into such a contract, the investor has hedged, or managed, the risk that the share price will fall in the future. Derivatives also enable an investor to synthetically restructure an investment portfolio, such as by buying an option that gives the right to buy or sell a certain stock at a specified price at a predetermined date. If at the exercise date in the future the investor still wishes to buy or sell the stock, the investor is able to proceed at the known price. The scope of managed products and derivative products quoted on an exchange is limited only by the depth of the market, the sophistication of market participants, the regulatory environment and competition. In this chapter, we briefly consider:

• exchange traded funds • contracts for difference • real estate investment trusts • infrastructure funds • options • warrants • futures. Derivative contracts are discussed in much more detail in Part 6.

4.5.1

E XCHANGE TRADED FUNDS

Exchange traded funds (ETFs) offered through a stock exchange such as the ASX generally invest in a basket of securities listed on the ASX, securities listed on an international stock exchange, foreign currencies or commodities. ETFs are part of a class of investments called exchange traded products (ETPs). Typically, the ETF will be a registered managed investment scheme. Investors purchase units in an ETF. The fund manager of an equity-based ETF seeks to track the performance of a benchmark stock

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exchange index, such as the S&P/ASX200, by using the funds raised from the sale of units in the ETF to purchase a securities portfolio that replicates the specified index. For example, the ETF would hold all or the majority of shares included in the S&P/ASX200 index. ETFs are distinguished from other types of ETPs. While an ETF traditionally tracks the performance of an index, other types of ETPs involve active management strategies. Active ETFs try to outperform an index rather than merely tracking it. ETPs also include structured products (SPs). SPs are instruments that involve a company promising an investor a rate of return that is based on the movement in the price of an underlying asset, such as an index. SPs are quite different in nature from both ETFs and active ETFs. By purchasing units in the ETF an investor gains access to a diversified portfolio of securities. The extent of diversification will depend on the benchmark index specified in the ETF. For example, an ETF that replicates the S&P/ASX200 provides exposure to the top 200 shares listed on the ASX. The risks involved in ETFs include exposure to the ups and downs in the underlying benchmark index. Should an investor wish to gain a diversified exposure to the international markets, then an ETF such as the iShares S&P500 gives exposure to the US markets, while iShares S&P Europe350 provides exposure to major European corporations listed on a number of European exchanges. The list of ETFs offered by a stock exchange will be found on their website. The risks involved with ETFs that track overseas indices include exposure to the volatility of those indexes and currency risks if the investments are denominated in a foreign currency. Most ETFs are open-ended funds; that is, the number of units offered by a fund is not fixed. For example, if demand for units in a particular fund increases, the fund manager can increase the number of units on offer. This ensures that units in the ETF trade at or near the net asset value of the securities held in the fund. Units in an ETF are bought and sold through a stock exchange in exactly the same way that ordinary shares of listed corporations are bought and sold. There has been strong growth in the ETF sector in Australia. Assets under management reached $25 billion in 2018. Most ETFs in Australia invest in Australian equities and international equities. However, some venture into fixed income securities and commodities. The innovation in the types of products offered as ETFs or ETPs provides more opportunities for investors but also raises concerns about how well those investors understand the risks that are involved.

4.5.2

Active ETFs a type of ETF that deploys strategies designed to outperform a market index

Structured products (SPs) instruments that promise a rate of return based on the movement in the price of some asset

C ONTRACTS FOR DIFFERENCE

A contract for difference (CFD) is a contract listed on a stock exchange that is an agreement between a buyer and seller to exchange the difference in the value of a CFD. The difference in value is calculated by subtracting the value of the CFD contract at the start date from the value of the contract at the close date. The CFD may be based on a nominated security listed on a local or international stock exchange, stock exchange indices, foreign currencies or commodities. For example, a CFD may be based on BHP Billiton Limited shares listed on the ASX. The value of the CFD is directly correlated with the value of the underlying BHP shares at the start and close date specified in the CFD contract. A CFD provides a high level of leverage for an investor as the buyer of a CFD only pays a deposit or initial margin; that is, the investor does not pay the full value of the underlying shares. This means that an investor may be able to take a much larger exposure to the market in that more of the underlying security can be bought or sold because full payment is not required to be made by the purchaser upon execution of the CFD. However, the risks associated with leverage are much higher as the full gain or loss associated with the underlying security will be made when the CFD is closed out. Therefore, investors must understand the upside and the downside risk associated with a leveraged investment such as a CFD. An investor may use a CFD to go long in a rising market, or go short in a falling market. For example, if an investor believes BHP Billiton shares are going to rise in value, the investor might take a long position by buying 1000 BHP Billiton CFD at $43.25 per share. The value of the

Contract for difference (CFD) an agreement between a buyer and seller, based on an underlying security, to exchange the difference between the contract start and close values

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CFD is $43 250, but the investor would only pay, say, a 10 per cent deposit of $4325.00. If BHP Billiton shares are trading at $45.76 on the CFD close date, then the investor would make $2510 profit. This is a 58.00 per cent return on the initial capital investment. If an investor believes that the market is going to fall, then the investor may decide to sell a CFD; that is, take a short position. If the underlying security of the CFD falls, then the investor will make a profit, but if the security rises in value, the investor will make a loss. A CFD has no expiry date so the position has to be closed by conducting a reverse trade.

4.5.3 Real estate investment trust (REIT) managed funds that provide investors with the opportunity to invest in a range of property categories such as industrial, hotels and retail

R EAL ESTATE INVESTMENT TRUSTS (REIT)

A real estate investment trust (REIT) purchases property and holds the assets within a trust. Units in the REIT may be listed on a stock exchange and traded in the same way as ordinary shares in listed corporations. Because investors are buying units in the listed trust, they gain access to a diversified real estate portfolio that otherwise would not be possible for the average investor. For example, an investor may purchase units worth $5 000 in a REIT, whereas, with that small amount, the investor could not purchase property directly. The type of property held in a REIT will be specified in the fund’s trust deed. The categories of property that a REIT may purchase include:

• industrial—such as warehouses, factories and industrial parks • hotel and leisure—including hotels, theme parks and cinema complexes • retail—in particular major shopping centres • office—such as multi-storey office buildings. Investors may benefit from both capital gains on the property assets as well as rental income generated by the properties. Also, units in a listed REIT are much more liquid than the underlying property; that is, it is easier to sell the units than it is to quickly sell the property held in the trust.

4.5.4 Infrastructure fund managed fund that provides investors with the opportunity to invest in infrastructure assets such as toll roads and utilities

Call option gives the buyer the right, but not the obligation, to buy a specified commodity or financial instrument at a specified price and date

I NFRASTRUCTURE FUNDS

An infrastructure fund is a managed fund that may be listed on a stock exchange and enables investors to gain access to investment opportunities in large-scale infrastructure projects such as toll roads. Infrastructure projects are normally multi-million dollar projects and therefore beyond the investment capacity of the average investor. The infrastructure fund accepts funds from a large number of investors to create a significant pool of funds. This enables the fund manager to then invest in these types of projects or assets. Returns to investors may take the form of capital gains and income generated from the project. For example, a toll road will generate income from the toll charged for vehicles travelling on the toll road. The categories of infrastructure assets held in a fund might include:

• utilities—such as power stations, electricity transmission lines and gas pipelines • transport and materials handling—including railway lines, airport terminals, port and dock facilities • communication facilities—such as broadcasting and communication towers and networks. The income earnings from many infrastructure assets are quite predictable as they are often regulated or guaranteed by government. Also, infrastructure projects typically have high barriers to entry (costs, technology, regulation) and therefore low levels of competition.

Put option gives the buyer the right, but not the obligation, to sell a specified commodity or financial instrument at a specified price and date

4.5.5

O PTIONS

An option contract gives the buyer of the option the right, but not the obligation, to buy (call option) or sell (put option) a specified security at a predetermined price, on or before a predetermined date.

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The buyer of the option must pay a premium to the writer, or seller, of the option; that is, the writer of the option is selling a right to the option buyer. For example, an investor who holds Santos Limited shares in an investment portfolio might be concerned that the share price will fall in the near term but does not want to sell the shares at this time. The investor may implement an options strategy to protect against the risk. The investor may decide to buy a put option, which gives the investor the right to sell, say, 1000 Santos shares at an exercise price of $7.00 per share within the next three months. The premium paid to the option writer is quoted at $0.20 per share. Assume that the share price actually falls to $6.00; the option buyer will then exercise the option and sell the shares at $7.00, or receive a cash settlement from the option writer. The investor has protected the investment portfolio to the amount of the exercise price minus the current market price less the premium paid, multiplied by the number of shares; that is, 1 000 ($7.00 − $6.00 − $0.20) = $800. An interesting feature of an option contract is that if the investor decides not to sell the shares, perhaps because the price in the share market has actually risen, there is no obligation to proceed. In this case, the cost to the buyer of the option is the initial premium paid to buy the option contract. A stock exchange may quote on a range of different types of option contracts, including stock options, index options, flexible options and low-exercise-price options. To find out more about the various option contracts offered on the ASX, you can look on the internet at www.asx.com.au. Option contracts are derivative contracts and are discussed in greater detail in Chapter 20.

4.5.6

the price specified in an options contract at which the option buyer can buy or sell

W ARRANTS

Another derivative product quoted on a stock exchange is the warrant. A warrant issuer, such as a bank, must be authorised by the stock exchange to write warrant contracts. The warrant issuer is able to determine the terms and conditions that will apply to a specific warrant series, but the warrant is then quoted and traded on the stock exchange. Warrant issuers are required by the exchange to make a market; that is, they must quote both buy and sell prices on their warrant series. Call and put warrants are quoted; a call warrant holder will benefit from an upward price movement in the underlying physical market share price or index, while a put warrant holder will benefit from a downward movement in prices. An equity-based call warrant gives the warrant holder the right to buy the underlying security at a particular price, on or before a predetermined date. Similarly, a put warrant gives the right to sell. Instalment warrants are often attractive to investors as they give the warrant holder the right to buy the underlying shares by payment of a number of periodic instalments, but still be entitled to receive any dividend payments and franking credits. Generally there are only two instalments on ASX quoted instalment warrants: an initial part payment and an optional final payment. A stock exchange may list a number of different types of warrant contracts. (A range of warrant contracts is discussed in Chapter 20.) You can obtain further information on warrant contracts offered on the ASX at www.asx.com.au. Similarly, other nation-state exchanges also provide details of their particular contracts on their websites.

4.5.7

Exercise price

Warrant a financial instrument that conveys a right in the form of an option

Warrant issuer a third party, such as a bank, authorised by a stock exchange to write warrant contracts

F UTURES CONTRACTS

Another type of derivative product that may be quoted on a stock exchange is the futures contract. A futures contract is a contract between two parties to either buy or sell a specified commodity or financial instrument at the expiry date of the contract. The value of the contract at commencement, and at the expiry date, will relate to the price of the underlying physical market price at each of those dates. Settlement of the contract will be specified in the contract, and may be by delivery of the underlying security, such as a share, or by payment of a cash equivalent. The underlying security of a futures contract may be a particular share of a listed company or a stock-market index. Stock-market indices are discussed in Chapter 6. Futures contracts are discussed in detail in Chapters 18 and 19. 145

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Not all stock exchanges offer all the above products. Stock exchanges will offer managed products and derivative products only if there is sufficient demand and liquidity for a particular product. Also, in some countries the regulator may restrict the types of products offered. In Australia, the ASX provides all the above products.

REFLECTION POINTS

exchanges may list a range of managed products and derivative products. These • Stock standardised products are known as exchange-traded contracts. traded funds (ETFs) usually invest in a basket of securities listed on the local • Exchange or international exchanges, foreign currencies or commodities. ETFs provide access to a diversified portfolio of securities. ETFs are just one type of exchange traded product (ETP). Other ETPs include active ETFs and structured products (SPs). contract for difference (CFD) is an agreement to exchange the net difference in value • Abetween the start date and the close date of a CFD. The CFD is based on a specified security. Only a deposit is paid initially, therefore the CFD is highly leveraged (increased risk). real estate investment trust (REIT) issues units in the trust in order to raise funds to purchase • Aproperty, including industrial, hotels and leisure, retail and office. Assets generate rental income and (hopefully) capital gains. funds enable investors to gain access to large-scale infrastructure projects, such • Infrastructure as utilities, transport, materials handling and communications facilities. option contract gives the buyer the right, but not the obligation, to buy (call option) or sell • An (put option) a specified security at a predetermined price and date. The writer of the option receives a premium payment from the option buyer. equity warrant gives the holder the right to buy (or sell) the underlying security at a specified • An price on or before a nominated date. Stock exchanges list a wide range of warrant contracts. contract is an agreement between two parties to buy (or sell) a specified commodity • Aorfutures financial security at a specified date in the future. The value of the futures contract moves as the price of the underlying asset in the physical market moves. Settlement may be for delivery of the asset or cash.

4.6 LEARNING OBJECTIVE 4.6 Examine the interest rate market role of a stock exchange.

Interest rate market listing, quotation and trading in debt securities

The interest rate market role of a stock exchange

Corporations fund their business operations with a combination of equity and debt. It has already been noted that the principal function of a stock exchange is to facilitate primary and secondary market transactions in shares of listed corporations. Another, lesser function of a stock exchange is the listing of some of the debt issues of corporations, financial institutions and government. An interest rate market is a market that facilitates the issue of debt securities and the subsequent trading of those securities on a formal exchange. Just as a corporation issues a prospectus to prospective shareholders, an issuer of debt similarly prepares a prospectus for potential investors. A prospectus issued by a corporation is a document stating the terms of its public equity issue or debt raising. The prospectus must meet the requirements of the stock exchange and the nation-state regulatory authority in the provision of information to potential investors. If a debt issuer chooses to list the issue on a stock exchange, the price of the issue will be quoted by the exchange and trading in the securities can

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occur. Trading will take place using the same procedures as those used when buying and selling shares (discussed in Section 4.7). The provision of an interest rate market by a stock exchange may be said to add value to issued debt and new debt issues in three ways: 1 Transparency. An exchange provides access to information about the price, yield, maturity, credit rating and other characteristics of debt securities. Information is the life-blood of the financial markets. An efficient stock exchange ensures that an informed market exists. 2 Ease of entry and exit. By using a stock exchange’s electronic trading system, investors are able to place orders through their stockbroker to buy or sell debt securities at a minimum cost, with little delay and at the current market price. 3 Liquidity. Quotation of debt issues on a stock exchange provides access to a much wider investment market. The formal market increases the negotiability of listed debt securities, as it brings buyers and sellers together and facilitates the transfer of ownership from the seller to the buyer. Traditionally, large debt issues have been made direct into the wholesale markets to institutional investors. However, listing on a stock exchange provides access to the broader retail market. Therefore, the stock exchange enhances the liquidity of debt securities. Fixed-interest securities listed on a stock exchange are typically long-term instruments. The main types are straight corporate bonds, floating rate notes, convertible notes and preference shares.

• A straight corporate bond is a fixed-interest security. The interest payment is called a coupon.

The bond issuer pays a specified coupon rate that will not change for the term of the bond. The face value of the bond is repaid to the holder at maturity. A corporate bond may be secured or unsecured. A secured bond is known as a debenture, the security being a charge over the assets of the issuing corporation. An unsecured bond is called an unsecured note. Since the interest paid on a corporate bond is fixed, the price of the bond will change along with interest rates for new issues of similar types of securities to reflect movements in the interest rate market (see Chapter 10).

• A floating rate note (FRN) is also a corporate bond, but it pays a variable rate of interest. Interest

coupon payments usually occur quarterly, half-yearly or annually. Interest rate changes will be based on a reference rate published in the market by Reuters (see Chapter 10).

• A convertible note is a hybrid security. It is a fixed-interest debt instrument that includes an option to convert the note at a future date into ordinary shares of the issuer company (see Chapter 5).

• Redeemable convertible preference shares are also a hybrid security. They pay a fixed dividend

(similar to a fixed interest payment) for a specified period, at which point the holder will have the option to redeem the preference shares for cash or convert them into ordinary shares in the company (see Chapter 5).

Stock exchanges therefore facilitate transactions in equity securities, hybrid securities and debt securities. In order to do this, an exchange must maintain a securities trading system and a transaction settlement system.

Straight corporate bond a long-term debt instrument paying a fixed interest coupon; principal repayable at maturity

Coupon the periodic interest payment attached to a bond issue

Floating rate note (FRN) a corporate bond that pays a variable rate of interest; principal repayable at maturity

Convertible note a hybrid fixed-interest debt security that includes an option to convert to ordinary shares at a specified date

Preference shares a hybrid security that combines characteristics of both equity and debt; preference shares usually pay a fixed dividend and offer the right to convert to ordinary shares at a future date (also known as a redeemable convertible preference share)

REFLECTION POINTS

• Corporations fund their operations from a combination of equity and debt. issues may be listed on a stock exchange and provide investors with transparency, • Debt liquidity and ease of entry and exit. continued

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corporate bond is a fixed-interest security that pays a periodic coupon. The principal • Ais straight repaid at maturity. A secured bond is known as a debenture; an unsecured bond as an unsecured note. As the interest rate is fixed, the value of the bond will change as interest rates in the current market change. floating rate note (FRN) is a corporate bond that pays a variable coupon rate, which will be • Abased on a published reference rate. convertible note is a hybrid security that pays a fixed interest rate and includes an option to • Aconvert the note at a future date into ordinary shares. redeemable convertible preference share is a hybrid security that pays a fixed dividend. • AIt has an option at maturity to redeem to cash or convert to ordinary shares at a specified price.

4.7 LEARNING OBJECTIVE 4.7 Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for share-market transactions by the Australian Securities Exchange (ASX).

ASX Trade the electronic securities trading platform used by the ASX to facilitate trading in equity securities listed on the ASX

ASX Trade24 the electronic securities trading platform used by the ASX to facilitate trading in futures, options and contracts for difference listed on the ASX

The trading and settlement roles of a stock exchange

People often talk about the good old days. Well, in the good old days trading on a stock exchange occurred by open outcry. Participants in the market would gather on the floor of a designated exchange and actively call out their buy and sell orders. For example, in the stock exchange in Melbourne, stockbrokers and their staff would meet in a very large room. At one end of the room was a raised platform, behind which was a large blackboard with the code and price for each company listed on the exchange. Down on the floor of the exchange, brokers’ clerks would scream out buy and sell orders. On the platform, stock exchange staff would take those verbal orders and run to the blackboard to change the relevant company information. Entries were made and altered in chalk; thus, these exchange employees were known as chalkies. Needless to say, when the market was hot, noise levels rose and everyone had to scream louder to catch the attention of a chalkie. Sadly, those days have mostly gone. Some open-outcry markets still remain, the best examples being the Chicago Board of Trade and the Chicago Mercantile Exchange. These institutions are worth visiting to get a taste of the intensity of an open-outcry market. Trading and settlement systems used by stock exchanges vary across the international markets. However, the systems are becoming more compatible as stock exchanges in nation-states seek to establish reciprocal trading arrangements with international exchanges. For example, the ASX uses electronic trading platforms known as ASX Trade and ASX Trade24. These platforms are used by other international stock exchanges, in particular the NASDAQ exchange in the USA. ASX Trade is an integrated trading platform that allows the stock exchange to trade all listed securities, including equities, derivatives and interest rate securities, using a single trading platform. ASX Trade24 facilitates global trading in derivative contracts. The buying and selling of listed securities on the stock exchange is initiated through authorised stockbrokers who have access to the ASX electronic trading and settlement systems. The ASX Trade trading platform allows stockbrokers to execute a client’s buy or sell order through computer-based trading from the broker’s office while the client waits on the telephone, or through a computer-based trade instruction given via the internet. In a liquid market, orders are confirmed almost instantly. Figure 4.3 shows the process for buying and selling shares. Buyers and sellers independently provide instructions to their stockbrokers on the quantity and price of a particular share they wish to buy or sell. The broker inputs the order into ASX Trade. The orders are electronically transmitted to the ASX host computer where the orders are recorded in price and time priority order. ASX Trade matches corresponding buy and sell orders based on the bid (buy) and offer (sell) prices and the time the order was received.

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Figure 4.3  Buying and selling shares on the ASX Buying shares

Selling shares

Buyer instructs broker to buy specific shares, including quantity, price

Seller instructs broker to sell specific shares, including quantity, price

Operator enters buy order on ASX Trade

Operator enters sell order on ASX Trade

ASX Trade records instructions in priority order based on price and time of receipt

ASX Trade matches buy/sell orders and executes the trade

Stockbroker sends contract note to buyer confirming transaction

Stockbroker sends contract note to seller confirming transaction

Buyer forwards amount direct, or credits funds to a cash management account held by broker

Seller advises the sponsor broker of the required uncertificated holder information

Shares transferred electronically by selling broker to buying broker through CHESS and share registry notified

Share registry records new ownership details and issues holding statements to both buyer and seller

At the same time, settlement funds are transferred between brokers via CHESS

With the ASX, the actual share certificate is no longer issued to the shareholder. An electronic record is maintained of share ownership. Therefore, shares listed on the ASX are known as uncertificated securities. On completion of the trade, each stockbroker will forward a contract note to the buyer and seller, confirming the transaction details. The trading transaction is completed through the Clearing House Electronic Sub-register System (CHESS). The buyer will arrange payment, usually by authorising the broker to draw on credit funds held in a cash management account held with the broker or other financial institution. Settlement, that is, the transfer of ownership and value payment, occurs through CHESS. The ASX plans to replace CHESS with a new system in 2021. ASX Trade provides a fast and efficient trading system, delivering data latency down to 250 microseconds; in addition, it disseminates information to the main market participants. The electronic system allows brokers to monitor the market constantly, to enter bid and offer orders and to monitor and adjust outstanding orders if necessary. Certain trading principles apply during normal business hours: overlapping bids and offers are executed at each price level in the order in which they were entered into the system. At the opening of

Uncertificated securities electronic record of share ownership; original share certificate is not issued

Contract note sent by a stockbroker to a client advising details of a share transaction

CHESS the electronic securities transaction settlement platform used by the ASX

Bid and offer bid is an order to buy; offer is an order to sell

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Settlement risk the possibility that one party to a financial transaction will not deliver value

trade, if there are bids and offers with overlapping prices, the trades are shared between all parties who had lodged orders, provided there is sufficient stock available. It is imperative for an efficient market to develop a secure settlement procedure in order to minimise the risk of failed settlement by a party to a buy/sell transaction. This risk is known as settlement risk. In volatile market conditions, the risk of non-settlement increases directly with the time that elapses between the execution of an order and the value settlement of the transaction. CHESS, the electronic settlement system used by the ASX, has two major functions: 1 It facilitates the settlement of transactions conducted through ASX Trade.

Electronic sub-register a computer-based system that records securities ownership

T+2

settlement of a share transaction will occur in two business days

CHESS sponsor market participant such as a stockbroker that has access to CHESS

2 It provides an electronic sub-register that records the ownership of listed securities. Currently, the ASX requires settlement of trades to occur two business days after the transaction (T + 2). In order to achieve this standard, all companies must issue uncertificated securities, so that electronic transfer of ownership and settlement can occur quickly. After a transaction, a shareholder will receive a holding statement from the CHESS sub-register or, alternatively, on the sub-register of individual companies. A shareholder who wishes to trade uncertificated shares must conduct the transaction with a CHESS sponsor. Participants with direct access to CHESS are sponsors and are able to facilitate transactions of other shareholders. Stockbrokers, most large institutional investors, custodian nominees and trustee companies all act as sponsors. CHESS maintains a record of all CHESS-sponsored transactions and changes in ownership, and that information is transferred electronically to the share sub-registry. Holding statements will be issued on behalf of companies to uncertificated shareholders who are sponsored by brokers or institutions that participate in CHESS. A separate statement is issued for each security held. The linking of CHESS to the Australian bank payments system provides for cleared funds settlement between the brokers of the buyer and the seller of shares. The above information relates to just one trading system and settlements system, and it is worthwhile to compare it with other systems. The internet provides an easy means of doing this. A recommended starting point is the New York Stock Exchange system, which can be accessed at www.nyse.com.

REFLECTION POINTS

support the primary market and secondary market roles, an exchange must provide trading • To and settlement platforms. Major exchanges use high-speed, robust technology-based systems. uses ASX Trade, which is an integrated system that allows the stock exchange to trade all • ASX listed securities. ASX Trade24 facilitates global trading in derivative contracts. stockbrokers have access to the ASX platforms. Investors lodge buy and sell orders • Authorised with their stockbroker, generally using the internet.

• The broker will issue a contract note, which provides full details of the transaction. will normally occur in T + 2 business days when transfer of ownership and financial • Settlement settlement will be processed through CHESS. • CHESS will issue a holding statement on the uncertificated shareholding. LEARNING OBJECTIVE 4.8 Recognise the importance of information flows to the efficiency and integrity of stock exchanges.

4.8

The information role of a stock exchange

Information moves share prices. In Chapter 7 important approaches to analysing and explaining share price movements are considered: fundamental analysis, technical analysis, the random walk hypothesis and the efficient market hypothesis. In particular, the hypotheses imply that the current

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price of a share will reflect all available information in the market, and that any change in the share price will be in response to new information coming to the market. Clearly, the role of a stock exchange in facilitating the flow of information to the market is critical for the efficiency and integrity of the market. Legislative and stock exchange requirements for the provision of information to the markets vary between countries. In this text, some of the requirements of the ASX are considered. The ASX has a number of specific listing rules that relate to the provision of information, in particular continuous disclosure rules that are designed to ensure a well-informed market. As new information is received by the ASX, it disseminates this information to market participants. For example, if you go to the home page of the ASX (www.asx.com.au), you will see a Price sensitive announcements box which lists the company code and time of the last 20 announcements. Click the ‘View all recent’ box to see all announcements. Any information concerning a listed entity that a reasonable person would expect to have a material effect on the price or value of the entity’s securities must immediately be given to the ASX. In Australia, the Corporations Act (Cwlth) states that a reasonable person would consider information to be material if it would be likely to influence persons who commonly invest in securities in deciding whether or not to subscribe to, or buy or sell, the securities. To give some idea of the extent of information that flows into the market, the following is a selection of material information relevant to a listed corporation that would require disclosure:

• a change in the corporation’s financial forecasts or expectations • the appointment of a receiver, manager, liquidator or administrator • a recommendation or declaration of a dividend or distribution • notice of a takeover bid or an intention to buy back issued shares • a proposal to restructure the capital base of the corporation • a notice of general meetings of shareholders, including motions to be put to the meeting and the outcomes of those motions • a change in the chairperson, directors or auditors • copies of any documents forwarded to shareholders • disclosure of directors’ interests. Listed corporations and other entities are also required periodically to report their financial statements to the exchange. (Note: the ASX listing rules are discussed in detail in Chapter 5.) The rapid flow and dissemination of information into the markets is essential to maintaining market efficiency and retaining the confidence of market participants. A stock exchange must establish rigorous rules and be vigilant in monitoring information flows to the exchange. Market participants that breach the stock exchange’s information rules will be subject to disciplinary action by the exchange and ASIC. In certain situations this might include the delisting of the company.

Listing rules specific criteria that must be met by an entity seeking listing on a stock exchange

Continuous disclosure a listed entity must promptly advise the stock exchange of any material changes relating to the corporation

Liquidator a party appointed to manage the winding up of a company

Directors’ interests assets, contracts and other items in which a director has a beneficial interest

REFLECTION POINTS

prices move as demand and supply for shares change. Demand and supply changes as a • Share result of new information coming to the market. exchange listing rules require continuous disclosure of information that may impact upon • Stock investment decisions and share prices. This is in addition to prescribed reporting requirements, such as the lodging of periodic financial statements. exchange will monitor information flows to ensure the market is fully informed in order • Atostock maintain the integrity and confidence in the market.

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4.9 LEARNING OBJECTIVE 4.9 Identify the principal regulators that affect the behaviour of participants in the Australian share market.

Australian Securities and Investments Commission (ASIC) the regulatory body responsible for the supervision of the Corporations Act in Australia

Delisting removal from quotation on a stock exchange of the securities of an entity

The regulatory role of a stock exchange

Given the importance of the share market in encouraging and facilitating the raising of risk capital or equity finance, it is important that the participants in the market have confidence in the integrity of its operation. Each nation-state is responsible for the regulation and supervision of its own stock exchanges. The methods vary from country to country; however, all developed countries maintain a government-appointed regulator to supervise the country’s corporations legislation, and each stock exchange assumes an important regulatory role over entities listed on its exchange. Here we consider the regulatory structure applied to the Australian equity market. In line with the more reputable of the international share markets, the operation of the Australian share market is quite heavily regulated and supervised. The two major supervisors are the Australian Securities and Investments Commission (ASIC) and each stock exchange itself. In 2009, the Australian government announced a policy initiative that allows increased competition in the securities market; that is, it is now possible for new stock exchanges to seek approval to operate in competition with the current principal stock exchange, the ASX. ASIC has responsibility for the supervision of real-time trading on Australia’s domestic licensed markets, including responsibility for the enforcement of laws against misconduct in the markets and the supervision of financial services licence holders. ASIC has an integrated market surveillance system to support its commitment to market integrity and a fair, orderly and transparent market. ASIC has established market integrity rules that apply to market operators, market participants, other prescribed entities and financial products traded on the relevant markets. ASIC is responsible for supervising compliance with these rules. ASIC is also responsible for the market disciplinary panel. This panel is the main forum for disciplinary action for breaches of the market integrity rules. Stock exchanges within Australia have a responsibility for the oversight of listed entities under the exchange’s listing rules. The exchange is also required to monitor and enforce compliance by market, clearing and settlement participants with its operating rules. For example, the ASX has a wholly owned subsidiary company, ASX Compliance, which is charged with these responsibilities. As mentioned above, the ASX has continuous disclosure provisions in its listing rules. ASX surveillance monitors market trading to identify situations where trading volumes or price movements indicate the market may not be fully informed. For example, a sudden increase in price and volume of a particular company share may be the result of information that has not been publicly announced to the market. The surveillance systems automatically generate an alert. If necessary, the relevant company will be asked to explain. If the explanation is not satisfactory, further action may be taken, such as a detailed investigation, the imposing of financial penalties, suspension or delisting from the official list of the exchange, and formal reporting to ASIC for further action. Another important participant in the regulatory structure in Australia is the Reserve Bank of Australia (RBA). The RBA is responsible for the monitoring and assessment of licensed clearing and settlement platforms and systems; for example, CHESS which is operated by the ASX. In particular, the RBA ensures participants comply with its Financial Stability Standards in order to reduce systemic risk within the financial system.

REFLECTION POINTS

nation-state is responsible for the regulation and supervision of its own stock exchanges. • Each Usually this role is shared between government-appointed regulatory authorities and the actual exchange itself. the Australian Securities and Investments Commission (ASIC) has responsibility for • IntheAustralia, supervision of real-time trading in the domestic licensed markets. 152

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is responsible for enforcement of laws against misconduct, and the supervision of • ASIC financial services licence holders. maintains an integrated surveillance system. Breaches of rules are enforced by a • ASIC disciplinary panel. also monitors continuous disclosure through its own compliance subsidiary. It may • ASX impose penalties, suspend or delist a corporation and forward a formal report to ASIC for further action. Reserve Bank (RBA) monitors the licensed clearing and settlement platforms and systems • The in order to ensure financial stability and reduce systemic risk in the financial system.

4.10

The private equity market

In this chapter we have focused on the stock market, as it is the major source of equity funding for corporations. However, in a competitive global market where there are only limited restrictions on the flow of capital, there has been considerable growth in another source of equity funds, namely, the private equity market. Private equity is an alternative equity funding source for those companies that are unable to, or choose not to, access equity funding through a public issue in the share market. For example, small unlisted companies may need to raise additional equity to support a new and growing business. Alternatively, a listed corporation may find itself in financial difficulty and seek to restructure the organisation by selling some of its non-core business to private equity investors. Typically, private equity funding is provided to higher-risk companies. Having regard to the direct relationship between risk and return, private equity providers are seeking to gain higher returns on their investment. Quite often, companies seeking private equity do not have adequate collateral or profit performance to attract investors within the normal share market or banking sources of funds. Private equity market funding is usually directed towards:

LEARNING OBJECTIVE 4.10 Explain the structure and purpose of the private equity market.

• start-up funds for new companies to allow the business to develop its products and services • business expansion funds that allow a company to grow the current business operations • recovery finance for companies that are currently experiencing financial difficulty • management buy-out financing where the existing company managers seek to buy the existing business funded, in part, with private equity.

The majority of private equity is provided through funds that are established for this purpose; that is, funds which specialise in seeking out and analysing potential private equity opportunities or targets. Within Australia, the major providers of funds for the private equity funds are superannuation funds and life insurance offices. These institutional investors seek to increase the overall return on their large investment portfolios by including a proportion of higher-risk investments. The nature of equity is long-term finance; however, the investment horizon of private equity investors is often for a shorter period, usually less than five to seven years. As private equity has limited liquidity—that is, it cannot be sold through the share market—a principal objective of private equity investors is to improve the profit performance of the company significantly so that the company can be listed on a stock exchange through an initial public offering (IPO) or sold to a trade buyer. Alternatively, the investors may seek to break up the company and sell the component parts in order to achieve a return on investment. Private equity funding tends to grow in times of sustained economic growth. On the other hand, in times of an economic downturn, new private equity funding will fall significantly. 153

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REFLECTION POINTS

• Private equity is an alternative source of equity funding for a company. equity may be provided for start-up companies, business expansion for existing • Private companies, recovery finance for corporations in financial difficulty or management buy-outs. • Specialist private equity funds obtain the majority of their funds from institutional investors. • Private equity funding is regarded as a higher-risk investment. principal objectives of private equity funds may be to improve company performance in • The preparation for an IPO or trade sale, or the break-up of a company so that the component parts may be sold separately.

CASE STUDY DEVELOPMENT OF INDUSTRIAL SCALE BLOCKCHAIN IN AUSTRALIA Digital currencies like bitcoins are based on blockchain technology, regarded as one of the most innovative and exciting developments in finance. The blockchain is envisioned to be the new internet with data integrity, authenticity and accuracy that enable development of future applications (Mermer, 2018). What is more interesting is that the world’s first industrial-scale blockchain will start operations towards the end of 2020 at the ASX in Australia. The ASX has revealed that the new technology will automate various corporate actions, streamline the processes and reduce costs. The current system used by the ASX, also known as CHESS (Clearing House Electronic Sub-register System), was extremely successful; however, the fact that more than 20 years have passed since its creation necessitated a change. It is expected that the new Distributed Ledger Technology (DLT) will be able to clear and settle cash worth $2 trillion in the Australian equities market (Eyers, 2018). According to the ASX, the benefits of such a transition could include the following; 1. Greater control to issuers and investors by offering high security and simplified access to the registers. 2. Smooth integration with upstream and downstream businesses globally with flexible technology. 3. An increase in user confidence in the system by making it traceable and secure. 4. The removal of paper-based processes and a reduction in the chances of manual errors because of new streamlined functions and workflows (Chohan, 2017). The traditional settlement mechanism, where participating organisations needed to send details of financial transactions to a clearing house for recording in a centralised registry, has proved to be timeconsuming. Industrial scale blockchain has captured the interest of such organisations, with its capability to reduce transaction time and costs while keeping security intact. In simple terms, blockchain is a data structure that creates digital transaction ledgers that will be shared among a network of participating organisations without a central authority. The major Australian banks, such as the Commonwealth, Westpac and NAB, commenced operations with DLT from late 2015 by joining Hyper Ledger project developed by IBM. When it comes to blockchain or any other technology with digital back-up, the primary concern revolves around the issue of security and opportunities for manipulation. It is notable that there exist two types of blockchain technology based on permissions. The public blockchain technology is subject to the risk of manipulation, whereas private blockchain is considered to be safe due to the extreme difficulty in addition or removal of data. While adding or removing a block of data to the registry, the majority of the

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References: Chohan, UW 2017, Blockchain and Securities Exchanges: Australian Case Study, 8 December 2017, SSRN: https://ssrn.com/abstract=3085631 or http://dx.doi.org/10.2139/ssrn.3085631 Eyers, J 2018, ‘ASX blockchain to go live at end of 2020’, Financial Review, 27 April, viewed 15 October 2018, https://www.afr.com/technology/asx-blockchain-to-go-live-at-end-of-2020-20180427-h0zcgx Gregory, M 2016, ‘Blockchain is here to stay’, The Australian Business Review, 18 May, viewed 15 October 2018, http://www.theaustralian.com.au/business/technology/opinion/blockchain-is-here-tostay/news-story/3199981db8accb21c18e3811195ff907 Mermer, GB, Zeydan, E & Arslan, SS 2018, ‘An overview of blockchain technologies: Principles, opportunities, and challenges’, In 2018 26th Signal Processing and Communications Applications Conference (SIU), May 2018, IEEE.

Discussion points

• •

Why did ASX vote for a transition from CHESS (Clearing House Electronic Sub-register System) to DLT (distributed ledger technology)?

CHAPTER FOUR REVIEW

participating organisations have to validate such changes, making it acceptable and safe for business organisations and governments (Gregory, 2018).

In the eyes of ASX, what could be the potential benefits of DLT?

Master before you move on LEARNING OBJECTIVE 4.1 Understand the structure of a corporation and identify advantages and disadvantages of being a publicly listed corporation. of the board of directors of a corporation are elected by shareholders at a general • Members meeting. board determines the objectives and policies of the firm, and appoints executive managers, • The who are responsible for managing the day-to-day business operations and reporting back to the board.

a limited liability company, the liability of a shareholder is limited to the fully paid issue price • With of the shares. a no liability company, a shareholder holding any partly paid shares cannot be forced to • With make further payment, but may forfeit the shares. of the corporate form of business include access to a large pool of equity funds • Advantages through the stock market, the separation of ownership (shareholders) and control (managers), the continuity of business operations, the ability to conduct large-scale operations and the opportunity for investors to hold a diversified share portfolio.

disadvantage of the corporate form is the agency problem, whereby managers may • Atrypotential to run the business for their own benefit rather than for the shareholders’ benefit. board of directors should establish strong corporate governance practices to ensure • The accountability and transparency.

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LEARNING OBJECTIVE 4.2 Consider the origins and purpose of a stock exchange.

• The origins of stock exchanges date back to 1553 in England. stock exchanges compete within the international markets where there are continuous • Today, flows of information. stock exchange facilitates the listing of corporations and the quotation, buying and selling of • Alisted securities. • An exchange operates a securities trading system and a transaction settlement system. • Stock exchanges, and other regulators, seek to maintain the efficiency and integrity of the market. LEARNING OBJECTIVE 4.3 Understand the primary market role of a stock exchange through which corporations raise new funding. primary market role of a stock exchange relates to the issue of new securities by listed • The corporations or other entities. • The listing of a new company is known as a float or an initial public offering (IPO). • The main form of equity issued by a corporation is the ordinary share (common stock). market issues of ordinary shares raise equity capital for corporations. Equity capital is • Primary typically used to enable a firm to grow. • Shareholders may receive dividends and/or capital gains (or losses). corporations may issue additional equity through rights issues, placements and dividend • Existing reinvestment schemes. • A stock exchange may also list debt instruments, units in public trusts and derivative products. • An issue of equity or debt to the public requires the preparation of a prospectus. • 2 279 companies were listed on the ASX as at May 2018.

LEARNING OBJECTIVE 4.4 Discuss the secondary market role of the stock exchange through which existing securities are bought and sold. secondary market role provides a market structure for the buying and selling of existing • The listed securities. and sell orders are lodged through a stockbroker that has access to the exchange’s trading • Buy and settlement platforms. market transactions do not raise additional equity for the original issuing corporation— • Secondary they are a transfer of ownership for value. liquidity is the ratio of turnover to market capitalisation. A deep and liquid market • Market encourages investors. • Market capitalisation is the number of issued shares multiplied by the share price.

LEARNING OBJECTIVE 4.5 Examine the managed product (exchange traded funds, contracts for difference, real estate investment trusts and infrastructure funds) and derivative product (options, warrants and futures contracts) roles of a stock exchange. exchanges may list a range of managed and derivative products. These standardised • Stock products are known as exchange traded contracts. 156

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portfolio of securities. ETFs are a type of exchange traded product (ETP). ETPs include active ETFs, where a manager deploys strategies to outperform a benchmark, and structured products (SPs), which promise to pay a rate of return based on the movement in the price of an underlying asset.

for difference (CFD) is an agreement to exchange the net difference in value between • Athecontract start date and the close date of a CFD. The CFD is based on a specified security. Only a deposit is paid initially, therefore the CFD is highly leveraged (increased risk).

real estate investment trust (REIT) issues units in the trust in order to raise funds to purchase • Aproperty, including industrial, hotels and leisure, retail and office. Assets generate rental income and (hopefully) capital gains.

funds enable investors to gain access to large-scale infrastructure projects, such • Infrastructure as utilities, transport, materials handling and communications facilities. option contract gives the buyer the right, but not the obligation, to buy (call option) or sell • An (put option) a specified security at a predetermined price and date. The writer of the option receives a premium payment from the option buyer.

equity warrant gives the holder the right to buy (or sell) the underlying security at a specified • An price on or before a nominated date. Stock exchanges list a wide range of warrant contracts. futures contract is an agreement between two parties to buy (or sell) a specified commodity or • Afinancial instrument at a specified date in the future. The value of the futures contract moves as

CHAPTER FOUR REVIEW

traded funds (ETFs) usually invest in a basket of securities listed on the local or • Exchange international exchanges, foreign currencies or commodities. ETFs provide access to a diversified

the price of the underlying asset in the physical market moves. Settlement may be for delivery of the asset or cash.

LEARNING OBJECTIVE 4.6 Explain the interest rate market role of a stock exchange.

• Corporations fund their operations from a combination of equity and debt. issues may be listed on a stock exchange, which  provides investors with transparency, • Debt liquidity and ease of entry and exit. corporate bond is a fixed-interest security that pays a periodic coupon. The principal • Ais straight repaid at maturity. A secured bond is known as a debenture; an unsecured bond as an unsecured note. As the interest rate is fixed, the value of the bond will change as interest rates in the market change.

floating rate note (FRN) is a corporate bond that pays a variable coupon rate, which will be • Abased on a published reference rate. convertible note is a hybrid security that pays a fixed interest rate and includes an option to • Aconvert the note at a future date into ordinary shares. convertible preference share is a hybrid security that pays a fixed dividend. It has • Aanredeemable option at maturity to redeem to cash or convert to ordinary shares at a specified price.

LEARNING OBJECTIVE 4.7 Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for sharemarket transactions by the Australian Securities Exchange (ASX). support the primary market and secondary market roles, an exchange must provide trading • To and settlement platforms. Major exchanges use high-speed, robust technology-based systems. uses ASX Trade, which is an integrated system that allows the stock exchange to trade all • ASX listed securities. ASX Trade24 facilitates global trading in derivative contracts. stockbrokers have access to the ASX platforms. Investors lodge buy and sell orders • Authorised with their stockbroker, generally using the internet. 157

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• The broker will issue a contract note, which provides full details of the transaction. will normally occur in T + 2 business days when transfer of ownership and financial • Settlement settlement will be processed through CHESS. will issue a holding statement on the uncertificated shareholding. The ASX plans to • CHESS replace CHESS in 2021. LEARNING OBJECTIVE 4.8 Recognise the importance of information flows to the efficiency and integrity of stock exchanges. prices move as demand and supply for shares change. Demand and supply change as a • Share result of new information coming to the market. exchange listing rules require continuous disclosure of information that may impact upon • Stock investment decisions and share prices. This is in addition to prescribed reporting requirements, such the lodging of periodic financial statements.

exchange will monitor information flows to ensure the market is fully informed in order • Ato stock maintain the integrity and confidence in the market.

LEARNING OBJECTIVE 4.9 Identify the principal regulators that affect the behaviour of participants in the Australian share market. nation-state is responsible for the regulation and supervision of its own stock exchanges. • Each Usually this role is shared between government-appointed regulatory authorities and the actual exchange itself.

the Australian Securities and Investments Commission (ASIC) has responsibility for • IntheAustralia, supervision of real-time trading in the domestic licensed markets. is responsible for enforcement of laws against misconduct, and the supervision of financial • ASIC services licence holders. maintains an integrated surveillance system. Breaches of rules are enforced by a • ASIC disciplinary panel. also monitors continuous disclosure through its own compliance subsidiary. It may impose • ASX penalties, suspend or delist a corporation and forward a formal report to ASIC for further action. Reserve Bank (RBA) monitors the licensed clearing and settlement platforms and systems in • The order to ensure financial stability and reduce systemic risk in the financial system.

LEARNING OBJECTIVE 4.10 Explain the structure and purpose of the private equity market.

• Private equity is an alternative source of equity funding for a company. equity may be provided for start-up companies, business expansion for existing • Private companies, recovery finance for corporations in financial difficulty or management buy-outs. • Specialist private equity funds obtain the majority of their funds from institutional investors. • Private equity funding is usually regarded as a higher-risk investment. principal objectives of private equity funds may be to improve company performance in • The preparation for an IPO or trade sale, or the break-up of a company so that the component parts may be sold separately.

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Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

The ‘publicly listed corporation’ is viewed as one of the most important innovations in the history of economic and financial development. Outline the advantages and disadvantages of the publicly listed corporation. (LO 4.1)

2

Smiles Inclusive Ltd is one of the newest public companies to list on the Australian Securities Exchange. Identify and discuss the rights, roles and responsibilities of Smiles Inclusive’s shareholders, board of directors and executive management now that it is a publicly listed company. (LO 4.1)

3

(a) Briefly explain the concept of corporate governance within the context of a corporation.



(b) What is the relationship between corporate governance and the so-called agency problem? (LO 4.1)

4

Most developed or developing countries seek to establish modern and efficient stock exchanges.

CHAPTER FOUR REVIEW

Questions

(a) Identify and discuss the five principal functions of a modern and efficient stock exchange.

(b) Why is it important to maintain modern and efficient stock exchanges? (LO 4.2)

5

Discuss why a strong primary market is important for economic growth within a country and explain how each of the main participants in the primary issue of securities interacts with each other during the share issuance process. (LO 4.3)

6

(a)  Discuss the secondary market role of a stock exchange and its importance to the corporation. Illustrate your answer by using examples.



(b) What is meant by the liquidity of the share market? Explain why liquidity in the secondary market is important both to shareholders and to corporations. (LO 4.4)

7

Explain the difference between an ETF and an active ETF. (LO 4.5)

8

With a CFD it is possible to lose many times the initial investment amount. Explain why this circumstance can arise. (LO 4.5)

9

An investor with a small amount ($15 000) to invest wants to gain exposure to the commercial property market in Australia. What sort of investment product is appropriate? (LO 4.5)

10 An investor currently holds shares in Amcor Ltd. The investor is worried about a decline in the price of the shares. What sort of instrument can the investor use to hedge the investment? (LO 4.5) 11 Woodside Petroleum Limited is considering issuing debentures in the capital markets and having the debt debentures quoted on the fixed interest market of the ASX. (a) As the chief financial officer for Woodside you have been invited to explain the issue to a group of investors. Prepare a list and explain the advantages to both Woodside and the potential investor in having the debentures listed.

(b) Briefly describe the main characteristics of a debenture. (LO 4.6)

12 (a) Using the example of the trading and settlement platforms used by the ASX, explain the process whereby one investor places a buy order for 1 000 Rio Tinto Limited shares and another investor places a sell order for 1 000 Rio Tinto Limited shares; both orders at market price. (LO 4.7)

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(b) Within the context of the above Rio Tinto share transaction, define and provide examples of the following:

• uncertificated shares • share contract note • settlement risk • T + 2 business days. (LO 4.7)

13 (a) It may be argued that information is the life-blood of an efficient stock market. Explain this proposition.

(b) Within the context of the ASX, explain the requirements and purpose of continuous reporting.



(c) Identify, using examples, five different pieces of information that are regarded as being material and therefore should be reported to the stock exchange. (LO 4.8)

14 Outline the regulatory structure and the responsibilities of the main supervisors of market integrity and market participants’ behaviour in Australian stock exchanges. (LO 4.9) 15 The private equity market is an alternative source of equity funding for business. Explain how this market typically operates. (LO 4.10)

KEY TERMS active ETFs  143

dividend reinvestment scheme 138

physical market  141

agency problem  135 ASX Trade  148

electronic sub-register  150

preference shares  147

ASX Trade24  148

exchange-traded contracts  142

primary market  138

Australian Securities and Investments Commission (ASIC) 152

exchange traded funds (ETFs) 142

prospectus 139

bid and offer  149

exchange traded products (ETPs) 142

put option  144

board of directors  134

exercise price  145

call option  144

floating rate note (FRN)  147

CHESS 149

hedge 142

right of perpetual succession 135

CHESS sponsor  150

infrastructure fund  144

rights issue  138

continuous disclosure  151

interest rate market  146

settlement risk  150

contract for difference (CFD) 143

limited liability company  134

share market  135

liquidator 151

share options  136

contract note  149

listing rules  151

straight corporate bond  147

convertible note  147

market capitalisation  141

structured products (SPs)  143

corporate governance  136

market liquidity  141

T + 2  150

corporation 134

uncertificated securities  149

coupon 147

new float or initial public offering (IPO)  138

delisting 152

no liability company  134

derivative 141

objectives and policies  134

directors’ interests  151

over-the-counter contracts  142

placement 138

publicly listed corporation  134 real estate investment trust (REIT) 144

warrant 145 warrant issuer  145 World Federation of Exchanges 138

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CHAPTER 5

Corporations issuing equity in the share market CHAPTER OUTLINE 5.1 The investment decision: capital budgeting 5.2 The financing decision: equity, debt and risk 5.3 Initial public offering 5.4 Listing a business on a stock exchange 5.5 Equity-funding alternatives for listed companies

Learning objectives LO 5.1

Understand issues related to the capital budgeting investment decision.

LO 5.2

Identify issues relevant to a corporation’s funding choice between debt and equity.

LO 5.3

Examine the listing and flotation or initial public offering (IPO) of a business on a stock exchange, including equity-funding alternatives that are available to a newly listed corporation.

LO 5.4

Consider important issues associated with listing a business on a stock exchange.

LO 5.5

Explore equity-funding alternatives that are available to an established listed corporation, including rights issues, share purchase plans, placements, takeover issues, dividend reinvestment schemes, preference shares, convertible notes and other quasi-equity securities.

Extended learning LO 5.6

Explain the listing requirements of the Australian Securities Exchange.

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CHAPTER SNAPSHOT Besides the trading opportunities that the equity markets present to investors and institutions, the equity markets represent a deep pool of potential capital to be sourced by corporations seeking to raise funds to manage and expand their existing operations. A company that has reached a certain stage of development may seek to access this pool of capital by listing on the ASX and becoming a publicly traded company. To do so, the company’s owners decide to undertake an initial public offering (IPO). With the help of advisers (investment banks), working on a fee-for-service basis, the company’s owners hope to sell part of their stake in the company at the highest possible price.

INTRODUCTION The objective of financial management of a corporation is the maximisation of shareholder value. A firm will typically seek to achieve a wide range of other objectives as well, but each of these objectives should ultimately add value to the corporation and therefore to its shareholders. Other objectives may include minimising the average cost of funding, maximising profit margins, maintaining earnings growth, ensuring a competitive position within the market, ensuring the firm meets its social obligations and managing the operations of the firm to ensure business continuity. Fundamentally, a corporation will create shareholder value by finding projects that return more than what they cost on a present value basis. A project could be a marketing campaign, a takeover of another company, a new product idea or positioning the company in a new geographical market. The decision to allocate capital to any of these projects is called the capital budgeting decision. For example, the decision by Apple Corporation to build and market the iPod was a capital budgeting decision. The iPod was a very successful project. It certainly returned much more than what it cost and created value for Apple’s shareholders. The focus of Part 2 of the text is on equity funding, but it must be understood that a corporation will finance its activities from a combination of equity funds and debt funds. Section 5.2.1 provides a discussion of the importance of the ratio of debt-to-equity financing. Later chapters will look specifically at the different types of short-term and longer-term debt financing available to a corporation. The study of corporate finance traditionally distinguishes four aspects of financial management. These are described as:

• the investment decision or capital budgeting process • the financing decision or capital structure process • liquidity or working-capital management • the dividend policy decision. The investment decision relates to the objectives of the corporation and is affected by the type of business activity the firm intends to conduct. In other words, what assets does the corporation need to obtain, or invest in, so that it can achieve its business objectives? Once the corporation has determined what assets it needs to acquire, it then needs to decide how it is going to raise the funds to finance the acquisition—the financing decision. This chapter considers how a firm wishing to become a publicly listed corporation will raise equity funds through an initial public offering (IPO), and then how an existing listed corporation is able to raise additional equity funds to support its ongoing business growth. Having acquired its assets, the firm needs to manage its day-to-day operations, and therefore its working capital. The corporation needs access to short-term funding to finance the purchase of inventory, to meet expenses and to pay creditors as they fall due. Finally, once the corporation begins to conduct its business activities, it is assumed that it makes a profit. Financial management therefore needs to consider issues related to the distribution of profits. 162

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What proportion of the profits should be returned to the owners of the business (the shareholders)? What proportion should be retained to provide further equity funds to support the future growth of the business? This is referred to as the dividend policy decision. This chapter extends the discussion on the first two aspects of corporate finance: (1) the investment decision and (2) the financing decision.

REFLECTION POINTS

principal objective of the financial management of a corporation is the maximisation of • Ashareholder value, but within the context of the firm’s objectives and policies. management includes the investment decision (capital budgeting), the financing • Financial decision (capital structure), liquidity or working-capital management and the dividend policy decision.

5.1

The investment decision: capital budgeting

Capital budgeting refers to the choices that a company makes when allocating or budgeting its capital. For example, capital may be allocated to an expansion of existing operations into new markets (such as overseas), the opening of new stores, the engagement of an advertising firm to launch a new marketing campaign for the firm’s products, the purchase of a new piece of machinery, the design and development of a new factory assembly line or the development of a new product. The range of possibilities for the decision maker is potentially unlimited. It may be desirable to expand the existing business in the same core areas in which it is currently operating, or it may be advantageous to diversify the scope of its business operations. Also, it may be appropriate for the business to invest funds in financial assets, rather than in real assets such as property, plant or equipment. This decision is referred to as the investment decision (or capital budgeting); that is, the process whereby a corporation manages its long-term investments. The investment decision is not simply a function of a corporation deciding what it wants to do. The basic principle—to maximise shareholder value—must be remembered. Therefore, the firm must be certain that its decisions will in fact add to shareholder value. At times, a corporation will have a number of choices as to which projects it might decide to carry out. Again, it needs to measure the relative financial and operational advantages of each choice and place each choice within the strategic context of the overall operations of the organisation. A corporation needs to be able to quantify its alternative investment opportunities in order to determine which proposal should proceed, and which should be deferred or rejected. Two important quantitative measures that assist management in making those decisions are:

LEARNING OBJECTIVE 5.1 Understand issues related to the capital budgeting investment decision.

Capital budgeting the choices that a company makes when allocating its capital

Investment decision the capital budgeting process that determines the strategic activities of a firm

• net present value • internal rate of return. 5.1.1

Net present value

The net present value (NPV) of an investment is the difference between its costs and its returns over time. What is meant by the present value? Money has a time value. Money today is worth more than the same amount received in the future. This is due to risk and uncertainty, the presence of inflation— which erodes purchasing power over time—and the fact that people are generally impatient. If you are promised a payment of $1 100 and the payment will be made one year from today, the present value of that payment is determined by discounting it. The magnitude of the discount rate reflects the market’s

Net present value (NPV) the difference between the cost of an asset and the present value of future cash flows

Present value the current value derived by discounting a future cash flow by a required rate of return

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assessment of uncertainty, risk, inflation and people’s desire to save or consume. If the discount rate is 10.00 per cent per annum, we find the present value of the $1 100 to be received one year from today by dividing it by one plus the discount rate or 1.10. The present value is $1 000. This can be written more formally as: Present value = S​    (1 + k)​​ −n​ ​ ​ ​​​     ​     ​ −1​ =​ ​  $1 100​    ( ​​ 1.10)​​  ​   = $1 000

5.1

where: S = the future amount k = the current discount rate expressed as a decimal n = the number of interest periods The present value is defined as the current value of future cash flows that have been discounted by a required rate of return. The NPV of an investment opportunity is therefore the net difference between the present value of cash flows associated with an investment and the cost of the investment. These calculations can best be understood by applying them to an investment. For example, a business is considering the purchase of a new processing machine that will coat macadamia nuts with chocolate. The machine will cost $40 000 to purchase and install, and has an expected life of three years. The company forecasts annual incremental costs of $15 000 per year and average annual cash sales of $35 000. The machine will have a salvage value of $10 000 at the end of the three years. The required rate of return for the company is 18.00 per cent per annum. The required rate of return is used interchangeably with the term ‘discount rate’. In practice, the firm will usually use the weighted average cost of capital (WACC) as the discount rate. The present value of the investment’s cash flows must be calculated. However, there are two sets of cash flows, each with different characteristics. There are the single cash flows resulting from the purchase of the machine (–$40 000) and the sale of the machine in three years’ time (+$10 000). There is also a series of equal cash flows that occur annually over the three-year period. These cash flows are the net of the cash sales ($35 000 less expenses of $15 000, equalling $20 000 per annum). Two formulae are needed to calculate the present values of the future cash flows: 1 the present value of the net annual cash flows can be worked out using the present value of annuity formula if all of the cash flows, C, are the same: Present value = C​​    [​​ ​ _     ​​  ]​​​ k 1 − ​ ( 1.18 )​​  ​ ​ ​​​ ​  =         ​  20 000​​  ​​ ​ −3​  ​​​​ _    [​​ ​  0.18 ​​]  ​   = $43 485.46 1 − ​(1 + k )​​ −n​

5.1a

2 the present value of the salvage value: Present value = S​    (1 + k)​​ −n​ ​ ​ ​​​     ​      ​​ ​ −3​ =​ ​  $10 000​    (1.18)​​  ​   = $6 086.31

5.1b

Add the two present values (above) together and the present values of the cash flows is $49 571.77. To determine the net present value of the project, the cost of the machine (–$40 000) must be deducted.    ​ Net present value ​​      ​  =​ − $40 000 + $49 571.77  ​​​ ​   = $9 571.77 NPV decision rule accept an investment opportunity that has a positive NPV

5.1c

The above investment produces a positive NPV based on the projected cash flows and the corporation’s required rate of return. The NPV decision rule that should be adopted is that a company should accept an investment proposal that has a positive NPV and reject any proposal with a negative NPV. (The discussion of the present value of a cash flow or a series of cash flows is extended in Chapter 8.) Calculating the NPV to determine whether an investment will add to shareholder value seems relatively simple. However, NPV is based only on the corporate finance team’s best forecasts or projections. The projected cash flows over the term of the project are estimates. The environment in which a business

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operates is dynamic; things change, including cash flows. This obviously will have an impact on the original NPV calculation. Management must challenge the cash-flow estimates and determine the level of confidence it has in them. Also, the discount rate used, or the required rate of return, will influence the NPV. Again, management must be able to support the discount rate applied to NPV calculations.

5.1.2

I NTERNAL RATE OF RETURN

Another method regularly used by corporations to determine whether a business investment proposition is acceptable is known as the internal rate of return (IRR). The IRR is often regarded as being easier to understand in that it provides an actual percentage figure as the rate of return. NPV, on the other hand, provides a positive or negative dollar amount. The IRR on a business investment is defined as the discount rate that results in an NPV of zero when it is used to discount an investment’s forecast cash flows. The basic rule is that an investment is acceptable to a corporation if its IRR is greater than the firm’s required rate of return (discount rate or weighted average cost of capital). If the IRR is less, it should be rejected. The IRR and the NPV are obviously related. If the IRR is greater than the required rate of return, the NPV will be positive and vice versa. Manually calculating the IRR on a business investment (without the use of an electronic calculator) is difficult, and usually requires a series of trial-and-error calculations. However, a basic financial calculator will calculate the IRR with a few keystrokes. The following example presumes access to a financial calculator. While the keystrokes for different brands of calculators may vary, the data inputs will be the same. The data required are the net cash flows per period and the number of periods per year. Continuing with the hypothetical chocolate-coating machine in the previous NPV example, and using a Hewlett-Packard Business calculator, input the following: payments per year = 1 net cash flows: period 0 = − $40 000 period 1​ =​ $20 000​ ​​      ​ ​  ​ ​  ​      ​ ​ ​ period 2 = $20 000 period 3 = $30 000 (i.e. $20 000 revenue + $10 000 salvage )

Internal rate of return (IRR) the discount rate that results in an NPV of zero

5.1d

Keystrokes: P  ​  1 ​ [secondfunction]  ​ ___ YR

− 40 000 ​ CFj 20 000 ​ CFj ​  ​  ​      ​    ​​ ​​ 20 000 ​ CFj      ​​​ 30 000 ​ CFj IRR ​  ​ ​ [second function]  ​ ___ YR ​ Answer:​  IRR = $31.45%​  

5.1e

Referring back to the calculation of NPV, the inclusion of the following two additional keystrokes on the calculator will obtain the NPV: ​​ 

I   ​  18 ___ ​ YR ​ ​ ​ [second function]  NPV ​         ​  ​ ​​​​

Answer: NPV = $9 571.77

5.1f

​

If the corporation’s required rate of return is less than 31.45 per cent per annum, the business investment opportunity is acceptable. The above IRR calculation is reasonably easy to achieve and interpret, providing the corporation is confident in its cash-flow forecasts. However, the simplified procedure suffers from two shortcomings, the solutions for which are beyond the scope of this text. 165

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Part 2 Equity markets Non-conventional cash flows occur when the ongoing cash flows from an investment are not always positive

Mutually exclusive projects from a choice of two or more projects, only one project will be chosen

The first problem occurs when the cash flows associated with an investment are non-conventional cash flows. In the example above, there was an initial negative cash flow followed by a series of positive net cash flows. To be precise, the ‘sign’ of the cash flows changed only once, from the negative initial cash flow to the series of positive cash flows. If there are multiple changes in sign, there will not be a unique IRR for the project. If there was a negative cash flow in the final period of the project because the company needed to clean up the site of its operations, for example, there would be two changes in sign (negative to positive to negative) and no unique IRR. In this situation the financial calculator will usually give an error message. The second problem occurs when investment choices are mutually exclusive projects. This is a situation where a business will choose one of two investment alternatives. The IRR may give a misleading decision rule in that it does not account for the present value of the cash flows. The timing and size of the cash flows associated with an investment are important when choosing between investment alternatives. In this situation it is better to revert to the calculation of NPV.

REFLECTION POINTS

investment decision derives from the firm’s objectives and relates to the acquisition of • The assets necessary to conduct business operations. firm will acquire assets that make a positive contribution to shareholder value. Two methods • Aused to measure this contribution are the net present value and the internal rate of return. net present value (NPV) of an investment is the difference between the present value of an • The investment’s costs and its returns over time. The present value discounts future cash flows by the required rate of return. A firm should accept an investment opportunity that has a positive NPV and reject those with a negative NPV. internal rate of return (IRR) on an investment is the required return that results in an NPV • The of zero when it is used as the firm’s discount rate. An investment may be accepted if the IRR is greater than the required rate of return. problems may be evident with IRR calculations; the first is when non-conventional cash • Two flows occur, and the second is when investment choices are mutually exclusive.

5.2 LEARNING OBJECTIVE 5.2 Identify issues relevant to a corporation’s funding choice between debt and equity.

Financing decision the capital structure that finances a firm’s assets and activities

Business risk exposures to factors that have an impact on a firm’s activities and operations

The financing decision: equity, debt and risk

The second financial management decision, referred to as the funding decision or financing decision, relates to the question of how a business investment is to be funded. In traditional terms, the decision makers have the choice of financing the investment through the use of debt or through the use of equity. In reality, a combination of both forms of finance will be used. The principal financial objective of the corporation is to maximise shareholder value over the longer term, subject to an acceptable level of risk. Risk can be defined as the variability or uncertainty of returns from the business’s investments. Since returns are generated from the net cash flows of the business, risk is measured by the variance in net cash flows. What are the sources of risk? Risk is often presented as deriving from two distinct sources: business risk and financial risk. Business risk is determined in part by the corporation’s choice of business activity, and the manner in which it conducts its business operations. A speculative mining company, while offering the chance of high returns, is generally exposed to high levels of operational risk, whereas a company with diversified business operations is typically exposed to a lower degree of risk, but offers lower expected returns. A company that is reliant upon technology-based product delivery systems is vulnerable to a failure of those systems. A business that currently enjoys a large proportion of market share for its product is exposed to the threat of new competitors entering the market and chipping away at that market share.

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Business risk is also affected by factors such as the rate of growth of that sector of the economy in which the firm is operating, the firm’s share of the market, the aggressiveness of the competition it faces and, most importantly, the competence of the firm’s management and workforce. The combination of these factors will determine the magnitude of the profits generated by the firm’s assets and the variability of the expected profit stream. Financial risk is important as it has a direct impact on the value of assets and liabilities on the balance sheet as well as affecting the level of cash flows passing through the business. There are many broad categories of financial risk.

• Interest rate risk is evident where interest rates may potentially move in a direction that adversely

Financial risk exposure to factors that affect the value of assets, liabilities and associated cash flows

affects the cost of funds or the return on investments. For example, a rise in interest rates will adversely affect the cost of variable-rate debt issued by corporations.

• Foreign exchange risk is evident when a firm has balance-sheet assets and liabilities, and associated cash flows, denominated in a foreign currency. Movements in the exchange rate will affect the value of these items. For example, a company that imports goods from overseas, where payment is to be made in USD, will be adversely affected by a depreciation in the exchange rate; that is, it will be more expensive to purchase the USD required to pay for the imported items.

• Liquidity risk is about having sufficient cash, liquid assets or access to funding sources to meet

forecast day-to-day operating requirements. For example, a company needs to be able to pay creditors when due, purchase inventory, pay staff and meet other operating expenses. A bank overdraft may be used for this purpose (see Chapter 9).

• Credit risk is a situation in which debtors do not repay their obligations on time or default in repayment. For example, a company might have provided goods to a client with payment due in 30 days, but the company is unable to collect the amount due because the client has gone into liquidation.

• Capital risk occurs when shareholders’ funds are insufficient to meet capital growth needs or, in

an adverse situation, to write off abnormal losses. For example, a corporation might be aware of a new business opportunity, but is unable to fund the purchase without breaching debt-to-equity loan covenants on an existing loan from its bank.

• Country risk is the risk of financial loss associated with a fixed exchange-rate currency devaluation,

currency inconvertibility, rescheduling of external debt, barriers to funds transfers, political developments in a nation-state resulting in expropriation of a company’s assets, legal restrictions, freezing of company assets or forced divestment of assets.

5.2.1

F INANCIAL RISK AND THE DEBT-TO-EQUITY RATIO

Financial risks attach to both debt and equity issued by a business; however, all else being equal, the greater the proportion of debt relative to equity, the greater the risk to the business and its shareholders. This conclusion flows from the obligation that attaches to debt. A fundamental characteristic of debt is that interest payments and principal repayments on debt must be paid when they fall due. On the other hand, shareholders only receive a dividend payment if the directors approve such a payment. Also, in the event of the failure of the business, the providers of debt funding rank ahead of equity holders in their claim on the assets of the corporation. To dispel any idea that the raising of debt finance is necessarily against the interests of the shareholders, however, it is important to recognise that increasing the degree of leverage, or debt, of the business may significantly improve the shareholders’ earnings attributable to ordinary shares, or expected earnings per share (EPS). This can be understood by considering a situation in which the business can borrow funds at 9.00 per cent per annum and in which it expects to be able to earn a net return of 15.00 per cent on its assets. Under those circumstances, shareholders benefit from the net 6.00 per cent positive return.

Earnings attributable to ordinary shares the net accounting earnings on a company’s shares expressed in cents per share

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However, if the debt-financed expansion resulted in a return of less than 9.00 per cent on assets, shareholders would suffer. In determining the appropriate mix of debt and equity, the corporate finance manager faces a dilemma. The higher the proportion of debt, the higher will be the potential return on shareholders’ funds, or EPS. However, increased debt exposes the shareholders to a greater variance in their EPS, and the firm is exposed to a greater risk of insolvency because income or revenue may fail to reach the expected levels; nevertheless, debt interest and principal payments must be paid when due. One reason for a sudden fall in expected revenue may be a downturn in economic activity, as was experienced during the global financial crisis. The higher the debt-to-equity ratio, the higher the degree of financial risk. One of the implications of an increase in financial risk is that rational equity holders would demand a higher expected rate of return to compensate them for incurring the higher financial risk.

5.2.2 Debt-to-equity ratio the proportion of a firm’s debt funds relative to its equity funds

Gearing ratio the percentage of a firm’s total funding provided by debt

Loan covenants conditions or restrictions placed on a borrower and specified in a loan contract

W HAT IS THE APPROPRIATE DEBT-TO-EQUITY RATIO?

Although there is a wealth of literature on financial management, there is no agreed ideal debt-to-equity ratio. The ratio appears to be decided, in practice, by reference to four main criteria.

• First, a firm may consider the ratio that is the norm in the industry in which the firm operates, and

adopt something near that ratio. Significant deviations from the industry norm may cause concern for the potential providers of both debt and equity funds.

• The second criterion for determining future gearing ratio is the history of the ratio for the firm.

The ratio employed in the past may be regarded as the norm, and management may be reluctant to change it greatly. If the business has been performing with a return on assets that is acceptable to shareholders, it may be deemed appropriate to continue with a similar gearing ratio. Any significant change in the ratio may result in the disaffection of the current shareholders.

• The third criterion, and a more appropriate one than the first two, is the limit imposed by lenders.

It is quite common for lenders to impose various loan covenants on the borrowings of a company. Loan covenants are conditions or restrictions incorporated into loan contracts that are designed to protect the interests of the lender. (This is discussed further in Chapter 10.) A common covenant is a limit on the ratio of debt liabilities to total assets. If a company exceeds a loan covenant limit, this will constitute a violation of the loan agreement with the lender. The lender may then require the loan to be repaid in full immediately.

• The fourth criterion in determining the debt-to-equity ratio, and perhaps the most relevant, is

management’s decision concerning the firm’s capacity to service debt. The assessment is made by determining the charges, the interest payments and the principal repayments associated with a given level of debt, and assessing the capacity of the firm’s expected future income flows to cover the payments while leaving sufficient profits to satisfy shareholders’ expectations for a return on their equity.

The critical issue in the fourth criterion is evaluation of the firm’s expected income flows. Since this clearly cannot be known with certainty, management should consider various scenarios, including the most likely and the most pessimistic income-flow expectations. If the pessimistic assessment shows that a given level of debt can be serviced while allowing shareholders’ expectations to be met, management may accept that level of debt as being satisfactory. Where the cost of debt is exposed to a variable interest rate, a similar range of scenarios must be used to test the capacity to service a given amount of debt under different interest rate scenarios. The most prudent debt-to-equity ratio is the largest ratio at which a corporation still has the capacity to service debt commitments under a pessimistic business scenario. Notwithstanding the above discussion, debt-to-equity ratios tend to vary quite considerably between industry sectors and between individual corporations. For example, in 2018, while the average debt-to-equity ratio in Australia was less than 1.00, ANZ Ltd’s debt-to-equity ratio was 12.78 and NAB’s 168

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was 13.60. This is typical of commercial banks. The nature of their business—that is, the borrowing of funds in order to provide loans to customers—inevitably means that they will have a great dependence on debt liabilities as a source of funds. However, corporations in many other industry sectors, such as the retail sector, maintain much lower debt-to-equity ratios. For example, in 2018, Woolworth’s debt-to-equity ratio was 0.30. This provides management with the flexibility to make further strategic investments in the future, and also to withstand the adverse impact of an economic downturn on future cash flows. Once a company decides on its appropriate debt-to-equity ratio, it faces the task of securing the desired equity funding. Section 5.3 examines the situation of a newly listed company raising equity through an IPO, Section 5.4 identifies the requirements that must be met by a business seeking to list on a stock exchange and Section 5.5 considers the funding avenues available to a corporation that has already listed on a stock exchange.

REFLECTION POINTS

financing decision analyses and determines the combination of funding sources used to • The finance the business. being the variability or uncertainty of returns from business investments, affects the • Risk, financing decision. exposures include business risks, such as competition and the economic cycle, and • Risk financial risks, such as interest rate risk and foreign exchange risk.

• The basic characteristic of debt is that it must be repaid; equity does not have to be repaid. firm must monitor its debt-to-equity ratio to ensure that it is able to service its debt • Acommitments over time. Too much debt will increase the risk profile of the company and therefore the cost of funds; too low a level of debt may not maximise shareholder value. ratios will vary between companies, between industry sectors and over time, • Gearing depending on the economic cycle.

5.3

Initial public offering

Our focus is on the publicly listed corporation. However, it should be noted that businesses often evolve from small beginnings: from a sole proprietorship to a private company and eventually to a size where listing on a stock exchange is a possibility. A sole proprietor is both the owner of the business and the manager of the business; the proprietor is personally liable for the liabilities of the business, but is also entitled to all the profits generated. As a business grows, a sole proprietor may seek additional equity funds and therefore form a small private company with a limited number of shareholders. Should the company grow to a point where it wishes to expand its equity and shareholder base further, then becoming a publicly listed corporation is an attractive proposition. Listing on a stock exchange provides access to a large equity capital market that is not available to an unlisted business entity. Access to this market enables a listed corporation to extend the funding base on which it can expand and grow its business activities into the future. Also, as discussed in Chapter 4, shares issued by listed companies are very liquid; that is, they can easily be sold or purchased through a stock exchange, and therefore are an attractive investment option for investors. Another advantage of listing for a corporation is that it raises its profile in the financial markets and in the markets for its products and services. The choice concerning the type of equity available to a business that is listing for the first time is relatively limited. Such a business does not have a history of share price performance, and is thus

LEARNING OBJECTIVE 5.3 Examine the listing and flotation or initial public offering (IPO) of a business on a stock exchange, including equity-funding alternatives that are available to a newly listed corporation.

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Initial public offering (IPO) an offer to investors of ordinary shares in a newly listed company on a stock exchange

Flotation of a business the public listing and quotation of a corporation on a stock exchange

Promoter the party (company) seeking to list as a corporation on a stock exchange

Underwriting a contractual undertaking to purchase securities that are not subscribed to by investors

initially precluded from the alternatives that are available to a successful listed company. The only choice facing most businesses is the form of incorporation; that is, should the business incorporate as a limited liability company or as a no liability company? These structures are discussed in the next subsection. Once the form of incorporation is determined, the sale of ordinary shares is the most usual option available to the business. As discussed below, another option is the issuing of instalment receipts. The initial offering of shares by a new publicly listed corporation is known as an initial public offering (IPO). An IPO is described as the flotation of a business. The method, terms, conditions and timing of an IPO are usually decided after consultation between the business seeking the flotation, known as the promoter, and its financial advisers. The advisers may include a stockbroker, an investment bank and other specialist advisers with the required financial, technical and legal expertise and industry knowledge. The promoter will inform the advisers about the company’s funding requirements, its expectations concerning future profitability and developments, and its expectations relating to the pricing of the shares. Based on the advisers’ experience and knowledge of similar types of companies in the market, and of investors’ current attitudes towards the industry, the advisers will recommend the appropriate timing and structure of the IPO. It is essential for advisers to be competent in legal aspects of an incorporation and listing of a company, and to have sound knowledge of the relevant markets, competitors and investors. The advisers also assist with the preparation of the prospectus (the public offer document) and its lodgement with the corporate regulator. They also ensure that the listing requirements of the stock exchange are met. The preparation of the prospectus is a critical component of the listing process. A prospectus provides detailed information on the past and forecast performances of the organisation, and includes reports from the board of directors and specialist experts and financial statements. All information contained in the prospectus must be verified for accuracy through a process of due diligence, as there are severe penalties for making false or misleading statements or for omitting relevant information. An application form used to subscribe for ordinary shares in the IPO is attached to the prospectus. The IPO advisers usually take an active role in promoting the issue to potential individual and institutional investors. To assist in the selling task, and to guarantee the promoter that all shares offered for sale will be taken up, the advisers may arrange an underwriting group. The advisers normally also take a significant underwriting position. There is no specific requirement that an issue be supported by an underwriter. If an underwriter is appointed, it may be a single underwriter or a syndicate of underwriters. The underwriters (usually one or more investment banks), in consultation with the advisers, will provide advice on:

• the structure of the issue • the debt-to-equity ratio • the pricing of the issue • the timing of the issue • the marketing of the issue • the allocation of securities.

Out-clause specific conditions that preclude an underwriting agreement from being fully enforced

It is possible that the time elapsed between the initial agreement between the promoter and advisers on the price and timing of the issue and the actual float may be such that market conditions have significantly changed, particularly in periods of instability in the share market. If market prices have fallen and the new issue is unattractive under the current circumstances, the underwriters may be left to take a large proportion of the shares on issue. Normally, the underwriters protect themselves against being caught in a situation where there are changes in circumstances that could not have been foreseen at the time of the initial agreement by including an out-clause in the underwriting agreement. The out-clause may relate to the level of a specified share price index, such as the S&P/ASX 200. If the index falls below a nominated level, or by a certain percentage, then the underwriters may be released from their underwriting obligation. It is usual in such circumstances for either the float to be withdrawn or the issue to be re-priced. The costs directly associated with an IPO include fees charged by the advisers for the structuring, valuation and preparation of documentation for the flotation, including legal, financial, technical,

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taxation and specialist expert reports (e.g. geologists’ reports). Other fees will be incurred for accounting advice, printing and distribution and the stock exchange listing. The costs on large issues may be up to 10.00 per cent of the amount raised, while for small issues the costs may be even higher. The underwriting fee usually includes about 1.00 per cent payable as brokerage on allotted shares.

5.3.1

O RDINARY SHARES: LIMITED LIABILITY COMPANIES

Two common types of corporate structures are:

• a limited liability company • a no liability company. Ordinary shares in a limited liability company are the principal source of equity funding for most listed corporations. Ordinary shares or common stock represent a residual ownership claim on the assets of the firm; that is, they provide a return to the shareholders only after the firm has met its obligations to all other providers of funds, and after all operating expenses have been paid. As contributors of risk capital, shareholders are owners of the business and are entitled to have control over its management. This does not mean that shareholders have a say in the day-to-day management of a firm; rather, control is derived from the voting right attached to each share. The voting right entitles the shareholder to vote for the board of directors and any other motions that the directors may put to the shareholders from time to time. Voting rights are exercised by shareholders at the annual general meeting and any extraordinary general meetings that may be called. The shareholder may vote in person or by proxy. A proxy is someone who is authorised to vote on a shareholder’s behalf at a general meeting of shareholders. For example, shareholders may give their proxy to the chair of the meeting, thus authorising the chair to vote on their behalf. Limited liability shares are usually sold on a fully paid basis; that is, on the initial issue of the share, the shareholder pays the total issue price to the corporation. However, the shares may also be issued on a partly paid or contributing basis, with the remainder to be paid on a specified date. Another form of issue is the instalment receipt. An instalment receipt is issued instead of a partly paid share; upon payment of a specified amount at a future date, the fully paid share is issued as a replacement for the instalment receipt. A holder of instalment receipts generally retains the same rights as a shareholder. In the case of contributing shares, also known as partly paid shares, and instalment receipts in a limited liability company, the shareholder has a contractual obligation to pay the remaining amount when it is called or due. Importantly, with ordinary shares issued by a limited liability company, the shareholder’s liability is limited to the extent of the fully paid share. Therefore, if the share has been fully paid, the shareholder cannot be required to make any further payment to the company, its creditors or a liquidator. The share issue price will be determined by reference to a range of variable factors. Important factors include the expected future earnings of the company, and the price to earnings (P/E) ratios of similar existing firms. Other related factors include the trend in economic activity, both domestic and international, the forecast levels of interest rates, the exchange rate, the performance of the particular industry, the firm’s products and services, and management expertise and performance.

5.3.2

Proxy a party authorised to vote on behalf of a shareholder at a general meeting

Instalment receipt issued upon payment of the first instalment on a new share issue; ordinary share issued when final instalment paid

O RDINARY SHARES: NO LIABILITY COMPANIES

In a diverse economy, a proportion of new business ventures will always be regarded as being highly speculative. This is particularly the case in the resources sector, where a great deal of uncertainty exists with new exploration ventures, such as the search for oil, gas and minerals. With many of these projects, considerable financial investment is required progressively over time before the venture begins to reach a point when positive cash flows are generated. 171

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Such ventures need access to equity funding, but potential shareholders may be deterred by the likelihood that there will be a high level of risk for an extended period. One solution to this problem is the formation of a no liability corporation. A no liability company will issue ordinary shares to raise equity funds, but the shares will be issued on a partly paid basis. In Australia, only mining companies are able to list on the ASX as a no liability company. For example, a gold-mining company has acquired the rights to explore in a certain location. To do this, the company will need finance and may issue ordinary shares at $2.00 per share, but with an initial call (or payment) of 15 cents per share. This will provide the company with enough equity funds to carry out the initial exploration process. If gold is discovered, the company will inform shareholders of the forecast quantities of gold reserves and the commercial viability of mining the gold. To move to the production phase of the business, the company may make a further call on the partly paid shares of 50 cents. At this point, with a no liability company, each shareholder can pay the 50 cent call or decide not to pay the call. The decision will be based on the shareholder’s view of the prospect of the venture succeeding. Shareholders in a no liability company cannot be compelled to meet a call on the shares, but those who do not meet the call forfeit their shareholding. In order to attract risk capital, a no liability company may also offer shareholders an option to purchase additional shares in the company at a predetermined price at a predetermined future date. An option gives the holder the right, but not the obligation, to buy a share at the nominated exercise price by a specified future date. If the company’s exploration proves to be successful, the option will increase in value (price) because the price of the company’s ordinary shares on the stock exchange should be trading above the option exercise price. The holder of the option can exercise the option and buy additional shares at the price specified in the option contract. If at the option expiry date the shares are trading below the option exercise price, the option would be allowed to lapse.

REFLECTION POINTS

• The listing of shares of a new company on a stock exchange is called an initial public offering (IPO). promoters of an IPO, in conjunction with their financial advisers, need to consider matters • The such as the structure, pricing, timing, marketing and allocation of the share issue. prospectus, the public offer document, is compiled and will include all information required to • Aallow investors to make an informed investment decision. of underwriters (investment banks) may be used to promote the issue and, subject • Atosyndicate the terms of the underwriting agreement, purchase any shares not taken up by investors. liability of shareholders in a limited liability company is limited to the value of their fully paid • The ordinary shares. in a no liability company cannot be required to pay calls on any unpaid amount • Shareholders on their partly paid shares, but they may forfeit those shares if a call is not paid.

5.4 LEARNING OBJECTIVE 5.4 Consider important issues associated with listing a business on a stock exchange.

Listing a business on a stock exchange

A company must apply to a stock exchange to have its shares quoted if it wishes to become a publicly listed corporation and raise equity capital through an offer of shares to the public. A company will normally apply to a stock exchange in its home country. The application must be accompanied by documentation outlining the company’s activities and performance. This information will be provided directly to the exchange and will be contained in a prospectus that supports the share offer to the public.

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The stock exchange will ensure that the company complies with the stock exchange listing requirements. A stock exchange’s listing rules are additional to a company’s statutory obligations under the corporations legislation of the nation-state in which the stock exchange is located. The stock exchange’s listing rules represent a very strong element in the regulation of listed companies. If a listed corporation does not comply with the listing rules of the stock exchange, the offending company is liable to be suspended from quotation or it may be delisted. The listing rules of a stock exchange are the rules that must be met by an entity seeking to be quoted on that stock exchange, and the rules with which a listed corporation must continue to comply if it is to remain a listed corporation on the exchange. A stock exchange will establish listing rule principles that embrace the interests of listed entities, the maintenance of investor protection and the need to maintain the reputation and integrity of the market. The main principles that form the basis of a stock exchange’s listing rules are:

Delisted removal from quotation of the securities of an entity that breaches stock exchange listing rules

• Minimum standards of quality, size, operations and disclosure must be satisfied. • Sufficient investor interest must be demonstrated to warrant an entity’s participation in the market. • Securities must be issued in circumstances that are fair to new and existing security holders. • Securities must have rights and obligations attached to them that are fair to new and existing security holders. • Timely disclosure must be made of information which may affect security values or influence investment decisions, and information in which security holders, investors and the ASX have a legitimate interest. • Information must be produced according to the highest standards and, where appropriate, enable ready comparison with similar entities. • The highest standards of integrity, accountability and responsibility of entities and their officers must be maintained. • Practices must be adopted and pursued that protect the interests of security holders, including ownership interests and the right to vote. • Security holders must be consulted on matters of significance. • Market transactions must be commercially certain. For those who wish to consider the listing rules of a stock exchange further, it is possible to view the rules of an exchange on the exchange’s website. The extended learning section at the end of the chapter provides an introduction to the listing rules of the ASX. While the majority of corporations list their shares solely on their domestic stock exchange, some large multinational corporations choose to list on more than one exchange. The shares of the corporation are said to have a dual listing. A company may seek dual listing to gain access to a much wider capital market for the issue of new primary market securities, and ensure greater liquidity in the secondary market trading of its existing shares. Dual listing is normally achieved by the creation of two holding companies, each entitled to 50.00 per cent of the group’s assets. Shareholders in both holding companies have equivalent economic and voting rights. For example, BHP Billiton is listed on the ASX and the London Stock Exchange (LSE) through two holding companies—BHP Billiton Limited (ASX) and BHP Billiton Plc (LSE).

Dual listing the shares of a multinational corporation are listed on more than one stock exchange

REFLECTION POINTS

• A company will usually apply to its home stock exchange for the listing and quotation of its shares. must comply with the listing rules of the stock exchange; failure to do so may result • Companies in the quotation of shares being suspended or the company being delisted. corporation may choose to become a dual-listed company by listing its shares • Aonmultinational more than one stock exchange in order to access the wider international capital markets and increase liquidity in the trading of its securities.

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5.5 LEARNING OBJECTIVE 5.5 Explore equityfunding alternatives that are available to an established listed corporation, including rights issues, share purchase plans, placements, takeover issues, dividend reinvestment schemes, preference shares, convertible notes and other quasi-equity securities.

Equity-funding alternatives for listed companies

Companies that are listed on a stock exchange—and that have a proven track record of sound management, good profitability growth and strong share price performance—provide attractive investment opportunities for shareholders. These companies have a much wider choice of equity funding alternatives available. For example, the raising of additional equity can be achieved through the issue of additional ordinary shares, preference shares, convertible notes and other forms of quasi-equity. Our discussion of these different forms of equity finance begins with a consideration of the various ways a listed corporation might raise equity funds through the issue of additional ordinary shares. These include:

• a rights issue or a share purchase plan • placements • takeover issues • dividend reinvestment schemes. This is followed by a discussion on some of the main hybrid securities that may also be issued, including:

• preference shares • convertible notes and other quasi-equity securities. 5.5.1

Pro-rata offer a proportional offer to buy securities based on an investor’s current shareholding

R IGHTS ISSUE OR SHARE PURCHASE PLAN

A company may seek to raise further equity funds by issuing additional ordinary shares to its existing shareholders. An offer made to existing shareholders to purchase additional ordinary shares in the corporation is called a rights issue. An application to take up shares offered under a rights issue must be attached to a prospectus. In making a rights issue, it is necessary to ensure that all shareholders receive an equal opportunity to participate. This is achieved by making the offer on the basis of a fixed ratio of new shares to the number of shares already held, that is, a pro-rata offer. For example, a 1:5 (one for five) offer grants shareholders the right to purchase one new share for every five shares held. The terms of the new share issue are determined by the board of directors in consultation with the board’s financial advisers and, if applicable, the underwriters of the issue. In determining the offer price, the board of directors will consider the following:

• The company’s cash-flow requirements. The greater the necessity of the company’s funding needs, the

lower the rights issue offer price may need to be to ensure a sufficient take-up rate of the issue by shareholders.

• The projected return on assets expected to derive from the new investments funded by the rights issue.

This is directly related to the ability of the company to maintain its return on equity to shareholders. This variable may have an effect on the price of the rights issue. The greater the expected earnings cash flows, the more attractive the issue would be to shareholders. The more attractive the additional shares are deemed to be, the smaller the discount that is required from the current market price to encourage sufficient shareholder participation.

• The cost of alternative funding sources. The company will carry out a cost–benefit analysis of various

funding forms and sources. For instance, if the company has a low debt-to-equity ratio, it may decide that further debt funding would be preferable to a rights issue of equity. If equity is required, the company may decide that a placement (see below) is a more preferable funding alternative.

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A rights issue is a financial instrument that provides a future right to the holder. Therefore, the right itself has value. A company may make a rights issue offer today which normally can only be exercised at a specified future date. Not all shareholders may wish to participate by purchasing the extra shares offered. The company may decide to list the rights issue on the stock exchange so that the right can be sold to another investor before the exercise date. Where a right may be sold, it is said to be a renounceable right. With a renounceable rights issue, the right of the existing shareholder to take up new shares on a pro-rata basis may be sold to another party during the period the right is on offer. The ultimate buyer may then exercise the right to take up the new shares with the rights offer. A rights issue that may only be exercised by the shareholder and not sold to another party is a ­ non-renounceable right. The effect of a rights issue on the share price is illustrated in Chapter 6. An alternative method of offering additional shares to existing shareholders is through a share purchase plan. Instead of offering new shares on a pro-rata basis under a rights issue, the company may offer shareholders the opportunity to purchase a fixed dollar amount of shares at a predetermined price. For example, shareholders may have the choice of purchasing $2500, $5000, $7500 or $10 000 worth of shares. The shareholder may choose not to purchase any shares.

5.5.2

Renounceable right a right attached to a security that can be sold to a third party

Non-renounceable right a right attached to a security that cannot be sold to a third party

Share purchase plan an offer to existing shareholders to purchase a fixed dollar amount of new ordinary shares

P LACEMENTS

Rather than make a rights issue or share purchase plan offer to all existing shareholders, the board of directors may decide to raise further equity funds by making a placement of ordinary shares with selected investors. Investors that purchase additional shares through a placement issue are institutional investors such as fund managers. There are numerous advantages to placements as a means of raising additional equity. A placement can be arranged and finalised much more quickly than a pro-rata rights issue. Whereas a pro-rata rights issue is likely to take over two months from the announcement of the rights issue to the receipt of funds, placements can be effected within a matter of days. This attribute is particularly important in times of volatile market behaviour. Another potential feature of the placement is that the discount to current market price may be less than that for a pro-rata rights issue. This is because a placement involves dealing with institutional investors who are expected to be better informed than individual investors on current market values and therefore may need less of an incentive to purchase the shares on offer. It is also possible with a selective placement of shares for the board of directors to sell the shares to institutional investors who are deemed to be friendly to the company and are likely to support the development of the business. One of the main disadvantages of the placement is that it dilutes the proportion of the ownership of the company by existing shareholders. However, existing shareholders’ interests may be partly protected by regulation, or by a stock exchange’s listing rules. For example, the ASX listing rules state that a corporation that proposes a placement that will bring its total placements in any 12-month period to more than 15.00 per cent of the company’s issued shares may do so only if shareholders ratify previous placements at the annual general meeting. An exception applies to smaller companies with a market  capitalisation of less than $300 million. These companies are permitted to raise an additional 10.00 per cent of their equity capital, above the 15.00 per cent limit, if shareholders approve. Nevertheless, placement issues have been abused in the past, when boards of directors favoured certain shareholders by placing shares with them at an attractive price, but disenfranchised other shareholders by excluding them from the offer. In many countries, legislation has been put in place to protect shareholders from this form of inequitable practice. In Australia, for example, ASIC requires that a placement consist of subscriptions of not less than $500 000, and that there must be no more than 20 participants. The discount from the current market price must not be excessive (more than 10.00 per cent). 175

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Memorandum of information information required to be provided to institutional investors with a placement offer

Equity-funded takeover a takeover company issues its shares in exchange for the shares of the target company

Placements may be made directly with institutions and individual investors who are deemed to be the clients of brokers without the need to lodge a prospectus, but a memorandum of information detailing the company’s activities must be sent to all participants.

5.5.3

T AKEOVER ISSUES

Mergers and acquisitions—where one company seeks to purchase another company—were discussed in Chapter 3, and it was noted that an investment bank may be consulted to advise a company on the takeover. In particular, the investment bank will advise the takeover company on the alternative financing strategies that are available to fund the takeover. An equity-funded takeover (or part-equity-funded takeover), in which the takeover company issues additional ordinary shares to fund the acquisition of the shares in the target company, is a popular method used to fund a merger and acquisition. For example, company A may decide to issue additional shares to finance a full-equity-funded takeover. Company A will offer those shares on a pro-rata basis to the existing shareholders in company B. As the value of shares in the two companies will not be the same, company B shareholders may be offered three shares in company A for every five shares they hold in company B. The pro-rata basis of the offer will depend on the value of the shares in each company and any incentive being offered to encourage company B shareholders to accept the offer. If shareholders in the target company B accept the offer, they will receive shares in the takeover company A in return for their shares in company B, provided that the takeover goes ahead. The offer may include both a pro-rata share issue and a cash component. For example, company A may offer a 3 for 5 share exchange, plus 50 cents cash for each share held. Interestingly, the number of all-share takeover deals has dropped considerably. According to the Financial Times, in the USA, only 10.00 per cent of transactions undertaken in 2017 were all-share deals. Since the GFC, around 20.00 per cent of transactions each year have been all-share deals. This represents a significant decline from the heyday of all-share deals in the late 1990s when this type of deal represented more than 80.00 per cent of transactions. For the time being, cash is king in the world of mergers and acquisitions.

5.5.4

D IVIDEND REINVESTMENT SCHEMES

The payment of dividends varies from corporation to corporation, between industries and even between nation-states. For example, in some industries in the USA companies retain profits within the company to finance future growth, rather than paying a dividend. In other countries, such as Australia, where the percentage of profits returned to shareholders in the form of dividends is higher, one method of encouraging shareholders to put further equity funds back into the corporation is through the use of a dividend reinvestment scheme. A dividend reinvestment scheme allows shareholders to reinvest their periodic dividend receipts by purchasing additional ordinary shares in the company. That is, instead of receiving the cash dividend, a shareholder may decide to reinvest the dividend back into the company and receive some additional shares. One of the advantages to shareholders of a dividend reinvestment scheme is that the corporation typically meets the associated transaction costs, such as brokerage fees, that otherwise would be incurred if shareholders independently sought to use their dividends to purchase additional shares. Dividend reinvestment schemes are also attractive to investors as they provide a simple savings regimen. For example, if an investor received a $100 dividend in cash, the investor may be likely to spend the cash received, but by automatically reinvesting the dividend into additional shares the investor is able to increase their investment portfolio and personal wealth over time. Dividends are usually paid twice a year: an interim dividend and a final dividend. This means that shareholders can progressively top up their shareholding in the company by reinvesting their dividends. 176

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The method by which the issue price of a share is determined differs from one company to another. However, a reasonably common practice is to take the weighted average of the market price of the company’s shares traded on the stock exchange for the five days following the ex-dividend date, and then adjust that price by the company’s stated discount. The discount on a dividend reinvestment scheme is typically between 0 and 5.00 per cent. Dividend reinvestment schemes are an attractive method of raising additional equity funds. They allow companies simultaneously to pay dividends to shareholders and, assuming a sufficient reinvestment rate, to maintain the necessary equity finance to fund the company’s future investments and growth. However, there may be times when reinvestment schemes are inappropriate, such as during periods when the company sees few new prospects for future profitable investments and when its cash position is quite healthy. By adding to the company’s equity base at a time of poor investment prospects, shares issued under dividend reinvestment schemes would dilute both the potential earnings per share and the company’s net tangible asset backing per share. Given these possibilities, a company with a dividend reinvestment scheme may suspend the scheme when it becomes concerned about future growth in the short term and the dilution effects on shareholder value. The scheme can be re-activated by the directors when business prospects improve.

5.5.5

P REFERENCE SHARES

Preference shares are a form of equity funding, but they have a number of features in common with debt that serve to differentiate them from ordinary shares. Preference shares may therefore be described as a hybrid security. Unlike ordinary shares, preference shares have their dividend rates fixed at the issue date. Preference shares rank ahead of ordinary shares in the payment of dividends and in their claim on assets in the event of a winding-up or liquidation of the company. On both accounts, however, preference shares rank behind the company’s creditors. A range of features may be attached to preference shares. A preference share issue will include a combination of the following features.

• Cumulative or non-cumulative. If a company is not able to make the fixed dividend payment on cumulative preference shares in one period, the amount due is carried forward to the next period. The company is required to pay any unpaid preference share dividends from past years before it can make any distribution to ordinary shareholders. On the other hand, with non-cumulative preference shares, if the company is unable to make the fixed dividend payment, the obligation is not carried forward.

• Redeemable or non-redeemable. Redeemable preference shares entitle the holder to redeem the

preference share on a predetermined date and to receive the specified value of the preference share in a cash payment. The holder of a redeemable preference share may have the option to redeem for cash or to convert into ordinary shares. A non-redeemable preference share would only be convertible.

• Convertible or non-convertible. Convertible preference shares may be converted into ordinary shares

in the company at a future date, generally at the lowest rate specified in the prospectus or at a discounted market price at the conversion date. It is unlikely that a preference share would be nonconvertible.

• Participating or non-participating. Holders of participating preference shares are entitled to a higher fixed dividend payment if the company should decide to pay ordinary shareholders a dividend in excess of a specified rate. In other words, a participating preference shareholder is given the opportunity to share in excess profit generated by the company.

• Issued at different rankings. First-ranking preference share issues have preference over secondranking issues of preference shares in their claim on dividends and in their claim on the assets of the company. Preference shares issued at different times may be given equal ranking.

Preference shares a hybrid security that combines characteristics of both equity and debt; preference shares usually pay a fixed dividend and offer the right to convert to ordinary shares at a future date (also known as a redeemable convertible preference share)

Cumulative preference shares fixed dividends not paid in one period carry forward until paid

Redeemable preference shares may be redeemed for cash at the expiry date

Convertible preference shares may be converted to ordinary shares at a future date and at a specified price

Participating preference shares holders will receive a higher dividend if ordinary shareholders receive a dividend above a specified amount

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A preference share issue may be desirable for a company that requires funds but has reached its optimal gearing level, that is, its debt-to-equity ratio. The company can issue additional preference shares that are, in effect, fixed-interest borrowings but count as equity. In this case, the preference share issue widens the equity base of the firm, and thus allows further debt to be raised in the future while maintaining the firm’s gearing ratio. Providing the shares are non-cumulative, the firm is not committed to an immediate dividend payment, as it would be if it were to issue straight debt. Stock exchanges allow corporations to list and quote preference share issues. This adds to the liquidity and attractiveness of the preference share to an investor. The security pays a specified rate of return, generally offers the option to convert to ordinary shares and is a liquid asset that can be sold on a stock exchange.

5.5.6

C ONVERTIBLE NOTES AND OTHER QUASI-EQUITY SECURITIES

This category includes those instruments that provide the holder with the right to convert the instrument into ordinary shares at a future specified date. The most common of these instruments is the convertible note. Company-issued options and warrants are also included in this category.

Convertible notes A convertible note is a hybrid debt instrument issued for a fixed term by the company and paying a stated rate of interest for the term of the note. The holder of the note has the right to convert the note into ordinary shares in the issuer company at a specified future date. The conversion price, when the notes are issued, is set close to the market price of the share and the rate of interest offered on the notes is usually lower than that offered on straight debt instruments. The lower rate of interest is due to the value of the explicit option embedded in the note, that is, the right to convert the note into equity at the specified future date and at a predetermined price. The expectation of the note holder is that the share price will increase over the term of the note. Therefore, the note holder will make a financial gain by converting the note into ordinary shares in the issuer company. Should the share price fall to a level lower than the conversion price, the holder can choose not to convert the note, but redeem the note for its nominal cash value. The attraction of the convertible note to the issuing company is that it enables the company to obtain funds on terms more favourable than would be applicable to straight debt. Not only is the rate of interest lower than that for straight debt, but the term to maturity of the notes is often for a considerably longer period than would be available through other debt instruments. Furthermore, the expense of the interest paid on convertible notes may, subject to certain conditions, be a tax-deductible expense of the company. A convertible note issue may be made by direct placement, rather than by a pro-rata issue to shareholders. The value of the placement must fall within the constraints of the rules of the stock exchange. For example, Australian regulation imposes the same requirements on the placement of convertible notes as for the placement of ordinary shares.

Company-issued options Company-issued option bestows a right, but not an obligation, on the holder to buy new ordinary shares in the company

A company-issued option is a security issued by a corporation that gives the holder the right, but not the obligation, to buy ordinary shares in the company on a predetermined date and at a predetermined price. If the holder of the option exercises the right to buy the shares offered, the company is able to raise additional equity funds. Typically, a corporation will offer company-issued options in conjunction with a rights issue or a placement. The option may be issued free, or sold at a price, at the same time as the underlying ordinary share issue. The option may add to the marketability of the underlying rights issue or placement, without the company having to incur the burden of an immediate increase in dividend payments. The company can also set the exercise date to coincide with expected future funding requirements. For example, if the company forecasts that it will need some additional equity in 12 months, the exercise

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date for the option can be set for that time. The company is able to match the timing of its cash-flow needs. However, the future funds are not guaranteed. The exercising of the option will depend on the option exercise price relative to the current market price of the share at the exercise date. The holder of a company-issued option gains a highly geared investment strategy that provides a potential future equity interest in the corporation. In the best case, where the option is issued free, investors have acquired the right to increase their equity participation in the issuer company in the future, apparently at zero cost. The right would be exercised if the predetermined exercise price is lower than the current market price of the share on the exercise date. If this sounds too good to be true, in part it is. It is most likely that market participants will attempt to estimate the likelihood of being able to exercise the option profitably. That is, they will calculate the value of holding the option, and that value would then be loaded into the price paid for the initial rights issue or placement with the attached option. The valuation of options is discussed in Chapter 20.

Company-issued equity warrants A company-issued equity warrant is simply a form of an option. There are many different types of warrants that are traded on a stock exchange and over the counter. This section considers those warrants issued by a corporation where the exercise of the warrant will result in the company raising additional equity capital. A company-issued equity warrant differs from a company-issued option in that the warrant generally attaches to a corporate bond debt issue of the company. Initially, an investor purchases bonds issued by the corporation, and in so doing receives the additional security of the warrant. The warrant gives the holder the right to exercise the warrant and buy ordinary shares of the company at a specified price over a given period. The terms of the warrant may allow the warrant to be detachable from the bond issue and traded separately from the bond. The investor in this situation has two securities that may be held or sold separately. For example, the investor could decide to retain the bond as an investment and sell the warrant. If the warrant is non-detachable, it can only be sold together with the associated bond. As the equity warrant provides the holder with a right to buy ordinary shares in the issuer company, it has a value. The warrant holder does not receive dividend payments, but may benefit from capital gains on share price rises above the warrant conversion price. Warrants are generally attractive to investors and, as such, may lower the cost of borrowing associated with the issue of the underlying corporate bonds.

Company-issued equity warrant an option to buy additional shares that is originally attached to a debt issue

Detachable warrant a warrant that can be sold separately from the original debt security to which it was attached

Non-detachable warrant a warrant that cannot be separated from the host debt security

REFLECTION POINTS

that are listed on a stock exchange have a number of choices when seeking to • Companies raise additional equity to fund further business growth. rights issue is the offer of additional ordinary shares on a pro-rata basis to all existing • Ashareholders at a specified future date, for example, one new share for every five shares held. The right to buy may be renounceable, whereby the right is listed on the stock exchange and can be sold before the exercise date. A non-renounceable right cannot be sold. share purchase plan provides the opportunity for existing shareholders to invest a specified • Adollar amount to buy additional shares in a company. occurs where a company offers additional shares to select institutional investors. • ATheplacement Corporations Act 2001 places limits on the issue of shares through a placement in order to protect existing shareholders. issue and a share purchase plan require a prospectus, whereas a placement requires • Aonlyrights a memorandum of information. continued

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takeover issue occurs when company A seeks to acquire company B and offers company B • Ashareholders a pro-rata number of shares in company A in exchange for company B shares. The takeover offer may also include a cash component. profitable company may pay cash dividends to its shareholders but offer shareholders the • Aright to reinvest that dividend by purchasing additional shares in the company. The dividend reinvestment scheme allows the company to pay dividends but also retain at least a portion of those dividends as capital available for growth. share is a hybrid security that pays a fixed dividend and at a specified date allows • Athepreference holder to convert the preference share into ordinary shares. Preference shares may be cumulative, redeemable, convertible, participating and issued with different priority rankings. notes are a hybrid security that pays a fixed-interest stream and offers the • Convertible opportunity to convert the note into ordinary shares at a future date. company-issued option gives the holder the right, but not the obligation, to buy ordinary • Ashares of the company at a specified date and at a specified price. A company-issued warrant is similar, but is usually attached to a debt instrument issued by the company, such as a bond. The warrant may be detachable or non-detachable.

CASE STUDY COVENANT-LITE LOANS—RISK IMPLICATIONS Loan covenants are conditions or restrictions specified in a loan contract and represent an important factor in credit analysis. Loan covenants represent promises by the borrower to do or refrain from doing certain things. The usual practices necessitated by loan covenants include maintaining interest coverage, leverage ratios and the lender’s position in the company’s capital structure (Osterland, 2018). According to the data from Moody’s, in early 2018 the protection of lenders from defaulting companies is now the weakest it has been since records began. Contributing to this, almost 80.00 per cent of leveraged loans were ‘covenant lite’, which do not come with certain conditions normally imposed by more comprehensive loan covenants. The risks inherent in such loans mean that there can be a significant loss in the financial value before lenders can undertake the necessary steps to recover some portion of what they are owed. It has been found that recovery rates following a bankruptcy declaration can differ substantially depending on whether strong loan covenants are in place (Scaggs, 2018). Even in the Australian economy, leveraged loans are often less protected by loan covenants than they once were. The issuance of covenant-lite corporate loans has expanded rapidly in the past few years, reaching almost 77.00 per cent of the estimated $1 trillion leveraged corporate loan market. Most of these loans are packaged and resold as bonds. KKR, the private equity firm, issued $1.3 billion of such bonds while completing its $8 billion leveraged buyout of Unilever’s margarine and spreads business. Investors who are desperate for better yields in a low interest rate environment have, according to some commentators, already overpaid to a point where they are not being compensated for the risks they have taken (Cohan, 2018). Loan covenants are critical in the sense that they help balance the financing requirements for firms against the risks that investors should be willing to bear given the yields that they have been promised (‘Understanding Covenants – BondAdviser’, 2018).

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Cohan, W 2018, ‘The big, dangerous bubble in corporate debt’, The New York Times, 9 August, viewed 15 October 2018, http://www.nytimes.com/2018/08/09/opinion/corporate-debt-bubble-next-recession .html Osterland, A 2018, ‘The booming loan market is getting riskier’, CNBC.com, 25 June, retrieved from http://www.cnbc.com/2018/06/21/the-booming-leveraged-loan-market-is-getting-riskier.html Scaggs, A 2018, ‘Loan covenant quality hits record low, says Moody’s’, Financial Times, 24 July, viewed 15 October 2018, http://www.ft.com/content/54a27838-8f4d-11e8-b639-7680cedcc421 Understanding Covenants (18 May 2018), Bond Adviser, retrieved from http://www.bondadviser.com .au/blog/understanding-covenants/

Discussion points

• •

Explain the role played by loan covenants to protect investors, and how covenant-lite loans affect investors. From the point of view of investors in corporate bonds, covenants are critical to assessing yields and risks. Discuss this statement.

CHAPTER FIVE REVIEW

Reference list

Master before you move on LEARNING OBJECTIVE 5.1 Understand issues related to the capital budgeting investment decision. main objective of a corporation is the maximisation of shareholder value. In seeking to • The achieve this objective, a corporation will consider its investment decision (the capital budgeting process), its financing decision (the capital structure process), the management of liquidity and working capital and the distribution of profits to shareholders.

decisions are based on the objectives of the corporation, which state, in part, those • Investment activities that the business intends to conduct. This determines the assets required to carry out those activities.

methods that are used to determine which business activities should be profitable—that is, • Two those adding to shareholder value—are net present value (NPV) and the internal rate of return (IRR).

NPV is the difference between the cost of an asset, or project, and the present value of its • The future returns. The present value is the discounted value today of a future cash flow or series of cash flows. The cash flows are discounted at the firm’s required rate of return on the investment. The corporation will accept investment proposals that indicate a positive NPV.

IRR is the discount rate on a project that results in an NPV of zero. If the firm’s required rate • The of return on an investment is less than the forecast IRR of the project, it may be acceptable. However, IRR suffers from two shortfalls: non-conventional cash flows and mutually exclusive investment opportunities.

the NPV and the IRR methods are exposed to the limitations and uncertainties of forecast • Both projections.

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LEARNING OBJECTIVE 5.2 Identify issues relevant to a corporation’s funding choice between debt and equity.

• A corporation must determine how it plans to finance its investment decisions. must consider its current debt-to-equity ratio and the associated degree of financial • Arisk.business If the ratio is such that increased debt can be sustained without an undue increase in financial risk, it is in the interests of the shareholders for the expansion to be funded through debt rather than equity.

debt commitments (interest and principal) must be paid when due. Therefore, a • However, corporation must forecast the business environment in which it operates and the impact of changes on future cash flows.

a business reaches an appropriate debt-to-equity ratio, further expansion requires • Once additional equity.

LEARNING OBJECTIVE 5.3 Examine the listing and flotation or initial public offering (IPO) of a business on a stock exchange, including equity-funding alternatives that are available to a newly listed corporation. way to access a much wider equity market is through the public listing (IPO) of a company • One on a stock exchange. majority of companies will incorporate as limited liability companies and issue ordinary • The shares. • A company engaged solely in mining may incorporate as a no liability company. case, the business will retain financial advisers with expertise in the procedures • Infor either listing on a stock exchange, the appropriate form of incorporation, the preparation of a prospectus and the timing, structure and pricing of the share flotation (IPO).

advisers may also arrange the underwriting of the issue and ensure that its structure meets • The stock exchange listing rule prerequisites for the admission of the company to its official list and for the quotation of its shares.

LEARNING OBJECTIVE 5.4 Consider important issues associated with listing a business on a stock exchange.

• A primary concern of a stock exchange is to maintain the efficiency and integrity of its markets. is achieved, in part, by requiring a company that is seeking admission to the stock exchange • This to comply with the exchange’s listing rules, as well as meeting its obligations under the relevant company law.

listed, corporations must continue to comply with the rules or risk suspension or delisting • Once of their securities from the official list. corporation may choose to become a dual-listed company by listing its shares • Aonmultinational more than one stock exchange in order to access the wider international capital markets and increase liquidity in the trading of its securities.

LEARNING OBJECTIVE 5.5 Explore equity-funding alternatives that are available to an established listed corporation, including rights issues, share purchase plans, placements, takeover issues, dividend reinvestment schemes, preference shares, convertible notes and other quasi-equity securities. that have listed on a stock exchange and have a track record of sound management, • Companies good profitability and good share price performance are generally able to raise additional equity funding in a number of different ways. 182

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rights issue requires a prospectus and can take time.

alternative method (the share purchase plan) is to offer existing shareholders the opportunity • An to invest a fixed dollar amount to purchase additional shares in a company. than offer additional shares to all existing shareholders, some companies prefer a direct • Rather placement of shares with selected institutional investors, such as fund managers. This can be finalised more quickly, does not require a prospectus (only a memorandum of information) and is often at a smaller discount.

ordinary shares may also be issued by a takeover company as full payment, or part • Additional payment with a cash component, in a merger and acquisition bid. reinvestment is another technique by which a listed corporation can raise additional • Dividend equity funds. It allows shareholders to elect to convert their periodic cash dividend receipts into new shares in the company. Dividend reinvestment schemes also give existing shareholders the opportunity to increase their equity holding, usually without the normal transaction costs such as brokerage.

may also issue preference shares to raise additional equity capital. Preference shares • Aarecompany hybrid securities, and differ from ordinary shares in that they offer a fixed dividend that is set

CHAPTER FIVE REVIEW

ordinary shares may be issued on a pro-rata rights basis to existing shareholders. • Additional A rights issue is usually offered at a discount to the current market price. However, a pro-rata

at the issue date and most frequently have a fixed term to maturity. In both of these attributes they are more like debt than equity. However, they rank behind the company’s creditors in their claim on the assets of the company if the business fails. A preference share issue may or may not be cumulative, redeemable, participating, convertible or issued with different rankings.

notes are hybrid securities that have attributes of both debt and equity. Holders of • Convertible convertible notes receive a predetermined rate of interest on their investment. However, the notes may be converted into shares at a future date at a predetermined price.

forms of quasi-equity securities are company-issued options and company-issued equity • Other warrants. A company-issued option provides the holder with the right to purchase ordinary shares at a predetermined price on a specified date. A company-issued equity warrant may be attached to a corporate bond debt issue and provides the holder with the right to exercise the warrant and convert the warrant into ordinary shares in the issuer company, also at a determinable price and on or by a specified date. The warrants may be detachable and sold separately to the host bond.

Extended learning LEARNING OBJECTIVE 5.6 Explain the listing requirements of the Australian Securities Exchange.

Australian Securities Exchange (ASX) listing rule requirements The objectives of the ASX include the provision of a fair and well-informed market for financial securities and the provision of an internationally competitive market. The ASX listing rules are a key element in achieving these objectives. The listing rules are set down formally in 20 chapters available at: https://www.asx.com.au/regulation/rules/asx-listing-rules.htm. An entity wishing to have its securities listed and quoted on an exchange must first seek admission to the exchange. The requirements imposed by stock exchanges will vary between exchanges and nation-states, but the principles (discussed in Section 5.4) will be essentially the same; any variation will mainly be in the detail. To gain an understanding of the listing requirements of one modern and efficient stock exchange, the Australian Securities Exchange (ASX) is considered. 183

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The ASX has absolute discretion concerning an entity’s admission to the official list, the quotation of its securities and its suspension and removal from the list. Listing rules are enforceable under the Corporations Act 2001 and are additional and complementary to common law and statutory obligations. An entity that applies to the ASX for admission to the official list must provide prescribed documentation, demonstrate compliance with the listing rules and pay listing fees. Entities that are admitted are categorised as general (within this category there are specific rules for mining exploration entities, investment entities and scientific research-based entities), debt issuer or exempt foreign. Some of the broad requirements for general admission to the official list include:

• The entity’s structure and operation must be appropriate for a listed entity. • The entity’s constitution must be consistent with the listing rules. prospectus, product disclosure statement or information memorandum must be issued and • Alodged with the corporate regulator, ASIC. foreign entity must establish, in Australia, an Australian securities register (or subregister), • Aappoint an agent for service of process and be registered as a foreign company under the Corporations Act 2001.

the entity is a trust, it must be a registered managed investments scheme and the responsible • Ifentity must not be under an obligation to allow a security holder to withdraw from the trust. entity must apply for and be granted permission for quotation of all the securities in its main • The class of securities. must be at least 300 holders each having a parcel of the main class of securities (excluding • There restricted securities) with a value of at least $2 000. • The entity must satisfy either the profit test or the assets test (discussed below). the entity issues restricted securities before it is admitted, it must comply with the related • Iflisting rules. conditions apply if an entity issued classified assets in the two years prior to application. • Special The ASX identifies several different types of classified assets. These include: (1) an interest in a mining, oil or gas exploration area; (2) an interest in intangible property; and (3) an interest in an asset that, according to the ASX, cannot be readily valued. See the ASX listing rules definitions (Chapter 19 of the listing rules).

entity has options on issue, the exercise price for each underlying security must be at least • If20thecents in cash. entity must appoint a person to be responsible for communication with the ASX in relation • The to matters associated with the listing rules. entity seeking listing must advise the extent to which it will, upon admittance, comply with • An the recommendations of the ASX Corporate Governance Council. The entity must advise the ASX of the reason for non-compliance with all the recommendations.

entity that is to be included in the S&P/ASX All Ordinaries Index must have an audit committee. • An If the entity is included in the top 300 of the index, it must comply with the recommendations of the ASX Corporate Governance Council.

Profit test minimum financial performance requirements to be met by an entity seeking listing on a stock exchange

• The entity must agree to authenticate and provide documents to the ASX electronically. • The entity must have a trading policy that complies with the ASX listing rules. Profit test To meet the profit test requirement of admission, an entity must satisfy each of the following conditions.

• The entity must be a going concern, or the successor of a going concern.

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entity’s main business activity at the date it is admitted must be the same as it was for the • The last three full financial years. entity must provide audited financial statements for the last three full financial years. The • The financial statements must be accompanied by audit reports, which must not be qualified with regard to the entity’s capacity to continue as a going concern, or satisfy the profit levels required.

entity’s aggregated profit from continuing operations for the last three full financial years • The must have been at least $1 million. entity’s consolidated profit from continuing operations for the 12 months to a date no more • The than two months before the date the entity applied for admission must exceed $500 000. entity must give the ASX a statement from all directors (in the case of a trust, all directors of • The the responsible entity) confirming that they have made inquiries and nothing has come to their attention to suggest that the economic entity is not continuing to earn a profit from continuing operations up to the date of application.

Assets test The assets test requirements of admission are as follows:

the time of admission an entity must have net tangible assets of at least $4 million after • Atdeducting the costs of fundraising, or an expected market capitalisation of at least $15 million. • The entity must have either one of the following:

Assets test minimum level of assets to be held by an entity seeking listing on a stock exchange

– Less than half of the entity’s total tangible assets, after raising any funds, must be cash or in a form readily convertible to cash.

– Half or more of the entity’s total tangible assets, after raising any funds, must be cash or in a form readily convertible to cash, and the entity must have commitments consistent with its business objectives to spend at least half of its combined cash and readily convertible assets. The business objectives must be clearly stated and include an expenditure program. If the prospectus does not contain a statement of the business objectives, the entity must give a statement of its business objectives to the ASX.

• The entity must satisfy each of the following:

– If its prospectus, product disclosure statement or information memorandum does not contain a statement that the entity has enough working capital to carry out its stated objectives, the entity must give the ASX a statement prepared by an independent expert. – The entity’s working capital must be at least $1.5 million, or, if it is not, it would be at least $1.5 million if the entity’s budgeted revenue for the first full financial year that ends after listing was included in the working capital. For mining exploration entities, the amount must be available after allowing for the first full financial year’s budgeted administration costs and the cost of acquiring plant, equipment and mining tenements. The cost of acquiring mining tenements includes the cost of acquiring and exercising an option over them. entity must provide financial statements for the last three full financial years. The financial • An statements must be audited, and must include audit reports.

Quotation of securities A general admission entity that wishes to have its main class of securities quoted on the official list of the ASX must satisfy the following conditions:

terms of the entity’s securities must comply with the ASX listing rules, including the rules • The relating to voting rights, dividends and equitable representation. issue price or sale price of all securities (except options) for which the entity seeks quotation • The must be at least 20 cents in cash. Restricted securities, after the escrow period ends, and employee incentive scheme securities may still be quoted even though they are issued or sold at less than 20 cents.

Escrow assets held by a third party that cannot be sold until conditions of a contract are fulfilled

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• Any CHESS requirements relating to the entity’s securities must be satisfied. the securities are initially partly paid, there must be a defined call program setting out the • Ifdate and amount of each proposed call. The security must be paid in full within two years. This condition does not apply to a no liability company.

the securities are debt securities, or convertible debt securities, a copy of the documents • Ifsetting out the terms of the securities must have been given to the ASX. • If the securities are debt securities, their aggregate face value must be at least $10 million.

Costs of listing An entity proposing to seek listing on the ASX should be aware that there are significant costs associated with the process. As discussed in the body of Chapter 5 and listed below, there are a number of fees and expenses associated with the public listing of a company. In addition, there are fees charged by the ASX. The extent of the costs of listing will depend ultimately on the complexity of the issue, the amount of equity issued, the method of issuing the securities, the number of advisers involved and the level of marketing undertaken. An indicative list of initial general expenses that may be incurred include:

• underwriting and handling fees • float management fees • legal fees • accounting and taxation fees • other expert adviser fees • printing costs • advertising and marketing costs • share registry expenses.

Specific fees charged by the ASX include:

• ASX initial listing fees • ongoing annual listing fees • other fees as determined by the ASX.

Fees charged by the ASX will vary from time to time, and will depend on the type of security issued (equity or debt) and the amount of the securities listed. The cost of listing is a significant initial demand on the liquidity of a corporation. Therefore, the listing corporation must ensure that it has access to sufficient sources of cash to be able to meet these initial cash-flow needs as they arise.

Continuous disclosure All corporations admitted to the official ASX list must comply with the continuing listing requirements. The first of these are the continuous disclosure requirements that were discussed in Chapter 4. These require a company immediately to notify the ASX of any information concerning the company that is necessary to ensure that trading in the entity’s securities occurs in a fair and well-informed market. That is, the company must inform the exchange of any information that a reasonable person would expect would have a material effect on the price or value of securities of the company. This is essential in order to maintain the integrity of the market. Notice must be given to the exchange by a listed corporation immediately when any relevant material information is available on issues such as:

• a change in an entity’s financial forecasts or expectations • the appointment of a receiver, manager, liquidator, administrator or change in directors transaction for which the consideration payable or receivable is a significant proportion of the • awritten-down value of the entity’s consolidated assets, usually 5.00 per cent 186

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• a recommendation or declaration of a dividend or distribution • a recommendation or declaration that a dividend or distribution will not be declared • under-subscriptions or over-subscriptions to an issue copy of a document containing market-sensitive information that the entity lodges with an • aoverseas stock exchange or other regulator which is available to the public. The document must be in English

• an agreement or option to acquire a mining tenement • giving or receiving a notice of intention to make a takeover agreement between the entity (or related party or subsidiary) and a director (or related party • an of the director) copy of any financial document that the entity lodges with an overseas stock exchange or • aother regulator which is available to the public. The document must be in English • a change in accounting policy adopted by the entity rating applied by a rating agency to an entity, or securities of an entity, and any change to • any such a rating • a proposal to change the entity’s auditor. In addition to the continuous disclosure requirements, there is a routine requirement that companies must provide the exchange with quarterly, half-yearly and annual reports at the same time as they are provided to the corporate regulator, but within a specified maximum time after the end of the reporting period.

Corporate governance Corporate governance represents the internal relationships between shareholders, the board of directors and managers. It consists of a system of structuring, operating and controlling an organisation in order to achieve:

• a fundamental ethical culture throughout the entire business operation long-term strategic objectives of shareholders—that is, the profitability of the organisation • the and the maximisation of shareholder value • compliance with legal and regulatory requirements across different jurisdictions • a regime of accountability, transparency and reporting disclosure. The ASX has formed a Corporate Governance Council which defines corporate governance as the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. It encompasses the mechanisms by which companies, and those in control, are held to account. Corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised. The ASX Corporate Governance Council has published eight principles and recommendations. The principles state that companies should: 1

establish and disclose the respective roles and responsibilities of the board and management

2

have a board of effective composition, size and commitment to adequately discharge its responsibilities and duties

3

promote ethical and responsible decision making

4

have a structure to independently verify and safeguard the integrity of their financial reporting

5

promote timely and balanced disclosure of all material matters concerning the company

6

respect the rights of shareholders and facilitate the effective exercise of those rights

7

establish a sound system of risk oversight and management and internal control

Transparency the level of information that is provided to market participants

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8

ensure that the level and composition of remuneration is sufficient and reasonable and that its relationship to performance is clear.

The foregoing discussion on the ASX listing rule requirements, although quite detailed, is selective and certainly not comprehensive. In fact, the ASX listing rules currently comprise some 20 chapters of specific requirements. Further information on the ASX listing rule requirements may be obtained at www.asx.com.au. For comparison, the listing rules of other stock exchanges may be found on their websites.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Marketing is often portrayed as a creative enterprise. Why would a marketing executive need to have an understanding of the capital budgeting process and techniques such as net present value and internal rate of return? (LO 5.1)

2

Disney Corporation is considering the re-release of its classic film library. The project will involve an investment of $78 000 000 and will produce a positive cash flow of $25 000 000 in the first year. The cash flows will increase by 10.00 per cent each year thereafter for another five years (i.e. the project runs for six years in total). At that stage the project will cease. The company expects a rate of return of 17.00 per cent on this type of project.

(a) Calculate the NPV and the IRR.

(b) Should the company proceed with this investment opportunity? Why or why not? (LO 5.1)

3

Explain the effect on the firm’s market value of an increase in the firm’s debt-to-equity ratio. (LO 5.2)

4

Compare and contrast the average debt-to-equity ratios of commercial banks and major retailers, such as Woolworths. Why is there such a big difference? (LO 5.2)

5

The owners of a successful private stationery business have decided that the next step in the company’s development is to expand into overseas markets. In order to raise the capital necessary to support this expansion, the company’s owners have decided to investigate the possibility of listing the company on the ASX. You work for a boutique investment bank and receive the first phone call from the owners. Explain the role that your company will play if the owners decide to retain your services as an IPO adviser. (LO 5.3)

6

Techno Pty Ltd is a private company that has developed a range of innovative software packages over the past five years. The company is considering seeking admission and quotation on a stock exchange. List and briefly explain the advantages to the company of a public listing. (LO 5.3)

7

Santos Limited has expanded its exploration program and has decided to fund the expansion through the issue of additional ordinary shares to its existing shareholders on a pro-rata basis of one new share for each five shares held. The issue price is $5.75 per share and the current market price is $6.50. The financial advisers to the corporation have recommended the use of an underwriting facility. The board of directors has noted that the underwriting facility has an outclause if the market price drops below $5.50. Using this information, answer these questions.

(a) What type of issue is Santos Limited making to its shareholders?

(b) What is an underwriting facility, and why might Santos use such a facility?



(c) What is the out-clause entered into by Santos? Discuss how the out-clause operates. (LO 5.3)

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Rio Tinto Limited has decided to sell its shale coal part of the business by establishing a new limited liability company to be known as Shoal Limited. Shoal Limited will be a listed corporation on the ASX. Rio Tinto and Shoal decide to issue the new shares at $2.65, but through the issue of instalment receipts. An initial payment of $1.25 is payable on application and a final payment of $1.40 is due 12 months later.

(a) Shoal Limited will be a limited liability company. What are the rights and financial obligations of shareholders that purchase shares in the company?

(b) The company has decided to structure the issue using instalment receipts. Explain how instalment receipts operate and why the company may have decided on this strategy. (LO 5.3)

9

A mining corporation has obtained the rights to explore for gold in a new tenement. The corporation decides to establish a new subsidiary company that will carry out this high-risk venture. The new company will be listed on the stock exchange. The gold exploration company expects to complete its exploratory search over the next 12 months, at which time it will report back to shareholders and make recommendations on the viability of the project.

(a) What form of legal structure would you recommend the gold exploration company incorporate? Why would you recommend this structure?

CHAPTER FIVE REVIEW

8

(b) What are the advantages to the company and also to the shareholders of the structure you recommended? (LO 5.3)

10 An efficient stock exchange will establish listing rules that support the interests of listed entities, maintain investor protection and ensure the reputation and integrity of the stock market. To achieve this, a stock exchange will adopt a number of listing rule principles. (a) List and explain five fundamental listing rule principles.

(b) If a multinational corporation seeks dual listing on two stock exchanges, how will this impact on the corporation’s adherence to the listing rules? (LO 5.4)

11 JB Hi-Fi is expanding its retail operations and seeks to raise capital to do so. The company advisers recommend the board of directors choose between a pro-rata rights issue or a private placement. Explain each of these funding alternatives and discuss the advantages and disadvantages of each alternative. (LO 5.5) 12 In some countries, such as Australia, it is common for corporations to offer shareholders a dividend reinvestment scheme. (a) Explain how dividend reinvestment schemes operate and discuss their significance as a source of equity funding.

(b) Discuss the advantages of a dividend reinvestment scheme from the point of view of the corporation and shareholders.



(c) Under what circumstances might such schemes prove to be unattractive to the dividendpaying company? (LO 5.5)

13 In recent years, the popularity of all-share takeover deals has declined. What is an ‘all-share takeover deal’ and what are some reasons for the decline in popularity? (LO 5.5) 14 Convertible notes, company-issued options and company-issued warrants are often referred to as quasi-equity securities. (a) What are the characteristics of each of these instruments that serve to distinguish them from straight equity or debt?

(b) Why might a company issue quasi-equity rather than straight debt or equity? (LO 5.5)

Extended learning question 15 Listing on a stock exchange might be highly desirable for a company, but there are a number of requirements, conditions and costs associated with becoming a publicly listed corporation. 189

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(a) Identify and explain 10 specific requirements that must be met by an Australian company seeking general admission to the ASX.

(b) Discuss the ASX profit test and asset test requirements, and explain why these rules are in place.



(c) Identify and explain the different costs that a company will have to meet in the process. What impact will these have on the liquidity management of the firm? (LO 5.6)

KEY TERMS assets test  185

escrow 185

NPV decision rule  164

business risk  166

financial risk  167

out-clause 170

capital budgeting  163

financing decision  166

company-issued equity warrant 179

flotation of a business  170

participating preference shares 177

gearing ratio  168

preference shares  177

company-issued option  178

initial public offering (IPO)  170

present value  163

convertible preference shares 177

instalment receipt  171

profit test  184

internal rate of return (IRR)  165

promoter 170

cumulative preference shares 177

investment decision  163

pro-rata offer  174

loan covenants  168

proxy 171

memorandum of information  176

redeemable preference shares 177

debt-to-equity ratio  168 delisted 173 detachable warrant  179 dual listing  173 earnings attributable to ordinary shares 167 equity-funded takeover  176

mutually exclusive projects  166 net present value (NPV)  163 non-conventional cash flows  166 non-detachable warrant  179 non-renounceable right  175

renounceable right  175 share purchase plan  175 transparency 187 underwriting 170

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CHAPTER 6

Investors in the share market CHAPTER OUTLINE 6.1 Share-market investment 6.2 Buying and selling shares 6.3 Taxation 6.4 Financial performance indicators 6.5 Pricing of shares 6.6 Stock-market indices and published share information

Learning objectives LO 6.1

Consider the role of an investor in the share market, appreciate the wide range of investment choices that are available and understand risks associated with investments in shares of listed corporations.

LO 6.2

Detail the process for buying and selling shares.

LO 6.3

Understand the importance of taxation in the investment decision process.

LO 6.4

Identify and describe various indicators of financial performance.

LO 6.5

Apply quantitative methods to the pricing of shares.

LO 6.6

Analyse the functions and importance of share-market indices and interpret published sharemarket information.

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CHAPTER SNAPSHOT Once a company’s shares trade on the stock market, they are subject to the jostling of supply and demand. These forces are in turn shaped by perceptions of risk, reward and expectations about the future. Investors consider both the risks specific to the company and the risks to which the company is exposed that derive from the economy as a whole. Finance theory distinguishes between these two types of risk. The first, company specific, is called unsystematic risk (not related to the economic system). The second, deriving from the economy as a whole, is called systematic risk. One of the key insights of finance theory is that unsystematic risk can be removed by diversification, leaving the investor exposed only to systematic risk. As such, it is only for bearing systematic risk that the investor should be rewarded.

INTRODUCTION In order to raise equity funds, a publicly listed corporation may issue various financial instruments that are quoted on a stock exchange. A stock exchange provides primary and secondary markets that facilitate the quotation and trading of equity, hybrids and some debt securities. This chapter specifically focuses on the share market from the point of view of investors who invest in ordinary shares issued by corporations. So why do investors purchase shares issued by corporations? Shareholders receive a return in two forms: 1 periodic dividend receipts 2 capital gains (losses) from changes in share value. However, there is no guarantee that a company will pay a dividend to its shareholders, nor is there any guarantee that the share price will increase in value over time. Clearly, such an investment must be regarded as having a higher level of risk than many other investment alternatives. One of the fundamental principles of finance is that higher risk should be rewarded with a higher return. It is therefore reasonable to assume that investments in shares should, on average, provide a higher return to shareholders than lower-risk investment categories such as fixed-interest and money-market securities. There are a number of other important factors that encourage investors to invest in securities quoted on a stock exchange. These include:

• the depth and liquidity of share markets • efficient price discovery. The depth of the market is measured by market capitalisation, that is, the number of shares issued multiplied by share prices. Liquidity is attractive to investors in a stock market because they know that in normal circumstances they are able to buy and sell shares at the current market price. This means that they can buy and sell long-term, higher-risk securities and at the same time maintain liquidity in their investment portfolio. A stock exchange measures liquidity as the volume of trading relative to the size of the market. For example, the depth and liquidity of the ASX is quite high, with a market capitalisation of around $2 trillion and daily turnover of approximately $5 billion. Combined with liquidity is efficient price discovery. How quickly does information get to the market, and how efficiently is that information absorbed by market participants and reflected in the current price of a share? Major global stock exchanges apply continuous disclosure rules that require any material information that may be expected by a reasonable person to have an effect on a share price to be provided immediately to the exchange. The stock exchanges publish this information on their websites; for example, the ASX site is www.asx.com.au. The efficiency of the markets is discussed in more detail in Chapter 7. This chapter first examines important issues relevant to share-market investment, including the process of buying and selling listed shares. Next, the impact of taxation on the net returns on a share 192

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investment is considered, followed by a number of financial performance indicators that influence share prices. This is followed by an introduction to some of the mechanical issues that affect the pricing of shares in the market. Finally, published share price information is analysed, and the structure and purpose of share-market indices are considered.

REFLECTION POINTS

buy shares issued by listed corporations in order to receive dividends and/or capital • Investors gains. However, these returns are not certain, in that company profits and share prices are variable over time. stock exchange should be deep and liquid. Depth is measured by market capitalisation, and • Aliquidity as the volume of trading relative to the size of the market. share market should also facilitate efficient price discovery. For example, continuous reporting • Arequirements ensure that investors are informed of material changes that may affect a share price.

6.1

Share-market investment

One of the major advantages of investing in securities listed on a stock exchange is that the investor has a wide range of investment choices. In Chapter 4 we noted that a stock exchange typically lists several categories of security:

• equity securities, in particular ordinary shares or common stock • quasi-equity or hybrid securities, such as preference shares and convertible notes • units in managed funds (e.g. property trusts and exchange-traded funds) • fixed-interest securities, such as certain corporate bonds • rights issues, being the right to purchase additional ordinary shares offered by a listed corporation • derivative securities, including options and warrants.

LEARNING OBJECTIVE 6.1 Consider the role of an investor in the share market, appreciate the wide range of investment choices that are available and understand risks associated with investments in shares of listed corporations.

The above list demonstrates the extent of choice available to an investor. However, within each category there are many hundreds of choices. For example, the ASX has more than 2 000 listed companies, each being an investment opportunity. To extend investment choice even further, corporations listed on a stock exchange are categorised into industry groups. This means that investors can select investment opportunities within a range of different industry sectors within an economy. These are:

• energy • materials • industrials • consumer discretionary • consumer staples • health care • financials • information technology • communication services • utilities. With such a range of choices, an investor is able to structure an investment portfolio to meet particular investment preferences. A primary preference will be the return on the portfolio. On average over time, there should be a direct correlation between the level of risk taken and the return gained. With share-market investments, return may be in the form of dividends received and/or capital gains (losses) made. Some investors will have a preference to receive more of their return in the form of 193

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Systematic risk exposures that affect the price of the majority of shares listed on a stock exchange

income; others will prefer to receive more in the form of capital growth. The board of directors of a company may pay income to shareholders in the form of a dividend, usually paid twice yearly. Capital growth relates to gains or losses in the current market price of a listed share. Investors need to consider the taxation implications of income versus capital growth. They also need to consider their liquidity requirements, that is, whether they need to generate a cash flow from the investment (dividends) or accumulate capital. Within the context of investing in shares listed on a stock exchange, risk is often categorised as (1) systematic and (2) unsystematic. Systematic risks are those risk exposures that will have an impact on share prices generally in the market; that is, the majority of shares listed on a particular stock exchange will be affected to a lesser or greater degree. This risk cannot be reduced by diversification. The impact may be positive or negative. Examples of systematic risk exposures include:

• changes in interest rates • changes in exchange rates • contraction or expansion in economic activity • introduction of new legislation • political stability • changes in market confidence and perception. Unsystematic risk exposures that specifically impact on the share price of a particular corporation

Diversified investment portfolio an investment portfolio that includes a wide range of financial securities and assets

Beta a statistical measure of the sensitivity of the price of an asset relative to the market

Active investment a portfolio structure based on share analysis, new information and risk/ return preferences

On the other hand, unsystematic risk affects a single corporation or a small group of companies. Examples of unsystematic risk exposures that will have an impact on a company’s share price include:

• the resignation of an executive manager • a change in future performance forecasts • the possibility of a merger • the failure of technology or communication systems • dissent within the board of directors • rumour or evidence of financial difficulty. Investment choices available through shares listed on a stock exchange enable an investor to diversify away a large proportion of the unsystematic risk. Investment theory contends that by holding a diversified investment portfolio an investor is able to minimise the risk exposures associated with investing in a single share. A diversified investment portfolio would include a range of investment categories, including shares, fixed-interest securities and property. The share component of an investment portfolio would hold a range of shares across different industry sectors within an economy. It is generally agreed that a well-diversified share portfolio will include somewhere between  10 and 25 stocks. Being able to diversify away unsystematic risk sends a very important message to investors, namely, that they will not be rewarded for accepting this risk exposure. The main risk exposure is therefore systematic risk. Investors will be rewarded for the level of systematic risk that is evident in an investment portfolio. Systematic risk is measured by the so-called beta coefficient. The beta coefficient, or beta, is the amount of systematic risk that is present in a particular share relative to an average share listed on a stock exchange. The market (as represented by an index such as the S&P/ASX 200) has a beta of 1.0. Therefore, if the shares of a listed company have a beta of 0.5, it will have only half as much systematic risk, while another share with a beta of, say, 2.0 has twice as much risk as the market as a whole. By taking the weighted average of the beta of individual shares, it is possible to determine the beta, or level of systematic risk, of an investment portfolio. Investors in the share market must also decide whether to take an active or passive investment approach. Active investment involves an investor making strategic stock selections to structure a share portfolio. An active investor will buy and sell shares based on new information received in the market. Two active investment approaches, fundamental analysis and technical analysis, are discussed in detail in Chapter 7. Each of these approaches will influence the structure and composition of an investment share portfolio.

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Briefly, technical analysis considers trends that are evident over time in individual share prices or in share-market indices. Technical analysts contend that market behaviour history will be repeated from time to time. Therefore, if an emerging share price trend corresponds to a past price trend, there is an expectation that current share prices will react as they did previously. Share price trends are plotted on graphs using a range of quantitative techniques, such as calculating a weighted 30-day moving average of price movements. The fundamental analysis approach, on the other hand, considers the domestic and international economic environments (top-down approach) and the financial performance of a corporation (bottom-up approach). For example, the top-down fundamental analysis approach considers economic fundamentals that will have an impact on the performance of a corporation or the share market generally, including interest rates, exchange rates, productivity levels, employment levels, the business cycle, government fiscal policy and central bank monetary policy. The bottom-up fundamental analysis approach involves the analysis of financial and accounting ratios such as the return on equity, the debtto-equity ratio, the debt-servicing capacity and liquidity. Passive investment involves building an investment portfolio based on shares incorporated in a share-market index. A share-market index is a grouping of shares listed on a stock exchange that shows changes in the overall prices of those shares day by day. (Share-market indices are discussed in Section 6.6.) Each stock exchange has its own set of indices. Well-known international indices include the Dow Jones Industrial Average (USA), the FTSE (UK), the Nikkei 225 (Japan) and the Hang Seng (Hong Kong). A passive investor who wishes to obtain returns on a share portfolio equal to the return achieved by the Dow Jones will purchase the 30 stocks included in that index. Another investor may replicate a sector index, such as the telecommunications sector or the industrials sector. A number of managed funds are index funds. Index funds use a range of sophisticated techniques to replicate or track the share market, including full or partial replication of a specified  sharemarket index. Full replication occurs when a fund manager purchases all the stocks included in an index. However, with a large index such as the S&P 500, the fund manager may hold only a percentage of the stocks, so long as sufficient stocks are held to ensure that the portfolio closely tracks the index. An investor needs to understand the risk and return characteristics of each share investment and its relationship with the total investment portfolio. It is not possible within this text to address portfolio theory in detail; there are many other excellent texts in this specialist area. However, an investor should be aware of risk and return relationships, including the spread of actual returns to expected returns, variance and standard deviation. For most investors it is necessary to consider the risk and return relationships of a diversified portfolio of shares. The expected return of a portfolio is the weighted average of the expected returns of each share. The weights are the proportion of each share to the total portfolio. Portfolio variance, or risk, is the variability of the portfolio’s returns over time. It is the result of the variance of each individual investment contained within the portfolio and the co-variance, or correlation, between pairs of securities within the portfolio. Co-variance or correlation measures the way two shares’ returns move in relation to each other. A positive correlation means that the shares’ returns move in the same direction, while a negative correlation means that the shares’ returns move in opposite directions. A diversified share portfolio reduces the impact of individual share return variances by combining shares with low co-variances or low or negative correlations. Interestingly, portfolio theory contends that the addition of a higher-risk share to a portfolio may in fact reduce the riskiness of the overall portfolio because of the co-variance characteristic. Finally, an investor must consider asset allocation within the share portfolio. Major considerations include:

• Risk versus return. This includes issues such as systematic and unsystematic risk, beta and

Passive investment a portfolio structure based on the replication of a specific sharemarket index

Index funds acquire shares so that a portfolio replicates a specific share-market index

Expected return of a portfolio weighted average of the expected returns of each share held in a portfolio

Portfolio variance the variability of the returns of an investment portfolio

Co-variance or Correlation the directional relationship between share price movements; either positive or negative

diversification.

• Investment time horizon. While speculative trading in shares is common, share portfolios, on average, produce consistently higher returns over the longer investment time horizon of five years or more.

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• Income versus capital growth. Each investor will have different liquidity needs that will influence investments in shares that pay regular dividends as opposed to those shares where price increases, or capital gains, are preferred.

Strategic asset allocation a portfolio structured to meet an investor’s personal preferences

Tactical asset allocation a portfolio structured to take account of a dynamic investment environment

• Domestic and international share investments. A diversified share portfolio will typically include

stocks from the investor’s home share market plus stocks from a selection of international share markets.

An investor may apply a strategic asset allocation approach; that is, the mix of shares satisfies the investor’s known and projected cash-flow requirements, tax position, risk tolerance and future lifecycle positions. At the same time, the investor may adopt a tactical asset allocation approach; that is, the mix of shares in the portfolio is changed to reflect altered circumstances of the investor and the share markets.

REFLECTION POINTS

• A stock exchange provides investors with a large choice of listed securities. listed on a stock exchange are categorised into industry sectors; each company • Corporations included in an industry sector provides an investment opportunity. investment risk is often categorised as systematic risk and unsystematic risk. • Share-market Systematic risks are exposures that affect most companies listed on the exchange (e.g. a change in interest rates); unsystematic risk affects only a single company or a small group of companies (e.g. a product recall). risk is measured by the beta coefficient. The share market index has a beta of 1.0; • Systematic therefore, the price of a share with a beta of 1.2 will move 20 per cent more than the market index.

• A diversified share portfolio of between 10 and 25 stocks minimises unsystematic risk. investment uses fundamental analysis (top-down approach and bottom-up approach), or • Active technical analysis to support investment decisions. investment simply replicates the shares in a specified share-market index such as the • Passive S&P/ASX 200. or correlation measures how two shares’ returns move relative to each other. • Co-variance A positive correlation means both shares’ returns move in the same direction, and a negative correlation means they move in opposite directions. that an investor will consider include risk, return, investment time horizon, income, • Issues capital growth and domestic and international investments. investor may apply a strategic asset allocation or a tactical asset allocation approach to the • An structure of a share portfolio.

6.2 LEARNING OBJECTIVE 6.2 Detail the process for buying and selling shares.

Buying and selling shares

For many people, being a shareholder is exciting, dynamic and fun. Probably more than with any other type of investment, a shareholder can analyse and monitor the day-to-day changes that occur in the price of a stock. By reading the financial press each day, and searching for information on the internet, an investor is able to keep abreast of new information that is continually coming into the market; the investor can interpret that information and make informed strategic and tactical decisions in relation to the structure of a share portfolio. An investor is able to experience the joy of watching personal stock selections increase in value, or suffer the low of realising that certain stocks are not performing as expected.

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Before making a direct investment, an investor should consider a whole range of issues in the share investment decision process. Some of these issues have already been mentioned and a number will be discussed in detail later in the chapter; however, it is useful to list briefly some of these considerations now:

• liquidity: how easily shares can be converted to cash (sold) • risk: including variance, standard deviation, beta, volatility • integrity: of the company, management, share market • charges: transaction costs such as fees on managed funds, or brokerage on direct transactions through a stockbroker • return: the type of return expected—dividends, capital growth • capital growth: factors that will affect the level of growth—inflation, interest rates, economic and business cycles • accessibility: the depth and liquidity of the primary market and secondary market • flexibility: portfolio restructuring, active investment, passive investment • taxation: income tax, capital gains tax, dividend imputation (if available) • social security: effect of investment on the income test and assets test associated with social security benefits (if applicable).

There are two approaches to buying and selling shares through a stock exchange: direct investment and indirect investment. With the direct investment strategy, an investor will choose to buy or sell shares directly through a stockbroker. Chapter 4 discusses the buying and selling of shares within the context of the ASX’s electronic trading and settlements systems, ASX Trade and CHESS. It may be useful to look again at Figure 4.3, as it depicts the processes of buying and selling securities on the ASX. As we noted, the ASX plans to replace CHESS in 2021. Briefly, an investor selects the company in which to invest and places an order with a stockbroker to buy or sell specific shares. The broker will place that order into the stock exchange’s electronic trading system. The system will prioritise by price and time, match corresponding buy and sell orders and execute the trade. The stockbroker will send a contract note to the buyer or seller confirming the transaction and advising of the stock traded, the number of shares, the date of the trade, the price, the transaction costs and the total amount. On the ASX, settlement will occur in T + 2 days; that is, the trade day plus two business days. The stock exchange will electronically transfer ownership of the shares to the buyer and forward financial settlement for the transaction to the seller. To enable financial settlement to occur, an investor will maintain a cash management trust account with a broker, or provide a broker with the authority to access an account with a financial institution such as a bank. The development of electronic trading and settlement systems, plus greater investor access to the internet, has radically changed the way stockbrokers function. Other important factors include an increase in investor knowledge, more affluent investors and an ageing population preparing for retirement. Further, globalisation of the investment markets, investor demand for higher performance outcomes and significantly increased competition for the provision of broker services have also changed the structure of the stockbroking sector. Stockbrokers can be categorised as discount (non-advisory) brokers or full-service (advisory) brokers. A discount broker accepts buy or sell orders from clients, but provides no advice or recommendations to the client in relation to investment alternatives or opportunities. The majority of orders to buy or sell shares are initiated by the client entering an instruction to the stockbroker via the internet. A full-service advisory broker offers advice and recommendations to clients on investment choices and strategies. The range of services provided includes:

• buying and selling shares on the instruction of clients • providing investment advice on securities listed on a stock exchange, including shares, fixed-interest securities, derivatives and listed trusts • giving advice on other investment opportunities such as cash management trusts, property trusts and equity trusts

Direct investment an investor buys and sells shares directly through a stockbroker

Stockbroker acts as the agent for an investor in the buying and selling of stockmarket securities

Discount broker executes buy and sell orders for clients; does not provide investment advice or services

Full-service advisory broker executes buy and sell orders, but also provides other services to clients, including investment advice

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• making recommendations and establishing and monitoring personal financial plans for clients • preparing retirement plans for clients, including superannuation • conducting investment research, forecasting and disseminating information to clients.

Indirect investment investing through a fund manager in a unit trust or a managed fund

Brokerage fees of a discount broker are lower than the fees of a full-service broker because of the level of service provided. Discount brokers’ fees in Australia range between $25 and $40 per transaction for smaller-value transactions, but increase to a percentage of the transaction value for larger-value transactions; for example, 1.00 per cent of transactions over $50 000. Investing in shares can also be achieved through indirect investment. The most common form of indirect investment in shares occurs when an investor purchases units in a unit trust or managed fund. The trustee of the fund will allocate part of the accumulated pool of the funds to professional fund managers. The fund managers will invest the funds in asset classes permitted under the terms of the trust deed of the fund. For example, a particular trust may be authorised to invest in domestic industrial and resource shares, while another fund may only be permitted to invest in selected international markets. Indirect investment fees may include entry, exit, management and administration fees; these will usually be higher than direct investment fees. (Managed funds and unit trusts are discussed in Chapter 3.)

REFLECTION POINTS

share investment occurs when an investor selects stock to be held in a portfolio and • Direct places buy or sell orders with a stockbroker; the stockbroker provides access to the exchange’s electronic trading and settlement systems. stockbroker may be a full-service broker who provides investment advice, facilitates buy/sell • Aorders and provides a range of other related financial services.

• A discount broker only accepts electronic buy and sell orders. buy/sell process and electronic trading and settlement systems are discussed in Chapter 4 • The (see ASX Trade and CHESS). issues a direct investor will consider before buying a stock include liquidity, risk/return, • Some integrity, transaction costs, capital growth/loss, accessibility, flexibility, taxation and social security. share investment is typically achieved by investing in a unit trust or managed fund. The • Indirect fund will use professional fund managers to invest in the share markets.

6.3 LEARNING OBJECTIVE 6.3 Understand the importance of taxation in the investment decision process.

Capital gains where the value of an asset increases over time

Taxation

The return received by an investor on a share portfolio may comprise dividend income and capital gains or losses. Dividends, if paid, are usually received twice yearly, being an interim dividend and a final dividend. The payment of a dividend from the profits of a company is at the discretion of the board of directors. Capital gains occur when the value of the share, or share price, increases. In either case, an investor may be required to pay taxation on total annual dividends received and realised capital gains (that is, any capital gain received when a share is sold). Therefore, an investor will need to be aware of the impact of taxation on an investment strategy. Taxation of investment returns varies from country to country, particularly in relation to:

• the taxation of dividend income • the taxation of capital gains • the rate of tax • the treatment of capital losses. This text briefly considers the taxation of income and capital gains within Australia. The taxation regimes of other countries may be accessed through the website of the taxation office in those

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countries. The address for the Australian Taxation Office is www.ato.gov.au. The taxation of individuals in Australia is based on a progressive tax system whereby the percentage of taxation increases relative to increases in taxable income. The personal tax income thresholds for the 2018–19 tax year are shown in Table 6.1.

Table 6.1 Personal income tax rates, Australia, from 1 July 2018 Annual taxable income

Personal income tax payable (a Medicare levy of 2.00 per cent of total taxable income is also payable)

0–$18 200

Nil

$18 201–$37 000

19c for each $1 over $18 200

$37 001–$90 000

$3 572 plus 32.5c for each $1 over $37 000

$90 001–$180 000

$20 797 plus 37c for each $1 over $90 000

$180 001 and over

$54 097 plus 45c for each $1 over $180 000

SOURCE: Australian Taxation Office.

The taxation of dividends in the hands of the recipient was introduced as a temporary measure during World War II. This tax effectively resulted in dividends being taxed twice. First, companies paid tax on their net profits before a proportion of those after-tax profits was then distributed to shareholders in the form of dividend payments. Second, tax was also payable by shareholders on the dividends received. The tax was levied at the shareholder’s marginal rate of tax. This essentially represented a system of double taxation. This double taxation continues in many countries today. However, in July 1987 Australia introduced a system known as dividend imputation which removed the double taxation of dividends. Table 6.2 illustrates a simplified example of the beneficial effects for shareholders of the dividend imputation system. Apart from the obvious taxation benefit, dividend imputation encourages investment and growth in the share market.

Marginal rate of tax the percentage of income tax paid progressively increases relative to the amount of income earned

Table 6.2 Dividend imputation (Australia) Company X:

Taxable income

$100.00

Tax liability (at 30%)(a)

−$30.00

After-tax profits distributed as dividends(b) Franked dividend received Income included in tax return (grossed-up amount, being the dividend of $70 plus the franking credit of $30) Shareholder:

Marginal tax liability (at, say, 39%)(c) Less the franking credit (paid by Company X) Tax payable

(a)

$70.00 $70.00 $100.00 $39.00 –$30.00 $9.00

Company tax rate for 2017–2018 = 30%; $30 tax paid by the company is available for allocation to shareholders as a franking credit. It should be noted that companies with turnover of less than $25 million pay 27.5% company tax. 

(b)

Assume 100% of profits are distributed as dividends to shareholders.

(c)

Assume personal marginal income tax rate = 37% plus 2.00% Medicare levy.

Franked dividends dividends paid to shareholders that have a tax franking credit attached that is derived from company tax paid

Grossed-up amount the total of the franked dividend plus the franking credit included in a shareholder’s taxable income

Franking credit

Under the current dividend imputation system, dividends on which the company has already paid company tax are referred to as franked dividends. For personal taxation purposes, the franked dividend received by the shareholder is grossed-up by the franking credit and the total amount is included in

the amount of company tax paid and transferred to a shareholder with a franked dividend

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taxable income. The individual shareholder is entitled to receive a tax rebate up to the amount of the franking credit. The franking credit is calculated as follows: company tax rate ​Franking credit = franked dividend × ​ __________________       ​​ 1 − company tax rate

Inflation component that part of a capital gain that is accounted for by the percentage increase in prices over the period

6.1

Therefore, as shown in Table 6.2, the franking credit is calculated as $30.00, being the fully franked dividend of $70.00 multiplied by ​0.30 / (1 − 0.30 ) .​ The franking credit of $30.00 is added to the franked dividend of $70.00 to give a grossed-up receipt of $100.00, which is included in the shareholder’s assessable income. The franking credit reduces the tax payable. In Table 6.2, the marginal personal income tax rate of 37 per cent, plus 2.00 per cent Medicare levy, is used. Tax payable on the grossed-up amount is $39.00, but the shareholder receives the benefit of the franking credit of $30.00, being the amount of tax already paid by the company. This reduces the tax payable by the shareholder to $9.00. Without the benefit of the dividend imputation system, the shareholder would have been required to pay $27.30 in tax on the $70.00 dividend received. A shareholder whose marginal tax rate is lower than the company tax rate will pay no tax on the dividend received, and the excess franking credit can be applied against other taxable income. If the shareholder is entitled to a franking credit greater than the income tax payable, the shareholder will receive a cash tax refund. Clearly, an investor needs to consider the tax implications of a share investment. The Australian dividend imputation system applies only to Australian company tax paid; therefore companies that generate part of their income overseas, and do not pay Australian tax on that income, cannot allocate a franking credit for the non-Australian tax paid overseas. In that situation the company may allocate a partly franked dividend based on Australian tax paid. Another relevant aspect of taxation is the tax payable on capital gains realised from the buying and selling of shares. This area of taxation has changed a number of times in Australia and both the previous and the current capital gains tax regimes are discussed here. Where shares were acquired (or deemed to have been acquired) after 19 September 1985, a capital gain that is realised from the sale of those shares within 12 months of purchase is taxed in full at the taxpayer’s marginal tax rate. Where a capital gain is realised on shares sold more than 12 months from purchase, different rules may be applied. From September 1985 until 21 September 1999, a capital gain was indexed; that is, it was adjusted to reflect the inflation component of the asset’s price change. The net capital gain after indexation was taxed at the taxpayer’s marginal tax rate. Since 21 September 1999 the rule has changed. Currently, 50 per cent of any non-indexed capital gain on shares acquired since that date is now taxed, where the shares have been held for at least 12 months. The tax rate is the shareholder’s marginal tax rate. For shares acquired between 19 September 1985 and 21 September 1999, the shareholder can choose between paying capital gains tax on the indexed capital gain, or the 50 per cent discounted gain. Capital losses can be offset against future capital gains.

REFLECTION POINTS

and realised capital gains are taxable. Taxation structures and rates vary • Dividends considerably between countries.

• In Australia there is a system of dividend imputation. imputation allows companies to pass tax credits for Australian company tax already • Dividend paid to shareholders when dividends are paid. This is a franked dividend and the tax transfer is called a franking credit. The grossed-up amount is added to the shareholder’s taxable income, but the shareholder is able to reduce the tax payable with the amount of the franking credit. Australia the taxation of capital gains has varied over time. Without considering retrospective • Inarrangements, the current system requires at least 50 per cent of a capital gain to be included as taxable income. Capital losses may be used to offset capital gains. 200

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6.4

Financial performance indicators

In deciding whether or not to purchase shares in a company, a potential shareholder who applies the fundamental approach to share investment analysis will be particularly interested in forecasting the future level of profitability of the company and the degree of risk associated with those forecast future cash flows. Though the emphasis of any share analysis should be based on future earnings, this generally is not possible and therefore an investor will, to a large extent, depend on historic data to form a view on the company’s projected performance. Significant indicators of a company’s past and present financial performance include its capital budgeting, capital structure, liquidity and cash management, dividend policies, record of profitability, overall performance relative to that of other firms in the industry and the impact of economic fluctuations on performance. The indicators of a company’s performance that we will consider are capital structure, liquidity, debt servicing, profitability, share price and risk.

6.4.1

Identify and describe various indicators of financial performance.

Capital structure

Capital represents the funds available to a company for its business purposes. This may seem a bit confusing because in Chapter 2 we referred to capital within the context of the Basel III capital accord as primarily equity-type funds. However, in this instance, capital structure refers to the proportions of funding derived from debt and equity. Capital structure is usually measured by the debt-to-equity ratio. The importance of the debt-to-equity ratio is discussed in detail in Chapter 5. Another relevant capital structure ratio is the proprietorship ratio, or shareholders’ interest ratio, which is the ratio of shareholders’ funds to total assets. The shareholders’ interest ratio is an indicator of the long-term financial viability and stability of a firm. Companies with a higher ratio of equity to other forms of finance are less dependent on external funding and thus have a lower level of financial risk. Such companies are also in a stronger position to grow the business, as they hold the necessary equity to support any expansion. It was pointed out in Chapter 5 that there is no single ideal ratio of debt to equity and that there is a wide spread between the ratios in different industries, and also between companies in the same industry. In analysing the debtto-equity ratio or the shareholders’ interest ratio, it is important to compare various industry groups. An examination of the ratio for a single company through time must also be carried out, typically over a three- to five-year period. The higher the level of debt financing relative to the proportion of equity provided by the shareholders of a firm, the greater the level of risk associated with future profitability. The higher level of risk derives from the nature of debt; that is, interest payments on debt and principal repayments must be made when they fall due. Should revenues from business operations fall as a result of adverse business conditions, the company might struggle to make these debt payments.

6.4.2

LEARNING OBJECTIVE 6.4

Capital structure proportion of company assets financed by debt and equity

Liquidity

A company must ensure that it has access to sufficient cash to be able to meet its current commitments and take advantage of future business opportunities. This is indicated by the company’s level of liquidity, that is, its ability to continue to meet its short-term financial obligations and thus to continue trading. One ratio used to measure the level of liquidity available to a company is the current ratio, that is, the ratio of current assets, being assets maturing within one year, to current liabilities, being liabilities due within one year. Current assets include cash, accounts receivable, stock (inventories) and short-term financial investments. Current liabilities include accounts payable and short-term debt commitments such as a bank overdraft facility, bills drawn and commercial paper issued.

Current ratio ratio of current assets to current liabilities

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current assets (maturing within one year) _________________________________ ​Current ratio = ​           ​​ current liabilities (due within one year) Liquidity ratio ratio of current assets, less inventory, to current liabilities, less bank overdraft

6.2

A second, more specific, ratio is the liquidity ratio, that is, the ratio of current assets less stock, to current liabilities less the company’s bank overdraft. current assets − inventory (stock on hand) __________________________________ ​Liquid ratio = ​           ​​ current liabilities − bank overdraft

6.3

Of the two ratios, the liquidity ratio provides a more realistic view of a company’s liquidity position. The reason for excluding inventory from current assets is that the liquidation of inventory may be quite difficult to achieve if the company is experiencing a liquidity crisis. Overdrafts are deducted from current liabilities because an overdraft facility with a bank is typically an ongoing financial arrangement and is less likely to be required to be repaid. On the liquidity criterion alone, it would seem that a company with a higher liquidity ratio or current ratio is in a healthier position than one with lower ratios. However, this is relative; the real question is whether a company has access to sufficient liquidity to meet its forecast needs under a pessimistic business scenario. Too much liquidity is not a good performance indicator, as there is a cost in maintaining a high level of liquidity; that is, the return received on liquid assets is generally lower. It is important to recognise that the ratios will vary considerably between firms in different sectors, and that there is no theoretical basis for the determination of the appropriate ratio even for firms within the same sector. One of the major reasons for the differences between the various sectors is different operating practices. For example, some firms and industries operate with a large volume of accounts receivable and inventories, and thus have a relatively high current ratio. Other companies will carry virtually no inventories, and will have little by way of accounts receivable; in this case, their liquidity ratios will be relatively low but will not necessarily indicate that there is a liquidity problem. It is important, therefore, that comparisons on the basis of liquidity be made only within the same industry group or sector. It may also be informative to compare, for the specific firm, the most recent performance of the ratios against a long-term average. That having been said, a rule of thumb generally accepted in the accounting literature is a current ratio of 1.5. This implies that a company with a 1.5 ratio will have liquid assets sufficient to cover its current liabilities one and a half times, thus providing a buffer to meet unexpected situations. A similar rule of thumb for the liquidity ratio may well be in the order of 0.7 to 0.8. This discussion of liquidity measurement has focused on the use of standard accounting ratios to measure the level of liquidity within a firm. These ratios are convenient for analysts and investors because the data needed for the calculations are available within published financial accounts. However, firms should adopt more sophisticated techniques for the internal measurement of liquidity. One method is to identify the liquidity characteristics of both assets and liabilities in order to understand the cash-flow implications of each asset and liability over different planning periods. This method recognises that the management of liquidity, as with other financial risks, is a dynamic rather than a static process. Liquidity within any corporation will change on a daily basis and therefore must be continually measured, managed and monitored.

6.4.3

Interest cover ratio the number of times a firm’s financial commitments are covered by earnings

Debt servicing

The amount and timing of cash flows available to a company are of critical importance to its ability to meet its short-term financing requirements and to ensure its solvency. Generally, companies always retain a level of debt because, as one debt issue matures, it is usually refinanced. However, refinancing may become very expensive when credit conditions in the capital markets are tight, so a strong cash flow is a good indicator of a company’s ability to maintain its ongoing operation. One measure of a firm’s capacity to service debt is the interest cover ratio. This ratio represents the number of times the business’s finance lease and interest charges are covered by its earnings before

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lease charges, interest and tax. The higher the ratio, the greater is the ability of the business to cover its interest commitments. Again, a rule of thumb in the accounting literature often gives a minimum interest cover ratio of two times. This means that a rise in interest rates will not result in an undue negative situation for the company. It also provides scope for the company to obtain further borrowings if necessary. An interest cover ratio of less than 1 means that the company will experience an operating loss before income tax, and a negative cover ratio indicates a loss situation even before interest expenses are deducted. earnings before finance lease charges, interest and tax ​Interest cover = ​ ___________________________________________             ​​ finance lease charges and interest

6.4.4

6.4

Profitability

A company’s profitability may be represented by a range of different accounting ratios. A ratio that allows for comparisons to be made between companies with different capital structures is the ratio of earnings before interest and tax (EBIT) to total funds employed: EBIT ​EBIT to total funds ratio = ​_______________________________________________             ​​ total funds employed (shareholders’ funds and borrowings)

6.5

A variation of this ratio is to exclude short-term funding. This eliminates the effects of seasonal fluctuations in the amount of short-term debt employed by some companies. This ratio is referred to as the EBIT to long-term funds ratio: EBIT ​EBIT to long-term funds ratio = ​______________________________________________              ​​ long-term total funds (i.e. total funds less short-term debt)

Return on equity

6.7

Another ratio considered by shareholders is earnings per share (EPS). Company data for this ratio are normally published daily in major newspapers and therefore are easy to obtain. The EPS ratio measures the earnings that are attributable to each ordinary share after abnormal items. One shortcoming of the EPS ratio is that it is impacted by the number of shares outstanding. Investors will usually complement their analysis of earnings with the firm’s price to earnings (P/E) ratio. We discuss this shortly. Table 6.3 shows the EPS ratios of selected companies in the retail, banking and resources sectors. There are quite wide differences between companies and sectors. However, prior to concluding that those with the highest ratios are the ones that should be invested in, it is important to consider a range of other indicators of an industry’s and a company’s performance, such as the price to earnings ratio. It is also important to consider the history of the ratio in order to allow for the effects of fluctuations in the overall economic environment on particular companies and industry sectors.

6.4.5

the profits of a firm before allowing for interest expenses and tax payments

6.6

A further measure of profitability is the return on equity. It is given by: operating profit after tax ​ eturn on equity = ​ _______________________ R         ​​ equity (shareholders’ funds)

Earnings before interest and tax (EBIT)

operating profit after tax as a percentage of shareholders’ funds

Earnings per share (EPS) earnings attributed to an ordinary share

Share price

The price of ordinary shares in a company listed on a stock exchange represents the opinion of investors as to the present value of the future net cash flows to be generated by the company. The more optimistic the evaluation of the company’s future earnings prospects, the greater will be the demand for its shares, and thus the higher the share price of the company. There are two commonly used measures of the investors’ evaluation of a firm. They are the price to earnings ratio and the share price to net tangible assets ratio. 203

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Table 6.3 Selected earnings per share ratios, July 2017 (cents) Retail sector Harvey Norman

40.85

JB Hi-Fi

186.83

Woolworths

110.45

Banking sector Australia and New Zealand Banking Group

195.33

Commonwealth Bank

556.45

National Australia Bank

239.30

Westpac Banking Corporation

233.32

Resources sector BHP Billiton

172.74

Rio Tinto

628.01

Santos

–22.08

Woodside Petroleum

154.38

SOURCE: Morningstar DatAnalysis, 2018.

Price to earnings ratio (P/E) the current share price divided by the earnings per share

Share price to net tangible assets ratio current share price relative to the firm’s net tangible assets

The price to earnings ratio (P/E) is the market price of a company’s shares divided by its earnings per share. This ratio is an indicator of investors’ evaluation of the future earnings prospects of a firm, rather than an indicator of the firm’s current or past performance. Where good earnings growth is expected, the P/E ratio will rise and be relatively high. Where there is less optimism about the future prospects, the P/E ratio will generally fall. Table 6.4 provides P/E ratios for selected companies within the retail, banking and resource industry classifications. The published data used in Table 6.4 are based on historic earnings rather than on a forecast of future earnings. Variations are evident between companies within the same industry sectors. This implies that the prices of company shares do, to some extent, already reflect anticipated changes in future earnings. While the P/E ratio is generally used and is conceptually quite simple, it is often difficult to calculate and interpret. The P/E ratio for a particular company can vary from one published source to another, depending on the earnings figure used in the calculation and on the estimation of the projected earnings growth rate. As noted above, the ratio should be based on expected future earnings. However, there are likely to be as many numbers put on the future earnings figure as there are analysts who are constructing P/E ratios for specific firms. Again, when interpreting P/E ratios published in the financial press, keep in mind that they will have been calculated using the immediate past earnings figures. Another measure of the value of a company is the share price to net tangible assets ratio. This is a measure of the discount or premium that a company’s share price is trading at relative to its net tangible assets. When the ratio is less than 1, the share price is at a discount and this may form the basis for another company to take over the assets of the company that theoretically may be undervalued. A ratio of less than 1 will not automatically result in a takeover. One of the inadequacies of this measure is that the value for net tangible assets (NTA) may not truly reflect the real, or replacement, value of the assets. For example, the valuation of some company assets may not take account of the fact that the assets cannot be converted into cash because they are purpose-built or they cannot be relocated.

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Table 6.4 Selected price to earnings (P/E) ratios (times), May 2018 Retail sector Harvey Norman

10.45

JB Hi-Fi

11.78

Woolworths

22.84

Banking sector Australia and New Zealand Banking Group

12.95

Commonwealth Bank

12.87

National Australia Bank

12.19

Westpac Banking Corporation

12.58

Resources sector BHP Billiton

15.16

Rio Tinto

12.93

Santos

—

Woodside Petroleum

19.71

SOURCE: Morningstar DatAnalysis, 2018.

6.4.6

Risk

Of fundamental importance in the decision to invest in a particular company or industry is the assessment of the risk that the investor would face from the investment. The notion of risk here is the variability, or fluctuation, in the share price. Modern portfolio theory provides a rigorous approach to analysing investment risk, in which risk is divided into two components: systematic risk and unsystematic risk. The nature of systematic and unsystematic risk was introduced in Section 6.1. That discussion is continued here. Systematic, or market, risk arises from factors that affect the whole market; that is, it relates to the variability of the general share market, not the variability of the shares of an individual firm. Variations in overall market performance could be brought about by:

• the state of the economy, including the levels of interest rates and the availability of credit, the rate •

of inflation, the rate of growth of the economy, changes in the taxation system and in government spending and movements in the exchange rate the state of international economies and the performances of major foreign share markets.

The second component, unsystematic risk, is caused by factors specific to an individual company. The relevant influences include:

• the effectiveness and experience of the managers of the company • productivity and the cost of labour • the particular impact of financial risk exposures (e.g. interest rate changes will have a greater impact • •

on highly geared companies, and unfavourable foreign exchange movements will affect companies that have not hedged their foreign currency exposures) exposures to particular operational risks (e.g. loss of computer systems, denial of access to company premises due to a flood or fire or industrial action by employees) the competitiveness of the company relative to other firms, both domestic and foreign, in the same industry. 205

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As discussed previously, one of the contentions of modern portfolio theory is that an investor can significantly reduce the effects of unsystematic risk through investment in a well-constructed and diversified portfolio. On the other hand, systematic, or market, risk cannot be diversified away. Therefore, in constructing a share portfolio it is important to identify the systematic risk of the firms to be included in the portfolio. The higher the systematic risk, the higher should be the expected rate of return. As discussed in Section 6.1, estimating systematic risk involves comparing the price history of a particular stock relative to movements in the market index. This measure of risk is referred to as the beta coefficient. The higher a stock’s beta, the greater the risk of that particular stock, and therefore the higher should be the expected rate of return. One of the problems in using beta calculations is that they are based on historic data. Nevertheless, beta is a very useful comparative measure of risk. Beta factors should be used as a starting point for the analysis of risk that may be inherent within various companies, and for the construction of an appropriate share portfolio. A company listed on a stock exchange with a beta of 1.15 indicates that, based on historic data, the share price can be expected to perform 15.00 per cent better than the overall market when share prices are rising, but 15.00 per cent worse if the market is falling. A company with a beta of 0.5 implies that the share price will rise, or fall, at only half the rate at which the overall market moves. However, what is relevant when choosing between investment alternatives is the expected future performance of a company. Chapter 7 considers some of the approaches that are used to assess the future performance of various sectors of the market and of individual companies.

REFLECTION POINTS

investor will consider a range of financial performance indicators when analysing the future • An earnings and profitability of a company. structure looks at the risks associated with the funding of a firm, including the debt-to • Capital equity ratio and the type of debt held. considers the access a company has to liquid funds to meet its day-to-day • Liquidity commitments. servicing analyses the ability of a company to meet payments on its liabilities over • Debt different business scenarios.

• Profitability analyses the earnings per share of a company and its return on equity. share price is the present value of forecast future net cash flows. Within this context, an • The investor will consider the price to earnings (P/E) ratio. investor will analyse systematic risks (e.g. the impact of an increase in interest rates on debt • An facilities) and unsystematic risks (e.g. the impact of a computer system failure). Investors should, in part, manage systematic risk using beta factors, and diversify away unsystematic risk.

6.5 LEARNING OBJECTIVE 6.5 Apply quantitative methods to the pricing of shares.

Pricing of shares

Share investors are particularly interested in share prices and will scan the newspaper, or the website of the stock exchange, each day to see if the prices of shares held in a share portfolio have risen or fallen. In general, people are excited when the price of a share has risen, but surprised and disappointed when a share price falls. Fundamentals that impact on the price of a share include company-specific performance indicators and macroeconomic effects such as changing interest rates, exchange rates, prices, employment levels and business cycles. This section looks at the ways an investor can estimate the price of an ordinary share issued by a listed corporation, and the impact on a current share price of dividend announcements and payments, the issue of bonus shares, share splits and pro-rata rights issues.

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6.5.1

Estimating the price of a share

The price of a share listed on a stock exchange is principally a function of the supply and demand for that stock. However, there are factors at work in the market that influence the level of supply and demand. One of the biggest influences is information. It may be argued that a share price moves in response to new information coming to the market. Why does new information have such an impact on share prices? The answer lies in the method that is used to estimate the price of a share. The price of a share is the present value of its future cash flows. New information will change investors’ expectations of forecast earnings and future dividends, and this will be reflected in a movement in the share price. That is, there will be a change in the supply and demand of a share as a result of the new information that changes expectations of future cash flows. Where the price of a dividend-paying ordinary share is equal to the present value of all future dividends, this may be expressed as: ​Dt​ ​​ ∞ ​​P​ 0​​ = ​∑ ​​ ​  ​  _______   t ​​   t=1 ​(1 + ​rs​ ​​)​​ ​

6.8

where: P0 = current share price Dt = expected dividend per share in period rs = required rate of return In fact, an accurate estimation of future dividends over an extended period is very difficult. The calculations are therefore often simplified by using two alternative assumptions. In the first case it is assumed that a company will continue to pay a constant dividend over time; in the second, that a company will pay a dividend that grows at a constant rate over time.

Valuing a share with a constant dividend When a company’s dividend payments are expected to remain constant, such that ​​D0​ ​​ = ​D1​ ​​ = ​D2​ ​​ = ... ​Dn​ ​​,​  the share price can be calculated based on a perpetuity. The present value of a perpetuity is the cash flow divided by the relevant discount rate. The discount rate is the required rate of return that an investor requires on this particular investment. The equation may be expressed as: ​D0​ ​​ ​​P​ 0​​ = ​ __ ​r​  ​​​​ 

6.9

s

For example, if Techno Limited’s last dividend payment of $0.50 per share is expected to remain constant, and the required rate of return on this investment is 15 per cent per annum, the price of the stock should be: ​P​ ​​ = ____ ​ 0.50 ​  ​ ​​ 0​  ​ ​  0.15​  ​​ ​ = $3.33

6.9a

The price of Techno Limited should change if the required rate of return changes as a result of new information coming to the market, or if new information implies a shift in the constant dividend to a new level.

Valuing a share with a constant dividend growth rate A more common situation is one in which the dividend paid to shareholders over time increases. (It is assumed that the growth rate is constant.) Therefore, the next dividend paid will be the last dividend multiplied by the growth rate (g). This is expressed as: ​​D​ 1​​ = ​D0​ ​​ (1 + g)​

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therefore: ​​D​ t​​ = ​D0​ ​​ ​(1 + g)​​ t​​ The original pricing formula can now be reconfigured so that: ​D0​ ​​(1 + g) ​​P​ 0​​ = ​ ________  ​​     (​rs​ ​​ − g)

6.11

This formula represents the constant dividend growth model. For example, Ocka Limited has a constant dividend growth policy of 7.00 per cent. In the last financial year the company paid a dividend of $0.75 per share. If an investor’s required rate of return on this investment is 12.00 per cent, the current price of the stock should be: ​D0​ ​​(1 + g)  ​ ​P0​ ​​ = ________   ​      (​rs​ ​​ − g) 6.12 ​ ​​ ​  ​  ___________  ​​    ​ ​ (0.75   × 1.07) ​ =    ​     ​ (0.12 − 0.07)     = $16.05 The constant dividend growth model recognises that a share price will be influenced by:

• a company’s earnings per share • the company’s dividend payout ratio • the expected growth rate in dividend payments • an investor’s required rate of return. While the formula seems to imply that it is simple to accurately calculate the price of a share, in fact each of the component parts of the formula is not known with any certainty.

6.5.2

Cum-dividend a share price includes an entitlement to receive a declared dividend

Ex-dividend date at which a share price is theoretically expected to fall by the amount of the declared dividend

Cum-dividend and ex-dividend share prices

In addition to fundamental factors that affect the price of a share, there are some other reasons— unrelated to the performance of the company—which lead to changes in a share price. These reasons are associated with the announcement by a company of a shareholder entitlement to receive a dividend, and the actual payment of the dividend to shareholders. Dividends are payments to shareholders, made out of the company’s after-tax earnings. Dividends are normally expressed as cents per share. Companies typically pay dividends twice a year: an interim (half-year) dividend and a final dividend. After a dividend is declared, shares are normally traded for a period of time with the dividend entitlement attached. That is, the share is said to trade cum-dividend (cum is the Latin for ‘with’). This occurs because there is a period of time between the announcement by the board of directors of a dividend payment during which the entitlement to receive that dividend moves to the new owner of the shares if the shares are sold. When a share is trading cum-dividend, the buyer of a share will also receive the next dividend payment. At a specified date, the share begins to trade ex-dividend (ex is the Latin for ‘without’) and the seller of a share, not the buyer, will receive the next dividend when the payment is finally made by the company. The ex-dividend share price should, theoretically, adjust downwards by the amount of the dividend. For example, if a company has declared a dividend of 5 cents per share, and its price cum-dividend is $1.00, the theoretical ex-dividend price would be calculated as: Share price cum-dividend

$1.00

Dividend paid

$0.05

Theoretical ex-dividend price

$0.95

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6.5.3

Bonus share issues

Occasionally, the board of directors of a company will issue additional ordinary shares to existing shareholders at no cost to the shareholder. The shares will usually be issued based on a predetermined ratio, such as one bonus share for every four ordinary shares held. The reason the board of directors makes a bonus issue is in order to convert accumulated reserves into equity; this is referred to as capitalising reserves. As with dividends, bonus share entitlements are traded cum-bonus and ex-bonus. When shares go ex-bonus there should be a downward adjustment in the share price. This is to be expected since a bonus issue does not result in a change in the total assets, or earnings expectations, of the company. Rather, it simply represents a change in the structure of the company’s financial capital. The price adjustment for ex-bonus shares should reflect the new number of shares in, or claims on, the asset value of the company. For example, if a company offers a one-for-four bonus issue, and its shares are currently priced at $10.00 cum-bonus, the theoretical price ex-bonus would be calculated as: Cum-bonus share price

$10.00

Market value of four cum-bonus shares

$40.00

Theoretical value of five ex-bonus shares

$40.00

Theoretical value of one ex-bonus share = $40.00/5

 $8.00

Bonus issue where a company capitalises reserves through the issue of additional shares to shareholders

The ex-bonus price may not fall to its theoretical value. The act of issuing bonus shares may be taken by the market as a signal from the management of the company that it anticipates an increase in profitability. This is because, with the bonus issue, there are a greater number of shares in existence, and thus there are a greater number of shares to be serviced with dividends in the future. Assuming that management will not want to pay lower dividends in the future, it must have reason to believe that higher profitability is expected. If that is the interpretation that is placed on the bonus issue, demand for the shares should increase and there would be a consequent increase in the price of the shares. In this case, the ex-bonus price may not be adjusted down by as much as the calculations above suggest.

6.5.4

Share splits

The board of directors may decide to split the number of issued ordinary shares of a company. A motivation for a share split might be to increase the liquidity of the shares on the stock market. For example, if the share price of a company has, over time, increased significantly, to a point where the dollar amount is large relative to the majority of other company shares traded on the exchange, the share may be seen as too expensive for some investors. If this is the case, those investors will be reluctant to buy the high-priced share and as such there will be less liquidity in the market for that share. A share split enables the board of directors to lower the price of the stock without changing the capital structure of the company or diluting the return to shareholders. A share split involves the division of the number of shares on issue. While the split often involves the doubling of the number of shares on issue (2 for 1), there can be other ratios as well. In assessing the impact of a share split on the market price of an ex-split share, it must be remembered that there is no fundamental change in the asset value of the company. The price adjustment should simply reflect the ratio of the split. For example, if a share with a current pre-split price of $40.00 is split two for one, then: Pre-split share price

$40.00

Theoretical ex-split share price

$20.00

Share split a proportional division of the number of shares issued by a company

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Should the split be a 5 for 1 split, that is, the split results in five new shares for one existing share, then, given a pre-split share price of $40.00:

6.5.5

Pre-split share price

$40.00

Theoretical ex-split share price

 $8.00

Pro-rata rights issues

A pro-rata rights issue was discussed in Chapter 5. Briefly, a rights issue comprises an offer to existing shareholders of additional ordinary shares in the company on a pro-rata basis, such as one new share for every five shares held. A rights issue allows a company to increase its issued capital. The offer or subscription price of a rights issue is typically made at a discount to the market price. Thus, one should expect, theoretically, a downward adjustment in the share price when it is traded ex-rights compared with the cum-rights price. The extent of the adjustment should reflect the number of new shares issued and the amount of funds raised from the issue of the additional shares. The greater the number of shares issued, and the deeper the discount at which they are issued, the greater is the expected downward adjustment in the ex-rights share price. For example, a company with a cum-rights share price of $2.00 has made a one-for-four rights issue priced at $1.80; that is, the new share will cost $1.80. The theoretical ex-rights price would be calculated as: Cum-rights share price

$2.00

Market value of four cum-rights shares

$8.00

Plus: New funds raised through take-up of one-for-four issue

$1.80

Gives: Market value of five ex-rights shares

$9.80

Therefore: Theoretical ex-rights share price ($9.80/5) =

Renounceable a right that can be sold before it is executed

$1.96

Typically, the board of directors will announce a rights issue today, but the right will be exercisable by shareholders at a future date, such as in six weeks’ time. From the investor’s point of view, if the board of directors makes the rights issue renounceable—that is, the entitlement, or rights to purchase the new share, can be sold—the rights offer has a value before it is exercised. If the shareholder from the above example holds four cum-rights shares priced at $2.00, and a rights issue of one for four is offered at $1.80, the value of the right is 16 cents. The value of the right is expressed as: N(cum-rights price − subscription price) ​Value of right = ​ _________________________________       ​​    N+1

6.13

where N is the number of shares required to obtain one rights issue share, and the subscription price is the discounted price of the additional share. Therefore: 4($2.00 − $1.80) ______________ Value of right =    ​   ​  5 ​ ​​ ​         ​  _____  ​​ ​ ​ $0.80 ​ = ​   ​    5 ​ = $0.16

6.13a

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Since each of the original shares has one-quarter of the right attached to it, being a one-for-four rights issue, each ex-rights share can be expected to fall in value by 4 cents, that is, from $2.00 to $1.96. This is exactly the theoretical ex-rights share price that was calculated previously. Quite often the ex-rights price will not fall to its theoretical value. This is explained by the informational content of the rights issue. The fact that the company has increased its equity base may be taken by the market to mean that it anticipates improved profitability. Investors may well presume that the additional capital raised with the rights issue will be used by the company for profitable growth. As with bonus shares, that presumption of profitable growth is necessary if the company is to maintain its current dividends and earnings per share on the increased number of shares.

REFLECTION POINTS

price of a company’s shares is the present value of forecast future cash flows. New • The information will change investors’ expectations and cash-flow forecasts and therefore the share price. a company is expected to pay a constant dividend over time, the price of the share is • Where the constant dividend divided by the required rate of return. a company pays a dividend that has a constant growth rate, the price of a share is the • Where current dividend multiplied by one plus the growth rate, divided by the required rate of return minus the growth rate. share is said to be cum-dividend when a company has announced that it will pay a dividend; • Aholders of those shares are entitled to receive the dividend. company will announce the date when a share goes ex-dividend; new shareholders after that • Adate are not entitled to receipt of that dividend. other things being unchanged, the price of the share will theoretically fall by the amount of • All the dividend on the ex-dividend date. a company issues bonus shares to existing shareholders, no additional capital is raised; • Iftherefore the share price should adjust downwards by the pro-rata number of shares issued. a company will decide to split the number of shares on issue, often to lower • Occasionally, the share price and generate more liquidity in the stock. The share price should adjust by the percentage of the split. rights issue provides shareholders with the opportunity to buy additional shares at a specified • Aprice on a pro-rata basis. The price of the share will adjust downwards relative to the current market price and the rights issue price. For example, if the current share price is $3.00 and a 1:1 rights issue has a subscription price of $2.80, the theoretical ex-rights price is $5.80 divided by 2, which equals $2.90.

• If a rights offer is renounceable, it has a value and can be sold on the stock exchange. 6.6

Stock-market indices and published share information

A stock-market index provides a measure of the performance of a share market or industry sectors within the overall market. An index incorporates a group of selected company stocks designed to represent changes in the value of the market over time. Each day, news reports on television and radio comment on movements in the share market. For example, the evening news normally reports movements in the S&P/ASX 200 index and compare it with other indices in the USA, Europe and Asia. Stock-market indices have become an important barometer of the mood of the markets. When the

Stock-market index a measure of the price performance of the share market or a sector of the market

LEARNING OBJECTIVE 6.6 Analyse the functions and importance of share-market indices and interpret published share-market information.

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Part 2 Equity markets Bull market a period when share prices are steadily rising over time

Bear market a period when share prices are steadily falling over time

indices are continually rising, it is said to be a bull market, but when the indices are steadily falling it is said to be a bear market. A stock exchange will publish a set of share-market indices that reflect the composition and strength of that market. Major stock exchanges around the world also publish a standard set of indices known as global industry classification standard (GICS®) indices. These are discussed below. Many stock exchanges use the services of specialist index providers. Two specialist index providers are S&P Dow Jones Indices (http://au.spindices.com) and MSCI Inc. (www.msci.com/products/indices/). The use of specialist managers for market indices is an acknowledgment of the increasing importance and global nature of investment. Fund managers typically now have an increasing pool of funds that are strategically invested in a wide range of international markets. Therefore, it is important that stock-market indices are comparable between countries. In this chapter, the focus is on S&P Indices as an index manager. By arrangement, and in consultation with a local stock exchange, S&P manages three main types of share-market indices: 1 performance benchmark indices 2 tradable benchmark indices 3 market indicator indices.

Performance benchmark index broad measures of share-market performance; based on capitalisation and liquidity

Stock liquidity the percentage of a corporation’s shares available for trading on a stock exchange

Tradable benchmark index a narrow index generally used as the basis for pricing certain derivative products

Market indicator index seeks to measure the overall performance of the share market

Share price index measures changes over time in the price of shares included in the index

Accumulation index measures changes in share prices, plus the reinvestment of dividends received

Global industry classification standard (GICS®) an international standard that groups listed companies into 10 standard industry sector indices

A performance benchmark index measures the performance and risk of a broad market, and includes a combination of company shares that represent 75–90 per cent of a share market’s capitalisation. Listed companies included in a performance benchmark index are required to demonstrate an adequate amount of market capitalisation combined with a high level of stock liquidity. Within the Australian equity market, the S&P/ASX 200 is the main benchmark index adopted by index (passive) fund managers. The index incorporates the shares of 200 eligible companies listed on the ASX. Eligibility is determined based on market capitalisation (size) and share liquidity (the percentage of shares actively traded). The S&P/ASX 200 covers around 80 per cent of the Australian market and is updated every quarter. A tradable benchmark index may also be a performance benchmark index, but it is a narrower index and is the basis upon which certain derivative contracts are priced, such as equity index futures contracts. Derivative contracts are discussed in detail in Part 6. The stocks included in this type of index are relatively stable in that they do not change regularly, thus enabling pricing consistency over time. Finally, a market indicator index measures the performance of an overall market, or the performance of a select group of stocks that indicate the performance of the overall market. Widely known international stock market indicator indices include the Dow Jones Industrial Average (USA), the S&P 500 (USA), the FTSE (UK), the DAX (Germany), the Nikkei 225 (Japan), the Hang Seng (Hong Kong) and the Straits Times (Singapore). It is interesting to note that the Dow Jones (a widely quoted US stock-market index) comprises only 30 stocks. Therefore, the S&P 500 has become the most widely used index in the USA. The S&P 500 incorporates 500 US stocks chosen primarily for their market size, liquidity and industry grouping. The Dow Jones Industrial Average index is a price-weighted index, while the S&P 500 index is a market value-weighted index; that is, the weighting of each company included in the index is proportional to each company’s share price and shares outstanding. The main market indicator index in Australia is the S&P/ASX All Ordinaries Index which incorporates 500 stocks. An index may be a share price index that measures the capital gains or losses evident from investing in an index-related share portfolio, or an accumulation index that recognises both changes in share prices and the benefit of reinvesting company dividend payments. The accumulation index facilitates comparisons between returns on a range of different investment products. If dividend imputation is available within a country (e.g. Australia), no allowance is made to an accumulation index for dividend franking credits, or for any discounts on dividend reinvestment schemes. S&P Indices manages its industry sector indices with a global industry classification standard (GICS®). The GICS comprises 10 standard international industry sector indices incorporating 24 industry groups, 67 industries and 147 sub-industries. Globally, around 27 000 companies are encompassed by this framework. Additional sector indices that recognise special market conditions

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that apply to a particular country may be added to the list; for example, in Australia additional industry sector indices include financials excluding property trusts, real estate investment trusts (property trusts), metals and mining industry and gold sub-industry indices. The additional GICS indices used in the Australian market are essentially components of standard GICS indices, and reflect certain strengths within the Australian economy; that is, metals and mining, financials, property trusts and gold. The 10 standard international GICS indices are:   1 Energy. This includes companies primarily involved in the exploration, construction, production, marketing, refining or distribution of oil, gas, coal and consumable fuels.   2 Materials. This includes corporations involved in commodity-related manufacturing, such as construction materials, chemicals, metals, glass, non-energy resources, aluminium, steel producers, gold and precious metals, forest products and paper.   3 Industrials. This sector incorporates manufacturers and distributors of capital goods, consumer and professional services, plus transportation industries. This includes aerospace and defence, construction, engineering and building products, electrical equipment, industrial machinery and industrial conglomerates. It also includes commercial services and suppliers such as printing, data processing, office supplies and employment services. Transportation industries include airlines, railroads, marine and trucking corporations and transport infrastructure.   4 Consumer discretionary. This index includes industries that tend to be more sensitive to economic cycles. This includes manufacturers such as automotive, household durable goods, textiles and apparel, and leisure equipment. The services segment of the index includes hotels, restaurants, leisure and education services. The media segment includes advertising, broadcasting, movies and publishing. The retailing segment includes merchandise distributors and department and speciality stores.   5 Consumer staples. Consumer industries in this index are less sensitive to economic cycles. The index includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. Examples include food retailers, brewers, soft drink manufacturers, agriculture products and beauty care products.   6 Health care. This includes health-care equipment and instrument manufacturers and suppliers, diagnostic services and operators of health-care facilities, including hospitals and medical clinics. It also includes companies involved in research, development, production and marketing of pharmaceuticals and biotechnology products.   7 Financials. This includes companies involved in banking, mortgage finance, consumer finance, corporate lending, specialised finance, investment banking, broking, asset management, custody services, insurance, financial investment and real estate, including property trusts.   8 Information technology. This includes software development for the internet, application-based software, systems software and IT consulting and other services. It also includes manufacturers and distributors of technology hardware and equipment, including communications equipment, computers and peripherals, electronic equipment and semiconductors.   9 Communication services. This includes diversified telecommunication services, such as fixed-line, cellular, wireless, high band width and fibre optic networks, as well as companies that offer related content and information through various media. 10 Utilities. This includes companies involved in the production and distribution of electricity, gas and water. Passive fund managers use stock-market indices to target certain investment performance outcomes. For example, a fund manager within the Australian market may adopt the S&P/ASX 200 index as the benchmark for a particular investment fund. In this case, the fund manager will purchase shares of those companies that are included in the index, in the same weighted proportions. The performance of the fund will then track the performance of the stock market generally, as the S&P/ASX 200 represents approximately 80 per cent of market capitalisation. In the USA, a funds manager might choose to replicate the S&P 500, while in Japan the Nikkei 225 might be appropriate. 213

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Major financial newspapers and other financial journals publish share-market information. The depth of information provided within the financial press does vary, and it is revealing to choose a local newspaper and analyse the stock-market information that is provided. To assist with your understanding of the information typically provided in the financial press, the following is a brief description of each of the column headings used by the Australian Financial Review (AFR). The daily share tables can be downloaded from www.afr.com/share-tables.

• 52 week high/low: the highest and also the lowest sale prices recorded over the past year. • Day’s high/low: the highest and lowest sale prices recorded during the trading day. • ASX code: an alpha code given by the stock exchange for each listed security; for example, Woodside Petroleum Limited is WPL.

• Company name: the abbreviated name of the company. • Last sale: the final sale price recorded at the close of trading on the previous business day. • + or – : the rise or fall in the share price, in cents, from the previous day’s closing price. • Vol 100’s: the total volume, in hundreds, of a company’s shares traded on the exchange for that day. • Quote buy: the highest price at which a buyer is offering to buy a share as recorded on the ASX Trade electronic trading system.

• Quote sell: the lowest price at which a seller is offering to sell a share as recorded on the ASX Trade electronic trading system.

• Dividend cents per share: the latest annual dividend, in cents per share, declared by the company.

(The letter f following a dividend figure denotes that the dividend is fully franked, the letter p that a dividend is partly franked.)

• Dividend times coverage: the number of times the dividend per share is covered by the earnings per share.

• NTA: total assets less total liabilities expressed in dollars per share. • Dividend yield per cent: the dividend return to the shareholder based on the current share price; calculated by dividing the current dividends by the last sale price.

• EPS (cents): earnings per share recorded in cents; represents the net profit divided by the total number of ordinary shares issued by the company.

• P/E ratio: the current share price divided by earnings per share. The P/E ratio is expressed as a multiple (times), and shows the number of times the share price covers historic earnings.

Other listed securities issued by corporations are also included in the daily published information; for example, pref indicates preference shares and opt indicates options issued. Students who feel they have an appreciation of the dynamics of investing in a stock market should consider two challenges: first, go to the website of the local stock exchange (e.g. www.asx.com.au) and explore the enormous amount of information that is readily available; second, look in the daily newspaper and interpret the stock exchange trading information that is published. Chapter 7 further extends the discussion of the share markets, with an analysis of factors that influence share price movements.

REFLECTION POINTS

stock-market index provides a measure of the performance of a share market or sectors • Awithin the share market. Indices manages three main types of share-market indices: (1) performance benchmark • S&P indices based on 75–90 per cent of a share market and including market capitalisation and 214

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liquidity requirements; (2) tradable benchmark indices which are narrower indices used to price certain derivative products; and (3) market indicator indices which are representative of an overall share market. share price index monitors movements in share prices, while an accumulation index also • Aincorporates the reinvestment of dividends. also manages global industry classification standard (GICS®) indices for industry sectors of • S&P energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, communications services and utilities. Additional GICS indices used in the Australian market are financials excluding property trusts, real estate investment trusts (property trusts), metals and mining industry and gold sub-industry indices. and printed media services provide investors with an enormous range of financial, • Electronic economic and share-market information relevant to share investments.

CASE STUDY PRIVATE EQUITY FIRMS, ANGEL INVESTORS AND EXIT STRATEGIES Apart from venture capitalists, angel investors and private equity firms are dominant forces in the private equity market. In the largest acquisition of an e-commerce company in history, the US retail giant Walmart is set to acquire India’s largest online retailer Flipkart for $16 billion in 2018, overcoming Amazon in the race for expansion. The transaction will also record the largest exit for private equity and venture capital investors in India, who collectively will make $14 billion by selling shares to Walmart (ET Bureau, 2018). The global private equity firms Tiger Global and Softbank have emerged as the major winners from the Walmart deal. Tiger Global is set to gain $424 million from its 2.20 per cent stake in Flipkart (Giriprakash, 2018). Walmart has agreed to pay between $4 to $4.5 billion for Softbank’s stake, which represents a 60.00 per cent return on Softbank’s (a Japanese conglomerate) $2.5 billion investment in Flipkart (Sen, 2018). In the world of private equity, the focus is drawn towards giants such as Blackstone, KKR and Carlyle, all set to explore the high potential of Asian markets. However, this opportunity has been long recognised by smaller firms such as Navis Capital Group. Navis Capital, which was founded in 1998, manages private and public equity funds worth $5 billion. Its success story started with the acquisition of King’s Safetywear, a Singapore based manufacturer of safety footwear. After taking the company private, Navis Capital initiated an expansion of King’s markets into Australia, India and South Korea, followed by negotiations for the acquisition of Oliver Footwear, the largest manufacturer of safety footwear in Australia. In 2011, Navis Capital exited from King’s footwear by selling the company for $430 million, earning a 350 per cent return on its initial investment. Beyond these large private equity firms lie the smaller angel investors who provide funds to a private business and who are not directly related to the owner or operator of the firm (DeGennaro, 2014). Investments by angel investors act as informal venture capital for fledgling companies. Scholars suggest that angel investors often look for entrepreneurial passion as an important investment criterion (Mitteness, 2012). Information about the investing records of angel investors is scarce. The Walmart–Flipkart deal, however, also features an angel investor, Ashish Gupta, who will reportedly earn $20 million by selling his stake in Flipkart, which he purchased in 2009. This will represent a return to this angel investor of 126 per cent (Dalal & Sen, 2018). References Cumming, D & Johan, S 2009, Venture Capital and Private Equity Contracting: An International Perspective, Academic Press, Oxford. 215

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Dalal, M & Sen, A 2018, ‘Ashish Gupta, the angel investor likely to make $20 million from FlipkartWalmart deal’, Hindustan Times, 11 May, viewed 16 October 2018, https://www.hindustantimes. com/business-news/ashish-gupta-the-angel-investor-likely-to-make-20-million-from-flipkartwalmart-deal/story-queRXfEdhTKBPv0lnbN86M.html DeGennaro, RP & Dwyer, GP 2014, ‘Expected returns to stock investments by angel investors in groups’, European Financial Management, 20(4), pp. 739–755. ET Bureau 2018, ‘Walmart acquires Flipkart for $16 billion in world’s largest ecommerce deal’, Economic Times, 10 May, viewed 16 October 2018, http://economictimes.indiatimes.com/smallbiz/startups/newsbuzz/walmart-acquires-flipkart-for-16bn-world’s-largest-ecommerce-deal/ articleshow/64095145.cms Giriprakash, K 2018, ‘Tiger Global’s 2.2% stake sale for $424 m boosts Flipkart’s valuation to $17-19 b’, The Hindu BusinessLine, 30 January, viewed 16 October 2018, https://www .thehindubusinessline.com/info-tech/tiger-globals-22-stake-sale-for-424-m-boosts-flipkartvaluation-to-19-b/article22597158.ece Mitteness, C, Sudek, R & Cardon, MS 2012, ‘Angel investor characteristics that determine whether perceived passion leads to higher evaluations of funding potential’, Journal of Business Venturing, 27(5), pp. 592–606, doi:10.1016/j.jbusvent.2011.11.003 Sen, S 2018, ‘Walmart top dollar to SoftBank for Flipkart: 60% returns on $2.5bn in eight months’, Factor Daily, 27 April, viewed 16 October 2018, https://factordaily.com/walmart-flipkart-softbanktop-returns

Discussion points

• •

What are the characteristics of angel investors? Describe the common exit strategies adopted by private equity firms.

Master before you move on LEARNING OBJECTIVE 6.1 Consider the role of an investor in the share market, appreciate the wide range of investment choices that are available and understand risks associated with investments in shares of listed corporations. quoted on a stock exchange provide investors with an enormous range of investment • Securities opportunities. corporation makes no promise of a return to ordinary shareholders, so the higher level of risk • Aattached to these securities creates an expectation in the investor of a higher level of return, on average, over the longer term.

exchange brings buyers and sellers together to form an efficient, deep and liquid market • Ain stock securities. in a listed company entitles an investor to receive a return on the investment in the form • Aofshare any dividends paid and any capital gain or loss accumulated on the current market value of the share.

associated with share investments are described as systematic and unsystematic. • Risks Systematic risk exposures affect the price of most shares listed on a stock exchange, to a 216

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theory demonstrates that, by holding a diversified share portfolio, unsystematic risk • Portfolio can be substantially reduced through diversification. The remaining systematic risk is measured

using a beta coefficient. This is a statistical measure of the sensitivity of a share price relative to the overall market (as represented by a market index).

will consider the cash-flow and investment characteristics of a particular share. An • Investors investor may adopt an active or a passive share investment approach. active approach might use fundamental analysis or technical analysis to structure a portfolio • The to meet the investor’s personal risk and return profile. a passive approach, an investor will seek to replicate the structure, and therefore the • With return, of a specific share-market index. a diversified share portfolio the investor will consider the correlation of risk and return • Within between shares. the allocation of shares within the portfolio will be both strategic, in that it meets the • Finally, investor’s personal profile, and tactical, in that it will be monitored and managed to take account

CHAPTER SIX REVIEW

greater or lesser extent. Unsystematic risk specifically impacts on the share price of individual stocks.

of new information that comes to the market.

LEARNING OBJECTIVE 6.2 Detail the process for buying and selling shares. investor buying or selling shares can take a direct investment approach or an indirect • An approach. the direct approach, an investor will select the shares to be included in a portfolio. The • With transaction will usually be carried out through a stockbroker. stockbroker accepts buy or sell orders from investors and acts as the agent in placing the • Aorders into the stock exchange’s trading system. share trading system used by the ASX is known as ASX Trade and the transfer and • The settlement system is known as CHESS. Settlement occurs in T + 2 business days. broker may be a discount broker that executes transactions but does not provide investment • Aadvice. A full-service broker will execute buy and sell orders, but will also provide investment advice and some other financial services.

the indirect investment approach, an investor does not select the stocks to be held in a • With portfolio; rather, the investor purchases units in a managed fund such as a public unit trust.

LEARNING OBJECTIVE 6.3 Understand the importance of taxation in the investment decision process. will impact on the net return received by an investor. Taxation regimes vary • Taxation considerably between countries. However, two major taxes that may be imposed on the return of a shareholder are income tax and capital gains tax.

investor needs to consider the level of income tax payable. For example, is income taxed at • An a flat rate or a marginal rate? Are realised capital gains taxed or not, and at what rate? example, in Australia the marginal tax rate ranges up to 45 per cent, plus a 2.00 per cent • For Medicare levy. Generally, at least 50 per cent of a realised capital gain is also taxed at the taxpayer’s marginal income tax rate.

there is a tax benefit available to Australian shareholders known as dividend • However, imputation. The dividend imputation system enables corporations to pay franked dividends to shareholders, whereby the company tax paid on profits can be passed as a franking credit to the shareholder. This reduces the amount of tax payable by the shareholder. 217

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LEARNING OBJECTIVE 6.4 Identify and describe various indicators of financial performance. analysing a share investment opportunity, an investor should consider a range of financial • When performance indicators. of a company’s liquidity, such as the current and liquid ratios, provide an indication of • Measures the company’s ability to meet its short-term financial obligations. long-term financial viability of a company is indicated by the company’s capital structure, as • The measured by the debt-to-equity ratio or the proprietorship ratio. profitability may be measured by different earnings ratios. These include the earnings • Past before interest and tax (EBIT) to total funds ratio, the EBIT to long-term funds ratio and the aftertax earnings on shareholders’ funds ratio.

important indicator is the company’s ability to ensure its solvency by being able to meet • Another its short-term financing commitments. This is frequently measured by the company’s interest coverage ratio. 

investor may also rank companies on the basis of the market’s current valuation of the • An business and its prospective earnings stream. Indicators of market valuation are obtained through the price to earnings (P/E) ratio and the ratio of share price to net tangible assets.

LEARNING OBJECTIVE 6.5 Apply quantitative methods to the pricing of shares. are interested in estimating the theoretical price of a share. The price may be said • Investors to be a function of the supply and demand for a stock. This is influenced by future earnings expectations.

price of a share is theoretically the present value of its future dividend streams. New • The information that changes future earnings forecasts will also change the share price. future dividend payments of a corporation may be constant over time; in this case, the dividend • The payment is simply divided by the required rate of return to estimate the theoretical share price. a dividend payment may increase over time. It is assumed that increase will be at a • Alternatively, constant growth rate. To calculate the share price, the last dividend is multiplied by one plus the constant growth rate; this is then divided by the required rate of return less the growth rate.

are other more mechanical issues that affect a company’s share price. These include the • There price adjustments that occur when a share trades ex-dividend. All other things being equal, a cum-dividend share price should fall by the amount of a dividend that is paid.

a company makes a bonus issue to shareholders, where no new capital is raised, the share • Ifprice will theoretically fall by the relative proportion of new shares issued. similar price adjustment expectation will occur with a share split. A share split changes the • Anumber of shares issued by a corporation, again without raising additional capital. reason for an adjustment in a share’s price is that, if it has been trading with an entitlement • Another to participate in a rights issue, the theoretical ex-rights price will be lower than the cum-rights price. • A renounceable right has a value in that it can be sold before the rights issue exercise date.

LEARNING OBJECTIVE 6.6 Analyse the functions and importance of share-market indices and interpret published sharemarket information.

• A stock-market index is a measure of the price performance of a specific sector of a share market. Indices provides specialist index management services to international stock markets and • S&P compiles a range of different market and industry sector indices. 218

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Chapter 6  Investors in the share market

informational technology, communication services and utilities). Indices representing specific market strengths may be constructed by S&P.

• An index may be a share price index or an accumulation index. is a wealth of share-market information that is published daily. Investors need to • There understand and interpret this information.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Outline two general strategies or approaches that can be taken to investing in the share market. (LO 6.1)

2

(a) Ms Brown has an investment portfolio comprising Australian shares. At a meeting with her investment adviser, she requests explanations of the definition of systematic risk and unsystematic risk, and an explanation of factors that are responsible for the two types of risk. Explain these issues to Ms Brown.



(b) Why should an investor not expect to be rewarded for the unsystematic risk element in a share portfolio? (LO 6.1)

3

An investor holds the following shares in an investment portfolio: JB Hi-Fi

$6 500

beta 1.20

Telstra

$8 600

beta 0.95

ANZ Bank

$7 900

beta 1.05

CHAPTER SIX REVIEW

global industry classification standard (GICS) comprises 10 industry sectors (energy, • The materials, industrials, consumer discretionary, consumer staples, health care, financials,

(a) What does each beta coefficient imply about the volatility of each company’s shares relative to the overall market?

(b) What is the portfolio’s beta?



(c) If the investor added to the portfolio with the purchase of $5 000 worth of shares in AGL Energy (beta 1.60), what impact would that purchase have on the risk structure of the portfolio? (LO 6.1)

4

Combining domestic shares with some international shares can help reduce portfolio risk. Explain how this risk reduction is achieved. (LO 6.1)

5

Jack and Jill have recently married and have decided to start buying shares for an investment portfolio.

(a) Explain the role of a stockbroker in the direct investment approach to share investments.

(b) Within the context of services provided by a stockbroker, discuss the two main types of stockbrokers that an investor may choose to use. Differentiate between the services provided by these brokers. (LO 6.2)

6

Condor Limited is listed on the ASX, and earns part of its income in Australia and part overseas, where it is required to pay tax. The Australian company tax rate is 30 per cent. Condor Limited can provide dividend imputation to Australian shareholders from Australian tax paid. Assume 219

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the shareholder’s marginal tax rate is 37 per cent, plus Medicare levy of 2 per cent. The investor receives a 70 per cent partly franked dividend of $12 700.00. (a) Explain the dividend imputation process.

(b) Why might a dividend be only partly franked?



(c) Calculate the income tax payable by the investor. (LO 6.3)

7

(a) Explain what is meant by the liquidity of a company. Define two common accounting measures of liquidity.



(b) Why is liquidity an important indicator that an investor should consider when analysing share investment opportunities? (LO 6.4)

8

Define the commonly used measures of the profitability of a firm. Which measure do you consider to be most informative in comparing the profitability of firms across different industry sectors? (LO 6.4)

9

(a) Define two measures of a company’s debt-servicing capacity.



(b) Explain why it is not appropriate to compare, on the basis of the identified measures, companies in different industry classifications. (LO 6.4)

10 A company with a lower P/E ratio is a better investment than a company with a higher P/E ratio. Discuss this statement. (LO 6.4) 11 Caltex Australia Limited pays a constant dividend of $0.60 cents per share. A fund manager is considering purchasing the shares as part of an investment portfolio. The fund manager requires a return of 15 per cent on the investment. Calculate the price that the funds manager would be willing to pay for the shares. (LO 6.5) 12 The last dividend paid to shareholders by Vicinity Centres was $0.10 per share. Assume that the board of directors of the company plans to maintain a constant dividend growth policy of 7.00 per cent. An investor, in evaluating an investment in the company, has determined that she would require a 12.00 per cent rate of return from this type of investment. If the current price of Vicinity shares in the stock market is $4.00, should the investor purchase the shares? (Show your calculations.) (LO 6.5) 13 AGL Energy Limited has declared a $0.33 cents per share dividend, payable in one month. At the same time the company has decided to capitalise reserves through a one-for-three bonus issue. The current share price at the close of business on the final cum-dividend date is $16.15. (a) Explain the strategy adopted by the company. In your answer, define the terms ‘cumdividend’ and ‘ex-dividend’.

(b) Calculate the theoretical price of the share after the bonus issue and the dividend payment have occurred. (LO 6.5)

14 Alumina Limited has a share price of $2.82. The company has made a renounceable rights issue offer to shareholders. The offer is a three-for-10 pro-rata issue of ordinary shares at $2.60 per share. (a) Explain the effect of the offer being renounceable.

(b) What is the price of the right?



(c) Calculate the theoretical ex-rights share price.



(d) Explain why an actual ex-rights price of a share may at times differ from the calculated theoretical price. (LO 6.5)

15 S&P Indices manages a global industry classification standard (GICS) for share-market industry sector indices. The standard comprises 10 international industry sector indices. (a) What is the purpose of share-market indices?

(b) How does the existence of standard international industry sector indices facilitate global investment?



(c) Identify and briefly explain the structure of the GICS indices. (LO 6.6)

220

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accumulation index  212

ex-dividend 208

active investment  194 bear market  212

expected return of a portfolio 195

beta 194

franked dividends  199

price to earnings ratio (P/E)  204

bonus issue  209

franking credit  199

renounceable 210

bull market  212

full-service advisory broker 197

return on equity  203

global industry classification standard (GICS®) 212

share price to net tangible assets ratio  204

grossed-up amount  199

share split  209

index funds  195

stockbroker 197

indirect investment  198

stock-market index  211

inflation component  200

stock liquidity  212

interest cover ratio  202

strategic asset allocation  196

liquidity ratio  202

systematic risk  194

earnings before interest and tax (EBIT) 203

marginal rate of tax  199

tactical asset allocation  196

market indicator index  212

tradable benchmark index  212

earnings per share (EPS)  203

passive investment  195

unsystematic risk  194

capital gains  198 capital structure  201 co-variance or correlation  195 cum-dividend 208 current ratio  201 direct investment  197 discount broker  197 diversified investment portfolio 194

performance benchmark index 212 portfolio variance  195

share price index  212

CHAPTER SIX REVIEW

KEY TERMS

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CHAPTER 7

Forecasting share price movements CHAPTER OUTLINE 7.1 Fundamental analysis: the top-down approach 7.2 Fundamental analysis: the bottom-up approach 7.3 Technical analysis 7.4 Electronic trading 7.5 The random walk, efficient market and behavioural finance hypotheses

Learning objectives LO 7.1

Identify and interpret economic variables that impact on share price movements within the context of the top-down approach to fundamental analysis.

LO 7.2

Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the analysis of the financial and operational performance of a corporation.

LO 7.3

Describe and apply technical analysis to forecasting movements in share prices.

LO 7.4

Examine the role of electronic trading in influencing share price movements.

LO 7.5

Explain the theoretical concepts that form the basis of the random walk hypothesis, and consider the implications of the efficient market hypothesis and the behavioural finance hypothesis when analysing and forecasting share price movements.

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Chapter 7  Forecasting share price movements

CHAPTER SNAPSHOT How accurate are the share prices that we observe on the world’s stock markets? This is one of the great debates of twentieth and twenty-first century financial economics. It started in 1970 when Eugene Fama, a finance professor at Chicago, published his famous account of the efficient markets literature. This sparked a long series of investigations aiming to determine whether share prices accurately reflected information relevant to company fundamentals, whether those prices quickly adjusted to new information and whether those prices were subject to influence from other factors, especially mass psychology and other decision-making biases. The counterarguments, raised by behavioural economists such as Robert Shiller, have resulted in a flourishing research program that continues today. Fama and Shiller shared the Nobel Memorial Prize for Economic Sciences in 2013.

INTRODUCTION Information is the lifeblood of the stock market. New information may derive from many sources, including company notices to the stock exchange, advice to shareholders at general meetings, management meetings with institutional investors (roadshows) or articles in the media. Sometimes the new information is rumour or speculation or noise. If shareholders become disenchanted with the performance of a company, they may decide to sell their shares. This increases the supply of the company’s shares on the market. The increased supply of shares is likely to bring about a fall in the share price. Conversely, if a company is expected to perform better than other companies, there will be an increased demand for the company’s shares and an increase in the share price. Given the importance of information as a determinant of supply and demand on the stock market, it is necessary to understand the main sources of information. Investment analysts tend to take one (or a combination) of three approaches when sourcing information:

Noise the opposite of information but can be mistaken for it

• fundamental analysis top-down approach, which considers economic variables that may affect the future performance of an investment opportunity • fundamental analysis bottom-up approach, which considers the historic and forecast performance of a specific investment opportunity • technical analysis, which evaluates and interprets historical share price movements over time. This chapter analyses each approach in turn. We also consider the impact electronic trading might have on influencing share price movements. Then, having gained an awareness of factors that influence demand and supply on the stock market, we introduce three theoretical concepts that seek to explain movements in share prices: 1 the random walk hypothesis, which recognises that share price movements respond to new information coming to the market 2 the efficient market hypothesis, which considers how quickly share prices respond to new information 3 the behavioural finance hypothesis, which attempts to explain share price movements based on psychological principles of investor decision making.

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REFLECTION POINTS

price of shares of listed corporations is a function of supply and demand; that is, if there are • The more sellers than buyers of a particular stock, the share price will fall; similarly, if the demand from investors increases for a stock, the price will be pushed upwards. information coming to the market is the primary determinant of factors that affect the • New supply and demand for a stock. may apply a number of approaches to the analysis of share investments and the • Investors forecasting of share price movements: fundamental analysis top-down approach, fundamental analysis bottom-up approach and technical analysis. theoretical concepts that consider the relationship of information and share price • Three movements are the random walk hypothesis, the efficient market hypothesis and the behavioural finance hypothesis.

7.1 LEARNING OBJECTIVE 7.1 Identify and interpret economic variables that impact on share price movements within the context of the top-down approach to fundamental analysis.

Fundamental analysis considers macro and micro fundamentals that may impact future share price changes

Top-down approach forecasts the overall global and domestic economic environment in which corporations operate

Industry sectors components of an overall economy defined by the nature of the participants’ business operations

Fundamental analysis: the top-down approach

Many people have an interest in the future performance of share prices and the overall stock market, including fund managers, stock analysts, individual investors, regulators, government and financial journalists. They may be expected to explore rational approaches to the analysis and forecasting of share price movements. Fundamental analysis is one such approach. Fundamental analysis seeks to identify factors that are likely to influence directional changes in the value of a company and hence its share price. These factors may be macro or micro in context. Macro factors are those that influence the overall market, typically economic fundamentals such as interest rates, economic growth, business investment and consumer confidence. Micro factors are firm-specific and relate to the financial and operational performance and strength of a company, and also to the influence of management on the company’s performance. For example, indicators will include the return on equity, the return on assets, sales growth and market share. Therefore, fundamental analysis is divided into two components: the top-down approach and the bottom-up approach. While each component is considered separately, in reality investors will use both approaches as each component supports the full analysis necessary to make informed investment decisions. The position taken by analysts in the top-down approach is that it is necessary to forecast and analyse the overall economic environment and consider how forecast changes in economic fundamentals will impact on the performances of various firms and industry sectors. Ideally, both the top-down and the bottom-up approaches should be used to determine the specific shares to include in an investment portfolio. For example, the top-down approach should be used to determine those industry sectors most likely to perform well given forecast changes in the overall economy and those sectors that are more likely to be adversely affected. An investment portfolio should then be restructured so that it is overweight in those sectors forecast to do well, and underweight in those sectors forecast to face a contracting economic and business environment. The top-down approach will be applied to the local economy and also other international economies. Having used the top-down approach to determine the better-performing industry sectors within an economy, the bottom-up approach should then be used to select the most robust firms within those industry sectors. Similarly, when deciding to sell shares of companies that operate in industry sectors that are not forecast to perform as well, the first to go should be those stocks identified by the bottomup approach as having less financial and management strength.

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As indicated above, the top-down approach seeks to identify factors within an economy which may impact on the future performance and profitability of corporations. These factors include:

• the rate of growth of major international economies • the exchange rate between a domestic currency and the currencies of major trading partners and competitors • interest rate movements resulting from monetary policy changes or credit supply factors in the financial markets • the rate of growth of the economy—what is the shape and sustainability of the business cycle? • developments in the balance of payments current account (i.e. the trade in goods and services with the rest of the world) • price rises, as measured by the rate of inflation (consumer price index) • the rate of growth in wages and productivity • government policy responses to developments in the above variables—both domestic and international.

This section considers these economic fundamentals. In commenting on each of them, it should be noted that the various parts of the list are interdependent. A change in one economic fundamental is likely to have a flow-on effect on many of the other variables. It is important to recognise and understand the effects of these interrelationships.

7.1.1

International economies

The rate of growth in major international economies can have quite a strong effect on the expected profitability of many companies within a domestic economy. The performance of regional economies (e.g. Asia and the European Union) and specific country economies (e.g. the USA, China, India and Japan) clearly has an impact on overall growth in the global economy. It is reasonable to assume that the higher the rate of growth in the rest of the world, the greater will be the demand for exports generally. For firms that have a large proportion of their output devoted to export markets, and for those that have branches or subsidiaries in overseas countries, an increase in the growth rate in those countries should be bullish, or positive. The potential size of exporting firms’ markets, and thus their expected earnings cash flows, should increase. The business and performance effects of economic changes may vary from company to company, and from industry sector to industry sector, depending on the nature of the growth in the different international economies. For example, if the growth was being driven by increased consumer demand, then the suppliers of the more consumer-related raw materials, products and services might obtain a relatively greater benefit. If, on the other hand, the growth was being driven by a surge in business investment in capital equipment, it is reasonable to assume that the suppliers and users of basic minerals and other resources could do quite well, as would the manufacturers of the component parts of such equipment. The extent to which the incomes of suppliers and manufacturers will be boosted depends on, among other things, the extent to which the expanding countries can rely on their stockpiles of commodities and inventories that may have accumulated during prior periods of low demand and lower prices. If their stockpiles, and those of the competing supplier countries, are relatively low, then exporters can be expected to do well. Their sales should expand, and as the demand for exports increases, so too should the price obtained per unit of export. The extent to which the profits of exporters are boosted depends, in part, on what is likely to happen to the exchange rates of the currencies of the trading partners and competitors (see below).

7.1.2

International economies the economies of overseas nation-states

Domestic economy the local or home economy of a nationstate

Exports the sale of goods and services into international economies

The rate of growth of an economy

While it is appealing to conclude that a faster rate of growth in an economy is more positive for the stock market and share prices than is a slower rate of growth, the story is not quite that clear. Certainly, 225

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stronger growth should be expected to improve companies’ expected future cash flows; however, unsustainable economic growth may also bring with it some less desirable outcomes. Some of the problems associated with rapid, unsustainable rates of growth in an economy include:

• a deterioration in the balance of payments current account; for example, increased demand for imported goods • an increase in inflationary pressures; supply constraints will push up domestic prices for goods and services • upward pressure on wages; labour shortages will result in higher wages costs • an eventual depreciation of the exchange rate; as economic activity becomes unsustainable, demand for the currency will fall • a rise in interest rates; monetary policy will need to be tightened to slow the economy to a sustainable level • an inevitable downturn in economic activity and the business cycle. These issues are discussed further in the following sections. What is a sustainable rate of economic growth? There is, unfortunately, no single definitive answer. It depends on a range of variables. Typically, it would seem that less developed economies are able to sustain relatively higher growth rates for some time, but if that growth is not eventually tempered, the economy will inevitably overheat to a point where growth is no longer sustainable. Developed economies have the advantage of being able to look at long-term historic growth trends, which tend to suggest that sustainable long-term growth is best achieved within a certain growth range: between 3.00 and 4.00 per cent per annum. Another issue relates to where the drivers of growth are coming from. Economic growth across an economy is often not uniform; therefore, it is necessary to ascertain in which industry sectors the growth is occurring in order to analyse whether that growth is likely to be sustained in the long term.

7.1.3

Foreign exchange risk the risk that the value of one currency relative to another currency will change

Exchange rates

In an environment of global growth, resource and commodity exporters are expected to experience increased demand for their products and they could expect increased profitability. However, if export contracts are priced in US dollars (USD), as many of them are, the level of profitability could be affected by foreign exchange risk. If there were a strengthening, or appreciation, of the exchange rate of a local currency against the USD, then profits from increased export sales would be less than if the exchange rate had remained constant. This occurs because the exporter will need to convert its USD income back into the local currency at the higher exchange rate. It is possible that an adverse change in the exchange rate could wipe out the exporter’s profit margin. As well as forecasting the future exchange rate, it is also necessary to forecast the rate of exchange between the USD and the currencies of other countries supplying the world markets in competition with a local supplier. If, for example, the currency of the country of a major business competitor were to weaken against the USD, that competitor company would receive the same amount of USD for each unit of exports, but when the USD income is converted into the competitor’s home currency, its profits would increase. The increased profit margin may allow the company to renegotiate a lower USD price for the export commodity and still maintain a reasonable profit. The lower USD price would undermine the competitiveness and profitability of the local supplier. The above principles also apply to contracts written in other foreign currencies such as the euro, yen or pound sterling. Changes in the foreign exchange value of a currency can also have some unexpected results. Firms that appear to have no contact with international trade may be affected by changes in the value of the domestic currency. For example, a fall or depreciation in a local currency will, over time, push up the price of imports and therefore add to the cost of living. That is, the depreciation in the exchange rate will put upward pressure on the rate of inflation in the economy. The flow-on effects of a currency exchange rate change are important. For example, if the workforce seeks to maintain its standard of living, wages

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will need to rise in line with the increased cost of living. Any increase in wages means that firms that were quite remote from the export-competing and import-competing sectors of the economy would find that their costs of doing business have been affected by the change in the value of the currency. It is quite probable that the central bank or government would intervene in an attempt to dampen the inflationary impact of a weakening currency. One form of intervention might be a tightening of monetary policy by the central bank through an increase in short-term interest rates. Another might be a cut in government spending. Both of these policies would be designed to slow the growth in the economy, with a view to reducing inflationary pressures. The former policy would increase the cost of funds to businesses; the latter would reduce the rate of business growth and would thus adversely affect future income flows. Profits would be squeezed from both sides.

7.1.4

Interest rates

The majority of firms are exposed to interest rate risk. Interest rates represent a significant cost of doing business. The cost of debt finance is the interest paid to the provider of the finance. Therefore, any future change in interest rates will have a direct impact on cash flows and the profitability of a firm. If interest rates are forecast to rise, the market expectation would be for a reduction in business profitability and a fall in current share values. At the same time, a rise in interest rates would signal a possible slowing of economic activity and also a further reduction in profitability. Conversely, a forecast fall in interest rates would lead to an expectation of an increase in profitability, business activity and share prices. The profitability effects of interest rate changes need to be analysed separately for each company, as each company will have a different level of debt. Furthermore, each company may have managed its exposure to potential interest rate movements differently. One company may have a policy to reduce interest rate exposures by hedging the risk through the use of derivative product strategies. For example, it may enter into a forward rate agreement with its bank that effectively locks in today an interest rate that will apply at a future date. Another company may manage a forecast exposure to a rise in interest rates by borrowing most of its funds at fixed interest rates. There is a strong relationship between the level of exchange rates and the level of interest rates. This relationship varies over time. For example, if an economy is perceived to be growing at an unsustainable rate, overseas investors will withdraw investment funds, thus placing downward pressure on the local currency. At a point in time, the central bank will typically decide to tighten monetary policy (increase short-term interest rates) in an endeavour to slow down economic growth. The rise in interest rates should adjust economic activity to more sustainable levels, increase investor confidence and, as overseas investors return, put upward pressure on the exchange rate. The timing and speed of these changes is an unknown and usually will vary from business cycle to business cycle. Understanding the relationship between interest rates, monetary policy and economic activity is therefore essential in analysing changes in share prices. Monetary policy is applied by a central bank to achieve economic and social objectives, principally by controlling the level of inflation in order to maintain levels of employment and economic growth. Central banks implement monetary policy by influencing the level of interest rates. Monetary policy is discussed in detail in Chapter 12.

7.1.5

Interest rate risk the sensitivity of the value of assets, liabilities and future cash flows to a change in interest rates

The balance of payments current account

The balance of payments current account is a financial record of earnings from the export of goods and services to the rest of the world, less imports, plus income earned on investments made overseas, less the cost of overseas borrowings. Therefore, it records cash receipts of a country resulting from the sale of goods and services, but deducts payments made for goods and services bought from overseas suppliers. The current account also recognises the receipt of income from local funds invested in the international markets. From this is deducted interest and dividends paid on foreign borrowings and on foreign investments.

Balance of payments current account record of net trade in goods and services, and international investment and borrowings, with the rest of the world

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Part 2 Equity markets Current account deficit international export and investment receipts are less than imports and overseas debt payment

If the total payments exceed total receipts, there is said to be a current account deficit. To finance the current account deficit it is necessary for a country to obtain funding from overseas. This results in the country building up its level of foreign debt, and thus increases the interest payment burden of future years. Progressively, more and more export income needs to be devoted to servicing the current interest commitments. What is the relevance of this to the share market? There is very clear evidence that the current account is affected by the rate of growth in an economy. The faster the rate of growth, the more a country as a whole imports and the worse the current account deficit becomes. Consequently, the level of foreign debt becomes greater. To contain the current account deterioration, the government or the central bank is likely to take measures designed to slow the economy. These measures may include a tightening of monetary policy—that is, a rise in interest rates—and significant reductions in government expenditure. These initiatives will be aimed largely at slowing the economy in order to slow import demand. Some of the impacts of tightened monetary and budgetary policy on the profitability of businesses were outlined above.

7.1.6

Nominal rate of interest the annual market interest rate; includes the real rate of return plus an anticipated inflation component

Compounding interest an arrangement where periodic interest payments accumulate on a financial instrument

Carded rate a financial institution’s advertised nominal interest rate on loans and deposits

Depreciation the amount by which the value of an asset is written down in an accounting period

Inflationary pressures

Inflation is a reflection of increases in prices. Inflation is typically measured using a consumer price index (CPI). The CPI measures changes in the cost of a basket of selected goods and services that typify those bought by individual households in a particular nation-state. Changes in the CPI over time are used as a measure of the rate of inflation. Care needs to be taken when comparing the CPI (or its equivalent) between countries, as the basket of goods and services will vary. Stronger economic growth is often—though not always—a precursor to increased rates of inflation. Many countries through their central banks now target a level of inflation that is deemed to be conducive to maintaining long-term sustainable economic growth. The target rate of inflation will generally fall within a defined band. For example, Australia, through the monetary policy actions of the Reserve Bank, targets a level of inflation between 2.00 and 3.00 per cent per annum (on average) over the business cycle. The policy tool used to maintain inflation within the target range is monetary policy. If the central bank is concerned that inflation is threatening to exceed the target range, there is a clear expectation that the central bank will begin to tighten monetary policy, that is, increase shortterm interest rates. Therefore, in forecasting the effects of strong economic growth on a company’s performance, it is necessary to consider the possibility and effects of inflation and monetary policy. Another aspect of inflation that should be appreciated is its impact on the nominal rate of interest. The nominal rate of interest is the unadjusted annual rate of interest; that is, no adjustment has been made to the rate to reflect the effects of compounding interest or the rate of inflation. The determination of interest rates is discussed in Chapter 13. Briefly, the nominal rate of interest has two major components: the real rate of interest and the rate of anticipated inflation. If the nominal rate or carded rate of a bank term loan is 6.50 per cent per annum and inflation is expected to run at 2.50 per cent, the approximation of the real rate of interest is 4.00 per cent per annum. If inflation is expected to increase to say 3.00 per cent, there is an expectation that the nominal rate of interest will also increase, to 7.00 per cent. Investors will require the higher rate of return in order to maintain the real rate of return and to compensate for the anticipated increase in prices. The increase in interest rates will make debt funding more expensive for business. A further implication to be taken into account is the varying impact of inflation on different companies within the context of the tax treatment of depreciation of capital assets. Capital-assetintensive companies may be particularly adversely affected by inflation. Depreciation allowances are based on the historic (or purchase) cost of an asset rather than its replacement cost, which rises during periods of inflation. The accounting and taxation system then overstates the true after-tax earnings of the firm. Investors need to be aware that a growth in reported earnings brought about by inflation may need to be discounted. The same argument applies for inventories. Inventories carried on the books at purchase price are later sold at higher prices during inflationary periods. However, they have to

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be replaced at higher prices. Thus the inventory profit may be illusory. Again, potential share buyers should discount the reported profits for this effect.

7.1.7

Wages growth

During periods of relatively rapid economic growth, business activity increases and therefore the demand for labour also increases. Firms wanting to expand will tend to seek workers who are skilled and already working in a similar type of employment. Expanding firms will attract labour by offering better salary packages than those offered by workers’ current employers. This competitive bidding can set up a wage spiral that ultimately affects the cost of labour for all employers. Wage increases that are in excess of an increase in the productivity of that labour will reduce the proportion of the company’s income revenue that goes to profit, and will render the company less attractive to shareholders and to potential share investors. This consequence is even more important to those firms that normally have a large proportion of their total costs as labour expenses. An increase in economic growth will not, however, automatically increase wages growth and reduce the share of income going to profits. Wages are also affected by the wage-setting mechanisms of a nation-state. For example, throughout Australia’s recent strong economic expansion, the share of national income going to wages actually fell and company profits increased. Many economists and market commentators attributed this outcome to government policies that set the parameters for possible wage increases.

7.1.8

Understanding the interrelationships of economic fundamentals

It is timely to restate the previous statement that the fundamentals considered above are often highly interrelated. This creates an analysis environment that is very dynamic. In attempting to forecast share price movements, an investor must not take a piece of information in isolation, but should consider the impact that information will also have on the wide range of other variables. The foregoing discussion on the top-down approach to fundamental analysis has been highly selective. While the main economic fundamentals were introduced, there are many more to be considered, and analysts will incorporate what they perceive to be other important economic fundamentals in their own models. Essentially, the top-down approach involves the forecasting of developments in the fundamentals of the domestic economy in which a business operates and in the economies of major trading partners. Once the forecasts are available, the task then is to identify those industry sectors of the economy and of the share market that are likely to be advantaged or disadvantaged by the forecast changes. The bottom-up approach should then be used to select specific firms within industry sectors that should benefit from the forecast changes for inclusion in a share investment portfolio.

REFLECTION POINTS

top-down approach considers macroeconomic factors that impact on the overall • The investment environment; it assists investors to determine which economies and industry sectors offer the best investment opportunities. rate of growth in international economies impacts on overseas investment opportunities • The and also affects the performance of investment opportunities in the local economy; investors need to consider international business cycles and government policy responses (fiscal and monetary). continued

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Part 2 Equity markets continued

that conduct business in the international markets are exposed to foreign exchange risk; • Firms that is, movements in exchange rates may adversely impact on future cash flows and the value of assets and liabilities. cost of debt funds is the interest rate. Any change in interest rates will affect the cash flows • The and profitability of a business. Interest rate changes (monetary policy) will impact on economic growth and the business cycle. in the balance of payments current account (exports of goods and services minus • Changes imports, and foreign interest earned minus interest paid) will affect economic performance and a current account deficit will need to be funded with increased foreign debt. bank monetary policy specifically targets the level of inflation; that is, changes in • Central inflation may result in interest rate changes which will affect economic activity. growth that is above the growth in productivity will reduce the profit margins of • Wages corporations.

7.2 LEARNING OBJECTIVE 7.2 Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the analysis of the financial and operational performance of a corporation.

Bottom-up approach performance analysis that focuses on accounting ratios and other measures of a firm’s performance

Accounting ratios measures of a company’s financial and management performance, strength and efficiency

Fundamental analysis: the bottom-up approach

Once an investor has completed a top-down analysis of the fundamentals that impact on the overall investment environment, the investor is able to determine which economies and industry sectors provide the best investment opportunities. For example, an investor may have decided that economic fundamentals indicate strong economic growth within the Swiss and Australian economies and that the growth will be particularly strong in the pharmaceuticals sector in Switzerland and the resources sector in Australia. The investor has a number of choices of company shares to buy within each of those sectors. In which companies should the investor purchase shares? How can the investor make an informed investment decision? Fundamental analysis using the bottom-up approach assists with that analysis. The fundamental analysis bottom-up approach considers micro factors that indicate a firm’s financial, operational and management performance. The approach focuses on accounting ratios and other measures of a firm’s performance. A number of the main ratios were outlined in Chapter 6. These included ratios for:

• capital structure • liquidity • debt servicing • profitability • share price and equity • risk. It may be useful to review Section 6.4 before proceeding. An appropriate starting point is to calculate the important ratios for the various companies, in particular, industries in which the investor is interested. Those companies with the most favourable combination of indicators would then be selected. It is important to make direct comparisons only between companies that are substantially in the same industry, since the norm, or the benchmark, for the various ratios often differs quite significantly between industry sectors. The fundamental analysis bottom-up approach to the selection of companies for inclusion in an investment portfolio is illustrated in Table 7.1.

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Chapter 7  Forecasting share price movements

Table 7.1 Financial characteristics of two retail companies

(a)

Ratio(a)

Company A

Company B

Current

1.85

1.10

Proprietorship (shareholders’ interest) (%)

71.00

31.50

EBIT/long-term funds (%)

17.00

12.50

Return on shareholders’ funds (%)

14.50

9.75

Debt/gross cash flow (years)

2.91

3.85

Interest cover (times)

3.10

2.30

P/E (times)

5.21

12.10

Price/NTA (times)

1.00

0.99

Chapter 6 provides a discussion on the ratios

Based on the bottom-up approach alone, of the two hypothetical companies presented in the table, company A would be the preferred choice for inclusion in an investor’s share portfolio. The table has been constructed so that the selection is obvious. On each criterion, company A outperforms company B. In reality, the choice will rarely be so apparent. It is more likely that the results of the calculations will be mixed and an investor will need to exercise both analysis and judgment in the investment decision process. Additional inputs that may help in making a decision include:

• intelligence on changes in key management positions • information on the corporate mission, corporate governance and planned strategic directions of the company into the future • an examination of the recent history of the indicators included in Table 7.1, typically over the past three to five years • a comparison of the performance indicators with other similar firms in the same industry. With this additional information, the investor should then keep in mind the position argued by modern portfolio theory: the greater the degree of systematic risk, the greater should be the expected rate of return. If a higher rate of return is not expected, then the higher risk is not worth accepting in the investment portfolio. A further issue is that a well-diversified portfolio, being one that is constructed to minimise unsystematic risk, will incorporate shares of firms from various industry sectors across geographic regions and in a range of countries. The selection processes outlined above would be applied to select the specific firms from within each of the desired industry sectors. While the detail and the discipline of the bottom-up approach are appealing to many investors, the approach may suffer from a major drawback. The drawback relates to the need to calculate the performance ratios using historic data. The historic data provides useful information on past performance, which may be an indicator of future performance, but it is also possible that future performance may be different. This raises the question of how to forecast the future direction of the performance of a firm, the industry sector and the stock market generally. The fundamental analysis solution is to combine a top-down approach with the bottom-up approach.

Corporate mission the ultimate objectives and purpose of a corporation as determined by the board of directors

Modern portfolio theory concepts that enable a portfolio to be constructed with optimal risk and return relationships

REFLECTION POINTS

an investor has determined which economies and which industry sectors offer the most • Once attractive investment opportunities, the investor must conduct an analysis of firms in those sectors to decide which shares to buy or sell. continued

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Part 2 Equity markets continued

bottom-up approach analyses a firm’s financial, operational and management performance • The over time using accounting ratios and other measures of a firm’s performance. ratios include capital structure, liquidity, debt servicing, profitability, share price and • Accounting equity ratios. will be measured over time and compared with those of similar corporations in the same • Ratios industry. (Note: Ratios use historic data that may not accurately reflect future performance.) indicators include information on key management positions, corporate governance and • Other the strategic direction of the firm.

7.3 LEARNING OBJECTIVE 7.3 Describe and apply technical analysis to forecasting movements in share prices.

Technical analysis explains and forecasts price movements based on past price behaviour

Share price pattern a graph over time of movements in a share price or a market index

Technical analysis

An alternative approach to forecasting the movement of share prices for individual companies, and forecasting the performance of particular industry sectors and the overall stock market, is technical analysis. This approach seeks to explain and forecast share price movements on the basis of the past behaviour of prices. One underlying assumption of technical analysis is that markets are dominated at certain times by a mass psychology, and that over time regular patterns in share price movements are evident. As a share price pattern begins to emerge, it is assumed that the historic pattern will re-emerge in full; that is, the full pattern will unfold this time as it did in the past. An emerging share price pattern formation is taken as being a pointer to the path of the future share price series. Most typically, analysts adopt either a technical approach or a fundamental approach. Rarely will an individual analyst adopt a combination of the two. However, some fund managers and individual investors take inputs from both approaches. Some research indicates that it is a combination of both approaches that provides the better forecasts. Fundamental analysis has a reasonable forecasting track record until the share market moves well above, or below, what the fundamentals would normally support. At that stage it is argued that the chartists, or technical analysts, provide the best forecasting record. For example, if the values of shares in a particular industry sector (e.g. technology sector) rise at rates well above forecast future cash earnings potential, then share prices may not be explained by economic fundamentals, and technical analysis may provide indicators of future share price corrections. The reason for the change in forecasting strategy has to do with timing. A limitation of fundamental analysis is that forecasting on the basis of the fundamentals can suggest that the market is overvalued and is due for a correction, but cannot predict the timing of the downturn. Once the market gets out of line with the fundamentals and it is widely recognised that an adjustment is due, an alternative method of analysis—the forecasting models of the technical analysts—may be used to signal the timing of the adjustment. Indeed, one of the major claims made by some technical analysts is that they can pick the timing of market turning points. Of the various types of technical analysis forecasting models, two will be considered here:

• moving-averages models • charting. 7.3.1 Price series a graph of historic share price or market index movements over time

Moving-averages models

An analyst is able to plot historic share price movements of individual corporations or, alternatively, price movements in a particular share price index on a graph. In either event, the analyst creates a price series. The graph will show price changes over the period, and from that graph certain price trends may be evident.

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Chapter 7  Forecasting share price movements

A technical analyst will usually apply more sophisticated price models; one type of model is based on moving averages. Constructing a moving-averages model (MA) from a series of numbers tends to smooth out more erratic price movements. It is designed to reveal more clearly the trends in a price series. For example, Table 7.2 illustrates the procedures for calculating a simple five-day MA. An average of five numbers in a series is obtained by adding the numbers together and then dividing that value by five. For series such as share prices, where the value changes daily, an MA is constructed in order to keep the average up to date.

Moving-averages model (MA) a graph of a series of average prices constructed over time

Table 7.2 Construction of a simple five-day moving average Day

Price

Delete

Add

Net change

Sum

Moving average

36

7.2

1

6

2

7

3

8

4

7

5

8

6

9

6

+9

+3

39

7.8

7

10

7

+ 10

+3

42

8.4

8

8

8

+8

+0

42

8.4

9

10

7

+ 10

+3

45

9.0

10

12

8

+ 12

+4

49

9.8

The construction of the value of the MA is quite simple. On the fifth day, the average daily price for the past five days is the sum of the prices divided by five. On day 6, the day 1 price is dropped and the day 6 price is brought in. The sum of the current set of five daily prices is divided by five, and the resulting figure gives the five-day MA on day 6. This process is repeated daily in order to update the MA series continually. Computer spreadsheet programs make this task very simple; however, even calculating it manually is simple. Once the actual price series and the MA series are plotted on the same graph, buy and sell signals are generated. Those who subscribe to the benefits of the MA technique would adopt the following rules:

• Buy when the actual price series cuts the MA from below—especially if the MA has been flat or is in a gentle decline. This is illustrated in Figure 7.1(a). • Buy when the MA series is rising strongly and the price series cuts or touches the MA from above, but then moves back above the MA after only a few observations, as shown in Figures 7.1(b) and (c). • Sell when the MA flattens, or declines after a steady rise, and the price series cuts the MA from above, as shown in Figure 7.2(a). • Sell when the MA series is in decline and the price series cuts or touches the MA from below, but then moves back beneath the MA after only a few observations, as shown in Figures 7.2(b) and (c).

Where an MA is constructed using daily price movements, the most commonly adopted periods are 10 days and 30 days. The 10-day MA will pick up short-term changes in trend, while the 30-day MA is more likely to pick up medium-term trend changes. Some analysts who use the MA approach prefer to use a combination of MA series in order to generate their buy/sell signals, rather than use a single MA with the actual price series. For example, a 10-day MA and a 30-day MA may be applied together. The buy/sell rules are the same as those presented above, except that the 10-day average substitutes for the actual price series in the buy/sell rules. 233

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Part 2 Equity markets

Figure 7.1  Buy signals: when the price series intersects, or tests, a rising MA line (a) Buy

(b)

Buy

(c) Buy

Figure 7.2  Sell signals: when the price series intersects, or tests, a falling MA line (a) Sell (b)

Sell

(c) Sell

Another variation is the use of a weighted MA rather than a simple MA. Analysts who prefer the weighted MA argue that the most recent price contains the most valuable information on what the market perceives the value of the share to be. It should thus carry the greatest weight in the calculation of the MA. In constructing a weighted MA, each piece of the raw price data is given a weighting; the latest price data is given a higher weight than the earlier price data. For example, in a five-day MA, today’s price may be given a weighting of five; that is, it is multiplied by five. Yesterday’s price, day 4, is multiplied by four and so on. The calculations are illustrated in Table 7.3. The sum of the five values is divided by the sum of the weights; in Table 7.3 this is day 1 + 2 + 3 + 4 + 5 = 15. 234

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Chapter 7  Forecasting share price movements

The calculation for day 6 would be as follows:

• Delete the day 1 price. • Recalculate the weighted values of the prices for days 2 to 6 and add them together:   ​(7 × 1) + (8 × 2) + (7 × 3) + (8 × 4) + (9 × 5) = 121​ • Divide the weighted total by the sum of the weights, being 121/15 = 8.07. • The new figure of 8.07 is added to the moving average in Table 7.3. Table 7.3 Construction of a weighted five-day moving average

(a)

Day

Price

Price × weight

 1

 6

6×1=6

 2

 7

7 × 2 = 14

 3

 8

8 × 3 = 24

 4

 7

7 × 4 = 28

 5

 8

8 × 5 = 40

 6

Weighted total

Weighted MA(a)

112

7.47

 9

121

8.07

 7

10

132

8.80

 8

 8

130

8.67

 9

10

138

9.20

10

12

153

10.20

Weighted total divided by the sum of the weights (i.e. 1 + 2 + 3 + 4 + 5 = 15)

An advantage of the MA technique is that, insofar as it works at all, it provides rule-based buy/sell signals; there is no need for discretion. On the other hand, the use of charting techniques for generating and interpreting buy/sell signals allows considerable scope for individual interpretation of the patterns that emerge in the charts. It is not surprising then that analysts who use charting techniques will differ from those using MA analysis in their interpretations of the same objective price series data.

7.3.2

Charting

The second type of technical analysis forecasting model considered in this chapter is charting. The following is an overview of the major patterns that are claimed by chartists to contain valuable information for forecasting share price movements. The patterns will be discussed under the headings:

• trend lines • support and resistance lines • continuation patterns • reversal patterns. Trend lines Many prices appear to move in trends. The chartist seeks to observe the trend and any changes that might occur in the trend. Two trend lines are considered:

• the uptrend line • the downtrend line. 235

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Part 2 Equity markets Uptrend line achieved by connecting the lower points of a rising price series

Downtrend line achieved by connecting the higher points of a falling price series

Return line a line drawn parallel to a trend line to create a trend channel

By connecting the lower points of a rising price series, an analyst is able to create an uptrend line. On the other hand, an analyst will draw a downtrend line by connecting the higher points of a falling price series. A return line is drawn parallel to the trend line in order to establish the trend channel. An important focus of attention for the chartist is the determination of when the trend is about to change. When does a penetration of the trend line constitute a signal that the trend has changed? Some of the patterns discussed below are used by chartists to shed some light on this question. In the meantime, the following are regarded as reasonably reliable generalisations:

• The longer a trend line has been in force, and the more times it has been tested, the greater is its validity. • If a trend line is of long standing and has withstood three or four tests, and then an indecisive break is experienced, this penetration can be ignored and the original trend retained.

• Intra-day trades that break through established trend lines are considered to be unimportant; however, if the breakout is on high trading volumes it may signal a weakening trend.

• Failure to reach the return line in a well-established trend indicates deterioration in the trend. • Once a trend is broken on the downside, prices fall from it and then often make a return move towards

the line. The pullback frequently retraces approximately 50.00 per cent of the move away from the trend. This pullback provides a good sell point, if the trader has not already sold at the break of the trend. Figure 7.3 shows an uptrend, a downtrend and a sideways trend.

Figure 7.3  Trend lines

rn Retu

line

end

Uptr

Dow

line

ntren

Retu rn

d line

line

Sideways trend

Return line

Support and resistance lines Support lines lower price levels where an increase in demand halts a price fall

Resistance lines higher price levels where an increase in supply halts a price rise

Chartists consider support and resistance levels to be next in importance to trends, and dotted lines are drawn across the chart at historic support and resistance levels. In addition to these strong support and resistance levels, some chartists include levels based on more recent activity in order to provide socalled weak support and resistance levels. Support lines occur at a price level where there is increasing demand, and sufficient volumes, to halt any further downward price movement. Resistance lines occur at that high price level at which supply, relative to demand, is sufficient to halt a further advance in prices. Figure 7.4 shows the support and resistance lines.

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Chapter 7  Forecasting share price movements

Figure 7.4  Support and resistance lines Resistance level

Resistance level Support level

Support level

A support/resistance pattern that is quite common in equity markets is the rectangle, which consists of sideways price fluctuations contained within horizontal support and resistance levels. This pattern represents a period of conflict between buyers and sellers, with the price being bounced between the two lines. Ultimately, it will be knocked through the top line or the bottom line to form a new pattern. Sometimes a prediction can be made as to the direction of the breakout. The following are said to be fairly reliable indicators:

• Rectangles tend to be characterised by reducing volumes, except for a few days before the breakout when there are strong increases in volumes of trade in the shares.

• If the last bottom does not touch the support level, beginning the formation of an ascending triangle, and if prices then rise rapidly, on increasing volumes, it is likely that there will be a topside breakout.

• Conversely, if the tops fail to reach resistance levels, beginning the formation of a descending triangle, then a downside breakout is likely.

Analysts often observe that when a break occurs from a rectangle, the extent of the breakout is likely to equal the height of the price rectangle.

Continuation patterns The price patterns mentioned above are called continuation patterns, since they are believed to occur most frequently during a pause in the trend channel. They are essentially sideways trading and do not normally signal a change in an established trend. Two main continuations are:

• triangles • pennants and flags. Triangles Symmetrical triangles are composed of a series of price fluctuations, with each top and bottom smaller than its predecessor; that is, each minor top and bottom stops short of its previous levels. Transaction volumes usually continue to diminish throughout this formation. No safe prediction of the direction of a breakout is offered by chartists, though most often the breakout is presumed to continue the previous trend. Ascending triangles usually form in an uptrend and are characterised by ascending bottoms and horizontal tops. Again, volumes decrease during the formation but increase, often sharply, just prior to the usual upside breakout. Conversely, descending triangles usually form in a downward trend and are characterised by descending tops and horizontal bottoms. Again, volumes decrease during the formation but increase just prior to the usual downside breakout. Figure 7.5 illustrates the three types of triangles.

Continuation patterns sideways share trading that does not normally signal a change in a trend

Symmetrical triangles a series of price fluctuations with each top and bottom smaller than the previous triangle

Ascending triangles form an uptrend characterised by increasing bottoms and horizontal tops

Descending triangles form a downward trend characterised by decreasing tops and horizontal bottoms

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Figure 7.5  Continuation patterns: triangles

Symmetrical triangle

Ascending triangle

Descending triangle

Pennants and flags

Pole rapid rise in share prices and volumes before a pennant or flag forms

Pennants and flags normally form in very fast moving markets. Both formations tend to form rapidly. In a rising market, this usually occurs after a very sharp increase in prices on high volumes. This part of the formation is referred to as the pole supporting the pennant or flag. During the formation of a pennant or flag, trading volumes fall and then increase suddenly to take prices sharply lower, then higher, respectively. The presumption of many chartists is that the breakout of prices will most often be to a height equal to the height of the pole that preceded the pennant or flag formation. These patterns can also develop in falling markets. Chartists consider these patterns to be very reliable. Figure 7.6 illustrates pennants and flags.

Figure 7.6  Continuation patterns: pennants and flags

Pennants

Flags

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Reversal patterns Typically, after a major share-market shift, trend lines begin to break up and various reversal patterns form. The so-called head and shoulders pattern is seen by chartists to be one of the most reliable of patterns. The structure of a head and shoulders pattern is depicted in Figure 7.7.

Figure 7.7  Reversal patterns: head and shoulders Head Right shoulder Left shoulder

Neckline

Breakout

Pullback

Volume

A simple head and shoulders pattern consists of three successive rallies and reactions, the second rally reaching a higher point than the rallies on either side. The left shoulder forms on an expanding volume-strong rally towards the end of an uptrend. This is followed by a reaction on quite reduced volumes. The head forms on a strong second rally, which carries the price higher than that for the left shoulder, and is followed by a reaction that sees prices moving back to the vicinity of the previous low. Volumes, though high on the peak, are not as high as those on the left shoulder. The formation of the right shoulder represents the conclusion of the pattern. The third rally is marked by reduced volumes and indicates price weakness. Completion of the pattern occurs when prices break through the so-called neckline, which is formed by a line drawn across the lows of the left and right shoulders. This line may be horizontal but is often slightly sloping, as illustrated in Figure 7.7. Following the breakout of the neckline, prices often move by at least the height of the head. Frequently also there is pullback; this represents the last selling position. Head and shoulder patterns bottoms are similar in form to their tops. There is a variety of other formations identified by chartists, including triple tops and bottoms, double tops and bottoms, V and saucer bottoms and so on, but these are beyond the scope of this study. An aspect of technical analysis worthy of note concerns the Elliott wave theory. Based on the statistical studies of an American analyst, the Elliott wave theory maintains that there are distinctive wave patterns that characterise share-market cycles. The key proposition is that a bull market consists of three major waves upwards, followed by two major down-legs, which result in a reversion of share prices to about 60.00 per cent of the peak. The objective with all charting techniques is to try and obtain early warning signals relating to likely movements in share prices. Often it is difficult for investors with a background in finance and economics to place significant credence in the techniques of technical analysts. However, insofar as they influence the trading behaviour of fund managers and other investors, the techniques should be examined along with fundamental factors when making an assessment of the likely course of share prices. Even if it is argued by some that the techniques of technical analysis have little validity, if a sufficient number of market participants employ technical analysis to guide their actions, they will have an impact on the behaviour of share prices at various times. We started this chapter by saying that new information moves the market. The determinations of technical analysts are in fact part of the comprehensive amount of new information coming into the market and therefore will affect share prices to some extent.

Head and shoulders pattern three successive rallies and reactions, the second rally being stronger than the first and third rallies

Left shoulder first rally and reaction in head and shoulders pattern

Head second, and strongest, rally and reaction in head and shoulders pattern

Right shoulder third rally and reaction in head and shoulders pattern

Neckline a line drawn across the bottoms of the left and right shoulders

Breakout occurs when prices break through the neckline

Elliott wave theory the existence of distinctive wave patterns that characterise sharemarket cycles

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REFLECTION POINTS

analysis does not consider fundamentals; rather, it seeks to explain and forecast • Technical share price movements on the basis of past price patterns. price movements over time creates a share price series. Technical analysts often • Plotting smooth out a series by constructing moving averages, such as a 30-day moving average. a straight moving average, the earliest data are deleted and the newest data are added to • With calculate the next average data plot. Some models may apply weights whereby the latest data have a greater weight than the older data. analysts also construct charts over time which allow the observation of trend lines • Technical (upward trend, downward trend, return line), support and resistance lines (share prices at which supply and demand halt a trend), continuation patterns (triangles, pennants, flags) and reversal patterns (left shoulder, head, right shoulder, breakout). wave theory contends that there are distinctive wave patterns that characterise share • Elliott market cycles.

7.4 LEARNING OBJECTIVE 7.4 Examine the role of electronic trading in influencing share price movements.

Program trading buy and sell orders automatically triggered by rules entered into a computer program

Fat finger trader error a keyboard input error where an instruction is entered involving an amount much greater than intended

High-frequency trading (HFT) supercomputer algorithms analyse data, identify investment opportunities and place thousands of buy/sell orders in seconds to take advantage of bid/ offer spreads

Electronic trading

In the fast-moving, high-volume and often volatile world of share trading, technology has been an integral part of the stock-market infrastructure for many years. Program trading refers to buy and sell orders, typically in large amounts, that are automatically triggered by computer-based programs in response to movements in share prices. There is the potential for program trading to increase the speed and magnitude of price declines. In recognition of this potential underlying problem, a number of stock exchanges, including the NYSE and the ASX, have rules in place that will suspend trading on the exchange if, on any day of trading, the overall market index moves by more than a specified percentage. The rationale for this rule is that large rises or falls in a single day may cause a panic contagion effect among other market participants who, though not program trading, may enter a stampede to sell or to buy. In addition to exacerbating market volatility, errors entered into electronic systems may cause sharp unexpected price movements that take place in a matter of seconds. On 6 May 2010, the NYSE experienced a ‘flash crash’ where the Dow Jones Industrial Average fell 1000 points or about 10.00 per cent and then rebounded by 1000 points in a matter of minutes. The source of this event was traced to the use of a particular type of computer algorithm used by a large market participant when selling securities as part of a hedging strategy and a sequence of high frequency trades that followed in its wake. Sometimes, the source of a flash crash is traced to a fat finger trader error. The speed and intensity with which traders operate in a high pressure environment make occasional errors like this inevitable. For example, in October 2016, the British pound fell by 6.00 per cent in value against the US dollar in just a few minutes before rebounding just as quickly. A fat finger trader error was thought to be responsible. In 2018, Deutsche Bank transferred 28 billion euros to an outside account. This was actually more than the market value of the bank! The growing use of sophisticated trading programs means that finance students really need to be aware of some of the techniques that are being deployed in the financial markets. The sophisticated trading programs and practices that we will discuss in this section include high-frequency trading, flash trading and dark pools. News analytics trading is another practice that is heavily used. High-frequency trading (HFT) is the application of high-speed supercomputers that are controlled by algorithms that analyse data, identify investment opportunities and influence stock order flows and therefore share prices in the market. For example, an HFT firm is able to electronically place thousands of orders in seconds and then immediately cancel them and place new orders. Up to 90.00 per cent of

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HFT orders are cancelled in this manner. The HFT algorithms allow a supercomputer to instantaneously identify spreads between bid (buy) and offer (sell) prices and place orders at a price that will either influence a change in the existing spread, or ensure the HFT order is processed above other orders. In this case, the HFT firm can sell at one price and immediately buy at a better price using the spread. As the spread changes, or if demand for a stock disappears, the HFT firm cancels its outstanding orders. HFT firms make between $0.001 and $0.002 cents per share traded, but as their volumes are enormous, so too are the profits. Flash trading is a situation where certain privileged institutional investors, typically HFT firms, receive (are flashed) information from a stock exchange of incoming stock orders a fraction of a second before this information is sent to the exchange’s trading system. By gaining access to this flash information before other market participants, the HFT firm is able to match the best bid or offer in the system and pick up the incoming order. This is known as a flash trade. Flash trades would appear to violate the principle of market fairness. The NYSE has banned flash trading but the practice is still encouraged in many other exchanges as a competitive measure to increase trading volume growth on an exchange. Dark pools is a dedicated trading system that operates within an exchange that allows certain institutional investors to place large buy or sell orders without having to disclose the trade to the entire market. Dark pools participants place an indication of interest to buy or sell a quantity of securities at a set price to be determined at a nominated time during the trading day. As the market is not aware of the dark pool trade, the price at which the trade is settled will not reflect the impact of the large trade. For example, if the dark pool trade was a large sell order and had been conducted on the open trading system, it would be expected that the share price would fall as the order was progressively fulfilled. However, the lack of transparency in the dark pool means the transaction will not push down the price during the trade. News analytics is another popular algorithmic-based trading strategy. Using computer technology, including natural language processing, financial institutions and traders scan large volumes of textual information, such as newspaper reports, internet sites, investor updates, forums, blogs and social media. For example, the algorithms may gather and assess the ‘sentiment’ across a large volume of textual information by determining whether the commentary is accompanied by a greater number of positive statements than negative statements (or vice versa). A trading strategy is attached to the result. If the computer detects a relatively large amount of positive commentary about a company, buy orders may be executed. The technology allows huge volumes of textual information to be scanned and assessed in nanoseconds. High-frequency trading, flash trading, dark pools and computer-executed news analytics-based trading all provide challenges for stock exchanges, market participants and market regulators. At the time of writing, regulators in the USA, UK and Europe are investigating whether more stringent regulation is required to cope with the potential negative impacts of these systems and practices. As mentioned above, some stock exchanges have already moved to ban or limit some of these practices. However, there is very strong pressure being exerted on the regulators by the HFT firms to allow HFT to continue. The HFT firms have invested heavily in this infrastructure and their competitive advantage results in enormous profits. Within the context of this chapter, program trading, HFT, flash trading, dark pools and news analytics trading all have short-term impacts on share prices and therefore may need to be recognised in models that forecast share price movements.

Flash trading privileged HFT firms receive information on incoming orders a fraction of a second before the information reaches the exchange’s trading system

Dark pools a trading system within an exchange that allows certain institutional investors to conduct large transactions without immediate disclosure to the market

News analytics the collection and analysis of text-based non-quantitative news and media stories

REFLECTION POINTS

trading refers to buy/sell orders that are automatically triggered by computer-based • Program share trading systems. automated programs may result in rapid share price changes, which in turn may trigger • Such further buy/sell orders. continued

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number of stock exchanges, including the NYSE and the ASX, have rules in place whereby • Atrading is suspended if the markets move by more than a specified percentage during a trading day. trading (HFT) is the application of high-speed supercomputers that are • High-frequency controlled by algorithms that analyse data, identify investment opportunities and influence stock order flows and therefore share prices in the market. trading is a situation where certain privileged institutional investors, typically HFT firms, • Flash receive (are flashed) information from a stock exchange of incoming stock orders a fraction of a second before this information is sent to the exchange’s trading system. pools is a dedicated trading system that operates within an exchange that allows certain • Dark institutional investors to place large buy or sell orders without having to disclose the trade to the entire market. analytics involves the analysis of large volumes of textual or qualitative information from • News newspapers, blogs, websites and social media in order to derive insights relating to factors such as sentiment that may be used as the basis for trading strategies. When executed algorithmically, large volumes of information can be analysed and buy or sell orders placed within seconds. trading, high-frequency trading, flash trading, dark pools and news analytics all have • Program an impact on share prices and therefore need to be considered when conducting analysis to forecast movements in share prices.

7.5 LEARNING OBJECTIVE 7.5 Explain the theoretical concepts that form the basis of the random walk hypothesis, and consider the implications of the efficient market hypothesis and the behavioural finance hypothesis when analysing and forecasting share price movements.

The random walk, efficient market and behavioural finance hypotheses

This chapter has described factors that influence share prices, and the methodologies used to forecast future share price changes. In trying to understand more completely how share pricing mechanisms work, investors attempt to theorise the interactions of the share markets. Within the context of forecasting share price movements, we now consider three of the most popular of modern theories on the determination of, and changes in the value of, shares and other securities:

• the random walk hypothesis • the efficient market hypothesis • the behavioural finance hypothesis. Although it is outside the scope of our discussion to go too far into the formalities of efficient markets theory, research into the efficiency of markets is one of the most important parts of the financial economics literature. In this literature, there are many papers that are purely theoretical in nature. These explore such issues as the meaning of ‘efficiency’ and the benchmarks against which efficiency can be measured. Most papers, however, are empirical and aim to determine whether the financial markets are indeed ‘efficient’. These investigations usually involve testing market prices for efficiency with regards to one or more information sets, where the information set might include information about the past history of prices, publicly available information such as financial data and announcements and privately held information such as takeover or merger plans. Researchers have designed many different types of tests of efficiency. To test whether the current market price efficiently reflects the information contained in the past history of prices, researchers have tried to determine whether it is possible to forecast future prices based on trends or other patterns that might be observed in the price history. We discuss this further in a moment.

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To test whether prices efficiently reflect information that is publicly available, researchers have tried to determine how quickly stock prices adjust to particular ‘events’, such as the release of a profit warning. Finally, to test whether prices efficiently reflect all information, even that which is privately held, researchers have tried to determine whether prices begin to reflect that information even before it becomes publicly available. For the most part, it appears as though there is little opportunity for risk-adjusted profits based solely on the past history of prices. That is, stock prices appear to follow a random walk (or, more technically, a martingale process). Also, stock prices quickly absorb information that becomes publicly available and there appear to be similarly scant opportunities for risk-adjusted profits based solely on publicly available information. The one information set that can be used profitably is the information that is privately held. Insider trading profits tell us that this is the case. The bad news for investors and traders, of course, is that trading on the basis of inside information is illegal!

7.5.1

The random walk hypothesis

The random walk hypothesis contends that each observation in a time or price series such as share prices is independent of the previous observation; that is, the path of a series of share prices is random and unpredictable. If the price of a share rises in period one, there is an equal probability that in period two the price may rise, fall or remain unchanged. Once the result for period two is observed, again there is an equal probability that in period three the price may rise, fall or remain unchanged. The important consideration for an investor is that if the random walk process does describe the movement of a share price, the history of the previous movements of the share price contains no valuable information as to likely future price movements. This would discount the methodologies used by technical analysts, other than that the analysis itself becomes a source of new information. Each share is assumed to have an intrinsic value that is based on investors’ expectations about the present value of the firm’s future net cash flows. The price of the share reflects investors’ estimation of the share’s intrinsic value, and is based on the latest information available and relevant to the company’s current state and its future prospects. Variations in the price of the share through time should only be in response to changes in the relevant information that comes to the attention of the market concerning the company. Though it is possible that the nature of the new information relevant to the particular company may be predominantly good or predominantly bad, it is most likely that, over time, the news will not have a particular trend. It is likely to be randomly distributed. Given this assumption, it follows that the movements in the share price will be random. Share prices react to new information coming into the market, and therefore it is necessary to consider how quickly information is provided to a stock exchange and how quickly that information is absorbed and reflected in share prices. One explanation can be found in the efficient market hypothesis.

7.5.2

Random walk hypothesis each new share price change is independent of the previous share price

The efficient market hypothesis

One aspect of the efficient market hypothesis is derived from the random walk hypothesis. Share markets are said to be information-efficient if share prices adjust virtually instantaneously to new information. If markets are efficient, it should not be possible for an investor to make abnormal profits through having superior information to that of the rest of the market. The efficient market hypothesis also denies that there is a chance of making superior profits from employing the techniques of technical analysis, since these techniques rely almost totally on the assumption that past price patterns will repeat themselves. The hypothesis also argues that employing fundamental analysis (either the top-down or the bottom-up approach) to share valuation will not yield superior results for one investor over another. This is because all of the information required in either approach should be available to all market

Efficient market hypothesis share prices reflect all available information; superior profits are not available

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Weak form efficiency share price changes are independent and not based on historic price data

Semi-strong form efficiency all publicly available information is fully reflected in a share price

Strong form efficiency all publicly available information and private research is fully reflected in a share price

participants. However, there would seem to be an obvious disparity between the ability of analysts to understand, evaluate and interpret information that comes into the market. Further, there are a large number of listed companies all generating, or impacted by, new information and therefore it is not possible for all market analysts and investors to absorb and act upon that information immediately. This raises issues in relation to the degree of efficiency within a market. The efficient market hypothesis has been tested on three different levels, with each level making different assumptions about the degree of information efficiency. In the least stringent test of the hypothesis, the so-called weak form efficiency, the hypothesis suggests that successive changes in the price of shares are independent of one another. Investors cannot make superior profits through determining the share’s trading behaviour on the basis of historic price data. The semi-strong form efficiency version of the hypothesis contends that all publicly available information regarding a company is fully reflected in the price of a share. Therefore, the semi-strong form efficiency states that an investor cannot make superior profits using publicly available information because it is already reflected in the share price. If this is the case, an analyst who seeks to identify mispriced shares using the fundamental analysis approaches will not be successful, again because the information will already be reflected in the share price. There would seem to be an issue of timing here. An important factor is how quickly market participants are able to absorb information. Clearly, electronic information systems facilitate the rapid dissemination of an enormous volume of news and information to the international markets. It cannot and will not be read by everyone at the same time. Therefore, who has access to that information; and when will it be read? Those analysts who read the information first and react to that information would seem to have an advantage. Another factor is the interpretation of information. A group of analysts will often produce a range of different outcomes while having access to the same information. Even when analysts might agree that a piece of information is positive or negative, they will often disagree on the extent of the impact of that news. The strictest form of the hypothesis, strong form efficiency, states that all information—including that which is publicly available and that which is available only through private inquiries and research— will be reflected fully in the market price of a share. The implication of the strong form hypothesis is that specialist analysts and insiders in the company, who may have access to information that is not yet public, cannot earn greater profits than can those who do not have access to the not-yet-public news. It would seem a reasonable assumption to state that private information does exist. Having access to that information will have a value. For example, a team of investment bankers working on a takeover proposal for a client will be privy to information that could affect the share price of both the takeover company and the target company. It comes down to a question of whether the use of that information is ethical or legal. What do the empirical research studies reveal about the level of efficiency of the share market? The studies generally show that prices tend to fluctuate around an intrinsic or base value in an unbiased fashion, and that market prices respond promptly to publicly available new information. Other studies have compared the profit performance of actively managed portfolios, managed by professional portfolio managers, with the profits derived from randomly selected portfolios bearing similar risk. On balance, such studies indicate that the former do not consistently outperform the latter. These results offer support for the weak and the semi-strong forms of the efficient market hypothesis. There is less agreement from the studies designed to test the strong form of the hypothesis. Some US studies indicate that share traders who possess inside information, including corporate executives, brokers and specialist analysts, have been able to secure profits beyond those available to average investors. There has also been evidence that, at least in the past, the returns on shares of smaller firms, for which there is likely to be less information publicly available, tend to be persistently higher than the returns earned on the shares of larger firms. Also, as discussed in the previous section, high-frequency traders often appear to have an advantage because of the sophisticated trading platforms they operate. If a conclusion can be drawn from the studies, it appears at this stage that there is support for the view that share markets are generally information-efficient. Share prices do appear generally to follow

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the random walk process, and to reflect the current information available. Above-normal profits are unlikely to be made by using currently available information, since that information is likely already to be reflected in the price of the share. Nevertheless, for some skilled analysts, and for those able to uncover not-yet-public information, above-average rates of return may be available. Also, it may be argued that a share market is not homogeneous and that different levels of efficiency may exist in different sectors of a share market; for example, share prices of the top 100 stocks may be more information-efficient than share prices of the smallest 100 stocks.

7.5.3

The behavioural finance hypothesis

Behavioural finance attempts to extend our understanding of investor behaviour, based on psychological principles of decision making. The focus of behavioural finance is to identify and recognise the importance of cognitive factors that may shape investor behaviour and lead to a divergence between actual share prices and those that would be expected to prevail in an efficient market. The efficient market hypothesis is essentially an equilibrium hypothesis. In fact, the efficient market hypothesis cannot be tested independently of a market equilibrium model such as the Capital Asset Pricing Model (CAPM). The central prediction of such a model, which mirrors the ideas that constitute the core of neoclassical economics, is that market prices and returns will settle at their equilibrium levels and return quickly to those equilibrium levels following a disturbance. The arrival of new information that alters the structure of market equilibrium will be followed by a smooth and rapid adjustment to a new point of equilibrium. Periods of disequilibrium will be short and we would not expect to see violent upheavals in the absence of new information relevant to the underlying equilibrium structure. Since all of the ups and downs in market prices and returns are due to the trading activity of people and the computer programs they have designed, a better understanding of the financial markets may be obtained by studying the psychology of investors. Dissatisfaction with the traditional models of decision making and the apparent incongruity of equilibrium theory with the volatility observed to characterise the markets has led to the development of an entire field of behavioural economics (or ‘economics and psychology’). Behavioural finance is perhaps the most well-developed part of this literature. Barberis and Thaler’s (2003) A Survey of Behavioural Finance identifies two main tenets of behavioural finance theory. The first is that rational investors may not necessarily correct the mistakes of irrational investors. The equilibrium-type arguments of neoclassical economics may be defended by arguing that, although investors may make mistakes and although some investors might be irrational, those mistakes and the market inefficiencies created by them will be quickly corrected by rational investors or arbitrageurs. Proponents of behavioural finance argue that market inefficiencies may remain uncorrected, even if rational investors recognise that an investment opportunity has been created, because there are ‘limits to arbitrage’. Such limits exist because the strategies that would need to be put in place to correct some market inefficiencies may be too risky or too costly. A perfect arbitrage that yields a risk-free return is rare and it may not be possible to perfectly hedge the type of position necessary to correct the market inefficiency. The position might also be very costly to implement and maintain. As a result, there is no incentive for rational traders to step in. There are limits to the arbitrage process that is supposed to return market prices to their equilibrium values. The ‘limits to arbitrage’ concept is both a challenge to the orthodox neoclassical equilibrium model and a defence of the rationale of behavioural finance theory. Behavioural finance theorists could not possibly take the position that there are no rational investors taking advantage of market inefficiencies because it is clearly the case that obvious profit opportunities do not usually exist for very long. Rather than rule out arbitrage in all shapes and forms, behavioural finance simply argues that the process is limited and may not operate even when rational investors are fully aware that a profit opportunity exists. As such, there should be market inefficiencies that will require an explanation that orthodox analysis cannot provide. The question remains, however, as to how and why market inefficiencies emerge in the first place. This leads us to the second tenet of behavioural finance theory, which argues that investors’ decisions

Behavioural finance explains investment decisions within the context of the impact of psychological factors

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Expected utility the sum of the utility of each possible outcome weighted (multiplied) by its probability of occurrence

Experimental economics a branch of economics that attempts to explore the operation of economic theory under controlled conditions

diverge from those that would be consistent with the efficient market hypothesis in ways that can be explained and predicted on the basis of cognitive psychology. The investigation of the underlying structure of individuals’ decision-making processes, particularly in the presence of risk and uncertainty, has led to the identification of numerous decision-making biases to which market inefficiencies might be traced. Before outlining the growing list of biases that seem to pervade decision making under conditions of risk and uncertainty, we should briefly outline the orthodox model of rational choice that is challenged by the discovery of these decision-making biases. In economic theory, an individual makes a choice from his or her available opportunities in a manner that maximises his or her utility or satisfaction. Human action is purposeful in the sense that people act in order to achieve some objective. Because resources are scarce and we cannot have everything that we desire all at once, we have to make choices. If I observe you heading off to the coffee shop rather than the pizza shop, I presume that you are using your scarce resources, including time, to satisfy your most pressing desire: coffee. All human action can be explained according to this model of choice. People act purposefully to achieve their ends or objectives. The achievement of objectives confers some satisfaction, like the quenching of thirst associated with a great coffee. We call this utility. For some other types of activity there is an added dimension: risk and uncertainty. Outcomes are risky when there is a chance that the actual outcome may be different from that which was expected. Risk and uncertainty characterise games of chance and strategy, and financial decisions. In choosing how to act, the individual cannot simply pick the opportunity with the outcome that will bring him or her the greatest utility or satisfaction. Each opportunity may yield many different outcomes, each with different levels of utility. The expected utility of a particular opportunity is the sum of the utility of each possible outcome weighted (multiplied) by its probability of occurrence. A formal representation of expected utility was developed by John von Neumann and Oskar Morgenstern in their Theory of Games and Economic Behaviour, published in 1947. If certain axioms or rules apply, choice under risk and uncertainty can be depicted in terms of the maximisation of an expected utility function. This implies that when confronted with risky opportunities, people assess their opportunities and make a choice by assessing the outcomes that are likely to be associated with each opportunity and the probability that possible outcome will occur. The weight that each possible outcome has on the person’s decision-making process is its probability of occurrence. In the example above, where I observed you heading off to the coffee shop, there was no risk. You would certainly get a coffee. Likewise, if you chose to go to the pizza shop, you would get your choice of pizza. Let’s say that there is a chance that either the coffee shop or the pizza shop is closed. Now you have to assess whether the chance of a coffee gives you more expected utility than the chance of a slice of pizza. As before, you would assess the utility of both opportunities. If you assign higher utility to coffee than to pizza, then you would go to the coffee shop if there was no risk (as before). However, even if you assign more utility to coffee than to pizza, the expected utility that you assign to each option may be different if the odds that the coffee shop will be closed are different from the odds that the pizza shop will be closed. If you assigned a utility value of 2.00 to coffee and 1.00 to pizza, you would go to the pizza shop if you thought there was only a 20.00 per cent chance that the coffee shop would be open versus a 50–50 chance that the pizza shop would be open (2.00 multiplied by 0.20 is 0.40 while 1.00 multiplied by 0.50 is 0.50). You cannot be in both places at the same time. Your time is scarce and must be allocated one way or the other. Although it is elegant and logical, dissatisfaction with the von Neumann and Morgenstern expected utility theory began to grow. Criticism of an existing model is, however, little use without a plausible replacement. This would take until the late 1970s to be developed. Throughout the 1970s, two cognitive psychologists, Daniel Kahneman and Amos Tversky, worked diligently to construct an alternative model to expected utility theory that would reflect the types of biases that they and others had identified in laboratory experiments. Applying experimental economics, Kahneman and Tversky had found that people do not seem to make their choices in the way prescribed by expected utility theory. Kahneman and Tversky identified several ways in which the decision-making process appears to diverge from expected utility theory: (1) people tend to assess their options against a reference point

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rather than absolutely; (2) people do not tend to weight possible outcomes by the probability that those outcomes will occur; (3) people tend to be averse to losses and would obtain more utility from avoiding a loss than acquiring a gain of the same magnitude; and (4) people will tend to be risk-seeking in the ‘loss domain’, preferring to gamble if there is some small chance to avoid a certain loss by doing so, and risk-averse in the ‘domain of gains’, preferring to play it safe when positive payoffs are there for the taking. Kahneman and Tversky’s attempt at incorporating these factors into an alternative model of choice under risk is called prospect theory. Prospect theory depicts the decision maker as assessing different risky opportunities or prospects on the basis of prospect value. The decision maker assesses the value of each prospect and chooses the one with the highest value. In this regard, expected utility theory and prospect theory involve conceptually equivalent depictions of the choice process; that is, the opportunities are assessed and the best one is chosen. However, where expected utility is determined quite simply by weighting utilities by probabilities and adding them up, prospect value is determined in a way that reflects the different types of behaviour that people were observed to exhibit while making choices in Kahneman and Tversky’s laboratory experiments. The process that prospect theory sets down is more complicated and the mathematical expression involves a number of additional equations. Unlike expected utility theory, where utility is assessed on the basis of ‘absolute outcomes’, the value for each prospect is determined by an assessment of gains and losses from a reference point. Even a positive outcome may be viewed as a loss if it falls short of the reference point. The values are then weighted, just like in expected utility theory. But in Kahneman and Tversky’s model, the weights are not the probabilities. Prospect theory uses a more complex weighting scheme to allow for the observation that people tend to weight losses more heavily than gains. The result of all this weighing up is a prospect value for each prospect that forms the basis for the person’s choice. An expected utility maximiser would choose the opportunity with the highest expected utility. The prospect-value decision maker would choose the prospect with the highest prospect value. Predictions regarding actual choices may be quite different depending on which model the economist decides to use. The development of prospect theory was a major milestone in the development of behavioural economics and behavioural finance, but much work remained to be done. The first version of prospect theory contained some theoretical and conceptual problems that required additional work. An updated version of prospect theory, cumulative prospect theory, was eventually published more than a decade later. In addition, more work needed to be done to investigate the structure of decision making under risk and uncertainty, and to determine the robustness of the behavioural biases that had been observed. This was in response to criticisms regarding the applicability of the results of economics experiments to real-world contexts where substantial sums of money are at stake rather than the small or hypothetical amounts that were usually used in experimental contexts. The identification and classification of decision-making biases that might be responsible for market inefficiencies continues. Some of the most important and interesting decision-making biases that have been identified are listed below. Investigation continues in order to determine whether these biases represent an explanation for some of the characteristics that we observe in market prices. Potentially, decision-making biases may lead to the overreaction of share-market prices to new information, excess volatility, higher returns on equities than predicted by the orthodox equilibrium model and momentum in share prices. It is important to keep in mind that debate is ongoing and nothing has been completely settled. By and large, it is plausible to conclude that the market is usually but not always efficient. Explaining and predicting departures from efficiency remains an open challenge to financial economists.

Prospect theory an alternative model of choice under risk

Cumulative prospect theory an updated version of prospect theory that resolves a number of theoretical and practical problems identified by critics of the original version

• People are overconfident. They overestimate the accuracy of their investment decisions and underestimate

their potential for error. When they happen to be correct, they attribute the positive outcome to their own ability, and when they happen to be wrong they blame external factors. Overconfidence may cause more pronounced divergences of share prices from fundamental values as investors initially overreact to either positive or negative news and then gradually correct their mistakes.

• People are averse to losses. This aspect of behaviour is a cornerstone of Kahneman and Tversky’s

prospect theory. Losses loom larger than gains of the same magnitude. Because share prices are 247

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volatile and losses are likely, a large premium may be required to entice investors into the share market. This may explain why the return on shares has been much higher than the orthodox equilibrium models predict (the so-called equity premium puzzle). People also tend to take more risk when trying to avoid losses. Rather than accept a certain loss of $100, they will engage in a risky gamble that may see them avoid the loss but will more than likely end up in an even greater loss.

• People exhibit framing bias. People make different decisions when the same problem is presented to

them in different ways. For example, people may purchase more apples when the choice is framed as ‘10 apples for $8’ rather than ‘apples 80 cents each’. The way in which an investment opportunity is presented can affect the investor’s decision. Investment decisions are subjected to various frames, such as the language used by financial planners in describing alternative investment options. If enough investors exhibit framing bias, share prices may diverge from fundamental values because investors are making decisions on the basis of the framing of the investment opportunities rather than on the basis of an assessment of the underlying risks and rewards.

• People exhibit representativeness bias. People sometimes make decisions on the basis of stereotypes.

This may lead investors and analysts to be more optimistic about recent winners (shares that have been going up in value) and more pessimistic about recent losers (shares that have been declining in value). The recent performance of an investment may be given too much weight in the decisionmaking process. As a result, there will be periods when winners are overpriced and losers are underpriced. If this departure from efficiency is corrected, we would expect losers to perform better than winners over time. This type of market behaviour has been observed, but it would be hasty to conclude that it is a manifestation of a decision-making bias such as representativeness. There is an orthodox explanation. Losers are very risky and should reward those investors brave enough to add them to their portfolios with a higher average return.

• People display cognitive dissonance. New information will sometimes conflict with a person’s existing

attitudes, values or beliefs and cause discomfort. Two cognitions, the new and pre-existing, are in dissonance or disagreement. To alleviate this discomfort people may try to convince themselves that their pre-existing ideas are correct. This may affect investment decisions in a number of different ways. In particular, people may tend to hold losing investments longer than they should as they try to convince themselves that their initial evaluation of the investment was correct, even though new information or the subsequent performance of the investment suggests otherwise. If enough people, having bought into an initial story (that the housing market will experience strong capital growth, for example), display cognitive dissonance in the face of new information, trends in market prices may be exacerbated.

• People make decisions with a reference point in mind. ‘Reference point dependence’ is another

cornerstone of Kahneman and Tversky’s prospect theory. It is not necessarily a bias but it is inconsistent with expected utility theory. The orthodox model depicts the decision maker as assessing the utility of outcomes. In general, positive outcomes will be accorded positive utility and vice versa. The assessment is made absolutely. Prospect theory depicts decision makers as assessing the value or utility of outcomes relatively against a reference point. A positive outcome may be accorded a negative value if it is below the reference point. If you observe all your friends making $1000 on their investments, you might feel as though you have lost even if you make $500. Reference point dependence may interact with other behavioural phenomena such as loss aversion. Faced with a positive financial payoff, but one that lies below your reference point, you may take additional risks in order to avoid the loss and record a gain or an outcome above your reference point.

Hopefully, this brief introduction to the concepts of behavioural economics and behavioural finance will begin to demonstrate that the financial markets are dynamic and extremely complex. The neat argument that market participants will act in a rational manner in order to maximise returns does not always hold. Further, investor actions will vary depending on the particular investment horizon or time-frame. Day traders and many fund managers operate on a short-term, often intra-day, time-frame. Other investors maintain a buy and hold strategy for the majority of their investment portfolio. 248

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Behavioural finance does not necessarily invalidate the efficient market hypothesis; rather, it recognises that there are many factors, other than simple rationality, that impact investment decisions and therefore influence market trends and prices.

REFLECTION POINTS

random walk hypothesis contends that each observation in a share price time series is • The independent of the previous observation; that is, the share price may rise, fall or remain unchanged. share has an intrinsic value, the present value of its forecast future cash flows. Only new • Each information that changes those forecasts should impact on the share price in the future. As the next piece of information is not known, then the next share price movement is also unknown. markets are said to be information-efficient if prices rapidly adjust to new information; • Share however, the level of efficiency in a share market is indicated by how quickly information reaches the market, and how quickly that information is absorbed into share prices.

• There are said to be three levels of efficiency: 1 weak form efficiency—where successive changes in the price of shares are independent of one another; therefore, investors cannot make superior profits on the basis of historic price data 2 semi-strong form efficiency—where all publicly available information regarding a company is fully reflected in the price of a share 3 strong form efficiency—where all information, including that which is publicly available and that which is available only through private inquiries and research, will be reflected fully in the market price of a share.

• Information efficiency may not be constant across all stocks listed on a stock exchange. finance recognises that investor psychological and cognitive factors impact upon, • Behavioural and sometimes impede, the expected rational investment decision process. Many of the anomalies that we observe on the financial markets could be the manifestation of investor decision-making processes. Further research will shed more light on this.

CASE STUDY THE EFFECTS OF SCANDALS ON THE MARKET In Chapter 7, three different ways were identified to analyse price movements in the share market including random walk theory, the efficient market hypothesis and the behavioural finance hypothesis. Random walk theory states that there is no information contained in the past history of prices that can be used as the basis for a profitable investment strategy, while efficient market hypothesis (EMH) goes further and proposes that market prices fully reflect relevant information (Fama, 1991). Behavioural finance theorists place more emphasis on the psychology of investor decision making. All three approaches consider the role of information and the ways in which investors respond to it. While considering the impact of relevant information on the market, it is interesting to explore the role played by scandals and rumours in the marketplace. After the Cambridge Analytica scandal that exposed data security issues with Facebook, the social media giant has been subjected to increased scrutiny. The scandal, which spooked investors, wiped more than $100 billion from the company’s market value. In the same period, data and network security firms Zscaler, Carbon Black and Tenable celebrated successful IPOs. When scandals send shock waves through the investment community, there can be opportunities for investors who take a broader view. While data breach scandals and security concerns 249

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were seen as detrimental to Facebook, the importance of cyber security was seen as an opportunity for other companies (Hackett, 2018). While scandals involving particular companies rarely have system-wide implications, scandals involving governments can. In Argentina, a bribery scandal emerged involving officials of the former government and business leaders. Oscar Centeno, the driver for former planning secretary Roberto Baratta, revealed details of the bribery. During the ensuing investigation, both the currency and share markets in Argentina experienced significant declines (Gillespie, 2018). In Greece, leading politicians were investigated over a bribery scandal involving Swiss pharmaceutical firm Novartis, estimated to have cost the country almost $30 billion (Smith, 2018). The political implications, including the possibility that the scandal will deliver gains to populist parties, are likely to be far-reaching. When a scandal comes to light, investors may react in different ways. When centred on a particular company, the first reaction will usually be to sell that company’s shares. Once the situation becomes clearer, investors will consider the impact of the scandal with more circumspection and might even identify opportunities for other companies. A scandal involving the government is more difficult to assess because its impact can be much wider. Reference list Fama, EF 1991, ‘Efficient Capital Markets: II’, The Journal of Finance, 46(5), pp. 1575–1617. doi: 10.2307/2328565 Frier, S & Ponczek, S 2018, ‘Facebook shares recover from Cambridge Analytica scandal’, Bloomberg, 11 May, viewed 18 October 2018, http://www.bloomberg.com/news/articles/2018-05-10/facebookshares-recover-from-cambridge-analytica-crisis Gillespie, P 2018, ‘How a chauffeur could bring down Argentina’s political elite’, Bloomberg, 11 August, viewed 18 October 2018, http://www.bloomberg.com/news/articles/2018-08-10/how-a-chauffeurcould-bring-down-argentina-s-elite-quicktake Hackett, R 2018, ‘Tenable IPO vs. Facebook’s flop: Identifying a stock market trend’, Fortune, 29 July, viewed 18 October 2018, http://fortune.com/2018/07/29/facebook-stock-price-tenable-ipo/ Smith, H 2018, ‘Novartis bribery claims: Greek MPs vote to investigate top politicians’, The Guardian, 22 February, viewed 18 October 2018, http://www.theguardian.com/world/2018/feb/22/greece-toinvestigate-top-politicians-over-novartis-bribery-claims

Discussion points

• •

The impact of government level scandals is greater than corporate scandals. Comment. How would the impact of a corporate scandal be treated by each of the three different theories of market price movements?

Master before you move on LEARNING OBJECTIVE 7.1 Identify and interpret economic variables that impact on share price movements within the context of the top-down approach to fundamental analysis. price of a share is essentially determined by the demand for and supply of the share. At any • The moment, the balance between buyers and sellers of a company’s shares is determined by their assessment of the future profitability of a company and forecast movement in the share’s price. 250

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future performance.

top-down approach looks at prospective developments in the broader economic • The environment within which the various industry sectors and specific companies are situated. variables that are identified as being of relevance to the future performance of various • Important industry sectors, and therefore companies operating within those sectors, include: – developments in major international economies – the rate of growth within a domestic economy – the variability and volatility of exchange rates, particularly those of major trading partners – changes in monetary policy settings and movements in interest rates balance of payments current account, and whether the current account is in surplus or – the deficit – upward pressures on wages growth relative to increases in productivity.

CHAPTER SEVEN REVIEW

and share analysts may conduct their evaluations and issue their buy/sell • Investors recommendations using fundamental analysis. analysis, incorporating the top-down approach and the bottom-up approach, • Fundamental examines variables that finance and economic theories identify as being relevant to a company’s

LEARNING OBJECTIVE 7.2 Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the analysis of the financial and operational performance of a corporation. an investor has determined which economies and which industry sectors offer the most • Once attractive investment opportunities (using the top-down approach), the investor must conduct an analysis of firms in those sectors to decide which shares to buy or sell.

fundamental analysis bottom-up approach uses accounting ratios and other performance • The measures to analyse the financial, operational and management performance of a particular company.

that are analysed include capital structure, liquidity, debt servicing, profitability, share • Ratios price and equity, and risk. will be measured over time and compared with those of similar corporations in the same • Ratios industry. (Note: Ratios use historic data which may not accurately reflect future performance.) • Other indicators include key management, corporate governance and strategic direction.

LEARNING OBJECTIVE 7.3 Describe and apply technical analysis to forecasting movements in share prices. analysis adopts an alternative approach to share price forecasting. The approach is • Technical based on the assumption that, over time, apparent trends and patterns in share price movements are formed.

is further assumed that as a new pattern emerges, the past behaviour pattern observed in an • Ithistoric pattern will also re-emerge. • Two principal models used by technical analysts are (1) moving-averages models and (2) charting. moving-averages model is a graph of a series of average prices constructed over time. The • Amoving average is designed to smooth out the effects of intra-period volatility. An example might be the construction of a 10-day moving-averages model or a 30-day model.

a weighted model may be structured in order to give greater value to the most • Alternatively, recent data observations. Therefore, the most recent information will have a higher weight than earlier or past data. 251

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analysts use strict decision rules; that is, if a model develops in a certain pattern, • Technical decisions to buy or sell are automatically triggered. form of technical analysis is the use of charting. A chartist will use price movements to • Another plot uptrend and downtrend lines. A return line is drawn to create a trend channel. A chartist is looking for support and resistance lines incorporating continuation patterns such as triangles, pennants and flags.

of these patterns denotes price behaviour patterns and enables the chartist to make • Each forecasts on future price movements. After a major shift in a trend line, a chartist will expect reversal patterns to emerge. One such pattern is known as the head and shoulders pattern.

wave theory contends that there are distinctive wave patterns that characterise share • Elliott market cycles.

LEARNING OBJECTIVE 7.4 Examine the role of electronic trading in influencing share price movements. trading refers to buy/sell orders that are automatically triggered by computer-based • Program share trading systems. automated programs may result in rapid share price changes, which in turn may trigger • Such further buy/sell orders. of stock exchanges, including the NYSE and the ASX, have rules in place whereby trading • Ais number suspended if the markets move by more than a specified percentage during a trading day. trading (HFT) is the application of high-speed supercomputers that are • High-frequency controlled by algorithms that analyse data, identify investment opportunities and influence stock order flows and therefore share prices in the market.

trading is a situation where certain privileged institutional investors, typically HFT firms, • Flash receive (are flashed) information from a stock exchange of incoming stock orders a fraction of a second before this information is sent to the exchange’s trading system.

pools is a dedicated trading system that operates within an exchange that allows certain • Dark institutional investors to place large buy or sell orders without having to disclose the trade to the entire market.

analytics involves the analysis of large volumes of textual or qualitative information from • News newspapers, blogs, websites and social media in order to derive insights relating to factors, such as sentiment, that may be used as the basis for trading strategies. When executed algorithmically, large volumes of information can be analysed and buy or sell orders placed within seconds.

trading, high-frequency trading, flash trading, dark pools and news analytics all have • Program an impact on share prices and therefore need to be considered when conducting analysis to forecast movements in share prices.

LEARNING OBJECTIVE 7.5 Explain the theoretical concepts that form the basis of the random walk hypothesis, and consider the implications of the efficient market hypothesis and the behavioural finance hypothesis when analysing and forecasting share price movements. random walk hypothesis contends that share price observations are independent of each • The other and that the next price movement cannot be directionally predicted. is, the next price of a share may be an increase or a decrease or it may remain the same. A • That change in a share price will occur in response to new information coming to the market. efficient market hypothesis is a formalisation of the information process of the random walk • The hypothesis.

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therefore all relevant information is already reflected in the current price of a share.

• Three forms of market efficiency are identified:

1 weak form efficiency—where successive changes in the price of shares are independent of one another; therefore, investors cannot make superior profits on the basis of historic price data 2 semi-strong form efficiency—where all publicly available information regarding a company is fully reflected in the price of a share 3 strong form efficiency—where all information, including that which is publicly available and that which is available only through private inquiries and research, will be reflected fully in the market price of a share. majority of empirical studies find in favour of the first two forms of efficiency; however, there • The is less agreement on the strong form efficiency. • Information efficiency may not be constant across all stocks listed on a stock exchange. behavioural finance hypothesis challenges aspects of the efficient market hypothesis and • The contends that psychological and cognitive factors actually influence the investment decision

CHAPTER SEVEN REVIEW

the view that analysts are able to select a portfolio of shares that will outperform • Itthechallenges overall market. The challenge rests on the view that markets are information-efficient and

process.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

The top-down approach to fundamental analysis includes an analysis of the local economy in which a company is situated, plus the economies of major trading partner countries and the global economy more generally. Why would an investor be interested in forecasting changes in these economies? (LO 7.1)

2

A fund manager is considering investment opportunities in China, Hong Kong and Japan. Data indicate the rate of economic growth over the past year as:

• China • Hong Kong • Japan

9.50 per cent 5.75 per cent 2.25 per cent

Based on these data, the fund manager concludes that the significantly stronger economic growth in China represents much higher potential investment returns in the form of capital growth on share investments. Critically analyse this conclusion. (LO 7.1) 3

Globally, interest rates have been low for some time as central banks maintained an easy monetary policy to stimulate economic growth. GPT Group is a property trust operating in Australia. The board is particularly concerned about the implications of rising interest rates for its retail investments. Analyse the situation and discuss how a tightening monetary policy may impact the performance of GPT and its share price. (LO 7.1)

4

P. Bateman & Partners Inc. is an investment fund with over $1 billion in investment assets. Much of the fund is exposed to the retail sector and discussions about sluggish wages growth have concerned the partners. Within the context of the top-down approach, discuss the potential impact of sluggish wages growth on the value of the fund’s retail assets. (LO 7.1) 253

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5

Evans and Partners is an investment advisory firm that provides specialist investment advice to its private clients. As part of the investment decision process, the senior investment analysts at the firm apply the bottom-up approach to the fundamental analysis of share prices. This approach focuses on the analysis of accounting ratios and other performance measures.



(a) Explain why Evans and Partners will use this type of analysis.



(b) Identify and discuss six different accounting ratios that should be included in a bottom-up approach model.



(c) Identify and discuss three other performance measures that may be used. (LO 7.2)

6

Perpetual Limited is a large funds manager within Australia. Perpetual is preparing a presentation to a new client on the investment approaches taken by the company. One approach used by Perpetual is the bottom-up approach to fundamental analysis. From past experience, Perpetual knows that the new client will ask a number of questions about the bottom-up approach. Assume you work for Perpetual and are required to answer these questions. Prepare an answer relating to the main advantages and disadvantages of the bottom-up approach to fundamental analysis. (LO 7.2)

7

An investor is evaluating the use of the bottom-up approach and the top-down approach to fundamental analysis. The investor wants to use the approach that will best enable them to structure a diversified share portfolio that will achieve specified income returns and capital gains. Which approach do you recommend the investor adopt? (LO 7.1 and 7.2)

8

After graduating from university, you obtain a position as a junior journalist with a local newspaper. A number of readers have made requests for information about technical analysis. You know that technical analysis seeks to forecast and explain share price and share-market movements. In conceptual terms, write a short article for the newspaper that explains how the technical analysis approach to share price forecasting operates. (LO 7.3)

9

Listed below are the close-of-business share prices for Fortescue Metals over the last 10 trading days:

$5.28 $5.29 $5.41 $5.54 $5.59 $5.46 $5.45 $5.39 $5.46 $5.31

(a) Calculate a five-day moving average and plot on a graph.



(b) Why might a technical analyst seek to plot moving averages?



(c) Recalculate the moving average using a simple weighted five-day moving average (show your calculations). What is the purpose and advantage of using this method? (LO 7.3)

10 A technical analyst has been charting movements in a share price and notices that the trend line has been rising for some time.

(a) As the analyst, draw and label an uptrend line and a return line on the chart. Explain how this is achieved.



(b) After a major shift in a trend line, a technical analyst might expect a reversal to become apparent. One reversal pattern is called the head and shoulders pattern. Describe the

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(c) You know that there are at least five reasonably reliable generalisations that can be made when analysing trend lines. Briefly identify and explain these generalisations. (LO 7.3)

11 (a) Explain why a funds manager might employ the services of both a technical analyst and a fundamental analyst even though each may argue that the other’s approach to share price forecasting is not reliable.

(b) Having regard to your understanding of the fundamentals of price movements in the share market, including fundamental and technical analysis, identify any intangible issues that an investor might need to consider. (LO 7.1, 7.2 and 7.3)

12 Stock-market regulators endeavour to maintain confidence in the markets by establishing regulation that ensures efficiency, transparency and fairness for all market participants. Within this context, briefly discuss the impacts of high-frequency trading, flash trading, news analytics and dark pools. (LO 7.4) 13 The random walk hypothesis is analogous to the Brownian motion model from physics, which describes how microscopic particles bombarded by water molecules, for example, trace a random haphazard pattern over time. Outline the main features of the random walk model and discuss the appropriateness of the analogy between share price movements and the random movements of physical particles. (LO 7.5)

CHAPTER SEVEN REVIEW

main characteristics of a head and shoulders pattern that you would expect to become evident.

14 (a) Briefly outline the main contentions of the efficient market hypothesis. In your answer, discuss the contentions of the efficient market hypothesis within the context of technical analysis and fundamental analysis.

(b) How can the hypothesis be tested? In your response, distinguish between the weak, semistrong and strong forms of efficiency. (LO 7.5)

15 A key finding in behavioural finance is that investors tend to keep their losing investments too long and sell their winning investments too soon. Use prospect theory (or other elements of behavioural finance) to explain this behaviour. (LO 7.5)

KEY TERMS accounting ratios  230

descending triangles  237

ascending triangles  237

domestic economy  225

high-frequency trading (HFT) 240

balance of payments current account 227

downtrend line  236

industry sectors  224 interest rate risk  227

behavioural finance  245

efficient market hypothesis 243

bottom-up approach  230

Elliott wave theory  239

left shoulder  239

breakout 239

expected utility  246

modern portfolio theory  231

carded rate  228

experimental economics  246

compounding interest  228

exports 225

moving-averages model (MA) 233

continuation patterns  237

fat finger trader error  240

neckline 239

corporate mission  231

flash trading  241

news analytics  241

cumulative prospect theory 247

foreign exchange risk  226

noise 223

fundamental analysis  224

nominal rate of interest  228

current account deficit  228

head 239

pole 238

dark pools  241

head and shoulders pattern 239

price series  232

depreciation 228

international economies  225

program trading  240 255

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prospect theory  247

semi-strong form efficiency  244

technical analysis  232

random walk hypothesis  243

share price pattern  232

top-down approach  224

resistance lines  236

strong form efficiency  244

uptrend line  236

return line  236

support lines  236

weak form efficiency  244

right shoulder  239

symmetrical triangles  237

256

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PART THREE

The corporate debt market CHAPTER 8 Mathematics of finance: an introduction to basic concepts and calculations

CHAPTER 9 Short-term debt

CHAPTER 10 Medium- to long-term debt

CHAPTER 11 International debt markets

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The corporate debt market Both business and government require a combination of short-term and medium- to long-term funds to finance their day-to-day operations and their capital expenditures. Most businesses finance their activities through a combination of debt and equity sources of funds. Part 2 presented a discussion of the range of equity-funding instruments that are available to medium-sized and larger businesses. Part 3 considers the main types of debt instruments that are issued by businesses to raise funds. Part 4 examines government debt alternatives. The law draws a distinction between debt and equity, in particular between the responsibilities of a corporation to its shareholders and the responsibilities of a corporation to the holders of its debt instruments. The responsibilities of a corporation to its debt holders are primarily contractual in nature. The duties are specific rather than general and are typically spelled out in detail in the loan agreement or contract. For example, the debt agreement will require the borrower to repay the debt. This may include the periodic payment of interest and repayment of the principal throughout, or at the end of the agreed period. On the other hand, equity in the form of ordinary shares is not redeemable, nor is there any contractual requirement for a corporation to pay a dividend to the holders of equity. The distinctions, however, are sometimes blurred with hybrid (or ­quasiequity) instruments such as preference shares and convertible notes (discussed in Part 2). There is clearly a cost to a corporation that issues paper (debt instruments and securities) in order to obtain debt funding: lenders of debt will require a return on their funds. That cost is typically measured as an interest rate or yield. The structure of the debt issue (how it is to be repaid), and the yield paid, will affect the amount of funds lent or borrowed. Therefore, consideration of the different forms of debt available requires an understanding of the mathematics of finance. Chapter 8 provides an introduction to these basic concepts and calculations. Factors and theories that influence the determination and level of interest rates are discussed in Part 4 (Chapters 12 and 13). The matching principle states that a business should fund its short-term assets with short-term liabilities, and its longer-term assets with longer-term liabilities and equity. Market participants within the financial system provide a range of short-term and longer-term debt instruments. Chapter 9 examines the purpose, structure and pricing of a range of short-term debt instruments and facilities. These include trade credit, bank overdrafts, commercial bills, promissory notes, negotiable certificates of deposit, inventory loans, accounts receivable financing and factoring. Longer-term funding techniques and instruments are presented in Chapter 10. As with the short-term debt instruments, longer-term techniques include both intermediated debt finance and direct debt issues. These include term loans, fully drawn advances, mortgage finance, debentures, unsecured notes and subordinated debt. Another financing technique discussed is leasing. More complex forms of financing include project finance and securitisation. These are discussed in the extended learning sections of Chapter 3 and Chapter 10 respectively. Part 3 concludes with an introduction to the major international debt markets. With globalisation and the integration of nation-state financial systems with those of the rest of the world, many businesses, financial institutions and governments now have access to significant offshore sources of funding. Two of the main international debt markets considered in Chapter 11 are the euromarkets and the US debt markets. When a borrower seeks to raise funds, particularly in the international markets, the borrower will need to obtain a credit rating for the proposed debt issue. The important functions and roles of credit rating agencies are also discussed. Finally, borrowing funds within the international debt markets will usually involve debt contracts being denominated in foreign currencies. The foreign exchange markets are discussed in Part 5.

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Chapter 8

Mathematics of finance: an introduction to basic concepts and calculations CHAPTER OUTLINE 8.1 Simple interest 8.2 Compound interest

Learning objectives LO 8.1

Understand and carry out a range of simple interest calculations, including:



— simple interest accumulation



— present value with simple interest



— initial yields



— holding period yields.

LO 8.2

Understand and carry out important compound interest calculations, including:



— compound interest accumulation (future value)



— present value with compound interest



— present value of an annuity



— present value of a perpetuity



— accumulated value of an annuity (future value)



— effective rates of interest.

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Part 3 The corporate debt market

CHAPTER SNAPSHOT Because financial cash flows occur over time and yet must be compared with an investment amount or purchase price today, we need some way to compare cash flows received at different points in time. This is why finance texts always have a chapter on (or make use of) present value and future value mathematics. If a company has to invest $200 million today in a product that will generate a series of cash flows over the next 10 years, it must compare the present value of that cash flow series against the initial investment amount. If an investor, by purchasing shares, is entitled to a stream of dividend payments going on for an indefinite period of time, he or she needs to compare the share price with the present value of those dividends. If a bondholder is entitled to a series of interest payments and a lump sum when the bond matures, he or she must compare the bond price with the present value of those cash flows. This gives us the rationale for exploring some financial mathematics. Fortunately, with a little practice everyone can do the necessary calculations.

INTRODUCTION When it comes to mathematics there seem to be two groups of people: those who love it and those who hate it. Either way, in the world of finance it is not possible to avoid financial mathematics. The most important thing to remember is that mathematical proficiency is not something you are either born with or not. There is no evidence for that. Rather, it is a matter of deliberate, concentrated practice. Only the number of hours that you practise separates a more proficient user of mathematics from a less proficient one. This chapter introduces the basic concepts that are used, and relevant calculations such as price and yields. To make the topic more interesting and perhaps easier to understand, each form of calculation is explained through the use of examples. The formulae to be used are represented by a set of symbols. Each symbol denotes an input to a formula. It is assumed that at this stage of your learning you will understand how to transpose a formula—that is, how to rearrange the symbols, or inputs, to enable the calculation of the answer to a particular question. One problem is that different textbooks often use different symbols to represent the same input. For example, in this text the current interest rate is represented by the symbol i, but in another text the symbols r or k may be used. Table 8.1 provides a list of the main symbols used in this chapter and generally throughout the book.

Table 8.1 List of symbols i

current nominal interest rate expressed as a decimal

n

number of interest periods

A

principal or present value

S

accumulated amount or future value

I

total dollar amount of interest paid or received

P

price or value

d

number of days

ie

effective rate of interest

C

coupon or interest payment

m

compounding periods per year

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Chapter 8  Mathematics of finance: an introduction to basic concepts and calculations

At times the formulae may seem a little intimidating, but Table 8.1 shows that there are relatively few symbols involved at this point. The list of symbols will increase in later chapters as the calculations are extended further. The formulae in this chapter form the basis of most of the calculations used in Chapters 9 and 10, when short-term and longer-term debt instruments are considered. Throughout this book, reference is frequently made to the cost of borrowing, return on investment, yield and the interest rate. This chapter examines some of the mathematics associated with calculating the cost of borrowing or the return earned on an investment. In doing so, it is necessary to distinguish between the following techniques for calculating interest charges or earnings:

• simple interest calculations • compound interest calculations • nominal interest rate calculations • effective interest rate calculations. The value of future cash flows in today’s terms—that is, the present value of future cash flows—is also discussed. Simple interest is used to calculate the prices of discount instruments in Chapters 9 and  12, such as bills of exchange, promissory notes, Treasury notes and negotiable certificates of deposit. Compound interest is used to calculate the instalment on a term loan or mortgage loan, plus the price of a coupon instrument such as a corporate bond, eurobond or Treasury bond, in Chapters 10, 11 and 12 respectively.

REFLECTION POINTS

and governments require access to both short-term debt funding and longer-term • Businesses debt funding. must be repaid, but the structure of the debt instrument will affect the amount of funds • Debt raised, and the cash flows associated with interest payments and principal repayment. are used to calculate the interest and principal repayment cash-flow requirements; • Formulae the formulae are represented by a set of symbols; each symbol denotes an input into a formula. financial mathematical concepts of simple interest, compound interest, present values, • Basic future values, annuities, nominal interest rates and effective interest rates form the basis of calculations associated with the different debt instruments issued as intermediated finance by financial institutions or direct finance issued into the money markets and capital markets.

8.1

Simple interest

The phrase simple interest is not used to describe the calculation as being easy; rather, it is used to signify that the calculation of interest is based only on the initial amount of funds invested or borrowed, that is, the original principal amount. For example, if you invest some funds in a term deposit with a bank, the amount invested is the principal. The bank will pay you a rate of return, or interest, on that investment. Let us assume that the amount is invested for two years with simple interest payable annually. At the end of the first year, the bank will calculate and pay the interest amount direct to the depositor. The principal amount remains unchanged. At the end of the second year, the bank will make another interest payment, plus also repay the original principal amount on the maturity date. A similar situation occurs if a company obtains an interest-only business loan from a bank and is required to make annual interest payments on the principal amount borrowed and repay the full principal amount at the maturity date.

LEARNING OBJECTIVE 8.1 Understand and carry out a range of simple interest calculations, including: simple interest accumulation; present value with simple interest; initial yields; and holding period yields.

Simple interest interest paid on the original principal amount borrowed or invested

Principal the face value amount of a loan or deposit

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8.1.1

S IMPLE INTEREST ACCUMULATION

The amount of interest to be paid on a debt, or earned on a deposit, depends on three things:

• the amount involved, that is, the principal or present value (A) • the time or duration of the loan; the number of interest payments payable during the term of the loan is represented by n (the number of interest periods)

• the current nominal interest rate per period (i), where i is expressed as a decimal. For example, if the interest rate is 5.25 per cent, then i = 0.0525 (calculated 5.25/100). The total dollar amount of interest paid or earned (I) is: d   ​  × i​ ​I = A × ​ ____ 365

8.1

The following examples illustrate the use of Equation 8.1 in the calculation of simple interest.

EXAMPLE 8.1 If $10 000 is borrowed for one year, and simple interest of 8.00 per cent per annum is charged, the total amount of interest paid on the loan will be: d   ​  × i I = A × ​ ____ 365 365 ​​​ ​       ​  =​  $10 000 × ​   ​​ ​  ​  × 0.08​ ____ 365 ​ = $800

EXAMPLE 8.2 Had the same loan been for two years, the total amount of simple interest paid would be: 730 ​  × 0.08 I = $10 000 × ​ ____ 365 ​​​     ​  ​   ​​ ​ ​ = $1 600

EXAMPLE 8.3 If the same amount is borrowed at the same rate of interest, but for a 90-day term, the total amount of interest paid would be: 90  ​  × 0.08 I = $10 000 × ​ ____ 365 ​​​     ​  ​   ​​ ​ ​ = $197.26

Market convention a common practice that occurs within a particular financial market

In Example 8.3 the amount was borrowed for 90 days, which must be converted into a fraction of a year in order to apply Equation 8.1. It is important to note that the market convention relating to the number of days in the year varies between countries. In the UK, Australia and a number of other countries, the convention is that a per-annum rate relates to a 365-day year. However, in the USA and in the euromarkets, the convention is to use a 360-day year. In this chapter, the 365-day convention is used. In the Examples 8.1 and 8.2 we used d/365. In fact, it would have been easier to use n. In Example 8.1 n would be 1 instead of 365/365, and in Example 8.2 n would be 2 instead of 730/365.

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Once the amount of interest is calculated, it is easy to determine the final amount payable. The amount would simply be the sum of the principal and the interest amount. Alternatively, the final amount payable can be calculated in a single equation. Let S stand for the accumulated amount payable, then: S = A + I ​​ ​​ ​  =​  A + (A × n × i) ​    ​​​ S = A​​[​​1 + (n × i)​]​​​

8.2

For the three examples above, the accumulated amounts payable, calculated using Equation 8.2, are as follows.

EXAMPLE 8.1a S = $10  000 ​​[​​1  + (1 × 0.08)​]​​​ ​​​     ​  ​   ​​​ ​ = $10 800

EXAMPLE 8.2a S = $10  000​ ​[​​1  + (2 × 0.08)​]​​​ ​​​     ​  ​   ​​​ ​ = $11 600

EXAMPLE 8.3a S = 10  000​​[​​1  + ​​(____ ​​​  90  ​  × 0.08​)​​​​]​​​ ​​​     ​  ​   ​​ ​ 365 ​ = 10 197.26

The illustration in Figure 8.1 reinforces the process of accumulation under conditions of simple interest. It shows the essential aspect of simple interest accumulation, namely, that for each interest period, interest is calculated on the original principal amount only.

Figure 8.1  Simple interest accumulation $100 invested for 3 years at 12% p.a.: Years

1 12%

A I

100

2 12%

100 12

3 12%

100 12

100 12

I = A × n × i = $100 × 3 × 0.12 = $36 S = A[1 + (n × i)] = $100[1 + (3 × 0.12)] = $100 (1.36) = $136

8.1.2

P RESENT VALUE WITH SIMPLE INTEREST

Section 8.1.1 considered the future or accumulated values of principal amounts of money invested or borrowed. However, in many situations it is the reverse situation that is relevant; that is, how much is a cash flow to be received in, say, two years’ time worth today? In other words, what is the present value today of a future cash flow? 263

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The present value may be defined as the current value of a future cash flow, or series of cash flows, discounted by the required rate of return. The notion of present value is clear from the following two statements:

• the future value of $100 in one year, with simple interest of 10.00 per cent per annum, is $110, so • the present value of $110 received in one year, with simple interest of 10.00 per cent per annum, is $100. Yield the total rate of return on an investment; comprises investment income and capital gains (or losses)

The present value can be thought of as the amount needed to be invested today to yield a particular value in the future. To calculate the present value of a future amount, simply rearrange Equation 8.2 (the future value equation). That is, rearrange: ​S = A​​[​​1 + (n + i)​]​​​​ where A (the principal or present value) is solved, given the future value S, the number of interest periods n and the simple rate of interest i: S   ​​  8.3 ​A = ​ ___________ ​[​​1 + (n + i)​]​​ This states that the present value of a future amount is the future amount discounted (or mathematically divided) by the simple interest factor. Examples 8.4 to 8.6 illustrate the use of Equation 8.3.

EXAMPLE 8.4 An investor has an asset that will be worth $100 000 in 120 days’ time. However, the investor would like to sell the asset today. The investor decides that, based on current market returns, the investment should be discounted at a rate of 11.00 per cent per annum. To find out the price that the investor will sell the asset for today, we need to calculate the present value of $100 000 payable in 120 days’ time at 11.00 per cent per annum simple interest. S   ​  A = ​ _________ ​[​​1  + (n + i)​]​​ $100 000 ​​A ​        ​  =​  _______________ ​  ​​ ​​ ​       ​[​​1  + ​​(____ ​​​  120 ​  × 0.11​)​​​​]​​ 365 ​ = $96 509.78

EXAMPLE 8.5 A company discounts (sells) a commercial bill with a face value of $500 000, a term to maturity of 180 days and a yield of 8.75 per cent per annum. How much will the company receive when it sells the bill? (Commercial bills are discussed in Chapter 9. Briefly, a bill is a debt security issued by a company to raise funds. A bill is a discount security; that is, it is issued with a face value payable at a date in the future, but in order to raise the funds today, the company sells the bill for less than the face value. The investor who buys the bill will receive the face value at the maturity date.) The price of the bill will be: $500 000 Price = ​ __________________       ​ 180 ____ ​[​​1  + ​​(​​​   ​  × 0.0875​)​​​​]​​ 365 ​​​        ​  ​   ​​ ​ ​ $500 000 ​ = ___________ ​       ​ ​[​​1  + 0.04315​]​​ ​ = $479 317.14 264

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Often there is more than one way to write a formula. For example, in Chapter 9 the money-market convention for the calculation of the price of a discount security is adopted and Equation 8.3 is rewritten as: 365 × face value Price = ___________________________ ​          ​ yield 365 × ​​(​​ ​ ____ ​ × days   to maturity​)​​​ 100 ​ ​ ​​ ​  ​            ​​ ​ ​ 365 × $500 000 ​  = __________________ ​        ​ 365 + ​(​​0.0875 × 180​)​​ ​    = $479 317.14

8.4

Compare the result using this formula with that of the formula above. The next step is to apply the discount security formula in Example 8.6, using another discount security that may be issued by government, the Treasury note (T-note). (T-notes are issued by the government to raise short-term funds and are discussed in Chapter 12.)

EXAMPLE 8.6 What price per $1 million of face value would a fund manager be prepared to pay to purchase 180-day T-notes if the current yield on these instruments is 5.82 per cent per annum? 365 × $1 000 000 P = ​ __________________       ​ 365 + (0.0582 × 180) ​​​        ​  ​  $365 000 000  ​​ ​ ​ ​ = ___________ ​     ​   375.476 ​ = $972 000.42

Figure 8.2 provides a pictorial presentation of the concept of present value under simple interest and the relationship between present value and future value.

Figure 8.2  Present value with simple interest The present value of $150000 due at the end of 3 years, with simple interest of 9% p.a.: Years

1

2

3 150 000 = S

A

9% p.a.

S A= 1 + (n × i) =

$150000 1 + (3 × 0.09)

= $118 110.24 The relationship between present value and future value: +I (or compounding) A

S –I (or discount)

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8.1.3

C ALCULATION OF YIELDS

In the examples given above, the interest rate or yield on an instrument was given. However, at times the yield may not be given and it will be necessary to calculate the yield on an investment or the cost of borrowing. Equation 8.1 can be rearranged to obtain the solution for the yield. Given that: d   ​  × i​ ​I = A × ​ ____ 365 and since the yield is the relationship between the principal and the interest earned over a certain period, then: 365 ​i = ​ ____    ​  × ​ __I  ​ A d

8.5

The following examples illustrate the use of Equation 8.5.

EXAMPLE 8.7 What is the yield (rate of return) earned on a deposit of $50 000 with a maturity value of $50 975 in 93  days? That is, this investment has a principal (A) of $50 000, interest (I) of $975 and an interest period (d ) of 93 days. $975 i = ____ ​ 365 ​  × ​ _______   ​  93 $50 000 ​​​       ​  ​  ​  ​​​ ​ = 0.07653 ​ = 7.65% p.a.

EXAMPLE 8.8 Which of the following commercial bills provides the better per cent per annum return? The first bill matures in 96 days’ time and is currently selling at $97.44 for each $100 of face value; the second matures in 132 days and is currently selling at $96.85. The yield on the first bill is: $2.56 i = ____ ​ 365 ​  × ​ ______   ​  96 $97.44 ​ ​​      ​  ​  ​ ​​​ ​ = 0.099891 ​ = 9.99% p.a. The yield on the second bill is: $3.15 i = ____ ​ 365 ​  × ​ ______   ​  132 $96.85 ​​​       ​  ​   ​​ ​ ​ ​ = 0.0899935 ​ = 8.99% p.a. The yield on the first bill is higher. Note: The interest earned (I) is the difference between the face value at maturity ($100) and the current price.

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8.1.4

H OLDING PERIOD YIELD

The odd days to maturity of the two commercial bills in Example 8.8 indicate that the bills probably had an original maturity of 180 days and they are now being sold by investors on the secondary market prior to their maturity. This occurs frequently with money-market securities for a range of reasons, including:

• The current investors may have bought them with the intention of investing surplus funds for a few

Secondary market a market that facilitates the buying and selling of existing securities

days or weeks only.

• The intention may have been to hold the securities to maturity, but the holder’s cash-flow position may have changed such that the holder needs to sell in order to raise cash.

• The securities may be sold because a better rate of return can now be obtained on an alternative investment; that is, there is a restructuring of an asset portfolio.

When a financial instrument such as a discount security is sold prior to the maturity date, the yield for the period over which the instrument has been held is likely to be different from the yield that would have been obtained had it been held to maturity. The two yields are referred to as the holding period yield (HPY) and the yield to maturity (YTM) respectively. The holding period yield is the actual return received on an investment, having regard to the cost of the instrument, the sale price and any interest, or return, received in the interim. In the event of the holding period being less than the period to maturity, the investor would need to calculate the holding period yield. The calculation of the holding period yield on a discount security is a relatively simple procedure. A discount security, such as a commercial bill, is sold today for less than its face value, which is payable at maturity. A discount security makes no interest payments. All that is required is the calculation of the difference between the purchase price of the instrument and the sale price. The difference between the two values is the dollar amount earned. This amount is then expressed in terms of a per cent per annum yield on the original purchase price. These steps are illustrated in Example 8.9.

Holding period yield (HPY) the actual percentage per annum return received for the period an investment is held

Yield to maturity (YTM) the return received on an investment held until its maturity date; expressed as a percentage of the sum invested

EXAMPLE 8.9 A commercial bill with a face value of $100 000 and 180 days to maturity is purchased with a yield to maturity of 7.85 per cent per annum. After the bill has been held for 50 days, it is sold at a yield of 7.35 per cent per annum. What rate of return was earned by the original holder of the bill; that is, what is the holding period yield? First, calculate the purchase price using Equation 8.3, or alternatively Equation 8.4: $100 000 purchase price = ​ __________________       ​ 180 ​​ ​​​​ ​​ × ​ ____ ​ ​​     ​  ​  ​[​​1  + ​​(​​0.0785   ​​ ​ 365)] ​ = $96 273.05 Next, calculate the sale price of the bill that is now yielding 7.35 per cent per annum and has 130 days remaining to maturity: $100 000 sale price = ​ __________________       ​ 130 ​​ ​​​​ ​​ × ​ ____ ​​​      ​  ​  ​[​​1  + ​​(​​0.0735   ​​ ​ 365)] ​ = $97 448.97 The investor bought low at $96 273.05 and sold high at $97 448.97 after 50 days. The return earned is the difference between the two prices; that is, $1 175.92. Using the yield equation (Equation 8.5), the holding period yield is: $1 175.92 365 ​  × ​ _________ HPY = ​ ____    ​  ​     ​​ ​  ​  50 $96 273.05​ ​​ ​ = 0.089166 or 8.92% p.a. 267

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In Example 8.9 the holding period yield is higher than the yield to maturity. This is because at the sale date the market yield had declined from the yield that prevailed at the original purchase date. As the yield declines, the price of the instrument is affected: the lower the yield, the higher the price of the instrument. In this example the owner of the bill has made a capital gain on the sale of the bill that increased the total yield. Had the bill been sold into a market in which the yield was higher than the yield that prevailed at the original purchase date, a capital loss would have been made and the holding period yield would have been less than the yield to maturity.

REFLECTION POINTS

interest calculations are based on the original principal amount; interest receipts or • Simple payments do not affect the principal amount of a simple interest loan or investment. amount of interest received on an investment or paid on a loan, based on the original • The principal amount, is: d   ​  × i​ ​I = A × ​ ____ 365

8.1

• Therefore, the amount of simple interest plus the principal amount is: ​S = A​​[​​1  + (n × i)​]​​​​

8.2

is an amount due at a future date worth today? The present value of a single cash flow • What with simple interest is: S   ​​  ​A = __________ ​  [1 + (n × i)]

8.3

• What is the present value of a money-market discount security? The discount security formula is: 365 × face value ​Price = __________________________ ​         ​​ yield 365 + ​​ ____ (​​​  100 ​  × days to maturity​)​​​

8.4

yield is the return on an investment or the cost of borrowing. The calculation of the yield, • The or the holding period yield, on an investment is the interest earned divided by the amount

LEARNING OBJECTIVE 8.2 Understand and carry out important compound interest calculations, including: compound interest accumulation (future value); present value with compound interest; present value of an annuity; accumulated value of an annuity (future value); and effective rates of interest.

Compound interest interest is calculated on the accumulated principal amount; interest is added to the principal

invested, adjusted for the number of days the investment is held: ​i = ____ ​ 365  ​     × ​ __I  ​​  d A

8.2

8.5

Compound interest

In the discussion in Section 8.1, the interest applied to a loan or an investment was calculated on the principal only (simple interest). However, more commonly, interest will accumulate on the principal amount over time. For example, you may invest an amount in a term deposit with a bank. The bank agrees to pay you monthly interest on the term deposit. Rather than receive the monthly interest payment in cash, you may decide to reinvest the interest by allowing it to add to the original principal. In each successive period, the bank will pay interest on the increasing amount invested. This is known as compound interest.

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8.2.1

C OMPOUND INTEREST ACCUMULATION (FUTURE VALUE)

When an amount is borrowed or invested for only a small number of periods, it is possible to calculate the compound interest payable by:

• calculating the first interest due, using the simple interest equation (Equation 8.1) • adding that interest to the original principal • calculating the next interest due on the adjusted principal • adding that interest to the previously adjusted principal, and so on. This process is illustrated in Example 8.10.

EXAMPLE 8.10 A loan of $5 000 is obtained for three years, at an annually compounding rate of 15.00 per cent per annum. The total amount will be repayable at the maturity date. In the first year, the accumulating interest is: I = A × n × i ​ ​​​   ​  =​ ​  $5 000 × 1 × 0.15​  ​​ ​  ​ = $750 In the second year the interest due is calculated on the adjusted principal; that is, the first year’s interest is compounded into the principal. The second year’s principal is now $5 750, and so: I = $5 750 × 1 × 0.15 ​ ​​   ​  ​   ​​​ ​ = $862.50 The compounding of interest into the principal is continued. For the third year the principal is $6 612.50, and so the interest for the third year is: I = $6 612.50 × 1 × 0.15 ​​​     ​  ​   ​​​ ​ = $991.88 The total interest on the loan for the three years is $2 604.38. The final amount payable, or the future value of the loan (S), is equal to $7 604.38.

This procedure is cumbersome, even in calculating I and S for such a small number of periods. When interest is compounded through a larger number of periods, for example the above loan may well have had monthly rather than annual compounding, the procedure is unacceptably time consuming. It is preferable to use equations appropriate to the compounding process. The general form of the compounding interest formula is: ​S = A ​(1 + i)​​ n​​

8.6

where: S = the accumulated amount or future value A = the present value ​​​ ​  ​                ​ ​  ​​​ i = the current nominal interest rate expressed as a decimal n = the number of compounding interest periods 269

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This equation is now used to calculate S for the loan described in Example 8.10, where A = $5 000, i = 0.15 and n = 3: S = 5 000(1 + 0.15)3 = 5 000(1.15)3 = 5 000(1.520875) = $7 604.38 This demonstration using a very simple example shows the advantage of using Equation 8.6 rather than the repeated application of the simple interest calculations. On many investments and loans it is often the case that interest will accumulate more frequently than once a year. For example, interest could accumulate daily, monthly, quarterly or half-yearly. It is necessary to recognise the effect of the compounding frequency on the inputs i and n in Equation 8.6. For example, if interest had accumulated monthly on the above loan, then it is necessary to divide the annual interest rate by 12 to obtain the monthly rate, and to multiply the monthly interest period by 3 years to obtain the total number of interest periods: A = $5 000  ​​​ i​​​  ​  =​  0.15 / 12​  =   0.0125 n   = 3 × 12 = 36 Then: S = 5 000(1 + 0.0125)36 = 5 000(1.0125)36 = 5 000(1.563944) = $7 819.72 The investment that has interest accumulating quarterly achieves a higher return than the investment where interest accumulates only half-yearly. In Example 8.11a the total amount was $12 837.65, whereas in Example 8.11b the total amount was $12 750.78. This can be explained by understanding the effect of compounding; that is, the investment is earning interest on its accumulated interest. The more frequently the interest accumulates, the greater the amount earned.

EXAMPLE 8.11a A term deposit of $8 000 is made for four years and will earn 12.00 per cent per annum, with the interest compounding quarterly. The interest paid at each interest date is 12.00 per cent per annum, but since it is paid four times per year the interest paid per quarter (i) is 12/4 = 3.00%, or 0.03. Similarly, n represents the number of interest periods, or principal conversion periods. In this example, n = 4 periods x 4 years = 16. Thus: A = 8 000 i = ____ ​ 12%  ​    p.a. ​    ​​ ​  ​  ​  ​  4 ​  ​ ​ ​​ ​ = 0.03 n = 16 periods Then: S = A ​(1  + i)​​  n​ ​ = 8  000 ​(1  +  0.03)​​  16​ 16 ​ ​​​            ​  =​ ​  8  000 ​(1.03)​​  ​  ​​ ​​ ​ ​ = 8 000  (1.6047) ​ = $12 837.65 270

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EXAMPLE 8.11b The effect of compounding can be further understood by considering a similar deposit of $8 000 paying 12.00 per cent per annum, but where interest accumulates half-yearly for four years: i = ____ ​ 12%  ​    p.a. 2 ​    ​​ ​  ​  ​  ​  ​ ​​ ​ = 0.06 n = 4 × 2 = 8 periods So: S = 8  000 ​(1  +  0.06)​​  8​ ​​​​       ​  =​  8 000  (1.593848)  ​​​​ ​ = $12 750.78

Figure 8.3 illustrates the nature of the compounding process. In both parts of the figure, the interest due from each interest period is compounded into the principal at period end. It then becomes part of the principal upon which the next period’s interest is calculated. In part (b), the more frequent compounding results in a larger accumulated value.

Figure 8.3  Compound interest accumulation (a) $100 invested for 3 years at 12% p.a. compounded annually: Years

1 12%

A = 100 I =

2 12%

112 12

3 12%

125.44 13.44

140.49 15.05

S = A(1 + i)n = $100(1 + 0.12)3 = $100(1.4049) = $140.49 (b) $100 invested for 3 years at 12% p.a. compounded semi-annually: Years 6% A = 100 106 I = 6

1

2

3

6% 6% 6% 6% 6% 112.36 119.10 126.25 133.82 141.85 6.36 6.74 7.15 7.57 8.03

S = A(1 + i)n = $100(1 + 0.06)6 = $100(1.4185) = $141.85

8.2.2

P RESENT VALUE WITH COMPOUND INTEREST

In the discussion of present values with simple interest, we noted that the calculation of the present value of a future amount involves the division of the future value by the discount interest factor. Exactly the same procedure applies in the case of compound interest. Equation 8.6 shows that the future value is the present value (A) multiplied by the interest factor (1 + i)n. The present value of a future amount 271

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then becomes the future value divided by the same interest factor, which, in the case of calculating present values, might be better referred to as the discount factor. This is expressed as: S   ​​  ​A = ​ _______ ​(1 + i)​​ n​

8.7a

Another way of expressing this relationship is: ​A = S ​(1 + i)​​ −n​​

Ordinary annuity periodic cash flows that occur at the end of each period

Annuity due periodic cash flows that occur at the beginning of each period

8.2.3

8.7b

P RESENT VALUE OF AN ANNUITY

The calculations in the previous examples relate to the present value of a single future amount; however, it is common for many financial arrangements to comprise a series of future cash flows over time. Where a series of periodic cash flows occurs, this is known as an annuity. If the annuity periodic cash flows occur at the end of each period, this is known as an ordinary annuity. If the cash flows occur at the beginning of each period, this is known as an annuity due.

EXAMPLE 8.12 What is the present value of $18 500 due to be paid at the end of three years, if current interest rates are 7.25 per cent per annum, compounded annually? Using Equation 8.7a: ​A = ______ ​  S  n ​​  ​(1  + i)​​  ​ where: S = $18 500 ​​i      ​  ​  =​  7.25% or 0.0725  ​​ ​ ​ n=3 therefore: $18 500 A = ___________ ​        ​ ​(1  +  0.0725)​​  3​ ​ ​​      ​  ​  $18 500 ​  ​​​ ​ = ​ ________   ​  1.233650 ​ = $14 996.15 That is, the holder of the entitlement to receive $18 500 in three years’ time could sell that entitlement to someone else today for $14 996.15, assuming a discount factor of 7.25 per cent per annum.

EXAMPLE 8.13 You have been offered a job that will pay a lump-sum bonus of $25 000 at the end of the seven-year contract. In assessing the offer, you wish to know the value of the bonus in today’s dollar terms. You decide that 10.00 per cent per annum compounded monthly is an appropriate discount factor. Calculate the present value: ​A = ______ ​  S  n ​​  ​(1  + i)​​  ​ 272

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where: A = $25 000 ​​i   ​  ​​     ​  ​  ​  =​  ____ ​ 10% ​ = 0.8333% or 0.008333​ 12 n = 7 × 12 = 84 therefore: $25 000 A = ​ ______________       ​ ​(1  +  0.008333)​​  84​ ​​​       ​  ​  $25 000 ​  ​​​ ​ = ________ ​     ​  2.007864 ​ = $12 451.04

For example, a business may obtain a loan where loan repayments are payable at the end of each month; this is an ordinary annuity. In another situation, an individual may be required to pay an insurance policy premium at the start of each year; this is an annuity due. Therefore, an annuity is any financial contract where a series of equal cash flows occur. Figure 8.4 shows a situation where an annuity of $100 is paid annually for three years using a discount factor of 12.00 per cent per annum.

Figure 8.4  Present value of an annuity The present value of a $100 annuity received every 12 months, for 3 years, if funds could be invested today at 12% p.a. compounded annually: Years

1 $89.28

Therefore:

2

100

100 $79.72

3 $71.18

100

$89.28 + $79.72 + $71.18 = $240.18

That is, $240.18 invested today, at 12% p.a., compounded annually, would provide a $100 annuity to be received at the end of each of the next 3 years.

As shown in Figure 8.4, the present value of an annuity stream may be calculated by applying Equation 8.7a or Equation 8.7b to each of the individual cash flows and then adding the present values to obtain the present value of the total annuity flow. This procedure would be slow even for the threepayment annuity illustrated in Figure 8.4, which requires only three separate present value calculations. Using this method to price a longer-term annuity with, say, half-yearly payments and perhaps 10 years to maturity would be extremely cumbersome: 20 payments would have to be converted into present value terms. Fortunately, there is a single equation that can be applied to calculate the present value of an annuity of any number of payments. Equation 8.8 is: 1 − ​(1 + i)​​ n​ ​A = C​​[__________ ​​​      ​  ]​​​​ i where: A = the present value C = the annuity payments (regular cash flows) ​​​ ​  ​                 ​  ​ ​​​ i = current nominal interest rate, per period, expressed as a decimal n = number of periods

8.8

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Therefore, using Equation 8.8, the present value of the annuity in Figure 8.4 is: 1 − ​(1 + i)​​ −n​ ​A = C​​[___________ ​​​      ​  ]​​​ i 1 − ​(1 + 0.12)​​ −3​ = $100​​ ______________ ​​​   ​​     ​​​ [ ] 0.12 = $100​​[__________ ​​​ 1 − 0.71178  ​​]    ​​​ 0.12 = $100(2.40183) = $240.18​ The following examples illustrate the use of Equation 8.8.

EXAMPLE 8.14 The present value of an annuity of $200, received at the end of each quarter for 10 years, where the required rate of return is 6.00 per cent per annum, compounded quarterly, would be: C = $200 i = ______ ​ 6.00%  ​     4 ​​​    ​  ​  ​  ​   ​​ ​  ​  ​ ​ = 1.50% or 0.015 n = 4 × 10 ​ = 40 Therefore: 1 − ​​(​​1  + i​)​​​​  n​ A = C​​[​​ ​ _________  ​   ​  ]​​​ i

1 − ​​(​​1.015​)​​​​  −40​ ​ = $200​​ ​​ ​ ___________     ​​  ​​​ [ ​​​               ​  ​  ​   ​​ ​0.015 ​ ​ ]​ ​ = ​$200​[​​29.9158452​]​​​ ​ = $5 983.17 ​ ​ ​

The calculations above have been for an ordinary annuity, that is, one in which the cash flows occur at the end of a period. If the cash flows occur at the beginning of the period, this is known as an annuity due. To calculate the value of an annuity due, it is necessary only to recognise that the interest effect occurs earlier; that is, the start of the interest period is brought forward to the beginning of the period. Therefore all that is needed is to multiply the ordinary annuity formula by (1 + i). This is shown in Equation 8.9. 1 − ​(1 + i)​​ −n​ ​A = C​​[___________ ​​​      ​  ]​​​(1 + i)​ i

8.9

The effect of the annuity due can be observed by changing the cash flows from Example 8.14 so that they occur at the beginning of each period. The higher present value of $6 072.92 in Example 8.15 recognises the benefit of the earlier receipt of the periodic cash flows at the beginning of each quarter. 274

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EXAMPLE 8.15 The present value of an annuity of $200, received at the beginning of each quarter for 10 years, where the required rate of return is 6.00 per cent per annum compounded quarterly, would be: C = $200 i = ______ ​ 6.00%  ​     4 ​ ​​   ​  ​  ​  ​   ​​ ​  ​  ​ ​ = 1.50% or 0.015 n = 4 × 10 ​ = 40 Therefore: 1 − ​(1  + i)​​  −n​ A = C​​[__________ ​​​   ​   ​  ​​​(1  + i) ] i 1 − ​(1  +  0.015)​​  −40​     ​​ ​​A ​              ​  =​  $200​​[​​​ _______________      ​ ]​​​(1 ​+ 0.015)​​​ 0.015 ​ = $200 [29.9158452 ] (1.015) ​ = $6 072.92

A special type of annuity is one where the case flow has no end date. That is, the regular cash flow goes on forever. This is called a perpetuity. We came across this type of cash flow when we discussed share valuation. Companies have no fixed lifespan and, as such, the cash flows that they are expected to generate are treated as being perpetual. The present value of a perpetuity is determined by simply dividing the cash flow amount by the discount rate. This is exactly the same method that we used to work out the theoretical value of a share with constant dividends. We will find that our present value mathematics also allows us to compute bond prices. Bonds are issued by corporations and governments to borrow long-term funds direct from the capital markets. Typically, a bond will pay a fixed-interest coupon for the term of the bond, with the principal (along with the last coupon) only repayable at the maturity date. The value of the bond must be determined by the present value of the future cash-flow entitlements. With a bond, there are two sets of cash flows, and therefore it is necessary to calculate the present value of each. The first is the present value of the annuity (being the periodic interest coupon payments) and the second is the present value of the principal (a single cash flow repaid at the maturity date). Bonds and their calculations are discussed in detail in Chapters 10 and 11, but an example is given here. In Example 8.16 below, we need to calculate the price today of an existing corporate bond that pays a fixed coupon rate of 12.00 per cent per annum compounding half-yearly and maturing in five years. Current yields in the market are 9.00 per cent per annum. (Note: i in the formula is based on the current yield, being 9.00 per cent per annum adjusted to half-yearly = 0.045.) The 12.00 per cent fixed-interest coupon rate means that this bond pays a coupon payment of $6 per $100 of face value every six months. (Note: The fixed interest payment is called the coupon.) The interest rate is fixed, therefore the half-yearly coupon amount will not change. With five years to maturity, there are 10 coupons to be paid. In addition to the coupons, the bond entitles the holder to a redemption value equal to the face value of the bond at maturity date. The price of the bond is determined by calculating:

Perpetuity a cash-flow series where the same regular payment occurs each period forever

• the present value of the periodic coupon stream 1 − ​(1 + i)​​ n​ ​A = C​​[__________ ​​​      ​  ]​​​​ i

plus

• the present value of the face value of the bond ​A = S ​(1 + i)​​ −n​​ 275

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Equation 8.10 combines the formulae we used above. The first part is the formula for the present value of a series of cash flows (the coupon payments), and the second part is the formula for the present value of a single cash flow (the face value of the bond). In the solution below, the calculations are performed on the basis of $100 face value. Now that we understand the construction of the pricing formulae, we can consider using a financial program on a personal calculator as a simple alternative to the manual calculation of present value formulae. There are fewer steps involved; for example, calculating the present value on a HewlettPackard business calculator would require the following keystrokes:

EXAMPLE 8.16 1 − ​(1  + i)​​  −n​ ​A = C​​[__________ ​​​   ​   ​  ​​​  + S ​(1  + i)​​  −n​​ ] i

8.10

where: ​C = $6, n = 10, i = 0.045 and S = $100​ therefore: 1 − ​​(​​1  + 0.045​)​​​​  −10​ A = $6​​ ​​ ​ ______________        ​​ ​​​  + $100 (1 +  0.045​)​​  −10​ [ ] 0.045 1 − 0.643928 −10 ​ = $6​​[​​ ​ ____________     ​​  ]​​​  + $100 (1 +  0.045​)​​  ​ 0.045 0.356072 ​​​ ​                         ​  =​  $6​​ ​​ ​ ________   ​ ​ −10​ ​ ​​​   [ 0.045 ​​  ]​​​  + $100 (1 +  0.045​)​​  ​ ​ = ​$6​[​​7.912711​]​​  + $100​(​​0.643928​)​​​

8.10

​ = $47.476266 + $64.392768 ​ = $111.87

10 4.5 −6 −100 Select Answer

N I/YR PMT FV PV PV = $111.87

Alternatively, present value tables can be used to calculate the present value of a single amount received in the future and the present value of an annuity flow. While some textbooks still supply present value and future value tables, they are of little use in the real world. Interest rates rarely fall exactly into those included in the tables. It is much better to understand the formulae and become proficient in the use of a calculator.

8.2.4

A CCUMULATED VALUE OF AN ANNUITY (FUTURE VALUE)

The same principles that were discussed in considering the present value of an annuity also apply to calculating the accumulated value, or future value, of an annuity, only in the opposite direction—that is, the value at some point of time in the future of a known income stream. The formula for calculating the accumulated or future value (S) is given in Equation 8.11. ​(1 + i)​​ n​ − 1 ​S = C​​[__________ ​​​      ​  ]​​​​ i

8.11

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EXAMPLE 8.17 A university student is planning to invest the sum of $200 per month for the next three years in order to accumulate sufficient funds to pay for a trip overseas once she has graduated. Current rates of return are 6.00 per cent per annum, compounding monthly. How much will the student have available when she graduates? C = $200 i = ______ ​ 6.00%  ​     12 ​ ​​   ​  ​  ​  ​   ​​ ​  ​  ​ ​ = 0.05% or 0.005 n = 3 × 12 ​ = 36 Therefore: (​​ ​​1  + i​)​​​​  n​  − 1 S = C​​[​​ ​ _________  ​   ​  ]​​​ i

​​(​​1  + 0.005​)​​​​  36​  − 1 ​ = $200​​ ​​ ​ ______________     ​​  ​​​ [ ] 0.005 ​ ​​          ​  ​   ​​ ​​ ​ 1.19668052 − 1 ​ = $200​​[​​ ​ ______________     ​​  ]​​​ 0.005 ​ = ​$200​[​​39.3361​]​​​ ​ = $7 867.22 The student will have accumulated $7 867.22. This should be sufficient for a very nice holiday overseas.

8.2.5

E FFECTIVE RATES OF INTEREST

Compound interest rates are normally quoted in terms of the nominal per cent per annum rate. The nominal rate of interest is the annual rate and is the rate that is typically advertised as an investment or borrowing rate. However, differences in the frequency of the compounding of interest can result in the nominal rate of interest having quite different effects on the future value of the principal, or on the present value of a future amount. Compounding represents an accumulation of interest payments into the principal. If compounding occurs more frequently than once a year, the principal amount on which interest is earned will increase over that year. In this situation, just observing the nominal interest rate does not fully reflect the actual interest earned or paid. Therefore, in order to accurately compare nominal interest rates, it is necessary to convert a nominal rate into a rate that reflects a common frequency of interest calculation and compounding. The rate described is called the effective rate of interest, which is denoted as ie. The formula for converting a nominal rate into an effective rate is: i ​​i​ e​​ = ​​(​​1 + ​ __ m  ​)​​​​  ​ − 1​ m

8.12

Effective rate of interest the rate of interest after taking account of the frequency of interest compounding periods

where ie is the effective rate of interest, i is the nominal rate of interest per period and m is the number of compounding periods per annum. The operation of Equation 8.12 is illustrated in Example 8.18. A comparison of the effective interest rates in Example 8.18 serves to reinforce the conclusion that the greater the frequency of the calculation and compounding of interest, the greater the effective interest rate. 277

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EXAMPLE 8.18 What is the effective rate of interest if you are quoted: (a) 10.00 per cent per annum, compounded annually? (b) 10.00 per cent per annum, compounded semi-annually? (c) 10.00 per cent per annum, compounded monthly? 0.10 (a)   ​ie​  ​​ = ​​(​​1  + ​ ____  ​​    ​​​​  ​  − 1 1 ) ​​​        ​  ​  ​  ​ ​ ​ = ​(1.10)​​  1​  − 1 ​ = 0.10 or 10% 1

0.10 ​​(​​b)​ ​​  ​ie​  ​​​ = ​​(​​1  + ​ ____  ​​    ​​​​  ​  − 1 2 ) 2

​​​ ​          ​  =​ ​  (1.05​)​​  2​  − 1​ ​ ​ ​​ ​ = 1.1025 − 1 ​ = 0.1025 or 10.25% 0.10 ​​    ​​​​  ​  − 1 ​​(​​c)​ ​​  ​ie​  ​​​ = ​​(​​1  + ​ ____ 12 ) 12

       ​ )​​  12 ​ ​  ​​ ​  =​ ​  (1 +  0.0083333​ ​​​​     − 1​ ​ = 1.104713 − 1 ​ = 0.1047 or 10.47%

The effective rate of interest takes account of the impact of compounding. The dollar effect of the frequency of the compounding was illustrated in Examples 8.11a and 8.11b. Comparison of the maturity values of those two deposit streams, each earning the same nominal rate of 12.00 per cent per annum, reveals that the greater the frequency of the interest calculation and compounding into principal, the greater is the compounding effect, and thus the greater is the final value. The same generalisation applies to the discounting of future values to obtain present values: the greater the frequency of the compounding, the greater the discount factor and the lower the present value of a given future amount. It is important to recognise the limitations of the material presented in this chapter. There are many complicating factors that are relevant in real-world situations that have not been considered here. For example, in discussing the calculation of yields, factors such as transaction costs and the effects of taxation have been ignored. In the case of pricing bonds, the examples assumed that the bonds were purchased with a full period before the next coupon date. In the majority of real-world transactions the timing will not be so tidy and adjustments have to be made to the calculations. The formula adjustment and examples for calculating the price of a bond between coupon payments are given in Chapter 10. For those who have invested time in mastering the techniques presented in this chapter, take heart! Despite the cautionary comments and the acknowledgment that there are many issues in the realm of the mathematics of finance that have not been touched upon here, the basic notions of interest accumulation, both simple and compound, and of discounting, or calculating present values, are at the centre of much of the further study of business finance.

REFLECTION POINTS

interest occurs where interest payments accumulate onto the principal amount. The • Compound interest for each ensuing interest period is calculated on the increased (compounded) principal amount.

• The accumulated or future value of a single cash flow using compound interest is: ​S = A ​(1 + i)​​  n​​

8.6

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• The present value of a single cash flow using compound interest is: or

​A = ______ ​  S  n ​​  ​(1 + i)​​  ​

8.7a

​A = S ​(1 + i)​​  −1​​

8.7b

1 − ​(1 + i)​​  −n​ ​A = C​​[__________ ​​​   ​   ​  ​​​​ ] i

8.8

annuity is a series of regular equal cash flows. Cash flows that occur at the end of an • An interest period are called an ordinary annuity. The present value of an ordinary annuity is:

annuity where the cash flows occur at the beginning of an interest period is called an • An annuity due. The present value of an annuity due is: 1 − ​(1 + i)​​  −n​ ​A = C​​[​​​ __________  ​   ​  ​​​(1 + i)​ ] i

8.9

bond pays periodic fixed-interest coupons and the principal is repaid only at maturity. • AThestraight price of the bond is the present value of the cash flows, being the present value of the interest coupons plus the present value of the principal (face value). The price of a bond (at a coupon date) is: 1 − ​(1 + i)​​  −n​ ​A = C​​[__________ ​​​   ​   ​  ​​​  + S ​(1 + i)​​  −n​​ ] i

8.10

• The accumulated or future value of an ordinary annuity is: ​(1 + i)​​  n​  − 1 ​S = C​​[​​​ _________  ​   ​  ​​​​ ] i

8.11

nominal interest rate is the annual interest rate, typically the advertised interest rate on • The an investment or a loan. However, when compounding occurs more often than annually, it is necessary to calculate the effective interest rate to compare advertised nominal interest rates. The effective rate of interest is: i ​​ie​  ​​ = ( ​​ ​​1  + ​ __ m   ​​ )​​​​  ​ −  1​ m

8.12

CASE STUDY THE RETIREMENT DREAM In Chapter 8, we introduced the basic concepts of financial mathematics and their calculations. These calculations will familiarise you with calculating present and future value. There is no doubt that calculating how much money a person will need in retirement as well as how long that money will last under certain circumstances could be approached from a present value/future value perspective. However, is there an easier way? Are there some rules of thumb that can be followed by people who do not understand the maths? Many people dream about retirement but have few concrete plans for achieving it or funding it once they get there. The 2018 consumer financial literacy survey in the USA revealed that less than half of the American population track their spending. In Australia, the sixth in the series of financial wellbeing surveys conducted by ANZ gave an average financial wellbeing score of 59 out of 100 for Australian adults, which is good news. However, only 32.00 per cent of respondents 279

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said that they had good knowledge of investment and retirement products (ANZ, 2018). The survey revealed that in order to lead a financially secure life, one doesn’t need to have detailed knowledge of all financial products and services. However, some basic knowledge is essential. There are two important questions: (1) how much money will I need in retirement; and (2) how much can I withdraw each year before my money runs out? There are rules of thumb for each question. A rule of thumb that guides how much a person should aim to save for retirement is the �multiply by 25’ rule. That is, if a person needs $40 000 annual income in retirement, they should aim to save $1 000 000. This rule is based on the assumption that it is possible to earn approximately 4.00 per cent each year without bearing much risk. Historically, this has been a valid assumption. If the investor saves $1 million, he or she should be able to earn $40 000 each year without placing the capital at risk of substantial diminution. The other question refers to how much can be withdrawn each year without running the risk that the capital will run out too soon. In 1990, financial analyst William Bengen put forward the 4.00 per cent rule (the inverse of the 25.00 per cent rule) after studying the stock and bond returns over a period of 50 years. Bengen argues that withdrawing 4.00 per cent annually would enable people to live off their nest egg for at least 30 years, regardless of market fluctuations. Even without knowledge of present and future value mathematics, a few rules of thumb can at least help investors identify the appropriate level of savings that they will need in retirement. Of course, before and after retirement, smart portfolio management is essential. For this, investors must take some positive steps to improve their financial knowledge. Reference list ANZ 2018, Financial wellbeing: a survey of adults in Australia APRIL 2018, viewed 19 October 2018, https://financialcapability.gov.au/files/anz-financial-wellbeing-summary-report-australia.pdf

Discussion point

•

Discuss the practicality of 25.00 per cent and 4.00 per cent rules for retirees in all market conditions.

Master before you move on An integral part of understanding debt is being familiar with the associated financial mathematics. Chapter 8 introduces the basic concepts and calculations that are the foundation of your understanding of financial mathematics. Chapter 9 (short-term debt), Chapter 10 (long-term debt) and Chapter 12 (government debt) will extend the foundations established in this chapter to calculations for financial instruments issued in the money markets and the capital markets. This chapter outlined the formulae used to calculate simple interest, compound interest and annuities. The following symbols are used in the formulae: i

current nominal interest rate, per period, expressed as a decimal

n

number of interest periods

A

principal or present value

S

accumulated amount or future value

I

total dollar amount of interest paid or received

P

price or value

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number of days

ie

effective rate of interest

C

coupon or interest payment

m

compounding periods per year

LEARNING OBJECTIVE 8.1 Understand and carry out a range of simple interest calculations, including: – simple interest accumulation – present value with simple interest – initial yields – holding period yields.

and governments require access to both short-term debt funding and longer-term • Businesses debt funding. must be repaid, but the structure of the debt instrument will affect the amount of funds • Debt raised and the cash flows associated with interest payments and principal repayment. are used to calculate the interest and principal repayment cash-flow requirements; • Formulae the formulae are represented by a set of symbols; each symbol denotes an input into a

CHAPTER EIGHT REVIEW

d

formula.

interest calculations are based on the original principal amount; interest receipts or • Simple payments do not affect the principal amount of a simple interest loan or investment. amount of interest received on an investment or paid on a loan, based on the original • The principal amount, is:

•

d   ​  × i​ ​I = A × ​ ____ 365 Therefore, the amount of simple interest plus the principal amount is: ​S = A [ 1 + (n × i) ]​

8.1

8.2

is an amount due at a future date worth today? The present value of a single cash flow • What with simple interest is: S   ​​  ​A = __________ ​  [ 1 + (n × i) ] What is the present value of a money-market discount security? The discount security formula is: 8.3

•

365 × face value ​Price = __________________________ ​         ​​ yield 365 + ​(____ ​   ​  × days to maturity)​ 100

8.4

yield is the return on an investment or the cost of borrowing. The calculation of the yield, or • The the holding period yield, on an investment is the interest earned divided by the amount invested, adjusted for the number of days the investment is held: ​i = ____ ​ 365  ​     × ​ __I  ​​  d A

8.5

LEARNING OBJECTIVE 8.2 Understand and carry out important compound interest calculations, including: – compound interest accumulation (future value) – present value with compound interest 281

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– present value of an annuity – present value of a perpetuity – accumulated value of an annuity (future value) – effective rates of interest.

interest occurs where interest payments accumulate onto the principal amount. The • Compound interest for each ensuing interest period is calculated on the increased (compounded) principal amount.

• The accumulated or future value of a single cash flow using compound interest is: 8.6

​S = A ​(1 + i)​​  n​​

• The present value of a single cash flow using compound interest is: • or

​A = ______ ​  S  n ​​  ​(1 + i)​​  ​

8.7a

​A = S ​​(​​1  + i​)​​​​  −n​​

8.7b

annuity is a series of regular equal cash flows. Cash flows that occur at the end of an interest • An period are called an ordinary annuity. The present value of an ordinary annuity is: 1 − ​(1 + i)​​  −n​ ​A = C​​[​​​ __________  ​     ​]​​​​ i

8.8

annuity where the cash flows occur at the beginning of an interest period is called an annuity • An due. The present value of an annuity due is: 1 − ​(1 + i)​​  −n​ ​A = C​​[​​​ __________  ​     ​]​​​(1 + i)​ i

8.9

bond pays periodic fixed-interest coupons and the principal is repaid only at maturity. • AThestraight price of the bond is the present value of the cash flows, being the present value of the interest coupons plus the present value of the principal (face value). The price of a bond (at a coupon date) is: 1 − ​(1 + i)​​  −n​ ​A = C​​[​​​ __________  ​     ​]​​​  + S ​(1 + i)​​  −n​​ i

8.10

• The accumulated or future value of an ordinary annuity is: ​(1 + i)​​  n​  − 1 ​S = C​​[_________ ​​​   ​   ​  ​​​​ ] i

8.11

nominal interest rate is the annual interest rate, typically the advertised interest rate on • The an investment or a loan. However, when compounding occurs more often than annually, it is necessary to calculate the effective interest rate to compare advertised nominal interest rates. The effective rate of interest is: i ​​ie​  ​​ = ( ​​ ​​1  + ​ __ m   ​​ )​​​​  ​ −  1​ m

8.12

is important to note that there are many complicating factors that are relevant in real-world • Itsituations that have not been incorporated into our introduction of the basics of financial mathematics, such as taxation and transaction costs. Importantly, the timing of transactions, relative to the timing of fixed cash flows, requires certain adjustments to formulae, which are given in Chapter 10. 282

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Chapter 8  Mathematics of finance: an introduction to basic concepts and calculations

Essay questions The following questions are intended to support your understanding and give you practice in applying the mathematical techniques introduced in this chapter. 1

Formulae symbols: (LO 8.1 and LO 8.2) A number of symbols are used to represent inputs to a formula. Briefly describe each of the following symbols.

i



n



A



S



I



P



d



C



m



ie

2

Simple interest accumulation:



(a) Define and explain the notion of simple interest.



(b) An investor makes a $3 500 deposit from 1 June to 31 August at 4.25 per cent per annum simple interest. How much interest will the investor earn?



(c) A bank accepts a $5 000 term deposit to mature in 547 days and pays 5.75 per cent per annum. How much interest will the bank have to pay?



(d) A bank accepts a deposit of $6 500 for a term of one year and 90 days, with an interest rate of 5.95 per cent per annum simple interest. Interest is payable six monthly and at the maturity date. What amount will be paid at each interest date and at the maturity date? (Assume the deposit is made on 1 July 2016.)



(e) What is the future value of $10 000 invested for 270 days at a current yield of 6.50 per cent simple interest? (LO 8.1)

3

Present value with simple interest:



(a) Explain the concept of present value. What is the relationship between the present value and the future value of an amount?



(b) What amount did an investor lodge in a term deposit that has a maturity value in 270 days of $27 470.34 if the term deposit earns 4.95 per cent per annum simple interest?



(c) A customer has received an invoice for $23 000 due in 30 days. The supplier offers a 2.50 per cent per annum discount for payment within 7 days. If the customer accepts the early payment offer, what amount would be due?



(d) An investor currently holds a financial asset that has a maturity value of $125 000 in 125 days. The investor decides to sell the asset today at a current market yield of 9.45 per cent per annum. What is the present value of the asset?



(e) A company issues a bank bill with a face value of $1 million and a term to maturity of 180 days at a yield of 8.25 per cent per annum. The company discounts the bill today. What amount will the company raise? (LO 8.1)

CHAPTER EIGHT REVIEW

Questions

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4

Yields:



(a) Explain the meaning of the term yield within the context of (1) a bank term deposit, and (2) the present and future values of discount securities.



(b) You are advised by a bank that a deposit of $5 000, with a term to maturity of 180 days, will have a maturity value of $5 215. What is the yield on the deposit?



(c) You have $3 000 to invest in a term deposit and your selection of the term is totally dependent on the higher per cent per annum yield. Which of the following deposits would you select?



i. a 90-day deposit that has a maturity value of $3 075.00



ii. a 130-day deposit that has a maturity value of $3 110.00



iii. a 145-day deposit that has a maturity value of $3 120.00



(d) What is the yield on a discount security bought at $97.80 (per $100 face value) and held 65 days to maturity? (LO 8.1)

5

Holding period yield (HPY):



(a) What is meant by HPY, and how does it differ from yield to maturity?



(b) A 90-day discount security with a face value of $500 000 is purchased to yield 8.23 per cent per annum. After 55 days it is sold at a yield of 8.45 per cent per annum. What is the HPY for the original purchaser?



(c) An existing discount security, with a face value of $750 000 and with 60 days to maturity, was purchased at a yield of 8.15 per cent per annum. After 21 days it is sold at a yield of 8.50 per cent per annum. What is the rate of return earned over the 21-day holding period?



(d) The new holder of the security in (c) above sells it into the money market after 7 days at the current yield of 7.90 per cent per annum.



i. What is the holding period yield received by the seller?



ii. If the buyer holds the security to maturity, what is the holding period yield? (LO 8.1)

6

Compound interest accumulation:



(a) Explain what is meant by the term compounding of interest. In your answer, explain the relationship between present values, future values and compounding.



(b) What is the accumulated value of a $3 150 deposit made for four years with a yield of 5.25 per cent per annum, compounding annually?



(c) What is the future value of the deposit described in (b) if interest is compounded quarterly?



(d) What is the maturity value of a $5 000 deposit made for one year and 60 days with a yield of 7.45 per cent per annum, compounded annually? (LO 8.2)

7

Present value with compound interest:



(a) What is the present value of $5 000 due in five years at an annually compounded rate of 6.33 per cent per annum?



(b) Calculate the present value of $7 000, due in three years at 5.40 per cent per annum compounded quarterly.



(c) Calculate the present value of $7 000, due in three years at 5.40 per cent per annum, compounded monthly.



(d) Compare the answers in (b) and (c) above and explain the difference in the present value amounts. (LO 8.2)

8

Present value of an annuity:



(a) Explain what is meant by an annuity, an ordinary annuity and an annuity due. Draw a timeline of the cash flows associated with an annuity of $5 000 per year for four years, with the first payment to be received at the end of the first year. Why is understanding the timing of annuity cash flows important?

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Chapter 8  Mathematics of finance: an introduction to basic concepts and calculations

(b) What is the present value of an annuity of $2 500 paid annually over four years, with the first payment to be received at the end of the first year, and with a yield currently of 6.30 per cent per annum, compounded annually?



(c) What is the present value of an annuity of $1 250 paid at the end of each half-year over four years, with yields currently of 6.30 per cent per annum, compounded half-yearly?



(d) Explain why the present values of the annuities described in (b) and (c) are different.



(e) What is the present value of an annuity of $1 250 paid at the beginning of each half-year over four years, with yields currently of 6.30 per cent per annum, compounded half-yearly?



(f) Why is there a difference between the answers in (c) and (e) above?



(g) What price would you pay for a corporate bond with a face value of $500 000, maturing in 7 years and paying 7.00 per cent per annum coupons semi-annually, if current market yields for this type of security are 5.00 per cent per annum?



(h) What price would you pay for a corporate bond with a face value of $500 000, maturing in 7 years and paying 6.00 per cent per annum coupons semi-annually, if current yields are 6.60 per cent per annum?



(i) Explain the price difference between (g) and (h). What generalisation emerges from the examples concerning the response in the price of coupon instruments when there is a change in current market yields? (LO 8.2)

9

Accumulated value of an annuity (future value):



(a) Explain the concept of the accumulated value of an annuity (future value).



(b) You are the winner of a lottery that pays a quarterly cash payment of $3 000 to you for the next seven years. You decide that the funds should be paid directly into a cash management trust held with an investment bank. The account is expected to earn 6.05 per cent per annum, compounding quarterly. What will be the accumulated value of the cash management trust at the end of the seven years?



(c) The grandparents of a new baby decide that they will try and provide funds for the grandchild’s education. They set up an education savings account with their local credit union. They commit to pay $200 into the account monthly for the next 10 years. The account will yield 5.90 per cent per annum, compounding monthly. How much will be available for the grandchild’s education in 10 years? (LO 8.2)

CHAPTER EIGHT REVIEW



10 Effective rates of interest

(a) Explain the difference between nominal interest rates and effective rates of interest.



(b) You have $6 000 to deposit for one year and you have the choice of three accounts:



i. one that pays 5.25 per cent per annum, with interest paid on maturity



ii. one that pays 5.18 per cent per annum, with interest paid quarterly



iii. one that pays 5.20 per cent per annum, with interest paid semi-annually Which account would you prefer if the objective is to obtain the highest dollar amount return on your deposit?



(c) What is the effective rate of interest on each of the three accounts described in (b) above? (LO 8.2)

11 You are saving up for a holiday by putting aside $250 each month in an account that pays 5.00 per cent per annum interest (compounding monthly). If you save for two years, how much money will you have at the end of that time?  12 You will inherit $200 000 in 20 years’ time from a rich aunt. Your brother offers to purchase your right to this inheritance for $75 000. If you agree, he will pay you today. The interest rate is 4.00 per cent per annum. Is your brother’s offer fair? 285

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KEY TERMS annuity due  272

market convention  262

secondary market  267

compound interest  268

ordinary annuity  272

simple interest  261

effective rate of interest  277

perpetuity 275

yield 264

holding period yield (HPY)  267

principal 261

yield to maturity (YTM)  267

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CHAPTER 9

Short-term debt CHAPTER OUTLINE 9.1 Trade credit 9.2 Bank overdrafts 9.3 Commercial bills 9.4 Calculations: discount securities 9.5 Promissory notes 9.6 Negotiable certificates of deposit 9.7 Inventory finance, accounts receivable financing and factoring

Learning objectives LO 9.1

Understand why the financial markets offer short-term debt and financing facilities.

LO 9.2

Consider the concept and reasons for the provision of trade credit.

LO 9.3

Explain the purpose and operation of a bank overdraft facility.

LO 9.4

Describe the structure of a commercial bill, including the parties to the bill, the flow of funds, and the establishment and advantages of issuing bank-accepted bills.

LO 9.5

Complete a range of calculations relevant to discount securities, including:

– price where the yield is known – face value where the issue price and yield are known – yield – price where the discount rate is known – discount rate.

LO 9.6

Describe the structure, advantages, establishment, underwriting and calculation of promissory notes (commercial paper).

LO 9.7

Explain the structure, issue and calculation of negotiable certificates of deposit.

LO 9.8

Discuss the nature and operation of inventory finance, accounts receivable financing and factoring.

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CHAPTER SNAPSHOT In running a business, it will sometimes be the case that cash must be paid (for inventory, say) out before it is received (from customers). Financial instruments have been developed that allow companies to manage their cash flows and continue in business during those periods of time where they are waiting for cash to come in. These instruments can be as simple as a bank overdraft facility or as complex as a rolling commercial bank bill facility. The purpose of all the instruments is simple: to allow companies to manage their income and expenses.

INTRODUCTION LEARNING OBJECTIVE 9.1 Understand why the financial markets offer short-term debt and financing facilities.

Net stable funding ratio (NSFR) the ratio of the amount of available stable funding to required stable funding

Short-term debt a debt financing arrangement for a period of less than one year

Consider a small business-owner who wishes to obtain an ongoing credit facility that allows access to funds to meet immediate commitments. Such a business may obtain this sort of financing facility from its bank. The bank may provide an ongoing facility that charges a variable rate of interest on the amount of debt outstanding on a daily basis. If the business were larger, it might find that it is better to raise the funds it needs by issuing short-term discount securities into the money markets. Short-term debt arrangements like these allow borrowers to follow the matching principle that was introduced in Chapter 1. The principle holds that a company should finance its short-term assets with short-term liabilities, and finance its longer-term assets with longer-term liabilities and equity. The purpose is to try and closely match the cash flows on both the asset and liability sides of the balance sheet. Failure to follow this fundamental principle can lead to disaster. At the heart of the GFC was a maturity mismatch problem arising because financial institutions were raising short-term funds to lend out as long-term loans. When confidence in the short-term debt markets collapsed, financial institutions were unable to raise the funds they needed to support their operations. One of the key regulatory initiatives introduced by Basel III relates to maturity matching. The net stable funding ratio (NSFR) aims to ensure that banks fund their activities with more ‘reliable’ sources of funding, such as deposits and other CET1 capital. As a result, Australian banks have issued far less short-term debt than previously and have instead relied much more on deposits and long-term debt. By 2018, short-term debt made up just 25.00 per cent of banks’ funding sources. This chapter considers the different methods that can be used by a company to meet the first condition of the matching principle, that is, fund short-term assets with short-term liabilities. Short-term debt is the term used for loans and financial securities issued into the money markets that a company may use to raise debt finance for a period that can be as short as one day and up to one year. Short-term financing arrangements considered in this chapter are:

• trade credit • bank overdrafts • commercial bills (bills of exchange) • promissory notes (commercial paper) • negotiable certificates of deposit • inventory finance, accounts receivable financing and factoring. REFLECTION POINTS

seek short-term financing arrangements that incorporate different features, such as the • Firms source of funds, the amount borrowed, the timing of cash flows (repayments), fixed or variable interest rate structures, terms to maturities, liquidity and risk.

finance may be intermediated finance provided by a financial institution such as a • Short-term commercial bank, or direct finance obtained from the sale of securities into the money markets. finance allows borrowers to apply an important part of the matching principle; that is, • Short-term to fund short-term assets with short-term liabilities. 288

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Chapter 9  Short-term debt

9.1

Trade credit

Trade credit is a facility offered by many suppliers of goods that provides the purchaser of goods with a specified period before the account must be paid. It is difficult to estimate how much trade credit is outstanding in Australia. The RBA estimates somewhat more than $100 billion. This indicates that it is a very important form of financing, particularly for smaller businesses. For example, a firm that supplies plumbing fittings to the trade may grant trade credit to registered plumbers in order to attract their business, that is, to encourage plumbers to buy fittings from that supplier. The plumber is able to obtain the fittings, carry out a plumbing job for a client and receive payment for that job before payment is due to the supplier. In this situation, the plumber has not had to provide their own funds to finance the purchase of plumbing fittings needed for the job. The terms of trade credit are usually specified on the invoice attached to the goods. The invoice typically contains information describing the goods supplied, the price, the total amount due and the terms of payment. If the terms include provisions other than cash on delivery, the purchaser is effectively being granted a short-term loan (trade credit). Suppliers who offer trade credit may encourage early payment by providing a discount for early payment of the account. For example, the terms may be ‘2/10, n/30’. The ‘2/10’ indicates that if payment is made within 10 days, the invoice price will be discounted by 2.00 per cent; ‘n/30’, or ‘net 30 days’, signifies that if payment has not been made within 10 days, the full invoice price is payable within 30 days. If a credit period and early payment period with a discount are provided, the purchaser has a choice: either pay early and receive the discount, or pay in full by the later specified date and obtain a longer period of credit. The choice should be determined by calculating the opportunity cost of the discount versus the benefit of the extended credit period. If the offer of the discount is taken, the purchaser will need to have the funds available to pay for the goods at that date. The purchaser needs to consider the opportunity cost associated with the two alternative situations: the after-tax cost of other available types of short-term credit, and the return that could be obtained from investing surplus cash during that period. For example, if the invoice provides for payment net in 30 days, or a 1.00 per cent discount if paid in seven days (1/7, n/30), the opportunity cost of not accepting the discount is: 365       ​ × ​ ___________________________________        ​ Opportunity cost = ______________ ​  % discount 100% − % discount days difference between early ​     ​​  and late settlement ​ ​​            ​   ​​​ ​  ​  365 ​  ​   = ____ ​ 1.0  ​  × ​ ___ 99.0 23 ​    = 0.160298 or 16.03% p.a.

LEARNING OBJECTIVE 9.2 Consider the concept and reasons for the provision of trade credit.

Trade credit a supplier provides goods to a purchaser with an arrangement for payment at a later date

Invoice details goods supplied to a customer and the payment arrangements

9.1

If the purchasing company (the plumber in the example above) can obtain funds at an after-tax rate of less than 16.03 per cent, the account should be paid within seven days. Similarly, if it has surplus cash that has alternative uses, but none of which return an after-tax rate above 16.03 per cent, the cash should be used for early payment of the invoice. From the perspective of the provider of the trade credit, there is clearly also an opportunity cost to be considered. It must consider the cost of the discount offered for prompt payment relative to the provision of the longer no-discount payment period. The calculation of the opportunity cost is complicated by the fact that the terms of trade credit are a marketing tool for a business. More generous terms may increase demand for its products; less generous terms may result in a loss of market share to competitors. The calculation of the opportunity cost is further complicated in that a supplier that offers generous trade credit terms may experience an increase in accounts receivable and bad debts. Accounts receivable is the record on the balance sheet of amounts due to a business, including trade credit. A relaxation of trade credit standards may attract more customers, but it may also increase the likelihood of bad debts in that some less creditworthy purchasers may not pay. From the provider’s point of view, the

Accounts receivable an asset on the balance sheet representing amounts due to the business

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advantages of increased sales volumes that may be generated from the provision of attractive trade credit conditions must be weighed against the potential costs associated with:

• the increased discount and/or the increased length of the discount period • the increased total credit period and the increase in accounts receivable • the increased risk of bad debts and associated recovery costs. Trade credit is an important source of short-term funding and often provides small businesses with a significant proportion of their short-term funding requirements. It reduces the need for more formal debt facilities.

REFLECTION POINTS

credit is a situation where a supplier of goods, such as an electrical parts wholesaler, • Trade provides those goods to tradespersons today, with payment due in, say, 30 days. invoicing the tradesperson the supplier will often offer an early payment discount, such • When as if payment in made within seven days. the provider of trade credit and the receiver of trade credit should consider the • Both opportunity cost associated with the facility. The opportunity cost of a discount is: % discount  ​  × ​ ___________________________________ 365 ____________ ​​               ​​ 100 − % discount

9.2 LEARNING OBJECTIVE 9.3 Explain the purpose and operation of a bank overdraft facility.

Operating account a cheque account through which a firm conducts its day-to-day financial transactions

Margin the interest charge above a specified reference interest rate that reflects the credit risk of a borrower

Prime rate a reference interest rate set by a financial institution for the purpose of pricing certain variable-rate loans

days difference between early ​      ​ ​  and late settlement

Bank overdrafts

The overdraft facility is a major source of short-term business finance. An overdraft facility allows a business to manage its day-to-day working-capital requirements and the monthly or seasonal mismatch between its cash inflows and cash outflows. A business needs to pay expenses when they fall due. Often this may occur before the business has received cash revenue associated with its business activities. For example, a manufacturer will have fixed costs, such as salaries, equipment and administration, and variable costs, such as stock and inventories, necessary in the manufacturing process. Many of these costs will need to be paid before sales are generated. This is described as a mismatch in the timing of the cash flows of a business. An overdraft facility enables a business to smooth out problems associated with cash-flow timing mismatches; that is, an overdraft provides funds when they are needed which are repayable when the business generates income. An overdraft facility is convenient in that it attaches directly to a firm’s current operating account. A firm’s operating account is usually a cheque account with a bank. An overdraft facility allows a firm to put its operating account into deficit up to an agreed overdraft limit. The limit is negotiated with the bank and is subject to regular review. If the bank is not satisfied with the financial performance of the firm, the overdraft may be repayable on demand. The interest rate payable on an overdraft is negotiated between the bank and the firm, and will normally be at a margin above a periodically published reference interest rate. The margin charged above the reference interest rate will relate directly to the bank’s determination of the credit risk of the borrower. For example, a large company that has an established credit history with a bank will usually be charged a lower margin than a new client that does not have an established relationship with the bank. The particular reference interest rate used by a bank will be specified in the overdraft agreement. The reference rate may be the bank’s own prime rate or it may be a published market rate such as the bank bill swap rate (BBSW).

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Chapter 9  Short-term debt

Each country tends to have its own published reference rates. For example, in the UK it may be LIBOR, in the USA it may be USCP or in Australia it may be BBSW. These reference rates are published daily by Thomson-Reuters, a major provider of information to the financial markets. BBSW is also published in Australia by the Australian Financial Markets Association (AFMA). The agreed interest charge is calculated on the daily debit balance outstanding on the overdraft. Deposits into the operating account reduce the overdraft, and thus reduce the daily interest charge. Deposits to reduce the outstanding debit balance, or overdraft, can be made at any time; that is, an overdraft facility does not require a regular repayment schedule. A characteristic of an overdraft facility is that banks require an overdraft to be operated on a fully fluctuating basis; that is, the borrower is expected to reduce or bring the overdraft back into credit as and when future cash flows are received by the company. In some countries, banks require the overdraft borrower to maintain a compensating credit balance, or to maintain over a specified period an agreed credit average balance. Where such additional requirements are imposed, the effective cost of the overdraft must take into account interest that may be forgone on the compensating credit balance, since such compensating and credit average balances often attract a lower rate of return than is available on other forms of deposit. Generally, in addition to the interest rate that will be charged on the balance outstanding, the lender will impose an establishment fee, a monthly account service charge and a fee on the unused overdraft limit. The unused overdraft limit fee compensates the lender for effectively committing funds for the borrower’s use, at a time determined by the borrower. That is, once the overdraft limit has been established, the firm can use that facility at any time without notice, up to the limit. The bank in effect has to maintain a contingency fund to meet the demands of the borrower should the borrower decide to go into overdraft up to the agreed limit. There is a cost to the bank in having those funds available, and that cost is reflected in the unused-limit fee. The unused-limit fee will be much less than the actual overdraft interest rate. In establishing an overdraft facility, and in considering a request for an increased overdraft limit, a bank will analyse the credit risk of the borrower. Its analysis will include consideration of at least the following:

• the past financial performance and future cash-flow forecasts of the company in order to assess its ability to service an overdraft • the length of the typical mismatch between the company’s cash inflows and outflows • the adequacy of the collateral, or security, available in the event of default by the borrower. A bank will also consider whether an overdraft is the appropriate form of funding for the business; that is, will an overdraft meet the actual needs of the firm or would a term loan be better?

LIBOR London interbank offered rate; the average of rates at which selected banks in the London money market will lend to each other for a specified currency

USCP United States commercial paper; discount securities

Fully fluctuating basis a requirement that an overdraft be brought back into credit from time to time

Establishment fee a fee charged by a bank to cover the costs associated with evaluating a loan application

Collateral property or other assets pledged to a lender as security to support a loan

REFLECTION POINTS

overdraft is a financing arrangement whereby a business is authorised to place its bank • An operating account into deficit up to an agreed limit. of the overdraft facility are negotiated with the bank, including the overdraft amount, the • Terms interest rate, an unused-limit fee and other fees. interest rate will typically be a variable rate based on a published reference rate such as • The the bank’s prime rate or BBSW. overdraft is used by a business to manage the timing of cash flows; therefore, an overdraft • An is fully fluctuating. It is placed in deficit when expenses are paid and brought back into credit when revenues are received.

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9.3 LEARNING OBJECTIVE 9.4 Describe the structure of a commercial bill, including the parties to the bill, the flow of funds, and the establishment and advantages of issuing bank-accepted bills.

Trade bill a bill of exchange issued to finance a specific international trade transaction

Bank-accepted bill a bill of exchange issued by a borrower that incorporates the name of a bank as acceptor

Commercial bills

Chapter 1 introduced the notion of the money markets and direct finance. Money markets are wholesale markets that facilitate the issue and trading of short-term debt securities, which are issued directly into the market. This chapter considers the main money-market securities issued by corporations: bills of exchange, promissory notes and negotiable certificates of deposit. The first of these securities is the bill of exchange. The bill of exchange market has grown because the bill is a negotiable instrument that is supported by a legal structure. In many countries, particularly those deriving from the English legal system, legislation has been enacted establishing the legal nature and structure of a bill of exchange. In countries without supporting legislation, a bill of exchange may be referred to as a banker’s acceptance. Bills of exchange may be categorised as trade bills and commercial bills. Trade bills are issued to finance specific international trade transactions. Commercial bills are simply a method of borrowing and may not relate to a specific transaction or purpose; that is, the borrower does not need to state the specific use of those funds. Commercial bills may be further categorised into bank-accepted bills, bankendorsed bills and non-bank bills. Figure 9.1 depicts the categorisation of bills of exchange. A commercial bill issued by a corporation is said to be a bank-accepted bill when a bank also puts its name on the face of the bill. By putting its name on the bill, the bank increases the bill’s creditworthiness. A bank-endorsed bill is one where the bank, as a previous holder of the bill, has signed (endorsed) the reverse of the bill when selling it to an investor in the money markets. Note that most endorsements these days are by way of an electronic record of transactions.

Figure 9.1  Categorisation of bills of exchange Bills of exchange

Commercial bills (used to raise non-specific business finance)

Trade bills (used to finance specific trade transactions)

Bank-accepted bills

Bank-endorsed bills

Non-bank bills

A bank-accepted bill incorporates all aspects of a bill facility; therefore, for our learning purposes this chapter examines the bank-accepted commercial bill.

9.3.1

F EATURES OF COMMERCIAL BILLS

A commercial bill is a discount security: a financial instrument that is issued into the money markets with a face value that is payable at a specified date in the future. The issuer sells the bill today in order to raise funds. A commercial bill pays no interest; therefore the issuer needs to sell the bill for less than its face 292

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value in order to attract a buyer. The face value of the bill will be discounted by the current rate of return, or yield, payable in the market on that type of security, hence the term discount security. The return to the holder of the bill at maturity is the difference between the discounted purchase price and the face value of the bill. Commercial bills are an important form of short-term finance for large- and medium-sized firms. The bill of exchange gains its standing from legislation. For example, in Australia a bill of exchange is defined by the Bills of Exchange Act 1909 (Cwlth) as: . . . an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to bearer. From the definition, it is clear that a bill involves a number of parties. The sample bill shown in Figure 9.2 demonstrates the various parties to a bill of exchange. In order to clarify the structure of a bank-accepted bill, the roles of these parties are defined as follows:

Figure 9.2  Example of a bank-accepted commercial bill (face side) Due Date 3/12/2019 To:

ABC Bank Ltd

Accepted 7 June 2019

On the

Third

Payable at:

Pay to the order of

Borrowing Corporation Ltd

The sum of:

One hundred thousand dollars ****

ABC Bank Ltd

Day of December 2019 fixed

290 Martin Place, Sydney For and on behalf of ABC Bank Ltd

$100 000 **** Dated this

Authorised signatories of acceptor Place of payment Acceptor Date of acceptance

Seventh

For and on behalf of

Day of June 2019

Borrowing Corporation Ltd

Authorised signatories of drawer Payee

Drawer Date of drawing

Maturity date

• The drawer is the party that issues the bill. In Figure 9.2 this is Borrowing Corporation Ltd. With

Drawer

•

Acceptor

•

a bank-accepted bill the drawer has a liability to repay the face value to the acceptor bank. The acceptor bank will pay the face value of the bill to the holder. If, however, the bill was dishonoured by the acceptor at maturity, the drawer would then be responsible to repay the holder of the bill; that is, the drawer has a secondary liability, after the acceptor. The acceptor is the party to whom the bill is addressed and who undertakes to pay the face value of the bill to the person presenting the bill at the maturity date. That is, a bank as an acceptor places its name on the face of the bill and thereby takes primary liability to repay the face value of the bill to the holder at maturity date. A bank usually carries out the role of acceptor on a bill. In Figure 9.2, ABC Bank Ltd is the acceptor. A bank will carry out this role on a fee-for-service basis; that is, the bank generates income by acting as an acceptor. The drawer of the bill is willing to pay the fee and add the bank as an acceptor, as this gives the bill a higher credit status; that is, it is regarded as being less risky. This makes it easier to sell (discount) the bill, and at a lower cost (yield). The payee is the party to whom the bill is specified to be paid, that is, the party who receives the borrowed funds when the bill is initially discounted. The payee is typically also the drawer, as in Figure 9.2. However, the drawer could specify some other entity as the payee. For example, a large parent company may draw a bill and specify a subsidiary company as the payee.

the party that issues a bill of exchange

a bank that puts its name on the face of a bill and takes primary liability to repay the holder at maturity

Payee the party who receives the funds when a bill of exchange is initially discounted

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In the example, ABC Bank Ltd has agreed to accept the bill drawn by Borrowing Corporation Ltd. In accepting the bill, ABC Bank has guaranteed that the holder of the bill will receive the face value of the bill ($100 000) at maturity on 3 December 2019. So far the borrower has not raised any funds. The drawer will now seek to sell the bill. At this point in the transaction, two further parties are introduced: Discounter the party that purchases a bill of exchange; the provider of funds

Endorser the party that signs the reverse of a bill when selling a bill; creates a legal chain of ownership

• The discounter is the party that discounts the face value and purchases the bill. The discounter is

•

therefore the provider of funds, that is, the lender. The discounter may or may not be the acceptor of the bill. For example, it is common for a business to arrange for a bank to be the acceptor of a bill and also for the bank to discount the bill. However, the drawer, having obtained the bank as acceptor, may look to discount the bill in the money markets at a lower yield (and thus raise more funds) than that offered by the bank. The endorser is a party that was previously a holder of the bill but who has subsequently sold the bill. When a bill is sold, the party selling the bill is required to endorse (or sign) the reverse of the bill. This creates a legal chain of ownership. The order of liability for payment of the bill runs from the acceptor to the drawer and then to the endorsers in ascending order from the last endorser, so that the first endorser can make a claim only against the drawer or the acceptor. A bill may well be sold several times if it is actively traded in the money markets. Endorsement now takes the form of an electronic record; it is no longer necessary for the seller actually to sign by hand.

The return to the discounter of the bill is the difference between the price paid for the bill and the face value of the bill obtained on maturity. If the bill is traded before maturity, the return is the difference between the buy price and the sell price obtained in the money market. On maturity, the final holder of the bill approaches the acceptor for repayment of the bill. The primary liability to exchange the bill at maturity falls on the acceptor, not the drawer. In Figure 9.2 the holder at maturity will approach ABC Bank to receive the $100 000 face value. ABC Bank would have established a separate contract with Borrowing Corporation Ltd (the drawer), wherein the company would be committed to pay ABC Bank the full face value of the bill at maturity. The short-term money market provides an active secondary market in bank-accepted bills. This does not mean that there are thousands of physical bills moving around the market each day. In an efficient market these transactions occur electronically through an authorised central securities depository. Once a bill has been drawn and discounted, the bill is physically lodged with the central securities depository where it is maintained in safe custody in its vaults. Each successive rediscounting of the bill, and changes in its ownership, are recorded electronically by the depository. There is no physical endorsement of the bills processed; instead, the computer records changes in ownership as evidence of the line of contingent liability until the bill is repaid and retired at maturity. In Australia, the main central securities depository that carries out this function is known as Austraclear, which is part of the Australian Securities Exchange (www.asx.com.au).

9.3.2

T HE FLOW OF FUNDS AND BILL FINANCING

The flow of funds associated with a bill transaction is illustrated in Figure 9.3 using the bill from Figure  9.2 as an example. On 7 June 2019 Borrowing Corporation Ltd (the drawer) issues a bill accepted by ABC Bank Ltd. The drawer then sells the bill to the discounter, who pays $95 800 for the bill. When the bill matures on 3 December 2019, the holder of the bill (the discounter) presents the bill to ABC Bank (the acceptor) and receives $100 000. ABC Bank then recoups the $100 000 from Borrowing Corporation Ltd under a separate agreement. ABC Bank has also previously charged Borrowing Corporation Ltd an acceptance fee to compensate it for bearing the risk of the borrower; that is, the acceptor is ultimately responsible for paying the bill at maturity. The bank has accepted the credit risk of the drawer. An alternative arrangement to that shown in Figures 9.2 and 9.3 is to have the commercial bill drawn by the bank, and to have the bill accepted by the borrower. For example, Mega Bank Ltd could 294

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Figure 9.3  Flow of funds: bank-accepted bills (a) Issue date: 7 June 2019

Bill accepted

Drawer (borrower) Borrowing Corporation Ltd

Bill discounted

Funds lent ($95 800)

Acceptor

Discounter

ABC Bank Ltd

(b) Maturity date: 3 December 2019

Repay acceptor ($100 000 plus fees and margin)

Acceptor Bill discharged (holder receives $100 000)

Drawer

Present mature bill

Discounter (current holder of bill)

be the drawer and discounter of the bill. The funds would then be lent to a corporation, XYZ Ltd as payee. Since XYZ Ltd is also the acceptor of the bill, on the maturity date it is liable to pay the face value of the bill to the holder of the bill. This arrangement has the advantage that there is no need for any additional agreements between the bank and XYZ Ltd. Since the borrower is also the acceptor, it has the primary liability to pay the face value of the bill on maturity. It is likely that the bank, after having drawn and discounted the bill, would then rediscount the bill; that is, it would sell it to a third party in the money markets. In that event, the bank would endorse the bill. The party that held the bill at the maturity date would present it to the acceptor and receive its face value. If the acceptor (XYZ Ltd) defaulted, the holder of the bill would then present the bill to Mega Bank Ltd as the drawer. The acceptor bank in Figure 9.2 is a commercial bank. Investment banks also provide acceptance, endorsement and discount facilities. In Australia, the market refers to bills accepted or endorsed by APRA-authorised banks as bank bills, and bills accepted or endorsed by other institutions, such as investment banks, as non-bank bills.

9.3.3

E STABLISHING A BILL FINANCING FACILITY

The starting point in establishing a bank-accepted bill facility would be for a business to approach a bank and outline its financing requirements. The bank will use its own credit risk assessment procedures to assess the projected cash flows and general credit standing of the business. It may also use information obtained from external credit rating agencies such as Standard & Poor’s. The bank will then advise the firm whether it will, for a fee, act as acceptor to bills issued by the firm as drawer. If the facility is to be offered, bills will normally be drawn with a maturity ranging from 30 days to 180 days. A bill usually has a minimum face value of $100 000. A bank will also indicate whether it is willing to discount the bill and the yield at which it will discount the bill. A bank therefore may provide both a bill acceptance facility and a bill discount facility. The issue of a commercial bill represents short-term finance, with a typical maximum term to maturity up to 180 days. In reality, a business may require funding for a longer period of time. By establishing a rollover facility with a bank, a business is able to extend the overall term of a bill financing 295

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arrangement. A rollover facility is an arrangement whereby a bank agrees to accept and discount new commercial bills for an issuer at each maturity date. Consider the example shown in Figure 9.4. A firm has established a two-year bank-accepted bill rollover facility with a bank. The firm issued a 180-day bill with a face value of $500 000, yielding 8.75  per cent per annum, for which it received $479 317.14 on the day of issue. In 180 days the bill matured and the holder was repaid $500 000. At the same time the bank discounted a new bill at the current yield of 9.25 per cent per annum. The company then paid the bank $21 813.18, being the difference between the face value of the old bill and the discount price of the new bill. This process continued for the two-year term of the rollover facility, at which time the firm must repay the bank $500 000, being the face value of the final bill at the completion of the rollover facility.

Figure 9.4  Commercial bill rollover facility

t0 Yield Price Cost

8.75% $479 317.14

180 days

180 days

180 days

180 days

9.25% $478186.82 $21 813.18

9.30% $478074.08 $21 925.92

9.00% $478751.31 $21 248.69

Repay face value of $500000

In addition to those factors that determine the general level of interest rates in the economy, the yield at which a particular bill is discounted will depend on the credit rating of the parties that incur a liability under the bill. Bank-accepted bills incorporate the higher credit standing of the bank acceptor and therefore are able to be discounted at a lower yield than would be applied to a bill of a drawer with a lower credit rating. This is to be expected, since there is a lower risk associated with a bill that has a bank as one of the parties responsible for repaying the bill at maturity. Bill facilities are subject to establishment fees. In addition, there is usually a facility fee, plus an activation fee that operates when the bill facility is used. These fees will add to the overall cost of a bill financing facility.

9.3.4

Bill line an arrangement whereby a bank agrees to progressively discount bills up to an agreed amount

A DVANTAGES OF COMMERCIAL BILL FINANCING

A major advantage of bill financing over other forms of short-term debt is that the cost is generally lower than the cost of alternative forms of business finance such as overdrafts and term loans. The primary reason for the lower cost of borrowing with bill financing is that a bank does not have to fund the bill on its balance sheet. For example, a bank can accept a bill for a customer and generate income from the fee. At the same time it may discount the bill and provide the debt funds to its customer. However, the bank does not need to retain the bill on its balance sheet. Typically, the bank will sell the bill into the money markets. The bank will make a margin on the sale of the bill and can then use the funds to issue further loan facilities. Not only does the bill facility potentially provide cheaper finance, it also provides a certain known cost of funds for the life of the bill. Once the bill has been drawn and discounted, the borrower has the use of the funds and has agreed on the yield, being the difference between the face value due at maturity and the discounted amount received at the issue date. The borrower is not affected by any subsequent movements in current interest rates throughout the term of the bill. However, as bills are only issued with a maturity ranging up to 180 days, the bill will be re-priced at each rollover date (as shown in Figure 9.4). Bills also offer considerable funding flexibility for the borrower. Once a firm has established a bill line with a bank, it can draw on that approved facility as required. A bill line is an arrangement with a bank whereby the bank agrees to discount bills up to an agreed amount. The bills are usually issued progressively over time. If the line is fully utilised, the firm can roll over the current bills outstanding at their maturity.

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In effect, short-term bill funding can be rolled over through successive periods and is thus converted into a longer-term funding arrangement. At each rollover date the new bill issue will be priced, or discounted, at the current market yield at that time. This rollover feature of the bill market makes bill financing particularly attractive to both borrowers and banks. Though the yield is fixed for the term of the bill, it is adjusted at each rollover, and shorter terms allow more frequent adjustments. A borrower who wishes to add certainty to the cost of funds at future rollover dates can achieve this through the use of derivative interest rate riskmanagement products such as forward rate agreements or bank bill futures contracts (discussed in Part 6). Another important advantage to the drawer of a bill facility is that the issuer’s name is associated with the discounting and rediscounting of the bill in the market. The broadcasting of the firm’s name, and its subsequent good performance in meeting its commitments on maturity dates, progressively enhances its credit standing and thereby reduces the cost of funding in the future. It may also open up other funding options that may be available only to borrowers that have a strong credit rating.

REFLECTION POINTS

bill of exchange issued by a company to raise short-term finance is called a commercial bill; • Amaturities range up to 180 days. not pay interest; it is a discount security. That is, the bill is issued today with a face value • Athatbillisdoes payable at the maturity date; the bill is sold today for less than the face value (discounted); the difference between the purchase price and the face value is the return to the investor. drawer is the issuer of the bill. The credit status of the bill is enhanced if a bank puts its • The name on the bill as acceptor (and thus takes primary liability to repay the bill at maturity). The payee is the party who receives the funds when the bill is sold, the discounter is the buyer of the bill (investor) and the endorser signs the bill on the reverse when it is sold. may act as both the acceptor and the discounter of a bill for a customer. The bank may • Aalsobank provide a rollover facility whereby it agrees to discount bills for a period of a few years.

• A bill provides fixed rate funding for the period of the bill, but is re-priced at each rollover date. • Banks often discount bills for a customer and then sell the bills into the money markets. 9.4

Calculations: discount securities

Chapter 8 introduced the mathematics of finance. In this section some of that knowledge is applied to calculate the price, yield and discount rate of discount securities such as commercial bills. One of the great advantages of the mathematics of discount securities is that the formulae and calculations are the same for the different types of discount securities issued into the money market. Commercial bills are one form of discount security; promissory notes and negotiable certificates of deposit (discussed later in the chapter) are others. Treasury notes, a discount security issued by the government, are discussed in Chapter 12. For convenience and consistency, commercial bills are used in the calculation examples below, but the same calculations also apply to all the other discount securities mentioned above.

9.4.1

C ALCULATING THE PRICE WHERE THE YIELD IS KNOWN

LEARNING OBJECTIVE 9.5 Complete a range of calculations relevant to discount securities, including: price where the yield is known; face value where the issue price and yield are known; yield; price where the discount rate is known; and discount rate.

Bills are issued and sold at a price that represents a discount from the face value of the bill. One formula used to calculate the price of a bill, where the yield on the bill is known, is: face value × days in year ​Price = ​ _________________________________           ​​ yield ____ days in year + ​​(​​​   ​ × days to maturity​   )​​​ 100

9.2

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EXAMPLE 9.1 A company issues a 180-day bill with a face value of $100 000 yielding 8.75 per cent per annum. What amount will the company raise on the issue date? $100 000 × 365 Price = ​ ______________       ​ 365 + (0.0875 × 180) ​        ​  ​  ________  ​ ​ $36 500 000 ​ = ​        ​  380.75 ​ = $95 863.43

EXAMPLE 9.2 Consider the bill in Example 9.1. The original discounter has held the bill for 90 days, and the bill now has only 90 days to maturity. Current 90-day bills are yielding 7.80 per cent per annum in the market. If the holder of the bill chose to sell (rediscount) the bill, what price would be obtained? $100 000 × 365 Price = _____________ ​       ​ 365 + (0.078 × 90) ​        ​  ​  ________  ​ ​ $36 500 000 ​ = ​        ​  372.02 ​ = $98 113.01 The return to the original discounter is the current price of $98 113.01 minus the initial issue price of $95 863.43 equals $2 249.58.

EXAMPLE 9.3 A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with a face value of $500 000. Having approached two prospective discounters, the company has been quoted yields of 9.52 per cent per annum and 9.48 per cent per annum. Which quote should the company accept, and what amount will the company raise on the issue? $500 000 × 365 _____________ ​       ​ = $496 118.05

365 + ​(​0.0952 × 30​)​ ​     ​  ​  ​ $500 000 × 365 _____________ ​       ​ = $496 134.23 365 + ​(​0.0948 × 30​)​ The company should accept the lower yield quote of 9.48 per cent per annum, as this represents a smaller discount and therefore a lower cost of borrowing. The company will raise $496 134.23 in funds for its inventory needs.

While this textbook has adopted Equation 9.2 to calculate the price of a discount security, there are alternative formulae that may be used. For example, another common expression of the discount security formula is: ​P = ​_____   F     ​ (1 + rt)

9.3

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where: P = price of the discount security F = face value ​​ ​  ​         ​   ​  ​​​ r = required yield expressed as a decimal t = days to maturity divided by 365 You might like to use this formula with Examples 9.1, 9.2 and 9.3 to verify the answers.

9.4.2

Calculating the face value where the issue price and yield are known

In many instances a company needs to raise a specific amount of funds from a bill issue. In this situation the price at which the bill will be sold is predetermined and, based on the yield at which the bill will be discounted, it is necessary to calculate the face value of the bill, that is, the amount to be paid to the holder at maturity. The formula is transposed to: ⎡ ⎤ yield 365 + ​​(____ ​​​   ​ × days to maturity​   ​​​ ) 100 9.4 ​Face value = price ​​ ___________________________ ​​​        ​​    ​​​​  365 ⎣ ⎦

⎢

⎥

EXAMPLE 9.4 A company needs to obtain additional funding of $500 000 to purchase inventory. The company has decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank has agreed to discount the bill at a yield of 8.75 per cent. At what face value will the initial bill be drawn? 365 + (0.0875 × 60) _______________ Face value = $500  000​​[   ​​​      ​​]​​​ 365 ​​​      ​  ​   ​​ ​ ​ = $507 191.78

EXAMPLE 9.5 At the first rollover date (after 60 days) a new bill is drawn and is discounted at a yield of 8.50 per cent. At what face value will the new bill be drawn? 365 + (0.0850 × 60) _______________ Face value = $500  000​​[   ​​​      ​​]​​​ 365 ​​​      ​  ​   ​​ ​ ​ = $506 986.30

9.4.3

C ALCULATING THE YIELD

The yield referred to in the formula refers to the rate of interest, expressed as per cent per annum, on the amount outlaid to purchase the discount security: that is, the discount amount or buy price. The formula for calculating the yield is given in Equation 9.5: (sell price − buy price) _______________ (days in a year × 100) ​Yield = ​ ________________     ​ × ​            ​​ buy price days to maturity

9.5

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Note that: 1 to calculate the holding period yield when a security is not held to maturity, use days held rather than days to maturity in Equation 9.5 2 at the maturity date of a discount security, the sell price equals the face value.

EXAMPLE 9.6 An investor is planning to purchase a 180-day bill with a face value of $100 000. The price of the bill is currently $95 000. The investor needs to determine the yield on the investment: ($100 000 − $95 000) _________ (365 × 100) Yield = ​ ______________        ​  × ​     ​   180 $95 000 ​​​          ​  ​  ______   ​ ​​​ $5 000 _____ ​ = ​     ​   × ​  36 500  ​     180 $95 000 ​ = 10.67% p.a.

EXAMPLE 9.7 In Example 9.3, a company issued a 30-day bank-accepted bill with a face value of $500 000. The bill was discounted at a yield of 9.48 per cent per annum, representing a price of $496 134.23. After seven days the discounter decides to sell the bill in the short-term money market for $497 057.36. The bill is not traded again in the market. Calculate (1) the yield to the original discounter and (2) the yield to the holder at maturity. (1) Yield to original discounter: ($497 057.36 − $496 134.23) _____ ​​ ___________________         ​  × ​  36 500  ​    = 9.70% p.a.​ 7 $496 134.23 Note: When the original discounter purchased the bill it had a yield of 9.48 per cent per annum, but when the bill was sold after seven days the holding period yield actually increased to 9.70 per cent per annum. This occurred because current yields in the market had fallen so the value of the original yield had increased the price of the bill. (2) Yield to holder at maturity: ($500 000.00 − $497 057.36) _____ ​​ ___________________         ​  × ​  36 500  ​     = 9.40% p.a.​ 23 $497 057.36

9.4.4

CALCULATING THE PRICE WHERE THE DISCOUNT RATE IS KNOWN

An alternative way of referring to a discount security is to identify it in relation to its current discount from face value. This method is used in the US markets and the euromarkets, but is not used in Australia. Where the discount rate is given, the price of the discount security is derived using the following formula: days to maturity ___________ ​Price = face value​​[​​1 − ​​(​​​ ____________        ​ × ​ discount rate  ​​)     ​​​​]​​​​ 100 days in year

9.6

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EXAMPLE 9.8 The price of a 180-day discount security issued in the USA, with a face value of $100 000 and selling at a discount of 14.75 per cent, would be: Price = $100  000​​[​​1  − ​​(_ ​​​ 180 ​  × 0.1 475​)​​​​]​​​ 360 ​​​          ​  ​   ​​ ​ ​ ​ = $100 000  (1 − 0.07375) ​ = $92 625.00 Note: The market convention in the USA and euromarkets is to use a 360-day year.

The discount in this formula is effectively the rate of return to the buyer of the bill, or the cost of funds to the drawer of the bill, expressed as a percentage per annum, in relation to the face value of the bill.

9.4.5

C ALCULATING THE DISCOUNT RATE

The formula for calculating the discount rate, when the face value and the current price are known, is: ​(​​face value − current price​)​​ ______________ ​(​​days in year × 100​)​​ ​Discount rate = ​ ___________________      ​ × ​            ​​ face value days to maturity

9.7

EXAMPLE 9.9 A 180-day discount security with a face value of $100 000, issued in the USA and selling currently at $92 000, with a full 180 days to maturity, has a discount rate of:

(​​​$100  000  − $92 000​)​​ _____ Discount rate = ​ ______________        ​  × ​  36 000  ​     180 $100 000 ​​​           ​  ​    ​ ​​​ ​ = 0.08 × 200.00 ​ = 16.00% The discount rate is expressed in terms of the face value of the security, while the yield is expressed in terms of the purchase price, or current price. The securities are identical, yet the discount rate and yield differ. It is therefore important to be certain which calculation is being used.

REFLECTION POINTS

price of a discount security (bill of exchange, promissory note, certificate of deposit, • The Treasury note) is: face value  × days in year ​Price  = ​ ________________________________          ​​ yield days in year + ​​ ____ (​​​  100 ​  × days to maturity​)​​​

• The formula to calculate the face value where the issue price and yield are known is:

⎢ ⎡

⎥

yield ⎤ 365 + ​​ ____ ​​​   ​  × days to maturity​ ​​​ ( ) 100 ​ ace value  =  price ​​ ​​​  __________________________ F         ​​ ​​​​  365 ⎣ ⎦

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• The formula to calculate the yield on a discount security is: •

(sell price − buy price) ________________ ​(​​days in a year  × 100​)​​ ​Yield  = ​ ________________        ​  × ​        ​​ buy price days to maturily The formula to calculate the price where the discount rate and face value are given is: days to maturity ___________ discount rate ​Price  =  face value​​ ​​1  − ​​ ​​​ ____________     ​  × ​     ​​  [ (   )​​​​]​​​​ days in year 100

formula for calculating the discount rate, when the face value and the current price are • The known, is: ​(​​days in years  × 100​)​​ ​(​​face value  − current price​)​​ _______________ ​Discount rate  = ​ __________________         ​  × ​        ​​ days to maturity face value

9.5 LEARNING OBJECTIVE 9.6 Describe the structure, advantages, establishment, underwriting and calculation of promissory notes (commercial paper).

Promissory notes (P-notes) discount securities issued by corporations without an acceptor or endorsement

Promissory notes

Promissory notes (P-notes) are discount securities. A P-note is issued with a face value payable at maturity, but is sold today by the issuer for less than the face value. The P-note is discounted at the current market yield. This means that the issuer raises an amount of funds that is less than the face value. The difference between the amount raised on the issue date and the face value payable at maturity is the discount amount and represents the cost of borrowing to the issuer. The P-note is an international security; that is, it is issued by corporations in all the major international financial markets. The market convention is to refer to the P-note as commercial paper. The commercial paper or P-note market is a well-established component of the short-term money markets. A P-note is defined as: an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay, on demand at a fixed or determinable future time, a sum certain in money, to the order of a specified person or to the bearer. This definition indicates that a P-note is similar to a bill of exchange, except that there is no acceptor involved. Therefore, P-notes are often described as ‘one-name paper’. Another difference between a P-note and a bill is that, when a P-note is sold in the market, unlike the bill, there is no requirement for the seller to endorse the note. This gives P-notes a decided advantage over bills, since any owner of a P-note can sell it into the money market without incurring a future contingent liability (which is the case with a bill endorsement). However, not all borrowers can use P-notes as a source of funds. Typically, only those corporations with an excellent credit reputation in the markets are able to attract investors willing to discount P-notes. There are two reasons for this: 1 The sole liability to repay the face value of a P-note at maturity is with the issuer. There is no party that acts as an acceptor, nor is there a series of contingent liabilities established by endorsement. 2 Notes are often issued as unsecured instruments in that they generally are not supported by the attachment of any security, collateral or balance-sheet covenants of the issuer. Having said that, some P-notes are issued with security attached; for example, in the period leading up to the global financial crisis, P-notes (commercial paper) were often issued as part of securitisation structures that were supported by housing loan mortgages held by the issuing trustee. Securitisation is discussed in the extended learning section of Chapter 10. The face value of a P-note is normally a minimum of $100 000; however, each P-note issue will often be for millions of dollars in total, with some international issues in excess of $1 billion. A P-note is a short-term discount security issued by corporations with a term to maturity generally up to 180 days. An issue will often be established with a revolving facility, which essentially converts a short-term issue into a longer-term issue (see Section 9.5.1).

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The calculation of the price and yield of a P-note is based on the discount securities formulae discussed in Section 9.4. These formulae also apply to P-notes. As part of their marketing effort, P-note issuers provide detailed information on their financial position. Nevertheless, investors will seek further information to confirm the creditworthiness of the issuer. The issuer will almost always need to obtain a credit rating for the P-note issue from a credit rating agency such as Standard & Poor’s or Moody’s Investors Service. The important role and functions of credit rating agencies in supporting debt issues into both the money markets and the capital markets are discussed in Chapter 11.

9.5.1

E STABLISHING A P-NOTE ISSUE PROGRAM

A typical P-note issue program is a revolving facility, with the issuer having the right to cancel the program subject to providing the dealers with the required period of notice, usually specified at 30 days. Major commercial banks, investment banks and merchant banks are the principal arrangers of most P-note issues within both the international markets and the domestic markets. Therefore, documentation is relatively standardised and will generally incorporate:

Revolving facility a rollover arrangement; as existing P-notes mature, new notes are issued and discounted

• a dealer agreement (specifies the lead manager and various panels and syndicates—see below) • an information memorandum (provides relevant financial and operational information about the issuer corporation to institutional investors) • an issuing and paying agency agreement (responsible for managing the associated cash inflows and outflows) • a supporting guarantee (if required) (may include security taken over collateral of the issuer; or an underwriting agreement) • a liquidity support facility (established with a bank—ensures issuer has access to cash if needed). The role of the dealer is important to the success of a P-note program. The lead manager or program arranger will, in consultation with the issuer, form a dealer panel from selected market participants. Dealers are chosen based on their ability to distribute the paper into the markets; that is, to encourage investors to purchase the paper and subsequently to sustain an ongoing secondary market in the paper. The size of the dealer panel will be sufficient to ensure that the P-notes are widely distributed in the markets, both domestic and international. A typical P-note issue will initially be for a maturity of 90 days, and may be issued by:

• tender, where dealers bid competitively for the paper • tap issuance, where issues are made progressively, but subject to investor demand; in this circumstance, •

investors will nominate their maturity and volume requirements. Tapping may occur at any time during the term of the facility dealer bids, where members of the dealer panel are asked to bid for the paper. Bids may be quoted at either a margin to a specified reference rate, such as LIBOR, USCP or BBSW, or as an absolute yield.

Lead manager the arranger of a syndicated debt facility, who structures the issue, forms the syndicate and prepares documentation

Dealer panel panel members promote and distribute debt issues to clients and maintain a secondary market in the paper

The purchase of P-notes is usually settled either by taking delivery from the issuing and paying agent or, if the notes are lodged with a central securities depository, through its electronic settlements system. The formula for calculating the settlement amount is the discount security formula (see Section 9.4). For your reference, Equation 9.2 is repeated here: face value × days in year  ​Price = ​ _________________________________           ​​ yield ____ days in year + ​​(​​​   ​ × days to maturity​   )​​​ 100 Note: Commercial paper issued in the USA or the euromarkets uses a 360-day convention. The equation will need to be adjusted to reflect this. Therefore, it is necessary to ascertain the calculation convention used when comparing yields on commercial paper. 303

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At maturity date, the P-note is redeemed by presentation to the issuing and paying agent, or through the central securities depository’s electronic payment system.

9.5.2

U NDERWRITTEN P-NOTE ISSUES

It has already been mentioned that the majority of P-note issuers have an investment-grade credit rating. In fact, this is the reason that many large corporations issue P-notes; they are able to rely on their credit rating and do not need to incur the expense of an acceptor on a bill facility. However, at times, and for a number of reasons, investors may be reluctant to purchase the debt securities issued by a company, and the issuer may be unable to raise the required funds. A P-note issue may not be successful if:

• the issuer does not have a strong name or reputation in the markets • the issue is incorrectly priced • other issuers in the market at the same time represent a more attractive investment opportunity • the credit rating of the issue is below investment grade, that is, less than the equivalent of the S&P A-3 short-term credit rating • economic and financial market conditions change for the worse after the announcement of the issue.

Underwriting syndicate promoters of an issue who agree to purchase paper that is not taken up by the tender panel

The issuer may therefore wish to guarantee that all the commercial paper will be sold and that the required funds will be raised by arranging for the issue to be underwritten. This is usually arranged through a commercial bank or an investment bank, which will arrange both an underwriting syndicate and a tender panel. The bank, as manager of the issue, typically receives a management fee of about 0.02 per cent on the funds to which the underwriters commit. Members of the underwriting syndicate will agree to purchase notes up to an agreed limit and at a prearranged price, should they be called upon. Generally, the members of the underwriting syndicate do not wish to purchase large amounts of the P-note issue themselves, and therefore they will actively promote the issue to investors in the market. The price agreed will reflect the credit standing of the borrower and the underwriting fee. The underwriters’ fee is typically about 0.10 per cent per annum on the amount of their commitment. It is apparent that costs associated with a P-note issue can be significant, and therefore P-notes are typically issued only on a large scale. Another feature of an underwritten P-note issue is that the issuer will often require the funding for a number of years. In this circumstance, the issuer will establish a rollover or revolving facility for the P-notes that may run up to three years. The underwriting commitment virtually assures the borrower of a line of credit extending beyond the short-term life of any particular P-note issue. If the lead manager has arranged a tender panel, members of the panel are given the first opportunity to buy the P-notes. They do not have any obligation to subscribe to the issue. Once the tender panel has put in its bids for the notes, the borrower, in conjunction with the manager, allocates the notes to the successful panel members. Subject to the underwriting agreement, the underwriters will purchase any outstanding notes.

9.5.3

N ON-UNDERWRITTEN ISSUES

P-note issues that are not underwritten may require no external management, in which case the issuer simply approaches the money market directly and does not usually go through a tender panel. However, where the issuer retains a commercial bank or an investment bank as lead manager, the bank will arrange a tender panel, promote the issue by providing a memorandum that details the features of the proposed issue and provide information on the borrower’s financial status. The managing bank has no financial commitment to the issue and only receives a fee for services provided. 304

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REFLECTION POINTS

is a discount security issued with a face value payable at maturity, but sold today for • AlessP-note than the face value; the face value is discounted by the current market yield; maturities range up to 180 days.

• The market convention is to refer to P-notes as commercial paper. • A P-note does not have an acceptor, so only corporations with a high credit rating are able to issue. company may appoint a commercial bank or an investment bank as the lead manager of a • Alarge commercial paper issue. The lead manager will prepare all related documentation and, depending on the size and structure of the issue, establish a dealer panel.

dealer panel will comprise a syndicate of domestic and international banks who will • The promote and distribute the paper in the markets. The dealer panel members will create an active secondary market in the P-note issue.

issuer may also use a syndicate of underwriters to assist with the distribution of the paper. • The They guarantee, subject to the terms of the underwriting agreement, to purchase any paper not taken up by the dealer panel or institutional investors.

• The discount security formulae are used to make P-note calculations. 9.6

Negotiable certificates of deposit

A negotiable certificate of deposit (CD) is a short-term discount security, issued by a bank, typically with an initial term to maturity up to 180 days. A CD is an investment product offered by banks in the money markets to attract institutional investors. Banks use the issue of CDs, in part, to manage their liabilities and liquidity. As part of their liability management, banks issue CDs to raise additional short-term funds to meet loan and funding commitments. For example, in the lead-up to a festive or religious season, customers may spend more money using their credit cards. The banks may need to raise additional short-term funds to finance the higher credit card lending. As a percentage of the credit will be repaid within a short period, banks often match the cash flows by issuing short-term CDs. Furthermore, as part of liquidity management, CDs may also be issued to raise cash to meet a bank’s day-to-day operational liquidity requirements. For example, a bank may experience a situation where customers withdraw a higher amount from their demand accounts than the bank had forecast. The bank may be short of liquid funds to meet these withdrawals and could raise funds through the issue of CDs into the money markets. Within the money markets there is an active secondary market in CDs. Pricing of CDs is also based on the discount securities formulae discussed in Section 9.4. Therefore, the price, yield, discount amount and face value calculations of a CD use the same formulae as for other discount securities.

LEARNING OBJECTIVE 9.7 Explain the structure, issue and calculation of negotiable certificates of deposit.

REFLECTION POINTS

negotiable certificate of deposit (CD) is a discount security issued into the money markets by • Aa bank. with other money-market discount securities, CDs typically have maturities ranging up to • As 180 days. may use CDs to manage their liability needs (short-term funding requirements) and their • Banks liquidity needs (managing day-to-day cash flows). • The discount security formulae are used for calculations. 305

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9.7 LEARNING OBJECTIVE 9.8 Discuss the nature and operation of inventory finance, accounts receivable financing and factoring.

The working-capital requirements for large firms can be met largely through the direct finance and intermediated finance arrangements discussed above, but small- to medium-sized companies may generally be excluded from the direct finance sources of funds. The main source of short-term funds available to smaller firms is usually restricted to intermediated finance, namely trade credit or an overdraft facility. There are, however, two other forms of funding that may be considered:

• inventory finance • accounts receivable financing and factoring. 9.7.1

Floor plan finance provision of finance for stock on a showroom floor

Bailment a situation where a finance company holds title to a dealership’s stock

Inventory finance, accounts receivable financing and factoring

I NVENTORY FINANCE

The most common form of this type of financing is floor plan finance. It is designed particularly to meet the needs of motor vehicle dealers to finance their inventories of vehicles. The key feature of this arrangement, from the point of view of the financier, is that it is part of a larger financial relationship between the dealer and the financier. It is expected that the dealer, when selling the vehicles, will promote demand for the financier’s consumer finance services; that is, the dealer encourages buyers to borrow from the financier to pay for the vehicle purchase. Indeed, the primary initial business of many general finance companies was the provision of floor plan financing. As they acquired a market presence through their financing of vehicle purchases, the finance companies expanded into more general personal financing. The more successfully the dealer promotes the financier to the end consumer, the lower will be the rate charged on the floor plan finance. Most frequently, the cost of floor plan finance is below the current market rates on other types of loans. A system known as bailment is commonly used to secure the financier’s commitment of funds. Under this arrangement, the vehicles are purchased from the manufacturer or distributor by the finance company (the bailor), and possession is granted to the vehicle dealership (the bailee) for display purposes. The dealer then seeks to sell the vehicles by receiving offers to purchase from retail customers; however, the dealer effectively has no right to sell the vehicles without the approval of the financier. Therefore, when a customer wishes to buy a vehicle, the financier will pass ownership of the vehicle to the dealer who can then pass ownership to the customer. As well as retaining ownership of the vehicles, financiers use other measures to ensure that their interests are protected. These include:

• establishing dollar limits on the dealer’s financial exposure • establishing limits on the ratio of new to used vehicles • prompt financial settlement once a sale contract is signed • regular physical audit of stock that is subject to floor plan financing • inspection of the dealer’s financial position to ensure that sales are being made on a profitable basis. 9.7.2 Accounts receivable financing a loan obtained by a firm using current accounts receivable debtors as security to support the loan

A CCOUNTS RECEIVABLE FINANCING AND FACTORING

Accounts receivable financing is the provision of a loan to a business against the security of the business’s accounts receivables, that is, its debtors. The main suppliers of this type of funding are finance companies. Before granting finance to a firm on the basis of its accounts receivables, the financier will review the structure of the debt held by the firm. Not all debtors on the books of the borrowing company will be acceptable. Common exclusions are debts that have been outstanding beyond a specified number of days, typically 90 days, and debts that for other reasons may be suspected of being doubtful or bad debts. Under the facility, the lending company takes a registered charge over the firm’s accounts

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receivables. Nevertheless, the borrower firm remains responsible for managing its debtor book and is solely liable for any future bad debts, that is, customers who do not pay their outstanding accounts. Factoring, on the other hand, involves a financier buying the accounts receivable assets of a company. The financier is usually a finance company and is called the factor company. Many businesses offer credit arrangements to their customers. A customer that owes funds to a firm is known as a debtor. The outstanding debt is an asset and is recorded on the firm’s balance sheet as an account receivable. If accounts receivable are not actively managed by the firm through the implementation of strategies to ensure that customers pay their debts on time, the firm may experience liquidity problems; that is, it will have to finance its own accounts receivable until the funds are actually received from the customer. For small businesses in particular this may cause a severe cash-flow problem. One solution that has developed is for the firm to sell its accounts receivable assets in order to generate immediate cash flows for the business. Clearly, there will be a cost to the firm in generating cash flows in this manner. The firm will sell the assets at a discount to their face value. The return to the factoring company is the difference between the discounted price and the face value of the accounts receivable when they are eventually paid. This form of finance is relatively expensive for the firm selling its accounts receivable. As the factoring company is accepting higher levels of risk in providing this type of finance, the required yield is correspondingly higher. Characteristics of factoring finance include:

Factoring the sale, at a discount, of a firm’s accounts receivable assets to raise funds

Factor company typically, a finance company that purchases firms’ accounts receivables

• Accounts receivable are purchased outright by the factor company and therefore the funds received by the firm are the proceeds from the sale of an asset. • The factoring arrangement is commonly of an ongoing nature; that is, as the firm accumulates more accounts receivable, these are also sold to the factor company. • The factor company, having bought the accounts receivable, is responsible for the collection of the outstanding receivables.

The factoring agreement will specify which parties are liable for future bad debts, and to what extent. For example, the factor company may be liable for bad debts up to an amount equivalent to, say, 7.00 per cent of the total amount. Thereafter, the firm is liable for any bad debts. There are two types of factoring arrangements: with-recourse factoring and non-recourse factoring. The with-recourse arrangement means that the factor company can make a claim against the firm in the event of an accounts receivable debt subsequently not being recoverable. A non-recourse arrangement, as the name suggests, means that the factor has no claim against the firm in the event of bad debts being incurred. Irrespective of whether the agreement is with-recourse or non-recourse, most agreements are on a notification basis. In this arrangement the factor company notifies the firm’s customers that payment is to be made directly to the factor company. This gives the factor company a greater degree of control in the management of the outstanding accounts receivable. Some arrangements are on a nonnotification basis, where payment is addressed not to the factor but to a post office box controlled by the factor company. This arrangement affords the firm some protection from possible adverse customer perception in relation to the firm selling the debt to the factor company. In assessing whether to provide finance to a firm, the factor company will be particularly concerned to establish a profile of the firm’s debtors and sales. For example, the following would result in a lower discount yield:

• a high credit rating of the firm’s customers • debtors being widely spread throughout various sectors of the economy • the firm’s customers being regular, longstanding buyers • a sales volume that is high and fairly evenly spread throughout the year • a positive outlook for the industry sector in which the firm operates.

With-recourse factoring the factor company can recover future accounts receivable bad debts from the firm

Notification basis a firm must notify debtors that accounts receivable should be paid directly to the factor company

Non-notification basis accounts receivables are paid by a firm’s debtors directly to an address controlled by the factor

When a firm considers the cost of factoring, which may range between 2.50 per cent and 4.00 per cent of the accounts receivable sold, it is important to calculate all of the benefits that flow from factoring the debts. These include not only the substitution of cash for accounts receivables, but also the savings resulting from the freeing up of resources that would otherwise be required to administer and collect the accounts receivable. 307

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REFLECTION POINTS

finance is provided to a retail outlet to fund the purchase of stock (inventory); for • Inventory example, floor plan finance is used to fund vehicles in a motor vehicle dealership. finance provider may use a system of bailment, whereby the finance company buys the • The inventory, allows the dealership to hold and sell the vehicles, but retains actual ownership of the vehicles until they are sold. receivable financing is the provision of loans to companies by finance companies, • Accounts using the accounts receivable debtors of the company as security for the loans. is an arrangement whereby a company sells its accounts receivable at a discount to a • Factoring factor company in order to raise additional funds. may be with-recourse, where the factor company can claim against the company if a • Factoring defined percentage of the accounts receivable is not recovered from debtors, or it may be nonrecourse. factoring agreement is often on a notification basis, whereby the factor company advises • The the accounts receivable debtors that repayment is to be made directly to the factor company.

CASE STUDY THE DEMISE OF LIBOR? LIBOR is a key reference interest used for pricing variable rate loans in the UK and in other major markets. Indeed, the rate is linked to more than $350 trillion in loans around the world (Vaughan and Finch, 2017). However, the rate was subject to ‘rigging’ or manipulation for a number of years prior to 2012; when the so-called ‘LIBOR Scandal’ came to light in the years following the GFC, it resulted in a number of reforms. LIBOR was calculated as the average of interest rates submitted by banks around the world. Banks were required to submit the exact rates they were paying but, as it emerged, some banks were deliberately overstating or understating rates in order to profit from certain trades or to give misleading indications about their financial positions. Following the scandal, LIBOR has been more tightly regulated with the aim of ensuring that the reference rate reflects actual market conditions. In a move that has caused some concern in the global financial community, the UK’s Financial Conduct Authority has decided to require banks to transition towards alternative interest rate benchmarks by 2021. In the UK, LIBOR will be replaced by SONIA (Sterling Overnight Index Average). In the USA, LIBOR will be replaced by the Broad Treasury Financing Rate (BTFR). Questions still remain, however, about how this will work in practice. Importantly, none of the new reference rates will have the global reach and status as a pillar of the financial system that LIBOR once had (Scaggs, 2017). In the Australian economy, the Bank Bill Swap Rate (BBSW) is the short-term interest rate benchmark that performs a similar function to other published reference rates such as LIBOR (Bank Bill Swap Rate (BBSW), 2018). In Australia, BBSW is administered by the ASX and efforts have been made to assure the confidence of market participants by introducing a new method for calculation. The new methodology came into effect from May 2018 and calculates the benchmark directly from market transactions with a longer rate-set window and involves a larger number of participants. This ensures that the benchmark relates to real transactions at the traded prices. (‘ASIC and RBA Welcome the New BBSW Calculation Methodology/ Media Releases/ RBA’, 2018).

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Reference list Bank Bill Swap Rate (BBSW) 2018, retrieved from http://www.investopedia.com/terms/b/bank-bill-swaprate-bbsw.asp Debelle, G 2016, ‘Interest rate benchmarks’ (Speech), Reserve Bank of Australia, 22 February, retrieved from http://www.rba.gov.au/speeches/2016/sp-ag-2016-02-22.html Scaggs, A 2017, ‘The demise of Libor is not a done deal for markets’, Financial Times, 3 August, retrieved from https://www.ft.com/content/43e1dcbc-7754-11e7-90c0-90a9d1bc9691 Vaughan, L & Finch, G 2017, ‘Libor scandal: the bankers who fixed the world’s most important number’, The Guardian, 18 January, retrieved from https://www.theguardian.com/business/2017/jan/18/liborscandal-the-bankers-who-fixed-the-worlds-most-important-number

Discussion points

• • •

Discuss the factors that led to the downfall of LIBOR?

CHAPTER NINE REVIEW

The change in methodology also ensures that BBSW is anchored to observable arm’s length transactions in an active underlying market and the calculation mechanism is robust to changing market conditions. However, financial analysts predict a drift from BBSW towards risk-free rates (like BTFR) (Debelle, 2016).

What is the importance of ensuring that reference rates reflect actual market conditions? What concerns surround the introduction of new reference rates to replace LIBOR?

Master before you move on LEARNING OBJECTIVE 9.1 Understand why the financial markets offer short-term debt and financing facilities. seek short-term financing arrangements that incorporate different features, such as the • Firms source of funds, the amount borrowed, the timing of cash flows (repayments), fixed or variable interest rate structures, terms to maturities, liquidity and risk.

finance may be intermediated finance provided by a financial institution such as a • Short-term commercial bank or direct finance obtained from the sale of securities into the money markets. finance allows borrowers to apply an important part of the matching principle; that is, • Short-term to fund short-term assets with short-term liabilities.

LEARNING OBJECTIVE 9.2 Consider the concept and reasons for the provision of trade credit. credit is a situation where a supplier of goods, such as an electrical parts wholesaler, • Trade provides those goods to tradespersons today, with payment due in, say, 30 days. invoicing the tradesperson, the supplier will often offer an early payment discount, such • When as if payment in made within seven days. the provider of trade credit and the receiver of trade credit should consider the opportunity • Both cost associated with the facility. The opportunity cost of a discount is: % discount  ​  × ​ ___________________________________ 365 ____________ ​​               ​​ 100 − % discount

days difference between early ​      ​ ​  and late settlement  309

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LEARNING OBJECTIVE 9.3 Explain the purpose and operation of a bank overdraft facility.

overdraft is a financing arrangement whereby a business is authorised to place its bank • An operating account into deficit up to an agreed limit. of the overdraft facility are negotiated with the bank, including the overdraft amount, the • Terms interest rate, an unused-limit fee and other fees. interest rate will typically be a variable rate based on a published reference rate such as the • The bank’s prime rate or BBSW. overdraft is used by a business to manage the timing of cash flows; therefore, an overdraft is • An fully fluctuating. It is placed in deficit when expenses are paid and brought back into credit when revenues are received.

LEARNING OBJECTIVE 9.4 Describe the structure of a commercial bill, including the parties, the flow of funds, the establishment and the advantages of issuing a bank-accepted bill. bill of exchange issued by a company to raise short-term finance is called a commercial bill; • Amaturities range up to 180 days. not pay interest; it is a discount security. That is, the bill is issued today with a face value • Athatbillisdoes payable at the maturity date; the bill is sold today for less than the face value (discounted); the difference between the purchase price and the face value is the return to the investor.

drawer is the issuer of the bill. The credit status of the bill is enhanced if a bank puts its • The name on the bill as acceptor (and thus takes primary liability to repay the bill at maturity). The payee is the party who receives the funds when the bill is sold, the discounter is the buyer of the bill (investor) and the endorser signs the bill on the reverse when it is sold.

may act as both the acceptor and the discounter of a bill for a customer. The bank may • Aalsobank provide a rollover facility whereby it agrees to discount bills for a period of a few years. • A bill provides fixed rate funding for the period of the bill, but is re-priced at each rollover date. • Banks often discount bills for a customer and then sell the bills into the money markets.

LEARNING OBJECTIVE 9.5 Complete a range of calculations relevant to discount securities, including the:

— price where yield is known — face value where the issue price and yield are known — yield — price where the discount rate is known — discount rate. price of a discount security (bill of exchange, promissory note, certificate of deposit, Treasury • The note) is: face value × days in year ​Price  = ​ ________________________________          ​​ yield days in year + ​​ ____ (​​​  100 ​  × days to maturity​)​​​

formula used to calculate the face value of a discount security, where the issue price and • The yield are known, is:

⎢ ⎡

⎥

yield ⎤ 365 + ​​ ____ ​​​   ​  × days to maturity​ ​​​ ( ) 100 ​ ace value  =  price ​​ ​​​  __________________________ F         ​​ ​​​​  365 ⎣ ⎦ 310

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​(​​sell price  − buy price​)​​ _______________ ​(​​days in a year  × 100​)​​ ​Yield  = ​ _______________        ​  × ​        ​​ buy price days to maturity

• The formula to calculate the price where the discount rate and face value are given is: days to maturity ___________ discount rate ​Price  =  face value​​ ​​1  − ​​ ​​​ ____________     ​  × ​     ​​  [ (   )​​​​]​​​​ days in year 100

formula for calculating the discount rate, when the face value and the current price are • The known, is: ​(​​days in years  × 100​)​​ ​(​​face value  − current price​)​​ _______________ ​Discount rate  = ​ __________________         ​  × ​        ​​ days to maturity face value

LEARNING OBJECTIVE 9.6 Describe the structure, advantages, establishment, underwriting and calculation of promissory notes (commercial paper).

is a discount security issued with a face value payable at maturity, but sold today for • AlessP-note than the face value; the face value is discounted by the current market yield; maturities

CHAPTER NINE REVIEW

• The formula used to calculate the yield on a discount security is:

range up to 180 days.

• The market convention is to refer to P-notes as commercial paper. • A P-note does not have an acceptor, so only corporations with a high credit rating are able to issue. company may appoint a commercial bank or an investment bank as the lead manager of a • Alarge commercial paper issue. The lead manager will prepare all related documentation and, depending on the size and structure of the issue, establish a dealer panel.

dealer panel will comprise a syndicate of domestic and international banks who will • The promote and distribute the paper in the markets. The dealer panel members will create an active secondary market in the P-note issue.

issuer may also use a syndicate of underwriters to assist with the distribution of the paper. • The They guarantee, subject to the terms of the underwriting agreement, to purchase any paper not taken up by the dealer panel or institutional investors.

• The discount security formulae are used to make P-note calculations. LEARNING OBJECTIVE 9.7 Explain the structure, issue and calculation of negotiable certificates of deposit.

negotiable certificate of deposit (CD) is a discount security issued into the money markets by • Aa bank. with other money-market discount securities, CDs typically have maturities ranging up to • As 180 days. may use CDs to manage their liability needs (short-term funding requirements) and their • Banks liquidity needs (managing day-to-day cash flows). • The discount security formulae are used for calculations.

LEARNING OBJECTIVE 9.8 Discuss the nature and operation of inventory finance, accounts receivable financing and factoring.

finance is provided to a retail outlet to fund the purchase of stock (inventory); for • Inventory example, floor plan finance is used to fund vehicles in a motor vehicle dealership. finance provider may use a system of bailment, whereby the finance company buys the • The inventory, allows the dealership to hold and sell the vehicles, but retains actual ownership of the vehicles until they are sold. 311

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receivable financing is the provision of loans to companies by finance companies, • Accounts using the accounts receivable debtors of the company as security for the loans. is an arrangement whereby a company sells its accounts receivable at a discount to a • Factoring factor company in order to raise additional funds. may be with-recourse, where the factor company can claim against the company if a • Factoring defined percentage of the accounts receivable is not recovered from debtors, or it may be nonrecourse.

factoring agreement is often on a notification basis, whereby the factoring company advises • The the accounts receivable debtors that repayment is to be made directly to the factor company.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

One of the metrics that Basel III sets down as part of its suite of monitoring tools refers to maturity mismatches in a bank’s funding profile. Why does the Bank of International Settlements emphasise maturity mismatches as part of Basel III? (LO 9.1)

2

A fencing contractor purchases a range of fencing materials from the local hardware store in order to build a number of paling fences for a housing project. The hardware store provides its standard trade finance facility to the fencing contractor.

(a) Explain the operation of trade credit and why the hardware store would provide this type of facility.

(b) What are the advantages to the fencing contractor in using trade credit?



(c) Calculate the opportunity cost of an invoice that specifies the following conditions: 1.25/10, n/30. (LO 9.2)

3

ANZ bank offers business overdraft facilities to approved customers. In advertising this product, ANZ uses the phrase, ‘Helps you keep doing business’. With reference to the nature of overdraft finance facilities and their use by business owners, explain the relevance of ANZ’s statement. (LO 9.3)

4

The Big Bank has approved an overdraft facility that allows a small business to manage its dayto-day liquidity position. In providing the overdraft to the business, identify and briefly discuss some of the liquidity-related issues that the Big Bank would have analysed before granting an overdraft. (LO 9.3)

5

As a lending manager with Mega Bank, you have been asked by a corporate client to explain commercial bill financing. Describe the structure of a bank-accepted bill facility. Include in your answer definitions and explanations of the roles of the parties associated with the bill issue.  (LO 9.4)

6

Commonwealth Bank offers a bill facility to business customers. The bank’s website explains the advantages of the product: ‘A bill facility helps you manage cash flow more effectively by making payments only on the maturity of the bill. It also provides interest rate protection and flexibility.’ Identify the main features of a bank-accepted bill and discuss the advantages identified by Commonwealth Bank. (LO 9.4)

7

A company issues a bank-accepted bill to fund a short-term business project. The bill is issued for 180 days, with a face value of $1 500 000 and a yield of 9.87 per cent per annum. What amount will the company raise to fund the project? (LO 9.5)

312

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Chapter 9  Short-term debt

After 43 days, the bank bill in Question 7 is sold by the original discounter into the secondary market for $1 447 326.50. The purchaser holds the bill to maturity. What is the yield received by:



(a) the original discounter of the bill?



(b) the holder of the bill at the date of maturity? (LO 9.5)

9

Woodside Petroleum Limited is about to raise additional short-term funding to meet its funding needs over the next three-month planning period. It is considering issuing commercial bills or promissory notes.

(a) What is a promissory note? Identify and briefly explain the roles of the parties to a P-note issue.

(b) What are the main differences between P-notes and commercial bills of exchange?  (LO 9.6)

10 Santos Limited issues 90-day P-notes (commercial paper) as part of a three-year underwritten facility established with an investment bank syndicate. The commercial paper has a face value of $29 million and is discounted at a yield of 9.20 per cent per annum. (a) Discuss the reasons why Santos has decided to use the services of an investment bank syndicate.

(b) What is the role of the underwriters? What are the advantages to Santos in paying for the underwriting facility?



(c) Explain how the yield paid on the paper will be impacted by the three-year facility.



(d) What is the price of the P-notes; that is, what amount will the sale of the commercial paper raise? (LO 9.5, LO 9.6)

CHAPTER NINE REVIEW

8

11 What is a negotiable certificate of deposit? In your answer:

(a) identify which type of institution issues CDs



(b) explain why this institution might issue CDs. (LO 9.7)

12 A customer of a bank has $50 000 in surplus funds that need to be invested for a short period of time. The bank offers to sell a 180-day negotiable certificate of deposit to the customer at a yield of 5.34 per cent per annum. Calculate the face value of the CD and advise the customer of the dollar return on the CD. (LO 9.5) 13 The finance division of a leisure boat manufacturer has received a request for the provision of floor plan financing from the manager of a marine dealership.

(a) Explain the purpose and operation of floor plan financing.



(b) Briefly identify a range of measures that the finance division will enforce in order to protect its position as the provider of floor plan finance. (LO 9.8)

14 As the manager of a small business you are pleased that sales have increased, but are concerned that the level of accounts receivable held has also increased significantly. The combination of these two factors is causing a cash-flow problem for the business. Explain how the firm might be able to use accounts receivable financing to solve the cash-flow problem. In your answer, explain how this form of finance works and who are the main providers of accounts receivable financing. (LO 9.8) 15 On further reflection, the business manager in Question 14 decides to implement a different strategy and factor the firm’s accounts receivable. The manager approaches a factor company and is advised that the factoring agreement will include with-recourse and notification conditions in the contract.

(a) Describe the nature and operation of factoring as a form of finance.



(b) Explain the effects of the with-recourse and notification conditions that may be incorporated in a factoring contract. (LO 9.8) 313

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Part 3 The corporate debt market

KEY TERMS acceptor 293

establishment fee  291

notification basis  307

accounts receivable  289

factor company  307

operating account  290

accounts receivable financing 306

factoring 307

payee 293

floor plan finance  306

prime rate  290

bailment 306

fully fluctuating basis  291

promissory notes (P-notes)  302

bank-accepted bill  292

invoice 289

revolving facility  303

bill line  296

lead manager  303

short-term debt  288

collateral 291

LIBOR 291

trade bill  292

dealer panel  303

margin 290

trade credit  289

discounter 294

net stable funding ratio (NSFR) 288

underwriting syndicate  304

drawer 293 endorser 294

non-notification basis  307

with-recourse factoring  307

USCP 291

314

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CHAPTER 10

Medium- to long-term debt CHAPTER OUTLINE 10.1 Term loans or fully drawn advances 10.2 Mortgage finance 10.3 The bond market: debentures, unsecured notes and subordinated debt 10.4 Calculations: fixed-interest securities 10.5 Leasing

Learning objectives LO 10.1

Explain term loans and fully drawn advances, including their structure, loan covenants and the calculation of a loan instalment.

LO 10.2

Describe the nature, purpose and operation of mortgage finance and the mortgage market, and calculate an instalment on a mortgage loan.

LO 10.3

Discuss the bond market, in particular the structure and issue of debentures, unsecured notes and subordinated debt.

LO 10.4

Calculate the price of a fixed-interest bond.

LO 10.5

Explain lease financing, including types of lease arrangements and lease structures.

Extended learning LO 10.6

Understand the detailed process of financial asset securitisation.

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CHAPTER SNAPSHOT Companies and individuals can access longer-term finance through a variety of institutions, instruments and markets. At some point, many people will take out a mortgage to purchase a property. Companies might find that longer-term finance can be accessed more efficiently and cheaply by issuing bonds into the bond market. The rate of interest in the mortgage and bond markets, like all prices on the financial markets, reflects the risk profiles of the borrowers. It is the task of lenders and investors to determine whether the rate of interest they require is sufficient given the risks involved in lending money to a particular borrower. If the risk– reward trade-off is misjudged, the consequences can be disastrous for the lending institution, investor and, at times, the economy.

INTRODUCTION There are several common debt arrangements and instruments through which medium- to long-term funds are acquired by business borrowers:

• Term loans or fully drawn advances. These involve the loan of a specific amount of funds for a stated

business purpose over a certain period of time. Term loan contracts may incorporate different forms of interest rates and loan repayment structures.

• Mortgage finance. This is a term loan to purchase property where a vested interest in the land and

property thereon (the mortgage) is conveyed to the lender. The mortgage is normally registered over the title of the land and the lender will take possession of the land if the borrower defaults on loan commitments.

• Debentures, unsecured notes and subordinated debt. Debentures are interest-paying bonds issued by

a company with security provided in the form of a charge over the assets of the company. An unsecured note is also a corporate bond, but does not have security attached. Subordinated debt pays interest to the holders, but any claims of the subordinated debt holders will only be paid after all other creditors of the issuing company have been fully paid.

• Leasing. Rather than borrowing funds to purchase an asset, a company may decide to borrow an asset under a lease agreement and make lease rental repayments instead of loan repayments.

The repayment schedule associated with debt finance for long-term projects should be aligned with the expected future cash flows generated by the project. There are a number of ways a firm can structure repayments on long-term liabilities: 1 A repayment schedule that requires only interest payments to be made during the term of the loan, with the repayment of the full principal amount due on the maturity date of the loan. 2 Payment of regular periodic loan instalments, each consisting of the interest due and a repayment of part of the principal. With the payment of the final loan instalment, the loan will have been fully repaid. This is known as an amortised loan, or a credit foncier loan. 3 A deferred repayment loan. Under such an arrangement, loan instalments will not commence until after a specified period, which is specified in the loan contract and based on expectations about when the project to be financed by the loan will begin to generate positive cash flows in the future. International debt instruments and markets are discussed in Chapter 11. Many corporate and government borrowers will raise funds through the issue of securities in both the domestic markets and the international markets. However, for the majority of borrowers, the local capital markets are the main source of funds. 316

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Chapter 10  Medium- to long-term debt

REFLECTION POINTS

intermediated and direct long-term financing arrangements allow borrowers to match • Various their funding needs to the cash flows generated from the business. and funding facilities considered in this chapter include term loans, mortgage finance, • Debt corporate bonds, subordinated debt and leasing. example, a loan may be interest only with principal repaid at maturity, amortised with • For periodic interest payments and principal repayments, or deferred where loan repayments begin once the project begins to generate positive cash flows.

10.1

Term loans or fully drawn advances

The major type of intermediated finance provided by financial institutions to the business sector is the term loan. A term loan is referred to as a fully drawn advance when the full amount of the loan is provided to the borrower at the start of the loan. It is an arrangement with a financial institution whereby an amount is advanced, or lent, to a borrower for a specified period. Major providers of term loans to businesses are the commercial banks and finance companies. Other lesser providers are investment banks, merchant banks, insurance offices and credit unions. Financial institutions provide term loans for a wide variety of purposes and their structure may vary considerably. This chapter considers the generic term loan; that is, the basic characteristics that would normally be expected to be found in a term loan. Within a competitive financial system, lenders may provide a range of variations to the generic term loan product.

10.1.1

Term loan structures

 

A term loan is generally granted for a period from between three years and 15 years. For a business, a loan is usually provided for a specific purpose, such as the acquisition of plant and equipment. The lender usually requires some form of security to be attached to the loan; for example, a loan for the acquisition of land and the construction or purchase of premises on the land will be secured by a mortgage over that property. (Mortgage finance is discussed in Section 10.2.) Alternatively, the lender may also take a charge over the assets of the company, such as stock, plant, vehicles and office equipment. If the borrower defaults on loan repayments, the lender will exercise the security and take possession of the pledged assets in order to recover the amount owing on the loan. Another form of protection is a debt covenant. These are discussed in the next section. The loan repayment structure of a large proportion of term loans is typically fully amortised over the period of the loan. With an amortised loan, regular equal repayments occur throughout the term of the loan. Each loan instalment incorporates an interest payment component and a principal repayment component. For example, a monthly loan instalment of $1 000 may comprise an interest component of $800 and a principal repayment of $200. As the periodic loan instalments are paid, the amount of principal outstanding will progressively reduce. Therefore, the interest due will also reduce so that an instalment may comprise $600 interest and $400 principal repayment. The progressive repayment of the principal will result in the interest payment component reducing each month and the principal repayment component increasing each month. By the end of the loan contract, the periodic $1 000 monthly loan instalments will have repaid the loan principal in full. These loans are sometimes referred to as credit foncier loans. Other term loans may be structured as interest-only loans, where each periodic loan instalment comprises interest payments over the term of the loan, and the principal is repaid in full at the end of the term.

LEARNING OBJECTIVE 10.1 Explain term loans and fully drawn advances, including their structure, loan covenants and the calculation of a loan instalment.

Term loan a loan advanced for a specific period, usually for a known purpose; may include a fixed interest rate or a variable interest rate

Fully drawn advance a term loan where the full amount is provided at the start of the loan

Amortised loan a loan that is progressively repaid by regular equal instalments that comprise interest payments and partprincipal repayment

Credit foncier loan loan with interest and principal repayments that are amortised over the term of the loan

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Deferred repayment loan repayment commences after a specified period, usually when a project becomes cash-flow positive

Fixed interest rate the rate of interest is set for a specified period in a financial contract

Variable interest rate an interest rate on a loan that changes from time to time; based on a specified reference interest rate

It is also possible to obtain greater flexibility in repayment schedules, with the lender and borrower negotiating a schedule tailored to meet the forecast cash flows of the borrower. For example, if the project to be funded does not generate income in, say, the first six months of its life, a reduced payment or deferred repayment schedule may be arranged for that initial period of the loan. Loan instalments will begin after the specified period when positive cash flows are expected from the project. Interest rates charged on term loans will vary from time to time, depending on the structure of the loan and the overall interest rate environment. A loan may be structured with a fixed interest rate or a variable interest rate. As the name implies, a fixed interest loan will specify an interest rate that is fixed for a specified period. Generally, a fixed-rate loan will be renegotiated or reset after a set period. For example, a 10-year term loan with a fixed interest rate may have a reset date set at the end of every two-year period of the loan. The interest rate paid will then be fixed for the next two-year period, and so on. With a variable rate loan, the interest rate may change from time to time. A variable rate loan agreement will specify a reference interest rate that will apply and as that variable rate changes, so will the interest rate charged on the term loan change. Reference interest rates used by lenders vary between lenders and also from country to country. For example:

• the US commercial paper rate (USCP) • the London interbank offered rate (LIBOR) • the Singapore interbank offered rate (SIBOR) • the Australian bank bill swap rate (BBSW) • a commercial bank’s own prime rate.

The majority of reference interest rates are calculated as an average of an interest rate relating to a specific debt instrument issued in the market on a particular day. For example, the BBSW rate is calculated daily by the Australian Financial Markets Association (AFMA) from data gathered on trades in eligible securities carried out by prime banks in the Australian market. BBSW represents the mid-rate observed on bids and offers in the open market at approximately 10:00 am on a Sydney business day. Negotiable certificates of deposit (CDs) comprise approximately 85.00 per cent of the market and bank-accepted bills (BABs) the remainder. The underlying market is regulated by ASIC. USCP, LIBOR and SIBOR are discussed further in Chapter 11. A loan contract will specify the published reference rate that will be used to price a loan and therefore there should be no argument between the parties as to the interest rate applied. Depending on the specified reference rate, both the borrower and the lender simply refer to the applicable ThomsonReuters or AFMA screens to ascertain the interest rate that will be applied to the loan. Banks also calculate their own prime rates. The prime rate reflects the banks’ borrowing costs and may contain an element that reflects their overhead costs. Though borrowers may be a little suspicious that this rate is set to serve the interests of the lender rather than those of the borrower, one of the advantages of the prime rate concept is that it tends to be less volatile; sharp changes in the interest rate occur less frequently than with other market reference rates, such as BBSW. For example, during periods of tight liquidity in the money markets, a reference rate may be expected to increase quite sharply, even if the tight liquidity is expected to last for only a very short period. If the reset date of a loan happens to coincide with a spike in the reference rate, that high rate would still be applied to the loan over the period to the next interest reset date. A bank’s prime rate is far less likely to be affected by short-term market illiquidity and the borrower is thus somewhat immune from the risk of very short-term fluctuations in the reference rate. Importantly, the variable interest rate charged on a term loan by a bank will be the specified reference rate plus a margin. The margin reflects the additional risk associated with an individual borrower. For example, a company with a strong financial standing and a history of good borrowing performance may be charged a rate at BBSW plus 25 basis points. There are 100 basis points in 1.00 per cent. Therefore, 25 basis points is one-quarter of 1.00 per cent. If BBSW is 6.50 per cent, the cost of the term loan will be 6.75 per cent per annum. On the other hand, a company that does not have an established credit history with the bank may be charged more; for example, BBSW plus 230 basis points, or 8.80 per cent per annum. 318

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Chapter 10  Medium- to long-term debt

Our discussion so far implies there is one BBSW rate published each day. In fact, there are a number of BBSW rates published daily. The AFMA publishes a 1-month, 2-month, 3-month, 4-month, 5-month and 6-month BBSW rate. The loan contract will therefore specify which BBSW reference rate is used. This also applies to other reference rates such as the LIBOR, SIBOR and USCP. Whether a loan has a fixed interest rate or a variable rate, the interest rate charged on a term loan will depend on the following:

• The credit risk of the borrower. This is the perceived creditworthiness of the borrower. Before granting

a loan, a lender will analyse factors such as the total debt-to-equity ratio of the firm, projected future cash flows, the financial strength of the borrower, past loan repayment performance, the projected performance of the industry and the economy generally, forecast interest rates, the management of the firm and the life cycle of the firm’s products. Because each of these variables will differ between business borrowers, each borrower will be perceived to have a different level of credit risk and therefore will pay a different rate of interest on the loan.

• The term of the loan. Under normal circumstances a long-term loan will attract a higher rate of

interest than a short-term loan; however, this can vary at times. Chapters 12 and 13 will explain some of the main factors that affect interest rates, including changes in the official interest rate by the central bank and the amount of liquidity in the credit markets. These and other factors affect the cost of funds.

• The repayment schedule. The frequency of loan repayments and the form of repayment may

influence the interest rate applied to a loan. For example, the rate for a borrower who has a loan which requires monthly repayments may be different from that of a borrower who makes quarterly loan repayments. Also, differences may occur between an amortised loan and an interest-only loan. For example, the interest rate charged on an interest-only loan may be slightly higher because the principal amount is not being reduced periodically and therefore the lender is fully exposed for the term of the loan.

In addition to the interest charge on the funds advanced to a borrower, banks will also normally charge an establishment fee and a periodic service fee. The establishment fee represents the costs incurred by the bank in considering the loan application and in the preparation of documentation on approval of the loan. The service fee represents the ongoing administrative costs incurred by the bank in maintaining the loan account. Service fees are generally charged monthly. Once a loan has been approved, the borrower will be given a short period to draw down the loan, that is, to take the funds from the bank. A commitment fee will usually be applied by the bank to any portion of the total approved loan amount that is not drawn down within that period. In comparing the cost of funds from various lenders, the borrower must be aware of the significant differences that may exist between various fee structures. For example, one lender’s offer may include a commitment fee, while another’s may include a line fee. A commitment fee is charged on the unused portion of the facility, and is usually paid in arrears; a line fee is applied to the total amount of the facility and is normally payable in advance. Therefore, a borrower must include all interest payments and associated loan fees when considering the cost of borrowing relative to the expected return on the use of those funds.

10.1.2

Service fee charged by a lender to offset ongoing loan account administration costs

Commitment fee a charge on any portion of a financing facility that has not been drawn down

Line fee a fee charged on the total amount of funds advanced to a borrower

Loan covenants

When granting a term loan, a lender will seek to protect its financial risk exposure; that is, the risk that the borrower may default on the loan. One method used is a loan covenant. Covenants can be specified within a loan contract and typically restrict the business and financial activities of the borrowing firm. Most loan contract covenants will require a firm to maintain a minimum level of interest cover as this is a measure of the borrower’s ability to meet its loan repayment obligations. Interest cover is calculated by dividing interest repayments into income. A borrower with a higher interest cover ratio is regarded as representing a lower risk of default.

Interest cover calculated by dividing loan interest payments into a borrower’s income; a higher ratio represents lower risk

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The following list gives some idea of the scope and extent of loan covenants that are often included in term loan contracts:

• maximum debt-to-equity (gearing) ratio—requires shareholders to contribute additional equity once the debt limit has been reached • restricted accumulation of additional debt—designed to stop borrowers obtaining further loans from other lenders without the approval from the current lender • minimum working-capital ratio—to ensure the borrower has sufficient liquidity to meet day-to-day cash-flow requirements • maximum level of secured and unsecured debt—to maintain a required level of collateral to support loan contracts • annual audited, and periodic unaudited, financial statements—to keep the lender informed on the financial position of the borrower • periodic cash-flow statements—to allow the lender to monitor the liquidity of the borrower relative to projected cash flows • restriction and notification requirements on mergers and acquisitions—to ensure secured loan assets remain protected • constraints on disposal of non-current assets—to ensure secured loan assets are not sold before debt commitments are paid.

Positive covenants actions specified in a loan contract which must be taken by a borrower

Negative covenants conditions included in a loan contract that restrict the activities and financial structure of a borrower

The inclusion of loan covenants is designed to protect the exposure of the lender to the borrower. Protective loan covenants are classified as either positive covenants or negative covenants. A positive covenant states certain actions that a company must comply with, such as maintaining a minimum level of working capital or the provision of financial statements to the lender. A negative covenant limits or restricts the business activities or financial structure of the company. For example, there may be a limitation placed on the amount of a dividend that can be paid to shareholders, or a requirement that the bank must approve further long-term borrowings by the company. A number of these loan covenants are based on accounting ratios. It is therefore necessary to be certain of the measurement inputs to be used in the formulae. For example, non-tangible assets are generally excluded from ratio calculations that require total assets. Covenants often do not restrict the off-balancesheet activities of the firm. Therefore, within the constraints of the cash-flow and contingent liability covenant restrictions, a firm may be able to use off-balance-sheet financing techniques, such as obtaining additional assets through leasing agreements, as these may not be in breach of existing loan covenants. A firm is in technical default on its loan contract if it breaches a loan covenant. The lender then has the right, within the conditions specified in the loan contract, to act to protect its exposure. This might involve taking possession of the assets of the company. However, if the company has not defaulted on actual repayments, it is more likely that the term loan may become repayable on demand.

10.1.3

Calculating the instalment on a term loan

One of the fundamental characteristics of debt is that it must be repaid. Repayment of a term loan normally takes the form of a series of periodic loan instalments. Before entering into a debt agreement, borrowers must be sure that they can meet the commitments attached to the loan; therefore, they must be able to determine the amount of the periodic loan instalments, that is, how much has to be repaid. The calculation for an interest-only loan is simply the principal amount multiplied by the interest rate, adjusted for the frequency of the loan payments. For example, if a company obtained a $100 000 interest-only loan at 12.00 per cent per annum, payable by quarterly instalments, then the quarterly loan payment would be $100 000 × 0.03 = $3 000. Note that the 12.00 per cent per annum interest rate is divided by four to reflect the quarterly payment (i.e. 0.12/4 = 0.03). The larger proportion of loans provided by commercial banks and other financial institutions is amortised loans. As we discussed previously, each loan instalment comprises an interest payment component and a principal reduction component. Therefore, the formula for calculating the amount of a loan instalment on an amortised loan is a little more complex. The formula is given in Equation 10.1: 320

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Chapter 10  Medium- to long-term debt

A    ​​ ​R = ​ _____________ ( )​​​​ −n​ 1 − ​​ 1 + i​ ​​ ​[​​ ​ ___________  ​  ​  ]​​ i where: R = the instalment amount

10.1

A = the loan amount (present value) i = the current nominal interest rate per period expressed as a decimal n = the number of compounding periods (number of loan instalments)

EXAMPLE 10.1 Kitchenware Limited has approached Mega Bank to obtain a term loan to finance the purchase of a new metal press to be used in the production of cutlery. The bank offers a $150 000 loan, amortised over five years at 8.00 per cent per annum, payable monthly. Calculate the monthly loan instalments. A = $150 000 i = ____ ​ 0.08 ​    = 0.006667 12 n = 5 years × 12 months = 60 ​​   ​  ​  ​  ​  ​         ​ ​    ​  ​​ $150 000 R = ​ ____________________         ​ 1 − ​(1  +  0.006667)​​  −60​ ​ ​​​ __________________        ​​ ​​ [ ] 0.006667 R = $3 041.49 per month

In Example 10.1 the cash flows occurred at the end of each month. This is therefore an ordinary annuity (see discussion on annuities in Chapter 8). If the loan instalments were payable at the beginning of the month this would be an annuity due, and Equation 10.1 would need to be adjusted to recognise the change in the timing of the cash flows from the end of each month to the beginning of the month. This is represented in Equation 10.2: A    ​​ 10.2 ​R = ​ ___________________ 1 − ​​(​​1 + i​)​​​​ −n​ ___________ ​[​​ ​   ​  ​  ​​​ 1 + i​ ​​ ​​ ]( ) i Note that (1 + i ) is added to Equation 10.1 to recognise that the cash flows (instalments) are occurring at the start of each period, that is, an annuity due.

EXAMPLE 10.2 A company is purchasing a computer system for the business at a cost of $21 500. A finance company has offered a term loan over seven years at a rate of 12.00 per cent per annum. The loan will be repaid by equal monthly instalments at the beginning of each month. Calculate the amount of each loan instalment. A = $21 500 i = ____ ​ 0.12 ​    = 0.01 12 n = 7 × 12 = 84 $21 500 _______________________     ​​R       ​        ​  ​  =​  ​    ​ 0.01)​​  ​ ​ −84​  ​​ ​​ 1 − ​(1  +  ​​ ​​​ ______________     ​​  ​​​(1  + 0.01) [ ] 0.01 $21 500 ​ = ​ _______   ​  57.21494 ​ = $375.78 per month 321

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Reflection points

term loan is intermediated finance provided by a financial institution to a customer to fund a • Aspecific purpose for a fixed period of time. interest rate structure may be variable or fixed; if a variable rate applies, it will be based • The on a published reference interest rate such as the bank’s prime rate, BBSW or LIBOR, plus a margin. bank bill swap rate (BBSW) is the mid-point of prime banks’ bid and offer rates for eligible • The securities in the CD and BAB secondary markets. repayment structure of a term loan may be amortised (each periodic instalment • The incorporates an interest component and a principal repayment component), interest only (each periodic instalment only comprises the interest due on the full loan amount) or deferred (repayment is deferred for a period until the business project generates positive cash flows). that a lender will consider when determining an interest rate and the margin include the • Issues credit risk of the borrower, the term of the loan and the loan repayment schedule. range of fees may also apply, including an establishment fee, a periodic service fee, a • Acommitment fee or a line fee. loan contract may include a range of loan covenants to protect the lender. They include • Apositive covenants, which state actions that must be taken by a borrower (e.g. provision of financial statements), and negative covenants, which limit the actions of a borrower (e.g. minimum debt-to-equity ratio). formula used to calculate the instalment on a term loan (when payments occur at the end • The of each period) is: A  ​R = ____________ ​      ​​ ( 1 − ​​ 1 ​​   + i​)​​​​  −n​ ​[​​ ​ __________  ​   ​  ]​​ i

10.2 LEARNING OBJECTIVE 10.2 Describe the nature, purpose and operation of mortgage finance and the mortgage market, and calculate an instalment on a mortgage loan.

Mortgagor the borrower who assigns security over land and the property thereon to a lender

Mortgage finance

Although mortgage financing has been referred to in the discussion on term loans, it deserves a separate mention because of its importance in the long-term debt markets. A mortgage is a form of security against which a loan is advanced. Under a mortgage agreement, the borrower (mortgagor) conveys an interest in the land (and property thereon) to the lender (mortgagee). The mortgage is discharged when the loan is repaid. During the life of the agreement, if the mortgagor fails to meet the terms of the loan contract, the mortgagee is entitled to take control of the property and to dispose of it in order to recover the outstanding debt. This is called the right of foreclosure. A mortgage loan is simply a term loan with a specific form of security attached, being the mortgage. The size of the mortgage debt market varies between countries, but typically will always be large, as lenders seek to secure their risk exposure by registering a mortgage over land and the property thereon. For example, in Australia, the mortgage market is the largest of the long-term debt markets. Lenders in the market include commercial banks, building societies, life insurance offices, superannuation funds, trustee institutions, credit unions, finance companies and mortgage originators. While the largest proportion of mortgage finance is for residential home loans, mortgage agreements are also used for commercial loans. Companies may obtain debt finance by providing security to the lender in the form of a mortgage over freehold land and, under certain circumstances, over leasehold property.

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Commercial mortgage finance tends on average to be provided with shorter terms to maturity than residential mortgage finance. In Australia, commercial property mortgages typically range up to 10 years, while residential housing mortgages are typically granted for periods up to 30 years. The difference in the term to maturity between the two types of mortgage finance can be explained in the nature of the associated cash flows. A commercial property is expected to generate future cash flows from its business purpose, and therefore the loan will be of a shorter period and will match the cash flows being generated by the business operations. On the other hand, a residential mortgage generally does not generate such cash flows and therefore is granted for a longer term to maturity. Mortgage finance is available with a choice of a variable interest rate loan or a fixed interest rate loan. Because a mortgage loan is long term, a lender will include a provision in a fixed interest loan contract that the interest rate will be reset periodically, such as every two years. The decision about whether to choose a fixed-rate or a variable-rate loan is a difficult one. Chapters 12 and 13 discuss interest rates in some detail. The factors discussed in those chapters need to be considered before deciding on which interest rate structure is best to meet a borrower’s needs. It is possible to obtain interest-only mortgage loans, but the interest-only period will normally be for only part of the loan period, such as the first five years of a 30-year loan. The borrower also needs to be able to show that the loan can be amortised from future income over the remainder of the loan period. The mortgagee may require the mortgagor to take out mortgage insurance up to 100.00 per cent of the value of the mortgage. Under such an arrangement, the insurance company contracts that, if the mortgagor is in default, the mortgagee will suffer no loss of interest or principal. The risk exposure of the insurance company is the difference between the realised return, after costs, from the sale of the default property and the amount of interest and principal outstanding to the lender. Bank lenders normally require a borrower to take out mortgage insurance when the amount borrowed is greater than 80.00 per cent of the loan-to-valuation ratio. The loan-to-valuation ratio is the ratio of the amount borrowed relative to the bank’s valuation of the property. A variation to the traditional form of mortgage lending discussed above is growing as a result of ageing populations. In order to raise cash to use in their retirement, a growing number of home owners are entering into a reverse mortgage with their bank. In this situation, an older person borrows against the value of their property and the lender will recover the amount due when the property is sold at some point in the future. Commercial banks and other financial institutions often use the process of securitisation to manage their mortgage loan portfolios. In a number of countries, deregulation of the financial system has enabled the establishment of dedicated mortgage finance providers. These institutions are often referred to as mortgage originators. Mortgage originators may obtain their ongoing funding through the process of securitisation. The originators are able to sell (securitise) a bundle of their mortgage loans in order to finance new mortgage loans. Securitisation is briefly discussed in Section 10.2.2 and a more detailed discussion can be found in the Extended learning section at the end of the chapter.

10.2.1

Mortgagee the lender who registers an interest in land and property thereon as security for a loan

Right of foreclosure the right of a lender to take possession and sell an asset to recover any amount owing on a loan

Mortgage insurance insurance cover that protects a lender in the event that a borrower defaults on a mortgage loan

Calculating the instalment on a mortgage loan

A mortgage loan is a term loan with a form of security attached, being the mortgage. Therefore the calculation of an instalment on a mortgage loan (Equation 10.3) is the same as for a term loan (Equation 10.1). A    ​​ ​R = ​ _____________ ( )​​​​ −n​ 1 − ​​ 1 + i​ ​​ ​[​​ ​ ___________  ​  ​  ]​​ i

10.3

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EXAMPLE 10.3 A company is seeking a fully amortised commercial mortgage loan of $650 000 from its bank to purchase a factory. The conditions attached to the loan include an interest rate of 8.00 per cent per annum, payable over five years by equal end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount. A = $650 000 i = ____ ​ 0.08  ​    = 0.02 4 n = 5 × 4 = 20 ​​         ​    ​  ​  ​  ​​ ​ ​ ​​ $650 000 R = _______________ ​        ​ −20 1 − ​​(​​1  + 0.02​)​​​​  ​ ​ ​​ ​ _____________     ​​  ​​ [ ] 0.02 ​ = $39 751.87 per quarter

10.2.2

Special-purpose vehicle (SPV) a trust established to hold securitised assets and issue asset-backed securities

Securitisation and mortgage finance

Mortgage finance is an important source of funds for borrowers in the intermediated finance markets. While commercial banks are the major providers of this form of finance, many other institutions, such as mortgage originators, building societies, credit unions, insurance offices and superannuation funds, also compete within this market. In March 2018, commercial banks in Australia held more than $1.6 trillion in residential mortgage loan assets on their books. This included just over $1 trillion in owner-occupied mortgages with the remainder allocated to investment property mortgages. With the mortgage loan market, there is no secondary market that trades in individual mortgage loan assets. The enormous accumulation of mortgage loan assets on the balance sheets of lenders prompted the development of an innovative financing technique to deal with this problem. The process is called securitisation, and evolved to allow the sale of non-liquid assets such as mortgage loans. Within the context of mortgage loans, securitisation involves the sale of a bundle of mortgage loans by the original lender (such as a bank) to the trustee of a special-purpose vehicle (SPV). The trustee obtains the funds to purchase the mortgage loan assets from the bank by selling new securities, such as bonds, to investors in the capital markets. Generally, investors like to invest in this form of bond because it is supported by the security of the mortgage loan assets held by the trustee. The bonds are therefore called ‘asset-backed securities’. The bond investors are entitled to receive regular interest payments and receive repayment of principal at maturity of the bond. The trustee is able to pay these cash outflows from the cash inflows received from the loan instalments paid by the mortgage loan borrowers. In Australia, $215 billion in mortgage assets had been securitised by 2007. However, the GFC severely limited the use of securitisation. As default rates on sub-prime housing loans increased, investors were not willing to purchase securities that were supported by securitised mortgage loans. Even though Australia did not experience significantly higher mortgage loan default rates, the securitisation market for mortgage assets had fallen to less than $106 billion by December 2013. By 2018, however, the securitisation market for mortgage assets in Australia had rebounded to more than $400 billion, representing about one-quarter of the total value of all outstanding mortgages. A more detailed discussion on securitisation is provided in the Extended learning section at the end of the chapter.

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Reflection points

finance is a term loan with a specific type of security attached, being a mortgage • Mortgage registered over land and the property thereon. The borrower (mortgagor) conveys an interest in the land to the lender (mortgagee). a borrower defaults on loan repayments, the lender has the right of foreclosure, whereby the • Iflender will take possession of the land and sell it to recover the amounts outstanding. mortgage market is very large and includes both residential mortgage loans and • The commercial mortgage loans. protection for the lender may be a loan condition that requires the borrower to take • Aoutfurther mortgage insurance. This is normally required where the loan-to-valuation ratio is above 80.00 per cent.

• The formula to calculate the instalment on a mortgage loan is: A  ​R = ___________ ​      ​​ 1 − ​​(​​1  + i ​)​​​​  −n​ _________ ​[​​ ​     ​ ​  ]​​ i mortgage lenders use a process of securitisation to finance continued growth in their • Some mortgage lending. The lender sells a parcel of existing loans to a trustee of a special-purpose vehicle. The trustee funds this purchase by issuing new securities such as bonds into the capital markets. The cash flows due on the mortgage loans held by the special-purpose vehicle are used to pay interest and principal commitments due on the bonds.

10.3

The bond market: debentures, unsecured notes and subordinated debt

So far this chapter has considered intermediated finance, that is, medium- to long-term debt provided by financial institutions. We now consider direct debt finance. This occurs when a borrower issues a financial security into the debt markets in order to raise funds. The major longer-term debt market in developed countries is the bond market. A bond is a longterm debt instrument issued directly into the capital markets. A bond pays a specified periodic interest rate for the term of the bond and the principal is repaid at maturity. The interest rate paid on a bond may be a fixed rate or a variable rate based on a reference interest rate such as BBSW or LIBOR. Bonds are issued in the domestic bond market and the international bond markets. For example, the structure of the Australian bond market is as follows:

LEARNING OBJECTIVE 10.3 Discuss the bond market, in particular the structure and issue of debentures, unsecured notes and subordinated debt.

• Treasury bonds issued by the Australian government. These bonds are called Commonwealth Government Securities (CGS).

• Bonds issued by state government borrowing authorities. For example, the state of New South Wales

Semis

• Bonds issued by Australian financial institutions such as the National Bank of Australia Limited

Covered bonds

borrowing authority is the NSW Treasury Corporation and the state of Victoria borrowing authority is the Treasury Corporation of Victoria. Bonds issued by these central borrowing authorities are known as semis. or Westpac Banking Corporation. These include covered bonds. Covered bonds issued by banks incorporate an underlying form of security to support the bond, being a claim against mortgage securities held by the bank.

• Bonds issued by Australian corporations direct into the domestic and international capital markets.

the term used to describe bonds issued by state government borrowing authorities in Australia bonds issued by commercial banks that are supported or secured by mortgage assets held by the bank

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• Asset-backed securities—see Section 10.2.2 and the Extended learning section on securitisation at end of this chapter.

Green bonds bonds issued to fund renewable energy infrastructure

Corporate bond market the markets for the direct issue by companies of longterm interest-bearing debt securities

Credit rating agency specialises in assessing the credit quality associated with financial obligations; provides a standard measure of the creditworthiness of a debt issuer

• Australian dollar bonds issued by non-resident borrowers. That is, foreign borrowers issue bonds that are denominated in Australian dollars. These are known as Kangaroo bonds. • The newest type of bonds are known as green bonds. The global market for green bonds remains

small (about $150 billion), with the Australian segment valued at around $3 billion. The bonds must meet certain criteria to be classified as ‘green’. They are usually issued to fund renewable energy projects.

For the remainder of this chapter we will focus on the corporate bond market, in particular the issue of debentures, unsecured notes and subordinated debt. (The international bond markets are discussed in Chapter 11 and the government bond markets are discussed in Chapter 12.) Why do corporations seek to raise debt funds direct from the capital markets? A major incentive is to remove the cost of the financial intermediary such as a bank. Clearly, banks include a profit margin in the interest rates they charge on a loan to a customer; that is, a bank charges for the intermediation service that it provides. Corporations that can borrow without the need to use a bank may save the cost of that margin. Borrowing direct from the markets also allows corporations to diversify their funding sources. Diversification is a risk management strategy. Corporations that obtain debt funds from a number of different sources are able, from time to time, to choose the most cost-effective sources of funds, and are more likely to be able to obtain funding from other sources if one source cannot provide funds for some reason. Why do investors provide debt funds directly to the market? Investors who lend direct accept the credit risk associated with the ultimate borrower. It might be argued that rational and risk-averse investors would rather place their funds with a financial institution, which would then accept the credit risk of the borrower. However, investors seek to maximise their returns within the constraints of their risk and return preferences. By lending direct, investors are able to share in the profit margin normally taken by a financial intermediary. The increased risk of lending direct is reflected in a higher rate of return or yield on the investment. Investors will endeavour to measure the credit risk of a particular debt issuer. One international standard used as a measure of the creditworthiness of a borrower is a credit rating. (Credit ratings are discussed in detail in Chapter 11.) Briefly, an international credit rating agency applies standard measures to ascertain its view of the creditworthiness of an issuer of debt. Credit rating agencies include Standard & Poor’s and Moody’s Investors Service. Each credit rating agency has its own set of symbols that represent a credit rating. A higher credit rating implies a lower credit risk and therefore a lower cost of borrowing. For example, a company that issues debt securities with an AA+ credit rating will be perceived as a lower-risk issuer than a company that issues securities with a BB rating. Based on the principle of risk and return, the AA+ company will be able to attract more investors and raise funds at a lower yield than the BB-rated company. In practice, a company with a low credit rating, or a company that has not obtained a credit rating, will find it difficult to raise substantial debt funds in the corporate bond markets. Where do direct investment funds come from? There is a staggering amount of capital available for investment in the international financial system. Deregulation of the financial system has removed many of the constraints that would otherwise limit the flow of funds around the world. This, coupled with technology that supports the rapid and efficient conduct of financial transactions, has encouraged the development of direct investment markets. Increased investor sophistication and the expectation of higher yields on investments have also drawn a greater pool of investors into the markets. In particular, there has been a significant growth in funds under management. These funds are managed by professional fund managers who have the knowledge and expertise to invest directly into the domestic and international capital markets. In many countries there is an ever-increasing pool of accumulated retirement and superannuation savings that are available for investment. Traditionally, direct investment is provided to government and also to the corporate debt markets. It is said that when the government sector borrows more funds from the pool of investment funds

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available, it creates a crowding-out effect by limiting the proportion of the total amount of funds available for business investment. In the years leading up to the GFC the reverse had occurred; many governments had sought to limit and reduce their net debt outstanding. This resulted in an even greater pool of funds available for direct investment in the corporate sector. The GFC put enormous pressure on government budget outcomes and many governments, particularly in the UK, USA and the eurozone, found it necessary to borrow greater amounts through the government bond markets. The discussion now turns to some of the different securities that are issued in the domestic capital markets of a country. Debentures, unsecured notes and subordinated debt are examined. Similar securities issued in the international capital markets are discussed in Chapter 11.

10.3.1

Crowding-out effect occurs where government borrows a larger proportion of the total funds available for investment

Debentures and unsecured notes

The financial press often refers to the corporate bond market. A bond is a debt security issued into the capital markets that pays the holder periodic interest payments in return for investing for a specified period of time. The market convention is to refer to the periodic interest payment as a coupon. The term derives from bearer bonds, where the actual physical bond has attached a coupon for each interest payment due. The bond holder detaches the interest payment coupon from the bond and presents it for payment when due. In many countries, bond issues are now recorded, and interest payments are made, electronically. However, the term coupon still remains. A corporate bond is a bond issued by a company. A corporate bond may be categorised as a debenture or an unsecured note. Debentures and unsecured notes are essentially contracts between the borrower and the lender which specify that the lender will receive regular interest payments during the term of the bond and receive repayment of the face value of the bond on the maturity of the contract. A debenture can be differentiated from an unsecured note by the form of security attached to the corporate bond issue. A debenture is secured by a fixed and/or a floating charge over the issuing company’s unpledged assets—those assets over which there has been no charge or interest conveyed to another party. The term unsecured note refers to a corporate bond issued where there is no underlying security attached. A company that issues debentures will usually convey a fixed charge over assets of the company that are described as being permanent assets—that is, assets that are not to be sold in the normal course of the business operations. For example, such fixed assets might include manufacturing equipment, computer systems and a vehicle fleet. The issuing company will also hold assets it expects to sell in the normal course of its business operations. For example, the company may be a tyre manufacturer. The company will accumulate stock that, in its manufacturing processes, it will convert into tyres. These tyres will be sold as they are manufactured. The company cannot issue a fixed charge over the tyres as it needs to sell them to generate income. In this case it will issue a floating charge over those assets. A floating charge allows the company to continue to operate and sell the tyres. However, if the company should default on bond payments, the floating charge is said to crystallise and become a fixed charge. At that point the bond holder will take possession of the remaining tyres that are currently held by the company. The distinction between the two types of bonds is most clear in the event of the failure of the issuing company. In that event, the ranking of bond holders in their claim on the company’s assets is as follows.

• First: fixed-charge debenture holders. These bond holders are entitled to the proceeds of the sale

of the assets over which the charge has been placed. If the proceeds from the sale prove to be inadequate to repay the debenture holders in full, the outstanding balance ranks equally with other unsecured debt holders.

Corporate bond a long-term debt instrument issued by a company and paying a regular interest stream

Unpledged assets assets of a company over which no interest has been conveyed to another party

Fixed charge the assets of a borrower that cannot be sold until bond holders have been repaid

Floating charge allows certain assets over which security is held to continue to be sold in the normal course of business

Crystallise if a borrower defaults, then a floating charge converts to a fixed charge over all unpledged assets of a company

• Second: floating-charge debenture holders. If assets are still available after full payment of fixed charge debenture holders, then the claims of floating charge debenture holders are payable. They rank ahead of unsecured creditors in their entitlement to the proceeds of the sale of assets.

• Third: unsecured note holders. These bond holders join all the remaining creditors of the company. 327

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Debenture trust deed specifies and protects the underlying security attached to a debenture bond issue

A company that issues corporate bonds in the form of debentures will formalise the type of security available to investors through a debenture trust deed. The deed defines and protects the priority of security of the debenture holders. It also contains the covenants and undertakings made by the company, which are aimed at ensuring that the company can meet its financial obligations to the debenture holders. Typical debt covenants were discussed earlier in the chapter.

10.3.2

Issuing debentures and notes

Companies that wish to raise funds through the issue of either debentures or unsecured notes may use three principal methods: 1 Public issues. The offer is made to the public at large, including retail and institutional investors. 2 Family issues. The offer is made to associated parties who are already holders of the company’s securities, including shareholders, bond holders and holders of convertible notes. 3 Private placement. The offer is made only to institutions that deal regularly in securities, or to other institutional investors such as fund managers and insurance offices. For the majority of corporate bond issues, the price paid on subscription is the same as the face value of the security. However, bonds may be offered from time to time that are not issued at face value. The issuing company and investors need to consider the cash-flow and taxation implications of the different bond issue structures that may be offered. Most countries have removed the tax advantages that may have been available from issuing discounted bonds. Some of the more common structures include:

• Discounted debentures. The issue price is at a discount to the face value. • Deep discount debentures. The issue price is at a significant discount. • Zero-coupon debentures. The return to the debenture holder is the difference between the purchase price and the face value of the debenture paid at maturity. There are no regular interest payments.

• Deferred-interest debentures. All of the interest earned is payable upon the maturity of the bond.

Corporations legislation in relation to the issue of debt securities will vary between countries. In most countries where a corporate bond market exists, legislation will require any invitation to the public to deposit money with or lend to a corporation to be accompanied by a prospectus that has first been registered with the regulator. For example, in the USA the regulator is the Securities and Exchange Commission (SEC), while in Australia it is the Australian Securities and Investments Commission (ASIC). In some countries, exemptions may exist for securities issued to qualified institutional investors. A prospectus is a formal written offer to sell securities to the public. Typically, a prospectus will provide detailed information about the business, including:

• financial statements • directors and executive managers • specialist accounting, taxation and legal reports • any material information that may affect the company • strategic business plans and the intended use of the funds received from the issue.

Information memorandum limited information provided to institutional investors with a private placement debt issue

The prospectus should enable an investor to make an informed decision regarding the investment opportunity; that is, the purchase of the bonds. The prospectus requirement is intended to protect the interests of the investors, but it creates certain disadvantages for a borrower. A prospectus is costly and time consuming to prepare and register. In particular, in a volatile market the time delay could prevent a borrower being able to come to the market with an issue at the most advantageous time. Because of these constraints on timing, and the high administrative and legal costs, companies have increasingly turned to private placements. In a number of jurisdictions, a private placement does not require the preparation of a prospectus. Instead there is a much less onerous requirement to provide institutional investors with an information memorandum.

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The presumption is that institutional investors are more informed than the general public and therefore it is not necessary to provide the full extent of the detail that is incorporated in a prospectus. The information memorandum must include up-to-date financial statements, material changes that will or may affect the business and the purpose of the debt issue.

10.3.3

Subordinated debt

Subordinated debt has been separated from debentures and unsecured notes because, although subordinated debt has some features in common with both, its typical attributes make it look more like equity than debt. Additional attributes included in a subordinated debt issue include the following:

• The debt ranks behind all other liabilities of the issuing company. • The holders of subordinated debt, in the event of the failure of the issuer, do not receive any payment •

Subordinated debt a long-term debt issue; holders’ claims are subordinated against all other creditors, but before equity holders

until all other creditors and other debt holders have been repaid in full; that is, they rank behind the holders of unsecured notes. The debt issue may include an agreement that the debt will not be presented for redemption for a specified period.

Given the relatively unattractive ranking of subordinated debt, it should be no surprise that subordinated debt is most frequently supplied from within the consolidated corporation; that is, the parent company or a major shareholder may be prepared to make funds available on the terms outlined above. The reasons for this are varied, but largely arise from the equity-like nature and treatment of subordinated debt. Subordinated debt may be recorded on the balance sheet as shareholders’ funds rather than as debt. As a result, the addition of subordinated debt is likely to improve the credit rating of the issuing company. The improved credit rating and the expansion of its quasi-equity base both serve to increase the borrowing strength of the company.

Quasi-equity a security that has the attributes of both debt and equity

Reflection points

corporate bond is a long-term debt security that pays specified periodic interest payments • A(coupons) for the term of the bond and the principal is repaid at maturity. bond issuers require a good credit rating issued by a credit rating agency to be able • Corporate to issue securities directly into the capital markets. • Debentures and unsecured notes are corporate bonds. debenture is a corporate bond with security attached. The security is a charge over the • Aunpledged assets of the borrower. This will include a fixed charge over permanent assets and a floating charge over other assets such as stock that pass through the business. If the borrower defaults, the floating charge is said to crystallise and become a fixed charge; the borrower will then take possession of the assets.

covered bond is a bond issued by a commercial bank that is supported by a claim over • Amortgage securities held by the bank. • An unsecured note is a corporate bond with no security attached. bonds may be offered as public issues, family issues or private placement. Bonds are • Corporate typically sold at face value; however, issues may include discounted, deep discounted, zerocoupon and deferred-interest debentures.

public issue of bonds requires a prospectus that provides detailed information on the • Aissuer corporation, the purpose of the funding, company financial statements and projections, management profiles, expert reports and other material information.

debt also pays a specific interest stream, but the claims of subordinated debt • Subordinated holders are ranked behind all other creditors, but before equity. 329

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10.4 LEARNING OBJECTIVE 10.4 Calculate the price of a fixed-interest bond.

Calculations: fixed-interest securities

The main fixed-interest security issued into the corporate debt markets is a bond (discussed in Section  10.3). The price of a bond is simply the present value of its future cash flows. Chapter 8 introduced the concept of present value. In order to calculate the present values, the cash flows associated with a particular bond issue must be identified. A bond has two sets of cash flows: the periodic coupon payments and the repayment of principal at the maturity date. The price of the bond is also affected by the date on which the bond is bought or sold, therefore we will calculate: 1 the price of a bond where the purchase occurs on an actual coupon date 2 the price of a bond where the purchase occurs between coupon dates. Before we examine the bond pricing formulae and calculations it is worthwhile to discuss the inverse relationship that exists between the price of an existing bond and the current bond yield in the market.

10.4.1

Bond price/yield relationship

At times, official interest rates may fall but financial commentators will discuss how much the price of bonds has increased. At first it seems strange that interest rates have fallen, but prices have actually risen. Similarly, if interest rates rise, then the price of bonds will fall. What is happening? To understand what is happening, it is necessary to remember that we are looking at the price of existing fixed-interest bonds. These bonds pay a periodic fixed coupon that has been locked in when the bond was issued. Therefore, if interest rates for new bonds being issued into the market are lower than the interest rate on an existing bond, the value of the existing bonds will also change. As the existing interest rate coupon is fixed, the only thing that can change is the price of the bond because the fixed higher coupon is worth more than the lower coupon offered on new bonds. That is, an investor selling the existing bond will sell the bond at an increased price because the fixed higher coupon has a greater value. Therefore, we say there is an inverse relationship between the price of an existing fixed coupon bond and changes in the current yield in the market. If current coupon rates rise, the price of existing fixed-interest securities will fall; alternatively, if current coupon rates fall, the price of existing securities will rise. It would be natural to enquire as to what could cause bond yields to change. The answer is relatively straightforward. Bond yields can change when the perception of risk for either a particular borrower or for borrowers in general changes. If risk is perceived to have increased, bond yields will increase and vice versa. Bond yields can also change because of inflation expectations. When inflation increases, bond yields increase and vice versa. That is why bond traders pay close attention to reports and data concerning inflationary expectations.

10.4.2

Price of a fixed-interest bond at a coupon date

Fixed-interest bonds are issued with a face value repayable at maturity, but also pay periodic fixedinterest payments (coupons) during the life of the security. It is important to understand that the interest payments on existing fixed-interest securities will not change over time; however, the current market interest rate on similar new securities may change over time. For example, a company may have issued a $100 000 face value 10-year bond four years ago and continues to pay a fixed coupon of 10.00 per cent per annum. However, interest rates in the market have fallen and if the same company were to issue new bonds today, it may only have to pay a coupon of 8.00 per cent per annum because interest 330

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rates have fallen generally in the market. Therefore, the current price of the existing bond will need to reflect the change in current market interest rates. The price of the existing security is based on the present value of the two cash-flow streams, being the periodic coupon payments and the face value repayable at maturity. The yield used in determining the present value of the cash flows is the current market rate that is applicable for that particular type of bond in today’s market. One formula used to calculate the bond price (at a coupon date) is as follows: 1 − ​​(​​1 + i​)​​​​ −n​ −n ​P = C​​[​​ ​ ___________     ​​  ]​​​ + A​​(​​1 + i​)​​​​  ​​ i

10.4

This formula is used because it clearly shows from where the price of the bond is derived—that is, the present value of the cash flows. An alternative formula, used by AOFM to calculate the price of government bonds, is given in the Extended learning section in Chapter 12. In reality, most bond calculations will be done on a calculator or a computer. Equation 10.4 may look a little intimidating, so we can break it down into its component parts: (a) the present value of the coupon stream, plus (b) the present value of the face value. (a) Present value of the coupon stream: 1 − ​​(​​1 + i​)​​​​ −n​ ​= C​​[​​ ​ ___________     ​​  ]​​​​ i

10.5

(b) Present value of face value: ​= A​(1 + i)​​ −n​​

10.6

where i is the current yield for the period, expressed as a decimal; n is the number of periods in which future coupon payments will occur; C is the periodic fixed coupon payment amount based on the fixed interest rate; and A is the principal or face value of the bond.

EXAMPLE 10.4 Current AA+ corporate bond yields in the market are 8.00 per cent per annum. What is the price of an existing AA+ corporate bond with a face value of $100 000, paying 10.00 per cent per annum halfyearly coupons, and with exactly six years to maturity? A = $100 000

​

​​(​​a​)​​​

​

​

0.10 C = ​$100  000  × ​ _  ​    =  $5 000​(​​half-yearly  coupons​)​​​ ​​             ​  ​  ​  ​  ​ 2 ​​​ i = ____ ​ 0.08  ​    = 0.04 2 n = 6 × 2 = 12 1 − ​​(​​1  + 0.04​)​​​​  −12​ P ​Vcoupons ​  ​​ = $5  000​​ ​​ ​ _____________     ​​  ​​​ [ ] 0.04 ​ = $46 925.37

plus ​ ​ ​ ​ ​​      ​                            ​  ​  ​  ​  ​  ​  ​ ​  ​​ ​ ​​ ​ (​​ ​​b)​ ​​​ P ​Vface value ​  ​​ = $100  000​​(​​1  + 0.04​)​​​​  −12​ ​ ​ ​

​ ​ = $62 459.70 ​ Price of the bonds = $46 925.37  +  $62 459.70 ​ ​ = $109 385.07

continued

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Note: Market yields have fallen from 10.00 per cent to 8.00 per cent; therefore, the price of the bond is at a premium to the face value ($109 385.07); that is, the bond is now worth more than its face value. This has occurred because the existing bond is paying a fixed interest rate of 10.00 per cent per annum, which is above the return that could be obtained from a current bond issue; therefore, it is worth more. The investor will need to pay more than the face value to obtain the higher-value income stream, thus the net yield to maturity for the purchaser will be equivalent to the current 8.00 per cent per annum yield.

10.4.3

Price of a fixed-interest bond between coupon dates

In Example 10.4 the price of the bond was calculated immediately following the last coupon payment. In other words, the pricing was based on exactly 12 coupon periods remaining. In reality, most bonds will be sold during a coupon period. In that circumstance, an adjustment needs to be made to the formula used to calculate the present value of the cash flows to allow for the number of days that have elapsed since the last coupon payment. That is, the seller of the bond will not receive any of the next coupon as the coupon will all be paid to the holder of the bond at the coupon date. Therefore, the seller will need to be compensated for the period the bond has been held without receiving any interest payment. The buyer of the bond must compensate the seller by increasing the price paid for the bond. The adjusted formula used to calculate the bond price is as follows: 1 − ​(1 + i)​​ −n​ −n k ​P = ​​{​​C​​[___________ ​​​      ​​  ]​​​ + A​(1 + i)​​  ​​}​​​​(1 + i)​​  ​​ i

10.7

Again, the calculation can be better understood by breaking the formula down into its component parts: the present value of the coupon stream (at the next coupon payment date), plus the present value of the face value. This amount is then adjusted by (1 + i)k, where k is the number of days elapsed since the last coupon payment, expressed as a fraction of the coupon period. (a) Present value of the coupon stream (at the next coupon payment date): 1 − ​(1 + i)​​ −n​ ​= C​​[___________ ​​​      ​​  ]​​​​ i

10.8

​A​(1 + i)​​ −n​​

10.9

plus (b) Present value of the face value: (c) Adjustment for the number of elapsed days in the current coupon period: ​(P ​Vcoupon ​  ​​ + P ​Vface value ​  ​​ ) ​(1 + i )​​ k​​

10.10

where k is the fraction of the elapsed interest period since the last coupon payment; that is, the number of elapsed days divided by the number of days in the current coupon period.

EXAMPLE 10.5 Current AA+ corporate bond yields in the market are 8.00 per cent per annum. An existing AA+ corporate bond with a face value of $100 000, paying 10.00 per cent per annum half-yearly coupons, maturing 31 December 2024, would be sold on 20 May 2019 at a price of: 1 − ​​(​​1  + 0.04​)​​​​  −12​ ​​​​(​​a​)​​​  P ​Vcoupons ​  ​​ = $5  000​​ ​​ ​ _____________     ​​  ​​​ [ ] 0.04 = $46 925.37 332

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plus ​​(​​b​)​​​  P​Vface value ​  ​​ = $100  000​​(​​1  + 0.04​)​​​​  −12​ = $62 459.70 PV = $46 925.37 + $62 459.70 = $109 385.07 140 ____

​​(​​c)​ ​​​     P = $109  385.07​​(​​1.04​)​​​​  ​ 181 ​ ​ = $112 754.27​ The number of elapsed days is for the period 1 January 2019 to 20 May 2019 inclusive, that is, 140 days. There are 181 days in the period 1 January to 30 June 2019. Therefore, k = 140/181. The adjustment for the elapsed period has in fact increased the price of the bond. The difference in value ($3 369.20) between Example 10.4 and Example 10.5 represents the present value of the elapsed period from the last coupon payment on 31 December 2018 and the sale date. At the next coupon payment date, 30 June 2019, the bond purchaser will receive the full coupon payment of $5 000.

Reflection points

price of a bond is the present value of the future cash flows, being the present value of the • The periodic coupons and the present value of the principal payable at maturity. is an inverse relationship between the price of an existing bond and current interest rates • There in the market. For example, if current yields (interest rates) rise, then the price of existing bonds will fall.

• A formula used to calculate the price of a bond at a periodic coupon date is: 1 − ​(1  + i )​​  −n​ ​P = C​​[_    ​​​      ​​]​​​ + A​(1  + i )​​  −n​​ i

majority of bonds are sold between coupon dates; therefore, the above formula is adjusted • The by (1 + i ) , where k is the number of elapsed days since the last coupon payment, expressed as k

a fraction of the coupon period. Therefore the formula is: 1 − ​(1  + i )​​  −n​ ​P = { ​​ ​​C​​[_ ​​​      ​​  ​​​  + A​(1  + i )​​  −n​​}​​​​(1  + i )​​  k​​ ] i

10.5

Leasing

A lease is a contract whereby the owner of an asset (the lessor) grants to another party (the lessee) the exclusive right to use the asset, usually for an agreed period of time, in return for the payment of rent. From the perspective of a business that needs to acquire an asset, how does a lease agreement represent funding? Instead of borrowing funds to purchase an asset, a business is able to lease (borrow) the asset itself in return for making periodic rental or lease payments. A company considering leasing an asset needs to analyse the benefits of such a financial arrangement. For example, a company considering the leasing of a computer system should carefully calculate the after-tax cost of leasing the asset and compare that with the after-tax cost of borrowing funds to buy the asset. The principal providers of lease finance are the commercial banks and finance companies, but lease finance is also available through specialist leasing companies and merchant banks. Some manufacturers of capital equipment provide their own lease finance as part of the marketing of their products.

Lessor the owner of an asset that is subject to a lease agreement; receives lease rental payments

Lessee the user of an asset that is subject to a lease agreement; makes lease rental payments

LEARNING OBJECTIVE 10.5 Explain lease financing, including types of lease arrangements and lease structures.

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From the lessee’s point of view, some of the advantages of leasing, as opposed to the ‘borrow and purchase’ option, may include the following: Lines of credit financial arrangement established to provide a source of funds in the future

• Leasing does not involve the use of the company’s capital and other unused lines of credit. This

allows the company to use its capital to take advantage of other investment opportunities that may arise.

• Leasing provides 100.00 per cent financing, in that the lessor provides the complete asset required

for use by the company under the lease agreement. On the other hand, debt financing will often require the borrower to contribute a portion of its own funds to purchase assets.

• Payments under a lease agreement may be structured to reflect the cash flows generated by the Interest capitalised interest payments due, but deferred, are added to the total amount owing

asset; that is, repayment scheduling may be more flexible under lease agreements than with debt financing. For example, payments may be deferred and interest capitalised until the project generates positive cash flows. This feature of a lease arrangement is important from the point of view of the company’s net cash flows in any period. It is also most important for income tax purposes. Lease payments are generally tax deductible and so it is important to structure the repayments to match taxable income streams.

• Borrowing covenants included in existing loan agreements may allow a company to use lease financing when negative covenants restrict further debt funding. (Negative covenants were discussed earlier in the chapter.)

• Where a particular asset is required by a company for a relatively short term, it may be preferable to lease the asset rather than to buy it and then have to dispose of it at the end of the short period.

From the lessor’s point of view, offering a client a lease agreement may also provide a number of advantages:

• In theory, leasing has a relatively low level of overall risk. If the lessee defaults, the lessor has the

right to take possession of the asset. In the case of default on a loan, however, the lender may face considerable delays in recovering amounts due on the loan. This is especially the case if a company is placed into receivership or liquidation. In that situation, a liquidator is appointed to wind up the affairs of the company, sell any assets and distribute the proceeds according to the legal ranking of creditors. In contrast, in a lease agreement, the lessor retains ownership of the leased asset and therefore a liquidator has no control of the asset if a company goes into liquidation. However, this assumes that the asset has not been damaged, lost or misappropriated by the company.

• Another advantage of leasing is that it may be administratively cheaper than providing a loan to a client. This is most likely to be the case where the amount involved is relatively small. The cost of the appropriate credit assessment of the potential client may not be justified by the small size of the loan. For the reasons outlined earlier, the resources devoted to credit risk assessment for a lease need not be as great as for a loan.

Leasing is an attractive alternative source of asset funding for both the business sector and the government sector.

10.5.1

Operating lease a short-term lease; the asset may be leased many times; asset maintained and insured by lessor

Types of leases

The complexity and sophistication of lease arrangements has increased as market participants seek to gain a competitive advantage and try to maximise the financial benefits that may be gained by both the lessor and the lessee. Four common leasing arrangements are described below.

Operating lease An operating lease is essentially a short-term arrangement where the lessor may lease the same asset to successive lessees over time in order to earn a return on the asset. For example, operating leases

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are often used for construction equipment such as a bulldozer or a back-hoe. The lessor will lease the bulldozer or back-hoe to a number of different contractors (lessees) over a period of years. A contractor may use the asset for several months to construct a road. The asset is then returned to the lessor who will then lease the asset to another contractor. Operating leases are often used to supply office equipment, computer systems, manufacturing equipment and vehicles to both businesses and governments. In making a decision to use an operating lease, a company will consider the following:

• An operating lease is a full-service lease, which means that the maintenance and insurance of the leased asset is the responsibility of the lessor (owner). • A lease arrangement normally contains only minor penalties for cancellation of the lease. • A company is able to lease an asset for a short-term project. For example, a company may need to lease an industrial cleaner for a month to carry out annual maintenance on a factory floor. • The risk of obsolescence of an asset remains with the lessor. For example, a company may lease a

Full-service lease the lessor is responsible for the insurance and maintenance of the leased asset

computer system for 12 months. At the end of that period the old computer system is returned to the lessor and the company can enter into a new lease for a new computer system.

Finance lease A finance lease is generally a longer-term arrangement between the lessor and the lessee, with the lessor earning a return on the asset from the one lease contract. The lessor’s role is essentially one of financing. The lessee contracts to make regular lease rental payments, usually monthly, over the period of the lease, which may be for more than two years. A distinguishing characteristic of the finance lease is that the lessee contracts to make a lump-sum payment, representing the residual value of the asset, at the end of the lease period. The lessee may well discharge this obligation by making up any shortfall after the lessor has sold the asset to another party. A finance lease is usually a net lease, as opposed to the full-service lease that is common in operating leases. Under a net lease arrangement, the costs of ownership and operation of the asset are the responsibility of the lessee. These costs include maintenance and repairs, insurance and other costs associated with the lease. Given that the sale value of the asset at the end of the lease will be used to offset the residual amount payable, there is a strong incentive for the lessee to maintain the asset in good condition. A garbage collection company may enter into a finance lease for the provision of a fleet of garbage trucks. Under the lease contract the company will agree to pay monthly lease payments, plus a specified residual lump-sum payment at the end of the lease agreement in, say, three years. The company will be responsible for servicing and maintaining the fleet of trucks. At the end of the lease, the company will pay the agreed residual amount and obtain legal title to the trucks. The company then decides whether to retain and continue to use the trucks or to sell them and enter into a new lease contract.

Finance lease long-term net lease; upon final payment of a specified residual amount, ownership of the asset passes to the lessee

Net lease the lessee is responsible for the insurance and maintenance of the leased asset

Sale and lease-back A sale and lease-back arrangement involves the sale of an asset by its original owner. The original owner, at the same time, enters into an agreement with the new owner to lease back the asset for an agreed period. This type of lease is most common in the area of commercial property, railway rolling stock and government car fleets. For example, a government may have previously built railway systems throughout the country. Part of that system included all the railway stock, that is, the railway engines, carriages and cargo trucks. Rather than continuing to finance the railway stock from its own balance sheet, the government may sell the railway stock through a sale and lease-back arrangement. This strategy removes an expensive asset class from the government’s balance sheet, but ensures that the railway system continues to operate. The lease payments will be financed from the income derived from the use of the railway stock.

Sale and lease-back arrangement asset is sold to a lessor on condition it is leased back to the previous owner

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Cross-border lease Cross-border lease a lessor in one country leases an asset to a lessee in another country

Globalisation of the financial markets extends to the lease markets. The cross-border lease is becoming increasingly apparent within the international markets. In most developed financial markets there are few constraints to leasing cross-border. Under a cross-border or offshore lease, a lessor in one country leases an asset to a lessee in another country. In such a lease arrangement, it is necessary to consider additional factors before entering into a lease contract. These include:

• the arrangements that are in place to recover an asset if the lessee should default on the agreement • the measurement and management of foreign exchange risk; that is, cash flows will need to be converted into another currency at the current exchange rate • the legal jurisdiction that will apply if legal action needs to be taken under the terms of the lease. 10.5.2

Lease structures

Our understanding of finance leases (discussed above) can be extended further with an examination of two different lease structures: 1 a direct finance lease 2 a leveraged finance lease.

Direct finance lease Direct finance lease a lessor purchases an asset and leases the asset directly to a lessee

Leasing guarantee an agreement by a third party to meet commitments of the lessee in the event of default

Leveraged finance lease lessor partnership borrows a substantial portion of funds required to buy an asset for leasing

With a direct finance lease the lessor—such as a finance company, a commercial bank, a merchant bank or a specialist leasing company—purchases an asset with its own funds and leases it to the lessee. The lease period is negotiated between the two parties, and payments may be required monthly, quarterly or less frequently, depending on the cash-flow pattern of the lessee. Monthly payments remain the most common. Where the monthly payments are of equal value, their calculation is based on the annuity stream that has a present value equal to the value of the asset being leased. Annuities and their calculation are discussed in Chapter 8. The lease contract contains details of the asset being leased and the terms of the transaction, including the lease rental payments and the residual value of the asset at the end of the contract. The lessor retains legal ownership of the asset and, in the event of default by the lessee, will take control or possession of the physical asset. The lease agreement serves as the lessor’s security in the leasing relationship. The security for the lessor may be further supported by a leasing guarantee provided by a financial institution, personal guarantees from the directors of the lessee company or a mortgage over property held by the lessee company.

Leveraged finance lease A leveraged finance lease is a lease arrangement in which the lessor borrows a large proportion of the funds necessary for the acquisition of the asset that is to be leased. A leveraged leasing arrangement is typically a multi-million-dollar transaction. The lease arrangement may run for up to 15 years. Given the size and terms available, this form of leasing is particularly suitable for the acquisition and leasing of big-ticket items such as ships and aircraft, and some governments have used this type of financing to fund power station developments. The lessor will often consist of at least two companies that have formed a partnership expressly to structure the leveraged lease. Most frequently, the lessor partnership involves banks and finance companies. The lessor partnership purchases the asset and leases it to the lessee. The partnership may contribute as little as 15.00 to 20.00 per cent of the purchase price from its own funds, and borrows the balance from institutional lenders (the debt parties). Since the lease rental payments may be sufficient

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only to meet the repayments on the borrowed funds, the lessors generally rely on tax deductions from the depreciation of the equipment and from the interest paid to the debt parties to earn their return. Since leveraged leasing can be quite complex and may involve quite a few parties to the arrangement, it is common for the arrangements to be handled by a lease manager. The lease manager structures, negotiates and places the lease transaction, and manages the transaction for the life of the lease.

Lease manager the arranger and ongoing manager of a leveraged lease that brings together the lessor, debt parties and the lessee

Reflection points

lease is a contract whereby the owner of an asset (the lessor) allows another party (the • Alessee) to use that asset for an agreed period in return for lease payments. Major providers of lease finance are banks and finance companies. of lease financing are that it does not use up lines of credit, it provides 100.00 per • Advantages cent financing, payments can be matched with revenue generation, payments are generally tax deductible, it may not breach existing loan covenants and assets can be leased for the actual periods they are needed. operating lease is a full-service lease where an asset is leased for a relatively short period, • An then returned to the lessor. The lessor maintains and insures the asset and leases it again and again. lease is a long-term net lease where an asset is leased once. The lessee maintains • Aandfinance insures the asset and makes periodic lease payments. The lessee is required to make a lump-sum residual payment at the completion of the lease contract. and lease-back occurs when the original owner of an asset sells the asset and then enters • Sale into an arrangement to lease back the asset. cross-border lease occurs when parties to a lease extend into another country; it involves • Aforeign exchange risk. direct finance lease involves two parties, the lessor and the lessee. The lessor retains • Aownership of the asset and may also seek additional guarantees to support the lease contract. finance lease is an arrangement whereby the lessor borrows to fund the purchase • Aofleveraged an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease manager will be responsible for the management of the contract.

CASE STUDY THE KANGAROO BONDS AND BLOCKCHAIN BOND-I’s Kangaroo bonds or Matilda bonds are Australian dollar-denominated bonds issued by non-Australian issuers after complying with local laws and regulations. They represent the largest share of the Australian domestic bond market after Australian Government Securities (AGS) and semi-government securities (semis) (Bergmann & Nitschke, 2018). The bond issuers are major banks and financial institutions of high credit quality who participate in the Australian foreign exchange and derivative markets. The experience of these firms in the Australian bond market also helps other countries develop their domestic bond markets (Batten, Hogan & Szilagyi, 2008). A company normally enters a foreign market to gain access to better interest rates. Kangaroo bonds are normally issued when interest rates in Australia are low relative to the domestic rate of the foreign corporation. This will help to lower the interest expense and cost of borrowing for the issuer. These bonds, which are denominated in the local currency, form an attractive investment opportunity for 337

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investors who wish to diversify their portfolios past their local borders. In effect, they offer opportunities to invest in foreign companies without having to manage the effects of currency exchange fluctuations (‘Kangaroo Bond’, 2018). The Kangaroo bond market is undergoing a transformation with the advent of bond-i by Commonwealth Bank of Australia. CBA has taken steps to develop the world’s first blockchain bond with the support of Northern Trust, QBE and Treasury Corporation of Victoria. Once launched, the bond will operate on the blockchain platform maintained by World Bank and CBA in Washington and Sydney (Rivera, 2018). Given the potential of this technology to simplify processes for raising capital, improve operational efficiency and enhance regulatory oversight, this initiative is predicted to be a positive development for bond markets. Reference list Batten, J, Hogan, W & Szilagyi, P 2008, ‘Kangaroo bond issuance in Australia’, The Finsia Journal of Applied Finance, Special Issue, retrieved from http://www.finsia.com/docs/default-source/jassa-new/ jassa-2008/batten_jassa_special-iss_web08.pdf?sfvrsn=76d9de93_6 Bergmann, M & Nitschke, A 2016, ‘The Kangaroo bond market’, Bulletin, September Quarter, Reserve Bank of Australia, retrieved from http://www.rba.gov.au/publications/bulletin/2016/sep/pdf/rba-bulletin2016-09-the-kangaroo-bond-market.pdf Rivera, K 2018, ‘World Bank taps CBA to issue world’s first blockchain bond’, your investment property, 14 August, retrieved from http://www.yourinvestmentpropertymag.com.au/news/world-bank-taps-cbato-issue-worlds-first-blockchain-bond-253635.aspx ‘Kangaroo Bond’ 2018, Investopedia, retrieved from http://www.investopedia.com/terms/k/kangaroo_ bonds.asp

Discussion points

• •

Discuss the opportunities presented by the Kangaroo bond market. Do you think the development of blockchain technology and the introduction of bond-i could change the bond market for good?

Master before you move on LEARNING OBJECTIVE 10.1 Explain term loans and fully drawn advances, including their structure, loan covenants and the calculation of a loan instalment. financial system provides corporations with a wide range of medium- to long-term loan and • The debt facilities. These facilities allow a corporation to diversify its funding sources and match its cash-flow requirements.

sources of medium- to long-term debt may be intermediated finance provided by financial • The institutions or direct finance obtained from either the domestic or the international capital markets. common form of intermediated debt is the term loan or fully drawn advance. The main • Aproviders of term loans are the commercial banks. However, investment banks, finance companies, insurance offices and credit unions also provide term loans to the business sector.

• Term loans are provided to fund a specific purpose or project for a fixed period of time. 338

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instalment only comprises the interest due on the full loan amount) or deferred (repayment is deferred for a period until the business project generates positive cash flows).

normal practice is to price a variable-rate loan at a margin above a reference interest rate. • The The margin will reflect the level of credit risk of the borrower. the term of a variable-rate loan, the interest rate will be periodically reset in relation to • During changes in the specified reference rate, such as LIBOR, BBSW or the bank’s own prime rate. bank bill swap rate (BBSW) is the mid-point of prime banks’ bid and offer rates for eligible • The securities in the CD and BAB secondary markets and is published by the AFMA. ThomsonReuters publishes LIBOR daily.

range of fees may also apply, including an establishment fee, a periodic service fee, a • Acommitment fee or a line fee. that a lender will consider when determining an interest rate and the margin include the • Issues credit risk of the borrower, the term of the loan and the loan repayment schedule. loan contract may include a range of loan covenants to protect the lender. They include positive • Acovenants, which state actions that must be taken by a borrower (e.g. provision of financial

CHAPTER TEN REVIEW

repayment structure of a term loan may be amortised (each periodic instalment incorporates • The an interest component and also a principal repayment component), interest only (each periodic

statements), and negative covenants, which limit the actions of a borrower (e.g. minimum debtto-equity ratio).

formula used to calculate the instalment on a term loan (when payments occur at the end of • The each period) is: A  ​R = ___________ ​      ​​ ( 1 − ​​ 1 ​​   + i​)​​​​  −n​ ​[​​ ​ _________  ​   ​  ]​​ i

LEARNING OBJECTIVE 10.2 Describe the nature, purpose and operation of mortgage finance and the mortgage market, and calculate an instalment on a mortgage loan. finance is a term loan with a specific type of security attached, being a mortgage • Mortgage registered over land and the property thereon. The borrower (mortgagor) conveys an interest in the land to the lender (mortgagee).

a borrower defaults on loan repayments, the lender has the right of foreclosure, whereby the • Iflender will take possession of the land and sell it to recover the amounts outstanding. mortgage market is very large and includes both residential mortgage loans and commercial • The mortgage loans. further protection for the lender may be a loan condition that requires the borrower to take out • Amortgage insurance. This is normally required where the loan-to-valuation ratio is above 80 per cent.

• The formula to calculate the instalment on a mortgage loan is: A  ​R = ___________ ​      ​​ ( 1 − ​​ 1 ​​   + i )​​​​​  −n​ ​[​​ ​ _________     ​   ​]​​ i mortgage lenders use a process of securitisation to finance continued growth in their • Some mortgage lending. The lender sells a parcel of existing loans to a trustee of a special-purpose vehicle. The trustee funds this purchase by issuing new securities such as bonds into the capital markets. The cash flows due on the mortgage loans held by the special-purpose vehicle are used to pay interest and principal commitments due on the bonds. 339

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LEARNING OBJECTIVE 10.3 Discuss the bond market, in particular the structure and issue of debentures, unsecured notes and subordinated debt. corporate bond is a long-term debt security that pays specified periodic interest payments • A(coupons) for the term of the bond and the principal is repaid at maturity. bond issuers require a good credit rating issued by a credit rating agency to be able • Corporate to issue securities direct into the capital markets. • Debentures and unsecured notes are corporate bonds. debenture is a corporate bond with security attached. The security is a charge over the • Aunpledged assets of the borrower. This will include a fixed charge over permanent assets and a floating charge over other assets such as stock that pass through the business. If the borrower defaults, the floating charge is said to crystallise and become a fixed charge; the borrower will then take possession of the assets.

covered bond is a bond issued by a commercial bank that is supported by a claim over • Amortgage securities held by the bank. • An unsecured note is a corporate bond with no security attached. bonds may be offered as public issues, family issues or private placement. Bonds are • Corporate typically sold at face value; however, issues may include discounted, deep discounted, zerocoupon and deferred-interest debentures.

public issue of bonds requires a prospectus that provides detailed information on the • Aissuer corporation, the purpose of the funding, company financial statements and projections, management profiles, expert reports and other material information.

debt also pays a specific interest stream, but the claims of subordinated debt • Subordinated holders are ranked behind all other creditors, but before equity.

LEARNING OBJECTIVE 10.4 Calculate the price of a fixed-interest bond. price of a bond is the present value of the future cash flows, being the present value of the • The periodic coupons and the present value of the principal payable at maturity. is an inverse relationship between the price of an existing bond and current interest rates • There in the market. For example, if current yields (interest rates) rise, then the price of existing bonds will fall.

• A formula used to calculate the price of a bond at a periodic coupon date is: 1 − ​(1  + i )​​  −n​ −n ​P = C​​[_    ​​​    ​​  ]​​​ + A​(1  + i )​​  ​​ i majority of bonds are sold between coupon dates; therefore, the above formula is adjusted • The by (1 + i) , where k is the number of elapsed days since the last coupon payment, expressed as k

a fraction of the coupon period. Therefore, the formula is: 1 − ​(1  + i )​​  −n​ ​P = { ​​ ​​C​​[_    ​​​      ​​]​​​  + A​(1  + i )​​  −n​​}​​​​(1  + i )​​  k​​ i

LEARNING OBJECTIVE 10.5 Explain lease financing, including types of lease arrangements and lease structures. is a contract whereby the owner of an asset (the lessor) allows another party (the lessee) • Atolease use that asset for an agreed period in return for lease payments. Major providers of lease finance are banks and finance companies. 340

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Chapter 10  Medium- to long-term debt

tax deductible, it may not breach existing loan covenants and assets can be leased for the actual periods they are needed.

operating lease is a full-service lease where an asset is leased for a relatively short period • An and then returned to the lessor. The lessor maintains and insures the asset and leases it again and again.

lease is a long-term net lease where an asset is leased once. The lessee maintains • Aandfinance insures the asset and makes periodic lease payments. The lessee is required to make a lump-sum residual payment at the completion of the lease contract.

and lease-back occurs when the original owner of an asset sells the asset and then enters • Sale into an arrangement to lease back the asset. cross-border lease occurs when parties to a lease extend into another country; it involves • Aforeign exchange risk. direct finance lease involves two parties, the lessor and the lessee. The lessor retains • Aownership of the asset and may also seek additional guarantees to support the lease contract. finance lease is an arrangement whereby the lessor borrows to fund the purchase • Aof leveraged an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such

CHAPTER TEN REVIEW

advantages of lease financing are that it does not use up lines of credit, it provides 100.00 • The per cent financing, payments can be matched with revenue generation, payments are generally

as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease manager will be responsible for the management of the contract.

Extended learning LEARNING OBJECTIVE 10.6 Understand the detailed process of financial asset securitisation. Securitisation Financial institutions and corporations accumulate financial assets and other entitlements, such as accounts receivable, mortgage-backed housing loans, credit card receivables and utility rates, which generate future cash flows over time. There are no secondary markets which specifically trade in individual assets such as these, so the process of securitisation has evolved to allow the sale of these types of non-liquid financial assets that have specified future cash flows associated with them. For example, housing loans have future cash flows attached in the form of periodic interest payments and principal repayment. Securitisation is a form of financing in which the cash flows associated with existing financial assets are used to service funding raised through the issue of asset-backed securities. For example, the securitisation of mortgage loans involves the bundling together of a group of mortgage loans with similar characteristics, such as term to maturity. The loan originator (e.g. bank) then sells the bundle of mortgage loans to the trustee of a special-purpose vehicle (SPV). In order to be able to pay for the purchase of the mortgage assets from the loan originator, the trustee of the SPV raises the funds by issuing new securities to investors, particularly institutional investors. Institutional investors are attracted to this type of investment because, in theory, the level of risk is relatively low because the securities issued by the SPV trustee are supported by the cash flows and mortgages associated with the loans purchased from the originator. As the owner of the mortgage loans, the trustee receives the future loan instalments paid by the housing loan borrowers. The trustee uses these future cash flows to pay interest on the new securities issued to institutional investors and repays those securities on maturity. The diagrammatic representation of the securitisation process is shown in Figure 10A.1, and may be summarised as follows:

assets (e.g. housing mortgage loans) accumulate and are funded on the balance sheet • Financial by a loan originator, such as a commercial bank. 341

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Figure 10A.1  Typical securitisation process (Trustee) Financial intermediary

Assets (e.g. loans)

Special-purpose vehicle

Issue Asset-backed securities

Investors

Credit enhancer

Cash flows (loan repayments—periodic)

Service manager

Cash flow (asset-backed securities interest and principal repayments)

with comparable maturity and risk structures (including interest rate, liquidity and credit • Assets risks) are pooled together and sold into a SPV controlled by a trustee. The assets have now moved from the balance sheet of the loan originator to that of the SPV.

trustee issues new negotiable securities to investors. In doing this, the trustee is able to • The raise the necessary funds to finance the purchase of the loan assets transferred into the SPV. new negotiable securities are attractive to investors because they are supported by the • The mortgage-backed assets held by the trustee, and by the associated future cash flows, which are the periodic interest and principal repayments due from the original housing loan borrowers.

improve the marketability of the new issue of securities, the SPV trustee may arrange for • To a AAA credit enhancement of the securities issued. This will be supported by a credit rating issued by a credit rating agency.

service or administration manager will be appointed by the SPV trustee to manage the • Aassociated cash flows. These cash flows are the receipts from repayments due from the original Custodial services an arrangement whereby securities are held for safekeeping

borrowers, and the payment of interest and principal due on the asset-backed securities issued by the trustee to investors. The service manager may also provide custodial services for the underlying securities. Often the SPV trustee may outsource these roles back to the initial loan originator, particularly if the originator is a commercial bank. The service manager is paid a fee.

cash flows are received from the original assets, they are used by the trustee to repay interest • As and principal due on the asset-backed securities issued to investors.

The securities issued by the SPV in a mortgage asset-backed securitisation program may be of two types: bullet maturity mortgage bonds or principal pass-through mortgage bonds. Bullet maturity mortgage bonds have a payment stream composed of regular interest payments, with the principal being redeemed as a lump sum at maturity. Principal pass-through mortgage bonds have as part of their regular income stream some repayment of principal; that is, the income stream more closely mimics the payments associated with the underlying credit foncier structure of the mortgage loan. Bonds are often accompanied by so-called financial enhancements in order to improve their credit rating. Since the payments on the underlying mortgage loans may involve early or late payments, it is common for the SPV trustee to arrange a stand-by facility in order to guarantee its ability to meet the obligations to the bond holders on time. Mortgage-backed bond issues represent the largest type of security issued by SPVs in the securitisation process; however, other short-term and medium- to long-term paper is also issued. This includes commercial paper, medium-term notes and floating rate notes, which provide investors with a choice of investment alternatives and often allow a better match of the cash-flow characteristics of the underlying securities, such as lease receivables or accounts receivable. 342

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CHAPTER TEN REVIEW

Securitisation can be used as a form of finance that allows business operations to expand without actually having to grow the asset side of the balance sheet and the capital that would otherwise be required to support it. Characteristics that support the use of securitisation include: return on • Increased shareholders’ funds.

equity. Business growth is increased without the need to dilute

of finance. Other traditional sources of intermediated and debt finance may not be • Source available. return on assets. Through the securitisation process, assets with lower credit ratings • Improved are upgraded with credit enhancement.

• Diversification of funding sources. Asset-backed securities often attract a new range of investors. credit exposure. The sale of assets may transfer the credit risk associated with the • Reduced pooled assets to the SPV and ultimate investors. advantage. Banks in particular are required to maintain minimum capital requirements • Regulatory based, in part, on their balance-sheet assets. Securitisation, where there is no recourse back to the bank, removes assets from the balance sheet and lowers the capital cost imposition. balance-sheet liquidity. Assets that previously were non-liquid and remained on the • Increased balance sheet are converted to cash. asset concentration. For example, banks tend to provide a large proportion of their • Reduced asset portfolio in mortgage finance. Securitisation allows a bank to divest itself of some of these assets and to give new mortgage finance without increasing its overall mortgage asset concentration. income. By divesting assets through securitisation, an institution effectively brings • Accelerated forward returns that would otherwise have occurred over time. financial ratios. Return on investment and return on equity may be improved through • Improved the process of securitisation. There are a number of alternatives available to a loan originator and a SPV trustee to enhance the credit rating of the underlying assets. These include a combination of the following: The asset-backed debt issued by the SPV trustee may be of different classes, • Subordination. ranging from senior issues to junior issues. Payment of interest and principal entitlements would be in that order, which means that the senior debt would be protected by the subordinated junior debt issue. When the asset pool is created, the loan originator will determine the • Over-collateralisation. historic credit performance of that type of security, that is, the level of past loan default. If the default rate is calculated at 5.00 per cent, the loan originator may be required to contribute 105.00 per cent of assets to the SPV pool. Alternatively, ultimate investors may purchase only a given percentage of the pool. For example, in some securitisation structures, investors purchase securities representing between 85.00 and 90.00 per cent of the underlying asset pool.

• Insurance of the underlying credit assets. This covers a specified level of loan default. guarantees. These may be provided by the SPV trustee to support the issue. The • Financial originating bank may provide a financial guarantee under a separate off-balance-sheet transaction. of credit. A stand-by finance facility may be provided by a bank to support possible credit • Letters losses experienced by the SPV. Credit enhancement increases the marketability of the asset-backed securities issued by the trustee and also lowers the yield, or cost of borrowing, for the issuer. A number of the parties to the securitisation process earn fees, including the SPV trustee, the service manager, the credit enhancer, the credit rating agency and the loan originator.

Credit enhancement a financial arrangement such as a letter of credit that supports an underlying security issue

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As mentioned previously in the text, the collapse of the US and UK housing markets has had a significant adverse impact on the securitisation market. Securitised assets that were previously regarded as low risk are no longer so. Therefore, those limited numbers of institutions that are still able to issue securitised asset-backed securities have been required to pay a much higher risk premium. Continued uncertainty within the major global financial markets has constrained the growth of the securitisation markets, but it still remains an important strategic funding option for financial institutions.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Reference interest rates apply in variable-rate loan agreements. What is a reference interest rate and what is its role in a variable-rate loan contract? (LO 10.1)

2

One of the National Bank’s commercial lending managers has a meeting scheduled with a business client. The purpose of the meeting is to review the structure of the loans provided by the bank. The business client operates in the mining sector and is very concerned at the possibility of a significant slowdown in the sector. The client wishes to discuss the relationship of its longer-term debt commitments and the forecast future cash flows being generated by the business.

(a) Within the context of the forecast slowdown in the mining sector, why is the client concerned about the timing of cash flows?

(b) Discuss the different longer-term loan repayment structures that National Bank may be able to offer the business client. (LO 10.1)

3

In a variable-rate loan contract, how does a commercial bank allow for higher or lower credit risk on the part of the prospective borrowers? (LO 10.1)

4

As the finance manager of a small manufacturing business, you are negotiating a fully drawn advance from the local bank, but the board of directors has indicated concern at the fees being charged by the bank. Explain to the directors the range of fees typically charged, and why the bank charges these fees. (LO 10.1)

5

Westpac Banking Corporation is currently writing a loan contract for a medium-sized pharmaceutical company. Within the loan contract Westpac intends to incorporate a number of positive and negative loan covenants.

(a) What are loan covenants?

(b) Explain why a financial institution would incorporate loan covenants into a loan contract.



(c) Discuss the nature of positive and negative covenants and give two examples of each. (LO 10.1)

6

As the owner of a small architectural firm, you approach the Commonwealth Bank to obtain a term loan so that the firm can buy a new computer-aided drawing machine. The bank offers your company a loan of $28 500 over a three-year period at a rate of interest of 8.65 per cent per annum, payable at the end of each month. Calculate the monthly loan instalment. (LO 10.1)

7

The architectural firm owner in Question 6 also approaches the National Australia Bank to obtain a quote on the loan facility. The competitor bank (NAB) also offers the company a fully drawn advance of $28 500 over a three-year period at a rate of interest of 8.65 per cent per annum, but payable in advance at the beginning of each month. Calculate the monthly loan instalment. Explain why the instalment payment is different from the instalment in Question 6. (LO 10.1)

8

Mr and Mrs Simcox have recently married and are in the process of purchasing their first home. They have lodged an application with the Commonwealth Bank for a housing loan. The bank

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9

After three years of excellent business growth, a local mattress manufacturer decides to expand and purchase new business premises costing $1 250 000. In addition, establishment expenses of 0.50 per cent of the purchase price, plus estimated legal expenses of $15 000 are payable. The total cost to purchase the property will be financed by $225 000 of the firm’s own funds plus a mortgage loan from ANZ Bank. The bank offers a mortgage loan at 8.15 per cent per annum. The loan will be amortised by monthly instalments over the next 12 years, payable at the end of each month. What is the amount of each monthly instalment? (LO 10.2)

10 BHP Billiton Limited is listed on the ASX and is expanding its business operations into China. In order to expand, the company will need to raise additional funds through the issue of corporate bonds direct to the capital markets. Two securities that are often issued into the corporate bond market are debentures and unsecured notes. (a) Discuss the structure and attributes of each of these securities.

(b) Within the context of a bond issued by a corporation, discuss the nature of a fixed and floating charge.



(c) Explain which types of borrowers will have access to funds through the issue of debentures and unsecured notes into the capital markets. (LO 10.3)

CHAPTER TEN REVIEW

has offered them a mortgage loan. Outline the main features of a mortgage loan. In particular, define a mortgage, explain the purpose and operation of a mortgage loan and identify and describe the parties to a mortgage loan. (LO 10.2)

11 The major global financial markets each have an active corporate bond market. These corporate bond markets are a significant source of funds for corporations raising finance direct from the capital markets. (a) Describe the structure and operation of the corporate bond markets. In your answer explain why corporations seek to raise debt funds direct from the markets, why investors provide debt funds directly to the capital markets and who are the main providers of direct finance in the capital markets.

(b) Commercial banks also issue bonds into the capital markets. Some of these bonds may be described as covered bonds. What are covered bonds issued by commercial banks? (LO 10.3)

12 Minnow Limited is a subsidiary of a large multinational organisation that has a BBB credit rating issued by Standard & Poor’s credit rating agency. Minnow Limited plans to issue debentures to raise additional funds to finance further growth within the company. The investment bank advising the company on the debenture issue has informed the company that it could issue the debentures through a public issue, a family issue or a private placement. (a) Explain each of the three issue methods; that is, public issue, family issue and private placement.

(b) Briefly discuss the prospectus and information memorandum requirements that will be required with each type of issue. (LO 10.3)

13 Woodside Petroleum Limited has issued $100 million of debentures, with a fixed-interest coupon equal to current interest rates of 7.70 per cent per annum, coupons paid half-yearly and a maturity of 10 years. (a) What amount will Woodside raise on the initial issue of the debentures?

(b) After three years, yields on identical types of securities have risen to 8.75 per cent per annum. The existing debentures now have exactly seven years to maturity. What is the value, or price, of the existing debentures in the secondary market?



(c) Discuss why the value of the debenture has changed; that is, explain the bond price/yield relationship using the above example. (LO 10.4)

14 On 1 January 2019 a company issued five-year fixed-interest bonds with a face value of $2 million to an institutional investor, paying half-yearly coupons at 8.36 per cent per annum. Coupons are payable on 30 June and 31 December each year until maturity. On 15 August 2020

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the holder of the bonds sells at a current yield of 8.84 per cent per annum. Calculate the price at which the institutional investor sold the bonds. (LO 10.4) 15 At GE Finance you are the manager of lease finance. You have begun to talk to local companies to try and sell the concept of lease finance for their businesses. (a) Explain to the companies the nature of lease finance, and distinguish between operating leases, finance leases, sale and lease-back leases, and cross-border leases.

(b) Provide examples of how a business might use each of these forms of lease arrangement.



(c) List and explain the advantages of lease finance to a business.



(d) From the perspective of a lessor, explain the structure of a direct finance lease versus a leveraged finance lease contract. (LO 10.5)

Extended learning questions 16 (a) Explain why the process of securitisation has grown into a major financial market.

(b) Draw a diagram that shows the basic securitisation structure and its associated cash flows.



(c) Using your diagram (above), explain in detail the securitisation process and the different cash flows that will occur. (LO 10.6)

17 Describe the trends in securitisation over the past 15 years. (LO 10.6)

KEY TERMS amortised loan  317

fixed interest rate  318

mortgagor 322

commitment fee  319

floating charge  327

negative covenants  320

corporate bond  327

full-service lease  335

net lease  335

corporate bond market  326

fully drawn advance  317

operating lease  334

covered bonds  325

green bonds  326

positive covenants  320

credit enhancement  343

information memorandum  328

quasi-equity 329

credit foncier loan  317

interest capitalised  334

right of foreclosure  323

credit rating agency  326

interest cover  319

cross-border lease  336

lease manager  337

sale and lease-back arrangement 335

crowding-out effect  327

leasing guarantee  336

semis 325

crystallise 327

lessee 333

service fee  319

custodial services  342

lessor 333

debenture trust deed  328

leveraged finance lease 336

special-purpose vehicle (SPV) 324

deferred repayment loan 318

subordinated debt  329

line fee  319

term loan  317

direct finance lease  336

lines of credit  334

unpledged assets  327

finance lease  335

mortgagee 323

variable interest rate  318

fixed charge  327

mortgage insurance  323

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CHAPTER 11

International debt markets CHAPTER OUTLINE 11.1 The euromarkets 11.2 Eurocurrency market 11.3 Euronote market 11.4 Eurobond market 11.5 Markets in the USA 11.6 Credit rating agencies

Learning objectives LO 11.1

Explain the origins and the continued existence of the euromarkets.

LO 11.2

Describe the eurocurrency market, in particular short-term bank advances, stand-by facilities and longer-term syndicated bank loans.

LO 11.3

Identify the types, structure, issuance and the price calculation of discount securities offered in the euronote markets, including euronote issuance facilities (NIF) and eurocommercial paper (ECP).

LO 11.4

Identify the structure and features, and carry out calculations, for the main securities issued into the eurobond market, that is, medium-term notes, straight bonds and floating rate notes.

LO 11.5

Consider the operation of the US money and capital markets and the structure of US commercial paper, US foreign bonds and American depositary receipts.

LO 11.6

Recognise the important roles and functions of credit rating agencies and explain the credit rating process.

Extended learning LO 11.7

Describe novation, subparticipation and transferable loan certificates.

LO 11.8

Explain the purpose, structure and advantages of convertible bonds and warrants.

LO 11.9

Identify the main features of a US medium-term note issue.

LO 11.10 Define the long-term and short-term credit ratings issued by Standard & Poor’s credit rating agency.

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Part 3 The corporate debt market

CHAPTER SNAPSHOT In a globalised world, investors, traders, companies and institutions are not restricted by geographical boundaries. If it is cheaper to borrow money offshore, this will be the path the borrower seeks to take. To meet this demand, various instruments and markets have been developed. The so-called euromarkets, which do not have anything to do with Europe but refer to the market for transactions in US dollars but outside of the USA, provide vast pools of capital to be accessed by companies, institutions and governments. It sounds complicated but the underlying principles of finance and economics remain the same. The interest rates that prevail there reflect the risk–reward trade-off and the supply and demand of funds.

INTRODUCTION The international debt markets are where foreign bonds are traded. If an Australian bank or corporation wants to raise capital to lend to its customers, it might do so using either the domestic debt market or the international debt market. If it uses the domestic debt market, the bank issues bonds within Australia denominated in Australian dollars. If it uses the international debt market, the bank issues bonds outside of Australia denominated in a foreign currency (e.g. US dollars). The wholesale debt markets, both domestic and international, are an important source of funding for Australian banks. In the first four months of 2018, Australian banks issued approximately $50 billion of bonds into the wholesale debt markets (both domestic and international). The relative share of international bond issuance to domestic bond issuance is a ratio of 70-to-30. That is, 70.00 per cent of bonds issued by Australian banks are issued in the international debt markets. According to reports in the Australian Financial Review, in January 2018, the ANZ bank issued $3 billion of short-term (three- and five-year) bonds in the domestic Australian debt market. At the same time, the National Australia Bank and Commonwealth Bank issued a combined $US3.75 billion of shortterm bonds in the US debt market while Westpac raised almost 2 billion euros in the eurozone. In 2018, Australian banks had approximately $400 billion of bonds on issue in international wholesale debt markets. The importance of the wholesale debt markets to Australian financial institutions, while obviously significant, has changed in recent years. Banks now rely much more heavily on deposits than they did prior to the credit crisis that accompanied the GFC. At the beginning of 2018, banks sourced more than 60.00 per cent of their funding for loans from deposits (up from around 40.00 per cent prior to the GFC). Consequently, issuance of short- or long-term debt in domestic and international debt markets by Australian financial institutions has fallen considerably. The decline in Australian financial institutions’ participation in the international debt markets is reflected most starkly by the change in the composition of capital inflows and outflows in Australia. Prior to the GFC, debt issued by ADIs accounted for around 5.00 per cent of capital inflows each year into the Australian economy. Since the GFC, this has declined to less than 1.00 per cent. According to the Reserve Bank of Australia, this is due to an increase in savings by the mining sector without corresponding investment. This significantly reduced the role of Australian banks as key intermediaries of capital inflows into Australia. Investors are attracted to the international debt markets because they provide deep and liquid markets while at the same time offering an opportunity to seek higher investment returns and greater portfolio diversification. Under normal circumstances, borrowers with a strong financial reputation and a very good credit rating are able to access funds from the international debt markets with relative ease, and to raise large amounts of funding that might not be available in their domestic financial markets. This chapter examines two of the major international debt markets: 1 the euromarkets, comprising the eurocurrency, the euronote and the eurobond markets 2 the US debt markets, including the commercial paper market, the medium-term paper market and the bond market. 348

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Chapter 11  International debt markets

As well as the euromarkets and the US markets, access to international funding is available within most of the major global financial centres, including London, Frankfurt and Paris in Europe and Hong Kong, Japan and Singapore in Asia. Of particular relevance to the operation of the international debt markets is the European Monetary Union (EMU). With the convergence of the currencies of EMU member countries, a new currency—the euro—has emerged. Debt securities denominated in euros have grown as the predictability, liquidity and volatility of the currency consolidates. This market is now often referred to as the eurozone and has developed as another major capital market within the international capital markets. The EMU is discussed in detail in Chapter 15. One confusing issue resulting from the creation of the euro, the eurozone and the issue of eurodenominated debt securities is the similar terminology used for so-called euromarket transactions. The euro is a currency in which debt securities may be denominated. The eurozone is the domestic market for member countries that have adopted the euro as their currency unit. Euromarket transactions are financial transactions carried out in a foreign country, but the transaction is not denominated in the currency of that country. For example, a New Zealand company issues bonds into Hong Kong that are denominated in USD. You will note that this example does not include the euro as the currency of the bonds, nor does the bond issue occur within Europe or the European Union. Nevertheless, it is a so-called euromarket transaction.

REFLECTION POINTS

• • •

Deregulation of financial systems, including the floating of major currency exchange rates, has created an environment in which the international debt markets have expanded. Financial institutions, particularly the major commercial banks, are the largest borrowers (issuers of paper) in the international debt markets. Borrowers with very good credit ratings are able to raise funds in many countries around the world, including in the euromarkets and the US capital markets.

11.1

The euromarkets

The euromarkets initially developed to enable financial market participants in a number of countries, including the UK and Russia, to hold US dollars (USD) outside the USA. Although the euromarkets originated in Europe, the prefix euro- means ‘outside’; it does not signify Europe. Therefore, it is a misconception to think that the euromarkets are situated only in Europe; in fact, a euromarket transaction can occur within the financial markets of any nation-state around the world. It is necessary to understand the basic characteristic that differentiates a domestic market transaction from a euromarket transaction. A euromarket transaction is denominated primarily in a currency other than the currency of the country in which a debt issue is made. For example, an Australian company that borrows funds through the issue of bonds into the Singapore market, where the bonds are specified in USD, has conducted a euromarket transaction. Similarly, an Indian company that issues commercial paper into the UK market that is denominated in Japanese yen is conducting a euromarket transaction. The euromarkets are vast money and capital markets, with major centres in London (and, to a lesser extent, other major European financial cities), the Middle East (mainly Bahrain) and Asia (particularly Hong Kong and Singapore). The dominant currency in the euromarkets is the USD; however, all major currencies are issued in the euromarkets.

LEARNING OBJECTIVE 11.1 Explain the origins and the continued existence of the euromarkets.

Euromarket transaction a financial transaction conducted in a foreign country, but not in the currency of that country

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The euromarkets provide intermediated finance and direct finance over a range of terms to maturity. Therefore, the euromarkets are categorised into:

• • • USSR a federation of Russia and a number of surrounding countries, dissolved in 1990

Cold War description of tensions that existed between the superpowers of the USA and the former USSR

the eurocurrency markets, providing intermediated bank finance the euronote markets, providing short-term direct finance the eurobond markets, providing medium- to long-term direct finance.

The initial boost to the supply of USD being held outside the USA was provided by the former USSR, which withdrew its USD deposits from US banks in the early 1950s. In the Cold War environment of that time, the USSR was concerned that funds held on deposit in US banks could have been frozen by the US government. (Such actions have been taken by the US authorities in more recent times, such as the freezing of Iranian assets in 1979 and the assets of Iraq and Kuwait in 1990.) While the USSR wanted to hold the funds outside the jurisdiction of the US authorities, they still wanted to keep them in USD because USD were, and still are, the major currency of international trade and investment. The relocation of USSR funds provided the seeding from which the euromarkets grew. Deposits continued to be attracted into the market. From the 1950s to the 1970s there were periods when the outflow of funds from the USA was regulated by the US government. Corporations, by depositing their funds outside the jurisdiction of the US authorities, could ensure they always had access to their USD funds. The growth of the euromarkets continued even after the removal of most controls on foreign exchange flows into and out of the USA and other major financial centres. The fundamental reason for the euromarkets’ ongoing growth is that the interest rates offered on deposits are generally higher than the interest rates offered on deposits in domestic markets. At the same time, the interest rates charged on euromarket loans in any currency are generally lower than the rates charged on loans available in the country from which the currency originates. Therefore, the growth of euromarket transactions is fundamentally driven by interest rate factors. How can interest rates on euromarket deposits be higher, and those on loans be lower, than the rates on similar deposits and loans issued in the domestic markets? It is possible because the costs faced by banks in their euromarket operations tend to be lower, per dollar of business transacted, than the costs they incur in their domestic or local operations. There are two main reasons: 1 The euromarkets do not deal in small retail market transactions and therefore their administrative and operating costs per dollar deposited are lower than for domestic operations. 2 Similarly, euromarket loans are usually large multi-million-dollar loans and are made to large corporations, financial institutions, governments and government agencies. The resources devoted to assessing the credit risk of the borrower can be less per dollar lent. For example, credit ratings issued by credit rating agencies are an important—and for the lender a cost-free—component of the credit assessment process. The foregoing analysis is shown diagrammatically in Figure 11.1. Since operating costs per dollar traded in the euromarkets are lower than those faced by banks in their domestic operations, euromarket bankers can narrow the spread between deposit and lending interest rates and still maintain a net interest margin similar to that attained by their domestic operations. By so doing, the euromarkets provide an ongoing incentive for funds to flow into the market, and they can simultaneously guarantee that there will be a demand for the funds by borrowers. If a borrower raises foreign currency funds in the euromarkets, it exposes itself to foreign exchange risk. Since interest payments and principal repayment on a foreign currency loan will be repaid in a foreign currency, the borrower is exposed to the risk that the price of the foreign currency may increase; that is, the local currency may depreciate in value during the term of the loan. If the local currency depreciation is greater than the interest advantage obtained by borrowing offshore, the effective cost of the loan would be greater than if the funds had been borrowed within the domestic market. However, the financial markets provide products that make it possible to hedge, or manage, foreign exchange risk. This is discussed in Part 5. However, some borrowers of foreign currency in the euromarkets will also

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Figure 11.1  Eurocurrency market interest rates Supply of deposits

Interest rates

Loans—domestic

Loans—euro

Deposits—euro Demand for loans Deposits—domestic

Quantity of deposits and loans

receive matching foreign currency revenues from their business operations. In this situation, and subject to cash-flow timing differences, the borrower might have a natural foreign currency hedge. That is, if the foreign currency revenues are nearly equal to the foreign currency payments related to the debt issue, then foreign currency risk exposures are minimised.

Natural foreign currency hedge a strategy that matches the denomination of foreign currency inflows and outflows

REFLECTION POINTS

• • • •

A euromarket transaction may occur in any country; it is defined as a financial transaction carried out in a foreign country but denominated in a currency other than the currency of the country in which the transaction occurs. The euromarkets are less regulated and often offer better interest rates than those of domestic financial markets because participants typically conduct a small number of very large transactions. The euromarkets are separated into the eurocurrency markets, the euronote markets and the eurobond markets. Participants in the international capital markets may be exposed to foreign exchange risk. It is possible to hedge, or manage, this risk.

11.2

Eurocurrency market

The eurocurrency market involves intermediated euromarket transactions; that is, banks accept eurocurrency deposits and provide eurocurrency loans. A eurodollar is a USD-denominated bank deposit held in a bank outside the USA. Similarly, other major currency deposits such as the europound, the euroyen or the euroAUD may be held in the respective currencies in accounts outside the country of that currency. The major forms of eurocurrency facilities discussed in this chapter are short-term bank advances, stand-by arrangements and medium- to long-term eurocurrency loans. Some quasi-securitisation strategies

LEARNING OBJECTIVE 11.2 Describe the eurocurrency market, in particular short-term bank advances, ­standby facilities and longerterm syndicated bank loans.

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that may be applied by eurocurrency lenders, including novation, subparticipation and transferable loan certificates, are introduced in Extended learning A at the end of the chapter.

11.2.1

SIBOR Singapore interbank offered rate: the average of rates at which selected banks in the Singapore market will lend to each other

Short-term bank advances are essentially the same as term loans or fully drawn advances obtained through a domestic bank (discussed in Chapter 10). The term of the advance is negotiated with a bank and the full amount drawn down on approval. A commitment fee is charged to the borrower if the advance is not drawn shortly after approval. For short-term advances, the repayment of principal and interest normally occurs as a lump sum at the end of the term of the loan, with no provisions for early repayment. The short-term advance can be extended to provide an ongoing facility by establishing a revolving credit arrangement, whereby a bank agrees to roll over the loan facility for a number of agreed periods. Under this arrangement, the borrower can usually nominate a mixture of currencies at each rollover date. One advantage of this arrangement is that the borrower can tailor the currency mix of the facility, and thus its repayment commitments, to match the expected currency inflows from its business transactions. The typical minimum amount of an advance is USD1 million. Although the USD is the most common currency advanced, other currencies are also available. Just as the rate of interest for a loan in the domestic market is determined by reference to the borrower’s credit risk and is set in terms of a margin above a reference interest rate, so too are rates for loans from the euromarkets. In the euromarkets the most common reference rate is the London interbank offered rate (LIBOR), which is an average interbank interest rate at which a selection of banks on the London money markets are prepared to lend to one another. LIBOR is published daily and is quoted for eight maturities ranging from overnight out to 12 months for five different currencies. For example, a three-month LIBOR rate and a six-month LIBOR rate are published in each currency. The Singapore interbank offered rate (SIBOR) is a similar benchmark rate and is often applied to loans issued by banks in the Asian region. Normally the lender bank will add a margin to the reference rate. The margin will represent the bank’s opinion of the additional credit risk of a borrower. The margin added to the reference rate will be quoted in basis points. For example, a company may obtain a loan from an Asian-based bank that is denominated in USD at a rate of SIBOR plus 75 basis points. For a revolving credit facility, the term of the reference interest rate will coincide with the frequency of the rollover. Even if the facility is for some years, it is usual to roll over, or renew, the facility at least every six months, in which case the reference rate would be the six-month SIBOR rate. Therefore, the loan is being re-priced at the current market SIBOR rate (plus the margin) every six months. One aspect of the cost of a short-term advance in the eurocurrency market that may need to be taken into account is the additional cost of interest withholding tax (IWT). IWT is levied in some nation-states where euromarket transactions occur, and is imposed on interest derived by non-residents. The tax is generally deducted at source at the time the interest payment is remitted to the overseas lender. Since euromarket loan agreements normally state that interest is to be paid ‘free and clear’ of IWT, the borrower has to gross up the interest payment so that once the IWT is deducted the lender receives the agreed interest payment. This, of course, adds to the cost of funds to the borrower. For further information refer to the Australian Taxation Office at www.ato.gov.au.

11.2.2 Stand-by facility a contingency line of credit that is established with a financial institution

S HORT-TERM BANK ADVANCES

E UROCURRENCY STAND-BY FACILITIES

Standby facilities may be arranged as a contingency, or back-up, source of funds, to be used in the event of an unanticipated need for short-term funding. From an international corporation’s point of view, the advantage of a stand-by facility arranged through the euromarkets is the reliability of the market as a source of funding. Typically, stand-by facilities will be needed during periods of tight liquidity, and if the facility is arranged with a domestic supplier of funds, there is the risk that the supplier will also be

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subject to liquidity constraints at the very time that the borrower needs to draw against the facility. By arranging the facility in the much larger euromarkets, it is less likely that the borrower and the lender will have liquidity problems at the same time. However, in unusual times, such as the recent global financial crisis, a stand-by facility may not be a reliable source of funds as funds will not be available to most borrowers in such periods of global uncertainty. Stand-by facilities are not intended by the lender to be used as a source of ongoing finance. Most frequently, the facility is arranged for a period of up to two years. To prevent a stand-by facility being used as a substitute source of ongoing finance rather than acting as a contingent facility, drawings may be limited to a fixed term of a few months over the total period of the facility. Alternatively, there may be a requirement that the facility remain unused for a specified number of months per year. Charges associated with a stand-by facility include both a commitment fee and an interest charge on the funds that are drawn. Since the facility will be drawn when cash flow is a problem, the lender will charge a higher risk premium on a stand-by facility than would be charged on a regular fully drawn advance; that is, the margin above the reference rate will be higher. The commitment fee is also likely to be higher on stand-by facilities than on other forms of finance.

11.2.3

M EDIUM- TO LONG-TERM EUROCURRENCY BANK LOANS

The terms and conditions on eurocurrency loans vary considerably. However, most facilities fall within the following parameters: the minimum size of a term loan is likely to be at least USD3 million; a single lender may be prepared to fund loans of up to USD100 million, but above that it is probable that a syndicate of banks would be involved in the loan. Where a syndicated loan facility is arranged, the lead manager takes the primary responsibility for arranging the transaction, structuring the facility, negotiating the price and terms of the loan and organising the participation of other banks in the syndicate. The lead bank may also underwrite the whole facility. Where the facility is large, it is likely that the lead bank will appoint co-managers. Co-managers assume some of the administrative responsibilities and also advise which banks should be included as participating banks. Participating banks have little or no role in the negotiation of contractual loan terms, acting merely as providers of funds to the borrower. A final participant is the agent bank, which acts on behalf of the syndicate in the administration of the loan once the facility has been drawn by the borrower. The term of the facility is commonly between five and 10 years. Loans are frequently drawn down in full at the commencement of the facility; however, depending on the cash-flow requirements of the borrower, an availability period may be arranged. The availability period is the period after arrangement of the facility during which the funds may be drawn. For example, the borrower may be able progressively to draw funds from the facility over a two- to three-year period. Where an availability period is in place, a commitment fee will be applied to any undrawn amount. The interest charged is normally at a margin above a specified reference rate such as LIBOR, with the interest period usually nominated by the borrower. Once the interest period is set (typically between one and 12 months), the interest rate is fixed for that period. At the end of the nominated period, the borrower has the right to nominate the length of the next period, which may be different from the previous period. In addition to the interest charge, the borrower will also face a series of fees. The fee structure will vary from one lender to another, but will most likely include an establishment fee, participation fees, legal fees, an annual commitment fee and fees payable to the agent bank for its administration of the loan. The loan repayment schedule is subject to negotiation between the parties. The lender may prefer repayments to amortise the principal throughout the life of the loan; however, the borrower may be able to negotiate a deferral of principal repayments for a year or two. The preference of the borrower would be to match, as closely as possible, the loan repayment schedule with the forecast cash flows to be generated from the project being funded.

Co-managers assist the lead manager of a syndicated debt facility

Participating banks banks that provide funds as part of a syndicated loan facility

Agent bank conducts the ongoing administration role of an established syndicated loan facility

Availability period the period specified in a loan contract in which the borrower can draw down a loan

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REFLECTION POINTS

• • • • •

The eurocurrency market is the equivalent of a local intermediated finance market; for example, a corporation that generates USD income in the UK is able to deposit the USD in a London-based bank. Similarly, an Australian corporation could borrow euro from a Singapore-based bank. A eurocurrency market short-term bank advance is a term loan provided by a bank to a borrower, but not in the currency of the country in which the bank is located. Such short-term loans may be set up as revolving credit and the interest rate will be re-priced at each rollover date based on a reference interest rate such as LIBOR. Eurocurrency stand-by facilities are usually an emergency source of liquidity funds set up by corporations with an international bank. A long-term eurocurrency bank loan is typically very large and therefore established as a syndicated loan facility with a group of bank lenders. The principal bank will act as lead manager with a number of co-managers. Funds will be provided by the participating banks and the ongoing loan managed by an agent bank. Other terms and conditions on bank eurocurrency deposits and loans will be similar to domestic market facilities.

11.3 LEARNING OBJECTIVE 11.3 Identify the types, structure, issuance and the price calculation of discount securities offered in the euronote markets, including euronote issuance facilities (NIF) and eurocommercial paper (ECP).

At this point some of the mystique that tends to surround the international financial markets can be dispelled. For globalisation to work efficiently, the financial institutions, instruments and markets need to be essentially the same. Thus, the securities discussed in the euronote market and later in the eurobond market may have different names but are fundamentally the same as the domestic moneymarket and capital-market securities that were discussed in Chapters 9 and 10. Understanding the international debt markets is therefore much easier. Within the euronote market there is an active market for short-term promissory notes (P-notes) or commercial paper. Euronotes take several forms. In this section, two of the main forms are considered:

• •

euronote issuance facility (NIF) eurocommercial paper (ECP).

11.3.1 Euronote issuance facility (NIF) an arrangement whereby P-notes are underwritten and issued into the euromarkets

Underwriting banks banks that agree to purchase any unsold notes at the issue and future rollover dates

Euronote market

E URONOTE ISSUANCE FACILITY

The euronote issuance facility (NIF) is simply referred to in the markets as an NIF. It is a short-term facility whereby an unconditional bearer promissory note is drawn by the borrower, in the borrower’s own name. While the NIF is essentially a short-term arrangement, it may provide a borrower with a flexible medium-term facility to raise funds through a rollover arrangement. The facility is converted into a medium-term funding commitment by the participation of underwriting banks, which are committed, up to the underwritten amount, to purchase any unsold notes at the issue and at all future rollover dates. The value and the timing of NIF issues, and the amount of notes outstanding at any one time, can be finetuned to meet the issuer’s cash-flow requirements and the current conditions prevailing in the market. The generic features of an NIF are outlined below.

The instrument An NIF facilitates the issue of P-notes in the name of the borrower, with a maturity usually in the range of 30 to 180 days. The notes are bearer securities, generally in denominations equivalent to USD100 000 or USD500 000. The notes are discount securities and therefore do not pay interest coupons, and are 354

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sold in the market at a discount to the face value. The face value is payable to the holder at the maturity date. (Refer to the detailed discussion on discount securities in Chapter 9.)

The structure of an NIF A typical NIF issue will be quite large and therefore a syndicate of banks will underwrite the NIF facility by agreeing to purchase any notes up to a predetermined amount and at a predetermined discount rate that are not bid for by the tender panel at or below the underwritten discount rate. A bid is the price offered for the note. The tender panel is a group of banks that have agreed to make a market in the securities being issued; that is, the tender panel banks will quote both bid and offer prices. The advantage to the borrower of underwriting the facility is that the borrower is assured that it will be able to raise funds for the entire underwriting period at a specified cost. The underwriters will charge a fee for this facility.

Selling procedures An NIF issue is generally sold through a tender process. Under this procedure the issuer invites the members of a tender panel to tender prices for the notes. The panel may include as many as 25 financial institutions, of which at least some are the underwriters of the issue. The tender process may involve the issuer specifying a posted rate at which it is prepared to sell the notes to the tender panel. Alternatively, the issuer may be prepared to receive unsolicited bids from member institutions of the tender panel.

Parties involved with an NIF issue

Bid the buy price offered for a financial asset

Tender panel a group of banks that agree to make a market in a particular security; quote bid and offer prices

Offer the sell price offered for a financial asset

Posted rate the quoted yield at which an issuer is willing to sell a security

In addition to the underwriters and the tender panel, there are other parties involved with an NIF issue.

• • • • • •

The arranger. The arranger discusses the issue and its syndication with the issuer, determines the appropriate institutions to include in various roles within the facility and invites their participation, and prepares the facility documentation and relevant information memoranda for the other participants. The arranger receives an upfront fee for the services provided. The lead manager. The arranger usually takes on the role as lead manager and structures the issue, forms the syndicate and prepares the necessary documentation. The lead manager also takes a major underwriting role in the issue. Co-managers and senior managers. These managers take on an underwriting role, but to a lesser extent than the lead manager. The inclusion of co-managers and senior managers helps to publicise and broaden the distribution of the issue in a number of geographic locations. The facility agent. The facility agent’s responsibility is to oversee the legal aspects of the facility. The tender panel agent. This agent notifies the panel of the intention of the issuer to discount notes, receives the tenders and advises each tender panel member of the outcome of their tender. The issuing and paying agent. This agent is responsible for the administration of the facility for the issuer. Tasks include the receipt of funds from, and the issue of notes to, each successful tender investor. The notes may be issued as bearer securities in their physical form (referred to as definitive notes) or through an electronic system (referred to as global notes). The major clearing houses are Euroclear and Clearstream. On maturity of the notes, the issuing and paying agent receives reimbursement from the issuer for redeeming the notes.

Definitive notes securities issued in their physical form; bearer securities

Global notes

Fees Additional fees attached to an NIF issue and rollover facility include establishment fees payable to the arranger, managers and underwriters, commitment fees and take-up fees to the underwriters and agency fees for various administrative services. It is likely that the fees will add about 50 basis points in the equivalent annual cost of the facility.

securities issued and controlled through an electronic clearing house

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11.3.2

Eurocommercial paper (ECP) an arrangement whereby P-notes that are not underwritten are issued into the euromarkets

E UROCOMMERCIAL PAPER

The development of the eurocommercial paper market occurred in response to the different needs of some borrowers in the euronote market, and the changed circumstances of financial institutions that acted as underwriters in the NIF market. Borrowers with high credit ratings and a history of successful performance as issuers in the NIF segment of the euronote market no longer needed to have their commercial paper issues underwritten as investors were happy to buy their securities. Therefore, the role of the underwriters became an unnecessary expense. The best-name borrowers therefore demanded a facility without the underwriting feature of an NIF that could deliver cheaper funds. The eurocommercial paper (ECP) facility meets this demand. On the supply side, with the international adoption of the Bank for International Settlements (BIS) guidelines for bank capital adequacy, the NIF lost some of its appeal for banks, which were the main underwriters of NIF arrangements. Prior to the adoption of the capital adequacy rules, the banks’ underwriting commitments were not subject to capital adequacy requirements, as underwriting was an off-balance-sheet exposure. However, under the BIS guidelines, off-balance-sheet exposures are now incorporated in minimum bank capital requirements. The capital requirement adds to the cost and/ or reduces the profit to be derived from the underwriting function, and therefore underwriting an NIF facility lost some of its appeal. Insofar as the underwriters pass the increased cost totally on to the issuers, it renders the NIF arrangement less attractive to borrowers. (The BIS Basel capital accord requirements are discussed in Chapter 2.) The key feature of the ECP facility is that the issue of commercial paper is not supported by underwriters. As a consequence, two important considerations arise for the borrower: 1 selection of the dealers responsible for marketing the issue 2 obtaining a credit rating from a credit ratings agency.

Tranches a larger issue of paper (debt) is broken up into smaller packages of securities with the same features and sold progressively over time

ECP issues are typically for more than USD250 million. Even so, the dealing group may contain fewer than six dealing institutions. Dealing groups are small because the facility could become fragmented if there were too many dealers, and each dealer could be left with insufficient paper to be attractive to its client investor base. Also, an excessive fragmentation of the dealer base might make it difficult to develop and monitor secondary market conditions. In selecting the dealer group, the issuer would normally seek a reasonable geographic spread of dealers and a range of institutions, covering commercial banks, investment banks, merchant banks and securities houses. Once the dealer group is selected, one of the dealers will be appointed as arranger to assist in the preparation of the documentation, information memoranda and publicity material. The arranger may also act as an intermediary between the issuer and the credit rating agency. Once the program is established, the issuer typically will not issue the full amount of paper agreed under the program. Smaller amounts will initially be issued in tranches of ECP with the same features, partly to test the market’s reaction and partly to match the issue with the borrower’s ongoing cash requirements. For example, one tranche may issue ECP denominated in USD with a maturity of 90 days, while another tranche may be denominated in EUR with a 180-day maturity.

11.3.3

C ALCULATING THE PRICE OF AN NIF AND AN ECP

The NIF and the ECP are discount securities, and therefore the calculations associated with these securities are simply those that were considered in Chapter 9. However, there is one important exception. The market convention in the euromarkets is to adopt a 360-day year. Therefore, the formula is: face value × 360 ​Price = ____________________ ​          ​ yield _ 360 + ​​(​   ​  × days to maturity​)​ 100

11.1

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EXAMPLE 11.1 A company is to issue a 180-day ECP with a face value of USD5 million yielding 8.25 per cent per annum. What amount will the company raise on the issue? $5 000 000 × 360 Price =  ​______________       ​ 360 + ​​(​0.0825 × 180​)​ ​ ​        ​  ​  $1 800 000 000  ​ ​ ​ = __________ ​        ​  374.85 ​ = $4 801 920.77

REFLECTION POINTS

• • • • • • •

The euronote market is the equivalent of a domestic short-term money market. A euronote issuance facility (NIF) is a discount security issued into a foreign country, but not in the currency of that country. An NIF is a promissory note (commercial paper) issued today with a face value that is payable at maturity; it is sold today for less than the face value (discounted). An NIF issuer will use a group of underwriting banks to promote and support the issue into the euronote market. NIFs may be issued as bearer securities called definitive notes or electronically as global notes. Eurocommercial paper (ECP) is also a discount security, but is not underwritten. ECP may be issued by corporations that have a very high credit rating and have established a good reputation in the euronote market with previous NIF issues. Calculations use the discount security formula (Note: euromarkets use a 360-day year): face value × 360 ​Price = ​ _____________________           ​​ yield 360 + ​​ _ ​   × days to maturity​ ​ ( 100 ​  )

11.4

11.1

Eurobond market

Just as the euronote market is the equivalent of a domestic money market, so the eurobond market is the equivalent of a domestic capital market. This section considers two of the principal long-term coupon debt securities issued into the eurobond market: 1 euro medium-term notes 2 eurobonds, including straight bonds and floating rate notes.

11.4.1

E URO MEDIUM-TERM NOTES

The development of the medium-term note (MTN) market emerged from the US equivalent market in order to meet particular needs of borrowers and investors. The MTN is an unsecured obligation sold directly by the issuer, often through an agent, with maturities ranging up to 15 years, although the average euro-MTN issue tends to be around three years’ duration. The MTN typically is a bearer security with annual interest coupons. The coupons may be

LEARNING OBJECTIVE 11.4 Identify the structure and features, and carry out calculations, for the main securities issued into the eurobond market, that is, mediumterm notes, straight bonds and floating rate notes.

Medium-term note (MTN) an unsecured, nonhomogeneous bearer security that pays a periodic coupon; issued in tranches

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Quoting two-way prices the practice of a dealer quoting both bid and offer prices on a financial asset

MTN tap approach each tranche within a euro-MTN issue incorporates specific maturities and coupon rates

Serial offering technique each series tranche has the maturity and coupon terms set when the facility is established

specified at a fixed interest rate or at a variable rate, with the coupon expressed in terms of a margin above a nominated reference rate, such as the 12-month LIBOR. An important aspect of the MTN facility is that the notes are not homogeneous. The facility may  include a range of note maturities, currencies and fixed- and variable-rate coupons. Also of importance is the fact that notes can be issued in whatever quantities and in as many separate tranches as the issuer requires. The issuer, in conjunction with the chosen MTN dealers, determines the amount of the facility and the preferred maturities of the notes. Once the terms and conditions are agreed, the dealers act as agents for the issuer in seeking investors. The other significant role of the dealers is that of promoting the secondary market in the notes by quoting two-way prices on the issued notes; that is, the dealers provide liquidity in the secondary market by standing ready to buy and sell the notes. The primary issue of the notes may be on a periodic basis or on a continuous basis. With periodic basis issues, the notes are issued regularly, but not on a continuous basis. Each issue may comprise notes of different amounts and maturities. Continuous issues are more common in the euro-MTN market and under this system notes are offered daily. These notes can be tailor-made to meet the preferences of investors with respect to amounts, currencies and maturities. In order to remove concerns that the flexibility of the MTN issue technique may lead to a highly fragmented stock of notes, two other distribution techniques are commonly attached to the periodic and continuous issues. The first, referred to as the MTN tap approach, involves the division of the full facility into a number of tranches, each with a specified minimum and maximum dollar amount, and with notes within the tranche having an identical maturity and coupon rate. A new tranche, consisting of notes of a different coupon and maturity, may not be offered to the market until the minimum amount of the first tranche has been sold. The second approach is labelled the serial offering technique, under which the maturity and coupon characteristics of the notes are determined at the time of the establishment of the facility. The facility may have several series of notes. Each series may still have some different characteristics such as the currency of the issue. Though this technique does not have the minimum/maximum constraint of the tap tranche approach, the establishment of the series also limits the diversity of the notes issued and should facilitate the development of a reasonably deep secondary market. The MTN offers the issuer great flexibility in meeting its funding requirements. The flexibility of the MTN relates to the amount of notes issued through any particular period, the maturity of the notes, the coupon of the notes and the currency of the notes. This allows the issuer to take advantage of changing market opportunities, to tailor the offerings to meet particular preferences of investors and thus broaden the potential investor base, and to schedule the issues to match the term structure of the issuer’s asset and cash-flow requirements.

11.4.2

E UROBONDS

A bond is a long-term coupon security; that is, a bond pays a regular interest coupon and the face value of the bond is repaid at the maturity date. The regular interest coupon may be based on a fixed interest rate or a variable interest rate. The global bond markets comprise three broad market groups: domestic bonds, foreign bonds and eurobonds.

Domestic bonds Domestic bonds a bond issued into a local market, in the local currency, by a local company

Foreign bonds a bond issued into a foreign market, in the currency of that market

Domestic bonds are bonds issued in a country by a local borrower within that country and denominated in the currency of that country. For example, a Malaysian company issues bonds in Malaysia that are denominated in ringgit.

Foreign bonds Foreign bonds are bonds issued by a borrower in a country other than the borrower’s own country that are denominated in the currency of the country in which the bonds are issued. For example,

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a New Zealand corporation issues USD bonds into the US capital market. Foreign bonds often have colourful names. Foreign bonds placed in the USA are known as Yankee bonds, those issued into Japan are known as Samurai bonds and those issued into Australia are known as Kangaroo bonds. In Australia, Kangaroo bonds are the second largest segment of the bond market (behind Australian Government Securities). The Kangaroo bond market has grown to be in excess of $200 billion.

Eurobonds Eurobonds are bonds issued into one or more overseas capital markets, but not in the currencies of those countries. For example, an Australian corporation issuing USD bonds into the Hong Kong and Singapore capital markets is making a eurobond issue. Eurobonds are generally underwritten by a multinational syndicate of banks. These bonds are not marketed on a single national bond market, but rather across a number of global markets. Therefore, they are often not subject to listing and trading requirements that may be imposed by national authorities on domestic or foreign bond issues.

11.4.3

Kangaroo bonds Australian dollardenominated bonds issued into the domestic Australian market by non-resident issuers

Eurobonds a bond issued into a foreign market, but not in the currency of that market

I SSUE AND TRADING OF EUROBONDS

Eurobonds are sold in a multistage process. The issue is organised by an international bank, called a lead manager. The lead manager is the arranger of a bond issue and discusses the issue and its syndication with the issuer, determines the appropriate institutions to include in various roles within the facility and invites their participation, and prepares the facility documentation. The lead manager invites usually between five and 30 banks to act as co-managers; together they form the management group. The management group prepares the bond issue, sets the final conditions of the bond and selects the underwriters and selling groups. The management group will usually subscribe to a large portion of the issue. The underwriters are invited to participate in the issue on the basis of their regional placement power. Their number may vary from 30 to 300 institutions and usually comprises international banks from all regions of the world. Together with the management group, the underwriters guarantee final placement of the bonds at a set price. The selling group is responsible for selling the bonds to the public. The group consists of managers, underwriters and additional institutions that have a good selling base. A particular participant may simultaneously be manager, underwriter and seller. A separate fee is paid to compensate the participants for the particular services they provide. Total fees payable range from 1.50–2.50 per cent of the issue price. The members of the selling group may pass some of their fee along to the final buyer of the bond. Unlike the requirements placed on underwriters in some domestic bond markets, eurobond underwriters are not obliged to maintain the bond’s market price at or above the issue price until the syndicate is disbanded. This means that the bonds may be placed at a price below the issue price. The typical timetable for a new issue is shown in Figure 11.2. A new issue may be placed within three to six weeks, which is a much shorter period than is typically required for a domestic bond program. First, the lead manager and the borrower discuss the terms of the bond. The terms to be determined include the amount, the maturity, whether it is to have a fixed coupon rate or a variable coupon rate, whether to include options and the currency of the issue. The terms of the bond often remain provisional until the official offering day. During the intervening period, the lead manager arranges the management group and prepares various documents, including a preliminary prospectus—at this stage sometimes called a red herring. On the announcement day, the managers send electronic messages describing the proposed bond issue and inviting banks to join the underwriting and selling groups. A week or two later, the final terms of the bond are set and the syndicate commits itself to the borrower. A final prospectus is printed and the bonds are publicly offered on the offering day. At the

Management group comprises the lead manager and comanagers

Subscribe agree to purchase some of the securities offered

Red herring a preliminary prospectus prepared by the lead manager

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Figure 11.2  Timetable of a new bond issue Decision to issue eurobond Discussion between borrower and lead manager (two weeks or more) Announcement of eurobond issue One to two weeks of pre-placement (grey market) Offering day with final terms Up to two weeks of public placement Closing day: selling group pays for bonds Total time elapsed: five to six weeks

Tombstone a notice placed in the financial press advising details of a completed issue of securities

Grey market contingent trading in a security before the actual closing date of the primary issue

Market-makers dealers that quote buy (bid) and sell (offer) prices on the secondary market

Bearer bonds physical stock is issued; current holder is presumed to have legal entitlement

Inscribed stock the physical bond is not issued; ownership is registered electronically with a registry

end of a public placement period, normally not more than two weeks, the subscription is closed and the bonds are delivered in exchange for cash paid to the borrower. Increasingly, the clearing houses of Clearstream or Euroclear are used in the settlement process. The completion of a successful issue is marked by the publication of an advertisement in the international financial press. The advertisement identifies the borrower and the nature of the instruments involved in the issue, and lists the participating banks and their roles in the issue. Since the advertisement marks the end of the issue, it is referred to as a tombstone. After closing day, public secondary market trading in the bonds begins. However, trading may actually take place before the closing day. A grey market for the bonds starts before the final terms have been set on the offering day. Trading during this period is contingent upon the final issue price. That is, bonds are traded in the grey market at a premium or discount relative to the future issue price. For example, a grey market quote of ‘less half’ means that if the bonds are issued at 99.50 per cent of the face value, they are priced in the grey market transaction at 99.00 per cent. The grey market is essentially a forward market for bonds that are not yet in existence. The selling group often uses this market to sell part of their bond allocation prior to issue. Though the bonds may be sold at a discount (as in the above quotation), the selling group member will still make a net profit if the discount is smaller than the fee that it earns from participating in the issue. Following closing day, secondary market transactions occur through an international network of dealers that act as market-makers. A market-maker quotes a price to the potential buyer or seller in the form of a bid (buy) or offer (sell) price. If an investor wishes to buy a specific eurobond, the investment manager calls several market-makers in order to get their best quotations, and concludes the deal at the lowest price quoted. The transaction is settled in seven calendar days, and the transaction is cleared through the relevant clearing house. One of the explanations for the existence of the eurobond market is that certain investors appear to prefer the anonymity associated with eurobonds. Eurobonds may be bearer bonds or inscribed stock. These days the majority of new eurobond issues are held in electronic form with either the Euroclear or Clearstream clearing houses. The euromarkets continue to grow because borrowers and investors alike recognise that the euromarkets are efficient, less costly, flexible and innovative.

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11.4.4

T YPES OF EUROBONDS

The eurobond markets continue to develop, with new types of instruments and issuing techniques appearing from time to time. The following descriptions relate to the generic features of the main bond instruments. The two classes of bonds discussed are straight bonds and floating rate notes. For those who wish to extend their understanding further, there is a discussion on convertible bonds and warrants in Extended learning B at the end of the chapter.

Straight eurobonds The main participants and features associated with straight eurobonds are as follows.

Straight eurobonds

Issuer and investor

a fixed-interest bond paying periodic coupons; principal repayable at maturity

Eurobond investors include retail investors and institutional investors. In order to be successful in the market, the issuers of eurobonds must have a very high credit rating and be household names. Individual investors are less inclined and less able than institutional investors to analyse the credit risk of the issuing entity, and are thus more reliant on the name of the borrower and the credit rating provided by external rating agencies. Standard & Poor’s, Fitch Ratings and Moody’s Investors Service are major credit rating agencies that provide credit ratings on international bond issues. Credit ratings and the role of credit rating agencies are discussed later in this chapter.

Amount and currency of denomination The costs associated with a eurobond issue constrain the minimum size of the issue to at least USD50 million or its equivalent in other currencies. The typical size of an issue has grown and an increasing number of issues exceed USD500 million. The predominant currency of eurobond issues is the USD. Other significant currencies of issue include the Japanese yen, the euro and the UK pound sterling.

Interest rate (or coupon) Straight eurobonds pay a fixed coupon rate that is set at the time of issue. Periodic interest payments are generally paid annually in arrears. With bearer eurobonds, the coupons are attached to the bond. The coupons are detached and presented to the issuer’s paying agent for payment on the due date. Alternatively, inscribed eurobonds require the periodic coupon payment to be made electronically to the investor’s bank account. As a straight eurobond only pays a fixed-interest coupon, the price of existing bonds will, over time, move inversely to any movements in current interest rates, and therefore will yield a return to secondary market buyers based on current market returns (see Section 11.4.5 for calculations).

Euro the currency unit of participating member countries of the Economic and Monetary Union of the EU

Maturity Fixed-interest eurobonds have a specified maturity date, and usually there is no option for the issuer or the investor to shorten or lengthen the life of the bond. Typical maturities range from three to 12 years. The majority of issues are structured with the principal repayable in full on maturity; this is known as a bullet repayment. It is possible, however, to structure an issue that is at least partly amortised throughout the life of the bond.

Listing

Bullet repayment when the principal amount due on a security is repaid only on the maturity date

The eurobond market has no specific physical location. Secondary market dealings occur through market-makers in a number of financial centres around the world. However, many eurobonds are listed on the Luxembourg, the London or the Singapore stock exchanges. Few, if any, transactions go through the exchanges. The listing is simply to ensure compliance with a minimum set of disclosure standards and to meet the requirement for the issuer to obtain a periodic public quotation. 361

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Participants

Paying agents arrange periodic coupon payments when due; redeem bonds at the maturity date

In addition to the lead manager and co-managers, and the underwriting and selling groups identified previously, there are normally two other parties involved: the trustee, who comes between the borrower and the investors, and who has a legal and fiduciary responsibility to ensure the protection of investors; and the paying agents, who pay the periodic interest coupons and redeem the bonds at maturity. There are normally a few agents appointed, and their geographic location will mirror the geographic location of the majority of investors.

Costs Commission payments usually range between 1.50 and 2.50 per cent of the issue price. In addition to the commission payable, the issuer is responsible for the direct costs of the issue, such as the printing of the bonds, listing fees, trustee fees and paying agents’ fees.

Floating rate notes Euro floating rate note (FRN) a bearer bond that has a variable coupon rate based on a reference interest rate

FRN call option gives the issuer the right to redeem a bond issue before the maturity date

A euro floating rate note (FRN) is a bearer bond issued in the euromarket, but, unlike a straight eurobond, does not have a fixed coupon. The rate of interest paid is related to a nominated reference interest rate. A eurobond FRN is generally indexed to the 6-month LIBOR. The coupon rate on an FRN is reset periodically, usually every six months. Since the coupon adjusts quite frequently throughout the life of a medium- to long-term FRN, the price of the instrument remains quite stable in comparison with the price of straight eurobonds. If, for example, the market rate of interest rises at the next reset date, the coupon rate on the FRN would be adjusted upwards. Insofar as an FRN exhibits price volatility, this can be expected to be greatest just after the reset date, when the interval until the next reset date is at a maximum. Sometimes an FRN may have a reset frequency greater than the actual coupon payment frequency. This reduces the interest rate risk to the investor. It is common also for an FRN to guarantee a ‘floor’ or minimum rate of interest. Some also include a cap or maximum rate of interest. Typically, an FRN issuer will pay a margin above the reference interest rate; the riskier the borrower, the higher the margin that must be paid. Supra-national issuers of bonds may issue at a margin that is less than the reference interest rate. Examples of supra-national borrowers include the International Monetary Fund and the World Bank. An FRN issue is typically at least USD100 million, although much larger issues of more than USD500 million are made. The majority of FRN issues have maturities ranging from five to 20  years. An FRN may provide the issuer with a call option. An FRN call option gives the issuer the right to redeem the bonds before the maturity date. An FRN may also have an investor FRN put option, which gives the investor the right to put—or sell—the bond back to the issuer prior to maturity.

FRN put option gives the investor the right to sell the bond back to the issuer prior to maturity

11.4.5

C ALCULATING THE PRICE OF FIXED-INTEREST EUROMARKET SECURITIES

The formula for calculating the price of fixed-interest euromarket securities, including an MTN or a straight eurobond, is the same fixed-interest security formula developed in Chapter 10. The formula calculates the present values of the future cash flows. The future cash flows comprise the coupon stream and the repayment of the principal at maturity. Example 11.2 demonstrates the calculation where a fixed-interest straight eurobond is sold between coupon periods: 1 − ​​(​1 + i​)​ −n​ −n k ​P = ​{​C​[​ ___________ ​      ​  ]​ + A ​​(​1 + i​)​  ​}​(​1 + i​)​  ​ i

11.2

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EXAMPLE 11.2 An institutional investor is considering the purchase of a straight eurobond as part of an investment portfolio. The investor obtains the following information. Current eurobond yields in the euromarkets are trading at a yield of 6.00 per cent per annum. An existing eurobond with a face value of USD1 million is paying annual fixed 7.00 per cent per annum coupons. This bond will mature on 31 December 2020. If the investor buys the bond on 20 May 2018, what is the price that should be paid? C = USD70 000 i = 0.06 (Note: this euromarket security pays an annual coupon) n = 3 (coupons due 31 December 2018, 2019, 2020) A = USD1 000 000 k = the number of elapsed days for the period 1 January 2018 (the last coupon was paid on 31 December 2017) to 20 May 2018 inclusive = 140 days divided by a 360-day year = 0.388889 (​​a)​​

​​​ ​ P ​Vface value ​  ​ = USD1 000 000(1 + 0.06​)​​  −3​

​ ​ = USD839 619.28 ​ plus      ​ ​ ​(​b)​​ ​​​ 1 − ​​(​1 + 0.06​)​ −3​ ​ P ​Vcoupons ​  ​ = USD70 000​​ ​ ____________      ​  ​ [ ​​        ​                       ​  ​  ​  ​  ​ ​ ​ ​​ 0 . 06 ​ ]​ ​ ​ ​ ​ ​(​c)​​

​ = USD187 110.84 PV = USD839 619.28 + $187 110.84 ​ = USD1 026 730.12 ​​​

​ ​

140 ____

P = USD1 026 730.12(1.06​)​​  ​ 360 ​ ​ ​ = USD1 050 261.57

REFLECTION POINTS

• • • • •

A euro medium-term note (MTN) is an unsecured debt issue that pays a fixed or a variable interest rate, with the principal repaid at maturity. The issue may be made on a periodic or continuous basis using either a tap approach or a serial offering technique. An MTN issuer will engage a group of dealers to promote the issue. An MTN may be issued in tranches into a number of countries, usually with a range of maturities, currencies and interest rate structures. The dealers will create a secondary market by quoting two-way (bid/offer) prices on the notes. Eurobonds are long-term debt securities that normally pay an annual coupon with the principal repayable at maturity. The difference between a domestic bond, a foreign bond and a eurobond is the currency and country in which the bonds are issued. A straight eurobond security pays a fixed coupon, while a floating rate note pays a variable coupon based on a reference interest rate (plus a margin). A eurobond issuer will use the services of a lead manager and co-managers. The management group will subscribe to a large part of the issue; this is supported by a syndicate of underwriters. The dealers create an active secondary market in the bonds.

• The formula for the calculation of the price of a eurobond is: 1 − ​​(​1 + i​)​  ​  ​   ​  ​P = ​{​C​[​ ​ _________ ]​ + A ​​(​1 + i​)​  ​}​(​1 + i​)​  ​ i −n

−n

k

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11.5 LEARNING OBJECTIVE 11.5 Consider the operation of the US money and capital markets and the structure of US commercial paper, US foreign bonds and American depositary receipts.

Securities and Exchange Commission (SEC) the regulator of the securities markets in the USA

Borrowers who wish to gain access to the euromarkets usually require a high investment-grade credit rating of AA or above. This restricts the number of financial institutions and corporations that can actually issue paper into the euromarkets. On the other hand, an investment-grade credit rating of BBB and above is often sufficient for foreign borrowers to gain access to the US capital markets. This means that the US markets are a funding alternative for a much larger group of international borrowers. In this section, we will discuss three components of the US markets that are important sources of funds for international borrowers: (1) the US commercial paper market, (2) the US foreign bond market and (3) American depositary receipts. To extend your understanding further, there is a discussion on the US medium-term note market in Extended learning C at the end of the chapter. The Securities and Exchange Commission (SEC) is responsible for the administration of US federal securities law and regulations. Regulation within the euromarkets is somewhat limited, whereas the regulatory requirements in the US market can be quite onerous. Non-resident issuers of securities into the US market are specifically referred to in legislation, the intent of which is to provide primary and secondary market participants with full and fair disclosure through a regimen of initial and ongoing continuous disclosure to the SEC. Non-exempt foreign issuers must register and file with the SEC a registration statement that includes:

• • • • Trust indenture appoints a qualified trustee and specifies a range of conditions designed to protect debt security holders

Markets in the USA

a description of the issuer’s business a detailed financial position results of operations and management a description of the securities on offer.

Foreign issuers of corporate bonds and other non-exempt debt securities must issue those securities under a trust indenture approved by the SEC. The trust indenture provides some protection for debt holders. The indenture will appoint a qualified trustee and contain protective clauses for debt holders, such as a requirement that investors receive periodic financial reports which must also be filed with the SEC. There are certain exempt transactions that operate in a less onerous regulatory environment:

• • •

Commercial paper. Not all commercial paper is exempt. It must be paper that is issued with a maturity of less than nine months, used for current transactions, of investment grade with a credit rating issued by a national credit rating agency and of the kind not normally offered to the general public. Private placements. Registration is not required for the transactions of a foreign issuer where there is no public offering. However, the legislation defines various levels of private placement, with different compliance requirements. For example, compliance requirements for a bond issue made to a limited number of institutional investors are less stringent than are those for a placement with a limited number of individual investors. Rule 144A placements. Rule 144A allows foreign issuers to place privately unregistered securities with qualified institutional investors. The rule also restricts or constrains the resale of such securities unless they are subsequently registered with the SEC.

11.5.1

C OMMERCIAL PAPER

US commercial paper (USCP) is a short-term promissory note with a maturity of less than 270 days. USCP is a discount security; that is, it is issued with a face value that is payable at the maturity date. As commercial paper does not pay interest, it is sold today for less than the face value. The amount of the discount from the face value will reflect current yields in the market and the number 364

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of days to maturity. The difference in the discounted issue price and the face value is the cost of borrowing to the issuer. The majority of USCP is investment-grade paper; that is, it has a short-term credit rating of A-3 or above, and is issued and traded by institutional investors within the wholesale money markets. Some issues are supported by credit enhancements such as a bank letter of credit or security over the assets of the issuer. The value of the USCP market is approximately $US1 trillion. Once a commercial paper program has been established, it provides a very flexible form of funding for the issuer. When additional funds are required (providing the full USCP issue has not already been made), the issuer simply contacts the USCP dealers during the morning on which it requires the funds in order to arrange a further sale of new paper in the markets. Where there is no public offering, placements of USCP with qualified institutional investors do not require official SEC registration. The documentation for exempt private placements and procedures for the issue of USCP include the following:

• • • • • • • •

Offering memorandum. This contains a description of the commercial paper, a statement of use, brief information about the issuer, summary financial statements and details of supporting credit enhancements. Dealers must supply an offering memorandum to each purchaser. Offer limitations. Offers and sales may be made only to qualified institutional investors. Private placements cannot include an offer to the general public, or any advertising. Dealer agreement. The dealers must provide certain representations and warranties, generally under a standard agreement form. The dealer will be indemnified against misstatement, omission and breach of representations and covenants by the issuer. Issuing and paying agent agreement. This is a standard agreement provided by the issuing and paying agent that administers the issuance, transfer, payment and cancellation of the USCP. Denominations. An aggregate sale of USCP to an investor generally must not be less than USD150 000. Resale restrictions. USCP purchased for investment purposes can be resold only to accredited investors, otherwise the paper must be registered with the SEC. This restriction also applies to the commercial paper dealers. Fiduciary purchasers. Third-party purchasers must also be accredited investors. Legal opinions. Legal counsel opinion will be required on the legal structure and compliance matters related to a non-US issuer and the USCP issue itself.

The USCP market allows book-entry USCP, which involves the electronic recording of new issues and payments. This reduces the cost of printing physical paper securities and of ensuring adequate security for the paper.

11.5.2

Book-entry USCP the electronic recording of USCP issues and payments

US FOREIGN BONDS (YANKEE BONDS)

The differences between a domestic bond, a foreign bond and a eurobond were discussed earlier in the chapter. We noted that the main difference between the classifications of bonds is the currency and country of issue. A Yankee bond is a foreign bond; that is, it is a debt security issued into the US capital markets by a foreign issuer, with the bonds denominated in USD. A bond is a long-term debt security, and the US bond market is particularly deep, with bond issues often made for periods in excess of 20 years. However, a typical issue would be for a shorter period. A straight bond is a fixed-interest security, paying equal periodic interest coupons for the term of the bond and repaying the face value at maturity.

Yankee bond a foreign bond issued into the US capital markets; issued in USD by a foreign borrower

Straight bond a fixed-interest bond paying equal periodic coupons; principal repayable at maturity

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Junk bond market the issue of securities with a credit rating of less than investment grade of BBB

Shelf registration registration with the SEC of a delayed or continuous debt issue

However, as with the domestic markets and the euromarkets, the modern financial system facilitates the issue of a multitude of variations to the straight bond. For example, a Yankee bond may be issued as a floating rate note with interest coupons based on a reference interest rate. It may well have debt or equity warrants attached (warrants are discussed in Extended learning B at the end of the chapter). Interest payments will be specified with the issue and are usually half-yearly or annual. Market conventions are important. In the US market, interest calculations are based on a 360-day year. A Yankee bond issue will require a credit rating from a credit rating agency such as Standard & Poor’s. The depth of the US market has encouraged two tiers of bond issues: bonds with an investmentgrade credit rating of BBB or above, and a junk bond market with issues rated at less than BBB. Yankee bonds fall within US legislative and regulatory requirements, particularly in relation to registration with the SEC. Rule 415 permits an eligible foreign issuer to register Yankee bonds under the Securities Act 1933 for sale in tranches from time to time on a delayed basis. The issue is restricted to the amount of bonds expected to be sold within a two-year period. This form of issue is known as a shelf registration. The documentation required for shelf registration of a Yankee bond issue includes the prospectus, trust indenture or charter provisions, distribution and underwriting agreements and the form of the bond issue. In order to retain access to the US capital markets for public offerings, an issuer must submit to the SEC copies of its audited financial statements for the fiscal year and its semi-annual unaudited statements.

11.5.3 American depositary receipt (ADR) a security (depositary share) issued by a US depositary bank that is supported by shares held of a foreign listed company

Depositary share represents ordinary shares of a foreign company listed on a foreign stock exchange

A MERICAN DEPOSITARY RECEIPTS

Any discussion of the US capital markets would not be complete without consideration of the American depositary receipt (ADR). The US market securities discussed previously were debt issues; however, the ADR is primarily a form of equity issuance, although debt issue ADR programs are possible. A depositary receipt is a security issued by a US depositary bank and is evidenced by a depositary share. A depositary share will represent one or more ordinary shares of a foreign company, which are listed on the foreign company’s home stock exchange. Typically, a depositary share will represent more than one share of the foreign issuer, where the domestic share is trading at a price lower than that to which US investors are accustomed. An ADR program provides the opportunity for a foreign company, which otherwise may not have been able to meet SEC listing requirements, to access the US capital markets to raise equity funds. Given the size of the US capital markets, the ADR has become a significant source of equity funding for foreign companies. An ADR program may take one of a number of forms:

• • • •

Level 1. Shares of the issuer company, listed on its home exchange, are deposited with a custodian bank in that country. ADR securities are issued and traded in the US over-the-counter market. This type of ADR is not listed on US exchanges and is not registered for public offering. The same disclosure requirements apply as for the home country. Level 2. Shares of the issuer company, listed on its home exchange, are deposited with a custodian bank in that country. This type of ADR is listed on one or more US exchanges (such as the New York Stock Exchange or NASDAQ) but is not sold as a public offering. There are extensive SEC disclosure requirements. Level 3. New shares of the issuer company, listed on its home exchange, are deposited with a custodian bank in that country. This type of ADR is listed on one or more US exchanges and is sold as a registered public offering; that is, the ADR issue is registered with the SEC for public offer to US investors and must meet extensive disclosure requirements. 144A/Reg S—private placement offering. An ADR facility may be established for the private placement of new shares of the issuer in accordance with Rule 144A of the Securities Act 1933. The issue is restricted to qualified institutional buyers (QIBs). Disclosure is subject only to QIB requirements and the issue is not registered with the SEC. This form of ADR program is often used by first-time ADR issuers as a stepping-stone to a later public offer.

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The role of the depositary bank is important to the ultimate success of an ADR program. Specialist banks such as the Bank of New York Mellon carry out this function. The depositary bank acts as administrator, depository, transfer agent and registrar for the program. The bank will assist with program structure and compliance matters, issue depositary receipts, maintain records of registered holders, process transfers, arrange dividend payments and generally facilitate an orderly market in the ADR issue. The ADR market is deep and liquid. An ADR is attractive to US investors because the issue is quoted in USD, and associated cash flows (dividends or interest payments) are denominated in USD and therefore are protected from foreign exchange risk. The issue is supported by the underlying shares of the issuer and is subject to US legal jurisdiction. An ADR program provides foreign companies with access to the large US capital markets. It is particularly attractive for companies expanding their business operations into the global market, because the ADR increases the international profile of the company. It also provides a much broader investor base for the company and allows further diversification of funding sources. ADRs are normally issued to US investors. A variation is the global depositary receipt (GDR), which is issued to investors in several financial markets. With the advent of the European Monetary Union, a market has developed for euro depositary receipts (EDRs).

REFLECTION POINTS

• • • • • • •

The US markets are a large source of funds for foreign borrowers. The market regulator is the Securities and Exchange Commission (SEC). Regulatory requirements vary depending on whether a debt issue is an exempt issue (e.g. Rule 144A placements) or a non-exempt foreign issue. US commercial paper (USCP) is a short-term promissory note. Foreign USCP issuers typically need at least a short-term A-3 or above credit rating. Often credit enhancements, such as a bank letter of credit, are attached to an issue. A USCP is usually progressively issued as part of a larger commercial paper program. The issuer simply advises the dealer group that further USCP will be issued. USCP is issued electronically as book-entry USCP. An exempt USCP issue may only be made to qualified institutional investors. Yankee bonds are foreign bonds issued into the USA that are denominated in USD. They may be issued as a straight bond or a floating rate note. Bonds with a credit rating of less than BBB are called junk bonds. An American depositary receipt (ADR) is issued by a US depositary bank and may be listed on a US stock exchange. The ADR is supported by securities listed on a stock exchange in another country. A US investor buying an ADR is effectively buying shares in a foreign corporation. Associated cash flows are denominated in USD, thus removing foreign exchange risk for the US investor.

11.6

Credit rating agencies

A credit rating is the opinion of a credit rating agency about the ability and willingness of an obligor, such as a corporation or government, to meet its financial commitments with respect to a debt issue or other financial obligation. Credit ratings are also an opinion about the credit quality of an issue, such as a bond or other debt security, and the relative likelihood that it may default. A credit rating is not a recommendation to an investor; rather, it is a structured assessment process that differentiates

LEARNING OBJECTIVE 11.6 Recognise the important roles and functions of credit rating agencies and explain the credit rating process.

Obligor a party who is bound to another by a contract or other legal procedure

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Rating symbols represent a credit rating; S&P long-term ratings range from AAA to D and short-term from A-1 to D

Investment grade a debt issue with a credit rating of BBB, or its equivalent, and above

Issue-specific credit rating an opinion of the creditworthiness of an obligor with respect to a specific financial obligation

Country risk the risk that changes in the laws of a foreign country will impact upon existing financial transactions

Sovereign risk a risk that a foreign government will default on its obligations

the credit quality of debt issuers. A credit rating is not an indication of the market liquidity of a debt security or its price in the secondary market. There are a number of major international credit rating agencies, including Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. While each rating agency adopts its own assessment methodology and rating symbols, the objective of each agency is to provide a standard assessment of relative credit risk. That is, each credit rating agency applies its own structured analytical process in order to determine its opinion of the creditworthiness of an issuer or issue. The remainder of this section focuses on the rating process applied by one rating agency, Standard & Poor’s (S&P). The S&P rating agency issues both long-term and short-term credit ratings. Long-term ratings range from AAA, which reflects the strongest credit quality, to D, the weakest. Ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. Debt issues with a credit rating of BBB and above are regarded as investment grade. Short-term credit ratings range from A-1 to D. The A-1 symbol may include a plus sign. The S&P long-term and short-term credit ratings with explanations are provided in Extended learning D at the end of the chapter. Although S&P will provide a rating of a corporation, most credit ratings are issue specific. The issue-specific credit rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations or a specific financial program. The credit rating of specific issues made into the international markets also considers country risk and sovereign risk factors that may give external debt a higher default probability. Country risk is the risk that the laws of a country may change such that a borrower is no longer able to meet outstanding financial commitments. Sovereign risk refers to the possibility that a government may default on its financial commitments. There is also a particular recognition of foreign exchange risk involved with international debt issues; that is, that the value of one currency relative to another will impact on future cash flows. As a matter of policy, S&P automatically issues credit ratings on the following debt and hybrid security issues:

• • •

all public debt and preferred stock issues over USD50 million sold in the US markets shelf registrations (registration with SEC of delayed or continuous bond issues) international issues of issuers with outstanding credit ratings.

In addition, upon request from the issuer, S&P also provides a credit rating on a range of other security issues, including:

• • •

private placements commercial paper international issues of issuers without a credit rating.

In order to obtain a credit rating, S&P charges the issuer a fee in the order of 4.95 basis points of the issue amount; that is, 0.00495 per cent. A credit rating provides an international measure of risk. As such, a bond issue made by a French corporation that has a BBB+ credit rating is regarded as having the same level of credit risk as a bond issued by an Australian corporation that also has a BBB+ credit rating. In order to achieve this international rating consistency, S&P applies a highly structured rating process (Figure 11.3) that involves:

• •

preparation of financial statements, analysts’ reports and other relevant information issuer meetings, where management must advise S&P: — the industry environment and prospects — an overview of major business segments, including operating statistics and comparisons with competitors and industry norms — management’s financial policies and performance goals

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Figure 11.3  S&P rating process Rating request from issuer

Initial evaluation

Meeting with issuer management

Rating committee review and vote

Analysis

Appeal

Notification to issuer

Publication of public rating opinions

Surveillance of rated issuers and issues

— distinctive accounting practices — capital spending plans — financing alternatives and contingency plans

• • • • • •

S&P analysts conduct a detailed analysis of information and prepare a report and recommendation for the S&P rating committee an S&P rating committee reviews the report and votes to determine the credit rating to be allocated to the issuer communication of the credit rating to the issuer an appeal process (if necessary, and then only if there is significant new information provided by the issuer) the publication and dissemination of the credit rating during the term of the issue, ongoing surveillance of all factors that influence a credit rating.

A credit rating evaluates default risk over the life of a debt issue and therefore incorporates an assessment of forecast future events to the extent that this is possible. The performance of an issue may differ from initial expectations, and a rating may be placed on credit watch as new information is sought and analysed. A credit watch designation may be positive, which indicates that a rating may be raised, or negative, which indicates that a rating may be lowered. The rating methodology develops a profile that incorporates a balance between (1) business risk, (2) financial risk and (3) environmental factors.

Credit watch advice to the market that a credit rating is under review; may be positive or negative

The S&P business risk analysis includes:

• • • •

issuer position and reputation within the industry marketing of the firm’s products and services cost efficiency—how effectively is capital being used technological expertise—will the current expertise meet future competitive and efficiency requirements 369

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• •

management evaluation—how effective is the board of directors and executive managers cyclical characteristics, including economic cycles, monetary policy impacts and foreign exchange issues

• •

barriers to entry or exit, in particular the entry of new competitors competition—reliance on key personnel, life cycle of products, new competitors.

The S&P financial risk analysis includes:

• • • • • • •

financial policy profitability, including return on equity and return on assets capital structure of assets, debt and equity cash-flow projections and ratios financial flexibility—is the firm’s financial position robust enough to change strategies if needed off-balance-sheet financing asset and liability diversification, mix and liquidity.

Environmental factors considered by S&P include:

• • • •

market environment: economy, regulation and competition information: extent of data, quality, timeliness, accounting standards, comparability and transparency country risk: economic, business and social environment sovereign risk: direct or indirect political interventions that may affect the ability of an issuer to meet its offshore obligations. It also includes politically related events such as strikes, riots, war and corruption.

Credit rating agencies are an important element of the capital markets in that they provide a measure of the riskiness of many financial instruments available to investors. The agencies analyse the ability of an issuer, including financial institutions, corporations and governments, to make interest and principal repayments as they fall due. Essentially, the agencies are providing their opinion of the creditworthiness of a particular issuer. Issuers with an investment-grade rating (BBB and above) should generally be able to obtain access to the international debt markets, whereas ratings below BBB are regarded as being speculative to varying degrees. Credit rating agencies assist in the efficient operation of the capital markets in that they provide an opinion which enables an investor to compare the relative riskiness of investment opportunities and to match that risk to the risk profile the investor is willing to accept in an investment portfolio. The relative credit rating on a particular issue will directly affect the yield to the investor and the cost of borrowing for the issuer. The higher the credit rating (the lower the credit risk), the lower is the yield on the issue. Therefore, an issuer with an A+ credit rating will pay less to borrow in the capital markets than an issuer with a BBB credit rating. It should be evident from this discussion that credit rating agencies hold a special position within the markets for direct finance. Very few debt issuers are able to issue securities, particularly into the international capital markets, without first obtaining a credit rating for the issue.

REFLECTION POINTS

• • •

Credit rating agencies provide their opinion of the creditworthiness of an obligor with respect to a debt issue or other financial obligation. Symbols are used by rating agencies such as Standard & Poor’s (S&P) to denote a credit rating; there are short-term debt issue symbols and long-term debt symbols. S&P long-term ratings range from AAA down to D; ratings of AA to CCC may also use a + or − symbol. Short-term ratings range from A-1 to D.

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• • • •

Debt with at least a BBB (long-term) or A-3 (short-term) credit rating is regarded as investment grade. A rating review will include business risk analysis, financial risk analysis and environmental risk analysis. Credit ratings establish a standard measure of risk on a global basis and support the efficient operation of the international debt markets. Corporations with high credit ratings are able to borrow in the international debt markets. The yield paid on an issue will be related to their credit rating; that is, a higher credit rating results in a lower cost of borrowing.

CASE STUDY SUPERVISION OF RATING AGENCIES In Section 11.6 we considered the important role played by credit rating agencies in the global capital markets. In 2017, Moody’s, a US rating agency, agreed to pay $1.1 billion to settle claims regarding inflated ratings. In the middle of 2018, they made another agreement to resolve charges related to their issued ratings of mortgage-backed securities following an inquiry by the US Securities and Exchange Commission (SEC) (Michaels & Banerji, 2018). Credit ratings agencies came under increasing scrutiny following the GFC. The employees of credit rating agencies often revealed their frustrations over conflicts of interests arising from the issuer-pays model. Arguments were made that the rating agencies function under pressure from investment banks who pay fees to the ratings agencies in return for their ratings service. The implication, of course, is that ratings agencies are compelled to rate bond issues more favourably than they otherwise would in order to avoid losing the business to another agency (Cash, 2018). In Australia, credit rating agencies need to hold an Australian Financial Services (AFS) licence. There exists six licensed CRAs in operation, namely AM Best Asia-Pacific Limited (AM Best), Australia Ratings Pty Ltd (Australia Ratings), Equifax Australasia Credit Ratings Pty Limited (Equifax), Fitch Australia Pty Limited (Fitch), Moody’s Investor Services Pty Limited (Moody’s) and S&P Global Ratings Australia Pty Ltd (S&P). In February 2018, the Australian Securities and Investments Commission (ASIC) conducted a marketwide study of these credit rating agencies and made numerous recommendations. The study identified a conflict of interest that affects the credit rating methodology, judgment and analysis. The recommendations focused on changing the corporate structure of agencies to reduce conflicts of interest and to maintain transparency. ASIC also recommended a series of changes, including practical management of conflicts of interest, regular agency board meetings to ensure compliance with licence requirements as well as the production of compliance reports containing details on testing and reviews (ASIC, 2018a). According to ASIC commissioner Cathie Armour, the credit rating agencies play a crucial role in the market by informing the market participants about the credit risks that inform their financing and investment decisions. It is important to ensure that the rating agencies operating in global markets do not lose sight of Australian regulations. ASIC actively participates in the supervisory colleges established for three international CRAs, namely Fitch, Moody’s and S&P. These supervisory colleges were established to enable information exchange between supervisors of internationally active CRAs to strengthen the supervision mechanisms (ASIC, 2018b). Reference list Australian Securities and Investments Commission (ASIC) 2018a, Surveillance of credit rating agencies – Report 566, February 2018, retrieved from http://download.asic.gov.au/media/4644648/rep-566published-15-February-2018.pdf 371

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Australian Securities and Investments Commission (ASIC) 2018b, ‘ASIC reports on Credit Rating Agencies’, media release, ASIC, 15 February, retrieved from https://asic.gov.au/about-asic/mediacentre/find-a-media-release/2018-releases/18-042mr-asic-reports-on-credit-rating-agencies/ Cash, D 2018, Regulation and the Credit Rating Agencies: Restraining Ancillary Services, Routledge. Michaels, D & Banerji, G 2018, ‘Moody’s investors service to pay $16 million over SEC probe of flawed rating models’, The Wall Street Journal, 28 August, retrieved from http://www.wsj .com/articles/moodys-investors-service-to-pay-16-million-over-sec-probe-of-flawed-ratingsmodels-1535469207

Discussion points

• •

Discuss why credit rating agencies may come under pressure to provide higher bond ratings. Discuss the supervision mechanisms implemented by ASIC for credit ratings agencies operating in Australia.

Master before you move on The international debt markets are a major source of finance for governments, financial institutions and corporations. While all major global financial centres attract foreign borrowers, the euromarkets and the US markets predominate as providers of short-, medium- and long-term debt finance.

LEARNING OBJECTIVE 11.1 Explain the origins and the continued existence of the euromarkets.

• • • • • • • •

The euromarkets originated from the preference of the then USSR to hold USD outside the jurisdiction of the US authorities during the Cold War era. The continued growth of the euromarkets has been prompted by the fact that they can normally offer higher deposit rates of return and lower borrowing rates than are available in domestic markets. In addition, the euromarkets are attractive to borrowers because of the wide range of lenders and instruments available, and thus facilitate funding diversification. Euromarket transactions occur in a number of financial centres around the world. A euromarket transaction is characterised by the currency and country in which the debt is issued. A euromarket transaction is predominantly denominated in a currency other than the currency of the country in which the debt is issued. The euromarkets are less regulated and often offer better interest rates than those of domestic financial markets because participants typically conduct a small number of very large transactions. The euromarkets are categorised as the eurocurrency market, the euronote market and the eurobond market. Participants in the international capital markets may be exposed to foreign exchange risk. It is possible to hedge, or manage, this risk.

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Describe the eurocurrency market, in particular short-term bank advances, stand-by facilities and longer-term syndicated bank loans.

• • • • •

The eurocurrency market is the equivalent of a local intermediated finance market; for example, a corporation that generates USD income in the UK is able to deposit the USD in a London-based bank. Similarly, an Australian corporation could borrow euro from a Singapore-based bank. A eurocurrency market short-term bank advance is a term loan provided by a bank to a borrower, but not in the currency of the country in which the bank is located. Such short-term loans may be set up as revolving credit and the interest rate will be re-priced at each rollover date based on a reference interest rate such as LIBOR. Eurocurrency stand-by facilities are usually an emergency source of liquidity funds set up by corporations with an international bank. A long-term eurocurrency bank loan is typically very large and therefore established as a syndicated loan facility with a group of bank lenders. The principal bank will act as lead manager with a number of co-managers. Funds will be provided by the participating banks and the ongoing loan managed by an agent bank. Other terms and conditions on bank eurocurrency deposits and loans will be similar to domestic market facilities.

CHAPTER ELEVEN REVIEW

LEARNING OBJECTIVE 11.2

LEARNING OBJECTIVE 11.3 Identify the types, structure, issuance and the price calculation of discount securities offered in the euronote market, including euronote issuance facilities (NIF) and eurocommercial paper (ECP).

• • • • • • •

The euronote market is the equivalent of a domestic short-term money market. A euronote issuance facility (NIF) is a discount security issued into a foreign country, but not in the currency of that country. An NIF is a promissory note (commercial paper) issued today with a face value that is payable at maturity; it is sold today for less than the face value (discounted). An NIF issuer will use a group of underwriting banks to promote and support the issue into the euronote market. NIFs may be issued as bearer securities called definitive notes or electronically as global notes. Eurocommercial paper (ECP) is also a discount security, but is not underwritten. ECP may be issued by corporations that have a very high credit rating and have established a good reputation in the euronote market with previous NIF issues. Calculations use the discount security formula (Note: euromarkets use a 360-day year): face value × 360 ​Price = ​ _____________________           ​ yield 360 + ​​ _ ​   × days to maturity​ ​ ( 100 ​  )

LEARNING OBJECTIVE 11.4 Identify the structure and features, and carry out calculations, for the main securities issued into the eurobond market, that is, medium-term notes, straight bonds and floating rate notes.

• • •

The long-term direct finance market is known as the eurobond market. The MTN is an unsecured bearer security that pays a periodic interest coupon that may be fixed or based on a variable reference rate. The MTN facility is very flexible and may include a range of maturities, currencies, amounts and fixed or floating rate coupons.

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• • • • •

The MTN program is often periodically issued in tranches into a number of different countries. The structure of each tranche can vary to meet the specific needs of the issuer and investors. Eurobonds include straight bonds and floating rate notes. Straight bonds are fixed-interest bonds that pay a regular coupon for the life of the bond, with the face value repaid at maturity. The maturity of the bond is typically between three and 12 years, and the most common currency of denomination is the USD. Parties associated with a eurobond issue include the lead manager, co-managers, the management group, underwriters, paying agents and market-makers. The price of a straight bond is the present value of its future cash flows: that is, future coupon payments and repayment of principal at maturity. The formula is: 1 − ​(​​1 + i​)​ −n​ −n k ​P = ​{​C​[​ _ ​      ​  ]​ + A​​(​1 + i​)​  ​}​(​1 + i​)​  ​ i

• • •

Eurobonds issued with variable coupons are known as floating rate notes (FRNs). The FRN enables the periodic re-pricing of the interest rate, based on a reference interest rate (plus a margin), in order to reflect current market yields. Only borrowers with a very high credit rating are able to issue into the euromarkets; usually a rating of AA and above is required.

LEARNING OBJECTIVE 11.5 Consider the operation of the US money and capital markets and the structure of US commercial paper, US foreign bonds and American depositary receipts.

• • • • • • • •

The US markets are a large source of funds for foreign borrowers. The market regulator is the Securities and Exchange Commission (SEC). Regulatory requirements vary depending on whether a debt issue is an exempt issue (e.g. Rule 144A placements) or a non-exempt foreign issue. Borrowers that do not have a credit rating that is high enough to gain access to the euromarkets may still be able to obtain funds in the US debt markets. US commercial paper (USCP) is a short-term promissory note. Foreign USCP issuers typically need at least a short-term A-3 or above credit rating. Often, credit enhancements, such as a bank letter of credit, are attached to an issue. A USCP is usually progressively issued as part of a larger commercial paper program. The issuer simply advises the dealer group that further USCP will be issued. USCP is issued electronically as book-entry USCP. An exempt USCP issue may only be made to qualified institutional investors. Yankee bonds are foreign bonds issued into the USA that are denominated in USD. They may be issued as a straight bond or a floating rate note. Bonds with a credit rating of less than BBB are called junk bonds. An American depositary receipt (ADR) is issued by a US depositary bank and may be listed on a US stock exchange. The ADR is supported by securities listed on a stock exchange in another country. A US investor buying an ADR is effectively buying shares in a foreign corporation. Associated cash flows are denominated in USD, thus removing foreign exchange risk for the US investor.

LEARNING OBJECTIVE 11.6 Recognise the important roles and functions of credit rating agencies and explain the credit rating process.

•

Credit rating agencies provide their opinion of the creditworthiness of an obligor with respect to a debt issue or other financial obligation.

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CHAPTER ELEVEN REVIEW

• • • • • •

Symbols are used by rating agencies such as Standard & Poor’s (S&P) to denote a credit rating. There are short-term debt issue symbols and long-term debt symbols. S&P long-term ratings range from AAA down to D; ratings of AA to CCC may also use a + or – symbol. Short-term ratings range from A-1 to D. Debt with at least a BBB (long-term) or A-3 (short-term) credit rating is regarded as investment grade. A rating review will include business, financial and environmental risk analysis. Credit ratings establish a standard measure of risk on a global basis and support the efficient operation of the international debt markets. Corporations with high credit ratings are able to borrow in the international debt markets. The yield paid on an issue will be related to their credit rating; that is, a higher credit rating results in a lower cost of borrowing.

Extended learning A LEARNING OBJECTIVE 11.7 Describe novation, subparticipation and transferable loan certificates.

Novation, subparticipation and transferable loan certificates In the Extended learning section in Chapter 10 the process of securitisation was discussed. Securitisation enables an organisation to convert non-liquid assets into new asset-backed securities that are then serviced with the continuing cash flows from the original assets. This section considers processes that may be described as quasi-securitisation: novation, subparticipation and transferable loan certificates. Term loans are not normally securitised; however, developments in the international capital markets have caused a type of secondary market in bank term loans to evolve. The genesis of the term loan secondary market can be traced to the emergence of the Third World debt problem in the 1980s. At that time, a number of developing countries were struggling to pay their outstanding loan commitments. With increasing numbers of interest payment deferrals and moratoria, providers of debt were anxious to remove at least some of the loans from their balance sheets. Rather than write off the value of their loans, some loan providers sought to sell the loans to other parties. As the original loans were not written with transfer provisions, the secondary market transactions in debt were problematical. However, most new loans now contain one form or another of a sell-down provision. A sell-down provision gives the holder of a loan the legal right to dispose of the asset by selling it to another party. Among the earlier of the sell-down provisions were novation and subparticipation provisions. Under a novation provision, the original lender is able to transfer to a third party all rights and obligations that are due under the original loan agreement. Once the new party signs the novation, there is effectively a new loan agreement. The borrower now has a new relationship, but one that contains the provisions of the original agreement. Through novation, the original lender removes the loan from its balance sheet. Novation developed from an earlier procedure known as assignment. Under assignment, the original provider of the loan sold its rights under the original agreement to a third party, but it retained the obligations of the original agreement; the loan thus remained on the books of the original lender. Subparticipation provisions allow the original lender to transfer to a third party its rights to receive interest and principal repayments, in return for a payment by the third party. As with assignment, the original lender retains the loan on its balance sheet. As a result of this feature, the buyer of the loan from the original lender has no direct claim against the borrower. The buyer is dependent on the original lender for the receipt of the interest and principal payments. The buyer is thus exposed to a double risk: first, the risk that the borrower may not honour the original loan conditions, and second, the risk that the original lender may not transfer the funds that it receives from the borrower.

Sell-down provision a clause in a loan contract that allows a lender to sell the debt to another party

Novation the process by which one party to a contract is replaced with another party

Subparticipation a lender retains a loan while transferring the right to receive interest and principal payments

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Transferable loan certificates (TLCs) a lender converts a loan into transferable certificates that have the same terms as the original loan

Given the limitations of subparticipation, it is not surprising that more satisfactory approaches have been developed. Many term loans are now written with a provision for the loan to be converted into transferable loan certificates (TLCs). The TLC provision allows a lender to convert a loan into transferable certificates that have the same terms and conditions as the original loan. The certificates can then be sold to third parties who are then registered by the agent bank as the new lenders. With the endorsement and sale of the TLC, the loan is no longer carried on the balance sheet of the original lender. There are some key features that distinguish the TLC from other marketable euro-instruments. The first is that a TLC is issued at the discretion of the lender, and the funding is an intermediated loan made to the borrower from the deposit base of the lending institution. In contrast, the direct debt facilities are funded by the borrower selling debt instruments into the euromarkets. This distinction is important in that it may be possible for a borrower to access the TLC-based loan market, yet be blocked from the other direct finance markets. This is so because the funding through the term loan is from an intermediary which, in most cases, can be expected to have better risk assessment facilities. Another difference between the markets is that TLC ownership is registered with the agent bank, whereas other euromarket instruments are usually unregistered bearer securities.

Extended learning B LEARNING OBJECTIVE 11.8 Explain the purpose, structure and advantages of convertible bonds and warrants.

Convertible bonds and warrants The bond markets, including the eurobond markets, have developed a number of innovative features. The most common innovation has been the issue of equity-related bonds. The equity link may include the following forms. Convertible bonds the bond holder has the option to convert a bond into another form, such as equity

• •

Host bond the original bond to which a warrant is attached

Naked warrants a warrant issued independently of a bond

Convertible bonds. Convertible bonds contain an option for the holder to convert the bond and receive the redemption proceeds in another form. In equity-related convertible bonds, the bond holder usually has the option to convert the bond into equity of the issuer, such as ordinary shares or common stock of the company. However, the conversion option may also provide the option to convert the original bond into other debt instruments of the issuer. Warrants. The warrant is essentially a call option that provides the holder with the right to purchase other specified securities at a determinable price on a nominated date or within a specified period. The specified security may be equity or other debt securities of the issuer. The warrant may be issued with a bond, referred to as the host bond. The warrant may be a detachable warrant, which means that it can be separated from the host bond and exercised or sold in the secondary market. As an alternative, the warrant may be issued independently of a bond. Such warrants are referred to as naked warrants.

One of the main distinctions between the convertible bond and a bond with a warrant attached is that with the convertible bond the exercising of the option extinguishes the original bond; that is, the original bond is converted into an alternative security. Should a warrant issued with a host bond be exercised, the host bond continues to exist until its redemption on maturity. Equity-related eurobond issues are attractive to both issuers and investors for the following reasons.

•

The option to convert to equity allows the investor to avoid the downside share price risk associated with a straight equity purchase. The investor acquires an instrument that provides a chance to benefit from positive movements in the price of the underlying equity without facing the downside risk.

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• • • •

The equity conversion factor may prompt investors to provide long-term funds in larger quantities than they might with the issue of straight bonds. Under either issue, the investor faces an interest rate risk that increases with the length of the term. However, with an equity link, the investor stands a chance of making a profit from the equity option. Given the value of the attached option, the coupon rate on equity-related bonds should be lower than that for straight bonds with otherwise similar attributes. If the option is exercised, the borrower is relieved of the foreign exchange risk that would be encountered in redeeming the bond, assuming that the bond was denominated in a currency other than its domestic or main operating currency. Because many convertibles are issued as subordinated debt, and thus may count as equity in some calculations, they do not have the same impact as straight bonds on the gearing ratio of the issuer. Investors in convertibles may be able to participate in any rights issues as if they were owners of the underlying share.

While the majority of convertibles have been equity linked or debt linked, there have been successful issues of warrants with commodities as the subject of the warrant. Two commodities that have been used are gold and oil. The most critical aspect of the successful marketing of equity-related issues is the pricing of the issue, and this will be the subject of detailed discussion between the issuer and the issuer’s advisers. The price, as with a straight bond, will be influenced by the credit rating of the issuer and by the coupon rate offered. Given the dual aspects of a convertible, however, the price paid for convertibles will also reflect the conversion premium at the time of issue relative to the current secondary market price. The lower the conversion price, the more attractive the convertible will be. Another aspect in the pricing of the issue is the relationship between the return on the bond and the yield on the underlying asset. It can be expected that the coupon rate on the bond will be higher than the dividend yield on the underlying share. All else being constant, the closer the dividend yield is to the coupon rate, the more valuable is the conversion right, and thus the more valuable is the convertible.

CHAPTER ELEVEN REVIEW

•

Once the convertible has been issued, a significant impact on its price in secondary market transactions is caused by the performance of the underlying share. Unlike a straight bond (whose price is the present value of the future cash flows of the bond), the value of the convertible is also affected by the value of the option to convert into the underlying asset. The valuation of options is discussed in Chapter 20.

Extended learning C LEARNING OBJECTIVE 11.9 Identify the main features of a US medium-term note issue.

US medium-term notes Medium-term notes (MTN) are coupon debt securities. The SEC requires an MTN program to be registered. However, once the program is registered and established, the issuer typically will issue on a continuous basis. A borrower will usually issue an MTN for varying amounts and for a range of maturities. This adds to the flexibility of this type of funding, as the issuer can match the ongoing issue tranches to its particular funding and timing needs. While new registration is not required at each issue, there are nevertheless certain regulatory requirements that must be met in relation to price disclosure and

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information transparency. The following is an introductory discussion on documentation associated with an MTN issue.

• • •

• • • • • • • • • • • •

Disclosure document. This contains a description of the MTN, general and specific terms of the issue, statement of use, information about the issuer, summary financial statements, details of supporting credit enhancements and pricing supplements when notes are delivered to investors. Dealers must supply an offering memorandum to each purchaser. Offeree and purchaser limitations. The offer to buy is generally made to qualified institutional investors. Indenture or issuing and paying agent agreement. The majority of MTN issues require the execution of a trust indenture with a qualified trustee. The indenture normally is open ended, that is, it does not restrict the principal amount of the MTN issue. The indenture may allow more than one type of debt security to be issued. In circumstances in which a private placement is to be made, it may be sufficient for the issuing and paying agents to prepare a less onerous agreement. In both cases, the terms of the issue are largely standardised. Distribution agreement. The MTN issuer will enter into a distribution agreement with a leading investment bank. The agreement governs sales of the notes and will be signed by all dealers and selling agents. Administrative procedures. An MTN issue is a continuous facility, and it is therefore necessary to document ongoing administrative procedures in relation to the offer, sale, issuance, value settlement and maturity of the notes. The procedures must specify the roles of the issuer, the trustee, the issuing and paying agent, the dealers and the selling agents. Forms of MTN. The MTN form is mostly standardised, which enhances the negotiability of the paper. The note will specify whether it has a fixed or a variable interest rate, and a legend note will clarify any restrictions on the sale and transfer of the notes pursuant to the method of issue. Letter of representation. The depositary trust company will require a letter of representation, signed by the issuer and the trustee or issuing and paying agent. Interest calculation agreement. This specifies the calculation of interest on a variable-rate MTN issue, including the specified reference interest rate, such as LIBOR or USCP. Exchange agency agreement. This specifies exchange rate agreements in relation to MTN cash flows that are not denominated in USD. Comfort letters. The issuer’s independent auditors will usually provide a letter of comfort in order to confirm the financial statements. Minimum principal amount. Most MTN programs specify a minimum principal amount of a sale to a single investor as not less than a certain amount; for example, USD150 000. Private placement memorandum. Selling agents must supply each purchaser with a private placement memorandum. Resale restrictions. The MTN can be resold only to accredited investors; that is, qualified institutional investors. Fiduciary purchasers. Third-party purchasers must also be accredited investors. Legal opinions. Legal counsel opinion will be required on the legal structure and compliance matters related to a non-US issuer and the MTN program itself.

As with USCP issues, an MTN issue may be made by book entry; that is, by electronic record rather than the issue of physical paper notes.

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Chapter 11  International debt markets

LEARNING OBJECTIVE 11.10 Define the long-term and short-term credit ratings issued by Standard & Poor’s credit rating agency.

Standard & Poor’s credit rating definitions Standard & Poor’s (S&P) is an international credit rating agency. S&P provides credit ratings on specific debt and hybrid issues, and corporate and government issuers of securities in the money and capital markets. S&P publishes long-term credit ratings, ranging from AAA to D, and short-term credit ratings, ranging from A-1 to D. Short-term ratings are generally assigned to those obligations with an original maturity of no more than 365 days. This section provides a list of the main long-term and short-term issue credit rating symbols and definitions used by S&P. Further information on the S&P credit rating definitions and terminology may be obtained from the S&P website at www.standardandpoors.com or www. understandingratings.com. An S&P issue credit rating is a forward-looking opinion about the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligation or a specific program (including rating medium-term note programs and commercial paper programs). It takes into consideration the creditworthiness of the guarantors, insurers or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. The opinion reflects S&P’s view of the obligor’s capacity and willingness to meet financial commitments as they come due and may assess terms, such as collateral security, and senior and junior subordinated obligations, which could affect ultimate payment in the event of default.

CHAPTER ELEVEN REVIEW

Extended learning D

The credit rating is not a recommendation to purchase, sell or hold a financial obligation, as it does not comment on market price or suitability for a particular investor. Debt issue credit ratings are based on current information furnished by obligors or obtained by S&P from other sources it considers reliable. S&P does not perform an audit or due diligence in connection with any credit rating and may, on occasion, rely on unaudited financial information. Credit ratings may be changed, suspended or withdrawn as a result of changes in, or the availability of, such information, or based on other circumstances.

S&P long-term issue credit ratings

• • • • •

AAA An obligation rated AAA has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong. AA An obligation rated AA differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong. A An obligation rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor’s capacity to meet its financial commitment on the obligation is still strong. BBB An obligation rated BBB exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. BB, B, CCC, CC and C Obligations rated BB, B, CCC, CC and C are regarded as having significant speculative characteristics. BB indicates the least degree of speculation and C the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.

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Part 3 The corporate debt market

• • • • • •

•

BB An obligation rated BB is less vulnerable than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions, which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation. B An obligation rated B is more vulnerable to non-payment than obligations rated BB, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation. CCC An obligation rated CCC is currently vulnerable to non-payment and is dependent upon favourable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation. CC An obligation rated CC is currently highly vulnerable to non-repayment. The CC rating is used when a default has not yet occurred, but Standard & Poor’s expects default to be a virtual certainty, regardless of the anticipated time to default. C An obligation rated C is currently highly vulnerable to non-payment, and the obligation is expected to have lower relative seniority or lower ultimate recovery compared to obligations that are rated higher. D An obligation rated D is in default or in breach of an imputed promise. For non-hybrid capital instruments, the D rating category is used when payments on an obligation are not made on the date due, unless Standard & Poor’s believes that such payments will be made within five business days in the absence of a stated grace period or within the earlier of the stated grace period or 30 calendar days. The D rating also will be used upon the filing of a bankruptcy petition or the taking of similar action and where default on an obligation is a virtual certainty; for example, due to automatic stay provisions. An obligation’s rating is lowered to D if it is subject to a distressed exchange offer. NR This indicates that no rating has been requested, or that there is insufficient information on which to base a rating, or that Standard & Poor’s does not rate a particular obligation as a matter of policy.

The ratings from AA to CCC may be modified by the addition of a plus (+) or minus (−) sign to show relative standing within the major rating categories. S&P short-term issue credit ratings

• • • • •

A-1 A short-term obligation rated A-1 is rated in the highest category by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is strong. Within this category, certain obligations are designated with a plus sign (+). This indicates that the obligor’s capacity to meet its financial commitment on these obligations is extremely strong. A-2 A short-term obligation rated A-2 is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rating categories. However, the obligor’s capacity to meet its financial commitment on the obligation is satisfactory. A-3 A short-term obligation rated A-3 exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meets its financial commitment on the obligation. B A short-term obligation rated B is regarded as vulnerable and has significant speculative characteristics. The obligor currently has the capacity to meet its financial commitments; however, it faces major ongoing uncertainties which could lead to the obligor’s inadequate capacity to meet its financial commitments. C A short-term obligation rated C is currently vulnerable to non-payment and is dependent upon favourable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation.

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Chapter 11  International debt markets

D A short-term obligation rated D is in default or in breach of an imputed promise. For nonhybrid capital instruments, the D rating category is used when payments on an obligation are not made on the date due, unless Standard & Poor’s believes that such payments will be made within any stated grace period. However, any stated grace period longer than five business days will be treated as five business days. The D rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action and where default on an obligation is a virtual certainty; for example, due to automatic stay provisions. An obligation’s rating is lowered to D if it is subject to a distressed exchange offer. SOURCE: Standard & Poor’s Financial Services LLC (S&P) does not guarantee the accuracy, completeness, timeliness or availability of any information, including ratings, and is not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of ratings. S&P GIVES NO EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. S&P SHALL NOT BE LIABLE FOR ANY DIRECT, INDIRECT, INCIDENTAL, EXEMPLARY, COMPENSATORY, PUNITIVE, SPECIAL OR CONSEQUENTIAL DAMAGES, COSTS, EXPENSES, LEGAL FEES, or LOSSES (INCLUDING LOST INCOME OR PROFITS AND OPPORTUNITY COSTS) IN CONNECTION WITH ANY USE OF RATINGS. S&P’s ratings are statements of opinions and are not statements of fact or recommendations to purchase, hold or sell securities. They do not address the market value of securities or the suitability of securities for investment purposes, and should not be relied on as investment advice.

CHAPTER ELEVEN REVIEW

•

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

The euromarkets have expanded into a significant global market.



(a) What is a euromarket transaction?



(b) Briefly outline the factors that led to the development of the euromarkets.



(c) Explain why the euromarkets continued to expand. (LO 11.1)

2

(a) Describe the features of a short-term eurocurrency bank advance. Explain why a corporation might seek this form of funding through the eurocurrency markets.



(b) Explain the structure and purpose of a stand-by facility. Identify and briefly explain risks that need to be considered by a borrower when establishing a stand-by facility in the euromarkets. (LO 11.2)

3

Banks in the eurocurrency markets provide long-term loans to highly-rated corporations. Describe the typical structure and participants in a large multi-million-dollar eurocurrency loan. (LO 11.2)

4

The euronote market is a generic term that incorporates both note issuance facilities (NIF) and eurocommercial paper (ECP).



(a) Describe the type of securities known as an NIF and an ECP.



(b) What features of these facilities are the same and in what ways do they differ from each another?



(c) BHP Billiton Limited is to issue ECP into the London euronote market. The 90-day ECP issue has a face value of USD100 million and a yield of 5.75 per cent per annum. Calculate the amount raised on issue by BHP Billiton. (LO 11.3) 381

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Part 3 The corporate debt market

5

Corporate borrowers often have different needs in relation to their borrowing requirements. The medium-term note (MTN) is designed to meet these varying needs as the MTN facility is typically not homogeneous.



(a) Explain and give examples of the non-homogeneous nature of the MTN.



(b) What steps have been taken to prevent the non-homogeneous nature of the notes resulting in a fragmented, poorly developed secondary market in MTN? (LO 11.4)

6

According to Reuters, each of the four big banks in Australia (CBA, NAB, ANZ and Westpac) require annual bond financing of between $20 and $30 billion. What options do the banks have in raising these longer-term funds? (LO 11.4)

7

BlackRock’s Euro Bond Fund is a product that allows investors to access the eurobond market. With reference to the characteristics of eurobonds in general, explain why such a fund might prove attractive to Australian investors. (LO 11.4)

8

What is the relationship between global geopolitical affairs and the popularity of eurocurrency or eurodollar deposits? Is this still an important consideration today? (LO 11.2)

9

Rio Tinto Limited has decided to issue debt securities into both the euronote market and the eurobond market. The company makes the following issues:

IFs maturing in 180 days with a face value of USD150 million and yielding LIBOR plus • N123 basis points traight bonds with a face value of USD350 million, paying an annual fixed coupon of • S8.00 per cent per annum and maturing in exactly seven years. Rio Tinto is issuing the bonds at a 25 basis point premium above the current market yield on similar bonds issued by other borrowers into the market. What is the total amount of funds raised with each issue? (show your calculations) (Note: Normally you would look at the relevant Thomson-Reuters screen to ascertain LIBOR. However, for this question, assume the 6-month LIBOR is 5.42 per cent per annum.)  (LO 11.3 and 11.4) 10 In the USA, but subject to certain requirements, a foreign borrower is able to place USCP (where there is no public offering) with qualified institutional investors without SEC registration. Discuss the procedures and documentation that would be required in this situation. (LO 11.5) 11 One type of bond issued in the US debt markets is a Yankee bond.

(a) Define a Yankee bond.



(b) Discuss how an issuer might issue these bonds through a shelf registration.



(c) Explain what occurs if the issue is being made by ‘book entry’. (LO 11.5)

12 Santos Limited is an Australian corporation listed on the ASX. Santos wishes to raise additional equity in the USA, but is not dual-listed on the NYSE. The company’s financial advisers suggest the company approach the Bank of New York Mellon to arrange an issue of American depositary receipts (ADR). Explain the existence and operation of the ADR market. Demonstrate in your answer how a foreign company might raise funds in the US capital markets through an ADR issue. (LO 11.5) 13 Credit rating agencies perform an important role within the international financial markets.

(a) Name three global credit rating agencies.



(b) Discuss the purpose and importance of a credit rating issued by a credit rating agency on a corporate debt issue from the perspective of both a borrower and an investor.  (LO 11.6)

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Chapter 11  International debt markets

Extended learning questions 15 The financial markets continue to develop innovative processes and products to meet the changing needs of market participants. Novation, subparticipation and transferable loan certificates are often described as quasi-securitisation financing methods.

(a) Briefly explain how each of these methods operates.



(b) Why are transferable loan certificates attractive to lenders and investors? (LO 11.7)

16 Wesfarmers Limited is considering issuing corporate bonds to fund its expansion into the retail hardware market. The chief financial officer is to advise the board of directors on the bond issue; in particular, on matters relating to convertible bonds and attached warrants.

(a) Describe the features of convertible bonds and warrants.



(b) What factors affect the attractiveness of these instruments from the point of view of lenders? (LO 11.8)

17 A medium-term note issued into the US capital markets will often require the execution of a trust indenture. Within this context, what is a trust indenture and what specific information is an indenture likely to contain? (LO 11.9)

CHAPTER ELEVEN REVIEW

14 Woodside Petroleum Limited proposes to raise additional debt finance to fund its growing gas exploration and production operations. The company requests S&P to provide a credit rating on the issue. Describe the structured credit rating process used by S&P. Include in your answer important issues that would be incorporated in the credit risk analysis. (LO 11.6)

18 Fund managers, such as superannuation funds and insurance offices, often establish a policy requirement that the funds are only permitted to invest in capital-market securities that have at least an investment-grade credit rating. Referring to the issue credit ratings used by Standard & Poor’s, discuss the above policy requirement. (LO 11.10)

KEY TERMS agent bank  353

euro floating rate note (FRN) 362

junk bond market  366

eurobonds 359

management group  359 market-makers 360

bearer bonds  360

eurocommercial paper (ECP) 356

bid 355

euromarket transaction  349

medium-term note (MTN) 357

book-entry USCP  365

euronote issuance facility (NIF) 354

MTN tap approach  358

American depositary receipt (ADR) 366 availability period  353

bullet repayment  361 Cold War  350 co-managers 353 convertible bonds  376 country risk  368 credit watch  369 definitive notes  355 depositary share  366 domestic bonds  358 euro 361

foreign bonds  358

Kangaroo bonds  359

naked warrants  376

FRN call option  362

natural foreign currency hedge 351

FRN put option  362

novation 375

global notes  355

obligor 367

grey market  360

offer 355

host bond  376

participating banks  353

inscribed stock  360

paying agents  362

investment grade  368

posted rate  355

issue-specific credit rating 368

quoting two-way prices  358

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Part 3 The corporate debt market

rating symbols  368

SIBOR 352

tombstone 360

red herring  359

sovereign risk  368

tranches 356

Securities and Exchange Commission (SEC)  364

stand-by facility  352 straight bond  365

transferable loan certificates (TLCs) 376

sell-down provision  375

straight eurobonds  361

trust indenture  364

serial offering technique 358

subparticipation 375

underwriting banks  354

subscribe 359

USSR 350

tender panel  355

Yankee bond  365

shelf registration  366

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PART Four

Government debt, monetary policy, the payments system and interest rates CHAPTER 12 Government debt, monetary policy and the payments system

CHAPTER 13 An introduction to interest rate determination and forecasting

CHAPTER 14 Interest rate risk measurement

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Government debt, monetary policy, the payments system and interest rates Policy initiatives and the financial transactions of government and the central bank have a significant impact on the operation of a domestic financial system. In some cases (as in the USA), these actions may also affect the global financial system. Policy initiatives are typically directed towards achieving economic growth, high levels of employment and a stable currency. Policies adopted to achieve these objectives may vary from country to country, but most developed economies tend to apply very similar principles. Each country has a central bank that is usually responsible for the implementation of monetary policy and maintaining the stability of the payments system. Also, a country will establish a number of other regulatory authorities that supervise aspects of the country’s financial institutions, instruments and markets. Typically, the central bank will participate in the financial markets through the issue of short-term and/or long-term government debt securities. Just as a business may have capital and current expenditures in excess of its present income, so too may the government sector. The mismatch between income and expenditure cash flows has to be managed, either by issuing equity or by borrowing the necessary funds. Governments confine themselves to the latter, that is, issuing debt securities. Government debt securities are much like the securities issued by the corporate sector, which were discussed in Chapters 9 and 10. However, the securities will vary slightly in structure and description between countries. This text concentrates on Australian government debt securities. Students interested in comparing the Australian government sector with that of another country will generally find valuable information at the website of a country’s central bank and other government authorities. A list of useful and interesting websites is provided at the beginning of this textbook. Chapter 12 opens with an examination of the recent history of the Australian Commonwealth Government’s borrowing requirements, followed by a discussion of the types of debt instruments that are issued by the government in order to fund its accumulated and current debt. Financial calculations of the price of Treasury bonds and Treasury notes are provided. The methods through which the instruments are marketed, and the major participants in the primary and secondary markets, are examined. While the main focus is on debt securities issued by the Commonwealth Government, a brief introduction to borrowing by state governments is also provided. The implementation of monetary policy by the Reserve Bank is examined next, including the transmission of that policy through the financial system and the economy, the means of implementing the bank’s initiatives through its market operations and the effects this may have upon liquidity in the financial system. This is followed by a discussion on the structure and operation of the payments system, including exchange settlement accounts, real-time gross settlement and repurchase agreements. The interest rates over which the central bank has its most direct influence are those at the very shortterm end of the financial markets. Chapter 13 considers factors that influence the determination of interest rates, and takes up the issue of the relationship that exists between short-term rates and long-term rates. A number of theories are advanced to explain the shape of the yield curve that derives from the term structure and risk structure of interest rates. Other factors that have an influence on interest rates, in addition to the actions of the central bank, are discussed.

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Interest rates essentially represent the cost of funds in the financial markets. Given the importance of interest rates to the financial markets and economic activity generally, it is necessary to gain some understanding of how interest rate risk exposures can be measured. Chapter 14 introduces some of the techniques used to measure interest rate risk exposures, including re-pricing gap analysis, duration and convexity. In Part 6 of the text, the discussion is extended to consider strategies that may be used to manage interest rate risk exposures using various derivative products.

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CHAPTER 12

Government debt, monetary policy and the payments system CHAPTER OUTLINE 12.1 The Commonwealth Government borrowing requirement 12.2 Commonwealth Government securities 12.3 State government securities 12.4 Monetary policy 12.5 The payments system

Learning objectives LO 12.1

Consider the reasons for the existence of government debt markets and the government borrowing requirement.

LO 12.2

Outline features of the main debt instruments issued by the Commonwealth Government, that is, the Treasury bond and the Treasury note, and describe the issuance process, participants and complete relevant calculations.

LO 12.3

Describe the purpose and structure of state government central borrowing authorities.

LO 12.4

Outline the monetary policy techniques currently employed by the Reserve Bank through which it influences the level of interest rates in Australia, including open market operations and the impacts on system liquidity.

LO 12.5

Describe the purpose and operation of the payments system, including exchange settlement accounts, real-time gross settlement and repurchase agreements.

Extended learning LO 12.6

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Calculate the price of a bond using the AOFM formula.

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Chapter 12   Government debt, monetary policy and the payments system

CHAPTER SNAPSHOT Like companies and individuals, governments also need to borrow funds. When a government sells bonds to raise funds, those bonds trade on the bond markets just like other bonds. However, because a government of a stable democracy is usually viewed as a low-risk proposition, the yield on those government bonds gives us an indication of the risk-free rate of reward that currently prevails on the financial markets. This gives us our benchmark or starting point for the remainder of the risk–reward trade-off. Companies are more risky than the government, so their bonds should have higher yields. Some companies are riskier than others, so their bonds should have yields that are higher again. The government’s borrowing and spending decisions are called ‘fiscal policy’. The other major policy instrument that can be brought to bear in managing the economy is ‘monetary policy’. The Reserve Bank of Australia is responsible for implementing monetary policy; that is, deciding on when and by how much interest rates should be increased or decreased.

INTRODUCTION All governments need to fund their capital expenditure and recurrent operations. As with any business, governments will from time to time issue debt securities into the financial markets to raise funds. The debt instruments issued are very similar to those issued by business into the money markets and the capital markets; that is, governments may issue both short-term discount securities and medium- to long-term coupon securities. There are minor variations between countries relating to the description and structure of government securities. For example, the short-term discount security issued by the Federal Reserve in the USA is known as a Treasury bill, whereas in Australia the same type of security is known as a Treasury note (T-note). Both T-bills and T-notes are often issued with different terms to maturity. The decision to raise funds by borrowing is a key part of the government’s fiscal policy. Fiscal policy relates to the annual incomes and expenditures of a government. If government income from taxes and other sources exceeds forecast expenditures, the budget is said to be in surplus. On the other hand, if expenditures exceed income, the budget is in deficit. Governments have choices as to whether their budget will be in surplus or deficit, and the extent of that surplus or deficit. Accumulated deficits need to be funded through the issue of debt securities. The government can influence the economy through its fiscal policy. For example, during a recession a government may borrow funds to spend on infrastructure to create jobs and stimulate economic activity. The other way that the economy can be managed is through monetary policy. Monetary policy is implemented by the central bank and affects the level of short-term interest rates. A central bank is able to influence the level of short-term interest rates by adjusting the level of liquidity in the financial system. Monetary policy seeks to target the level of inflation in order to achieve economic growth, high employment and a stable currency. The central banks of most developed economies currently apply very similar principles in implementing monetary policy.

Reflection points

may issue debt securities into the money markets and capital markets to fund • Governments their capital and recurrent expenditures when the amount or timing of taxation revenues and other income does not meet expenditure needs. policy relates to the annual budget of a government, that is, its income and expenditure; • Fiscal a budget may be in surplus or deficit. A deficit needs to be funded. policy relates to the actions of a central bank that target the level of inflation by using • Monetary interest rates to modify economic activity. 389

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Part 4 Government debt, monetary policy, the payments system and interest rates

12.1 LEARNING OBJECTIVE 12.1 Consider the reasons for the existence of government debt markets and the government borrowing requirement.

Commonwealth Government the central government of Australia

The government must manage its financial position, including the timing of its cash flows and the financing of capital expenditures. The matching principle (discussed in Chapter 1) also applies to government; that is, the government funds any shortfall in short-term liquidity requirements with the issue of short-term debt securities, and any shortfall in its long-term capital expenditures and commitments with the issue of long-term debt securities. A liquidity shortfall may occur if there is a mismatch between the timing of government intra-year expenditures and the receipt of revenues. A capital expenditure shortfall occurs when a budget is in deficit, that is, when capital expenditures are greater than tax and other income receipts. If necessary, the Australian government issues two main forms of debt security: the short-term Treasury note and the longer-term Treasury bond. This section examines, first, the Commonwealth Government’s long-term (or full-year) borrowing requirements, and, second, the government’s short-term liquidity requirements (those that exist within a financial year).

12.1.1 Budget deficit occurs when a government’s expenditures exceed its revenues over a fiscal year

The Commonwealth Government borrowing requirement

The borrowing requirement: full financial year

A borrowing requirement arises when a government’s expenditures exceed its revenues in any particular period. Over a full financial year this situation gives rise to a budget deficit. As can be seen in Figure 12.1, the Commonwealth Government’s financial position has changed quite significantly throughout the last 14 years.

Figure 12.1  Commonwealth Government budget outcomes ($ billions) 30

26.7 28.1

20 14.2 10 –14.5 2017–18

2015–16

2014–15

2013–14

–18.2 –33.2

2018–19

–37.4 –40.4

2016–17

–47.0 –23.5

2011–12

2010–11

2009–10

2008–09

2007–08

2006–07

–10

2005–06

0

–44.5 –52.0

2012–13

–56.5 –31.3

–20 –30 –40 –50

Budget surplus occurs when government revenues exceed expenditures over a fiscal year

Fiscal constraint a significant reduction in government recurrent expenditure

–60

SOURCE: Commonwealth of Australia 2018. Mid-Year Economic and Fiscal Outlook (MYEFO), various issues.

Before the GFC, the Australian government maintained a budget surplus. This was the result of good economic conditions and the fiscal constraint exercised by the government at the time. This changed considerably with the onset of the global financial crisis and the stimulus spending enacted by

390

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Chapter 12   Government debt, monetary policy and the payments system

the government in an attempt to avoid economic recession. During and after the GFC, the government increased its borrowing and spending in order to stimulate the economy. This generated large budget deficits and sparked considerable economic and political debate. The securities issued by the government to raise funds are held by market participants for a range of reasons. These include:

Economic recession defined officially as two consecutive quarters of negative economic growth

• Liquidity management—there is an active secondary market in government securities; therefore, the

paper is held because investors know that the paper can be easily sold to generate cash (liquidity) when needed.

• Portfolio investments—government securities pay a rate of return, therefore fund managers may hold these securities as part of a larger investment portfolio.

• Risk management—government securities are regarded as risk free; therefore, an investor may hold this type of security as part of a portfolio so that the overall risk of the portfolio is lowered.

• Payments system requirements—see the discussion in Section 12.5. • Prudential requirements—financial institutions are required by the prudential regulator (APRA) actively to manage liquidity risk.

Changes in budget outcomes affect interest rates, exchange rates and the flow of funds within the markets, as government demand for debt funding fluctuates. When a government deficit is high, the government demand for debt funding will reduce the amount of funds available for investment in the private sector and therefore limit growth within the economy. This is the so-called crowding-out effect.

12.1.2

The borrowing requirement: within the financial year

Independent of the overall state of a budget for the full financial year, within each year there may be month-by-month mismatches between the inflow of funds to the government and the government’s cash outflows. In other words, the government needs to manage its day-to-day liquidity requirements just like any other business. Government derives its main source of funds from taxation receipts. However, the timing of these receipts is not perfectly matched to the timing of certain fixed expenditures of government. For example, the government makes regular fortnightly payments to pension and benefit recipients, including the age pension and unemployment benefits. At other times it will have sudden and unexpected demands for liquidity, such as to make cash payments to victims of a natural disaster such as a flood. Therefore, within a budget year it is possible that the government may need to issue debt securities to finance its operations during cash-flow-deficit months. Ideally, the instruments issued during the deficit months should mature during the months in which the cash flows are in surplus, so that the surplus funds can be used to retire the maturing debt. In other words, the instruments issued for intrayear budgetary purposes should, ideally, be short-term securities. The securities are known as Treasury notes (T-notes) and are discussed later in this chapter.

Day-to-day liquidity having access to sufficient funds to meet commitments when they are due

REFLECTION POINTS

matching principle applies to government; therefore, government may need to borrow both • The short-term funds and long-term funds. funds are generally used to finance capital infrastructure expenditures such as • Long-term hospitals and roads; short-term funds are used to manage day-to-day liquidity for recurrent expenditures such as pensions.

• A budget deficit occurs when expenditure exceeds revenues from taxation and other income. • Government borrowing may have a crowding-out effect on borrowing by the business sector. 391

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12.2 LEARNING OBJECTIVE 12.2 Outline features of the main debt instruments issued by the Commonwealth Government, that is, the Treasury bond and the Treasury note, and describe the issuance process, participants and complete relevant calculations.

Commonwealth Government securities

Just as the private sector issues fixed-coupon instruments such as debentures and unsecured notes, and discount instruments such as bills of exchange and commercial paper, so too does the Commonwealth Government. The interest coupon securities issued by the Commonwealth Government are called Treasury bonds. Treasury bonds currently issued are straight bonds; that is, the bond pays a periodic fixed-interest coupon and the principal is repaid at maturity. Bonds with special features, such as the indexation of the coupon or the indexation of the capital value of the bond, may be issued from time to time. The other major Commonwealth Government debt instrument, the Treasury note (T-note), is a discount security.

12.2.1

Treasury bonds

This section examines the main features of Treasury bonds, how they are sold in the primary and secondary markets, the types of investors who buy them and some financial calculations used in their pricing.

Main features Coupon payment the periodic interest payment attached to a debt security

Money-laundering transaction executing a transaction in order to move illegally gained funds into the financial system

Treasury bonds are coupon instruments. The holder of a Treasury bond (the investor) receives a periodic payment known as a coupon payment, normally paid every six months. A coupon payment is simply the interest payment for the period. It is called a coupon in the market because many bonds issued in the international capital markets are bearer securities with actual interest payment coupons attached to the bond. These coupons are removed from the bond and presented for payment at each interest-due date. Treasury bonds are not bearer securities, and therefore the coupon payment is made electronically to the registered holder of the bond. The registered holder redeems the face value of the bond on the specified maturity date. For example, the holder of a 5.00 per cent July 2022 bond is guaranteed receipt of $25 each six months on a $1 000 face value bond, and in July 2022 will receive the face value of $1 000 plus the final coupon payment. The Treasury bond holder does not have the right to early redemption of the bond at face value. A bond holder who wishes to redeem a bond early must sell it to another investor in the secondary market. A bond holder thus faces an element of risk. If current market yields on similar-maturity Treasury bonds were to rise, then the price, or value, of the July 2022 bond would fall in the secondary market and the bond holder would experience a capital loss. In this circumstance, the value of the fixed-interest bond must fall, as the coupon payment will not change over the life of the bond; therefore, the only variable is the price. The future fixed cash flows are now worth less in present value terms. We mentioned above that an issuer of bonds may choose to issue the bonds either as bearer bonds or as inscribed stock. With bearer bonds, the holder of the physical bond is presumed to have legal title to the bond. The bearer is able to detach the printed coupon from the bond and present it for payment on the interest date. The bearer similarly has the presumed right to sell the bond in the secondary market, or to present it for redemption on maturity. With inscribed stock issues, a receipt is issued but not the physical bond, and ownership is registered electronically. Since 1984, the Australian government has only issued inscribed stock. There are advantages associated with the issue of inscribed stock:

• It is less costly to maintain a register of bond holders than it is to print and distribute the physical bonds. • More importantly, the ownership of bearer bonds is not registered anywhere, allowing the non •

disclosure of interest income for taxation purposes. Similarly, bearer bonds may facilitate moneylaundering transactions. Inscribed stock restricts these activities. From the bond holders’ points of view, inscribed stock protects them from the risks of theft, destruction or misplacement, since the ownership right to coupon payments, and to the redemption value of the bond, is registered at an inscribed stock registry. When inscribed stock is sold in the secondary market, the ownership of the bond is transferred in the registry.

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Primary market transactions The system used in Australia for the primary market issue of Treasury bonds is known as the tender system. The federal treasurer has the power to decide on the timing of each tender, and on the maturities, coupons and quantities of bonds to be marketed. This is currently managed through the Australian Office of Financial Management (AOFM). With the tender system, the AOFM is confident that investors will always purchase any Treasury bonds on offer. The bonds are offered with a fixed interest rate, but a tender will be lodged to buy the bonds in terms of the yield to maturity. That is, an investor will offer to buy at a premium, or a discount, to the face value. For example, if an issue is announced carrying a coupon of 5.75 per cent per annum but an investor requires a rate of 6.00 per cent per annum, under the tender system the series will still be fully subscribed. Buyers will put in a tender with their bid price being sufficiently below the face value of the bond so that the existing 5.75 per cent fixed-coupon payments, plus the capital gain at maturity, will return an effective yield of 6.00 per cent on the purchase price. That is, the investor will buy the bond for less than the face value today, receive the periodic fixed-coupon payments and finally receive the face value of the bond at the maturity date. The current procedures involved in bidding for bonds are available on the website of the AOFM at www.aofm.gov.au. Fixed-coupon Treasury bond bid conditions include the following:

Tender system investors bid a price on government securities, thus setting the yield; allocated in order of lowest yields

Australian Office of Financial Management (AOFM) a body established to manage Commonwealth Government debt issues

• Bids may only be submitted electronically by registered bidders through the AOFM tender system. The AOFM tender system is accessed via the electronic Yieldbroker DEBTS System. • The minimum bid must be for a face value of $1 million, and thereafter in multiples of $1 million. • Bids are to be made in terms of yield to maturity up to three decimal places, not in terms of price. • • •

The yield is calculated using the formula specified in the prospectus (see the Extended learning section at the end of the chapter). Bids are accepted in ascending order; that is, the lowest-yield bid, which corresponds to the highest price, is accepted first and the quantity of that bid is allotted. Then the second lowest of the tendered yields is accepted and so on, until the issue is fully subscribed. This is illustrated in Table 12.1. Bidders may submit multiple bids, at different yields, for the one bond series. Treasury bond purchases are settled using the Austraclear settlement system.

Table 12.1 Treasury bond series tender: bids and allotments Bid

Yield Competitive bids Allotment: Allotment: Reserve (% p.a.) ($ millions) competitive ($ millions) Bank ($ millions)

1

6.30

30

30

2

6.40

35

35

3

6.50

25

25

4

6.60

30

10

5

6.65

25

nil

Weighted average yield

6.42

Totals

20 145

100

20

Table 12.1 illustrates a hypothetical bond tender where the government issues $120 million of Treasury bonds. Twenty million dollars of the issue is allocated to the Reserve Bank at the weighted average issue yield announced for the relevant tender. The remaining $100 million is allotted according to the bids that are received. In the example, the AOFM receives competitive bids from five parties totalling $145 million, and these have been arranged in ascending order in the table. The first bidder

Weighted average issue yield the average of the proportional yields bid on a bond issue

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has lodged a tender for $30 million at a yield of 6.30 per cent per annum—the lowest yield and thus the highest price at which a bid was lodged. This bidder is allotted the full $30 million bid. The second and third bidders are also successful in attaining the full quantity of bonds for which they bid. The fourth bidder receives different treatment from that given to the preceding three. Since the first three have been allotted $90 million of the $100 million available to competitive bidders, the fourth bidder is allotted only $10 million, even though that tender was for $30 million. The tender of the fifth bidder is unsuccessful. You will note that the Reserve Bank does not compete for the bonds. It takes them at the weighted average yield established at tender. The Reserve Bank has an accumulated portfolio of government securities that it uses in its dealings with the financial markets from time to time. Such dealings may be carried out to achieve objectives that:

• alter the overall maturity composition of bonds on issue • affect the amount of liquidity available in the financial system. Who buys Treasury bonds?

Financial system liquidity the amount of exchange settlement accounts funds in the system

Operational liquidity access to funds to meet day-to-day expenses and take advantage of business opportunities

Prudential liquidity liquidity held above operational liquidity needs; may be prescribed by a regulator

On-exchange transactions buying and selling securities on a formal exchange such as a stock exchange

Over-the-counter transactions buying and selling of securities conducted directly; no formal exchange; mostly between institutional investors

Exchange traded Treasury bonds (eTBs) rights to Treasury bonds that can be traded on the ASX

The Reserve Bank of Australia holds a large portfolio of government securities. This portfolio is an important tool in the management of the financial system. The Reserve Bank, as part of its monetary policy initiatives, is able to change the level of financial system liquidity by either buying or selling government securities to other investors. Monetary policy is discussed later in the chapter. Banks hold government paper in their securities portfolios. Banks need to manage their operational liquidity and prudential liquidity. As there is a deep and liquid secondary market in government paper, the banks hold these securities as part of their liquidity management strategies. The banks know that the government securities can easily be sold and converted into cash when required. Trustee companies such as superannuation funds also hold government securities as part of their liquidity management strategies, as do insurance offices. It is interesting to note, however, that more than half of the bonds issued by the Australian government are held by non-residents. A large part of this group will be central banks from other countries and overseas institutional investors generally.

Secondary market transactions In the secondary market—that is, the market through which previously issued securities are traded— Treasury bonds can be bought and sold as on-exchange transactions or over-the-counter transactions. Most bonds are traded in over-the-counter transactions. However, in order to provide greater access to the bond market and reduce the government’s reliance on off-shore investors, in 2012 the government introduced exchange traded Treasury bonds (eTBs). The owner of an eTB holds the right to a Treasury bond in the form of CHESS depository interest (CDI). The ownership of the CDI entitles the holder to all of the benefits of ownership but the legal title remains held by the ASX as the nominee of the CDI holder. This innovation ensured that smaller investors could gain access to the bond market in Australia. For large institutional investors, the trading of large parcels of bonds takes place in over-the-counter transactions. The Australian Financial Markets Association (AFMA) has published conventions that apply to trading in the over-the-counter market of long-dated debt securities such as Treasury bonds. These details can be viewed at AFMA’s website at www.afma.com.au. We have briefly mentioned above why investors might purchase Treasury bonds in the primary market. These same reasons apply for secondary market transactions.

• Funding requirements. Financial institutions, especially commercial banks, borrow large amounts

of funds by issuing debt securities directly into the international capital markets. These funds are generally used to provide loan facilities to customers progressively over a period of time. In this situation, the institutions will invest the funds raised in the international markets until they are needed for loan commitments. Commonwealth Government Securities are an attractive strategy for investing short-term excess funds; they provide a return, but can very quickly be sold when the funds are required for customer loans.

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• Liquidity requirements. A financial institution or corporation with a need for cash to meet its day-

to-day liquidity requirements may choose to sell some of its government securities portfolio. Other financial institutions and corporations may have short-term surplus funds that they may temporarily invest in government securities.

• Reserve requirements. Banks in some countries are required to hold a proportion of their assets in

government securities. An increase in deposits into the banks necessitates the purchase of more government securities by the banks. In Australia, the prudential supervisor has removed prescriptive liquidity reserve ratios, but the banks are still required to manage liquidity prudently to the satisfaction of the supervisor, and therefore continue to hold government securities for that purpose.

• Interest rate expectations. If market participants, such as fund managers, expect that interest rates are

going to fall, they may increase their holdings of long-term fixed-interest government securities in order to take advantage of potential future capital gains. Therefore, as interest rates fall, the price of a fixed-interest security will rise.

• Managing the maturity profile of a bond portfolio. Some fund managers will have a preference regarding

the average maturity of the bonds that they hold in their portfolios. For example, life insurance offices and superannuation funds tend to prefer longer-term bonds, while a cash management trust may prefer short-term-to-maturity bonds. As the former groups find that the maturity profile of their existing portfolios is shortening over time, they will sell the short-dated paper and buy longer-term paper.

In Australia, transactions in Commonwealth Government Securities are settled through the Austraclear clearing house.

Treasury bond pricing When Treasury bonds are traded in either the primary market or the secondary market they are quoted in terms of their redemption yield or yield to maturity. Yield is the return, including both interest and capital gain (or loss), received by an investor over the holding period on an initial amount invested. Treasury bonds are a fixed-interest security; that is, the interest coupon will not change during the term of the bond. However, current market interest rates do change over time. Since the coupon cannot change, the price of existing bonds will change if current market rates change. Therefore, the rate of the fixed coupon will generally be different from the actual yield to maturity. Given the convention of quoting redemption yields, how is the price of a bond calculated? Treasury bonds are priced in the same way as corporate bonds. The pricing of bonds was discussed in Chapter 10, and is reviewed here. The price paid for the bond (P) is the present value (PV) of the future cash flows derived from the bond; that is, it is equal to the sum of the PV of the coupons ​​​(​​P​Vc​ ​​​)​​​​ plus the PV of the face value of the bond ​​​(​​P ​Vf​ ​​​)​​​.​ That is:

Austraclear an electronic clearing house for a range of financial instruments, including Treasury bonds

Redemption yield the total return (interest and capital gains) received if a security is held to maturity

​P = P​Vc​ ​​ + P​Vf​ ​​​ The above calculation needs to be adjusted to take account of the fact that most transactions occur between coupon dates. The holder of a bond will need to be compensated for the time the bond has been held during the next six-month coupon period, that is, the number of elapsed days. This formula can be written using Equation 12.1: 1 − ​​(​​1 + i​)​​​​ −n​ −n k ​P = ​​{​​C​​[___________ ​​​      ​​  ]​​​ + A​​(​​1 + i​)​​​​  ​​}​​​​​(​​1 + i​)​​​​  ​​ i

12.1

where: i = the nominal interest rate per period expressed as a decimal n = the number of coupon periods ​​k​ ​ ​  =​  the fraction of the elapsed interest period since the last coupon                       ​ ​ ​ ​​​ C = periodic coupon payments A = the face value of the bond 395

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This is the same formula that was used to calculate the price of a corporate bond in Chapter 10 and the price of a eurobond in Chapter 11, and for consistency it is also used here. The formula clearly shows that the price of the Treasury bond is the present value of the coupons plus the present value of the principal amount, adjusted for the number of days elapsed in the current coupon period. The AOFM uses a different Treasury bond pricing formula that achieves the same result. The AOFM formula is provided in the Extended learning section at the end of the chapter.

EXAMPLE 12.1 An existing Treasury bond has been issued with a face value of $1 000. The bond pays half-yearly coupons at a fixed rate of 7.00 per cent per annum, and matures on 15 November 2021. Assume that the bond is sold on 15 July 2018. Current market yields for similar Treasury bonds are now 8.00 per cent per annum. Calculate the price of the bond in the secondary market, where: ​A = $1  000 ​​(​​face value​)​​​ C = $35 ​​(​​fixed rate 7.00 per cent per annum; coupons paid half-yearly​)​​​ i = 0.08/2 = 0.04 (​​​​current market rate divided for half-yearly payments​)​​​ n=7 ​  ​(​​bond sold on 15 July 2018; therefore remaining coupons will be paid on  15 November​ 2018, 15 May and 15 November 2019, 15 May and  15 November 2020, and 15 May and 15 November 2021 = 7 coupons) k=6 ​ 1/184 ​(​​last coupon paid 15 May 2018; days elapsed from 16 May to 15 July  inclusive = 61;​ ​total days in coupon period from 16 May to 15 November  = 184​)​​​​ 1 − ​​(​​1  + 0.04​)​​​​  −7​ 61 ____ P = ​​ ​​$35​​ ____________ ​​​     ​​  ​​​  +  $1  000​​ ​​1  + 0.04​ ​​​​  −7​​ ​​​​​(​​1  + 0.04​)​​​​  ​ 184  ​​  { [ ] ( ) } 0.04 ​​​             ​    ​ ​​​ ​ = ​​[​​$210.07  + $759.92​]​​​1.013087 ​ = $982.68 The price of the Treasury bond is $982.68. You will have noted that the price has fallen below the face value because the current market rate has risen.

12.2.2

Treasury notes

Governments need to manage their liquidity position. When day-to-day cash outflows exceed cash inflows, a government will need to borrow short-term funds. The main type of short-term security issued by a government is a discount security. The name of the discount security issued by governments may vary between countries. For example, in the USA the short-term security is the Treasury bill, whereas in Australia it is the Treasury note. Treasury notes (T-notes) are short-dated securities that may be issued by the Commonwealth Government in order to manage the within-year timing mismatches of the government’s revenue and expenditure cash flows. The Commonwealth Government, through the AOFM, may from time to time issue T-notes with differing terms to maturity. The term to maturity of a T-note issue will be set to coincide with the government’s main revenue receipt dates during the year. The AOFM is a government-established agency responsible for the management of the Commonwealth Government’s debt issues. T-notes are short-term discount securities; they are sold at a price below their face value in the same way as commercial paper (discussed in Chapter 9). The return to the holder of a T-note is the difference between the purchase price and the face value received at maturity. If the T-note is sold before maturity, the return is the difference between the purchase price and the price at which the T-note is sold. 396

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T-notes, as with Treasury bonds, may be issued by tender in the primary market. The main features of the tender arrangements are:

• Bids may only be submitted electronically by registered bidders through the AOFM tender system. The AOFM tender system is accessed via the electronic Yieldbroker DEBTS System.

• The minimum bid must be for a face value of $1 million, and thereafter in multiples of $1 million. • Bids are to be made in terms of yield to maturity up to two decimal places, not in terms of price. • Bids are accepted in ascending order; that is, the lowest-yield bid, which corresponds to the highest price, is accepted first and the quantity of that bid is allotted. Then the second lowest of the tendered yields is accepted and so on until the issue is fully subscribed.

• T-note purchases are settled using the Austraclear settlement system. Treasury note pricing The T-note is a discount security. The financial calculations for discount securities were considered in Chapter 9, including calculating the price and yield, and are revisited below.

Calculating the price of a T-note where the yield is known T-notes are bid for and traded at a price that represents a discount from the face value. The formula used to calculate the price of a T-note, where the yield is known, is: face value × days in year ​Price = ​ __________________________________           ​​ yield ____ days in year + ​​(​​​   ​ × days to maturity​   )​​​ 100

12.2

EXAMPLE 12.2 A bank is to bid at tender for $1 million of 182-day T-notes at a yield of 5.50 per cent per annum. What price will the bank pay if the tender is successful? $1 000 000  × 365 Price = ​ _____________       ​ 365 + ​​(​​0.055  × 182​)​​​ ​​​        ​  _________  ​​ ​ ​ $365 000 000 ​ = ​     ​   375.01 ​

=  $973 307.38

EXAMPLE 12.3 The T-note in Example 12.2 was purchased by the bank and now has only 74 days to maturity. T-notes are currently yielding 4.95 per cent per annum. If the bank sells the T-note, what price will be obtained? $1 000 000  × 365       ​ Price = ​ _____________ 365 + ​​(​​0.0495  × 74​)​​​ ​​​        ​  _________  ​​ ​ ​ $365 000 000 ​ = ​     ​   368.663 ​

=  $990 064.09 397

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Calculating the holding period yield The yield in the formula below (Equation 12.3) refers to net return, expressed as per cent per annum, on the amount outlaid to purchase the T-note. The basic formula for calculating the holding period yield is: ​(​​sale price − current price​)​​ _______________ ​(​​days in a year × 100​)​​ ​Yield = ​ __________________      ​ × ​            ​​ current price days to maturity

12.3

(Note: At the maturity date the sale price will equal the face value.)

EXAMPLE 12.4 The yield on a T-note with a face value of $1 million, a current price of $975 400 and 182 days to maturity is: ​(​​1  000  000  −  975 400​)​​ ______ ​(​​36  500​)​​ Yield = ​ ______________        ​  × ​   ​     182 975 400 ​​​          ​  ______   ​ ​​​ 36 500 ​ = ​  26 600   ​   × ​ _____  ​     182 975 400 ​

= 5.06%

EXAMPLE 12.5 A fund manager purchased a T-note with a face value of $1 million, maturing in 35 days. The T-note was discounted at a yield of 5.40 per cent per annum, representing a price of $994 848.59. After seven days, the fund manager sells the bill for $995 850.60. Calculate the yield to the original discounter (the fund manager) and the yield to the holder to maturity (the final purchaser). 1.

Yield to fund manager:

(​​​$995 850.60  −  $994 848.59​)​​ _____ ​Yield = ​  ___________________         ​  × ​ 36 500  ​     7 $994 848.59 = 5.25%​ 2.

Yield to holder to maturity:

(​​​$1 000 000.00  −  $995 850.60​)​​ _____ ​Yield = ​  ____________________         ​  × ​  36 500  ​     28 $995 850.60 = 5.43%​

REFLECTION POINTS

• The long-term security issued by the Commonwealth Government is the Treasury bond. Treasury bond pays a fixed-interest coupon half-yearly with the principal repaid at maturity • The (straight bond). • Treasury bonds are issued as inscribed stock and sold through a tender system. in terms of yield to maturity to three decimal places, are made through the AOFM tender • Bids, system; the lowest yield bids are accepted in ascending order. 398

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• A formula used to calculate the price of a Treasury bond is: 1 − ​​(​​1  + i​)​​​​  −n​ −n k ​P = { ​​ ​​C​​[​​​ _     ​​  ]​​​  + A​​(​​1  + i​)​​​​  ​​}​​​​​(​​1  + i​)​​​​  ​​ i are able to sell securities into the markets because commercial banks and other • Governments institutional investors hold government paper for liquidity management, portfolio investment, risk management, payments system requirements and prudential requirements. short-term security issued by the Commonwealth Government is the Treasury note • The (T-note); it is also sold by tender. T-note is a discount security, sold today at a price less than the face value, which is • The payable at maturity.

• The formula used to calculate the price of a T-note is: face value × days in year ​Price = ________________________________ ​          ​​ yield days in year + ​​ ____ (​​​  100 ​  × days to maturity​)​​​

• The formula to calculate the holding period yield on a T-note is: ​(​​days in a year   ×  100​)​​ ​(​​sale price   −  current price​)​​ _______________ ​Yield = ___________________ ​         ​  × ​        ​​ current price days to maturity

12.3

State government securities

The discussion in this chapter has so far focused on securities issued by the Commonwealth Government. However, Australia is a federation of states and territories, each with its own government. State governments are responsible for providing a wide range of services, such as hospitals and roads. When expenditures exceed receipts, state governments may need to raise funds from the issue of debt securities. Each state has formed a central borrowing authority to undertake borrowings on behalf of the state government and its instrumentalities; for example, the New South Wales Treasury Corporation, the Treasury Corporation of Victoria and the Western Australian Treasury Corporation. The central borrowing authority approach has a number of advantages, which can be expected to result in a lower cost of funds. Some of the advantages are:

•

Economies of scale can be achieved. Rather than numerous authorities and instrumentalities separately approaching the capital markets, and each bearing the costs of advertising and marketing, a single issue can be made by the central borrowing authority.

LEARNING OBJECTIVE 12.3 Describe the purpose and structure of state government central borrowing authorities.

Central borrowing authority established by each state and territory government to manage debt programs

• The timing of the issues can be controlled, and they can be brought to the market at the most opportune time, particularly with respect to the level of interest rates.

• The potential for competition between different debt issuers within the same state is overcome. • The size of the single debt issues will be larger than the borrowings of separate state authorities and instrumentalities.

• The central borrowing authority is able to use more effectively tender and dealer panels similar to those described in the discussion on P-notes and eurobonds.

• The development of a secondary market in state government, or semi-government, securities is

encouraged by the existence of large issues of instruments with identical features, as opposed to numerous small issues of instruments with non-identical features. 399

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Semi-government securities (semis) long-term coupon securities issued by central borrowing authorities

In marketing their securities, the central borrowing authorities have the choice of public or private, underwritten or non-underwritten placements. Public loans involve the issue of a prospectus outlining the details of the issue, plus the advertising and marketing of the stock. Private issues avoid the need for a prospectus, and generally require only an updated information memorandum. Private placements are quicker and less costly. Increasingly, the central borrowing authorities are dispensing with public issues and going straight to the market with private placements. Typically, each central borrowing authority will appoint tender and dealer panels that will be responsible for the placement of a new issue and for making a market in secondary transactions; that is, panel members will quote bid and offer prices in the market. Also, the paper issued by central borrowing authorities has an investment-grade credit rating that is generally sufficiently attractive to institutional investors, and so issues generally are not underwritten. The securities issued by the state governments’ central borrowing authorities are essentially the same as those discussed in Chapters 9, 10 and 11. Issues usually comprise a combination of discount securities, medium-term notes and long-term bonds. The medium- to long-term securities are often referred to as semi-government securities (semis). Each state has its own credit rating, issued by a major credit rating agency such as Standard & Poor’s, Fitch Ratings or Moody’s Investors Service. The credit ratings vary between states; therefore, the cost of borrowing for a state such as Tasmania, which has a lower credit rating, is more expensive than the cost of borrowing for higher-rated states such as New South Wales and Victoria. The semi-government debt market is currently affected by the same factors affecting the Commonwealth Government’s debt issuance programs: the markets have contracted as budget deficits are reduced or brought into surplus and debt is retired from funds raised through the privatisation of government instrumentalities. The contraction in the Commonwealth Government’s and the state governments’ borrowing programs have resulted in an expansion of the corporate debt markets. This represents a reversal of the crowding-out effect that was discussed previously. Governments are borrowing less of the available pool of investment funds and therefore there is a greater share of the funds available for investment in the corporate sector. It is to be expected that the level of government borrowing will change as economic cycles change.

REFLECTION POINTS

Australia, state governments borrow to meet their capital and recurrent expenditures; • Within the paper issued is often referred to as semi-government securities. Cash rate the interest rate on unsecured overnight loans between banks

state has established a central borrowing authority that issues debt securities to raise • Each funds on behalf of the state government and its instrumentalities. borrowing authorities are able to maximise economies of scale, access the international • Central capital markets, manage the timing of debt issues and associated cash flows better and, based on the state’s credit rating, achieve a lower average cost of funds.

LEARNING OBJECTIVE 12.4 Outline the monetary policy techniques currently employed by the Reserve Bank through which it influences the level of interest rates in Australia, including open market operations and the impacts on system liquidity.

12.4

Monetary policy

The effective implementation of monetary policy is an essential component in achieving sustainable economic growth. In Australia, as with a number of other developed economies, inflation targeting is the basis of the current monetary policy framework. The Reserve Bank’s monetary policy actions are directed towards influencing the level of interest rates in the financial system in order to maintain inflation within a target range and thus achieve its economic objectives. The target interest rate is the cash rate, which is the interest rate on unsecured overnight loans between banks.

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Through its impact on the cash rate, the Reserve Bank can affect rates further out on the maturity spectrum. In an efficient market, if the cash rate is bid up, rates for other short-term-to-maturity securities will also increase. As these rates rise, rates on other maturity securities will increase to maintain the pricing equilibrium of those instruments. Typically, short-term money-market instruments such as bank bills respond immediately to an official interest rate change. Once bank bill rates have increased, the banks will adjust other lending rates and so on. The transmission of an interest rate change through the maturity spectrum is typically not instantaneous. For example, when interest rates rise, bank loan rates tend to rise quite quickly, but deposit rates are likely to adjust more slowly. On the other hand, if interest rates fall, it is possible that banks will lower rates on deposits while delaying rate reductions on at least some of their loans. In a recent past interest rate cycle, where interest rates were falling, public pressure was brought to bear on lenders so that mortgage rates moved more closely in tandem with official announcements of changes in the cash rate target. The Reserve Bank, in determining its monetary policy stance, must consider its legislative charter and as such strive to achieve:

Official interest rate the central bank’s target interest rate for the overnight cash rate

1 the stability of the currency of Australia 2 the maintenance of full employment in Australia 3 the economic prosperity and welfare of the people of Australia. In attempting to achieve the above objectives, the Reserve Bank’s current monetary policy actions are principally directed towards an inflation target of between 2.00 and 3.00 per cent, on average, over an economic or business cycle. This policy objective allows for the short-term fluctuations that will occur during a cycle. The economic impact of the implementation of monetary policy changes in the cash rate takes time to work through an economy. While some impacts are immediately evident, the full impact of monetary policy changes takes up to two years to work through the economy fully. By considering the ‘average’ inflation over the cycle, the Reserve Bank does not need to respond to shortterm changes in the consumer price index (CPI) that will no longer be evident by the time a monetary policy change has worked its way through the system. Therefore, while the inflation target is measured against the CPI, the Reserve Bank is often more concerned with an analysis of the underlying level of inflation over the cycle. In reviewing current monetary policy settings, some of the important underlying indicators considered by the Reserve Bank include:

• official interest rates • other interest rates for borrowers • the exchange rate • unemployment levels and trends • economic productivity and capacity • trends in asset values • the condition of the credit markets • international monetary and economic conditions. The transmission of monetary policy and its effects on the economy are depicted in Figure 12.2. While monetary policy is directed at the overnight cash rate, over time it has an influence on output, employment and prices through a number of complex channels. These channels ultimately affect:

• the cost and availability of funds to the business and household sectors • the value of assets and liabilities within the domestic economy • the exchange rate and its impact on the price of imports and exports, plus foreign-currencydenominated cash flows, assets and liabilities.

Over time, these outcomes have a direct impact on economic activity. For example, the Reserve Bank may tighten monetary policy by selling government securities to the market, thus reducing the 401

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Figure 12.2  Transmission of monetary policy

Reserve Bank Expectations of inflation and output

Market operations Demands for funds: government deficit and business investment

Supply of funds

Interest rates: cash rate target

Credit terms and conditions

Deposits and money

Bond and stock prices

Household net worth

Cost and availability of credit

State and local government spending

Business investment

Exchange rate

Housing

Consumption spending

Import, export prices

Trade

Economy: output, employment, income, prices

SOURCE: © 2007 Reserve Bank of Australia

Monetary policy channel the effects of monetary policy changes on interest rates and economic activity

Credit channel the effects of monetary policy changes on the availability of credit in the financial system

Wealth channel the effects of monetary policy changes on asset values

Foreign exchange channel the effects of monetary policy changes on the exchange rate, exports, imports and investment

supply of funds in the financial system. The overnight cash rate will immediately rise, followed by other short-term money-market rates. Sustained increases in short-term interest rates will place upward pressure on other interest rates. Higher interest rates will increase the cost of funds and over time will cause business investment and household expenditure to fall. This influence on the economy is referred to as the monetary policy channel. At the same time, the tightening of monetary policy will increase the perceived level of investment risk, which may result in a reduction in bank lending as borrowers find it more difficult to repay higher-cost loans. It will also become more difficult to raise direct finance, as investors withdraw from the market in times of higher loan-default risk. The reduced availability of funds, as opposed to the increased cost of funds, will slow down economic activity. This is referred to as the credit channel. Coupled with the monetary policy channel and the credit channel is the wealth channel, whereby there is a reduction in asset values. The lowering of asset values weakens business and household balance sheets, leading to a loss of confidence, reduced creditworthiness and a further contraction in economic activity. The next critical channel is the foreign exchange channel. All other variables being equal, a rise in interest rates from a tightening of monetary policy will see an appreciation in the exchange rate. This will raise the relative cost of Australian exports and lower the relative price of imports. The reduced

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demand for exports and an increase in imports will have an adverse affect on the balance of trade and economic output. The interactions of the above channels would operate in the opposite direction if the Reserve Bank eased monetary policy, that is, if it lowered interest rates. The Reserve Bank publishes periodic statements on monetary policy in the RBA Bulletin. Copies of these statements and a wealth of other information, including the minutes of its monthly meetings, can be obtained from the Reserve Bank’s website (www.rba.gov.au). Some insight into the Reserve Bank’s current monetary policy thinking can be gained by visiting the website and reading the highly informative Reserve Bank publications. Articles written by the Reserve Bank are usually written in a language that is clear and easy to understand. How does the Reserve Bank tighten, or ease, monetary policy? The Reserve Bank is able to change the cash rate through the conduct of its open market operations and its ability to control the liquidity of the financial system on a day-by-day basis. The discussion now turns to the Reserve Bank’s market operations.

12.4.1

Open market operations

There is a separation between the processes associated with government debt management and the implementation of monetary policy. The accumulated debt of the Commonwealth Government is fully funded by the issue of debt securities at market rates of interest using the tender system discussed in Section 12.2. The Reserve Bank uses its open market operations to manage monetary conditions. These operations allow the central bank to manage the overall supply of funds available in the money markets in order to keep the overnight cash rate consistent with the desired stance of monetary policy. Open market operations are conducted primarily by: 1 repurchase agreements (repos) based on a range of nominated debt securities 2 outright or direct transactions in short-dated Commonwealth Government Securities (CGS)

Open market operations actions of the Reserve Bank in the money markets to maintain the cash rate consistent with its stance on monetary policy

3 foreign exchanges swaps. Repurchase agreements are discussed later in the chapter. Briefly, a repurchase agreement is a contract whereby the Reserve Bank agrees to buy certain securities today at their current price on the condition that they are repurchased at a specified later date. Direct sales of CGS by the Reserve Bank reduce the supply of funds in the money market, while purchases inject additional funds. A reduction in the money supply will place an upward pressure on the overnight cash rate to a level targeted by the Reserve Bank to achieve its monetary policy objectives. Similarly, an increase in the money supply will place downward pressure on interest rates. A foreign exchange swap is similar to a repo, except that the Reserve Bank will agree to swap foreign currency for Australian dollars (AUD) on the understanding that the transaction will be reversed at a specified exchange rate at a later date. To conduct these operations, the Reserve Bank needs to hold and manage a portfolio of CGS. It also has to ensure the maintenance of liquidity in the market for CGS, which is important for the effectiveness of its operations. In order to maintain an appropriate portfolio of CGS, the Reserve Bank makes purchases in the secondary market, and at times takes an allotment at tender in a primary issue. When the Reserve Bank takes up securities at tender, the size of its allocation is announced at the same time as other tender details, and it takes up its securities at the weighted average yield achieved in the tender. The Reserve Bank normally uses this channel only to replace stock maturing from its portfolio, although on occasions it has used tender subscriptions to help increase holdings of CGS when it has needed to do so. Such a need may arise when the Reserve Bank sells foreign exchange and needs to buy CGS to neutralise the sale’s impact on the money supply—that is, when it is changing the composition of its assets from foreign exchange to domestic securities. The temporary cash-flow mismatches, which remain a feature of government finance, do not hinder the Reserve Bank in its monetary policy management activities. The resulting day-to-day flows 403

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of liquidity to and from the money market and, more importantly, between participants in the market assist the Reserve Bank in using its open market operations to influence monetary conditions. These flows underpin the demand for money-market cash. This is important, as the Reserve Bank needs a large and stable demand for money-market cash at all times so that it can operate with predictable effects on money-market conditions.

12.4.2

Impacts on financial system liquidity

The principal determinants of the daily liquidity of the financial system, otherwise known as the system balance or the money-market cash position, are the financial transactions of the official sector. The official sector’s transactions take place almost continuously throughout the year and affect the moneymarket cash position on a day-by-day basis. Three major factors affect financial system liquidity: 1 Commonwealth Government budget surpluses or deficits 2 official foreign exchange (FX) transactions 3 net sales of CGS and repurchase agreements.

1 Commonwealth Government budget surpluses or deficits The main types of Commonwealth Government budget transactions that influence the daily cash position are:

• taxation receipts, including income tax, company tax, capital gains tax, goods and services tax, fringe benefits tax • government securities: — tender subscriptions for T-notes and Treasury bonds — interest or coupon payments on Treasury bonds — principal repayments on T-notes and Treasury bonds

• budget recurrent expenditures, such as social security pensions and benefits, and public service expenses • budget capital expenditures, such as payments to fund the building of roads, hospitals and schools. Cash flows change depending on seasonal and cyclical factors. Seasonal factors include, for example, the due date for company tax payments or increased expenditure at Christmas. Cyclical factors relate to the state of the economy. If the economy is growing, private and business expenditure is likely to be higher, which affects financial system liquidity and cash flows generated from taxation. Commonwealth expenditures add liquidity to the system; the payment of taxes to the government withdraws liquidity from the system.

2 Official FX transactions Official FX transactions can take place at any time. It was noted previously that the Reserve Bank can enter the FX market to conduct FX transactions on behalf of the Commonwealth Government, or occasionally to support the value of the AUD against other currencies. The central bank is banker to the government. Therefore, if the government purchases goods from overseas, the central bank will arrange payment for the government. This will require the purchase of the necessary foreign currency in the FX market. In purchasing the foreign currency, the Reserve Bank will pay in AUD. This means that there will be an increase in liquidity in the financial system. To offset this liquidity increase, the central bank will neutralise its FX transactions through its market operations; that is, if it buys FX, it will at the same time sell CGS. The increased supply of AUD from the FX transaction is neutralised by the reduced supply of cash resulting from the market 404

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transaction. The neutralisation strategy means that there will be no net impact on its monetary policy interest rate stance. The central bank’s sales of foreign currency reduce financial system liquidity. On the other hand, the purchase of foreign currency adds to system liquidity. For example, if the Reserve Bank was concerned that the AUD was rapidly falling in value, and that in its view such a fall was not warranted by economic fundamentals, it might decide to enter the FX market and begin buying AUD. This is achieved by selling foreign currencies from its FX reserves. The purchase of the AUD would provide support for the AUD and allow time for the FX markets to stabilise at a rational exchange rate level.

3 Net sales of CGS and repurchase agreements The third impact on system liquidity comes from the net sales of CGS and repurchase agreements. During any week, the money-market cash position may be boosted if Treasury bonds or T-notes mature or are redeemed. Repurchase agreements (discussed below) also affect system liquidity. There is a drain on system liquidity when the private sector pays for its purchases of CGS in the periodic CGS tender system. It is the sum of the three sets of transactions that determines the daily money-market cash position. If payments from the official sector to the private sector exceed the flow of funds to the official sector, there will be a system surplus, also known as the system being ‘oversquare’. If the reverse is true—that is, if payments to the official sector exceed official sector payments to the private sector—there will be a system deficit, often referred to as the system being down. When the flows in opposite directions are equal, the system is said to be ‘square’. In order to understand fully how the Reserve Bank obtains almost complete control of the level of short-term interest rates, it is necessary to recognise the relationships that are evident between the payments system, exchange settlement account transactions, real-time gross settlement and repurchase agreements.

System surplus occurs when payments by the official sector to the private sector exceed payments to the official sector

System being down occurs when payments by the official sector to the private sector are less than payments to the official sector

REFLECTION POINTS

• In Australia, the Reserve Bank implements monetary policy to maintain inflation within a range of 2.00 to 3.00 per cent, on average, over the economic or business cycle. • The central bank targets the overnight cash rate by carrying out open market operations. In an • • • •

efficient market, if one interest rate changes (cash rate), then other rates will also progressively change to return to equilibrium. A change in interest rates will have a transmission effect on the cost and availability of funds, the value of assets and liabilities, and the exchange rate; that is, it will impact on the level of economic activity. These transmission effects are referred to as the monetary policy channel, the credit channel, the wealth channel and the foreign exchange channel. Central bank monetary policy open market operations involve the buying or selling of government securities within the money markets. If the central bank buys securities from the market, it will pay cash for them, thus increasing liquidity in the system and allowing interest rates to fall. To raise the rates, the central bank would sell securities. Open market operations are conducted primarily by (1) repurchase agreements (repos) based on a range of nominated debt securities, (2) outright or direct transactions in short-dated Commonwealth Government Securities (CGS) or (3) foreign exchange swaps. Liquidity in the financial system is affected by transactions between the official sector and the private sector. Official sector transactions are Commonwealth Government budget surpluses or deficits, official FX transactions and net sales of CGS and repurchase agreements.

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12.5 LEARNING OBJECTIVE 12.5 Describe the purpose and operation of the payments system, including exchange settlement accounts, real-time gross settlement and repurchase agreements.

Payments system facilitates the transfer of value from one party to another for financial transactions

The payments system

Within a modern economy, millions of the transactions that occur daily for goods and services use a financial instrument to represent value for the transaction. For example, an individual may issue a cheque drawn on a bank and present the cheque to another party, such as a business, in payment for goods and services received. The business will deposit the cheque in its current account, which may be held with a different bank. The cheque must be cleared through the payments system in order to obtain actual value. The funds are debited to the account of the individual at the first bank and credited to the account of the business at the second bank. The value transfer between the banks is completed through the payments system. According to the RBA, the clearing of value payments system transactions in Australia is coordinated by the Australian Payments Network (AusPayNet). AusPayNet is a limited liability company that manages clearing for cheques, direct entry payments, ATM and debit card transactions and high-value payments. Other payments clearing systems that are independent of AusPayNet include MasterCard, Visa and American Express. Payments system transactions may be cash or non-cash instruments and they may be either highvalue or low-value transactions. There are five payments system clearing systems:

• the Australian Paper Clearing System for cheques, payment orders and other paper-based payment instructions • the Bulk Electronic Clearing System for recurring electronic credit and debit payment instructions • the Issuers and Acquirers Community (IAC) for proprietary-card-based ATM and EFTPOS transactions • the High Value Clearing System for high-value payment instructions • the Australian Cash Distribution Exchange System for the movement of notes and coins. High-value payments large-value transactions that are cleared by realtime gross settlement

Electronic funds transfer at point of sale (EFTPOS) an electronic system that facilitates value transactions for goods and services

Pay anyone an internet banking service that enables funds to be transferred to any financial institution in Australia

High-value payments generally relate to large dollar-value transactions for assets (e.g. property settlements, wholesale market equity, debt securities and foreign exchange transactions). Low-value payments generally comprise normal day-to-day transactions for goods and services, particularly by the household sector. While cash still remains a commonly used low-value payment method, most people now use electronic payment systems such as electronic funds transfer at point of sale (EFTPOS) and ‘pay anyone’ via internet banking. The EFTPOS payments system is usually available at retail traders such as supermarkets. The EFTPOS system allows goods purchased at the supermarket to be paid for through an electronic transfer of value from the customer’s account with one financial institution to the merchant’s account with another financial institution. Non-cash payments account for the greatest monetary value of payments in the financial system. Non-cash instruments are further classified as paper or electronic value transactions. Cheques, EFTPOS, direct entry credits (including ‘pay anyone’) and debits, and credit card transactions are the most important low-value paper instruments. The principal non-cash, high-value paper instruments are bank cheques and warrants. Bank cheques are drawn on a bank and issued to the bank’s customer to allow the customer to facilitate payment, such as settlement of a property transaction. Warrants are issued in direct payments between banks. Within Australia, the payments system has witnessed many innovations that have facilitated the move away from paper-based payments towards electronic payments over a number of years. The most recent of these innovations includes the New Payments Platform (NPP), which became operational in 2018. The NPP facilitates real-time retail payments that enable a recipient of funds, following a retail transaction, for example, to access those funds almost immediately. Millions of low-value transactions are cleared through the payments system each day. Settlement of low-value transactions does not occur between banks for each cheque, but rather the net position is settled at the end of each day on a deferred settlement basis. Settlement of value transactions between

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banks and other participants in the payments system is facilitated through their exchange settlement accounts held with the Reserve Bank.

12.5.1

Exchange settlement accounts

Commercial banks and other authorised providers of payments services maintain a special account with the Reserve Bank to facilitate the settlement of value transactions within the payments system. This account is called the exchange settlement account. The Payments System Board of the Reserve Bank requires that applicants for exchange settlement accounts must be able to demonstrate that they have the ability to provide ongoing liquidity for the operation of such an account, particularly in seasonal peak periods and under conditions of stress. Institutions supervised by the Australian Prudential Regulation Authority (APRA) are eligible for exchange settlement accounts, but the Reserve Bank may impose transitional collateral requirements for those new participants with limited payments experience. Other organisations that are not supervised by APRA need to meet collateral requirements on an ongoing basis, except where they are always net receivers in payments-clearing arrangements. Participants in Australia’s real-time gross settlement (RTGS) system (discussed in the next section) who demonstrate that they have the necessary operational capacity and adequate liquidity are not subject to ongoing collateral requirements. Where transactions occur between private sector participants, such as two commercial banks, the payment and settlement process does not change the net funds available within the payments system. Funds are simply redistributed from one bank to the other. However, where payment instructions are written by the official sector—that is, the Reserve Bank or the government—for payment to the private sector, or written by the private sector for payment to the official sector, there is a net change in the level of cash within the system. Given the multiplier effect of transactions between the official sector and the private sector, it would be by pure chance that the value of transactions to and from the exchange settlement accounts balanced on a day-by-day basis. If, on a particular day, official transactions are such that on cheque clearance the system is in deficit, or the market is down, the balances in the exchange settlement accounts are reduced. If the exchange settlement accounts did not start in sufficient credit, then the day’s transactions would take the exchange settlement accounts overall into deficit. Consider the example shown in Table 12.2, where each of the transactions takes place on the same day.

Exchange settlement account same-day funds held with the Reserve Bank; facilitates settlement of payments system value transactions

Table 12.2 Effect of transactions on the money-market cash position Transaction ($ millions) $750 Treasury bonds mature

Effect on money-market cash position ($ millions) + 750

Commonwealth Government payments to state governments of $1 200

+ 1 200

Company and other tax receipts of $1 800

– 1 800

Reserve Bank sales of foreign currency of $350

– 350

Total

– 200

This set of transactions would take the system into a deficit of $200 million. To meet the need for cash in the overall system, the Reserve Bank may enter the market and (in this case) buy CGS, either directly or through repurchase agreements, from the banks. If the Reserve Bank were to buy $200  million of CGS, the net level of cash, or liquidity, in the system would be maintained. If, on the other hand, the Reserve Bank did not enter the market, each bank would need to consider its net position within the system. Banks and other participants must ensure that their exchange settlement accounts do not go into deficit, even on an intra-day basis. 407

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Same-day funds funds that do not require clearing through the payments system; required for exchange settlement account

The Australian system differs from that used in the USA, Europe and the UK where banks and other participants are required to meet specific reserve requirements over a period of time. Exchange settlement account transactions require the use of same-day funds. In essence, same-day funds are those funds that can be credited directly to an exchange settlement account without having to go through the payments system. There are four sources of same-day funds:

• surplus balances in a bank’s own exchange settlement account • surplus balances in other banks’ exchange settlement accounts • Reserve Bank payments in its open market operations • repurchase arrangements with the Reserve Bank. It is important to note that transactions of the Reserve Bank are regarded as same-day funds. They do not need to go through the payments system to be cleared. The Reserve Bank pays a rate of return on surplus balances maintained by the banks in their exchange settlement accounts. This rate is 25 basis points below the targeted cash rate in the overnight money market. The return paid by the Reserve Bank is less than that for other investment opportunities, and therefore banks endeavour to manage their surplus exchange settlement account position prudently. Even so, banks will not always have sufficient funds in their exchange settlement accounts to meet large, unexpected payments. Should an individual bank find it is in a deficit position on a given day, it may seek to purchase surplus same-day funds from another bank. If this is not possible, the bank may have no alternative but to use the repurchase agreements offered by the Reserve Bank. At this point there are two outstanding issues to discuss: real-time gross settlement and repurchase agreements.

12.5.2 Real-time gross settlement (RTGS) high-value payments system; transactions are settled immediately through exchange settlement accounts

Systemic risk the risk that the failure of an institution will adversely affect the market as a whole

Real-time gross settlement

Many countries, including Australia, that aspire to an efficient financial system operate a system of real-time gross settlement (RTGS) for high-value payment transactions. RTGS requires each high-value payment transaction to be settled immediately by transfer of exchange settlement account funds (held with the Reserve Bank) from the sending institution to the recipient institution. High-value transactions are not defined in dollar-value terms, but rather are payments designated as such by market participants. Interestingly, over 80.00 per cent of non-cash payment system transactions are settled as RTGS transactions. Clearly, the more payment system transactions that a bank processes through RTGS—and therefore receives credit in its exchange settlement account—the less of a liquidity management problem it will have in meeting its exchange settlement account commitments to other banks. RTGS settlements are irrevocable; that is, neither party to the payment is able to revoke the transaction. The purpose of RTGS is therefore to increase certainty within the payments system, and in particular to reduce settlement risk and minimise potential systemic risk if an institution should fail to settle a transaction within the financial system. Systemic risk is the possibility that the payments system will collapse because of the failure of one or more of the system participants to complete value transfer commitments when due. The Reserve Bank requires banks to maintain their exchange settlement accounts in credit with same-day funds. If a bank has insufficient same-day funds in its account, the payment will be dishonoured. Obviously, banks must manage their liquidity positions to ensure that they always have sufficient same-day funds. RTGS requires the banks to monitor their liquidity position throughout the day. In order to facilitate the orderly management of liquidity, the Reserve Bank provides an intra-day repurchase arrangement for exchange settlement account holders. The Reserve Bank does not charge interest on the intra-day facility, but does charge an initial margin (fee) based on the term to maturity and credit rating of the securities being used as collateral. To assist further with liquidity shortfalls that may occur within RTGS at the close of business each day, the Reserve Bank also offers an end-of-day repurchase agreement.

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12.5.3

Repurchase agreements (repos)

Under RTGS, the Reserve Bank will provide intra-day liquidity for same-day funds to exchange settlement account holders in order to ensure the smooth flow of payments through the system. This type of facility is known as a repurchase agreement, or repo. Under this arrangement, the Reserve Bank will, during the day, accept eligible debt securities as collateral for a repurchase agreement from institutions that need to obtain immediate same-day funds. The securities that the Reserve Bank will accept in domestic market repurchase agreements are listed at www.rba.gov.au. An institution entering into an intra-day repurchase agreement must unwind the repo by the end of the day. The Reserve Bank provides this liquidity free of charge, apart from a Reserve Bank Information and Transfer System (RITS) transaction fee. The Reserve Bank also provides an end-of-day repurchase facility. It is possible that at the end of each day exchange settlement account holders will be under pressure to obtain same-day funds to close out their final positions and to unwind any intra-day repos. Again, to maintain certainty and stability within the system, the Reserve Bank will stand ready to provide the necessary liquidity using overnight repo arrangements. However, in order to provide an incentive for banks to manage their liquidity positions without regular recourse to the overnight repo facility, interest is charged at 25 basis points above the official cash rate on an overnight repo. There is therefore an incentive for exchange settlement account holders to trade exchange settlement funds with each other, as the Reserve Bank pays a return on surplus exchange settlement account balances at 25 basis points below the cash rate, and charges repos at 25 basis points above the cash rate. A 50-basis-point margin exists for the trading of same-day funds. The other avenue that may exist for the banks to obtain same-day funds is for them to sell to the Reserve Bank eligible debt securities held in their securities portfolio that have more than a short term to maturity. When the Reserve Bank informs the banks of the market’s cash position in its 9.30 am announcement each day, it also informs the market of its initial dealing intentions for the day. Because of the liquidity implications of RTGS, the Reserve Bank may decide to deal further during the day. In the situation described above, if the Reserve Bank did not want interest rates to rise, it may well declare that it is offering to buy long-term eligible debt securities. It would then be up to individual banks to determine whether they would make an offer to sell to the Reserve Bank to generate same-day funds in order to manage their liquidity positions. The above arrangements facilitate the management of liquidity within the payments system and support RTGS. They also enable the Reserve Bank, on a day-to-day basis, to maintain the target cash rate at the desired monetary policy setting.

Repurchase agreement (repo) the Reserve Bank purchases eligible debt securities in order to provide the seller with same-day funds; repo is reversed at a specified date

REFLECTION POINTS

• The Reserve Bank is responsible for the soundness of the payments system. payments system facilitates the transfer of value for financial transactions conducted within • The an economy. part of the payments system, banks are required to maintain an exchange settlement • As account with the Reserve Bank. For example, if a bank’s customer writes a cheque payable to another bank’s customer, the funds will be transferred from the first bank’s exchange settlement account to the second bank’s account. are required to keep their exchange settlement accounts in credit at all times with so • Banks called same-day funds, that is, funds that have already been cleared through the payments system. continued

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of same-day funds are surplus balances in banks’ exchange settlement accounts, • Sources Reserve Bank payments for market operations or repurchase arrangements with the Reserve Bank. central bank requires high-value transactions in the payments system to be settled by real • The time gross settlement (RTGS); that is, funds must be available in a bank’s exchange settlement account immediately. The purpose is to reduce settlement risk and systemic risk. support RTGS, the Reserve Bank provides an intra-day liquidity facility for same-day funds or • To an overnight liquidity facility, known as a repurchase agreements (repo). Reserve Bank will provide a repo based on underlying eligible securities. An intra-day • The repo must be unwound by the end of the day.

CASE STUDY THE NEW PAYMENTS PLATFORM (NPP) IN AUSTRALIA AND THE RISK OF FRAUD In Chapter 12 we examined the establishment of a new payments platform in Australia that enables quick payments. The basic structure of NPP includes a network to connect participants, a switch that transfers messages between participants and an addressing service with a simpler payment address such as a phone number or an email address. The platform is equipped with a faster payment service that enables real-time handling and settlement of transactions, regardless of size. The platform uses the ISO 20022 standard for electronic data interchange between financial institutions with the capability to convey more data than most of the other messaging formats (NPP Australia, 2018). Financial institutions and customers are expected to reap the benefits of the new platform; however, critics argue that the number of fraudulent transactions will rise. It is notable that most credit card frauds take place online or over the telephone and involve stealing details (card numbers, names etc), not the plastic card itself. According to the Australian Payments Network, almost 85 per cent of thefts involving credit cards occurred when the details were compromised. The NPP enables instant transfer of money, and such transfers are deemed to be irreversible. Each financial institution could impose limits on the upper value of transfers; however, these are expected to be higher than credit card limits and similar to limits on transfers using BSB numbers. According to critics, this is a potential problem. Online fraud has almost doubled in the UK since a faster payment system was adopted. The system had a payment limit of £100 000 in 2010 and £250 000 in 2015. In 2017, there was a notable case known as the ‘Friday afternoon fraud’, where a group of fraudsters hacked into the emails between solicitors and their home-buying clients on the day money was to be transferred. The fraudsters impersonated the solicitor and communicated to the clients that the payment details had been changed and that the payments should be made to a different account. By the time the victims realised, the money had been transferred (Worthington, 2018). Earlier, the banks had up to three days to stop a transfer when a scam was detected, but with the transition to faster payments there was less time to detect and stop fraudulent transactions such as these (Yeates, 2018). There is reason to be optimistic that advances in security will outpace the ingenuity of fraudsters. Traditional security measures, like passwords, are on the decline. Knowledge-based passwords are often compromised. Australian banks are planning to introduce biometrics, including voice recognition, facial recognition and fingerprints. Last year, ANZ added a voice-ID function to its banking app that allows customers to carry out high-volume transactions without a PIN or a password. HSBC also experienced success in detecting fraud by implementing biometrics. Approximately $7 million of attempted fraud 410

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References New Payments Platform (NPP) Australia 2018, ‘How it works: New Payments Platform Australia’, retrieved from http://www.nppa.com.au/the-platform/how-it-works/ Schwarz, R 2018, ‘Australia’s New Payments Platform: How voice biometrics can help prevent fraud’, ComputerWorld, 7 February, retrieved from http://www.computerworld.com.au/article/633090/australianew-payments-platform-how-voice-biometrics-can-help-prevent-fraud/ Worthington, S 2018, ‘Banks and customers alike benefit from efficient New Payments Platform—but so do fraudsters’, Smart Company, 7 September, retrieved from http://www.smartcompany.com.au/finance/ fraud/banks-customers-fraudsters-benefit-new-payments-platform/ Yeates, C 2018, ‘Banks wary of higher fraud risk from real-time payments’, Sydney Morning Herald, 14 February, retrieved from http://www.smh.com.au/business/banking-and-finance/banks-wary-of-higherfraud-risk-from-real-time-payments-20180213-p4z06j.html

Discussion points

• •

Discuss the challenges facing any payments system but especially one that facilitates ‘fast’ payments.

CHAPTER TWELVE REVIEW

was detected and intercepted (Schwarz, 2018). The countermeasures taken by banks to prevent fraud cannot replace vigilance on the part of customers, which is the first line of defence.

In the light of the UK ‘Friday afternoon’ fraud, discuss the possible safety measures that could be adopted.

Master before you move on LEARNING OBJECTIVE 12.1 Consider the reasons for the existence of government debt markets and the government borrowing requirement. time to time governments need to fund a shortfall in their short-term operational • From expenditures and their long-term capital expenditures. debt securities issued to raise the necessary funds are very similar to those often issued by • The the corporate sector, that is, discount securities and coupon securities. chapter uses the example of debt securities issued by the Australian Commonwealth • This Government and state governments. main source of revenue for the Commonwealth Government is taxation receipts; however, • The at times expenditures exceed receipts and the government may have a budget deficit.

LEARNING OBJECTIVE 12.2 Outline features of the main debt instruments issued by the Commonwealth Government, that is, the Treasury bond and the Treasury note, and describe the issuance process, participants and complete relevant calculations. the government’s annual budget be in deficit, the government borrows from the markets • Should through the sale of medium- to long-term Treasury bonds. • Treasury bonds may also be issued to refinance existing bonds that are due to mature. • The bonds sold by the Commonwealth Government are coupon securities. 411

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straight Treasury bond, which is sold through a tender process, has a fixed coupon that is • The paid six-monthly. The face value of the bond is redeemed at maturity. • Treasury bonds are inscribed stock, that is, ownership is registered; they are not bearer bonds. main buyers of bonds are central banks, financial institutions and fund managers. There is a • The very active secondary market in Treasury bonds. price of a fixed-interest Treasury bond is the present value of the income stream (coupon • The payments), plus the present value of the bond’s face value, based on the current yield on this type of security in the market. Alternative formulae are: 1 − ​​(​​1  + i​)​​​​  −n​ −n k ​P = { ​​ ​​C​​[_ ​​​      ​​  ]​​​  + A​​(​​1  + i​)​​​​  ​​}​​​​​(​​1  − i​)​​​​  ​​ i or (see the Extended learning section at the end of the chapter): ​Price per $100 face value = v​ ​​  ​ d  ​ ​​​(​​c + g​a​n​  ​​ ​ + 100​v​​  n​​)​​​​ __f

12.4

a financial year, the government may experience a mismatch in the timing of its cash • Within flows and may need to raise short-term funds to smooth out its cash flows over time. To fund those deficit months, the government is able to issue short-term securities known as Treasury notes (T-notes).

are sold at tender with variable-term maturities that closely match the cash-flow • T-notes requirements of the government across the higher- and lower-revenue months in a year. are discount instruments and are sold at a discount to their face value, with the face • T-notes value paid at maturity. The price of a T-note is calculated using the discount securities formula: face value × 365 ​Price = __________________________ ​         ​​ yield 365 + ​​ ____ (​​​  100 ​  × days to maturity​)​​​

LEARNING OBJECTIVE 12.3 Describe the purpose and structure of state government central borrowing authorities. state and territory governments and their instrumentalities also raise funds through the sale • The of securities. state and territory has established a central borrowing authority for the marketing and sale • Each of securities. • The instruments sold by the central borrowing authorities are known as semi-government securities.

LEARNING OBJECTIVE 12.4 Outline the monetary policy techniques currently employed by the Reserve Bank through which it influences the level of interest rates in Australia, including open market operations and the impacts on system liquidity.

• The Reserve Bank is responsible for the implementation of monetary policy. policy is directed towards maintaining inflation between 2.00 and 3.00 per cent, on • Monetary average, over the cycle in order to achieve economic outcomes that result in the stability of the currency, full employment and economic prosperity.

Reserve Bank implements monetary policy by targeting the level of the overnight cash • The interest rate. Reserve Bank periodically announces its intention to change the target setting for the • The overnight cash rate. wishes to change the monetary policy target cash rate, it conducts open market operations • Ifbyiteither entering into repurchase agreements or outright transactions in CGS and other eligible debt securities or foreign exchange swaps. 412

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LEARNING OBJECTIVE 12.5 Describe the purpose and operation of the payments system, including exchange settlement accounts, real-time gross settlement and repurchase agreements instruments.

• The Reserve Bank is also responsible for the stability of the payments system. in the payments system are required to maintain an exchange settlement account • Participants with the Reserve Bank for the purpose of settling value transactions. exchange settlement account must always be kept in credit with same-day funds. Therefore, • The institutions must manage their liquidity positions to ensure they have access to sufficient sameday funds. sector payments do not affect the net money supply or system liquidity. However, official • Private transactions of the Reserve Bank or government with the private sector will change the amount of funds in the system. is short, the banks must obtain same-day funds. The Reserve Bank may choose • Iftothebuysystem eligible debt securities from the banks, thus injecting liquidity (and same-day funds) back into the system; alternatively, banks may be forced to enter into intra-day, or overnight, repurchase agreements with the Reserve Bank.

CHAPTER TWELVE REVIEW

in the cash rate will progressively flow through to interest rates on other financial • Changes instruments.

Reserve Bank is able to affect the level of interest rates by implementing its monetary • The policy open market operations and by influencing the level of same-day funds (or liquidity) in the payments system. the overnight cash rate has changed, dealers in short-term money-market instruments • Once will change their rates. The transmission of monetary policy will eventually flow through to most other financial instruments issued in the financial system. Ultimately this will affect the level of economic activity. majority of financial transactions settled in the payments system are by real-time gross • The settlement (RTGS). requires immediate value settlement of high-value transactions through exchange • RTGS settlement accounts held with the Reserve Bank. means institutions must manage their intra-day liquidity. The Reserve Bank provides intra • This day liquidity by offering short-term repurchase agreements (repos). an intra-day repo arrangement the Reserve Bank will provide liquidity based on eligible • Under debt securities and credit an exchange settlement account, but the position must be unwound by the end of the day.

Extended learning LEARNING OBJECTIVE 12.6 Calculate the price of a bond using the AOFM formula. Fixed-coupon Treasury bonds: price calculation using the Australian Office of Financial Management (AOFM) formula The settlement price per $100 face value, extended to the third decimal place, will be calculated on the basis of the following formula: ​Price per $100 face value = v​ ​​  ​ d  ​​​​ (​​c + g​a​​n​  ​​ ​​ + 100​v​​  n​​)​​​​ __f

413

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where: ​v = 1/​​(​​1  + i​)​​​ where i is the annual percentage yield divided by 2 f = the number of days from the date of settlement to the next interest payment date d = the number of days in the half-year ending on the next interest payment date c = the amount of the interest payment ​​(​​if any​)​​​ per $100 face value at the next interest  payment date g = the fixed half-yearly coupon interest rate payable ​​(​​equal to the annual fixed rate  divided by 2​)​​​ n = t he number of full half-years between the next interest payment date and the date of  maturity. It should be noted that n does not include the very next coupon. For example,  if the investor is entitled to the next coupon and there are a further 7 coupons  remaining after that, n = 7.​ (​​​1  − ​v​​  n)​​ ​​ 12.5 ​​a​​n​  ​​​​ = v + v​ ​​  2​ + . . . + v​ ​​  n​ = _____ ​   ​​    i SOURCE: www.aofm.gov.au.

The settlement amount will be rounded to the nearest cent (0.5 cent being rounded up). The bond shown in Example 12.1 earlier in this chapter has a face value of $1 000, pays 7.00 per cent per annum with half-yearly coupons and matures on 15 November 2021. Assume that the bond is sold on 15 July 2018. Current yields for similar Treasury bonds are 8.00 per cent per annum. Calculate the price of the bond in the secondary market: 1 1 − (_______ 6 ​​ ​ 1 + 0.04    ​)   ​​​  ​ 1 1 _______ ______________ $3.50 + 3.50 + $100(_______) P=( ​​​  ​​{ ​[​      ​ ​​ ​     ​   ​​​  ​}​ ​ ​​ ​ ​1 + 0.04​    ​)   1 + 0.04 0.04  ​ ] 6

____ ​ 123 ​  184

= 0.974123​​[​​3.50  + 18.347479 + 79.031453​]​​​ = 0.974123 × 100.878932 = 98.268 per $100 face value = 98.268 ×  10 ​​(​​representing $1  000 face value​)​​​ = $982.68​

12.6

The current price of the Treasury bond is $982.68. This is the same answer that was calculated using Equation 12.1 in Example 12.1.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

The government’s budget deficits have tended to be somewhat ‘counter-cyclical’ with deficits increasing during recessions and surpluses eventually accruing during good economic times. List and discuss several reasons for this pattern. (LO 12.1)

2

For many years, governments in Australia have debated the size of the ‘deficit’ and the need to return to surplus. Outline the main features of the government’s surpluses and deficits since before the global financial crisis (GFC) up until the present day. (LO 12.1)

3

(a) As the financial officer of a major bank, you are about to submit a tender for the purchase of Treasury bonds in an issue announced today. Outline the procedures adopted for the primary market issue of Treasury bonds.



(b) What are the advantages and disadvantages of this system? (LO 12.2)

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(a) Within the capital markets, who are the main investors in Commonwealth Government securities?



(b) From the perspective of a commercial bank, discuss why a bank holds CGS in its investment portfolio.



(c) Outline the advantages of inscribed stock over bearer bonds. (LO 12.2)

5

Use a timeline to show the cash flows associated with the primary market purchase of a fiveyear Treasury bond that is held to maturity, with a purchase price of $980, a face value of $1 000 and a half-yearly coupon of 6.00 per cent per annum. (LO 12.2)

6

The Commonwealth Government has announced a $500 million Treasury bond issue by competitive tender. The 10-year bonds have a fixed coupon of 6.50 per cent per annum. The Reserve Bank plans to take $100 million of the allocation and the remaining $400 million will be allocated according to bids received. The following bids are received: Bank A

$150 million

Yield 6.75% p.a.

Bank B

$150 million

Yield 6.70% p.a.

Bank C

$175 million

Yield 6.80% p.a.

Bank D

$250 million

Yield 6.50% p.a.

Bank E

$100 million

Yield 8.50% p.a.

CHAPTER TWELVE REVIEW

4

Allocate the competitive bids. At what yield will the Reserve Bank obtain its $100 million allocation? (LO 12.2) 7

You are considering the purchase of a Treasury bond in the secondary market. Bonds with exactly 12 years to maturity, paying a half-yearly coupon of 5.00 per cent per annum, are currently yielding 5.50 per cent per annum. The bond has a face value of $1 000.



(a) What price should you pay for the bond today? (Note: The previous coupon has been paid today to the present holder of the bond.)



(b) What will happen to the price of the bond today if the current yield immediately falls to 3.80 per cent per annum? Show your calculations. (LO 12.2)

8

A managed fund is to restructure its balance sheet through the sale of $15 million of Treasury bonds that mature on 30 September 2024. The bonds pay a fixed half-yearly coupon of 5.50 per cent per annum. Settlement date for the sale is 20 July 2019. Current yields on Treasury bond are 5.25 per cent per annum. Calculate the price at which the bonds will be sold.  (LO 12.2)

9

(a) Calculate the market price as at 30 April 2019 of a T-note with a $1 million face value, yielding 5.50 per cent per annum and maturing on 18 June 2019.



(b) Assume that T-note yields remain unchanged between 30 April 2019 and 14 May 2019, but on 15 May 2019 yields fall by 0.50 per cent per annum. Calculate the market price of the T-note at 13, 14 and 15 May 2019.



(c) Calculate the holding-period yield if the T-note is sold on 15 May 2019. (LO 12.2)

10 State governments in Australia are active participants in the bond market and issue bonds to raise funds to finance their ongoing operations and special projects. In 2017, the ANZ Banking Group drastically reduced its holdings of bonds issued by South Australia. The primary reason given by ANZ was that policy changes in the state increased the risk of financing the state. Importantly, ANZ noted that Basel III requires the bank to hold a substantial amount of Australian government and state government debt. With reference to the relationship between prices and yields, identify the potential impact of ANZ’s decision and outline ANZ’s options regarding the replacement of South Australian government debt with equivalent securities that satisfy the Basel III capital requirements. (LO 12.3)

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11 While the implementation of monetary policy directly targets interest rates, there are four identifiable transmission channels. Identify the four transmission channels and explain, within the context of monetary policy, the impact each channel has on economic activity. (LO 12.4) 12 (a)  The Reserve Bank is responsible for the implementation of monetary policy. Define monetary policy and discuss the current direction of that policy in Australia.

(b) The Reserve Bank seeks to implement monetary policy by influencing the level of interest rates through its open market operations. Describe the process whereby the Reserve Bank may seek to increase the level of interest rates. (LO 12.4)

13 Outline the role of AusPayNet in the Australian financial system. (LO 12.5) 14 (a) Explain the function and operation of an exchange settlement account. In your answer, include a discussion on the source and nature of same-day funds.

(b) The Reserve Bank offers repurchase agreements (repos) to members of the payments system. Discuss the purpose and operation of two repo facilities, and explain why the Reserve Bank offers repos to payment system members. (LO 12.5)

Extended learning question 15 A funds manager plans to buy $1 million (face value) of Treasury bonds that mature on 31 December 2021. The bonds pay a fixed half-yearly coupon of 6.50 per cent per annum. Settlement date for the sale is 18 October 2018. Current yields on similar bond issues are 7.25 per cent per annum. Using the AOFM bond pricing formula, calculate the price at which the bonds will be bought (show your calculations). (LO 12.6)

KEY TERMS Austraclear 395

exchange settlement account 407

pay anyone  406 prudential liquidity  394

budget deficit  390

exchange traded Treasury bonds (eTBs)  394

budget surplus  390

financial system liquidity  394

real-time gross settlement (RTGS) 408

cash rate  400

fiscal constraint  390

redemption yield  395

central borrowing authority 399

foreign exchange channel  402 high-value payments  406

repurchase agreement (repo) 409

Commonwealth Government 390

monetary policy channel  402

same-day funds  408

coupon payment  392

money-laundering transaction 392

semi-government securities (semis) 400

credit channel  402

official interest rate  401

system being down  405

day-to-day liquidity  391

on-exchange transactions  394

system surplus  405

economic recession  391

open market operations  403

systemic risk  408

electronic funds transfer at point of sale (EFTPOS) 406

operational liquidity  394

tender system  393

over-the-counter transactions 394

wealth channel  402

Australian Office of Financial Management (AOFM)  393

payments system  406

weighted average issue yield  393

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CHAPTER 13

An introduction to interest rate determination and forecasting CHAPTER OUTLINE 13.1 The macroeconomic context of interest rate determination 13.2 The loanable funds approach to interest rate determination 13.3 The term structure of interest rates 13.4 The risk structure of interest rates

Learning objectives LO 13.1

Describe at a macroeconomic level how the liquidity effect, the income effect and the inflation effect influence the determination of interest rates.

LO 13.2

Explain the loanable funds approach to interest rate determination, highlighting variables that affect the demand and supply for loanable funds. Consider the effects of changes in those variables on interest rate equilibrium.

LO 13.3

Understand interest rate yields and the shape of various yield curves. Apply the expectations theory, the segmented markets theory and the liquidity premium theory within the context of the term structure of interest rates.

LO 13.4

Explain the risk structure of interest rates, discuss the so-called risk-free interest rate and consider the effect of default risk on interest rates.

Extended learning LO 13.5

Apply calculations used to forecast interest rates based on the assumptions of the expectations theory.

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CHAPTER SNAPSHOT Forecasting the direction in which interest rates might move is important business, even though the chances of complete success are small. Interest rates go up and down with changes in the borrowing (demand) and lending (supply) behaviour of individuals, companies and governments. Supply and demand, in turn, reflect changes in economic conditions. Interest rates also fluctuate with changes in the expected rate of inflation and changes in risk perceptions and risk appetites. Once more, it is best to keep in mind the fundamentals of supply and demand and risk and reward to avoid being swept away by the complex details of individual markets and instruments. Regardless of how complicated something may seem, its nature can be reduced to these factors.

INTRODUCTION The central bank of a country usually is responsible for the implementation of monetary policy within that country. In Chapter 12 we discussed monetary policy and noted that in Australia monetary policy is currently directed towards maintaining inflation between 2.00 and 3.00 per cent, on average, over the business or economic cycle. Central banks in a number of other developed economies also direct their monetary policy towards specified inflation targets. The Reserve Bank of Australia uses interest rates as its main tool in implementing monetary policy. Through its open market operations, the Reserve Bank maintains the overnight interbank cash rate at a specified rate. If the Reserve Bank conducts open market operations (see Chapter 12) either to increase or to decrease the cash rate, there is an expectation that, in an efficient market, other interest rates will also change over time as the markets move to establish a new equilibrium between various interest rates. Therefore, by controlling one interest rate (the cash rate) the central bank is able to influence desired economic performance outcomes over the longer term. Understanding the determination of interest rates is essential to understanding the financial system and its important relationship to economic growth. Interest rates are the price of money. Yields on investments and the cost of borrowing are measured in interest rates. Any change in interest rates will affect returns received on investments and the cost of borrowing. Importantly, this will flow through to changes in future economic growth and business activity. It is necessary to develop an understanding of what might motivate the central bank of a country to change monetary policy interest rate settings. Participants in the financial markets who have a good understanding of a central bank’s motivations should be expected to make more informed decisions than those who do not pay attention to the relevant signals indicating that interest rates may change. Similarly, both lenders and borrowers may be more confident in making decisions on the structuring of their financial assets and liabilities if those decisions are taken with an analysis of the central bank’s likely monetary policy interest rate decisions. The first part of this chapter provides a brief introduction to some of the macroeconomic variables that affect a central bank’s perception of the appropriate setting for interest rates. The loanable funds approach to interest rate determination is also explained. Of the various theories and approaches used in explaining interest rate determination, the loanable funds approach has been selected because it forms a key part of the framework adopted by the financial markets when forecasting likely changes in interest rates and considering the impacts on the value of financial assets and liabilities and future cash flows resulting from those forecast interest rate changes. The second part of the chapter looks at the extent to which monetary policy transmission (discussed in Chapter 12) actually takes place. That is, how effective is a central bank’s direct influence over short-term interest rates in extending to longer-term rates? This chapter presents theories that have been advanced to explain the relationship between interest rates on short-term, medium-term and long-term securities, including the expectations theory, the segmented markets theory and the liquidity premium theory. 418

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Chapter 13  An introduction to interest rate determination and forecasting

REFLECTION POINTS

central bank of a country is typically responsible for the implementation of monetary • The policy. In Australia, as in many other countries, monetary policy is directed towards maintaining inflation within a defined band or range in order to achieve desired economic outcomes. inflation target in Australia is between 2.00 and 3.00 per cent, on average, over the • The economic or business cycle. main monetary policy tool used by the Reserve Bank is open market operations to maintain • The the interbank overnight cash rate at a specific interest rate. in the cash rate will flow through to other interest rates, which will lead to a change in • Changes economic activity. the major factors that impact on the determination of interest rates is important • Understanding in understanding the financial system and its relationship to economic growth.

13.1

The macroeconomic context of interest rate determination

As discussed above, the central bank is normally responsible for the determination and implementation of monetary policy within a country. Current monetary policy in a number of countries is principally directed towards containing inflation within a specified target range. Central banks contend that by maintaining inflation within a specified range, a number of desirable economic objectives can be more easily achieved. A central bank’s main tool used to implement monetary policy is interest rates. However, before the central bank proceeds with any change in interest rates it needs to establish a view on the desired levels of economic activity, employment, balance of payments and exchange rate that should maintain inflation within the target range. The central bank will adjust its monetary policy interest rate settings from time to time if these variables move significantly out of line with the levels or values that the bank considers appropriate. While the central bank’s principal consideration is the level of inflation, changes in major economic variables will have an impact on inflation and therefore the central bank closely monitors, analyses and forecasts all aspects of an economy. For example, a central bank will generally increase interest rates if:

• the rate of inflation over the business cycle is above its target range • the rate of growth in gross domestic product is excessive • the current account of the balance of payments is significantly in deficit • credit growth within the financial system and associated debt levels are expanding too rapidly • there are ongoing and unsustainable price increases in major economic sectors such as the property sector or the mining sector • the currency is under excessive downward pressure in the foreign exchange markets. In each of these cases the central bank can be expected to tighten monetary policy, that is, increase interest rates, in order to correct an evolving problem. Remember, the focus is on the level of inflation and those factors that will impact on the level of inflation into the future. By continuously monitoring the economy, the central bank seeks to adjust monetary policy settings before inflation breaks out of its target range. If the central bank increases short-term rates, and these higher rates are maintained for some time, medium- to long-term interest rates will also increase. The aim of a tightening of monetary policy is to slow spending in the interest-sensitive sectors of the economy. For example, as spending slows down, the position of suppliers of goods and services in the marketplace will weaken; as a result, the rate at which the suppliers are likely to increase their prices should also fall, and therefore the rate of inflation should decline.

LEARNING OBJECTIVE 13.1 Describe at a macroeconomic level how the liquidity effect, the income effect and the inflation effect influence the determination of interest rates.

Business cycle the change in economic activity over time through cycles of expansion and contraction

Gross domestic product the aggregate value of goods and services produced within a domestic economy

Balance of payments a record of a country’s transactions with the rest of the world

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Liquidity effect on interest rates the effect on the money supply and system liquidity of a central bank’s open market operations

Income effect on interest rates if interest rates rise, economic activity will begin to slow and incomes will fall, thus allowing rates to begin to ease

Inflation effect on interest rates as an economy slows, the upward pressure on prices will ease, thus allowing interest rates to fall

As spending slows and there is more of a balance between the economy’s production and spending levels, the demand for imported goods and services from overseas should decrease, bringing about an improvement in the balance of payments. Finally, by increasing short-term interest rates, it is likely that there will be an increase in the flow of investment funds into the country, and as a result there will be an increase in the demand for the local currency in the foreign exchange market. The price of the local currency should appreciate. Chapter 12 discussed the method used by a central bank to implement its monetary policy—open market operations. Three main open market operations strategies were discussed: (1) the direct buying and selling of government securities, (2) repurchase agreements (repos) and (3) foreign currency swaps. These transactions affect the money supply and the level of liquidity in the financial system. This is referred to as the liquidity effect on interest rates. In addition, there are two other effects that need to be considered. These are referred to as the income effect and the inflation effect. The income effect on interest rates refers to the flow-on effect from the initial liquidity impact on interest rates. In the example above, the central bank increased interest rates in order to reduce the levels of spending in the economy. This may have been achieved by selling government securities (CGS) into the market and thus reducing liquidity in the system. That is, the private sector buys CGS and therefore must pay the amount due to the central bank; thus, liquid funds (cash) are taken out of the financial system and held by the central bank. Reduced levels of spending result in lower incomes in all sectors of the economy: the household sector, the business sector and the government sector. This occurs as employment growth falls, the demand for goods and services eases and taxation revenues to government decline. Also, as the rate of growth in economic activity slows, the demand for loans falls. The slowing in the demand for loans results in an easing in interest rates. Insofar as the economy was previously experiencing inflationary pressures due to high levels of demand, now the slowing of the pace of economic activity will cause the rate of inflation to ease. This easing allows interest rates to ease as well. This is referred to as the inflation effect on interest rates. Briefly, the market rate of interest may be said approximately to comprise two components: the real rate of return and compensation for the expected rate of inflation. Therefore, if the rate of inflation is expected to fall, market rates of interest should also fall. The three impacts on interest rates outlined above are illustrated in Figure 13.1. The impacts need not always be in the sequence suggested. For example, without a change in the monetary policy stance of a central bank, an increase in the level of economic activity and an increase in inflationary expectations would cause interest rates to rise. Similarly, if the level of interest rates is relatively high, and there is a drop in the rate of growth in the economy and a drop in the expected rate of inflation, interest rates could be expected to fall independent of monetary policy. However, the central bank will endeavour to forecast and act before inflation actually reaches that turning point and therefore, in both instances, it would be expected that the central bank would change its monetary policy stance first in response to forecast changing conditions. With this understanding of the processes of interest rate determination, forecasting interest rates should be a relatively straightforward task. All that is needed is to know is:

• the liquidity effects on interest rates: how will the central bank respond to current and forecast rates of growth in the economy, the rate of inflation and the balance of payments? • the income effect on rates: how will the demand for money adjust to changes in the level of economic activity? • the inflation effect on interest rates: will the rate of inflation change? Though it is a simple task to identify these three effects, in practice it is difficult to forecast accurately the extent to which each will change in a dynamic economy. For example, the level of growth, or decline, in each economic variable typically will vary over each reporting period. The central bank and participants in the financial markets spend considerable time analysing the economy. Often, releases of new data or information on the state of the economy present conflicting indications; some data may indicate a slowdown, while others may suggest that the economy is still growing. Often, different sectors 420

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Chapter 13  An introduction to interest rate determination and forecasting

Figure 13.1  Interest rates: liquidity, income and inflation effects (a) Contractionary monetary policy Income effect

Inflation effect

Interest rates (% p.a.)

Liquidity effect

Market rate of interest

Time (b) Expansionary monetary policy Income effect

Inflation effect

Interest rates (% p.a.)

Liquidity effect

Market rate of interest

Time

within an economy will be experiencing different growth rates. For example, the farming sector may be in a downturn because of a drought, but the resources and mining sector may be booming because of increased exports to growing international economies such as China and India. Therefore, economic indicators may be ambiguous as to the exact position of an economy in the business cycle and whether previous monetary policy interest rate settings have achieved the outcomes that were expected. Have interest rate movements been sufficient? Are current interest rate settings appropriate? Are further interest rate actions required? Central bank research indicates that it may take up to two years for monetary policy changes to work through an economy fully. Where this is the case, it is necessary for a central bank to forecast well into the future, often beyond the time-frame implied in new economic data. This ambiguity is also quite typical when an economy is at a turning point, that is, when the economy approaches a business cycle peak or a business cycle trough. In the absence of a single reliable measure, it is necessary to look at a range of indicators in order to obtain a picture of the current state of the economy on which to base a forecast of future interest rates. Indicators are often divided into three categories:

• Leading indicators. Economic data in leading indicators change before changes in the trend in the level of economic activity occur. These indicators are useful in anticipating changes in the business cycle. For example, housing loan approvals data can be considered a leading indicator.

Economic indicators economic sector data that provide some insight into possible future economic growth

Business cycle peak the highest level of economic activity during a business cycle

Business cycle trough the lowest level of economic activity during a business cycle

Leading indicators economic variables that change before there is a change in the business cycle

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Part 4 Government debt, monetary policy, the payments system and interest rates Coincident indicators economic variables that change at the same time as the business cycle changes

Lagging indicators economic variables that change after the business cycle has changed

• Coincident indicators. These provide same-time tracking of the level of economic activity. For

example, these indicators increase as the rate of growth in the economy increases, and they turn down as the economy slows. For example, non-farm payroll data and industrial production are coincident indicators.

• Lagging indicators. These are economic variables that change after a change in the business cycle.

They are useful in confirming that an increase, or decrease, in economic growth has taken place. An example of a lagging indicator is the unemployment rate data.

Figure 13.2 illustrates one economic variable, real gross domestic product (GDP). In this example, real GDP is shown as a coincident indicator. The relative timing of leading and lagging indicators is also shown.

Figure 13.2  Indicators of economic activity Trough

Peak

Real GDP

% change

% change

Peak

% change

Coincident indicator

% change

Leading indicator

Lagging indicator

Years

If any particular indicator were to perform consistently as a leading, coincident or lagging indicator, and if the lead or lag period could be established with certainty, the task of knowing where the economy is and where it was heading would be made easy. However, life is not that simple. For example, there was a time in Australia when the rates of growth in money measures acted as leading indicators, but even so the length of the lead time was variable. In more recent years it appears that the rates of growth in money measures are now lagging indicators. Financial market economists, central banks and governments constantly analyse movements in numerous indicators, as no single indicator is consistent in its lead or lag time, or consistently in the one category as a leading, coincident or lagging indicator. Some of the key indicators that are monitored are listed in Figure 13.3. They have not been identified as leading, coincident or lagging 422

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Chapter 13  An introduction to interest rate determination and forecasting

indicators, since their membership of one group or another can change over time. However, it may be an interesting challenge to have a look at each indicator and consider which you think may currently be leading indicators. The indicators listed in Figure 13.3 are not exhaustive, but are sufficient to suggest that knowing the state of the economy and where it might be headed with reasonable accuracy is neither simple nor straightforward. Yet it is an issue that must be addressed by the central bank, government, financial market participants, business managers and individuals.

Figure 13.3  Indicators of economic activity Gross domestic product

Imports

Gross national income

Capacity utilisation

Balance of payments

Motor vehicle registrations

Housing loan approvals

Retail sales

Non-residential building approvals

Share price index

Private sector credit growth

Telephone service connections (business)

Unemployment rate Ratio of full-time to part-time employment Job vacancies Wages growth

Surveys (including surveys of consumer sentiment, business investment plans, and businesses’ expectations relating to sales, employment and future profits)

Hours of overtime

REFLECTION POINTS

central bank will generally increase interest rates if the rate of inflation is forecast to increase • Aabove a specified target range. policy changes in interest rates are said to have three effects over time: the liquidity • Monetary effect, the income effect and the inflation effect. The liquidity effect relates to changes in funds available for lending within the financial system. The income effect relates to changes in economic activity and therefore future income levels. The inflation effect relates to the eventual impact on inflation of the liquidity and income effects. initial liquidity effect on interest rates is eventually offset by the opposite effects of income • The and inflation. If the liquidity effect initially pushes up interest rates, the later income and inflation effects will eventually see interest rates decline. participants monitor economic indicators for some insight into economic growth and the • Market future direction of monetary policy initiatives. economic data may be a leading (change before the economy turns), lagging • Published (change after the economy has turned) or coincident indicator (change at the same time as the economy changes).

13.2

The loanable funds approach to interest rate determination

The loanable funds approach to explaining and forecasting interest rates is often preferred by financial market analysts, and is implicit in their comments on interest rates. This preference may be explained, in part, by the conceptual simplicity of the model. Other theories of interest rate determination (such as those traditionally presented in macroeconomics texts) explain interest rates in terms of the demand for and supply of money.

LEARNING OBJECTIVE 13.2 Explain the loanable funds approach to interest rate determination, highlighting variables that affect the demand and supply for loanable funds. Consider the effects of changes in those variables on interest rate equilibrium.

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Loanable funds the amount of funds available for lending within the financial system

Whereas those theories look at why people and institutions hold money, the loanable funds approach looks at the reverse side of that question, in that it focuses on lending. It proposes that interest rates are determined by the supply of, and demand for, loanable funds. Loanable funds are the funds that are available within the financial system for lending. In the loanable funds approach there is a downward-sloping demand curve and an upward-sloping supply curve, as shown in Figure 13.4. The equilibrium interest rate is at the intersection of the demand and supply curves.

Figure 13.4  The loanable funds approach to interest rate determination

Interest rate (i)

S

Equilibrium interest rate

D

Q

Loanable funds

The downward slope of the demand curve implies that the demand for loanable funds will fall as interest rates rise; conversely, the upward-sloping supply curve shows that an increase in the supply of loanable funds will allow interest rates to fall. Changes in the positions of the demand curve and the supply curve will result in changes in the rate of interest, as shown in Figure 13.5. In Figure 13.5(a) the increase in demand from D1 to D2 has resulted in an increase in interest rates, while in Figure 13.5(b) the increase in supply from S1 to S2 has resulted in a fall in interest rates.

Figure 13.5  Effects of changes in loanable funds demand and supply curves (a)

S1

(b) S1

Interest rate (i)

Interest rate (i)

S2

D2 D1

Loanable funds

D1 Q

Q

Loanable funds

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13.2.1

T HE DEMAND FOR LOANABLE FUNDS

Within the context of the overall economy it is generally assumed that there are two sectors that have a net demand for loanable funds. First, there is the business sector’s demand for funds to finance shortterm working capital and longer-term capital investment. The lower the rate of interest, all else being constant, the greater the volume of debt funds demanded by the business sector. This is represented by the downward-sloping curve (labelled B) in Figure 13.6. Any factors that cause the business sector to increase its demand for loan funds would be represented by a shift to the right in the B curve. A decrease in demand would shift the curve to the left. The curve shown represents the net business sector demand for funds, so retained earnings and depreciation allowances, which represent business savings, are subtracted from the gross business sector demand for funds.

Figure 13.6 Demand for loanable funds (B = business sector; G = government sector)

B

Loanable funds

Interest rate (i)

Interest rate (i)

Interest rate (i)

G+B

G Q

Loanable funds

Q

Loanable funds

Q

The second component of demand is the government sector. Governments must fund their annual budget capital and recurrent expenditures that are in excess of their revenues (taxation); that is, finance any budget deficit. Also, government will need to fund daily liquidity shortfalls that will occur when expenditures such as pension payments must be made before taxation revenues are received; that is, intra-year liquidity. In terms of the loanable funds approach, it is the total government sector’s deficit that is relevant. For example, in Australia this is referred to as the public sector borrowing requirement and includes the borrowing requirements of the Commonwealth, state, territory and local governments and their instrumentalities. It is normally proposed that the borrowings of the government sector are independent of the rate of interest, and this is represented by the vertical line labelled G in Figure 13.6. Government expenditures generally are not discretionary, in that once a government has made a budget commitment to an expenditure program, that program will proceed regardless of the current interest rate. Therefore, as government borrowing is not significantly influenced by the interest rate, a vertical demand curve is used to show that demand is unaffected by interest rate levels. An increase or decrease in government sector borrowing would result in the G curve moving to the right or left in the diagram. If the total government sector borrowing requirement is negative as a result of budget surpluses, the G curve would disappear and the surplus would be represented as savings in the supply curve. The demand curves of the government sector and the business sector are combined to give the total demand for loanable funds. This is labelled G + B in Figure 13.6.

Public sector borrowing requirement the total borrowing requirements of various levels of government and their instrumentalities

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13.2.2

T HE SUPPLY OF LOANABLE FUNDS

The supply of loanable funds is composed of three principal sources. The first and major source of funds is the savings of the household sector, identified as S in Figure 13.7. The curve is drawn with an upward slope on the basis of the common presumption that as interest rates increase, people will save a larger proportion of their incomes. In the figure, the curve is very steep, suggesting that increases in interest rates will cause only small increases in the quantity saved. This is supported by empirical evidence indicating that there is not a strong relationship between the rate of interest and savings.

Figure 13.7 Supply of loanable funds (savings plus changes in the money supply) S

Interest rate (i )

Interest rate (i )

S

S+

M

Q

Loanable funds

Money supply the total amount of money in an economy; includes currency and deposits with financial institutions

Dishoarding the situation where normal cash holdings are reduced and invested in financial instruments

M

Loanable funds

Q

The second impact on the supply of funds is changes in the money supply (ΔM). Broadly, money supply is the total amount of money in the economy, consisting mainly of currency in circulation and deposits with financial institutions. Since the money supply is assumed to be independent of the rate of interest, changes in the money supply are represented diagrammatically as a parallel line to the S curve. When ΔM is added to the savings curve, it simply changes the location of the curve (S + ΔM in Figure 13.7); it does not change the slope of the curve. If the central bank increases the money supply, the S + ΔM curve would move to the right of the S curve. If the central bank reduces the money supply, the S + ΔM curve would move to the left of the S curve. Changes in the money supply may occur if the central bank buys or sells CGS. For example, if the Reserve Bank bought CGS from the market, then it would increase the money supply when it paid for the securities. The final source of loanable funds is labelled dishoarding (D in Figure 13.8). The notion of hoarding is that a proportion of the total savings in the economy will be held as currency, or hoarded. Currency is not available for lending unless it is deposited or invested in other financial assets. As interest rates increase, there is an incentive for those individuals and businesses holding cash to invest those funds in order to obtain the increased yields that are available. This may simply involve depositing the funds into a bank account. Investing those hoarded funds into the financial system means that currency holdings are reduced and dishoarding occurs. Therefore, as interest rates increase, more funds are made available within the financial system. Conversely, as interest rates fall, people have less incentive to invest their surplus cash holdings and hoarding takes place, resulting in a reduction in loanable funds. An example of the reasoning behind hoarding behaviour at lower rates of interest may be explained by considering bonds. Bonds are coupon securities, and the lower rates of interest have their counterpart in increased prices of existing bonds. (In Chapter 10 we observed that the price of fixed-interest securities increases as current market rates fall and vice versa.) Some holders of bonds

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may take advantage of the increased bond price and sell them to make a capital gain. By so doing they withdraw loanable funds from the market.

Figure 13.8  Supply of loanable funds (S + ΔM + dishoarding) S + ΔM + D

Interest rate (i)

S + ΔM

S + ΔM – H Q

Loanable funds

In Figure 13.8, dishoarding (D) is added to the S + ΔM curve to give the total supply of loanable funds curve. At higher rates of interest, the supply of loanable funds is increased through dishoarding and the supply curve is shown as S + ΔM + D. At lower rates of interest, the supply of funds is reduced through hoarding (H) and the supply curve is shown as S + ΔM – H.

13.2.3

E QUILIBRIUM IN THE LOANABLE FUNDS MARKET

The rate of interest in the loanable funds market will adjust to the point where the demand for funds is equal to the supply of funds. This rate is referred to as the equilibrium rate, and the market is said to be in equilibrium. In Figure 13.9 the equilibrium rate would be at point E, at a rate of interest of i0. Point E is only a temporary equilibrium outcome, because over time the rate of interest will continue to move as the dynamic variables also continue to change.

Figure 13.9  Equilibrium in the loanable funds market S + ΔM

Interest rate (i)

S + ΔM + D

i0

E a

b

G+B

Q0

Loanable funds

Q

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The reasons for expecting a change in the rate of interest away from what appears to be an equilibrium outcome in Figure 13.9 include the following:

• At i

dishoarding to the extent of ab is taking place, and this cannot continue period after period. 0 Once portfolios have been reallocated away from holding currency and towards holding securities, the dishoarding process will cease. Dishoarding of ab will not continue and the supply curve will adjust upward.

• The supply curve includes a positive ΔM; that is, the central bank has increased the money supply. Unless the money supply is increased by proportionately the same amount in the next period, the S + ΔM component of the supply curve would change its position.

• In Figure 13.9, the increase in the money supply and the dishoarding result in interest rates being

lower than in the previous period. As a result, business investment and therefore business demand for funds (B) can be expected to increase, resulting in a rightward shift in the G + B demand curve. However, as business investment and production levels increase, the demand for funds by the government sector (G) should decline. This result is expected because the higher levels of production and national income would result in increased tax receipts and reduced expenditure on unemployment benefits, resulting in a lower budget deficit and government borrowing requirement.

• The increased level of national income referred to above would also result in increased savings, which would affect the supply curve.

These points highlight a problem with the loanable funds approach. A final equilibrium interest rate cannot be determined because the supply and demand curves are not independent of each other. Changes in the supply of funds are likely to cause changes in the demand for funds, and vice versa. In using this framework, care must be taken to recognise the interdependence between the demand for and the supply of loanable funds. Bearing this in mind, the loanable funds approach still provides a very useful framework within which the numerous impacts on interest rates and the flow of funds can be analysed. In the following sections the loanable funds framework is used to analyse the impacts of two disturbances on the rate of interest: the level of economic activity and changes in inflationary expectations.

13.2.4

Loanable funds—an expected increase in the level of economic activity

The initial response to an expectation of increased economic activity may come from the business sector. As such, there will be an increase in business demand for funds to finance investment projects aimed at taking advantage of an anticipated increase in the demand for goods and services as economic activity increases. In a loanable funds demand and supply graph, the increase in B would shift the demand curve to the right, resulting in an increase in the rate of interest. This is exactly the same outcome as that predicted through the income effect discussed in Section 13.1 within the macroeconomic context. What is actually going on in the financial markets to bring about this result? As businesses increase their investment in inventories and in capital equipment, they will borrow from the banks or issue financial instruments into the markets to obtain funds. As the supply of financial instruments in the market increases, the prices of those instruments will fall and their yields will increase. The lower prices on the securities (higher yields) will cause some savers to rearrange their portfolios. They will give up cash and buy securities; that is, dishoarding will take place. It is important to recognise that the forecast increase in interest rates is only a temporary equilibrium. As was emphasised above, there will be feedback mechanisms to consider in forecasting interest rate changes further into the future. For example, the dishoarding that accompanied 428

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the initial increase in interest rates will cease after the desired portfolio reallocations have been completed. With no further dishoarding, interest rates may have to rise further in order to encourage even more dishoarding. However, as the increase in business investment adds to the expected increase in economic activity, there will be an increase in savings and this will relieve some of the upward pressure on interest rates. In addition, the increase in output will see an improvement in the government’s budget deficit, with an associated reduction in the government’s borrowing requirement. This will also relieve some of the upward pressure on rates. A final impact may be introduced through the exchange rate effect of the initial increase in interest rates. The appreciation of the exchange rate for the currency that might be expected to accompany the increased interest rate is likely to result in a reduced demand for exports and an increase in the demand for imports. Businesses in the export-competing and import-competing sectors of the economy will cut back on their investment, and thus reduce their demand for funds. This will relieve some of the upward pressures on interest rates.

13.2.5

Inflationary expectations in the loanable funds approach

The traditional approach to the analysis of the effects of inflation on interest rates is shown in Figure 13.10. The initial equilibrium interest rate is i0, at the intersection of the original demand and supply curves.

Figure 13.10  Inflation, loanable funds and interest rates (the Fisher effect)

Interest rate (i )

S1

i1 (i1 = i0 + Pe)

S0 Pe

i0

Q0

D0

Loanable funds

D1 Q

With an increase in inflationary expectations, the suppliers of funds will demand a higher rate of interest in order to maintain the same real rate of return on their funds. Diagrammatically, the supply curve will move vertically by the extent of the inflationary expectation (Pe), from S0 to S1. The demand for funds will also change in response to the increased inflationary expectation. The demand curve increases, by the extent of the inflationary expectations, from D0 to D1. The demand for funds increases because businesses, in anticipating higher inflation, recognise that they will require a greater quantity of funds merely to maintain their pre-inflation investment plans. The result of the increased inflationary expectations is that interest rates will rise to the full extent of the anticipated inflation (Pe), and the quantity of loanable funds will remain unchanged at Q0. Though the outcome provided in Figure 13.10 is the common textbook response to the effects of a change in inflationary expectations, known as the Fisher effect, it is by no means the only result 429

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that can be hypothesised. Figure 13.11 reproduces the previous supply and demand curves (S1 and D1) that result in the Fisher effect outcome, with the interest rate increasing from i0 to i1. It also shows an alternative outcome: the D2 and S2 curves (represented by dashed lines), resulting in an equilibrium interest rate at i2. This is above the original rate, but considerably lower than that predicted by the Fisher effect. The demand curve in this alternative approach has not moved up as far as it did in the previous case. The reason for this is that the government demand for funds may be reduced by the higher rate of inflation. Higher inflation typically results in a rise in wages, the dollar value of goods sold and the dollar value of business profits. As a result, tax revenues will increase. Tax revenue is likely to rise faster than the rate of inflation and faster than the inflation-induced increase in government expenditure. In short, inflation is likely to see a reduction in government borrowing, resulting in D2 in Figure 13.11.

Figure 13.11 Inflation, loanable funds and interest rates (a non-Fisher outcome) S1

Interest rate (i )

i1

S0 S2

i2 i0 D1 D2 D0

Loanable funds

Q

The supply curve may shift, not to the left (or upwards) as in Figure 13.10, but to the right (or downwards) as shown by the dashed supply curve labelled S2 in Figure 13.11. There are a few reasons for suspecting this, at least as a short-run response. First, with higher inflation, savers begin dishoarding, since cash balances suffer an erosion of their real value during periods of inflation. To the extent that dishoarding takes place, there is an increase in the supply of loanable funds. This is identified as S2 in Figure 13.11. A second reason for suspecting that there may be an increase in loanable funds is that increases in inflation may cause uncertainty, and in response to that savers may increase their savings (S2, which is greater than S1, and may be greater than S0). Even if voluntary savings are not increased, there is a strong likelihood that contractual savings—an important component of savings—will increase during periods of increased inflation. A major component of contractual savings is contributions to superannuation funds, and since these are often tied to the contributor’s wage or salary, they will increase as wages rise along with inflation. Another important component of contractual savings is payments for life insurance policies, and though they may not always rise during inflationary periods, they will not be reduced in response to higher inflationary expectations. Throughout the preceding discussion, reference has been made to the rate of interest, but without elaborating upon it. The next section redresses this obvious shortcoming by acknowledging that at any one time there are numerous rates of interest on offer to savers, while borrowers also face different rates of interest. We will now consider the term structure of interest rates and the risk structure of interest rates to explain the different rates of interest that simultaneously exist at any particular moment on financial instruments. 430

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REFLECTION POINTS

loanable funds approach to interest rates considers factors that impact on the demand for • The and supply of loanable funds, that is, funds available for lending in the financial system. of the downward-sloping demand curve are government and the business sector. • Components Government borrowing is usually not affected by interest rates, whereas business sector demand for loanable funds will fall as interest rates rise. of the upward-sloping supply curve are savings, changes in the money supply and • Components dishoarding. Savings derive from surpluses within the household sector, changes in the money supply result from the open market operations of the central bank and dishoarding relates to the amount of funds (cash) held outside the financial system.

• The equilibrium interest rate is at the intersection of the demand and supply curves. expected increase in economic activity will initially result in increased business demand for • An loanable funds, thus putting upward pressure on interest rates. This initial change in rates will cause a complex set of interactions; some may increase rates further while others may relieve the pressure on interest rate rises. outcome of an anticipated increase in inflation will be an increase in interest rates. • The However, it is contended that the non-Fisher effect expected rise in rates will be less than the Fisher effect expected rise in interest rates.

13.3

The term structure of interest rates

Financial instruments, such as a bank term deposit, a bank-accepted bill or a corporate bond, that have different maturity dates are likely to have different yields. The yield is the total rate of return on an investment. For financial instruments, such as bank term deposits, the interest rate payable is equal to the yield. However, for other instruments, such as a bond or a share, the holder may receive interest or dividend payments respectively, plus a capital gain (or loss). In this case, the yield is the total return. The yield curve illustrates the term structure of interest rates for a specific security at that point in time; it can be graphed with the yield on the vertical axis and the term to maturity on the horizontal axis. Figure 13.12 shows a hypothetical Treasury bond yield curve over a 10-year maturity spectrum. You will note that the shape and slope of the curve change over time.

Figure 13.12  Yield curve: Treasury bonds

LEARNING OBJECTIVE 13.3 Understand interest rate yields and the shape of various yield curves. Apply the expectations theory, the segmented markets theory and the liquidity premium theory within the context of the term structure of interest rates.

Yield curve a graph, at a point in time, of yields on a particular security with a range of terms to maturity

10

8

Yield (% p.a.)

6.85 6.10 6

6.20

6.20

5.90

4.85 4.20

4.10

4

3.85

Term structure of interest rates the relationship between interest rates and term to maturity for debt instruments in the same risk class

4.15

2

0 0

1

2

3

4

5

6

7

8

9

10

Term to maturity (years)

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Part 4 Government debt, monetary policy, the payments system and interest rates Normal or positive yield curve long-term interest rates are higher than shortterm rates

Differently shaped yield curves occur from time to time and are determined by market expectations in relation to future interest rates. The shape of the yield curve represents the term structure of interest rates. In Figure 13.13 three different types of yield curves are shown:

• 13.13(a) the normal or positive yield curve. With yield curves of this shape, long-term interest rates are higher than short-term interest rates, therefore the curve slopes upwards.

Figure 13.13  Types of yield curves—normal, inverse, humped (a)

Yield (% p.a.)

Normal or positive curve

Term to maturity

Yield (% p.a.)

(b)

Inverse or negative curve

Term to maturity

Yield (% p.a.)

(c)

Humped curve

Term to maturity

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• 13.13(b) the inverse or negative yield curve. In this interest rate environment, short-term interest rates are actually higher than long-term interest rates, therefore the curve slopes downwards. • 13.13(c) the humped yield curve. In this case the shape of the yield curve changes over time from being a normal yield curve to being an inverse yield curve.

Clearly, the term structure of interest rates is important as changes in interest rates over the term structure affect the cost of borrowing and the return on investment. An analysis of the term structure will be incorporated into the decision process applied by borrowers and investors. Therefore, in order to understand the shape and slope of yield curves we will consider three major theories: the expectations theory, the market segmentation theory and the liquidity premium theory. While each theory is considered individually, there are clear interrelationships between them. Each has its weaknesses and its strengths, but combined they assist in our understanding of the term structure of interest rates.

13.3.1

Inverse or negative yield curve short-term interest rates are higher than longterm rates

Humped yield curve the shape of the yield curve changes over time from normal to inverse

The expectations theory

Under the expectations theory, the current short-term interest rate and expectations about future shortterm interest rates are used to explain the shape of the yield curve and changes in its shape. The theory contends that long-term interest rates will be equal to the average of the current short-term rate and the expected future short-term rates. The following simplified example illustrates the idea behind the expectations approach. A more formal statement of the theory is presented later in the chapter. Consider an investor in the following situation.

Expectations theory a theory that explains the shape of a yield curve through current and future short-term interest rates

• The investor has funds available for investment for a two-year period. • The current interest rate being offered on a one-year-to-maturity investment is 7.00 per cent per annum. This rate will be identified as 0i1, where the zero prefix indicates the time at which the rate is available (today) and the suffix ‘1’ indicates the term over which the rate applies, being one year.

• The investor has conducted an analysis of economic fundamentals and forecast that interest rates

on a one-year investment should increase to 9.00 per cent per annum, commencing in one year’s time. That is, E1i1 = 9.00%, where E indicates an expected, or future, rate of interest, and 1i1 is the interest rate that will prevail in one year’s time on a one-year instrument.

• Using the contentions of the expectations theory, the investor is able to determine the equilibrium

rate of interest that should be available on a two-year investment commencing today, that is, the i  rate. 0 2

If the expectations theory of the yield curve is a good approximation of the equilibrium interest rate, and if this investor is typical of other participants in the market, there will be a unique value for the 0i2 interest rate. The investor will place the available funds such that the rate of return earned over the two-year period is maximised. The investor has a choice as to the placement of the funds. They can be invested in the one-year instrument now at 7.00 per cent, and the funds received on maturity in one year’s time could then be reinvested in another one-year instrument at the expected rate (E) of 9.00 per cent. However, the investor also has the choice to invest the funds in a two-year instrument today. Using the expectations theory, if the markets are operating efficiently, the rate of return available now on the two-year investment should be equal to 8.00 per cent per annum. That is: ​(​  ​​​i​ ​​ + ​Ei​ ​​​i​ 1​​) ​ ​ 0​​​i​ 2​​ = _______ ​  0 1  ​     2 ​ ​​ ​  ​  _______       ​ ​ ​​ 0.07 + 0.09 ​ = ​   ​    2 ​ = 0.08 or 8% p.a.

13.1

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Any 0i2 rate other than this would not be a sustainable equilibrium rate. For example, if the actual i rate is 9.50 per cent per annum, the investor would clearly choose to place the funds in the two-year 0 2 instrument. This will earn a rate of return that is 1.50 per cent per annum higher than is available through the other strategy of investing in a one-year instrument now and following that with a further one-year investment. On the assumption that the investor’s expectations are the same as those held by other investors in the market, there would be a great demand for the two-year investment. This demand would result in the price being bid up, and thus the rate of return on the two-year investment would fall. This demand would continue until such time that the price of the two-year investment rose to the extent that its rate of return fell to 8.00 per cent per annum. At this rate, investors would be indifferent between the two possible investment strategies that were outlined above. What would happen to the 0i2 rate if market participants expected the future short-term rate to be lower than the current short-term rate? For example, assume the previous 0i1 rate of 7.00 per cent per annum and an E1i1 rate of 5.00 per cent per annum. Under these conditions, the 0i2 rate would be approximately: ​(​  ​​​i​ ​​ + ​Ei​ ​​​i​ 1​​) ​ ​ 0​​​i​ 2​​ = _______ ​  0 1  ​     2 ​ ​​ ​  ​  _______       ​ ​ ​​ 0.07 + 0.05 ​ = ​   ​    2 ​ = 0.06 or 6% p.a. If an investor rearranges the above formula, it is possible to easily calculate the expected one-year rate that should apply in one year’s time; that is, E1i1. For example, if a bank is offering a one-year term deposit with a rate of 4.25 per cent per annum and a two-year term deposit with a rate of 4.75 per cent per annum, then E1i1 approximation will be 4.25 plus 4.75 divided by 2 = 4.50 per cent per annum. The expectations theory of the yield curve can be summarised, based on the following assumptions.

• There are a large number of financial investors who hold reasonably homogenous expectations about the future values of short-term interest rates.

• There are no transaction costs, so investors can move into and out of instruments at no cost as they

change their expectations and as they see market rates that are inconsistent with their expectations.

• There are no impediments to market rates moving to their competitive equilibrium levels. • The goal of investors is to maximise their expected rate of return; that is, if all bonds are perfect substitutes for each other regardless of their term to maturity, then long-term interest rates paid on bonds will be equal to the average of the short-term interest rates expected to prevail over the longterm period.

If expectations about future short-term interest rates are the only factor impacting on long-term rates, certain deductions can be made in explaining the differently shaped yield curves shown in Figure 13.13.

• An inverse yield curve will result if the market expects future short-term rates to be lower than

current short-term rates. That is, even though the central bank may increase rates at the short end of the yield curve to achieve its monetary policy objectives, market participants expect that once those objectives have been achieved short-term rates will be lowered again. In this circumstance, long-term rates will not rise to the same extent as the policy-induced change in short-term rates, and therefore the yield curve will slope downwards. This is illustrated in Figure 13.14 for a simplified two-period yield curve. It shows that if E1i1 < 0i1, the yield curve will be inverse.

• A normal yield curve will result from expectations that future short-term rates will be higher than

current short-term rates. In this case, the central bank may reduce short-term rates, but since the market believes that future short-term rates will be higher than current short-term rates, long-term rates will not fall as far as the policy-induced cut in short-term rates, and therefore the yield curve will be upward sloping. That is, if E1i1 > 0i1, the yield curve will be normal. This is illustrated in Figure 13.15.

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Interest rate (i)

Figure 13.14  Inverse yield curve (E1I1 < 0I1)

i

01

i

02

E1i1

1 year

2 years

Term to maturity

Interest rate (i )

Figure 13.15  Normal yield curve (E1I1 > 0I1)

E1i1

i

02

i

01

1 year

2 years

Term to maturity

• The humped yield curve is more difficult to explain under the pure expectations approach. It requires that investors expect that short-term interest rates will initially rise, but that there will be a subsequent fall in short-term rates in the longer term.

The expectations theory of the yield curve poses the question: on what basis are expectations formed? One response is that expectations are formed on the basis of market participants’ understanding of the economic fundamentals that cause changes in a central bank’s interest rate settings, and of the factors that affect the demand for liquidity. That is, market participants will be aware of issues raised earlier in this chapter and in Chapter 12. A more detailed discussion on calculations used to forecast interest rates, based on the expectations theory approach, is provided in the Extended learning section at the end of the chapter.

13.3.2

The segmented markets theory

The segmented markets theory rejects two of the assumptions of the expectations theory, namely: 1 that all bonds are perfect substitutes for one another 2 that investors are indifferent between holding instruments with a short term to maturity and holding instruments with a long term to maturity.

Segmented markets theory all bonds are not perfect substitutes; investors have different preferences when investing in either shortor longer-term bonds

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The segmented markets theory explains the yield curve by asserting that market participants do not necessarily regard securities in different maturity ranges as perfect substitutes for one another. For example, does an investor really consider an investment in a one-year-to-maturity bond the same as an investment in a 10-years-to-maturity bond? Whereas bonds with a very short term to maturity may well be close substitutes for each other (and likewise bonds with long terms to maturity), a one-year-tomaturity bond is less likely to be seen as a close substitute for a 10-year bond. The other ingredient of the segmented markets theory is the view that some market participants have a preference for short-dated securities, and others have a preference for longer-term maturities; that is, different investors have a preference for different segments of the market. The particular preferences are motivated out of a desire by the various participants to reduce the riskiness of their portfolios. Investors will seek to minimise their exposure to fluctuations in the prices and yields associated with their assets and liabilities. The essence is to match the cash flows and maturities of their assets and liabilities. As an example, a bank whose deposit base is primarily composed of short-term deposits is susceptible to uneven liquidity demands—that is, to the demands of depositors wishing to withdraw funds or borrowers seeking long-term loans. The bank can protect itself from such liquidity demands if it holds a percentage of its investment portfolio in short-term securities that can be quickly sold into the money markets to raise additional cash. Life insurance offices and superannuation funds have relatively long-term liabilities (insurance contracts and retirement savings respectively), and so they normally prefer to invest a larger proportion of their total assets at the long end of the yield curve in order to match the cash-flow characteristics of their liabilities. The essence of the segmented markets theory is its emphasis on the behaviour of market participants in seeking to minimise the riskiness of their portfolios, rather than seeking profit maximisation (one of the main assumptions of the expectations theory). The implication of the segmented markets approach is that it is the relative demand for, and supply of, securities in the various maturity ranges that determine yields. The shape and slope of the yield curve are determined by the relative demand and supply conditions that exist along the maturity spectrum. To illustrate the operation of the segmented markets theory, consider the outcome if, for example, the central bank increased the supply of Treasury bonds with one year to maturity. All else being constant, the price of those bonds would decline and their yields would rise. The short end of the yield curve would lift and (assuming that prior to the disturbance the curve was relatively flat) the end result would be an inverse yield curve. There would be a disturbance to interest rates on bonds with maturities around the one-year to maturity end of the yield curve; the impact would not be felt at the long-term end of the yield curve. If, on the other hand, the central bank concentrated on sales of 10-year bonds, the rates at the long end of the yield curve would increase and short-term rates would be unaffected. These two examples are illustrated in Figures 13.16 and 13.17.

Interest rate (i)

Figure 13.16  Segmented markets: central bank sales of short-term securities

Term to maturity

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Interest rate (i)

Figure 13.17  Segmented markets: central bank sales of long-term securities

Term to maturity

In a further example, the central bank wishes to increase the average maturity of the stock of bonds in the hands of the public; it therefore initiates purchases of short-term bonds and sells an identical amount of long-term bonds. Under the segmented markets approach, the central bank’s purchase of the short-term bonds will push up their price and reduce their yield. Its sale of long-term bonds will result in reduced prices on those securities and increased yields. Even though there is no change in liquidity within the financial system (the sale of long-term bonds being matched by purchases of shortterm bonds), there are impacts on the level and composition of economic activity. Those areas of expenditure sensitive to short-term interest rates will expand, while those more affected by long-term rates will contract. In contrast to this forecast, the expectations theory proposes that merely changing the maturity composition of the stock of bonds will have no effect on expectations about future short-term rates of interest, and therefore no impact on the yield curve. If the yield curve is unaffected, the central bank’s actions will have no impact on the real economy. Another illustration of the different implications of the two theories is provided by the example of a government budget deficit that is financed by the sale of bonds. Under the segmented markets theory, the maturity of the bonds issued will impact on the shape and slope of the yield curve. If the maturities of the bonds are spread fairly evenly across the maturity spectrum, the whole yield curve will lift. If the sales are concentrated on the long end of the spectrum, the long end of the yield curve will lift and the short end will be unaffected. If the sales are concentrated at the short end, short-term rates will rise and long-term rates will be unaffected. In contrast, under the expectations approach, the maturity composition of the bonds offered for sale will be virtually irrelevant. What matters is the market participants’ expectations about the impacts of the current budget deficit on interest rates in the future. Given the divergence in forecasts that emerges from the two theories, which is the preferred theory?

13.3.3

The expectations approach versus the segmented markets approach

The logic of both theories is appealing, at least when each is considered in isolation. However, the segmented markets approach contains problems. Its emphasis on the risk management motivation of market participants is too narrow. It denies the existence of participants in the market who seek to take advantage of arbitrage opportunities. Without their participation, the extreme segmentation hypothesis would allow for discontinuities to appear in the yield curve. For example, if the central bank entered the market as a buyer of long-term bonds, their yields would be bid down but those on short-term bonds would be unaffected. If the yield curve was reasonably flat prior to the central bank’s actions, the long end would be lower but there would be no change at

Arbitrage simultaneously taking advantage of buy and sell price differences between markets

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the short end. Such an outcome is highly improbable in reality. Arbitrageurs, who are indifferent about the maturity of the bonds that they hold, would sell their long-term bonds and simultaneously buy the cheaper, higher-yielding short-term bonds. Short-term bond prices would therefore be bid up and their yields down. As a result, the central bank’s actions in the long end of the market would be transferred through the length of the yield curve. In addition to arbitrage, there are also the trading actions of speculators to be considered, which are totally dictated by expectations. The segmented markets theory also cannot explain the empirically observed relationship between monetary policy settings and the shape of the yield curve. In summary, the major problem associated with the segmented markets theory is that it only allows for risk managers in the market. It ignores the motivations of other participants in the market, such as the seeking of arbitrage and speculative profits. In addition, with the rapid development and growth in the popularity of risk management products (dealt with in Part 6), the emphasis on the risk management motivation of participants in the bond markets is perhaps less important. The bond market is more than ever likely to be dominated by participants who, as assumed in the expectations theory, seek to maximise profits. The management of risk associated with their portfolios is likely to be handled using specialised risk management products. The expectations approach is the more fruitful approach to explaining and forecasting the yield curve.

13.3.4

Liquidity premium theory investors prefer short-term securities; therefore, they require compensation to invest longer term

Liquidity premium compensation (higher yield) received for the increased risk of investing for a longer period

T HE LIQUIDITY PREMIUM THEORY

One criticism of the pure expectations theory is its assumption that investors are indifferent as to whether they hold long-term or short-term bonds. However, there is one important characteristic that distinguishes short-term and long-term securities, and it may result in a violation of the assumption of indifference. The distinguishing characteristic is that long-term-to-maturity bonds are more susceptible than short-term instruments to a risk of large price fluctuations. This can be verified by using the bond pricing formula in Equation 12.1 to calculate the effect on the price of a $1000 bond. Consider the example of a bond that currently is paying half-yearly coupons at 8.00 per cent per annum, where there is an increase in interest rates to 10.00 per cent. The price of a bond that has one year to maturity will fall to $981.40, whereas the price of a bond that has 15 years to maturity will fall to $846.28. The short-term bond fell in price by 1.86 per cent, while the long-term bond fell in price by 15.37 per cent. The liquidity premium theory contends that investors have a preference for short-term securities, as these assets have greater liquidity and less interest rate risk. Also, lenders are less exposed to default risk over the short term. However, borrowers generally prefer to obtain long-term funds in order to spread their repayment commitments and match their long-term cash flows. Therefore, lenders are willing to accept lower yields on short-term investments as a trade-off for greater liquidity and reduced risk exposures. In essence, an investor requires compensation for investing for a longer period. Given the greater risk associated with long-term securities, it is reasonable to accept that investors will require a liquidity premium if they are to invest in longer-term securities. If this is the case, the pure expectations theory explanation of the level of long-term rates may be presented in Equation 13.2 as being approximately: ​(​ 0​​​i​ 1​​ + ​E1​ ​​​i​ 1​​ + L) ​​ ​ 0​​​i​ 2​​ = ​ _________  ​​      2

13.2

where L is the liquidity premium that is demanded in order to hold the higher-risk, longer-term security. Therefore, the theory contends that the longer the term to maturity of a particular instrument, the greater the value of L. The effect of the addition of a liquidity premium to the expectations theory is seen in Figure 13.18. Support for the addition of the liquidity premium to the expectations theory is derived from observations of the shape of the yield curve over time. In the earlier discussion of the various shapes 438

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Figure 13.18 Liquidity premium: observed yield curve versus expectations theory yield curve Observed yield curve Liquidity premium

Interest rate (i)

Expectations yield curve

Term to maturity

of the yield curve, it was noted that the positive or upward-sloping curve is labelled as the normal yield curve. Figure 13.18 depicts a normal yield curve explained by the expectations theory, and the current yield curve observed in the market. The slope of the observed current yield curve is steeper than that of the expectations curve. The difference between the expectations curve and the observed curve is the liquidity premium. It is also apparent in the figure that the liquidity premium is increasing over time, illustrating the contention that liquidity risk increases over time, and therefore investors need to be compensated for that increasing additional risk. From time to time an inverse curve may be evident. What impact will the liquidity premium have in this situation? As Figure 13.19 shows, the combination of the expectations theory and the liquidity premium explains the observed dominance of the normal curve. In the figure, even though the expectations outcome is an inverse curve, the addition of the liquidity premium results in a positive or normal yield curve.

Figure 13.19 Normal yield curve: inverse expectations yield plus liquidity premium

Interest rate (i)

Observed yield curve (E + L)

Expectations yield curve (E ) Liquidity premium (L)

Term to maturity

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While Figure 13.19 implies that the liquidity premium may change the shape of an observed yield curve from inverse to normal, this is not always so. At times of tight monetary policy an inverse yield curve will remain inverse. The liquidity premium has not disappeared, but its effect on the slope of the yield curve is not enough to change the shape from inverse to normal. The observed inverse curve will, however, be less steep, or will flatten out, as a result. Figure 13.20 demonstrates the impact of the liquidity premium on the slope of a yield curve that remains inverse in shape.

Interest rate (i)

Figure 13.20  Inverse yield curve: expectations curve plus liquidity premium

Observed yield curve Liquidity premium Expectations yield curve

Term to maturity

In all situations, the liquidity premium has over time changed the slope or steepness of the yield curve. Therefore, it may be argued that the combined expectations and liquidity premium theories are of greatest value in understanding the behaviour of the yield curve within the context of the term structure of interest rates.

Reflection Points

is the rate of return on a financial instrument; a yield curve is a graph of yields over time • Yield for a specific instrument. main types of yield curves are normal (upward sloping), inverse (downward sloping) and • The humped (a normal slope followed by an inverse slope). expectations theory contends, in part, that long-term interest rates will be the average of • The expected future short-term rates. Therefore, a normal yield curve indicates an expectation that future short-term interest rates will rise, while an inverse yield curve indicates that future shortterm interest rates will fall. segmented markets theory rejects two expectations theory assumptions: that all bonds • The are perfect substitutes and that investors are indifferent about holding short-term or long-term securities. The yield curve is therefore influenced by supply and demand factors within various maturity ranges. In a modern financial system the segmented markets argument may be minimised by using risk management strategies based on derivative products. liquidity premium theory contends that investors have a preference for short-term • The securities and therefore they need to receive a higher yield in order to invest in longer-term securities. The liquidity premium they receive will increase the steepness of the yield curve; that is, longer-term yields will be higher.

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13.4

The risk structure of interest rates

To this point our discussion has considered the term structure of interest rates on securities with the same level of default risk. The discussion of the various theories of the term structure of interest rates mainly centred on yields on government bonds. Within the financial markets, government bonds are typically assumed to have a zero default risk; that is, it is accepted that on each coupon date the government will meet its interest payment obligation and that on the maturity date it will repay the full face value of the bond. Since government bonds are assumed free of default risk, the yield on these bonds is referred to as the risk-free rate of return and serves as the benchmark rate when evaluating the expected rate of return on other securities with similar terms to maturity. Securities issued by other borrowers involve some element of default risk. Default risk is the risk that a borrower may not meet financial commitments, such as loan repayments, when they are due. The extent of the risk will vary from borrower to borrower, and for any particular borrower the risk may vary from time to time. Given the presence of risk, lenders demand a higher rate of return when lending to these borrowers in order to compensate for accepting the higher risk. For example, Standard & Poor’s credit rating agency rates each state within Australia. The state of Victoria currently has a longer-term debt credit rating of AAA, whereas Tasmania’s rating is AA+. Tasmania is perceived to have a slightly higher level of credit risk and therefore will need to pay a higher interest rate on its debt issues. Similarly, BHP Billiton Pty Ltd has a credit rating of A+, whereas Newcrest Mining Pty Ltd has a rating of BBB–. From time to time, each company issues corporate bonds into the long-term debt markets. BHP Billiton’s cost of borrowing will be much less than Newcrest’s cost of borrowing as it has a much higher credit rating. BHP Billiton may be able to issue bonds at LIBOR plus 40 basis points while Newcrest may need to pay LIBOR plus 135 basis points. (Refer to Chapter 11 for a more detailed discussion.) Figure 13.21 illustrates the effect of varying default risks on the yield curves. The figure is conceptual in that there will be many corporate bond issuers in the debt markets: each will have a different risk premium attached to a debt issue and therefore a different yield curve. However, conceptually, the yield on default-risk-free Treasury bonds is less than the yield on bonds issued by corporations. Further, Figure 13.21 shows that the yield on AA-rated corporate bonds is less than the yield on BBB-rated corporate bonds. Note that the AA-rated bonds may be debentures with security attached, while the BBB-rated bonds may be unsecured notes. These securities were discussed in Chapter 10.

LEARNING OBJECTIVE 13.4 Explain the risk structure of interest rates, discuss the socalled risk-free interest rate and consider the effect of default risk on interest rates.

Risk-free rate of return the yield on a security issued by the government; zero default risk assumed

Figure 13.21  Risk premium effects on yield curves Corporate bonds (BBB-rated)

Interest rate (i)

Risk premium

Risk premium

Corporate bonds (AA-rated) Treasury bonds

Term to maturity

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It might be expected that the risk premium of a borrower will be constant over time. However, Figure 13.22 purposely challenges that view. It shows an increasing gap throughout the maturity spectrum for the relatively low-risk borrower. This will not always be the case, but it is demonstrated in this figure simply to illustrate the possibility.

Figure 13.22  Yield curves for borrowers with different risk profiles

High-risk borrowers’ securities

Interest rate (i)

Low-risk borrowers’ securities

Risk-free securities (government bonds)

Term to maturity

One plausible set of conditions under which such a widening of the gap may occur is if the corporate borrower has been a highly successful corporation but its future is a little less clear. This could occur if the corporation’s flagship products are towards the end of the product life cycle, and the company has not devoted sufficient resources to the research and development of a new product or production technique that will maintain its competitive advantage. The gap could also increase if the company has recently been involved in a takeover or merger, the likely commercial success of which has not been clearly established. In both cases, there is a low risk of default on the near-to-maturity instruments, but greater uncertainty about the company’s performance further into the future. The yield curve for the higher-risk borrower shows a narrowing of the gap as the term to maturity increases, even though throughout the yield curve it is faced with a higher risk premium than that faced by the other two borrowers. What such a yield curve shows is that the near-to-maturity securities are trading at low prices (high yields), while securities with a longer term to maturity are trading at relatively higher prices (lower yields). Such an outcome could result from a concern that, in the current business environment, the company may have difficulty in redeeming the soon-to-mature instruments. The concern could be based on a perception that the company may have difficulty in redeeming the maturing instruments because of a present inability to generate sufficient cash flows from its business or to borrow from a financial institution. At the same time, market participants could believe that if the company survives the near term, its prospects are relatively good. The divergent assessments of the company could be associated with a range of factors: the company may be involved in a reasonably speculative exploration activity, the development of a new technology or an attempt to convert a laboratory discovery into a commercial product. If the yield curves for the borrowers are drawn at a different date, it is most probable that the risk gaps will have changed, and it is also possible that the slopes of the yield curves will have changed. For example, during periods of economic downturn the risk premium gaps for corporate borrowers will 442

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increase because the risk of default is higher. The incidence of bankruptcies tends to be higher during economic downturns than during periods in which the economy is expanding. It is apparent that there are key differences between government and other debt issuers. For example, corporate debt issues, even of the most creditworthy borrowers, embody some element of default risk and lenders will demand a risk premium if they are to lend to the corporate sector. The benchmark interest rate on which a lender will add a risk premium for the cost of funds for corporate borrowers will be the yield on similar-term government bonds. The risk premium that a corporate borrower will have to offer above the risk-free rate will be determined by, among other variables, a lender’s assessment of the default risk of the borrower. The risk premium will certainly vary between borrowers. It is also likely to vary for any particular borrower over time.

REFLECTION POINTS

borrower has a perceived level of risk. Therefore, the yield curve associated with • Each securities issued by a borrower will reflect the risk premium applied to that issuer. The yield on government bonds is called the risk-free rate. All other borrowers will pay a yield premium above the risk-free rate. This is the risk structure of interest rates. curves can be constructed for bonds with different risk premiums. This is represented • Yield by the position of the yield curve. For bonds with a higher risk premium, the yield curve will be located wholly above the yield curves for bonds with lower risk premiums. ‘gap’ between yield curves for bonds with different risk premiums will widen or contract • The depending on changes in perceived differences in risk. For example, a change in business conditions that is expected to negatively impact the creditworthiness of corporate borrowers relative to the government will see the yield curve for corporate bonds move upwards, widening the gap with the yield curve for government securities. a context where the economic environment is improving and it is expected that corporate • Inborrowers will be able to meet their obligations more easily and with less chance of default, the gap between the yield curve on corporate bonds and the yield curve on government bonds will shrink.

CASE STUDY THE RESERVE BANK’S BALANCING ACT In Section 13.1, we discussed the macroeconomic context of interest rate determination and the reasons why rates are changed by central banks. These include the rate of inflation, downward pressure on the currency in foreign exchange markets and unsustainable price changes in the major economic sectors such as property market. The Reserve Bank of Australia (RBA) has not changed the official interest rate in Australia since August 2016. In 2018, despite the RBA keeping the overnight cash rate on hold, Westpac, CBA and ANZ undertook ‘out-of-cycle’ rate increases (not in line with RBA) to counter the rising funding costs that threaten the profit margin of the banks. For example, Westpac increased its mortgage rate from 5.24 per cent to 5.38 per cent, which added approximately $30 per month to the average $300 000 home loan (Cotton, 2018).

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Peter Costello, the longest-serving Treasurer in Australian history, urged the RBA to lift the interest rates to avoid households taking more debt. In his opinion, the status quo of low interest rates will only contribute to massive imbalances in the economy. He noted that many Australian households face a ‘debt trap’ stemming from the large increase in Melbourne and Sydney house prices since 2013. Costello is also concerned about the consequences that might be observed when asset prices return to more normal levels (price reversal) (Creighton, 2018). Apart from imbalances caused by asset prices, low interest rates have implications for foreign exchange markets which, in turn, may prompt changes in interest rates. Low relative interest rates have placed significant downward pressure on the Australian dollar. Moody’s have reported that the falling Australian dollar, particularly against the US dollar, could force the RBA to lift interest rates (Berry, 2018). Despite concerns coming from various commentators, the RBA seems to be focused less on rising mortgage interest rates and debt in the property market and more on the current inflation rate. According to RBA governor Philip Lowe, the official interest rate will remain stable at 1.50 per cent until 2020 because inflation is expected remain under 2.50 per cent (within the inflation target rate of 2.00 to 3.00 per cent). The RBA’s confidence in the underlying strength of the Australian economy and its ability to absorb and resolve imbalances stemming from particular sectors has been boosted by positive business conditions and increasing investment in non-mining businesses (Letts, 2018). The unemployment rate in Australia is low (5.50 per cent). With wages growth sitting just above 2.00 per cent, there appears to be little pressure on inflation caused by rising wages (Scutt, 2018). A decline, orderly so far, in house prices also reduces pressure on the RBA to increase interest rates (Jericho, 2018). Reference list Berry, P 2018, ‘Moody’s: Falling Australian dollar could trigger RBA rate hike, Canstar, 1 August, retrieved from http://www.canstar.com.au/home-loans/moodys-falling-australian-dollar-trigger-rba-ratehike Cotton, I 2018, ‘Westpac left to justify out-of-cycle interest rate hike as other banks may follow suit’, SmallCaps, 31 August, retrieved from http://smallcaps.com.au/westpac-interest-rate-hike-other-banksfollow-suit/ Creighton, A 2018, ‘Lift interest rates now to avoid problems later: Costello, The Australian, 21 August, retrieved from http://www.theautsralian.com.au/news/nation/lift-interest-rates-now-to-avoid-problemslater-costello/news-story/fd3abb87055de24d20af4422d01530d8 Jericho, G 2018, ‘Forget the calls for interest rates rises. The Reserve Bank won’t budge yet’, The Guardian, 17 July, retrieved from http://www.theguardian.com/business/grogonomics/2018/jul/17/ forget-the-calls-for-interest-rates-rises-the-reserve-bank-wont-budge-yet Letts, S 2018, ‘RBA keeps rates on hold at a historic low of 1.5pc’, ABC News, 5 June, retrieved from http://www.abc.net.au/news/2018-06-05/rba-keeps-rates-on-hold-at-historic-low-of-1.5pc/9835536 Scutt, D 2018, ‘This group of economists thinks the RBA should hike interest rates tomorrow’, Business Insider Australia, 30 April, retrieved from http://www.businessinsider.com/rbs-interest-rate-outlook-anushadow-board-rate-hike-tax-cuts-2018-4

Discussion points

• • •

Discuss the rationale behind the RBA’s decision to refrain from increasing interest rates for so long. Discuss what prompted out-of-cycle rate increases by Australian banks. Detail the role of interest rate changes in shaping debt levels in Australian households.

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LEARNING OBJECTIVE 13.1 Describe at a macroeconomic level how the liquidity effect, the income effect and the inflation effect influence the determination of interest rates. forming a view on the future direction of interest rates, it is necessary to recognise that • Inchanges in monetary policy settings are likely to affect the state of the economy, which in turn affects interest rates generally.

the macroeconomic context, these progressive changes are referred to as the liquidity • Within effect, the income effect and the inflation effect on interest rates. liquidity effect derives from monetary-policy-induced changes to interest rates, such as an • The increase in interest rates due to a reduction in liquidity in the financial system. interest rates rise, economic activity will slow and incomes fall. This will cause interest rates • As to begin to ease or fall. This is the income effect. income effect will reduce upward pressure on prices as the economy slows and there is • The likely to be a reduction in the rate of inflation, thus causing interest rates to fall further (the inflation effect).

when trying to forecast the state of an economy and future interest rates, policy • Therefore, makers, economists and financial market participants consider a range of economic indicators, such as the level of employment, productivity and housing approvals.

CHAPTER THIRTEEN REVIEW

Master before you move on

• Indicators may be described as leading, coincident and lagging indicators of future economic activity. LEARNING OBJECTIVE 13.2 Explain the loanable funds approach to interest rate determination, highlighting variables that affect the demand and supply for loanable funds. Consider the effects of changes in those variables on interest rate equilibrium. disciplined approach to forming a view on the future direction of interest rate movements is • Aprovided by the loanable funds approach. the demand for loanable funds within the financial system originates from the business • Typically, sector and the government sector and is represented by a downward-sloping demand curve. supply of loanable funds derives from the savings of the household sector, changes in • The the money supply and the hoarding or dishoarding that takes place in response to changes in interest rates. This is represented by an upward-sloping supply curve.

the loanable funds approach, the prevailing rate of interest is determined by the • Under intersection of the demand and supply curves: the equilibrium point. that cause the demand or supply curves to change will result in a change in the rate of • Factors interest. the framework is useful in identifying impacts on interest rates, its major shortcoming is • While that the supply and demand curves are interdependent. For example, changes in the level of economic activity or inflationary expectations may impact both the demand side and the supply side of the curves. As a result, it is not possible to determine a unique equilibrium interest rate.

shortcoming of the loanable funds approach is that it addresses interest rate • Another determination as if only one interest rate exists at a particular time. This is clearly not the case in reality. At any point there are many rates of interest.

differences in rates reflect the different terms to maturity of instruments and the credit risk • The of a borrower. Differences between the interest rates on instruments of similar risk, but with different terms to maturity, are explained by theories of the term structure of interest rates.

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Part 4 Government debt, monetary policy, the payments system and interest rates

LEARNING OBJECTIVE 13.3 Understand interest rate yields and the shape of various yield curves. Apply the expectations theory, the segmented markets theory and the liquidity premium theory within the context of the term structure of interest rates.

• The term structure of interest rates is represented by a yield curve. yield is the rate of return on debt instruments and a yield curve graphs the relationship • The between interest rates and the term to maturity of debt instruments in the same risk class. • The shape of the yield curve may be normal, inverse or humped. normal yield curve is an upward-sloping curve where there is an expectation that short-term • Ainterest rates in the future will rise. A steeper normal curve indicates an expectation that there will be larger interest rate increases in the future.

inverse yield curve is a downward-sloping curve, typically induced through a tightening of • An monetary policy by a central bank. It indicates that current short-term interest rates are high, but that there is an expectation that in the future there will be an easing of monetary policy and short-term interest rates will begin to fall.

expectations theory argues that, in an efficient market, interest rates on longer-term • The instruments are determined by two factors: the current short-term interest rate and the shortterm rates that are expected to prevail over the longer term.

segmented markets theory provides a further explanation of the shape of the yield curve. • The It contends that investors do not view bonds of different maturities as being close substitutes. It is argued that investors will have a preference to accumulate a majority of securities in an investment portfolio that have predominantly short-term, medium-term or long-term maturities. The implication is that the shape of the yield curve is explained by the demand and supply conditions that are evident in the various maturity segments of the overall yield curve.

the arguments of the segmented markets theory ignore the role of market arbitrage • However, and speculation in ensuring that the yield curve over the maturity spectrum remains in equilibrium. Also, in a modern financial market, risk managers are able to hedge such risk using synthetic risk management products such as derivatives. As a result, the forecasts derived from the segmented markets approach must be treated with caution.

extension to the theory is obtained by the inclusion of a liquidity premium. The liquidity • An premium theory contends that investors need to be compensated for a loss of liquidity and the higher risk levels that may exist in long-term investments; that is, investors will require a borrower to pay a liquidity premium before they are willing to give up their preference for shortterm assets. Therefore, the liquidity premium will change the slope of a yield curve.

LEARNING OBJECTIVE 13.4 Explain the risk structure of interest rates, discuss the so-called risk-free interest rate and consider the effect of default risk on interest rates. other element that has to be considered in explaining the range of interest rates that are • The available at any one moment in time is the default or credit risk of the borrower. Higher-risk borrowers must pay a higher rate of return than would be required of lower-risk borrowers.

risk-free rate of interest is defined as the yield on government Treasury bonds. All other • The borrowers will pay a risk premium above the risk-free rate. risk structure of interest rates incorporates the level of credit risk, over time, attached to a • The particular debt issue. corporation with a AA + credit rating will pay a lower yield than a corporation with a BBB credit • Arating, but both will pay a margin above the risk-free rate of the government Treasury bond. yield curve evident within the financial markets for a particular security will change in its • The shape and slope from time to time, in particular as business and economic conditions change. 446

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Chapter 13  An introduction to interest rate determination and forecasting

LEARNING OBJECTIVE 13.5 Apply calculations used to forecast interest rates based on the assumptions of the expectations theory. The yield curve and expectations theory calculations This section considers calculations required for forecasting interest rates, based on the expectations theory. Earlier in this chapter a simple arithmetic average of the current interest rate and the expected future interest rate was used to explain the current two-period rate of interest. That is: ​(​  0​​​i1​  ​​  + ​E1​  ​​​ii​  ​​) ​0​​  i​​​​​​  2​​ = ​ _______  ​     2 ​​​       ​  ​  0.07 + 0.09 ​ ​ ​​ ​ = ​ _______     ​   2 ​ = 0.08 or 8% p.a.

13.1

However, in pricing bonds, it is assumed that the first interest payment coupon is reinvested at the prevailing interest rate for the second period. As a result, the compounding of interest should be acknowledged in the foregoing equation (i.e. the 0i2 rate should be calculated as a geometric average). This can be expressed as: ​​(1  + ​​​  0​​i​​​  2​​)2​​  ​  = (1 + ​​​  0​​i​​​  1​​)(1  + ​E1​  ​​​i1​  ​​)​

CHAPTER THIRTEEN REVIEW

Extended learning

or: ​(1  + ​​​  0​​i​​​  2​​)  = ​​[​​(1  + ​​​  0​​i​​​  1​​)(1  + ​E1​  ​​​i1​  ​​)]​ 0.5 ​​​​  ​​ so: ​​​​  0​​i​​​  2​​  = ​​[​​(1  + ​​​  0​​i​​​  1​​)(1  + ​E1​  ​​​i1​  ​​)]​ 0.5 ​​​​  ​  − 1​ For example, if 0i1 = 10.00 per cent, and E1i1 = 12.00 per cent, then: ​​​  0​​i​​​  2​​ = ​​[​​(1  + 0.10)(1 + 0.12)​]0.5 ​​​​  ​  − 1

​ = ​​[​​(1.1)(1.12)​]0.5 ​​​​  ​  − 1 ​​​ ​             ​  =​  ​(1.232)​​ 0.5​  − 1​ ​​ ​ ​ ​

​​

= 1.109954954 − 1 = 0.109954954 or 10.9954954% p.a.

This result compares with a neat 11.00 per cent per annum using the simple average process. However, the difference, although minor in the case of the two-period illustration, increases with a greater number of periods, and the arithmetic average gives increasingly poor approximations of the appropriate figure. Equation 13.1 incorporates the compounding of the first coupon, but it is limited in its application because it only deals with single-period and two-period instruments. Since the yield curve may be drawn out to 20 years or more, the equation must be generalised. The general form of the expectations theory of the yield curve is: __ ​ 1 ​ 

​​​​  0​​i​​​  n​​  = (1 + ​​​  0​​i​​​  i​​)(1  + ​E1​  ​​​i1​  ​​)(1  + ​E2​  ​​​i1​  ​​) ... ​(1  + ​En−1 ​  ​​​i1​  ​​)n​​  ​ −  1​

13.3

That is, the current rate on a bond with n years to maturity is equal to the nth root of the product of the current one-period rate and expected rates that apply to each of the intervening, or future, one-period bonds. Implicit forward interest rates It was also indicated earlier that market participants’ expectations about the future rate of interest could be deduced, on the basis of the current one-period and two-period rates of interest. When 447

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Part 4 Government debt, monetary policy, the payments system and interest rates

Equation 13.1 is solved for E1i1, the algebraic expression for the market’s expectations about the rate that will apply on a one-year bond commencing in one year’s time can be obtained. This is: ​(1  + ​​​  0​​i​​​  2​​)2​​  ​ ​​E1​  ​​​i1​  ​​  = ​​ ​​​ _  ​​  ​​​  −  1​ [ (1 + ​​​  0​​i​​​  1​​) ]

13.4

The use of Equation 13.4 can be illustrated using the data from the previous example: 0i1 = 10.00 per cent and 0i2 = 10.9954954 per cent. On the basis of that market data: ​(1.109954954)​​ 2​ ​E1​  ​​​i1​  ​​ = ​​ ​​​ ___________        ​​ ​​​  − 1 [ ] 1 + 0.10

​(1.109954954)​​ 2​ ​ = ​​ ​​​ ___________     ​​  ​​​  − 1 ] 1.10 ​​​           ​  ​  [ ​  ​ ​​​ 1.232 _ ​ = ​​[​​​     ​​ ​​​  − 1 (1.10) ] ​ = 1.12 − 1 ​ = 0.12 or 12% This solution is exactly the same as the E1i1 rate that was used to illustrate the use of Equation 13.1. If the value of the 0i2 rate had been rounded to 11.00 per cent, that rounding error may have caused a slightly different result for the calculated E1i1 rate. Equation 13.4 can therefore be generalised to cope with more than two-period calculations. This is particularly important since, if the expectations theory does prevail, the yield curve that exists at any moment provides information on the expectations of market participants concerning a large range of future interest rates. That is, implicit in the yield curve there is news, or information, on the market’s expectations about future interest rates. Figure 13.23 illustrates (for a very limited section of a yield curve) the number of rates implied by the existing market rates of interest. The unbroken

Interest rate (% p.a.)

Figure 13.23  The yield curve: implicit future rates of interest

12

11

1

0

2 3 Term to maturity

1

4

5

2

3

4

Term to maturity

0ik

11% p.a.

{

11.5% p.a. 12% p.a. 12.5% p.a. 1ik

{

1i3 2ik

{

2i2 3ik

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Chapter 13  An introduction to interest rate determination and forecasting

The general form of Equation 13.4, and the formula used to calculate the future rates that are implied by the current rates, is given in Equation 13.5: (​ 1  + ​ ​  0​​​in+k ​  ​​)n+k ​​  ​ k ​​En​  ​​​ik​  ​​  = ​​  ___________ ​   ​     ​​​  ​ − 1​ [ ​(1  + ​ ​  0​​​in​  ​​)n​​  ​ ] __ ​ 1 ​ 

13.5

where: n = the number of periods until the future rate starts ​​      ​  ​  ​ ​​ k = the number of periods over which the future rate applies The following examples illustrate the implementation of Equation 13.5.

EXAMPLE 13.1 On the basis of the data contained in Figure 13.23, what is: 1 the 1i3 rate of interest, that is, the implied three-year rate of interest beginning one year from now?

CHAPTER THIRTEEN REVIEW

lines in the figure represent actual rates that are available in the hypothetical market. The dashed lines represent the future rates that are implied by, and can be estimated on the basis of, the actual interest rates.

2 the 2i2 rate of interest, that is, the implied two-year rate of interest beginning two years from now? Using: __ ​ 1 ​ 

​(1 ​+ ​  0​​​in+k ​  ​​)n+k ​​  ​ k ​​ n​  ​​​ik​  ​​  = ​​ ​​​ _________ E  ​​    ​​​​  ​ − 1​ [ ​(1 ​+ ​  ​​​i​  ​​)n​​  ​ ] 0n 1 n = 1 and k = 3: (​ 1  + ​0​​  i​​​​ ​  4​​)4​​  ​ 3 ​​E1​  ​​​i3​  ​​ = ​​  ​  ______    ​  ​​​  ​  − 1 [ ​(1  + ​0​​  i​​​​ ​  1​​)1​​  ​] 1 ​  ​ __

(​ 1  +  0.125)​​ 4​ 3 = ​​  ​  __________  ​   ​​​  ​  − 1 [ (​​ ​​1  + 0.11​)1​​​​  ​ ] = 0.13005 = 13.005%​ __ ​  1 ​ 

2 n = 2 and k = 2: (​ 1  + ​0​​  i​​​​ ​  4​​)4​​  ​ 2 ​​E2​  ​​​i2​  ​​ = ​​  ​  ______    ​  ​​​  ​  − 1 [ ​(1  + ​0​​  i​​​​ ​  2​​)2​​  ​] __ ​ 1  ​

(​ 1  +  0.125)​​ 4​ 2 = ​​  ​  __________  ​     ​​​  ​  − 1 [ ​(1.115)​​ 2​ ] = 0.13509 = 13.509%​ 1  ​ ​ __

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Part 4 Government debt, monetary policy, the payments system and interest rates

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Compare and contrast the nature and implementation of monetary policy with fiscal policy as the two primary tools of economic management. Outline the recent trends that characterise the implementation of each policy type. (LO 13.1)

2

The macroeconomic context of interest rate determination attempts to explain the interactions of a change in monetary policy settings with changes in interest rates. The macroeconomic context of interest rate determination identifies three distinct effects of a change in monetary policy.



(a) List the three effects



(b) If the central bank tightens its monetary policy settings, describe the expected interactions that should occur based on the three effects identified in part (a). (LO 13.1)

3

Market participants, including financial institutions, fund managers and corporations, must understand monetary policy setting impacts on economic activity and the business cycle. A central bank will typically implement monetary policy settings in order to achieve certain economic outcomes over a business cycle. In order to forecast future economic conditions and business activity, business managers therefore need to understand the business cycle.



(a) Briefly describe the principal monetary policy objective of the Reserve Bank of Australia.



(b) Draw a diagram and explain the structure of a business cycle over time.



(c) Discuss and give examples of different economic indicators that may give an insight into the future stages of a business cycle. (LO 13.1)

4

At a recent financial markets seminar, a participant asked the guest speaker to explain the loanable funds approach when forecasting interest rates.



(a) Describe the basic concept of the loanable funds approach to interest rate determination.



(b) Extend your answer in (a) above and draw diagrams showing the demand curve, the supply curve and the equilibrium interest rate. With each diagram, identify and explain each of the components that comprise the supply and the demand curves, plus discuss how the equilibrium interest rate is derived. (LO 13.2)

5

A problem with the loanable funds approach to explaining interest rates is that since the supply and demand curves are interdependent, a unique equilibrium rate of interest cannot be determined. Explain and illustrate this problem by reference to the effects of:

(a) an increase in inflationary expectations using the basic Fisher effect, followed by the nonFisher effect

(b) an expectation of a decrease in the level of economic activity. (LO 13.2)

6

Interest rates play an important role in monetary policy determinations, economic performance and the business cycle, and the cost of funds. Financial market participants must therefore understand the term structure of interest rates.



(a) Define in detail the term yield and explain how a yield curve is constructed.



(b) Identify three different types of yield curves. Describe each of these yield curves and draw a fully labelled diagram of each curve. (LO 13.3)

7

Market participants observe that the yield curve is normal (upward sloping). Use expectations theory to explain this observation. (LO13.3)

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Chapter 13  An introduction to interest rate determination and forecasting

Over time, market participants observe that the yield curve has changed from being upward sloping to being downward sloping. Use expectations theory to explain why the yield curve has changed shape. (LO 13.3)

9

The segmented markets theory extends our understanding of factors that influence the determination of interest rates.



(a) Identify and explain two assumptions of the expectations approach that are challenged by the segmented markets approach to interest rate determination.



(b) It may be argued that the segmented markets approach is negated by modern risk management practices, arbitrage and speculation. Explain what is meant by this assertion. (LO 13.3)

10 If financial market participants considered that anticipated inflation would rise significantly in the future, what effect would you expect this forecast to have on the slope of a normal yield curve? Why? (LO 13.3) 11 The liquidity premium theory seeks to extend our understanding of the expectations theory and the determination of interest rates.

(a) Outline the principal contention of the liquidity premium theory.



(b) How does the historic prevalence of a normal yield curve provide indirect evidence of the existence of a liquidity premium?



(c) Does the existence of an inverse yield curve indicate a violation of the liquidity premium contention? (LO 13.3)

CHAPTER THIRTEEN REVIEW

8

12 The daily financial press regularly report data released on current economic variables and provide expert analysis on the forecast impact of changes in these variables on the future direction of interest rates. Market participants, including policy makers, regulators and corporate managers, also actively monitor changes in economic variables and interest rates. Within this context, why is it important for market participants to understand the term structure of interest rates? Provide examples in your response. (LO 13.3) 13 A group of university students are asked to investigate interest rates on debt securities issued in the financial markets. They soon discover that many interest rates exist. The students are then asked to explain:

(a) the term ‘risk-free rate of interest’



(b) why the existence of the risk-free rate of interest is important when examining the level of interest rates generally in the financial markets. (LO 13.4)

14 The lending manager at a commercial bank is asked to explain to a corporate borrower what the bank’s policy is in relation to risk premiums on corporate loans. (a) Discuss the concept of a risk premium and the effect that a risk premium will have on the yield curve for a corporate borrower.

(b) Is it inevitable that the risk premium for a corporate borrower will be constant throughout the maturity spectrum? Explain your response. (LO 13.4)

Extended learning questions 15 This question requires calculations relating to the yield curve and the expectations theory.  (LO 13.5)

(a) If an investor possesses the following information, and expectations on Treasury bond yields are: ​ ​  0​​​i1​  ​​ = 4.25% p.a.    ​​ ​  ​  ​​​ ​E1​  ​​​i1​  ​​ = 5.20% p.a.

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Part 4 Government debt, monetary policy, the payments system and interest rates

calculate the yield on a two-year bond (0i2) that would result in the investor being indifferent between placing funds in a one-year bond now, to be followed by a one-year bond in a year’s time, or placing the funds in a two-year bond now. ​ ​  0​​​i1​  ​​ = 4.00% p.a. ​ 1​  ​​​i1​  ​​ = 5.00% p.a. E    ​​ ​  ​  ​  ​​​ ​E2​  ​​​i1​  ​​ = 5.75% p.a. ​E3​  ​​​i1​  ​​ = 6.20% p.a. On the basis of the expectations theory of the yield curve, complete the following.

(i)

Calculate the 0i2, 0i3 and 0i4 rates.



(ii) Explain what is meant by implicit forward rates of interest.



(iii) List the full range of one-year implicit rates of interest that could be calculated on the basis of the yield curve data that provide the current rates on bonds with one, two and three years to maturity.



(iv) Given the following yield curve data, calculate the 2i2, 1i2 and 3i1 implicit rates: ​i1​  ​​ = 4.00% p.a. i​2​  ​​  = 5.15% p.a.       ​​ ​  ​  ​  ​ ​​​ ​i3​  ​​  = 5.80% p.a. ​i4​  ​​  = 6.25% p.a.

KEY TERMS arbitrage 437 balance of payments  419 business cycle  419 business cycle peak  421 business cycle trough  421 coincident indicators  422 dishoarding 426 economic indicators  421

income effect on interest rates 420

loanable funds  424

inflation effect on interest rates 420

normal or positive yield curve 432

inverse or negative yield curve 433

public sector borrowing requirement 425

lagging indicators  422

risk-free rate of return  441

leading indicators  421

segmented markets theory 435

money supply  426

expectations theory  433

liquidity effect on interest rates 420

gross domestic product  419

liquidity premium  438

term structure of interest rates 431

humped yield curve  433

liquidity premium theory  438

yield curve  431

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CHAPTER 14

Interest rate risk measurement CHAPTER OUTLINE 14.1 Interest rate risk 14.2 Exposure management systems 14.3 Assets re-priced before liabilities principle 14.4 Pricing financial securities 14.5 Re-pricing gap analysis 14.6 Duration 14.7 Convexity 14.8 Interest rate risk management techniques

Learning objectives LO 14.1

Understand interest rate risk and various techniques that may be used in the measurement of interest rate risk exposures.

LO 14.2

Identify components of an interest rate risk exposure management system.

LO 14.3

Consider the principle of assets re-priced before liabilities.

LO 14.4

Revisit the pricing of financial securities and consider its relationship to interest rate risk exposures.

LO 14.5

Analyse the structure and benefits associated with interest rate risk measurement using repricing gap analysis.

LO 14.6

Analyse the structure and benefits associated with interest rate risk measurement using duration and convexity.

LO 14.7

Appreciate the availability of both internal and external interest rate risk management techniques.

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Part 4 Government debt, monetary policy, the payments system and interest rates

CHAPTER SNAPSHOT When interest rates change, borrowers and lenders are affected. Some will gain and some will lose, depending on the direction and magnitude of the change. As such, measuring and managing exposure to interest rate risk is a primary consideration for governments, companies, individuals and institutions. Companies and financial institutions will have sophisticated systems in place to manage interest rate risk exposure and make use of various financial instruments that have been created to help companies and financial institutions manage their interest rate risk exposure.

INTRODUCTION In previous chapters we recognised that interest rates change from time to time; in particular, we now understand that central banks implement their monetary policy initiatives by influencing interest rates. For example, if a central bank is of the view that inflation has risen above the target range, perhaps because economic growth is increasing at a rate that is not sustainable in the medium to long term, it will begin to tighten monetary policy and conduct open market operations to raise the interbank cash rate. If the cash rate increases, then it is expected that other interest rates will also increase as the markets move to a new interest rate equilibrium. On the other hand, if the economy needs a stimulus, the central bank will consider easing monetary policy by pushing down the cash rate. Again, this will, over time, flow through to a fall in other market interest rates. Chapter 13 considered the determinants of interest rates. The macroeconomic context in which interest rates are formed and the loanable funds approach to interest rate determination were both reviewed. A number of theories were analysed that attempt to explain interest rates, including the pure expectations theory, the liquidity premium theory and the segmented markets theory. It is evident that interest rates do change over time and that the possibility of interest rate changes creates an economic and business environment of uncertainty. The problem is that the extent and timing of interest rate changes are unknown. A central bank does not advise the financial markets of an impending interest rate change. Market participants will consider the current economic and business environment and will develop a view on the future direction of interest rates, but this provides no certainty. Each new piece of information or data that comes into the market has the potential to change current interest rate forecasts significantly. For example, one economic sector in the market (e.g. the housing sector) may be showing strong growth, which may suggest that a tightening in monetary policy is probable. However, another economic sector (such as the rural sector) may be struggling because of a lengthening drought, which is an indicator that interest rates will not increase. Conflicting economic indicators are quite common. Even if market participants were able to forecast accurately when a change in interest rates was going to occur, they would also need to be able to forecast the extent of that change. Will rates change by 25 basis points or 50 basis points? Will there be one change or a series of changes? How frequently will the changes occur? What will be the eventual total change in interest rates? These questions indicate that interest rate risk is evident and that this risk needs to be measured and managed. Why does interest rate risk need to be managed? Interest rates represent the cost of borrowing or the return on an investment. Also, interest rates affect the value of financial assets and liabilities. Changes in interest rates will often change future cash flows associated with borrowing and investment. Clearly, interest rate risk is a major financial risk exposure that needs to be measured and managed. 454

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Chapter 14  Interest rate risk measurement

REFLECTION POINTS

• The monetary policy actions of a central bank are a major determinant of interest rate changes. majority of businesses are exposed to the risk that interest rates may change over a • The planning period; therefore, interest rate risk needs to be measured and managed. Fund managers and investors are also exposed to interest rate risk. participants try to forecast future interest rate changes, and may make business • Market decisions based on those forecasts, but uncertainty remains. interest rates change? How much will they change? Will there be more than one change, • Will and, if so, how frequently will they change? What will be the total change in interest rates?

14.1

Interest rate risk

Risk is the possibility that an outcome will be different from that which has been forecast, or that something will occur that has not been taken into account. A business may have forecast that interest rates will rise by 50 basis points over the next 12-month planning period. Presumably, the business will implement strategies to manage the forecast rate rises. However, the firm is exposed to the risk that interest rates could rise faster and higher than forecast, and thus needs to consider the probability that this could happen. Another firm may export goods to the USA but has not considered the impact on future business orders if the USA experienced a tightening of monetary policy. For example, the cost of borrowing in the USA will rise and economic activity may be expected to slow. At the same time, the Australian dollar may appreciate (USD depreciates) and the exported goods will become more expensive in the USA and sales may fall. This interest rate risk exposure is a possibility that must be analysed by the firm. Interest rate risk is the sensitivity of future cash flows, and the value of assets and liabilities, to movements in interest rates. That is, a change in interest rates will affect forecast future cash flows and will change the value of interest-rate-sensitive assets and liabilities. For example, an investor who holds a bond portfolio will find that the value of the bonds will change inversely with movements in interest rates. This contention will be tested later in the chapter when the pricing of financial securities is reviewed. A firm that has borrowed variable-rate debt from a bank will find that interest payments will rise as market interest rates rise. This will have an impact on the firm’s liquidity and cash flows as the firm now needs to find the additional cash to meet the increased loan payments. As mentioned above, the increase in interest rates should slow economic activity, which may have a negative impact on the business. Interest rate risk can therefore be described in two forms:

LEARNING OBJECTIVE 14.1 Understand interest rate risk and various techniques that may be used in the measurement of interest rate risk exposures.

1 reinvestment risk 2 price risk. Reinvestment risk relates to an organisation’s cash flows. Yields on assets and liabilities may change over time as interest rates change. This will have an impact on cash flows. For example, the cost of funds on a business loan that has a variable interest rate will move up or down depending on changes in market rates over the period of the loan. The bank that has given the firm a loan will also be affected, in that it is uncertain at what yield it will be able to reinvest the loan repayments it receives from the firm. If the bank had originally given the firm a loan at a rate of 8.00 per cent per annum and market interest rates subsequently fell to 7.50 per cent per annum, the bank would only be able to reinvest those funds on repayment of the original loan at the current 7.50 per cent per annum. All else being equal, the change in interest rates would have had a negative impact on the bank’s net interest margin.

Reinvestment risk a change in interest rates will also change future cash flows related to an investment or debt

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Part 4 Government debt, monetary policy, the payments system and interest rates

Price risk the impact of a change in interest rates on the value of assets and liabilities

Inverse relationship a rise in interest rates results in a fall in the value of an asset, or vice versa

Direct interest rate risk a change in interest rates affects the value of assets, liabilities and future cash flows

Indirect interest rate risk a change in interest rates affects the future actions of market participants

In another example of reinvestment risk, a fund manager who holds a bond investment portfolio will be exposed to changes in the rate at which they are able to reinvest interest coupons associated with the bonds. This will affect the yield received on the bond portfolio over time. Price risk relates to the value of balance-sheet assets and liabilities. There is an inverse relationship between interest rates and the price of a security. If the investor purchases a company’s bonds when they are issued at a yield of 5.00 per cent and interest rates for bonds of the same risk characteristics later fall to 4.00 per cent, the value of the bonds will increase. Conversely, if interest rates increase, the value of the investor’s holdings will decrease. The investor is exposed to price risk. Interest rate risk exposures may also be described as being direct, indirect and basis. Direct interest rate risk has been described above, whereby a change in interest rates impacts on future cash flows and the value of existing assets and liabilities. Indirect interest rate risk exposures relate to the future actions of market participants. For example, if a bank increases interest rates on its loans to customers, the customers may seek new loans elsewhere. They may also repay existing loans and reduce the total amount borrowed. The change in interest rates has resulted in a consequential or indirect impact on the loan business conducted with the bank. The third type, basis risk, will be discussed in much more detail in Part 6. However, basis risk occurs when pricing differentials appear between markets. For example, in Chapter 19 it will be noted that pricing differentials may occur between the futures market and the underlying physical market. In that case, participants in the futures market are anticipating interest rate changes that may occur in the future in the debt markets, and therefore pricing of futures contracts already reflects the forecast change.

REFLECTION POINTS

rate risk is the sensitivity of future cash flows, and the value of assets and liabilities, • Interest to changes in interest rates; it relates to uncertainty and the probability that rate changes may occur that are not forecast. components of interest rate risk are reinvestment risk (How will future cash flows be • Two affected by an unexpected rate change?) and price risk (What effect will a rate change have on the value of assets and liabilities?). rate risk exposures may be direct (affect cash flows and the value of assets and • Interest liabilities), indirect (impact the future actions of market participants) or basis (affect the pricing differentials between markets) risk exposures.

14.2 LEARNING OBJECTIVE 14.2 Identify components of an interest rate risk exposure management system.

Exposure management system structured procedures that enable a firm to identify, measure and manage risk effectively

Exposure management systems

Interest rate risk is a financial risk that must be identified, measured and managed. This section discusses issues that should be incorporated by an organisation into an interest rate exposure management system. An exposure management system ensures that a structured process is established that enables a firm to measure and manage risk effectively. The board of directors of an organisation must ensure that objectives and policies relating to interest rate risk management are documented. The objectives will state what the organisation intends to achieve in relation to interest rate risk management and the policies will state how those objectives are to be achieved. Executive management will document procedures and implement strategies to ensure that the organisation achieves its interest rate risk objectives and policies. This requires a structured process that covers:

• forecasting • strategies and techniques • management reporting systems.

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14.2.1

F ORECASTING

In order to measure and manage interest rate risk, an organisation needs to understand factors that will impact on risk exposures and the environment in which the organisation operates. First, the organisation must know the current structure of its balance sheet. It must then be able to forecast accurately expected changes in that structure—that is, variations in its assets, liabilities and shareholder funds over a series of planning periods. For example, a company will need to be able to forecast whether it will need to increase its debt levels. If so, will the funds be raised for a short, medium or long term? Will the firm seek loans with a fixed or a variable interest rate? Will the new debt change the existing interest rate risk structure of the balance sheet? To answer these questions, the firm will need to forecast its future business activity, which will depend, in part, on the level of growth in the economy. A forecast of economic growth is therefore necessary. Further, the firm will need to develop a view on future interest rate movements. Forecast changes in interest rates will impact on economic activity, business growth opportunities and the cost of funds.

14.2.2

S TRATEGIES AND TECHNIQUES

As part of its exposure management system, an organisation will develop a range of strategies and techniques to enable it to measure and manage interest rate risk exposures. These strategies will relate to the types of interest cash flows that are associated with its assets and liabilities. For example, a firm may have a policy that a specified percentage of its outstanding debt must have a fixed-interest-rate structure, while another specified percentage must have a variable-interest-rate structure. The remaining debt will be managed to take advantage of forecast interest rate changes over time; for instance, if interest rates are forecast to rise, the firm may increase the overall percentage of fixed-rate debt held. Another strategy for managing exposure to forecast interest rate movements will require the firm to monitor and adjust the maturity structure of its assets and liabilities. The firm will take into consideration the term structure of interest rates, having regard to the shape and the slope of the yield curve. An upwardsloping, normal yield curve will indicate that short-term interest rates are expected to rise in the future. The steepness of the slope will suggest how much rates may rise. An inverse yield curve will indicate tight monetary policy, but a belief that short-term interest rates will eventually fall as monetary policy is eased. For example, a strategy that results in a shift in the liability structure of a firm will have an impact on the cost of funds. If a normal yield curve is evident and interest rates are forecast to rise, then a restructure to longer-term fixed-rate liabilities will result in an immediate increase in the cost of funds, but if the forecast rise in rates occurs there will be a net saving in the medium to longer term, as the lower rate has been locked in. Liability diversification is another interest rate risk management strategy that may be applied by an organisation. Different interest rates will apply to the range of funding alternatives. For example, a company may consider diversifying between short-term and longer-term debt issues, through both intermediated finance and direct finance. This may include the local debt markets and the international debt markets. Usually, a company will obtain a balance of the various sources of funds that are available. Liability diversification means that the borrower is not limited to a single source of funds and therefore is less exposed to potential interest rate changes in that market. At this stage two broad interest rate risk management techniques are considered: internal methods and external methods. Internal methods relate to the management of risk through the restructure of an organisation’s balance sheet and associated cash flows. For example:

Maturity structure the relative proportions of assets and liabilities maturing at different time intervals

Liability diversification where a firm raises debt funds from a range of different sources and types of securities

• A firm may change the pricing structure associated with assets and liabilities held in the balance sheet. For example, it may seek more fixed-rate funds in a period when interest rates are forecast to rise.

• A financial institution may seek to limit its interest rate exposure through the securitisation of part of its loan portfolio (see the Extended learning section in Chapter 10).

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• A financial institution may impose early-exit fees in order to discourage borrowers from repaying

variable-rate loans early in periods when interest rates are rising. (Note: In July 2011 the Australian government banned exit fees on new mortgage loan contracts.) While the ban does not apply to previously existing contracts, some lending institutions have removed this fee voluntarily.

• Institutions may move from a complete reliance on interest rate income to one in which a portion of income is generated from fees.

Derivative products a risk management product that derives its value from an underlying physical market product

External interest rate risk management techniques involve strategies outside the balance sheet and are primarily related to the use of derivative products. These products are futures contracts, forward rate agreements, interest rate options and swaps. (The use of derivative products to manage financial risk exposures is discussed in Part 6.) Essentially, a derivative strategy allows a party to lock in an interest rate today that will apply at a specified date in the future. For example, a forward rate agreement (FRA) entered into between a bank and a company might stipulate an interest rate that will apply on a notional principal amount at a specified date. One party will compensate the other party if the future reference interest rate specified in the FRA varies from the interest rate locked into the FRA.

14.2.3

M ANAGEMENT REPORTING

An exposure management system must ensure that an organisation is fully informed in relation to the measurement and management of its interest rate risk exposures. This requires the application of sophisticated management reporting systems that are capable of timely and accurate gathering and reporting of exposures. Management must ensure that policies and procedures provide clear instructions on the type of information and reports required from management, including the frequency of reporting and whose responsibility it is to act on those reports. For example, a company may require a weekly report that details the firm’s fixed-interest commitments and its interest-sensitive commitments. This report would be analysed in conjunction with a review of current interest rate risk management strategies in order to determine whether those strategies need to be modified. Controls need to be established that state exactly who has responsibility for a risk management task, the levels of delegation that are permitted and the strict reporting hierarchy that must be observed. These controls are necessary to ensure that proposed changes in the structure of an organisation’s balance sheet are reported to the interest rate risk managers, and that risk managers periodically report to senior and executive management on the outcomes of the risk management strategies that have been implemented. The organisation must also ensure that risk management policies and procedures are subject to rigorous periodic audit. The audit policy will state how often an audit is to occur and who is to receive the resulting audit reports; generally the risk management committee, but with copies to the executive management group and the board of directors. Finally, risk management is not a static process, rather, risk is dynamic. That is, risk exposures change as the organisation’s products, procedures, balance sheet and cash flows change. Interest rate risk management strategies and techniques need to be sufficiently robust to be able to respond to change as it occurs.

REFLECTION POINTS

exposure management system is a structured process that should enable a business to • An identify, measure and manage an identified risk exposure effectively. exposure management system will be established within the context of the interest rate risk • An management objectives and policies determined by the board of directors and implemented by executive managers. system will broadly cover forecasting, strategies, techniques and management reporting • Asystems. 458

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involves knowing the structure of the balance sheet and related cash flows, using • Forecasting models to analyse information, to prepare forecasts on possible interest rate changes and to measure the impact of these possible rate changes. and techniques look at the models available to measure interest rate risk and the • Strategies wide range of products and methods available to manage any exposures. Internal strategies are based on the management of the balance sheet and cash flows; external strategies use derivative products to manage risk exposures. must be informed on the level of exposure to interest rate risk. Policies should • Management establish what reports need to be generated, how frequently the reports should be generated, to whom the reports should go and who is responsible to act on those reports.

14.3

Assets re-priced before liabilities principle

Interest rate risk is the sensitivity of assets, liabilities and cash flows to changes in interest rates. Therefore, understanding the re-pricing of assets and liabilities is essential in interest rate risk measurement and management. Re-pricing is important and leads us to one of the basic principles of risk management: assets re-priced before liabilities (ARBL). In an interest rate environment in which interest rates are forecast to rise, an organisation will endeavour to implement strategies that result in assets being re-priced before liabilities. This is described as achieving a positive ARBL gap. A positive ARBL gap means that an organisation is able to benefit, at least in the short term, from an upward movement in interest rates. For example, a bank provides its customers with loans that represent assets on the bank’s balance sheet. The loans are funded from the bank’s sources of funds, being liabilities and shareholders’ funds. If interest rates are forecast to rise in the future, the bank will be able to increase its net interest margin if it can raise the interest rates on its loans (assets) before it has to increase the interest rates it pays on customer deposits and debt issues (liabilities). In that situation, ARBL is occurring. Alternatively, a company may have obtained a variable-rate loan (liability) from a bank and is exposed to increases in interest rates. If the company is able to re-price its goods (assets) before—or at the same time as—interest rates on the loan change, it is able to protect its profit margins. In considering this strategy, the company will need to evaluate the potential impact of the asset price increase on its competitiveness in the market. In another situation, a bank may find that it has a negative ARBL. If interest rates are forecast to rise, the bank will implement strategies to mitigate the adverse impact of a rate rise by reducing the negative ARBL gap to a smaller level. It is not possible to change quickly a large balance sheet from a negative ARBL gap to a positive ARBL gap. However, it is possible to actively manage the interest rate sensitivity of balance-sheet assets and liabilities based on forecast interest rate directions in the future. This requires an organisation to measure its ARBL interest rate sensitivity over a range of planning periods: short term, medium term and long term. Conversely, in an environment in which interest rates are expected to fall, an organisation will endeavour to achieve a negative ARBL gap. In that case, for example, a bank would desire to lower the interest rate it pays on its deposits and other liabilities before it lowers the rates it receives on its loans. To some degree, it would seem that, so long as the ARBL principle is followed, interest rate risk measurement and management are easy. In reality, it is not easy to restructure the interest rate characteristics of a balance sheet. For example, a large commercial bank may have some hundreds of billions of dollars in assets, incorporating a wide range of interest payment structures and maturities. Similarly, on the liability side of the balance sheet there will be a wide range of maturities and interest payment structures. Each is a contractual arrangement with a customer that may not be easily changed, particularly in the short term. The issue of ARBL and gap management will be considered further in this chapter within the context of re-pricing gap analysis.

LEARNING OBJECTIVE 14.3 Consider the principle of assets re-priced before liabilities.

Assets re-priced before liabilities (ARBL) a risk management principle that ensures net margins and profitability are protected

ARBL gap a positive ARBL gap exists when assets are re-priced before liabilities, and a negative ARBL gap exists when liabilities are re-priced before assets

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REFLECTION POINTS

the context of interest rate risk, a basic principle is that, if possible, assets should be re • Within priced before liabilities if interest rates are expected to rise. generate income, whereas liabilities (debt) incur an interest expense. These cash flows • Assets are exposed to changes in interest rates over time. interest rates are forecast to rise, the cost of debt will rise; therefore, financial institutions and • Ifbusinesses will seek to minimise the impact of the rate rise by targeting a positive ARBL gap. rates are forecast to fall, the opposite strategy is required; that is, organisations will • Iftryinterest and achieve a negative ARBL gap, or at least lower a positive ARBL gap.

14.4 LEARNING OBJECTIVE 14.4 Revisit the pricing of financial securities and consider its relationship to interest rate risk exposures.

Pricing financial securities

Understanding the effects of interest rate changes on the price of an interest-rate-sensitive asset or liability is essential in the risk measurement process. The pricing of discount securities was discussed in Chapter 9, and the pricing of corporate bonds and government bonds in Chapters 10 and 12 respectively. The pricing of securities is briefly revisited in this section, as it is important that you are confident with the relevant calculations.

14.4.1

D ISCOUNT SECURITY PRICING

Discount securities include bills of exchange, promissory notes (commercial paper), negotiable certificates of deposit and Treasury notes. Discount securities are issued and sold at a price that represents a discount from the face value of the security. One formula used to calculate the price, where the yield is known, is: face value × 365 ​Price = ​ ___________________________         ​​ yield 365 + ​​(____ ​​​   ​ × days to maturity​   )​​​ 100

14.1

EXAMPLE 14.1 A company is to issue a 90-day bank bill with a face value of $500 000, yielding 9.50 per cent per annum. What amount will the company raise on the issue? $500 000 × 365    ​ Price = ​ _____________    365 + ​​(​​0.0950  × 90​)​​​ ​​ ​        ​​ ​ ​ $182 500 000  ​   ​ = ​ _________    373.55 ​ = $488 555.75 If the company has a rollover facility in place for this bill, it is exposed to interest rate risk at the next re-pricing date, that is, the rollover date in 90 days’ time. If interest rates have risen and the yield at the next rollover date is 9.75 per cent per annum, the company will raise: $500 000 × 365 Price = ​ _____________       ​ 365 + ​​(​​0.0975  × 90​)​​​ ​​ ​        ​​ ​ ​ $182 500 000 ​ = ​ _________     ​   373.775 ​ = $488 261.66 In this example, the cost of borrowing has increased by $294.09 for the next 90 days. That is, the company was able to borrow $488 555.75 on the first bill, but only $488 261.66 on the rollover bill. 460

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14.4.2

F IXED-INTEREST SECURITY PRICING

Fixed-interest corporate bonds and government bonds are issued at a face value repayable at maturity and pay regular interest coupons. The interest coupons on existing fixed-interest securities will not change over the term of the security; however, the current market yield on similar new securities will change. The price or value of the existing bond is calculated as the present value of the two cash-flow streams, being (1) the periodic coupon payments and (2) the face value repayable at maturity. The yield used in determining the present value of the cash flows is the current market rate for the particular type of security. One formula used to calculate the price is: 1 − ​​(​​1 + i​)​​​​ −n​ −n k ​P = ​​{​​C​​[___________ ​​​      ​​  ]​​​ + A ​(1 + i)​​  ​​}​​​​​(​​1 + i​)​​​​  ​​ i

14.2

where: i = current yield for the period, expressed as a decimal n = number of periods in which cash flows occur ​​C​ =​ periodic fixed coupon payment amount based on the fixed interest rate​ ​ ​ ​  ​                       ​ ​ ​  ​​ A = principal amount k = fraction of the elapsed interest period since the last coupon payment. Note: If the AOFM bond pricing formula is preferred, refer back to the Extended learning section in Chapter 12. The above formula is used here because it shows clearly how the price of a bond is determined: being the present value of the coupon stream plus the present value of the principal amount, adjusted for the elapsed period since the last coupon was paid.

EXAMPLE 14.2 A fund manager is holding a corporate bond in an investment portfolio. The bond has a face value of $1 000 000 and pays 10.00 per cent per annum half-yearly coupons, maturing on 31 December 2024. Assume that today is 20 May 2019 and that current yields on similar securities are 12.00 per cent per annum. What is the value of the bond, given the interest rate change? where: C = $50 000 (10 %  / 2 of $1 million) A = $1 million i = 0.06 (​​​​12 %  / 2)​ ​​​ n = 12 (​​​​6  × 2​)​​​ k = 140 / 181 (January 31 days, February 28 days, March 31 days, April 30 days and  May 20 days = 140 days) 1 − ​​(​​1  + 0.06​)​​​​  −12​ 140 ____ ​​ P ​​ = ​​ ​​$50  000​​ ​​ ​ ____________     ​​  ​​​  + $1 000 000​(1 +  0.06)​​  −12​​ ​​​​(1  +  0.06)​​  ​ 181 ​ ​​ ​​​ ​ [ { [ ] } ] 0.06 ​        ​  ​  ​  ​            = $419 192.20 +  $496  969.36 ​​(​​1.046101​)​​​ ​            = $958 397.52 ​ Because of the exposure to interest rate risk, the bond has fallen in value by $41 602.48 and therefore the value of the investment portfolio has fallen. In reality, a fund manager may have been holding more than $100 million of similar bonds and therefore the impact on the value of the portfolio and the performance of the fund manager are significant. 461

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REFLECTION POINTS

rate changes impact on the price of financial securities. The discount securities formula and • Interest the bond price formula are shown below. Each includes the current yield or interest rate as a variable. face value × 365 Discount security price = ​ __________________________         ​ yield 365 + ​​ ____ (​​​  100 ​  × days to maturity​)​​​​ ​​ ​​      ​  ​  1 − ​​(​​1  + i ​)​​​​  −n​ −n k Bond price ​= ​{​​C​​[_ ​​​      ​​  ]​​​  +  A ​(1  + i )​​  ​​}(​​​​​ ​​1  + i ​)​​​​  ​ i

• Discount securities will be re-priced at the current market yield at each rollover date. is an inverse relationship between the price of a fixed-interest security and a change in • There interest rates; if current interest rates rise, the price of existing securities will fall. 14.5 LEARNING OBJECTIVE 14.5 Analyse the structure and benefits associated with interest rate risk measurement using repricing gap analysis.

Re-pricing gap analysis monitoring interest rate sensitivities of assets and liabilities over specified planning periods

Interest rate sensitivity occurs when an asset or liability is to be re-priced during a planning period

Re-pricing gap rate-sensitive assets minus rate-sensitive liabilities

Re-pricing gap analysis

When the principle of ARBL was discussed in Section 14.3, we noted that an organisation will seek to implement strategies that will result in a positive ARBL gap, or reduce an existing negative ARBL gap, if interest rates are forecast to rise over a planning period. This section considers a model that analyses rate-sensitive assets and rate-sensitive liabilities. This is referred to as re-pricing gap analysis. Re-pricing gap analysis is the monitoring of the interest rate sensitivities of an organisation’s assets and liabilities over specified planning periods. Interest rate sensitivity relates to the re-pricing of an asset or liability within the planning period. For example, in a one-month planning period a 90-day discount security issued by a company is not interest rate sensitive; that is, the security will not be repriced during that one-month planning period. However, over a six-month planning period the 90-day discount security will be re-priced and therefore is rate sensitive. Therefore, the same security may be rate sensitive or not, depending on the planning period used to measure interest rate risk exposures. Clearly, the selection of a planning period is critical to the measurement of an organisation’s interest rate risk exposure. Typically, an organisation will carry out gap analysis over a range of different planning periods in order to ascertain the level of risk evolving over time. The shorter a planning period, the more accurate is gap analysis in measuring interest rate risk exposures. However, the size of a planning period is often constrained by the cost of gathering more detailed information on cash flows and interest re-pricing. The interest sensitivity, or re-pricing gap, is defined as rate-sensitive assets minus rate-sensitive liabilities. In order to calculate the gap, assets and liabilities on an institution’s balance sheet are grouped according to their interest rate sensitivity in that planning period. An example is shown in Table 14.1. (Note: We have used a bank as the example as this demonstrates a range of rate-sensitive assets and liabilities on the balance sheet.) Where interest-sensitive assets are financed by interest-sensitive liabilities, a movement in interest rates will affect both sides of the balance sheet. For modelling purposes (and convenience) we assume that interest rates will move at the same time and to the same extent for both assets and liabilities; in which case there is no net interest rate risk exposure. However, in reality this assumption is weak and timing differences will often be evident. Fixed-rate assets financed by fixed-rate liabilities and equity are not exposed to interest rate risk during a planning period, as the cost of funds and the return on funds is fixed; that is, re-pricing does not occur. The final group represents the interest rate risk identified in the re-pricing gap analysis model. If ratesensitive assets are financed by fixed-rate liabilities, or vice versa, then one side of the balance sheet will be exposed to interest rate risk while the other is not. Table 14.1 provides a simplified balance sheet that demonstrates the allocation of assets and liabilities within a one-month planning period. The table shows the amount for asset and liability classes within maturity groupings, plus average yields. The information in Table 14.1 is used to calculate the annual profit position of the organisation based on the current balance sheet, as shown in Table 14.2. The profit is calculated by multiplying the amount of each grouping by its average yield. The calculations in Table 14.2 result in a net annual profit of $4.0525 billion.

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Table 14.1 Re-pricing gap analysis: rate-sensitive assets and liabilities: one-month planning period $ billions

Average yield (%)

Fixed-rate commercial loans >30 days

19

12.00

Fixed-rate personal finance >30 days

22

$ billions

Average yield (%)

Demand deposits

11

1.50

8.50

Term deposits 30 day maturity

30

4.00

Variable-rate corporate lending

12

11.50

7-day certificates of deposit

6

3.75

Variable-rate personal finance

18

8.00

90-day certificates of deposit

5

3.80

Discount securities 30 days to maturity

9

5.00

Subordinated debt issues

9

6.50

Assets

Fixed-rate personal loans 30 days

2.28

Demand deposits

0.165

Fixed-rate personal finance >30 days

1.87

Term deposits 30 days

15

8.15

Variable-rate personal loans >30 days

48

Fixed-rate commercial loans 30 days

36

4.50

8

9.95

Term deposits 30 days

10

4.25

Long-term debt securities (fixed)

31

6.25

107  

 

 

107  

Assets

Total

Liabilities

 

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Chapter 14  Interest rate risk measurement

(a) Calculate the current re-pricing gap.



(b) If interest rates are forecast to fall by 25 basis points at the start of the one-month planning period, what will be the annualised dollar impact on the profitability of the bank? Show all calculations. (LO 14.5)

7

A large funds management organisation offers investors a specialist fund that invests mainly in fixed-interest securities. The fund manager finds duration a particularly useful tool for measuring the fund’s exposure to interest rate risk. Define duration and explain why it is so useful for measuring interest rate risk in a fixed-interest securities portfolio. (LO 14.6)

8

A major bank is to sell securities from an existing security portfolio to ensure it has sufficient liquid funds available over the next one-month planning period. The bank wishes to sell the group of securities with the higher interest rate risk. Using the data below:



(a) Calculate the duration of each of the groups of securities. Show all calculations.



(b) Which securities will the investor sell? (LO 14.6)

Data:

face value $30 million, four years to maturity, fixed annual coupon of 9.25 per cent • Eperurobonds, annum. orporate bonds, face value $30 million, three years to maturity, fixed annual coupon of • C10.40 per cent per annum. urrent yields on these securities are 9.60 per cent per annum and 10.85 per cent • Cper annum respectively. 9

The holder of a $100 000 debenture issued by BHP Billiton is concerned that the value of the debenture will change if interest rates rise. The debenture pays a fixed annual coupon of 8.25 per cent per annum and has exactly three years to maturity. Current market yields are 8.50 per cent per annum.



(a) Calculate the duration of the debenture. Show calculations.



(b) Using your duration answer in (a), calculate the percentage change in the price of the debenture if rates rise a further 25 basis points. Show calculations.



(c) Using the duration approximation, what will be the new price of the debenture if the forecast rate change is correct? (LO 14.6)

CHAPTER FOURTEEN REVIEW



10 Listed below is a simplified balance sheet showing the dollar value and duration of assets and liabilities held. For ease of calculation, we will assume an average interest rate of 6.00 per cent per annum; that is r = 0.06. Assets

$ millions

Duration

Debentures

41

6.885

Euronotes

25

4.420

Government bonds

10

3.345

Total assets

76

 

Liabilities

 

Short-term commitments

25

1.485

Long-term debt issues

38

5.844

Total liabilities

63

 

Equity

13

 

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(a) Calculate the duration of the asset portfolio and the duration of the liability portfolio.



(b) Calculate the value of the asset portfolio and the value of the liability portfolio if there is a general increase in interest rates of 75 basis points.



(c) Calculate the change in equity. Draw a table and reconstruct the new balance sheet showing total assets, total liabilities and equity only. Show all calculations. (LO 14.6)

11 Duration is a useful risk measurement tool that is commonly used by fixed-interest portfolio managers. However, duration suffers from a number of limitations. Identify and discuss the limitations associated with using duration to measure interest rate risk. (LO 14.6) 12 Fixed-interest fund managers measure convexity in conjunction with duration to better measure their exposures to interest rate risk. Discuss the concept of convexity within the context of interest rate risk measurement, duration and the bond price–yield curve. (LO 14.4 and 14.6) 13 A fund manager is holding fixed-interest bonds with a face value of $4 750 000. The bonds pay an annual coupon of 6.00 per cent per annum and will mature in exactly three years. The fund manager has forecast that interest rates will rise by 50 basis points. Based on the forecast change in interest rates:

(a) Calculate the price of the bond using duration.



(b) Calculate the price of the bond using the bond pricing formula.



(c) Draw and fully label a diagram to explain the relationship between duration and convexity using the data from (a) and (b). (LO 14.4 and 14.6)

14 Unsecured notes issued by Woodside Petroleum Limited have a face value of $1 million and pay an annual coupon of 9.65 per cent per annum. The note matures in exactly two years. Current yields on this type of security are also 9.65 per cent per annum.

(a) Use duration to calculate the price of the notes if yields increase by 70 basis points.



(b) Calculate the actual price of the notes using the bond pricing formula.



(c) Explain any difference in answers between (a) and (b).



(d) Calculate the convexity of the price–yield curve of the notes.



(e) Use duration, adjusted for convexity, to calculate the price of the notes. Show all calculations. (LO 14.4 and 14.6)

15 Mega Bank is conducting a review of its interest rate risk exposures associated with its loan portfolio. Once the bank has identified and measured its potential exposures to interest rate risk, it will investigate a range of internal and external risk management techniques that may be used to manage the risk exposures. Where possible, the bank will endeavour to use internal risk management techniques. Identify and discuss five internal risk management techniques that the bank may adopt. In your answer, give examples that are relevant to the loan portfolio. (LO 14.7)

KEY TERMS ARBL gap  459

duration of a portfolio  467

maturity structure  457

assets re-priced before liabilities (ARBL)  459

exposure management system 456

price risk  456

convexity 470

indirect interest rate risk  456

re-pricing gap analysis  462

derivative products  458

interest rate sensitivity  462

reinvestment risk  455

direct interest rate risk  456

inverse relationship  456

duration 465

liability diversification  457

re-pricing gap  462

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PART Five

The foreign exchange market CHAPTER 15 Foreign exchange: the structure and operation of the FX market

CHAPTER 16 Foreign exchange: factors that influence the exchange rate

CHAPTER 17 Foreign exchange: risk identification and management

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The foreign exchange market Our study of the financial system now moves to the dynamic world of the foreign exchange (FX) markets. The FX markets are truly global in that they trade the currencies of the majority of nation-states. The FX markets never close; somewhere in the world participants are trading currencies 24 hours a day. Exchange rates, that is, the price of one currency relative to another, change all the time. As new economic, political, financial and social information is released to the markets, FX dealers reassess the value of a currency. Foreign exchange rates also change in anticipation of new information coming to the market. Some may argue that perceptions, confidence and fear are the main drivers of prices in the FX markets. Nevertheless, the FX markets are volatile and participants rely on instant access to information. Organisations such as Thomson-Reuters and Bloomberg specialise in providing information to the financial markets, including the FX markets. The purpose of Part 5 of this text is to provide a detailed analysis of the FX market and to consider the implications of movements in exchange rates for corporations, financial institutions and governments that conduct transactions that are denominated in a foreign currency. In Chapter 15 the structure and operation of the FX market is explained and the market participants that conduct FX transactions are identified. The types of transactions and the conventions adopted by FX market participants in quoting and dealing in FX are introduced and explained. Finally, the European Monetary Union (EMU) and the significance of its impact on the structure and operation of the international FX markets are discussed. Chapter 16 moves beyond the more mechanical aspects of the FX market and its operation, and provides a framework within which fluctuations in exchange rates may be analysed. Factors are identified that are commonly thought to have a major influence on the FX value of a currency. The chapter concludes with the  view that, while some of the key determinants of the value of a currency can be identified, the influence of the variables may vary from one period to another, and sometimes from one country to another. Consequently, the forecasting of the value of a currency is quite difficult and often inaccurate. As a result, corporations, financial institutions and governments that conduct transactions denominated in a foreign currency are exposed to FX risk. Chapter 17 introduces issues related to the identification, measurement and management of FX risk, in particular those aspects of risk associated with FX transactions. The use of forward exchange contracts as a strategy for managing FX risk exposures is considered. Other derivative products that may be used to manage FX risk are futures, options and currency swaps. These risk management methods are discussed in Part 6. This chapter concludes with an examination of the potential advantages of using internal hedging strategies, such as matching cash inflows and outflows in the same currency, as a means of managing forecast FX exposures.

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CHAPTER 15

Foreign exchange: the structure and operation of the FX market CHAPTER OUTLINE 15.1 Exchange rate regimes 15.2 Foreign exchange market participants 15.3 The operation of the FX market 15.4 Spot and forward transactions 15.5 Spot market quotations 15.6 Forward market quotations 15.7 Economic and Monetary Union of the EU and the FX markets

Learning objectives LO 15.1

Understand the nature, size and scope of the global FX markets and the main exchange rate regimes used by different countries.

LO 15.2

Identify and discuss the major groups of participants in the FX markets.

LO 15.3

Describe the functions and operations of the FX markets.

LO 15.4

List and explain the types of FX transactions, in particular spot and forward transactions.

LO 15.5

Introduce the conventions adopted for the quotation and calculation of spot exchange rates.

LO 15.6

Describe the role of the forward market and calculate forward exchange rates.

LO 15.7

Identify factors that complicate FX market price quotations and calculations.

LO 15.8

Recognise the important impact on the FX markets of the Economic and Monetary Union of the European Union (EMU).

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CHAPTER SNAPSHOT The exchange rates for foreign currencies that can be seen on the displays of any money exchange window in any shopping mall derive from the buying and selling on the world’s foreign exchange (FX) markets. The quotations that can be seen on display at these money exchanges are ‘spot’ rates. A customer can purchase FX immediately at the advertised rate. The FX markets also facilitate trading in ‘forward’ rates. That is, buying and selling can take place for future delivery. This allows FX market participants to lock in a rate now for a future transaction. This is one way in which the risk of exchange rate fluctuations can be managed.

INTRODUCTION LEARNING OBJECTIVE 15.1 Understand the nature, size and scope of the global FX markets and the main exchange rate regimes used by different countries.

Bank for International Settlements (BIS) the central bank of central banks; conducts research and makes recommendations relating to the supervision and stability of the international financial system

SWIFT electronic system operated by global financial institutions that facilitates international financial transactions

The City the term used to describe the financial centre within London

The FX markets exist whenever and wherever financial transactions are conducted that are denominated in a foreign currency. The FX markets facilitate the exchange of value from one currency to another and allow market participants to buy and sell foreign currencies. There is an enormous demand to buy and sell foreign currencies, arising from:

• • • •

financial flows associated with international trade in goods and services cross-border capital transactions involving the investment and the borrowing of funds speculative transactions aimed at profiting from favourable movements in future exchange rates central bank transactions within the FX markets.

A primary function of the FX markets is to facilitate international trade and investment. For example, an Australian company may enter into a trade agreement denominated in US dollars (USD) to import manufactured goods from Singapore. The Australian importer will need to buy USD to pay to the Singapore exporter, who in turn may wish to convert the USD back into the local Singapore dollars (SGD). In another situation, a UK-based fund manager may wish to purchase shares of companies listed on the Australian Securities Exchange. The fund manager will need to sell UK pounds (GBP) to purchase Australian dollars (AUD) in order to pay for the shares. Future dividend payments received by the UKbased fund manager will need to be converted from AUD back into GBP. The Bank for International Settlements (BIS) estimates an average daily turnover in the FX markets in excess of USD5000 billion (i.e. 5 trillion US dollars). London is the largest FX market, followed by New York. Other regional centres include Frankfurt, Hong Kong, Paris, Singapore, Sydney, Tokyo and Zurich. While we mention some of the main centres, FX transactions may be conducted wherever access to the markets is available. The speed and efficiency of the FX markets is facilitated by sophisticated systems such as SWIFT (Society for Worldwide Interbank Financial Telecommunications). SWIFT was founded in the 1970s and is a member-owned cooperative based in Belgium. It links more than 10 000 banking organisations across more than 200 countries within a standardised and secure communications framework. In 2018, SWIFT had daily ‘message traffic’ of more than 30 million messages. The messages are payment orders that are settled by the financial institutions using the system. SWIFT is not a financial institution itself. It does not clear or settle orders or manage accounts. London’s position as the largest FX market derives from a number of factors. London has always been a centre for international finance generated from insurance, shipping, commodities, financial institutions, debt and equity funding. For example, the major global insurance market, Lloyds of London, is situated in the City, as is the London Metals Exchange and representative offices of all large financial institutions from around the world. London is also able to trade with the global FX market; for example, it is able to trade with Europe during the full day, the Far East and the Asia Pacific region at the start of the London day and the US markets at the close of the London day. Around 70.00 per cent of transactions conducted through London involve counterparties from another country.

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Foreign exchange transactions may be between participants in different cities and in different countries. Given both of these features, it is important that participants in the market communicate effectively. To reduce the risk of ambiguity, internationally adopted FX market conventions have developed. Many of these conventions are discussed in this chapter. The main types of contracts that are traded in the markets are analysed, and the conventions adopted in expressing exchange rates are discussed. The procedures involved in deriving other exchange rates (including transposed rates and cross-rates) on the basis of quoted rates are also explained.

REFLECTION POINTS

• • • •

The global FX markets facilitate transactions that are denominated in foreign currencies. FX market transactions include trade (imports and exports), capital (borrowing and investing), speculative (buying and selling currencies) and central bank transactions. The FX markets operate around the globe 24 hours a day; daily turnover is more than USD5 trillion. Major FX markets include London, New York, Tokyo, Hong Kong, Singapore, Sydney and Zurich.

15.1

Exchange rate regimes

Each nation-state, or monetary union, around the world is responsible for the determination of the country’s exchange rate regime, that is, the method by which the exchange rate of the currency is calculated. Major currencies, such as the US dollar (USD), the UK pound sterling (GBP), the Japanese yen (JPY), the Economic and Monetary Union of the European Union euro (EUR) and the Australian dollar (AUD), all adopt a floating exchange rate regime, or a free float. A floating exchange rate regime exists when the exchange rate for the currency of a country is allowed to move as factors of supply and demand dictate. Put very simply, if the demand for a currency increases in the FX markets, then that currency will appreciate relative to other currencies. If the demand for the currency falls, then the currency will depreciate. Chapter 16 discusses factors that will impact upon the demand and supply for a currency in the FX markets. Therefore, the exchange rate in a floating rate regime is not directly controlled by the government or the central bank. However, there have been times when a central bank may enter the FX markets to influence the exchange rate. In the floating rate regime, a central bank will only seek to influence the exchange rate when there has been a significant and rapid appreciation or depreciation of the currency, and the central bank is of the view that the rapidly rising or falling exchange rate is not supported by economic fundamentals. In order to influence the exchange rate, a central bank will enter the FX market and either buy or sell the currency in sufficient quantities that the exchange rate will be affected. In this situation, the central bank is unlikely to stop the exchange rate moving; rather, it will slow down the movement so that the FX markets have time to reassess the underlying fundamentals. The reason a central bank normally cannot stop an appreciation or depreciation in the exchange rate is that the FX markets are so large that even a combination of the major central banks is not strong enough to stop the market if it decides that a currency should move. Other types of exchange rate regimes include the managed float, the crawling peg and the linked exchange rate. Countries that operate a managed float regime generally allow the currency to move within a defined range, or band, relative to another major currency such as the USD or a group of currencies. The exchange rate is allowed to adjust providing such movements do not adversely impact upon the economic objectives of the country. Countries that currently use the managed float regime include China, Singapore, Malaysia and Indonesia.

LEARNING OBJECTIVE 15.1 Understand the nature, size and scope of the global FX markets and the main exchange rate regimes used by different countries.

Exchange rate the value of one currency relative to another currency

Floating exchange rate an exchange rate is determined by supply and demand factors in the FX markets

Managed float an exchange rate is held within a defined band relative to another currency; limited fluctuations allowed

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Crawling peg a managed float where an exchange rate is allowed to appreciate in controlled steps over time

Linked exchange rate regime the value of the pegged currency is tied into the value of another currency or basket of currencies

The managed float regime may also be used to maintain competitive trade equilibrium. For example, in the Asia region, China is a major exporting nation. China adopts a managed float regime which limits exchange rate movements within a 2.00 per cent ‘band’ against a basket of currencies, including major trading partners such as the USA and Europe. At times, this has caused some degree of unhappiness with trading partners who believe that China’s currency is undervalued and that this gives China an unfair trading advantage. Another exchange rate regime is known as the crawling peg. The crawling peg allows the currency to appreciate gradually over time, but within a limited range established by the government. In many ways it is similar to a managed float, but it is generally accepted in the international markets that the currency is undervalued, particularly if fundamentals such as the country’s foreign exchange reserves and level of exports are taken into account. While China contends that it operates a managed float regime, there are commentators who contend that it is really a crawling peg regime. A further exchange rate regime is the linked exchange rate regime (or fixed exchange rate regime) as is used by Hong Kong. With a linked exchange rate, a currency is directly linked to another currency. In the case of Hong Kong, the Hong Kong dollar (HKD) is linked to the USD. The Hong Kong Monetary Authority has pegged the HKD exchange rate between 7.75 and 7.85 HKD to the USD. FX exchange rate regimes change from time to time. For example, a country that currently adopts a managed float may, in the future, decide that the strength of its economy is such that the country should move to a floating exchange rate regime. The countries that currently have a floating exchange rate regime used different regimes in the past.

REFLECTION POINTS

• • • • •

LEARNING OBJECTIVE 15.2 Identify and discuss the major groups of participants in the FX markets.

FX markets markets that facilitate the buying and selling of foreign currencies

An exchange rate is the value of one currency relative to another currency. Each country, or group of countries within a monetary union, is responsible for determining the form of their exchange rate. Most major currency exchange rates are determined using a floating exchange rate regime, including the currencies of the USA, UK, EMU, Japan, Australia and New Zealand. A floating exchange rate is determined by factors that affect supply and demand within the FX market. Countries such as China, Singapore, Malaysia and Indonesia operate a managed exchange rate regime, whereby the exchange rate is allowed to move within a defined range relative to a specified major currency or basket of currencies. A crawling peg exchange rate regime allows the currency to appreciate over time, but within a limited range determined by the government. It may be argued that China actually uses this regime. With a linked exchange rate regime, as used by Hong Kong, the exchange rate is locked into a ratio with a nominated currency, such as the USD.

15.2

Foreign exchange market participants

The FX markets are enormous and involve a range of different participants around the world all conducting transactions that involve foreign currencies. Participants in FX may be categorised as:

• • •

foreign exchange dealers and brokers central banks firms conducting international trade transactions

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• • •

investors and borrowers in the international money markets and capital markets foreign currency speculators arbitrageurs.

Categorising the FX market participants by type allows an appreciation of the nature of the transactions that underlie the need for the FX markets.

15.2.1

F OREIGN EXCHANGE DEALERS AND BROKERS

Foreign exchange dealers are organisations that act as principals in the FX market. The main FX dealers are the commercial banks, investment banks and merchant banks. In many countries, such as Australia, an FX dealer requires an authority to deal from a prudential supervisor. FX dealers quote two-way prices in the market. That is, the FX dealer will quote prices at which they are prepared both to buy and to sell foreign currencies. The FX dealer is not concerned whether a transaction is a buy or a sell as they will make a profit on the spread between the two prices. In addition to the dealers, there are FX brokers, whose transactions are almost exclusively with the FX dealers and not with the public. The brokers act in the FX market in a role very similar to that performed by stockbrokers in the share market. The FX brokers seek out the best exchange rates in the international markets and match buy and sell orders that they receive from various FX dealing rooms. FX brokers also provide anonymity to participants until a transaction is carried out. The FX dealers pay a fee, or brokerage, for the service provided by the brokers.

FX dealers institutions that quote buy (bid) and sell (offer) prices and act as principals in the FX markets

Two-way prices the dealer quotes both a buy (bid) and a sell (offer) price on a currency

FX brokers

15.2.2

C ENTRAL BANKS

The central banks of nation-states enter the FX markets periodically, for one or other of the following reasons.

• • •

obtain the best prices in the global FX markets and match FX dealers’ buy and sell orders for a fee

To acquire foreign currency to pay for their government’s purchases of imports, such as defence equipment, and to pay interest on, or to redeem, the government’s overseas borrowings. To change the composition of the central bank’s holdings of foreign currencies as part of its management of official reserve assets. For example, a central bank may decide that it needs to increase its holding of USD and fund this purchase from a reduction of its holding of EUR. To influence the floating exchange rate, particularly if the exchange rate is appreciating or depreciating rapidly and, in the central bank’s view, this is not supported by economic fundamentals. Under normal conditions, this form of intervention in the FX markets would not occur often. A clean float is said to occur when a central bank does not intervene in the FX market. Conversely, where a central bank regularly intervenes in the FX market to influence the FX rate, this is regarded as a dirty float. This role of a central bank is discussed further in Chapter 16.

15.2.3

F IRMS CONDUCTING INTERNATIONAL TRADE TRANSACTIONS

Businesses that export goods or services in the international markets often receive payment in a foreign currency. Similarly, those businesses that import goods and services from the international markets will need to pay for those goods and services, usually in a foreign currency. Typically, the dominant currency of international trade transactions is the USD, but other currencies, such as the GBP, JPY and the EUR, are also quite prominent. Since these currencies are often not useful for transactions within the recipient’s home country, the exporter is likely to sell the foreign currency and buy the local currency through the FX market. On the other hand, importers have to buy foreign currency in order to pay for their imports.

Official reserve assets central bank holdings of foreign currencies, gold and international drawing rights

Clean float when an exchange rate is determined by market forces without central bank intervention

Dirty float when a central bank regularly intervenes in the FX market to influence a floating exchange rate

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15.2.4

I NVESTORS AND BORROWERS IN THE INTERNATIONAL MONEY MARKETS AND CAPITAL MARKETS

Deregulation of the international financial markets has resulted in an enormous increase in the flow of funds around the world. The financial press regularly contains announcements that large corporations, financial institutions and governments have raised funds in the international capital markets. Chapter 11 discussed international finance and recognised the motivations and benefits that are available to borrowers with very good credit ratings that borrow in the international money and capital markets. In particular, we have noted previously that commercial banks borrow significant sums in the international capital markets as part of their active liability management strategies. A very large proportion of funds borrowed in the international markets will be converted in the FX markets into the home currency of the borrower. At the same time, corporations, institutional investors and financial institutions invest overseas. For example, fund managers for managed investment funds or superannuation funds will invest a proportion of their portfolios in international shares and debt securities. The fund managers need  to purchase FX in order to acquire overseas investments. Dividend or interest payments received by the fund managers will be denominated in a foreign currency. The managers may sell these receipts on the FX markets to convert them back into the home currency for distribution to fund members.

15.2.5

S PECULATIVE TRANSACTIONS

It is estimated that over USD5 trillion moves through the FX markets daily. Much of this does not involve trade, investment or central bank transactions and therefore may be described as speculative FX transactions. Speculative FX transactions are motivated by the pursuit of profit. The volume of speculative transactions implies that, at times, speculators are able to move the market price of a currency. These transactions are always accompanied by an element of risk. For example, if it was expected that the AUD was about to fall in value (depreciate) against the USD, one might buy the USD (sell the AUD) now. If the expectation proved to be correct, then converting the USD back into AUD after the AUD has depreciated will make a profit. The following example illustrates the steps involved. If, today: ​Spot rate: USD1 = AUD0.7725 Exchange rate expected today + n days: USD1 = AUD0.8225​ Then, today: ​Buy USD1 at a cost of AUD0.7725​ Then, at today + n days: ​Sell USD1 and obtain AUD0.8225​ While the example makes it look easy, there are risks involved. A loss will be made if the exchange rate moves in a direction opposite to that expected, such as where, at today + n days, the exchange rate turned out to be USD1 = AUD0.7672. There is also a risk of loss if the exchange rate moves in the expected direction, but not to the extent that was expected. This loss arises if the gain made on the exchange rate change is not sufficient to cover the transaction costs and opportunity cost associated with the transactions. 490

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An example of institutional FX speculators is hedge funds. Not all hedge funds speculate in the FX market; nevertheless, hedge funds have grown to be a significant group of speculators in the market. Hedge funds are discussed in Chapter 3. A hedge fund will analyse all available information relevant to the determination of the future value of a currency and then may take a large position in the market. Investors, businesses and financial institutions will also, at times, indulge in speculative transactions. For example, businesses that have foreign currency receivables may choose to hold the  foreign currency for some time before exchanging it for the home currency if it is expected that the foreign currency is about to strengthen against the home currency. In another example, an FX dealer buys USD from a corporate client and, rather than selling it immediately to another market participant, holds the USD on its own account on the expectation of the value of the USD rising in the near future. That is, it will take on a long position in the USD. At other times, a speculator may believe a currency is likely to depreciate in the near future and could decide to take a short position in the FX market; that is, selling a currency that the speculator currently does not hold. This may be achieved by entering into a contract today to sell a foreign currency at a specified exchange rate on a future nominated date. The speculator hopes to be able to buy the necessary foreign currency to cover the short position once it has depreciated and is available at the lower price. Forward exchange contracts are discussed in Section 15.6.

15.2.6

Long position occurs when the underlying asset has been bought forward

Short position entering into a forward contract to sell an asset that is not held at that time

A RBITRAGE TRANSACTIONS

Arbitrage transactions are possible when differences occur between buy and sell prices in markets. The arbitrageur is able to carry out simultaneous buy and sell transactions in two or more markets to achieve a risk-free profit. Within the context of the FX markets, arbitrage refers to the pursuit of a profit through the conduct of simultaneous FX transactions that involve no FX risk exposure. An arbitrage opportunity would occur if the exchange rate quoted by two or more dealers between currencies was different. For example, a triangular arbitrage occurs when exchange rates between three or more currencies are out of perfect alignment. This situation is illustrated below. The following rates are given:

Arbitrageur a party that simultaneously conducts buy and sell transactions in two or more markets in order to take advantage of price differentials between markets

​USD1 = AUD1.3525 USD1 = SGD1.3525 AUD1 = SGD0.9870​ It is clear that AUD1 should be equal to SGD1 as their exchange rates are identical against the USD. An arbitrage profit can be made without risk by simultaneously:

• • •

selling AUD1.3525 to receive USD1 then selling USD1 to receive SGD1.3525 then selling SGD1.3525 to receive AUD1.3703.

In this transaction the arbitrageur commenced with AUD1.3525 and finished with AUD1.3703, a profit of 1.78 cents. This may not seem like much of a profit, but if it is based on typical transactions larger than AUD1 million, then such instantaneous, risk-free profits are worthwhile. Risk-free profit opportunities like this are rare in an efficient market. The FX markets are deep and liquid and therefore the demand for, and supply of, currencies will generally eliminate pricing differentials. However, it may be argued that mispricing can occur from time to time because markets are not perfectly efficient and because prices or exchange rates may not adjust immediately to new information in all markets. When these conditions do occur, the actions taken by arbitrageurs in order to profit from the differential will quickly result in the closing of the opportunity; that is, the arbitrage demand/supply transactions will move the exchange rate back into equilibrium. 491

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REFLECTION POINTS

• • • • • •

FX dealers, such as commercial banks, investment banks and merchant banks, quote two-way prices on all major currencies. FX brokers assist FX dealers in obtaining competitive exchange rates in the global markets. Central banks hold foreign currency reserves, conduct international transactions on behalf of their government and occasionally buy or sell currencies to influence the exchange rate in the FX markets. Firms that import or export goods usually conduct those transactions in currencies such as the USD, GBP, JPY and EUR. Financial transactions conducted by investors and borrowers in the international money and capital markets are also usually denominated in foreign currencies. Speculators buy and sell foreign currencies in the hope of making profits from exchange rate movements. An arbitrageur conducts a series of simultaneous FX transactions to lock in a profit if price differentials should occur between different FX markets.

15.3 LEARNING OBJECTIVE 15.3 Describe the functions and operations of the FX markets.

FX dealing room physical location of FX dealers, usually within an institution’s treasury operation

The operation of the FX market

The FX market is a global market, with transactions being carried out in most international currencies, 24 hours a day. Typically, the price of each currency at any point in time will be identical, regardless of the geographic location of the FX dealing rooms offering the quotes; otherwise arbitrage profits could be made. The larger FX dealers, including the commercial, investment and merchant banks, provide their FX function as part of their overall treasury operations. Within the treasury operation they establish an FX dealing room. The number of dealers in an FX dealing room may range from a few to more than 100 depending on the scale of an institution’s FX operations. Apart from the FX dealers, an institution will probably also have dealers that trade in derivative contracts based on financial instruments and commodities, cash products and debt securities. To facilitate such transactions it is essential that the various dealing rooms around the world have access to the same information at each moment in time. The information sought by FX dealing rooms is not only the current buy and sell rates for the various currencies, but also the economic, political and social news that may affect the values of any particular currency. There are a number of global electronic networks, such as Thomson-Reuters and Bloomberg, that provide such information. The dealing rooms of large FX dealers, such as the banks, typically access information from more than one information provider. These organisations facilitate the efficient flow of information into the FX markets. In an FX dealing room, the array of computer screens is the most obvious manifestation of the global communications network that links the electronic trading platforms of FX dealers. The electronic screen pages provide information on indicative buy and sell rates for a particular currency, with rates on that currency from numerous dealers. The rates are indicative, rather than firm, since they may change within a matter of seconds. Firm rates, at which FX dealers are prepared to transact, are obtained from each dealer’s electronic trading platform. Retail and institutional clients are given authorised access to the electronic trading system. Other FX dealers and brokers will also have access to the trading system. Given the nature of the communications between the market participants, and given the FX volumes traded and the often very hectic pace of the market, FX dealers have developed conventions and a language of their own. The following sections present and explain some of the conventions and the language used in the FX markets.

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REFLECTION POINTS

• • • •

The global FX market comprises market participants conducting transactions in foreign currencies. FX dealers use sophisticated electronic information, communication and trading systems and platforms in their treasury dealing rooms. New information may change exchange rates; dealers access information within seconds; major information providers include Thomson-Reuters and Bloomberg. Typically, FX dealer exchange rate quotes will be identical around the globe at any point in time.

15.4

Spot and forward transactions

Of the various currency contracts that can be bought or sold on the FX markets, the most common are those that have a maturity date, otherwise referred to as the value date or delivery date, which is:

• •

two business days after the FX contract is entered into—referred to as spot transactions, or more than two working days after the FX contract has been entered into—referred to as forward transactions.

A spot transaction may arise, for example, when an importer has a USD account to pay within the next few days. The importer would purchase the required amount of USD through an FX dealer and would nominate a US bank account to which the USD are to be credited. The importer would also indicate the account from which the local currency is to be automatically debited in order to make financial settlement to the FX dealer for the transaction. The spot contract to buy the USD would be entered into today, at an exchange rate determined today, but with the settlement of the contract occurring in two business days from today. For example, if the transaction occurred on a Wednesday, then the spot value date is the Friday, providing there is no public holiday in either of the centres in which the currencies are being traded. Since a spot FX contract may involve the transfer of funds in two locations, the spot delivery date allows two working days in both locations. Should the second day be a public holiday or a weekend in either location, the delivery date is advanced to the next working day. The convention of two days for delivery is a carryover from the days of less sophisticated communications and settlement systems between FX trading centres. In Canada, the value date for spot transactions is one business day after today. A forward transaction may arise when, for example, an importer has to pay a foreign currency amount to an exporter in, say, two months. If the contract is denominated in EUR, the importer may be concerned that the EUR may appreciate (increase in price) during that period. One way of covering, or hedging, against that risk is to enter into a forward contract. The basic features of the forward buying of the EUR are as follows:

• • •

LEARNING OBJECTIVE 15.4 List and explain the types of FX transactions, in particular spot and forward transactions.

Value date the FX contract date at which delivery of a currency and financial settlement occur

Spot transaction locks in an exchange rate today for settlement and delivery in two business days from the date of the transaction

Forward transaction locks in an exchange rate today for settlement and delivery at a specified date beyond the spot date

the contract to buy EUR is entered into today the price of the EUR is determined and locked in today the value or delivery date, when the local currency is paid and EUR received, is a date in the future, but specified today.

Forward contracts can be obtained for virtually any future date that the corporate client may wish; however, the standard quoted rates are for one or more months hence. The monthly dates are the dates corresponding to the spot dates; that is, if today is Monday, 13 August, then:

• • •

the spot delivery date is 15 August the one-month forward delivery date is 15 September the two-month forward delivery date is 15 October and so on. 493

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Tod value transactions an FX contract with settlement and delivery today

Tom value transactions an FX contract with settlement and delivery tomorrow

Should any of the forward delivery dates fall on a non-business day, then the delivery day is advanced to the next business day, except at the end of the month. In the USA, the spot value date is only moved out a further day for a holiday if that holiday falls on the value date. If the holiday falls on the intervening day of a spot transaction, then the spot value date does not change. In addition to the spot and forward transactions, a dealer may provide what is known as shortdated transactions. Transactions entered into today, with same-day value or settlement, are referred to as ‘today’, or tod value transactions. Those entered into today, for settlement tomorrow, are referred to as ‘tomorrow’, or tom value transactions. The timeline in Figure 15.1 shows the labels for the various transactions described in this section. It is assumed that the FX transaction is entered into today.

Figure 15.1  Timeline of tod, tom, spot and forward FX transactions Value day

Today

Today + 1

Today + 2

Today + 3 and beyond

Transaction

Tod

Tom

Spot

Forward

REFLECTION POINTS

• • • • •

FX transactions are classified by the delivery date of the relevant foreign currency. Spot transactions set an exchange rate today for delivery and settlement in two business days’ time. Forward FX transactions set an exchange rate today for delivery and settlement in more than two days. The one-month forward date will be the spot delivery date plus one month. Short-dated FX transactions may be tod (delivery today) or tom (delivery tomorrow).

15.5 LEARNING OBJECTIVE 15.5 Introduce the conventions adopted for the quotation and calculation of spot exchange rates.

Spot market quotations

The FX market has a well-defined set of conventions governing the quotation of the price of one currency in terms of another. Participants in the markets must be aware of these conventions, otherwise they risk entering into an FX transaction that does not meet their requirements. For example, a firm may ring an FX dealer and ask for the price of the USD. However, the price of the USD can be expressed in terms of any of the world’s currencies, and it is therefore necessary to be specific: to ask for the price of the USD in terms of a named currency, such as the Japanese yen (JPY) or the pound sterling (GBP). Further, the order in which the particular currencies are expressed, for example USD/ JPY or JPY/USD, has a specific meaning in the FX markets.

15.5.1

A SKING FOR A QUOTATION

A firm may wish to obtain the exchange rate between the AUD and the EUR, because it wants to sell AUD it is holding and buy EUR to pay for goods it has imported from Germany. The firm might ask, ‘What is the AUD/EUR spot rate?’ or ‘What is the Aussie euro spot?’ By asking for the exchange rate in this way, the FX dealer will understand that the firm is asking for the spot price of AUD1 in terms of EUR. 494

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Had the firm asked ‘What is the euro Aussie spot?’ it would have received a quite different response from the FX dealer. That quotation would be understood to be a request for the spot price of EUR1 in terms of AUD. The convention in the ordering of the two currencies in asking for a quotation is that the first currency mentioned is the one whose price is being sought. It is referred to as the base currency or the unit of the quotation, since it is the price of one unit of that currency that is being quoted. The second currency in an FX quote is referred to as the terms currency. The terms currency is used to express the value of the base currency. The currency on the left-hand side of a quote is the unit of the quotation and the currency on the right is the terms currency. For example:

• • •

USD/EUR means the price of USD1 in terms of EUR. GBP/USD means the price of GBP1 in terms of USD. AUD/JPY means the price of AUD1 in terms of JPY.

15.5.2

T WO-WAY QUOTATIONS

Let us assume that the importing firm, above, asks for the euro Aussie spot. Observing the above convention, the firm would receive two sets of numbers in response to the request. For example, the EUR/AUD spot rate might be given as:

Base currency the first-named currency in an FX quote; one unit expressed in terms of another currency

Unit of the quotation the first-named currency in an FX quote; one unit expressed in terms of another currency

Terms currency the second-named currency in an FX quote; used to express the value of the base currency

EUR/AUD1.3755–1.3765 and would be expressed in words as ‘euro Aussie spot is one thirty-seven fifty-five–sixty-five’. This form of quotation raises two questions:

• •

How is the verbal expression to be interpreted? Why are there two prices?

Interpreting verbal quotations In the euro Aussie spot quote above, it can be noted that:

• •

the decimal point in the verbal quotation is not mentioned the words do not include all of the numbers in the written quotation.

It is expected that participants in the FX market have a good knowledge of the approximate values of various currencies against each other, and thus the inclusion of the decimal point is not necessary when giving, or receiving, a quotation over the telephone. In the quote above, ‘one thirty-seven fifty-five’ would be understood by market participants to mean EUR/AUD1.3755. The other convention illustrated in the quotation in the ‘euro Aussie spot’ rate is that the second number in the quotation is considerably abbreviated. The number 1.3765 is spoken as ‘sixty-five’. Generally, where digits in the second number are the same as those in the first number, the common digits are not repeated. In the quotation, 1.37 (one thirty-seven) is common to both numbers and so is not repeated when the second number is given. That is, ‘euro Aussie spot is one thirty-seven fifty-five–sixty-five’ means: EUR/AUD1.3755–(1.37)65 The following examples may help to clarify this convention.

EXAMPLE 15.1 ‘Aussie Sing dollar is one twenty-seven sixty–seventy’ means: AUD/SGD1.2760–1.2770 495

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EXAMPLE 15.2 ‘Dollar yen is eighty-two fifty-eight–sixty-six’ means: USD/JPY82.58–82.66 Note: When a quote states ‘the dollar’ without qualification it is referring to the USD.

The above convention of quoting FX rates applies to a relationship between an FX dealer and a corporate client. Transactions between FX dealers and brokers in the market are abbreviated even further. The convention, where FX trades occur between FX dealers, is not to quote the big figures; that is, the dealer will only quote the final two points in both the buy and sell quote. In Example 15.2 above, the FX dealer would quote to a broker ‘fifty-eight sixty-six’.

Two-way prices Price-maker a dealer that quotes both bid and offer prices

The focus now returns to the euro Aussie spot rate (EUR/AUD1.3755–1.3765) and the reason for there being two numbers. The two numbers identify the price at which the price-maker FX dealer will buy and sell the unit of the quotation. That is:

• •

Bid price the price at which an FX dealer will buy the base currency

Offer price the price at which an FX dealer will sell the base currency

Ask price the price at which an FX dealer will sell the base currency

Spread the points difference between bid and offer prices in a quote

Point the final decimal place in an FX quotation

the price-maker FX dealer will buy EUR1 for AUD1.3755. From the price-taker’s point of view, it would sell EUR1 and receive AUD1.3755 from the FX dealer the price-maker FX dealer will sell EUR1 for AUD1.3765. From the price-taker’s point of view, it receives EUR1 on payment of AUD1.3765 to the FX dealer.

The buy price is referred to as the bid price: the price at which a dealer will buy the unit of the quotation. The sell price is referred to as the offer price: the price at which the dealer will sell the unit of the quotation. Some market participants refer to the sell prices as the ask price; therefore, offer and ask are the same. The above quotations reveal that the price-maker FX dealer buys low and sells high. The difference between the FX dealer’s bid and offer quotes is referred to as the spread. This is represented in percentage terms by Equation 15.1: offer price − bid price ​Percentage spread = ​(​ ​ ___________________        ​)​ × 100​ bid price

15.1

The spread for wholesale transactions between dealers will normally be only a few points. A point is the final decimal place in an FX quotation. Therefore, a quote of AUD/GBP0.6250–53 has a spread of three points. The number of decimal places quoted depends on the number of units in the quote. A quote with fewer than 10 units of the terms currency is quoted to four decimal places, while a quote of more than 10 units of the terms currency is quoted to only two decimal places. For example, the AUD/USD may be quoted as AUD/USD0.7554–0.7559, while the AUD/JPY may be quoted as AUD/JPY83.43–83.49. The spread in the wholesale FX market is small for commonly traded currencies as there are economies of scale available with large FX transactions. The dealer makes money on the small spread from the multi-million-dollar size of these transactions. The spread for retail transactions is typically much larger, generally in excess of 50 points. The spread on retail FX transactions is much wider than in the interbank market, reflecting the higher average costs incurred by banks in such transactions. Retail FX transactions often incur a fee over and above the spread. Spreads also tend to be wider when FX dealers are uncertain about currency movements. On days when there is a lot of news affecting the market, the spreads on FX quotations might be expected to increase.

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In the wholesale FX markets the bid and offer rates are given from the perspective of the dealer. You should note, however, that Australia breaches this convention in the retail market and quotes rates from the perspective of the customer. In this situation the bid rate is higher than the offer rate.

15.5.3

T RANSPOSING SPOT QUOTATIONS

In the previous section we considered a quote EUR/AUD1.3755–65, where the EUR was the unit of the quotation. To find the value of the AUD/EUR, the quotation would need to be transposed. Given the EUR/AUD rate, it is possible, using a simple rule, to calculate the quote that should prevail if the AUD is to become the base currency; that is, AUD/EUR. The rule to transpose an existing rate is ‘reverse then invert’. Therefore: EUR/AUD1.3755–1.3765 1 Reverse the bid and offer prices: 1.3765–1.3755 2 Take the inverse; that is, divide both numbers into one, which gives: AUD/EUR0.7265–0.7270 The reasoning behind the requirement that the original bid and offer rates be reversed should be clear if the original quotation is considered. In the original EUR/AUD quote, the dealer’s bid rate is the rate at which the dealer would buy the EUR. The other way of seeing that transaction is that if the dealer is buying the EUR, it is the AUD that is being sold; that is, ‘dealer buys EUR’ is equivalent to ‘dealer sells AUD’. Thus, the bid rate in the original quote is the number relevant to the offer rate in the transposed situation. If the ‘reverse’ rule is not observed, a quotation should immediately look incorrect. The resulting calculation would show the dealer’s buy rate to be higher than the sell rate.

15.5.4

C ALCULATING CROSS-RATES

Within the FX markets all currencies are quoted against the USD. There are two ways in which currencies can be quoted against the USD:

• •

a direct quote, where the USD is the unit of the quotation, or the base currency an indirect quote, where the USD is the terms currency and the other currency is the unit of the quotation.

Direct quotations (such as USD/JPY) are the most common in the FX markets; however, within the eurozone the euro is generally quoted as the base currency (EUR/USD). This also happens in most member countries of the Commonwealth, including the UK, Australia and Singapore. An exception is Canada, which quotes on a direct basis with the USD. When FX transactions take place between two currencies, where neither currency is the USD, it is necessary to calculate the cross-rate. For example, an importer may wish to calculate the EUR/JPY exchange rate. Assuming each currency is quoted against the USD, the calculation used in determining the cross-rate bid and offer rates will depend on whether the USD quotes are direct or indirect:

•

Direct quote the USD is the base currency in an FX quotation

Indirect quote a currency other than the USD is the base currency in an FX quotation

Cross-rate the exchange rate of two currencies, neither being the USD

Crossing two direct FX quotations (see Example 15.3 and Figure 15.2). — Step 1 Place the currency that is to become the unit of the quotation first. — Step 2 Divide opposite bid and offer rates; that is: — Step 3 Divide the base currency offer into the terms currency bid (this gives the bid rate). — Step 4 Divide the base currency bid into the terms currency offer (this gives the offer rate). 497

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EXAMPLE 15.3 Crossing two direct FX quotations: USD/EUR0.7250–55 USD/JPY81.40–50 To determine the EUR/JPY cross-rate: 81.40/0.7255 = 112.20 81.50/0.7250 = 112.41 EUR/JPY112.20–41

Figure 15.2  Calculating a cross-rate: direct FX quotations USD/new base currency

Bid

USD/new terms currency

Bid

USD/EUR

0.7250

USD/JPY

81.40

2

1

Offer Offer

2

1

0.7255 81.50

EUR/JPY112.20–41 1 First calculation: divide offer into bid 2 Second calculation: divide bid into offer

•

Crossing a direct and an indirect FX quotation (see Example 15.4). — Step 1 Multiply the two bid rates (this gives the bid rate). — Step 2 Multiply the two offer rates (this gives the offer rate).

•

Crossing two indirect FX quotations (see Example 15.5). — Step 1 Place the currency that is to become the unit of the quotation first. — Step 2 Divide opposite bid and offer rates; that is: — Step 3 Divide the terms currency offer rate into the base currency bid rate (this gives the bid rate). — Step 4 Divide the terms currency bid rate into the base currency offer rate (this gives the offer rate).

All the above different types of calculations may seem daunting, but within the FX markets, crossing two direct FX bid/offer rates is the most common situation. It is much easier to just remember the calculation for the two direct quotations. If a cross-rate is given in an indirect quote, simply transpose the quote to a direct quote using the ‘reverse and inverse’ rule that was discussed previously; then it is only necessary to follow the calculations in Example 15.3. Figure 15.2 gives a diagrammatic representation of the crossing of two direct quotes. Remember, the process requires the new base currency of the quotation to be placed first. 498

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EXAMPLE 15.4 Crossing a direct and an indirect FX quotation: GBP/USD1.6270–75 USD/NZD1.3292–97 To determine the GBP/NZD cross-rate: 1.6270 × 1.3292 = 2.1626 1.6275 × 1.3297 = 2.1641 GBP/NZD2.1626–41

EXAMPLE 15.5 Crossing two indirect FX quotations: AUD/USD0.7262–69 GBP/USD1.3270–75 To determine the AUD/GBP cross-rate: 0.7262/1.3275 = 0.5470 0.7269/1.3270 = 0.5477 AUD/GBP0.5470–77

REFLECTION POINTS

• • • • • • •

Participants in the global FX markets use standardised quotation conventions; for example, USD/AUD1.3569–75. The first-named currency (USD) is the base currency, or unit of the quote; the second-named currency (AUD) is the terms currency. The first figure (1.3569) is the dealer’s bid rate; that is, the dealer will buy one USD and give AUD1.3569; the second figure (1.3575) is the dealer’s offer rate; that is, the dealer will sell one USD and receive AUD1.3575. The difference in points between the bid and offer rates is the dealer’s spread. Common figures are not repeated in a quote; a quote with fewer than 10 units of the terms currency (as above) is quoted to four decimal places; a quote with more than 10 units is quoted to two decimal places. The above FX quote can be transposed to AUD/USD0.7366–69; the rule is reverse, then invert. Two sets of exchange rates that are quoted with the USD can be used to calculate a cross-rate: USD/AUD and USD/JPY to calculate AUD/JPY.

— Step 1 Place the currency that is to become the unit of the quotation first. — Step 2 Divide the base currency offer into the terms currency bid (this gives the bid rate). — Step 3 Divide the base currency bid into the terms currency offer (this gives the offer rate). 499

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15.6 LEARNING OBJECTIVE 15.6 Describe the role of the forward market and calculate forward exchange rates.

In addition to spot market transactions, foreign currencies may be bought or sold at a price determined today, but with delivery taking place at a specified date beyond spot. Such transactions are referred to as forward transactions. This section discusses:

• • •

the principles that underlie the calculation of forward points and a forward exchange rate the procedures to be adopted in calculating the forward points on an FX quotation some special matters that need to be taken into account when dealing with the first two issues.

15.6.1

Forward exchange rate the FX bid/offer rates applicable at a specified date beyond the spot value date

Interest rate parity principle that exchange rates will adjust to reflect interest rate differentials between countries

Forward market quotations

F ORWARD POINTS AND FORWARD EXCHANGE CONTRACTS

Just as there are particular conventions adopted in the expression of spot rates, so there are standard conventions employed in expressing the prices relevant to forward market transactions. The quotation of prices in the forward market is different from the practice in the spot market. First, the forward exchange rate varies from the spot exchange rate. Interest rate parity is the principle behind this variance. Interest rates vary from country to country, and the differential is therefore taken into account when calculating forward exchange rates. When obtaining a forward quotation, the market convention is to quote the spot rate and also to quote forward points for the forward exchange rate. The points will be at either a premium or a discount to the spot price. The forward exchange rate can be obtained by adding or subtracting the points to or from the quoted spot rate. Whether the points are added or subtracted will depend on whether the base currency is at a premium or a discount. In the following example it is assumed that a firm has a USD payable in six months’ time and that the firm is concerned that the AUD is going to depreciate relative to the USD. The firm decides to enter a forward exchange contract today, with a six-month delivery date, and telephones an FX dealer with the following request: ‘What is the AUD/USD spot and six-months forward?’ (Note: The firm has asked for an indirect quote where the AUD is the base currency.) The response the firm would receive would be something like: ‘The Aussie dollar is seventy-six thirty–forty, thirty-two–twenty-seven’. Recalling the conventions discussed in the previous section, this can be understood to mean that the spot rate is: AUD/USD0.7630–40 The other numbers (that is, 32 and 27) are the six-month forward points.

Forward points the forward exchange rate variation to a spot rate based on interest rate differentials

The points are then added to, or subtracted from, the spot rate. This, however, raises two questions:

• •

Where are the points to be located for the addition or subtraction process? Once correctly located, are the points to be added to, or subtracted from, the spot rates?

To solve the first question, line up the forward points underneath the last two decimal places of the spot bid and offer rates. Remember, the AUD/USD will be quoted to four decimal places as it has fewer than 10 units. An exchange rate with more than 10 units is quoted to only two decimal places. To determine whether to add or subtract the forward points, examine the points, and:

• •

if the points are rising (going from smaller to larger), add them to the spot rate if the points are falling (going from larger to smaller), subtract them from the spot rate. These rules can be demonstrated using the above quotation. Given AUD/USD (spot): 0.7630–40

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and six-month forward points: 0.0032–0.0027 then, since the forward points are falling, subtract them from the spot rate to obtain the six-month forward rate of: 0.7598–0.7613 If the spot and forward quotations are compared, it is evident that, today, the AUD is priced lower in the forward market than it is in the spot market. This situation is described as the base currency being at a forward discount. If the base currency of the quotation is priced higher in the forward market than it is in the spot market, it is described as being at a forward premium. It is possible to generalise as follows:

• •

If the forward points are falling at a specific forward date, the base currency is at a forward discount. If the forward points are rising at a specific forward date, the base currency is at a forward premium.

The forward points quoted in the above example were for a six-month forward contract. The forward points are almost always different for each delivery date. For example, the quote for a three-month forward exchange contract may have been AUD/USD0.7630–40, 17–15. Therefore, the three-month forward rate is AUD/USD0.7613–25. How does an FX dealer calculate forward points? The calculation of forward points is a function of the interest rate differentials between the two countries of an FX quote. The reference interest rates applied in the forward points calculation are generally taken from the eurocurrency market. (The eurocurrency market is discussed in Chapter 11.) For example, if forward points were to be calculated on a three-month forward exchange contract for the USD/CHF, the dealer would look at the interest rates on three-month eurodollars and three-month euroSwiss francs (CHF). As explained below, the dealer would use the relevant interest rates to calculate the points and then add or subtract the points from the USD/CHF spot rate. Another rule of thumb is that points are subtracted from the spot rate when the interest rate on the base currency is higher than the interest rate on the terms currency. When the interest rate of the base currency is lower, the points are added to the spot rate. Equation 15.2 gives a generalised formula to calculate forward points: 1 + ​​(​It × forward days/days in year​)​ ​Points = S​​ _____________________________ ​          ​ − 1​ ​ [1 + ​ ​(​Ib × forward days/days in year​)​ ]

Forward discount the forward exchange rate is less than the spot rate; interest rates in the base-currency country are higher than the terms-currency country

Forward premium the forward exchange rate is higher than the spot rate; interest rates in the terms-currency country are higher than the base-currency country

15.2

where: S = spot rate It = interest rate of terms currency Ib = interest rate of base currency

EXAMPLE 15.6 A company approaches an FX dealer for a forward quote on the USD/CHF with a three-month (90-day) delivery. The spot rate is USD/CHF1.1560. The dealer needs to calculate the forward points. Let us assume that the three-month eurodollar interest rate is 3.00 per cent per annum and the three-month euroSwiss franc interest rate is 4.00 per cent per annum. 1 + ​​(​0.04 × 90 / 360​)​ Points = 1.1560​​[_________________ ​    ​ − 1​]​ 1 + ​  ​     ​    ​(​0.03 × 90 / 360​)​ ​ ​ = 29 points The three-month forward rate is USD/CHF1.1589. The points are added to the spot rate because the interest rate in the base currency is lower than the interest rate in the terms currency. 501

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Forward exchange contract a contract that locks in the exchange rate on a currency pair that will apply at a future nominated date

Equation 15.2 and Example 15.6 do not take account of the different borrowing and lending interest rates that will apply in the euromarkets. An FX dealer will need to adjust the formula to take account of the different interest rates. A dealer may also incorporate a margin for costs and perhaps adjust the points to reflect the dealer’s overall relationship with the company and market competition. An FX dealer will quote forward points on standard delivery dates (usually monthly out to 12 months) of a specified amount of one currency against another currency. This is a forward exchange contract. What is the basis of using the interest rate differentials between the two currencies to calculate the forward points on a forward exchange contract? In our example of the three-month forward rate, the FX dealer does not know what the spot rate will be at that date; therefore the dealer will carry out the FX transaction today even though delivery will not occur until the future date. To carry out a buy transaction today, the dealer will need to borrow the funds in one market and then invest the purchased foreign currency in that market until delivery is due. The difference between the cost of borrowing the funds needed to buy the foreign currency and the return received on the invested foreign currency will be adjusted against the spot rate today. That is, the FX dealer will add or subtract the forward points as discussed above. Applying the data in Example 15.6, assume that a Swiss company has entered into a forward exchange contract with the FX dealer for delivery of USD1 million in three months. Today: 1 Buy USD1 million at the spot rate of 1.1560 (cost: CHF1 156 000). 2 Borrow CHF1 156 000 for three months at 4.00 per cent per annum (amount due: CHF1 167 560). 3 Invest the USD1 million in a three-month euro-deposit at 3.00 per cent per annum (at maturity: USD1 007 500). 4 The forward exchange rate = 1 167 560/1 007 500 = 1.1589 (29 forward points). In three months’ time: 5 Repay CHF borrowing. 6 FX dealer delivers USD. 7 Company makes CHF payment to the FX dealer based on the USD/CHF1.1589 forward exchange rate. In the above example the FX dealer has purchased the USD today at the spot rate, even though delivery to the customer was not required for another 90 days. The dealer therefore needs to finance the purchase of the USD today by borrowing CHF, while at the same time the dealer will invest the USD until they are required for delivery. The difference between the cost of borrowing the CHF and the return received on the invested USD will be reflected in the forward exchange rate. The forward exchange rate is a function of the spot rate, plus or minus the net interest rate differential of the two countries, adjusted for the number of days. Forward exchange contracts may be used to hedge FX risk associated with international trade and capital-market transactions. Chapter 17 explores FX risk identification and management, including the use of forward exchange contracts to manage FX risk exposures.

15.6.2 LEARNING OBJECTIVE 15.7 Identify factors that complicate FX market price quotations and calculations.

S OME REAL-WORLD COMPLICATIONS

Before concluding, it is important to emphasise that both the example and the formula used above are simplified illustrations. The real-world financial markets are a little more complex. However, the principles outlined are exactly those that prevail in reality. Some of the complexities that have to be incorporated into calculations include:

• • • •

two-way FX quotations different interest rate year conventions borrowing and lending interest rates compound interest period.

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Two-way FX quotations FX dealers quote both bid and offer rates on a pair of currencies. FX quotations are given as the rate at which the dealer will buy the base currency, and the rate at which the dealer will sell. In calculating the forward points, the dealer must be careful in selecting the appropriate bid and offer rates. Examples of the FX bid and offer conventions and their application to transposing a quote, calculating a cross-rate and calculating forward points have been provided throughout the chapter.

Different interest rate year conventions It was noted previously that some interest rates are quoted on the basis of a 360-day year, while others are quoted on the basis of a 365-day year. For example, the USA, Japan and Europe calculate interest based on the 360-day convention, whereas most Commonwealth countries, including the UK, Australia and New Zealand, use the 365-day convention. When interest rates are based on different conventions, it is necessary to convert one or other rate so that the two are comparable. For example, an FX dealer may need to calculate a forward exchange rate for JPY/NZD, where the interest rate is 2.00 per cent in Japan and 7.00 per cent in New Zealand. The dealer would need to adjust one of the rates to allow for the different quotation conventions. The dealer would adjust only one of the interest rates, such that either:

•

the New Zealand interest rate of 7.00 per cent per annum became: 7.00% × 360/365 = 6.9041% p.a. on a 360-day basis; or

•

the Japan interest rate of 2.00 per cent per annum became: 2.00% × 365/360 = 2.0278% p.a. on a 365-day basis.

Borrowing and lending interest rates In Section 15.6.1 forward points were calculated on a forward exchange contract. At that time it was noted that, when calculating forward points, an FX dealer must recognise borrowing and lending interest rate margins when calculating the interest rate differential which forms the basis of the forward points calculation. The generalised formula given in Equation 15.2 can be extended to take account of the appropriate borrowing and lending interest rates, as shown in Equation 15.3 and Equation 15.4. Calculating bid forward points: 1 + ​​(​I ​tbid ​  ​ × forward days/days in year​)​ ​Bid forward points = S ​​ ________________________________ ​          ​ − 1​ ​ [1 + ​(​ ​I ​boffer ​  ​ × forward days/days in year​)​ ]

15.3

Calculating offer forward points: 1 + ​(​ ​I ​toffer ​  ​ × forward days/days in year​)​ ​Offer forward points = S ​​ ________________________________ ​      ​ − 1​ ​ [1 + ​​(​I ​bbid ​  ​ × forward days/days in year​)​ ]

15.4

EXAMPLE 15.7 A company approaches an FX dealer for a forward quote on the USD/CHF with a three-month (90-day) delivery. The spot rate is USD/CHF1.1555–60. The dealer needs to calculate the forward points. Let us assume that the three-month eurodollar bid and offer interest rates are 3.00 per cent and 3.30 per cent continued

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Part 5 The foreign exchange market continued

per annum and the three-month euroSwiss franc interest rates are 3.70 per cent and 4.00 per cent per annum respectively. Bid forward points: 1 + ​​(​0.037 × 90 / 360​)​ Bid forward points = 1.1555​​[__________________ ​    ​ − 1​]​ ​       ​  ​    ​(​0.033 × 90 / 360​)​ ​ 1 + ​ ​ = 11 points Offer forward points: 1 + ​​(​0.04 × 90 / 360​)​ Offer forward points = 1.1560​​[​ _________________    ​ − 1​]​ ​       ​  ​    ​(​0.03 × 90 / 360​)​ ​ 1 + ​ ​ = 29 points The forward points are rising so they will be added to the spot rate. Therefore, the three-month forward exchange rate will be USD/CHF1.1566–89.

Compound interest period A final complication also relates to interest rate quotations. In addition to the 360-day or 365-day conventions, the interest-compounding period varies somewhat between countries. This may be a problem, especially in calculating forward points for delivery dates beyond 12 months. Chapter 8 shows that the more frequent the interest compounding period, that is, the more frequently interest is added to the principal, the higher the effective rate of interest becomes. This must be taken into account in determining the true cost of borrowed funds and the effective value of deposits. Therefore, the effective rate of interest should be used in the calculation of the forward points.

REFLECTION POINTS

• • • •

•

With a forward rate, the dealer will quote the spot rate and forward points; for example, AUD/ USD0.7647–50, 28–32. If the points are rising (as above), they are added to the last decimal places of the spot rate (AUD/USD0.7675–82); if they are falling, they are subtracted. A dealer calculates the forward points based on the relevant interest rate differentials between the two countries; that is, the dealer will carry out the FX transaction today at the spot rate, calculate the cost of funding the transaction (local interest rate), then invest the foreign currency (overseas interest rate) until the forward delivery date. The calculation of forward points is: 1 + ​​(​I ​tbid ​  ​ × forward days/days in year​)​ ​Bid forward points​  =​  S ​​ ​ ________________________________            ​ − 1​ ​ [1 + ​​(​I ​boffer ​  ​ × forward days/days in year​)​ ]

15.3

1 + ​​(​I ​toffer ​  ​ × forward days/days in year​)​ ​Offer forward points​  =​  S ​​ ​ ________________________________       ​ − 1​ ​ [ 1 + ​​(​I ​bbid ] ​  ​ × forward days/days in year​)​

15.4

The calculation of forward points also needs to consider interest rate year conventions (360day year or 365-day year), deposit versus borrowing interest rates and the frequency of compounding of interest rates.

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Chapter 15  Foreign exchange: the structure and operation of the FX market

15.7

Economic and Monetary Union of the EU and the FX markets

In December 1991, the European Heads of Government Council agreed to a ‘treaty on European union’—the Maastricht Treaty—which took effect in November 1993. The vision of the Maastricht Treaty was progressively to create an economic and monetary union within Europe. The objective of economic union, through the creation of a single market, is to allow the free flow of goods, services, labour and capital between member states. Although this may seem like ‘ancient history’, the EU and the EMU continues to evolve and shape the world’s financial markets. The EMU and the birth of a new single currency, the euro, took effect on 1 January 1999. By 2018, 28 countries were members of the European Union (EU). In 2018, the UK remained a full member but plans to exit the EU. As Table 15.1 demonstrates, only 17 member states have adopted the euro as their nation’s currency. All 28 member states of the EU are members of the EMU and almost all of the countries that have not yet adopted the euro as their currency have committed to adopting it in time (or once they fulfil certain criteria). The UK never committed to adopting the euro. The EMU involved the establishment of the European Central Bank, which is responsible for the determination and implementation of EU monetary policy. The European Central Bank was also responsible for the determination of the irrevocable exchange rates at which member states’ currencies were converted into the euro.

LEARNING OBJECTIVE 15.8 Recognise the important impact on the FX markets of the Economic and Monetary Union of the European Union (EMU).

Table 15.1 European Union member states and the EMU (as at 1 January 2018) Member states that have adopted the euro

Member states with no commitment to adopting the euro

Member states who have not completed the ‘third stage’ of EMU membership (including adopting the euro)

Austria

Denmark

Bulgaria

Belgium

United Kingdom

Czech Republic

Cyprus

 

Hungary

Estonia

 

Latvia

Finland

 

Lithuania

France

 

Poland

Germany

 

Romania

Greece

 

Sweden

Ireland (the Republic of)

 

Croatia

Italy

 

 

Luxembourg

 

 

Malta

 

 

Netherlands (the)

 

 

Portugal

 

 

Slovakia

 

 

Slovenia

 

 

Spain

 

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Hard currency currencies, including the USD, JPY, GBP and EUR, which are generally accepted in international trade and financial transactions

The euro was initially introduced as a currency in which financial instruments could be denominated. Euro notes and coins were later issued into circulation on 1 January 2002, and the domestic currencies of initial participating member countries ceased to be legal tender on 30 June 2002. The implementation of the EMU has created a major economic and financial bloc, with the group of countries who have completed their membership of the EMU often referred to as the eurozone, which has the capacity to compete directly with the largest markets of the USA. The size and liquidity of euro equity and debt markets has increased as euro-denominated securities have gained prominence and acceptance within the global financial markets. The single currency has removed the need for the existence of separate markets within each member state, and strategic alliances are being formed between different stock exchanges and derivative exchanges of EU member countries. The EMU has resulted in a rationalisation of institutions and markets within the EU. The most obvious impact of the EMU is its effect on the FX markets. To date, the EMU has removed 17 foreign currencies from the FX markets and introduced the single euro. This effect will increase as new member states also join the EMU in the future. The USD is the dominant global currency, with approximately 50.00 per cent of international commodity trade transactions and 80.00  per  cent of international financial transactions being denominated and settled in USD. Other important global currencies are the yen (JPY) and pound sterling (GBP). The euro has now also become a new global currency—a hard currency used for international trade and financial transactions. Central banks around the world support the euro, in that each central bank holds some of its foreign reserves in euro. Another flow-on effect of the introduction of the euro has been an increase in the liquidity of the euro FX market and other FX markets around the globe. With the removal of EMU member currencies, FX market participants now look to other FX markets to conduct their trading of foreign currencies. Given the economic and financial consequences that emerged with the currency crises of the late 1990s (particularly in Thailand, Indonesia and Malaysia), central banks will be concerned with any future changes in FX market trading and speculation. The euro has reduced FX currency risk that previously was associated with financial transactions between the majority of EU member states. Finally, the euro-denominated capital markets are flourishing; significant debt issues have been successfully issued into the international capital markets by corporations, financial institutions and governments.

REFLECTION POINTS

• •

The Economic and Monetary Union of the European Union (EMU) has changed the structure of the FX markets; 17 currencies have disappeared and been replaced by the euro (EUR); other countries will also join the EMU in the future. The euro has become a hard currency; that is, it is widely used in international trade and capital transactions; other hard currencies include the US dollar (USD), the pound sterling (GBP) and the Japanese yen (JPY).

CASE STUDY FIXED EXCHANGE RATES AND CURRENCY MISALIGNMENTS We learned in this chapter that countries might adopt either a fixed or floating exchange rate regime. An important question, of course, is which is better? One way to answer this question is to see whether currencies are more or less aligned with ‘equilibrium values’ under one regime or the other. It might be the case that a fixed exchange rate regime maintains a closer alignment with equilibrium because market fluctuations are smoothed out. On the other hand, it might be that a floating exchange rate regime 506

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Chapter 15  Foreign exchange: the structure and operation of the FX market

In recent years, a situation has emerged in FX markets that provides an opportunity to test which exchange rate regime is more effective in generating alignment between a currency’s value and its ‘equilibrium’ value. Over the past decade or so, countries such as Brazil, Russia, India, Indonesia, China and South Africa (BRIICS) have moved towards floating exchange rate regimes. By defining a currency’s equilibrium value as the value at which a balance of payments is achieved, Giannellis and Koukouritakis (2018) investigated whether the market value of these currencies (real, ruble, rupee, yuan and rand) has more closely approximated equilibrium since the move towards floating exchange rates. The researchers concluded that a move towards freely floating exchange rates and a more liberal exchange rate policy practised by the Chinese government has resulted in a reduction in currency misalignments with equilibrium values. Indeed, misalignment rates are now no higher than 2.00 per cent, whereas before under or overvaluations of up to 20.00 per cent were observed (Giannellis & Koukouritakis, 2018). References Giannellis, N & Koukouritakis, M 2018, ‘Currency misalignments in the BRIICS countries: Fixed vs. floating exchange rates’, Open Economies Review, pp. 1–29.

Discussion points

•

CHAPTER FIFTEEN REVIEW

leads to quicker and more accurate adjustment to equilibrium because chronic under or overvaluations introduced by fixed or pegged exchange rate regimes are removed (Giannellis & Koukouritakis, 2018).

Can we argue, based on the evidence presented by Giannellis and Koukouritakis, that a floating exchange rate regime is better?

Master before you move on LEARNING OBJECTIVE 15.1 Understand the nature, size and scope of the global FX markets and the main exchange rate regimes used by different countries.

• • • • • •

FX markets exist wherever transactions are denominated in a foreign currency, including international trade transactions, cross-border capital transactions, speculative transactions and central bank transactions. The FX markets operate through a highly sophisticated network of telecommunications systems that link the numerous FX dealers and FX brokers located in all of the major cities of the world. An exchange rate is the value of one currency relative to another currency. Each country, or group of countries within a monetary union, is responsible for determining the form of their exchange rate. Most major currency exchange rates are determined using a floating exchange rate regime, including the currencies of the USA, UK, EMU, Japan, Australia and New Zealand. A floating exchange rate is determined by factors that affect the supply and demand of currencies within the FX market. Countries such as China, Singapore, Malaysia and Indonesia operate a managed exchange rate regime, whereby the exchange rate is allowed to move within a defined range relative to a specified major currency or basket of currencies.

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• •

A crawling peg exchange rate regime allows the currency to appreciate over time, but within a limited range determined by the government and/or central bank. A major difference between a managed float and the crawling peg is that market participants generally agree that a currency using the crawling peg is typically undervalued. This may in fact describe the regime used in China. With a linked exchange rate regime, as used by Hong Kong, the exchange rate is locked into a ratio with a nominated currency, such as the USD, or a basket of currencies.

LEARNING OBJECTIVE 15.2 Identify and discuss the major groups of participants in the FX markets.

• • •

Participants in the FX markets include those who have underlying commercial and financial transactions denominated in foreign currencies. This includes importers and exporters, and those investing or borrowing overseas in a currency other than their home currency. In addition, there are speculators who buy and sell foreign currencies in the expectation of making profits from favourable exchange rate movements, and there are those who arbitrage exchange rate and/or international interest rate differentials across the different international markets. Central banks also enter the FX markets as buyers and sellers of foreign currency. A central bank may enter the FX market in order to provide its government’s foreign currency requirements or, from time to time, in an attempt to influence the value of a currency in the market or to adjust its foreign currency reserve portfolio.

LEARNING OBJECTIVE 15.3 Describe the functions and operations of the FX markets.

• • •

The FX markets operate somewhere around the globe 24 hours a day. The markets are dynamic, with exchange rates changing in response to the continuous flow of economic, political, financial and social news and information into the markets. It is estimated that around the equivalent of USD5 trillion pass through the FX markets each day, facilitated by FX dealing rooms that use sophisticated, technology-based computer and communication systems.

LEARNING OBJECTIVE 15.4 List and explain the types of FX transactions, in particular spot and forward transactions.

• • • •

The contracts that are traded in the FX markets are distinguished by their maturity or delivery dates. Spot and forward contracts are the most common contracts traded. Spot transactions have a value date that is two business days from today; that is, they require delivery of the foreign currency and financial settlement two business days from the contract date. Forward contracts specify a value date more than two business days from today.

LEARNING OBJECTIVE 15.5 Introduce the conventions adopted for the quotation and calculation of spot exchange rates.

• • • •

Because of the technology-based nature of the trade in foreign currencies, universal conventions are adopted in the FX markets. For example, a spot quote may be AUD/USD0.7550–56. The first-named currency in an FX quote is called the unit of the quotation, or the base currency. The base currency represents one unit of the currency. The second-named currency is known as the terms currency.

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Chapter 15  Foreign exchange: the structure and operation of the FX market

• • • • • • • •

FX dealers, or price-makers, quote two-way rates: the first and lower rate is the one at which the dealer buys the base currency; the second and higher rate is the one at which the dealer sells the base currency. FX dealers will abbreviate their verbal FX quotes by removing decimal points and not repeating common numbers. Exchange rates with less than 10 units of the terms currency are quoted to four decimal places, and currencies with more than 10 units are quoted to only two decimal places. The spread is the difference between the bid and offer rates. A point is the final decimal place in a quote. It is possible to derive a range of additional exchange rates on the basis of existing published rates; for example, transposed and cross-rates can be calculated. To transpose a quote from, say, a direct USD/AUD quote to an indirect AUD/USD quote, the rule is to reverse the quote and then invert by dividing into 1. As all currencies are quoted against the USD, it is often necessary to calculate a cross-rate that does not incorporate the USD, such as SGD/NZD. To calculate the cross-rate for two direct quotes, place the new base currency quote first, followed by the second quote. Simply divide opposite bid and offer rates to obtain the cross-rate.

LEARNING OBJECTIVE 15.6

CHAPTER FIFTEEN REVIEW

•

Describe the role of the forward market and calculate forward exchange rates.

• • • • • •

The convention adopted in the quotation of forward rates is that the dealer quotes the forward points rather than the outright forward rates. To obtain the outright rate, the forward points are added to, or subtracted from, the spot rate. In calculating the forward points, the dealer uses the spot rate and the differential rates of interest of the two countries whose currencies are quoted. When the interest rates of the base-currency country are higher than interest rates in the termscurrency country, then the base currency will be at a forward discount and the forward points are subtracted from the spot rate, or vice versa. If the forward points are rising, they are added to the spot rate and vice versa. The calculation of forward points is: 1 + ​​(​I ​tbid ​  ​ × forward days/days in year​)​ ​Bid forward points​  =​  S ​​ ​ ________________________________            ​ − 1​ ​ [ 1 + ​​(​I ​boffer ​  ​ × forward days/days in year​)​ ]

15.3

1 + ​​(​I ​toffer ​  ​ × forward days/days in year​)​ ​Offer forward points​  =​  S ​​ ​ ________________________________       ​ − 1​ ​ [ 1 + ​​(​I ​bbid ​  ​ × forward days/days in year​)​ ]

15.4

LEARNING OBJECTIVE 15.7 Identify factors that complicate FX market price quotations and calculations.

•

We need to consider real-world complications that affect the calculation of forward points and a forward exchange rate. These include:



— different interest rate year conventions; for example, the USA uses a 360-day year while the UK uses a 365-day year



— two-way quotations (bid and offer quotes)



— different borrowing and lending interest rates



— the effects of compounding periods. 509

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LEARNING OBJECTIVE 15.8 Recognise the important impact on the FX markets of the Economic and Monetary Union of the European Union (EMU).

• • •

The Economic and Monetary Union has had a significant impact on the structure and operation of the FX markets. Seventeen foreign currencies have been replaced by a single currency, the euro. The euro has become a hard currency for commercial and financial transactions and a major currency traded in the FX markets.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Discuss the potential impact on financial markets, especially FX markets, of the United Kingdom’s exit from the EU. (LO 15.1)

2

As we have seen, the world’s foreign exchange markets are characterised by a mixture of fixed and floating exchange rate regimes.

(a) Use your research skills to find out which European countries operate a fixed exchange rate regime. Identify some of the economic advantages that may be associated with maintaining such a system.

(b) Discuss why China, as a major trading country, might move to adopt a floating exchange rate regime. (LO 15.1)

3

Importers, exporters, investors and borrowers may all be participants in the FX markets. Explain why each of these parties would be involved in FX market transactions. (LO 15.2)

4

(a) Distinguish between speculative and arbitrage transactions in the FX market.



(b) The FX dealing room of a major bank has calculated that it is long in the USD, but is short in the EUR. Explain what is meant by these positions.



(c) Describe arbitrage transactions, using an example of a triangular arbitrage. (LO 15.2)

5

Many developed economies operate within a floating exchange rate regime. Where a country has a floating exchange rate, identify and discuss the circumstances in which the central bank of that country might conduct transactions in the FX market. (LO 15.2)

6

Outline the impact that communications technology has had on the development of a global FX market and discuss some of the operational risk factors that banks and financial institutions might need to consider in such a context. (LO 15.3)

7

Outline the features of the main types of contracts that are created in the FX markets, distinguishing between short-dated, spot and forward transactions. (LO 15.4)

8

The following is a quote from the FX Global Code, which applies to traders in the FX market in Australia and around the world: ‘Market participants involved in electronic trading should put in place appropriate and proportionate controls to reduce the likelihood of and mitigate any consequences of generating or acting upon electronic quotations that may result in erroneous transactions or market disruption such as off-market quotes or trades, fat finger errors, unintended or uncontrolled trading activity arising from technological failures, flaws in trading logic, and unexpected or extreme market conditions.’ In light of our discussion of the operation of the FX markets, discuss the importance of this statement. (LO 15.3)

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Chapter 15  Foreign exchange: the structure and operation of the FX market

Using the context of the currency pair USD/JPY, explain the terms base currency, terms currency, direct quotation and indirect quotation. (LO 15.5)

10 An FX dealer is quoting spot USD/SGD1.2750–56.

(a) Explain from the perspective of the dealer what the FX quote indicates.



(b) Transpose the quotation. (LO 15.5)

11 A men’s fashion label in the UK is exporting goods to Denmark. In order to ascertain the firm’s exposure to foreign exchange risk, the company needs to calculate the GBP/DKK cross-rate. An FX dealer quotes the following rates: USD/DKK 5.4031–37 USD/GBP 0.6063–69 Calculate the GBP/DKK cross-rate. (LO 15.5) 12 A Swiss manufacturer generates receipts in USD from its exports of chocolate to America. At the same time, the company imports cocoa from Nigeria, incurring commitments in NGN (naira). Rates are quoted at: USD/NGN 162.2520–29 CHF/USD 1.1310–19 Calculate the CHF/NGN cross-rate. (LO 15.5)

CHAPTER FIFTEEN REVIEW

9

13 A German importer has entered into a contract under which it will require payment in GBP in one month. The company is concerned at its exposure to foreign exchange risk and decides to enter into a forward exchange contract with its bank. Given the following (simplified) data, calculate the forward rate offered by the bank. Both countries use a 365-day year; assume 30-day contract. (LO 15.6) EUR/GBP (spot):

0.8260–67

One-month German interest rate:

4.75% p.a.

One-month UK interest rate:

3.25% p.a.

14 While the FX markets are a global market, variations in calculation conventions can occur. When considering interest rate differentials and forward exchange rate calculations between currencies such as the USD and the GBP, what important adjustments need to be taken into account? (LO 15.7) 15 The establishment of the Economic and Monetary Union has had a significant impact on the structure and operation of the global FX markets.

(a) Discuss the process of monetary union in Europe and the issues relevant to the FX markets that are implied in the above statement.



(b) Discuss the ways in which the continued evolution of the EMU may shape FX markets in the future. (LO 15.8)

KEY TERMS arbitrageur 491

the City  486

exchange rate  487

ask price  496

clean float  489

floating exchange rate  487

Bank for International Settlements (BIS)  486

crawling peg  488

forward discount  501

cross-rate 497

base currency  495

direct quote  497

forward exchange contract 502

bid price  496

dirty float  489

forward exchange rate  500

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forward points  500

spread 496

forward premium  501

linked exchange rate regime 488

forward transaction  493

long position  491

terms currency  495

FX brokers  489

managed float  487

tod value transactions  494

FX dealers  489

offer price  496

tom value transactions  494

FX dealing room  492

official reserve assets  489

two-way prices  489

FX markets  488

point 496

unit of the quotation  495

hard currency  506

price-maker 496

value date  493

indirect quote  497

short position  491

interest rate parity  500

spot transaction  493

SWIFT 486

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CHAPTER 16

Foreign exchange: factors that influence the exchange rate CHAPTER OUTLINE 16.1 The FX markets and an equilibrium exchange rate 16.2 Factors that influence exchange rate movements 16.3 Measuring exchange rate sensitivity to changes in economic variables

Learning objectives LO 16.1

Explain how factors that affect the demand for a currency, or the supply of a currency, affect the determination of an equilibrium exchange rate.

LO 16.2

Understand how the major factors that influence exchange rate movements operate, particularly:

— relative inflation rates — relative national income growth rates — relative interest rates — exchange rate expectations

— central bank or government intervention.

LO 16.3

Explore regression analysis as a statistical technique applied to variables that impact on an exchange rate.

Extended learning LO 16.4

Apply purchasing power parity concepts and calculations to the determination of foreign exchange risk measurement.

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CHAPTER SNAPSHOT The FX markets are large and complex but, once more, we find that the fluctuations in prices (FX rates) are due to risk, reward, supply and demand. In turn, these factors are influenced by expectations about international trade and capital flows. For example, in a growing world economy with strong demand for raw materials, we might expect demand for Australian iron ore and coal to increase. To purchase Australian iron ore and coal, customers require Australian dollars. When they purchase these Australian dollars using some other currency, the rate at which the Australian dollar exchanges for other currencies may be expected to increase. That is, demand goes up and the price goes up.

INTRODUCTION The previous chapter discussed the foreign exchange (FX) markets—how they are structured, the important conventions used in the markets, and how participants carry out transactions. We also recognised that exchange rates are constantly changing as new information comes to the FX markets. To gain an understanding of the impact of new information on exchange rates, this chapter identifies the main factors that affect the equilibrium value of currencies on the FX markets. Several factors can be identified that have an important effect on changes in the value of a currency. However, a number of these factors may change at the same time and their influences may well act in opposing directions, rendering analysis of these factors difficult. A further complication is that, at any point in time, the most critical determinant of the FX value of a currency is the expectations that market participants hold about the future value of the currency. One or more of these factors can cause the value of a currency to increase or decrease. When a currency increases in value relative to another currency, for example, if the AUD/USD moves from 0.7207–12 to 0.7225–29, it is said that there has been an appreciation of the currency. On the other hand, if the currency falls in value it is said that there has been a depreciation of the currency. In the first part of this chapter the exchange rate is presented as the price that equates the demand and supply of a currency in the FX markets. This can be depicted by a graph where the equilibrium exchange rate is the price of a currency at the point where the demand and supply curves intersect. A change in the demand or supply will cause a change in the equilibrium exchange rate. The second part of this chapter identifies major factors that influence the equilibrium price for a currency. These include relative rates of inflation, relative income levels, relative interest rates, exchange rate expectations and central bank intervention. This is followed by a brief discussion of how regression analysis as a technique may be used to measure the sensitivity of the exchange rate to changes in the main factors that affect an exchange rate. Finally, the Extended learning section at the end of this chapter explores the proposition of purchasing power parity.

REFLECTION POINTS

exchange rate is the value of one currency relative to another. With a floating exchange rate • An regime, past information is reflected in an exchange rate and new information coming to the market will impact upon the exchange rate. factors that affect an exchange rate and being able to apply this knowledge in • Understanding an attempt to forecast exchange rate movements is important to participants in the FX markets. an exchange rate increases, there has been an appreciation in the currency; a fall in the • When exchange rate is a depreciation of the currency. 514

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Chapter 16   Foreign exchange: factors that influence the exchange rate

16.1

The FX markets and an equilibrium exchange rate

The exchange rate represents the price of one currency in terms of another. For example, an FX dealer’s bid/offer rates of USD/EUR0.8850–55 mean that the dealer will buy USD1 for EUR0.8850 and will sell USD1 for EUR0.8855 (see Chapter 15). This study assumes the existence of a floating exchange rate under normal conditions, with no central bank intervention. In Chapter 15 we identified that the participants in the FX markets—including FX dealers and brokers, importers, exporters, investors, borrowers, central banks, speculators and arbitrageurs— carried out FX transactions with an equivalent value of over USD5 trillion every day. Therefore, any small movement in exchange rates will have a significant financial impact on market participants. Unexpected movements in exchange rates have the potential to wipe out future profits on commercial and financial transactions conducted in the international markets. For example, if we observe year-onyear changes in the AUD/USD exchange rate, we see that there have been significant movements in the exchange rate. June 2008 June 2009 June 2010 June 2011 June 2012 June 2013 June 2014 June 2015 June 2016 June 2017 June 2018

LEARNING OBJECTIVE 16.1 Explain how factors that affect the demand for a currency, or the supply of a currency, affect the determination of an equilibrium exchange rate.

AUD/USD0.9626 AUD/USD0.8114 AUD/USD0.8523 AUD/USD1.0739 AUD/USD1.0237 AUD/USD0.9132 AUD/USD0.9273 AUD/USD0.7705 AUD/USD0.7447 AUD/USD0.7688 AUD/USD0.7643

While the above year-on-year exchange rates clearly demonstrate the changes in exchange rates that occur, it should be noted that exchange rates are changing continuously throughout each trading day, and in periods of market uncertainty they become quite volatile.

16.1.1

D EMAND FOR A CURRENCY

Figure 16.1 provides a conceptual demand curve for a local currency. It shows the quantity of the local currency demanded at a range of prices. The curve is downward sloping, since it is reasonable to expect that the cheaper the local currency, the greater would be the demand for the currency by the rest of the world. A principal reason why there is a demand for currencies in the FX market is to purchase goods, services and financial assets that have a price denominated in a foreign currency. The parties to a transaction need to buy or sell the currency in order to complete the transaction. From the point of view of the rest of the world, a fall in the exchange rate of a country’s currency is equivalent to a reduction in the price of goods, services and financial assets in that country. It is reasonable, therefore, to expect more of those goods, services and financial assets to be demanded, with a consequent increase in the quantity of the local currency demanded in the FX markets.

16.1.2

S UPPLY OF A CURRENCY

The curve showing the supply of a local currency on the FX market is provided in Figure 16.2. It shows the quantity of the local currency offered for sale at various prices. 515

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Price or value of the currency

Figure 16.1  The demand curve for a currency

D

Quantity of currency

Figure 16.2  The supply curve for a currency

Price or value of the currency

S

Quantity of currency

The supply curve is upward sloping; the reason for this is that the supply of a local currency in the FX markets occurs when holders of that currency buy foreign currency. As the price of the local currency increases in the FX markets, the relative prices of foreign currencies fall; and therefore the price of all goods, services and financial assets denominated in foreign currencies also falls. The demand (from holders of the local currency) for those goods, services and financial assets can be presumed to increase, and with it the demand for the foreign currencies. Therefore, the quantity of the local currency supplied to the FX markets increases. The converse position also holds. As the price of the local currency declines, the supply curve shows that less will be supplied. A decline in the price of the local currency is equivalent to an increase 516

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in the price of foreign currencies. Holders of the local currency will perceive the price of foreign goods, services and financial assets as having increased, and thus they will demand fewer of them. As the demand for foreign goods, services and financial assets declines, the demand for foreign currencies will also decline; that is, there will be a smaller quantity of the local currency supplied to the market.

16.1.3

E QUILIBRIUM EXCHANGE RATE

The demand and supply curves are brought together in Figure 16.3, which shows the unique exchange rate at which both the demand and the supply of a local currency will be satisfied. This unique exchange rate occurs where the demand and supply curves intersect. Only at that rate is the quantity of the currency supplied to the market equal to the demand for the currency. This rate is the market clearing rate or the equilibrium exchange rate. Unless there is a change in either the demand curve or the supply curve, this exchange rate will prevail; any price other than the equilibrium rate is not sustainable.

Price or value of the AUD (AUD/USD)

Figure 16.3  The equilibrium exchange rate

Equilibrium exchange rate the exchange rate at the point where the demand and supply curves intersect

S 0.8100

0.7800

Equilibrium

0.7500

D 20 billion

40 billion

Quantity of AUD

The data incorporated into Figure 16.3 will help to understand the concept of an equilibrium rate. In the figure an indirect AUD/USD quote is applied. The equilibrium exchange rate is AUD/USD0.7800. If, however, the actual exchange rate was AUD/USD0.7500, the quantity of AUD demanded would be $40 billion, but only $20 billion would be supplied, leaving an excess demand for the AUD. There would be a large number of frustrated demanders of the AUD. FX dealers would not be able to meet the demands of their clients and clients would have to instruct their FX dealers to offer a higher price. The higher price would have a twofold effect: first, as the price of the AUD was bid up, the quantity supplied would increase; and, second, some of those who demanded the AUD at USD0.7500 would withdraw from the market as the price rose. The combined effect of the increase in price would be to reduce the excess demand. The price would continue to be bid up to a rate of AUD/USD0.7800, at which point there is no pressure in the marketplace for the price to change further. Had the above exercise started with a price of, say, AUD/USD0.8100, the market would experience an excess supply of AUD. Those wanting to sell (supply) the AUD in excess of the quantity being demanded would have to instruct their FX dealers to offer the AUD for sale at a lower price. The lower price would cause adjustments in the quantities demanded and the quantities supplied. Only when the price reaches AUD/USD0.7800 would the excess supply pressure be eliminated. 517

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Given the demand and supply curves presented in Figure 16.3, the exchange rate would remain settled at AUD/USD0.7800; but this conclusion stands only while the demand and supply curves remain where they are. However, factors that determine the positions of the demand and supply curves will change over time, and thus the equilibrium exchange rate will also change. The next section identifies some of the important factors that influence the positions of the demand and supply curves.

REFLECTION POINTS

a floating exchange rate regime the exchange rate is determined by the demand for and • Insupply of a currency. demand for a currency is represented by a downward-sloping curve. A lower exchange • The rate will increase the competitiveness of a country’s exports, thus attracting buyers of the local currency in order to purchase those goods, services and financial assets. supply of a currency is represented by an upward-sloping curve. As the local currency • The appreciates, the relative cost of foreign currencies fall, thus attracting sellers of the local currency (i.e. buyers of the foreign currency). equilibrium exchange rate is at the intersection of the demand and supply curves. In an • The efficient market any other exchange rate would result in an increase in either demand or supply, thus maintaining the equilibrium exchange rate.

16.2 LEARNING OBJECTIVE 16.2 Understand how the major factors that influence exchange rate movements operate, particularly relative inflation rates, relative national income growth rates, relative interest rates, exchange rate expectations and central bank or government intervention.

Factors that influence exchange rate movements

In Section 16.1 we saw the significant changes that have occurred in the AUD/USD exchange rate over recent years. Exchange rates are much more dynamic in that they are changing throughout every trading day. The level of volatility in exchange rates also changes depending on the impact of information coming to the FX markets. An understanding of the dynamics of exchange rates may be gained by examining the main factors that influence exchange rate movements. These are:

• relative inflation rates • relative national income growth rates • relative interest rates • exchange rate expectations • central bank or government intervention. 16.2.1

R ELATIVE INFLATION RATES

The most enduring hypothesis advanced to explain changes in the equilibrium exchange rate between a pair of currencies relies on changes in the rates of inflation in the two countries. Consider what would happen in a textbook world if, for example, Australia and the USA had been experiencing similarly low rates of inflation, and then the USA experienced a substantial and prolonged increase in its inflation rate. What would happen to the AUD/USD demand and supply curves shown in Figure 16.3? First, the price of goods and services manufactured in the USA would increase in USD terms, and therefore Australian demand for those goods and services would decline. As a consequence, there would be a reduction in Australian demand for the USD. Recall that a reduction in the demand for 518

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Figure 16.4 Effect of increased foreign inflation on the equilibrium exchange rate

Price or value of the AUD (AUD/USD)

S1

S0

D1

D0

Quantity of AUD

the USD is the equivalent of a reduction in the supply of AUD on the FX market. This change is represented in Figure 16.4 by the movement in the supply curve from ​​S0​ ​​  to  ​S1​ ​​​. In addition, the surge in US inflation would cause US residents to search for relatively cheaper goods and services in the rest of the world. Since, in this example, Australia’s rate of inflation is less than that in the USA, some of the US demand for goods and services would switch to the relatively cheaper Australian items. This means that there would be an increased demand for the AUD, shown as a new demand curve, ​​D1​ ​​​, in Figure 16.4. The increased demand for the AUD, combined with the reduced supply, would cause an increase in the price of the AUD, that is, an appreciation of the currency. (The above discussion is based on the assumption that there will be no offsetting US government intervention or policy changes designed to lower the rate of inflation. This will be discussed later in the chapter.) Repeat the above exercise using a country of your choice; for example, forecast the impact on the Indian rupee (INR) of an increase in India’s inflation while that of Japan remains stable. Trace through the effects on the demand and supply curves for the INR, bring both movements together into a single supply and demand graph similar to that in Figure 16.4 and identify the new equilibrium rate. If correct reasoning has been followed, it will be apparent that the INR will fall in price; that is, the currency will depreciate relative to the JPY. The precise movement in the value of a currency cannot be determined in the two situations above, because not enough information has been provided. However, logic requires that the exchange rate should adjust to offset completely the inflation differential between the two countries. In the first example, with US inflation higher than that in Australia, the AUD appreciated. What caused the appreciation? It was the switching of demand towards the relatively cheaper Australian goods and services. However, as this occurred, the AUD became more expensive; it appreciated. The appreciation would continue until it offset the inflation differential. Until an appreciation of that extent has occurred, there would be an incentive for US residents to continue to buy Australian goods and services, adding to the demand for the AUD and pushing the price of the AUD higher. On the other side of the FX market, until the AUD has appreciated sufficiently, Australian residents would continue to switch their demand away from US goods and services. That would result in the supply of AUD continuing to fall and the price of the AUD continuing to appreciate. This view of the determination of the FX value of a currency is given the formal title of the purchasing power parity (PPP) theory. The theory effectively states that any national currency should

Purchasing power parity (PPP) where exchange rates adjust to ensure prices of the same goods are equal between countries

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have equal purchasing power (parity of purchasing power) in its own country, or in any foreign country once the currency is exchanged into the foreign currency at the prevailing exchange rate. This is exactly the conclusion that was reached in the above example. Parity of purchasing power of the AUD was maintained in Australia and the USA even though prices rose faster in the USA than they did in Australia. The higher prices in the USA were offset by the appreciation of the AUD. A formal treatment of the PPP theory of exchange rate determination is presented in the Extended learning section at the end of the chapter. There is, however, reason for suspecting the viability of a theory as simple as PPP. There must be other variables that affect the demand for and supply of a currency. This is not intended to suggest that a PPP type of mechanism is irrelevant, but rather that there are variables in addition to relative rates of inflation that are important. Some of these variables are considered below.

16.2.2

R ELATIVE NATIONAL INCOME GROWTH RATES

A second factor that can affect the equilibrium exchange rate is changes in relative income growth. To illustrate a possible mechanism through which the rate of growth in national incomes and the exchange rate are connected, assume that the rate of growth in the Australian national income increases substantially while that in the USA remains constant. In this scenario, Australia’s demand for imports would increase. To pay for the imports there would be an increase in the supply of AUD on the FX market from ​​S0​ ​​  to  ​S1​ ​​​ (Figure 16.5) as holders of AUD sell them to buy the foreign currency. With national income growth in the USA remaining unchanged, the US demand for Australian goods and services, and thus the demand for AUD, would remain at its original level, ​​D0​ ​​​. The effect on the equilibrium exchange rate is that the AUD would depreciate.

Figure 16.5 Effect of an increase in national income growth on the equilibrium exchange rate—increased imports scenario

Price or value of the AUD (AUD/USD)

S0

S1

D0

Quantity of AUD

The relationship presented here between changes in the relative growth rates in national incomes and the exchange rate operates through changes in the demand for imports and exports. There is very clear evidence in support of one part of the proposed relationship, that is, between the growth in national income and the demand for imports. However, the change in imports and in exports as foreign income growth changes may not lead to the forecast impact on the exchange rate. It is possible that there is an additional mechanism through which changes in national income growth may affect the value of the currency. 520

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To illustrate the second mechanism, assume again that Australia’s national income begins to grow quite rapidly while that in the USA remains constant. With improved growth prospects, Australian businesses may decide to expand. To do so, they would require additional funds, and these may be raised through the issue of additional equity and increased debt. Some of the equity and debt funding is likely to be provided by foreign investors. Foreign investors would be attracted to Australian equity and debt because, with higher growth in the Australian economy, it would be reasonable to expect improved profit prospects and lower default risk for Australian businesses. The foreign currency supplied by foreign investors would have to be converted into AUD for use in Australia; that is, there would be an increase in demand for the AUD in the FX market from ​​D0​ ​​  to  ​D1​ ​​​ (Figure 16.6). If this impact could be taken in isolation, the higher growth rate in Australia would result in an appreciation of the AUD.

Figure 16.6 Effect of an increase in national income growth on the equilibrium exchange rate—increased overseas investment scenario

Price or value of the AUD (AUD/USD)

S0

D1

D0

Quantity of AUD

So what can be concluded about the relationship between relative national income growth rates and the exchange rate? The first part of the analysis argued that higher income growth would be associated with increased import demand, and, all else being constant, there would be a depreciation of the currency. It was noted that the relationship between income growth and import growth is quite strong. However, it was also argued that stronger income growth may well be associated with foreign investment inflows, which could result in an appreciation of the currency. That is, there are conflicting influences on the value of the currency arising out of changes in relative income. The question of which influence dominates cannot be resolved at a theoretical level. What is required to resolve the issue is the use of empirical techniques, such as regression analysis (referred to briefly later in the chapter), and a familiarity with what is going on in the economy and with how domestic and foreign investors are reacting to new economic data at that particular time.

16.2.3

R ELATIVE INTEREST RATES

A third, and perhaps the most obvious, impact on the demand for and supply of a currency in the FX markets is the rate of interest in a country relative to the rate of interest in the rest of the world. Consider the situation in which Australian interest rates rise, while those in the USA remain relatively stable. Investors in the USA would be expected to place some of their excess cash in interest-bearing 521

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instruments in Australia in order to obtain the higher rate of return. This would be represented by an increase in demand for AUD, that is, ​​D1​ ​​​ in Figure 16.7. At the same time, Australian investors and businesses would be likely to keep their surplus funds in investments in Australia where there is a higher rate of return than in the USA. With fewer AUD being invested overseas, there would be a reduction in the supply of AUD in the FX market, represented by ​​S1​ ​​​ in Figure 16.7. The combined effect would be that the increase in interest rates in Australia would result in an increase in the demand for AUD and a reduction in the supply of AUD, and consequently an appreciation of the AUD. Using the same logic as that above, it is possible to explain why a relative increase in foreign interest rates, or a relative reduction in local interest rates, would result in a depreciation of a local currency and, similarly, why a relative reduction in foreign interest rates would result in an appreciation of the local currency. While the flows of funds generated by the change in relative interest rates have an intuitive appeal, this explanation omits an important variable that must be taken into account before investors decide where to place their surplus funds. They must consider what is likely to happen to the value of the currency during the period of their investment. The data in Table 16.1 illustrate this point.

Figure 16.7 Effect of an increase in interest rates on the equilibrium exchange rate

Price or value of the AUD (AUD/USD)

S1

S0

D1

D0

Quantity of AUD

Table 16.1 Interest rate differential and expected change in exchange rate Scenario

Interest Australia (%)

Interest USA (%)

Expected change in value of AUD (%)

1

8

5

−5

2

8

5

−2

In scenario 1, although rates of interest are higher in Australia than they are in the USA, there would not be an inflow of funds into Australia. From the perspective of a US-based investor, if funds were placed in Australia to take advantage of the higher rate of interest, and if the expected 5.00 per cent depreciation of the AUD did eventuate, then the investor would be 2.00 per cent per annum worse off compared with the return that would be earned in the USA. The 3.00 per cent per annum benefit obtained by placing funds in the Australian money market would be more than offset by the 5.00 per cent depreciation of the AUD when interest payments and principal are converted back into USD. 522

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From the perspective of an Australian resident, assuming that the expected depreciation does occur, the best rate of return on funds would be obtained by placing funds in the US money markets. The 3.00 per cent per annum lower US rate of interest would be more than compensated for by the FX gain made when, eventually, the USD-denominated funds were converted back into the 5.00 per cent cheaper AUD. Given the flows of funds identified here, the AUD would depreciate despite the higher rate of interest in Australia. That is, there would be a reduced demand for the AUD and an increased supply of the AUD associated with the reduced inflow of USD and the increased outflow of AUD into the US money markets. Under the assumptions of scenario 2, there would be an appreciation of the AUD. There is a net advantage to be obtained by bringing funds into the Australian money market. For a US fund manager, there is a 3.00 per cent per annum interest advantage gained from placing funds in Australia. That benefit would be only partly offset when the funds are converted back into USD at the end of the investment period if, as forecast, the AUD falls by 2.00 per cent during the period. The net expected benefit to a US investor from placing funds in Australia is approximately 1.00 per cent per annum. Australian fund managers would have no incentive to place funds in the USA. The 3.00 per cent per annum interest forgone would not be compensated for by the 2.00 per cent FX gain that would be made when the USD are converted back into AUD at the end of the period. The message behind this discussion of interest rate differentials and their effect on the value of a currency is that one should avoid jumping to apparently obvious conclusions. It is important to look beyond the obvious; a change in the interest differential between the two countries is not all that matters. Of critical importance are the expectations of FX market participants with regard to exchange rates. These expectations will be discussed briefly below; however, some preliminary observations are made here. Chapter 13 included a discussion on the yield curve, which referred to the Fisher effect. It was pointed out that the nominal rate of interest ​​(​inom ​  ​​)​​ is primarily composed of two components: the real rate of return on funds (r) plus the inflationary expectations premium ​​(p​ e​ ​​)​​. That is: ​​i​ nom​​ = r + ​pe​ ​​​ Nominal interest rates can therefore change either as a result of a change in the real rate of return or because of a change in inflationary expectations. In forecasting the effect of a change in the exchange rate, it is important to determine from which source the change in interest rates is coming. If, for example, the increase in the rate of interest is the result of an increase in inflationary expectations, then, all else being constant, it is reasonably safe to expect that the currency will not appreciate, and may well depreciate. The reasoning behind this conclusion can take a couple of forms. First, based on the PPP-type reasoning, the increase in inflationary expectations is likely to be associated with an expectation of a depreciation of the currency. If the currency is expected to depreciate, that expectation is likely to offset the perceived advantage to be gained from the higher interest rates. A second influence is that, during periods in which inflation is expected to increase, businesses and individuals seek to economise on their cash holdings because cash loses value as prices rise. In reducing cash balances, surplus cash will be converted into financial instruments whose rate of return is expected at least to keep pace with inflation. Some of the funds will be invested offshore. The incentive to place funds offshore is strengthened if fund managers expect a depreciation of the local currency. If funds are invested offshore in, say, USD before the depreciation of the local currency, and are then converted back into the local currency after the depreciation, an FX gain is made. If, on the other hand, the increase in interest rates results from an increase in the real rate of return, with no change in inflationary expectations, the currency may be expected to appreciate. The increased real rate of return can be expected to result in an inflow of funds from the rest of the world. As a result, the local currency would appreciate. The following generalisations can be made:

• If an increase in the interest rate is a result of an increase in inflationary expectations, then, all else being constant, the currency will depreciate. • If an increase in the interest rate is due to an increase in the real rate of interest, then, all else being constant, the currency will appreciate.

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16.2.4

E XCHANGE RATE EXPECTATIONS

So far, we have discussed the impact of relative inflation, national income and interest rates on exchange rate movements. With each factor we mentioned that market participants not only observe current changes in these factors, but also attempt to forecast future changes. Therefore, we can argue that exchange rate expectations have a significant impact on exchange rates today. The importance of expectations is particularly evident with speculative FX transactions, as speculative FX transactions represent a large proportion of the daily turnover in the FX markets. Once the expectations of market participants are formed, the impacts of their actions on the exchange rate are clear. For example, all else being constant, a depreciation of a currency will occur if sufficient speculators expect this will happen. Anticipating the depreciation of a currency provides a strong incentive for fund managers to move investment funds offshore. Also, market participants will try to buy foreign currencies before the value of the local currency falls. This will increase the supply of the local currency, shown as ​​S1​ ​​​ in Figure 16.8. Simultaneously, there will be a reduced demand for the local currency ​​(​D1​ ​​)​​ as purchases of the currency are deferred until after the expected depreciation occurs. The combined outcome is a depreciation of the currency.

Figure 16.8 Effect of an expectation of a depreciation on the equilibrium exchange rate

Price or value of the currency

S0

S1

D1

D0

Quantity of currency

What causes a change in exchange rate expectations? Essentially, the answer relates to the flow of information into the financial markets. As new information becomes known to the market, it is analysed to try and gain insights into the future. Since it is argued that changes in relative inflation, relative national income and relative interest rates will each affect the equilibrium exchange rate, it is reasonable to accept that expectations about future developments in each of these variables will also influence exchange rate expectations. It is quite probable that expectations will dominate the other variables in influencing the value of a currency. For example, if Australia’s rate of inflation is higher than that in the USA, a PPP-type forecast would suggest that the AUD will depreciate. However, if market participants expect that the central bank will put in place policies aimed at reducing inflation (such as tightening monetary policy), the AUD may well remain stable in value, or even appreciate: that is, the current value of the currency may be reflecting expectations about the future levels of the relevant variables. 524

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Though it is relatively simple to integrate expectations into exchange rate forecasting as a textbook exercise, it is far from simple in the complexity of the real world. Market participants not only need to know the current state of the relevant variables, they also need to forecast the future value of the variables. In Part 4 some of the difficulties involved in forecasting interest rates were discussed, but interest rates are only one of the variables that are needed to forecast the future value of a currency. Given the complexity of the task, it is not surprising that market participants turn to alternative approaches to forecasting the exchange rate. One approach uses the various techniques of technical analysis that were presented in Part 2. Another approach is to isolate a single variable that may serve as a proxy for the combined effects of a number of the fundamental determinants that were identified above. One readily available proxy is the forward margins quoted daily in the FX markets. (Forward margins are discussed in Chapter 15.) Another variable that has received considerable attention over the years that relates particularly to the Australian market is the index of commodity prices. Australia is a major commodity exporter. Therefore, in Australia’s case there is reason to expect the value of the AUD and the commodity price index to be related, and the relationship can be expected to be positive. As the value of commodities increases, all else being constant, the value of the AUD should also increase; falls in the index should be associated with a fall in the value of the currency. The Reserve Bank publishes a commodity price index comprising 20 commodities ranging from rural commodities (including beef, wheat and wool), base metals (including aluminium, copper and lead) and other resources (including coal, iron ore, crude oil and gold). The index is the weighted average of recent changes in commodity prices relative to a base year. The base year is currently 2011/2012. The RBA periodically reviews the composition of the index and will add or remove commodities if their percentage contribution to commodity export income changes significantly. The reason for selecting commodity prices as an indicator is that export income from commodities accounts for over 15 per cent of Australia’s gross domestic product (GDP). In addition, commodity prices may also indicate the strength of growth, and expected growth, in the national income of major trading partners. The stronger the actual and forecast growth, the greater is the demand for commodities to use as inputs in production. For example, the sustained economic growth in China has seen a large increase in iron ore, other metallurgicals and coal exports to China and an associated increase in prices. The increased demand for these commodities results in an increase in both commodity prices and the volume of exports. Export revenue is enhanced through both avenues. As Australia’s export earnings improve, international sentiment about the value of the AUD should improve. The positive forecast outlook will also increase speculative demand for the AUD, which would further increase its value. Unfortunately, using the commodities index as a proxy indicator only works some of the time in Australia. Though it would be convenient if one indicator could be identified that consistently and accurately provided a forecast of the value of a currency, the dynamics of domestic and international economies means that it is unlikely that a single reliable indicator will prevail. Exchange rates change constantly during a trading period, but the commodity price index is based on average monthly prices. Therefore, within the context of a dynamic FX market, it only provides a partial longer-term indicator. The index also is based on movements in recent past prices and is slow in identifying commodity quantity and price changes. For example, it may be argued that the commodity price index would only be a lagging indicator if a sudden slowdown in economic activity in China occurred.

16.2.5

Commodity price index an index of changes in the monthly weighted average prices of rural, base metal and resource commodities

C ENTRAL BANK OR GOVERNMENT INTERVENTION

In addition to the economic variables already discussed, the intervention of a government, generally through the FX market transactions of its central bank, is a potential influence on the exchange rate. There are numerous ways in which central banks or governments may affect the value of a currency. Any of their policy measures that alter the relative rate of inflation, relative income or relative interest rates will have an impact. An example of a policy change would be a central bank’s action in changing monetary policy settings in order to influence inflation levels within the country. An expectation by 525

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market participants that there will be an alteration in the policy settings of a country in the near future will also affect the value of the currency. Also, a government or central bank may seek to influence the currency by three other means: 1 intervening in international trade flows 2 intervening in foreign investment flows 3 intervening directly in the FX market. The first of these (intervening in international trade flows) is aimed at increasing exports or reducing imports. The most common technique for increasing exports is subsidising export production so that producers can lower the selling price of their output on the international markets. A lower price makes the exports more competitive, generating an increased demand for the exports, and increasing the demand for the currency of the exporting country. Alternatively, a government may intervene on the import side by changing policies in relation to: Tariff a charge levied by a government on imports into the country

Quota a government restriction on the amount of a specified good that may be imported into the country

Embargo prohibition on the import or export of specified goods

FX smoothing central bank buy/sell actions in the FX market designed to stabilise a volatile market

• a tariff, which increases the prices of imports and results in a reduction in the quantity demanded in the domestic market • a quota, which places a direct limit on the amount of particular goods that may be imported • an embargo, which prohibits the importation of specified goods or services. Each of these devices will affect the demand for imports and therefore lower both the equilibrium exchange rate and the supply of the country’s currency on the FX markets. Governments also intervene from time to time in the flows of investment funds between countries, and in doing so alter the supply and demand conditions in the FX markets. This intervention ranges from prohibitions on the outflow of funds from the home country, to the imposition of penalty taxes, either on residents who earn interest income offshore or on non-residents’ interest income earned in the home country. The final form of intervention occurs when a central bank intervenes directly in the FX markets. There are two motivations. The first is to dampen volatility in the value of the currency. This is sometimes referred to as FX smoothing, and is occasionally undertaken when a central bank perceives that speculators are dominating the market and causing volatility in the value of the currency that is not warranted by the underlying economic fundamentals. A smoothing intervention tends to be prompted by inexplicable increases or decreases in the value of a currency over very short periods. The central bank enters the market as a buyer of the local currency when sell orders are swamping the FX market, and as a seller of the local currency when buy orders are dominating the market. These actions are designed to moderate short- and medium-term currency fluctuations caused by temporary random events. The key feature of a smoothing intervention is that the central bank does not enter the market with the goal of changing the value of the currency; its goal is to introduce stability into a volatile market. The second motivation for official intervention in the FX markets is to achieve an exchange rate target value that may be different from the market’s perception of the appropriate level for the currency. Unlike smoothing, this form of intervention is characterised by the central bank’s transactions being on one side of the market. This is illustrated in Figure 16.9. If, for example, the Reserve Bank decided that it wanted the AUD to fall in price from its free market rate of, say, AUD/USD0.78, it could attempt to shift the price by coming into the market as a seller of AUD (i.e. a buyer of USD). This is shown in the figure by the new supply curve (S + Gov). The central bank’s actions cause the value of the AUD to fall to 0.6800. On the other hand, if the central bank wanted the AUD to appreciate from its free market exchange rate, it would enter the market as a buyer of AUD. The increase in demand for the AUD would push the equilibrium exchange rate higher. Before 1973 this was exactly the type of intervention that was required of governments and their central banks in most countries around the world. For most of the post-war period until then, exchange rates had been fixed in value against the USD. A parity value was established and, regardless of fluctuations in the demand and supply conditions generated by private market participants, national

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Figure 16.9 Central bank intervention in the FX market to achieve a depreciation of the AUD

Price or value of the AUD (AUD/USD)

S0

0.7800

S + Gov

0.6800

D

Quantity of AUD

governments undertook to maintain the exchange rate within 1.00 per cent of the agreed parity value. Towards the end of the life of the global fixed exchange rate system, the width of the band of permissible fluctuations around the parity value was widened to allow movements of 2.25 per cent on either side of the parity rate. Even this was not sufficient to accommodate the increased volatility of private sector demand and supply in the FX markets, as the volume of international trade and investment flows increased and the fundamental determinants of these flows became more volatile. The ability of a central bank to maintain the value of a fixed exchange rate currency required the central bank to always be willing and able to buy or sell the domestic currency. The ability of a central bank to be able to buy or sell was limited by the amount of FX reserves held by the country. This sometimes became a significant problem when speculators targeted a particular currency. Therefore, maintaining a relatively fixed exchange rate imposed strains on national economies, governments and central banks, and eventually resulted in the adoption by most major countries of a floating exchange rate regime in March 1973. Australia, however, experimented with a number of hybrid floating exchange rate systems before finally adopting a fully floating currency in December 1983. The floating exchange rate system relieves central banks of the need to focus on maintaining a particular value of the currency in the FX markets. It also allows the government to remove most restrictions on international investment flows. Removing capital flow restrictions allows the country’s domestic money markets and capital markets to become an integrated part of the international financial markets. The RBA has intervened in the FX markets from time to time. Three notable situations that resulted in RBA intervention were the stock-market crash of October 1987, the Asian financial crisis from mid1997 and the global financial crisis. The RBA intervened in the FX markets on a total of 10 days during 2007 and 2008. Before then, there had been no interventions since 2001. The interventions in 2007 and 2008 involved sales of foreign exchange totalling $4 billion. Like most of the RBA’s interventions in the FX markets, these transactions were undertaken in the AUD/USD exchange market under the RBA’s name to alert market participants of the RBA’s views and presence in the market. The purpose of the intervention was to address the illiquidity that had emerged in the FX markets and the increasingly wide bid–ask spreads associated with that illiquidity. This was a smoothing operation. The RBA has not intervened in the FX markets since 2008. This discussion of the factors that affect exchange rate movements has identified variables that have an impact on demand and supply in the FX markets, and has provided some analysis of the 527

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effects of changes in those variables on the equilibrium exchange rate. It should be evident that, even in a textbook world, the task of explaining and forecasting exchange rate movements is not simple. Even in theoretical models of the exchange rate, changes in some of the relevant variables can cause conflicting outcomes. Further, variables are likely to change continuously and simultaneously. It is therefore necessary to be able to assess the relative impacts of each variable on the exchange rate. Market participants who have many years of experience in observing the reactions of the exchange rate to changes in economic news may develop some feel for the nature and magnitude of relationships. For those more remote from the market, the technique introduced in the next section may provide some insight into:

• the direction of the relationship between changes in the underlying variables and in the exchange rate • the relative importance of each of the variables in causing changes in the exchange rate. REFLECTION POINTS

power parity (PPP) theory contends that movements in exchange rates will ensure • Purchasing that the cost of identical goods and services will be equal across countries. A change in inflation represents a change in prices in a country; PPP argues that a change in relative inflation rates between countries will be offset by a change in the exchange rate. in relative national income growth rates also affect an exchange rate. For example, • Changes increased national income will typically result in increased imports and therefore an increase in the supply of the local currency on the FX markets. However, in a dynamic market, increased national income might encourage business growth, with associated local and overseas investment. This will also have an impact on demand and supply factors in the FX markets. interest rates also affect an exchange rate. For example, a relative increase in local • Relative interest rates will attract overseas investors; these investors will purchase the local currency and sell their own currency. Investors need to consider interest rate differentials in conjunction with forecast changes in the exchange rate. Future exchange rate changes will affect the value of future cash flows associated with international investments. rate expectations have a strong influence on exchange rates. Market participants • Exchange analyse new information in order to try and forecast future impacts on an exchange rate. It may be possible to adopt a specific market indicator as a proxy for exchange rate expectations. For example, in Australia, the commodity price index is often used as a proxy. If sufficient participants form a view, the exchange rate will move; speculators play a large role in forming exchange rate expectations. time to time a central bank may buy or sell its local currency in the FX markets in order to • From influence the level of an exchange rate, particularly if the central bank believes that the value of the currency is significantly out of line with underlying economic fundamentals.

16.3 LEARNING OBJECTIVE 16.3 Explore regression analysis as a statistical technique applied to variables that impact on an exchange rate.

Measuring exchange rate sensitivity to changes in economic variables

Regression analysis may be used to assess how movements in a range of variables affect another variable. This chapter has identified a range of variables, or factors, that will affect exchange rates between currencies. Therefore, we can use regression analysis to consider the impact on an exchange rate of movements in these variable factors. The model of the exchange rate developed in the previous section said that an exchange rate would primarily be affected by changes in relative inflation rates (I), relative national income growth rates (Y),

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relative interest rates (i), central bank intervention (G) and exchange rate expectations. Within the context of the AUD/USD exchange rate, the regression model may be specified as: Percentage change in AUD/USD exchange rate in period ​t = ​a0​  ​​ + ​a1​  ​​ ​(​IUS ​  ​​ − ​IA​  ​​)​ t​​ + ​a2​  ​​ ​(​YUS ​  ​​ − ​YA​  ​​)​ t​​ + ​a3​  ​​ ​(​iUS ​  ​​ − ​iA​  ​​)​ t​​ + ​a4​  ​​ ​(​GA​  ​​)​ t​​ + ​a5​  ​​ ​(​GUS ​  ​​)​ t​​ + ​Ut​ ​​​ where ​​a0​  ​​​ is the intercept term or constant, ​​a1​  ​​  to  ​a5​  ​​​ are the regression coefficients that measure the responsiveness of the exchange rate to the particular variable and U is the regression error term. Once the data for all variables are compiled, and the regression program is run, estimates of each of the regression coefficients will be provided. Assume the following results from the regression model: ​a1​  ​​ = 0.9 a​​​ 2​  ​​ = 0.6​  ​​ ​a3​  ​​ = − 0.75 The coefficient ​​a1​  ​​ = 0.9​ suggests that a one-unit change in the inflation differential ​​(I​ US ​  ​​ − ​IA​  ​​)​​ is associated with a 0.90 per cent change in the value of the AUD. The positive relationship provides support for the PPP theory of exchange rate determination. If ​​IUS ​  ​​​ is greater than ​​IA​  ​​​, that is, if ​​(​IUS ​  ​​ − ​IA​  ​​)​​ is positive, PPP suggests that there would be an appreciation of the AUD. The coefficient ​​a2​  ​​ = 0.6​ suggests that there is a positive relationship between the income growth differential ​​(Y ​ US ​  ​​ − ​YA​  ​​)​​ and the value of the AUD. Higher growth in the USA relative to that in Australia would be associated with an appreciation of the AUD. Similarly, higher growth in Australia relative to the USA, that is, ​​(Y ​ US ​  ​​ − ​YA​  ​​)​​ is negative, would be associated with a fall in the value of the AUD. If the results assumed here were generated from real data, they would resolve the debate presented earlier, where it was suggested that changes in relative output growth could be associated with conflicting forces on the exchange rate. Higher growth is associated with increased demand for imports and thus with a weakening of the currency. But higher growth may also attract more foreign investment inflows and thus strengthen the currency. If the real coefficient was positive (as assumed here), it would suggest that the import effect outweighed the foreign investment effect. A negative coefficient would suggest that the foreign investment effect outweighed the import effect. The sign on coefficient ​​a3​  ​​​ reports a negative relationship between the value of the AUD and the interest rate differential ​​(​iUS ​  ​​ − ​iA​  ​​)​​. This suggests that if rates of interest were higher in the USA than in Australia, the AUD would depreciate. However, the earlier discussion on the impact of interest rates on the exchange rate suggests that this coefficient could well be positive. It was argued previously that, in considering the impact of interest rates on the exchange rate, it is important to determine whether the change in interest rates was a result of a change in the real rate of interest or a change in inflationary expectations. If the change resulted from a change in the real rate of interest, the sign on coefficient ​​a3​  ​​​ should be negative. If the change is predominantly the result of changes in inflationary expectations, the sign on the coefficient should be positive. The inclusion of government or central bank intervention in the regression is more problematic than the previous variables. It was suggested in the previous section that government intervention could take various forms, including intervention in trade and foreign investment flows. Also, the central bank may use direct intervention by buying or selling currency in the FX markets. It may be argued that there is no single data series that can capture each of these forms of intervention. One way of coping with the problem is through the use of a so-called dummy variable. This variable takes a value of zero for each period during which government or central bank controls or direct actions are not imposed. A value of one is assigned to the variable in each period in which direct actions are imposed. Following that procedure, if coefficient ​​a4​  ​​ = 1.1​, this would suggest that the value of the AUD would be 1.10 per cent higher in the presence of intervention compared with its value in the absence of intervention. An indication of a central bank’s direct intervention in the FX market is changes in its holdings of foreign currency. If a central bank sells foreign currency in order to push up the value of the currency, its foreign currency reserves decline. If a central bank buys foreign currency to depress the value of the currency, its foreign currency reserves increase. On this basis, it would be expected that coefficient ​​a4​ ​​​ would be negative; that is, as official holdings of foreign currency increase, the value of the AUD would fall.

Regression analysis a statistical technique that determines the relationship between a dependent variable and independent variables

Regression coefficient measures the responsiveness of a dependent variable to an independent variable

Dummy variable a binary method (either zero or one) used to distinguish between two sets of data

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However, a central bank often conducts FX transactions that are not associated with direct intervention to influence the exchange rate, such as arranging government foreign-aid payments or paying for defence equipment purchases (selling AUD). It is assumed that such transactions are neutralised by the central bank conducting opposite, but equal, transactions in the FX market (buying the AUD). The model assumes an efficient market; therefore, the exchange rate expectation variable should be zero. For the variable to be other than zero there would need to be an unexpected change in the exchange rate. The efficient market hypothesis would contend that this would normally not occur. Previously, we noted that exchange rate expectations do have an impact on exchange rate movements. This model assumes that in an efficient market, those expectations are reflected in the other variables and therefore already incorporated in the model. Once the regression coefficients have been estimated, it is necessary to test them in order to determine whether they are statistically significantly different from zero. If they are, it can be argued that a relationship exists between the variables and the exchange rate. Further tests of the statistical properties of the data and the regression estimates are also necessary before conclusions can be drawn about the possible relationships between the variables. Such tests are outside the scope of this text, but a further study of statistical or quantitative methods is recommended.

REFLECTION POINTS

analysis is a quantitative method that measures how movements in variables impact • Regression on another variable. regression model that measures percentage changes in an exchange rate should include • Avariables of relative inflation rates, relative national income growth, relative interest rates, government or central bank intervention and exchange rate expectations. model will calculate regression coefficients that measure the responsiveness of the • The exchange rate to a particular variable. dummy variable may be used for variables that do not have a data set (e.g. government • Aintervention). A value of one would be assigned to periods where intervention occurred and the value zero to non-intervention periods. An indication of periods when central bank intervention occurs may be changes in the central bank’s holdings of foreign currency reserves.

CASE STUDY TERRORIST ATTACKS AND FX MOVEMENTS In this chapter, the factors that influence exchange rates were explored. While some of these explain the longer-term fluctuations in exchange rates, we also note that events will affect exchange rates in certain ways. In recent years, terrorism has been in the news a lot. When there is a major terrorist attack, like the 9/11 attacks, we know that stock markets will be affected, at least temporarily. Newly published research has investigated the effect of terrorist attacks on foreign exchange rates. In their paper, published in Economic Inquiry, Narayan et al. (2018) investigated the effect of terrorist attacks on the value of 21 different currencies against the US dollar. The data used were the market quoted exchange rates quoted at 10-minute intervals for the period 1996 to 2014. As such, very shortterm upticks and downticks in the value of different currencies following a terrorist attack could be observed. The data relating to terrorist attacks was collected from the Global Terrorism Database (GTD) (see www.start.umd.edu/gtd). This is an excellent open source database and it is very instructive to 530

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The study found that terrorist attacks do affect exchange rates, leading to both appreciations and depreciations in different currencies following attacks. Most of this effect is experienced on the day of the attack. However, the study found that the effect sometimes lingers for more than a few days. For traders with a very short-term focus, therefore, the study shows that a terrorist attack is expected to influence exchange rates and must be considered in trading decisions that follow these types of events. On the plus side, terrorist attacks do not lead to across-the-board currency depreciations or prolonged depreciations that continue for many days. Further reading Narayan, P, Narayan, S, Khademalomoom, S & Phan, DHB 2018, ‘Do terrorist attacks impact exchange rate behaviour? New international evidence’, Economic Inquiry, 56, pp. 547–61.

Discussion point

•

As a guess, one might suppose that a terrorist attack will lead to currency depreciations. The study found that terrorist attacks lead to appreciations in some currencies. Why do you think this is the case?

CHAPTER SIXTEEN REVIEW

compare terrorism in, say, Western Europe in the 1970s with the period post-2010. We think we are living in a period characterised by more terrorist attacks, but we are not!

Master before you move on LEARNING OBJECTIVE 16.1 Explain how factors that affect the demand for a currency, or the supply of a currency, affect the determination of an equilibrium exchange rate.

• An exchange rate is the price of one currency in terms of another currency. developed economies operate a floating exchange rate regime whereby the price of the • Most currency is determined by the demand for and the supply of that currency in the FX markets. change in the factors that impact upon the demand for and supply of a currency will result • Any in a change in the exchange rate. LEARNING OBJECTIVE 16.2 Understand how the major factors that influence exchange rate movements operate, particularly relative inflation rates, relative national income growth rates, relative interest rates, exchange rate expectations, and central bank or government intervention. 1



Relative inflation rates

theories advanced to explain the exchange rate, and changes in the equilibrium rate, • Othef the purchasing power parity (PPP) theory is the longest standing. nder PPP, a country with a higher inflation rate relative to another country can expect its • Ucurrency to depreciate. erhaps the most critical shortcoming of PPP is that there are variables in addition to inflation • Pthat affect the value of a currency. he Extended learning section considers PPP calculations that apply inflation differentials • Tbetween two countries to determine the expected change in the exchange rate.

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2

Relative national income growth rates



here is wide agreement that changes in the relative rates of growth in national incomes • Taffect the exchange rate. • There is disagreement, however, as to the nature of the effect. n increase in the relative rate of growth is likely to result in an increased demand for • Aimports, which will result in a depreciation of the currency. n the other hand, an increase in the growth rate may also result in an increase in foreign • Oinvestment inflows, which will cause the currency to appreciate. oth mechanisms are likely to operate, with the balance between the two changing from • Btime to time.

3

Relative interest rates

he interest rate differential between two countries is also important in determining the • Tdemand for and supply of a currency in the FX market; however, the effects of a change in the interest rate differential are ambiguous.

t is important to determine whether the change is due to a change in inflationary • Iexpectations, or a change in the real rate of interest. f the increase in interest rates is a result of an increase in inflation expectations, a currency • Ishould depreciate. However, if the increase is due to a rise in the real rate of interest, then the currency should appreciate. 4

Exchange rate expectations

n addition to the economic fundamentals, exchange rate expectations are important in • Idetermining the FX value of a currency. f the markets expect the exchange rate to depreciate, this will ultimately result in FX buy or • Isell transactions that cause the depreciation; if an appreciation is expected, an appreciation typically will be experienced.

he modelling of expectations is a particularly difficult task. Theoretically, expectations • Tshould be formed on the basis of the expected values of economic fundamentals. However, the FX market often reacts to new information before the impact on the longer-term economic fundamentals is fully analysed.

t may be possible to adopt a specific market indicator as a proxy for exchange rate • Iexpectations. For example, in Australia, the commodity price index is often used as such a proxy. 5

Central bank or government intervention

t times, the actions of governments or central banks are another variable that may be • Aimportant in the FX markets. he monetary policy setting of a central bank will impact upon the demand and supply • Tfactors that affect an exchange rate. Also, a central bank or government may intervene in the FX markets to influence directly the level of an exchange rate by intervening in international trade flows, intervening in foreign investment flows or conducting FX transactions in the markets.

in an attempt to increase the FX value of its currency, a central bank may • Fsellor example, foreign currency and buy the local currency; alternatively, to reduce the value of its

currency, the central bank may buy foreign currency. Alternatively, a government may implement policies that change tariff, quota or embargo settings relating to goods and services.

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Explore regression analysis as a statistical technique applied to variables that impact on an exchange rate. analysis is a statistical technique that may be used to try to ascertain the relationship • Regression between a dependent variable and changes in independent variables, • An exchange rate may be the dependent variable. independent exchange rate variables are relative inflation rates, relative national income • Major growth, relative interest rates, government or central bank intervention, and market expectations.

Extended learning LEARNING OBJECTIVE 16.4 Apply purchasing power parity concepts and calculations to the determination of foreign exchange risk measurement. Purchasing power parity The purchasing power parity (PPP) theory has been used to determine whether or not various currencies are appropriately valued in FX markets. Anyone who travels overseas, or buys goods online, can test the application of the PPP theory by comparing the prices between different countries.

CHAPTER SIXTEEN REVIEW

LEARNING OBJECTIVE 16.3

For example, let us assume that you wish to purchase a DVD of a new-release movie. You compare the price of purchasing the DVD in Australia and also in the USA. The theory contends that, if the price of the DVD in the USA increases by 5.00 per cent but the price remains unchanged in Australia, the AUD should appreciate by 5.00 per cent. If the AUD did not appreciate by that amount, the AUD is undervalued, and market participants would expect the AUD to appreciate. This PPP test is illustrated in Table 16A.1.

Table 16A.1 The DVD test of PPP DVD price Australia

DVD price USA

Year

AUD

% change

USD

% change

AUD/USD

% change

1

12.50

 

8.95

 

0.7160

 

2

12.50

0%

9.40

+5%

0.7518

+5%

3

12.50

0%

9.87

+5%

0.7743

+3%

In year 1 an Australian resident could purchase the DVD for AUD12.50 in Australia, or could convert AUD12.50 into USD8.95 at the spot exchange rate of AUD/USD0.7160 and purchase the identical product in New York; that is, PPP holds. By year 2 the purchase in New York costs USD9.40, and, even though prices remain constant in Australia, the appreciation of the AUD has maintained PPP (AUD12.50 × 0.7518 = USD9.40). However, PPP is violated in year 3. Here, the US price for the DVD has again risen by 5.00 per cent, to USD9.87, but the AUD has appreciated by only 3.00 per cent to AUD/USD0.7743. The Australian movie buff would find it cheaper to buy the DVD in Australia. If PPP could be relied upon to provide an accurate forecast of movements in the exchange rate, market participants would conclude that the AUD was certain to appreciate. Based on the PPP test using the DVD example, the AUD could be expected to appreciate to AUD/USD0.7893. 533

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The best that can be said of PPP as a theory of exchange rate determination is that the numerous tests that have been conducted on its accuracy suggest that it provides reasonable results in the long run. It is not very useful in explaining movements in exchange rates where the periods under consideration are as short as a few months or even a few years. Some of the numerous factors that account for the poor performance of PPP as an explanation of short-term movements in exchange rates could be seen in the earlier discussion on relative rates of inflation. The mechanism through which PPP may be expected to work is through adjustments in the demand for goods and services between countries with different rates of inflation. It was assumed in the initial example (Section 16.2.1) that US residents could find substitutes for US goods in Australia, where inflation was lower, and that Australians would switch their demand away from US goods to the cheaper Australian substitutes. However, such substitutes may not exist. Even if they do exist, buyers of goods may be reluctant to change their demand to new, unknown and untried suppliers. They may prefer to pay the higher price and stay with suppliers with whom they have had a longstanding business relationship. With such relationships there are often associated benefits, such as good terms for payment, known reliability of quality and supply and preferential after-sales service. PPP also ignores the time factor, distance and information availability. US residents may not be fully informed of substitute goods and services available in Australia. There are also transaction costs to be considered, such as transportation, which in Australia’s case may be quite significant. It takes additional time to ship goods overseas, and services provided in one country may not be readily provided in another country. However, in the long term PPP often provides a stronger explanation. To demonstrate the derivation of the PPP conclusion, assume that the price levels in the home country (​​​ ​​​Ph​  ​​​)​​​​ and in the foreign country ​​(P ​ f​  ​​)​​ are equal. That is: ​​Ph​  ​​ = P ​ f​  ​​​ In that situation the exchange rate between the home currency and the foreign currency would be one for one, for example AUD/USD1.0000. If PPP exists: ​P​  ​​ ​​Ph​  ​​​​(​​S​)​​​ = P ​ F​  ​​ or ​Ph​  ​​ = __ ​  f ​​  S where: ​S = spot AUD/USD = 1.0000​ Assume now that the home country experiences inflation over time at a rate of ​​l​ h​​​ and the foreign country experiences a rate of inflation of l​ ​​f​​​. The price level for the home country now becomes: ​​Ph​  ​​ = ​(1  + ​lh​  ​​)​​ and the price level for the foreign country becomes: ​​Pf​  ​​ = ​(1  + ​lf​  ​​)​​ PPP theory suggests that the exchange rate would adjust to maintain parity in purchasing power. The percentage change in the exchange rate (S%) should offset the change in the inflation differential between the two countries. From the perspective of the home country, the foreign price level would now be: ​P​  ​​​(1  + ​l​  ​​)​ ​(​​1  + S%​)​​

f _______ ​​  f    ​​ 

Therefore, under PPP conditions: ​P​  ​​​(1  + ​lf​  ​​)​ ​​Ph​  ​​​(1  + ​lh​  ​​)​ = _______ ​  f    ​​  ​(​​1  + S%​)​​ 534

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​P​  ​​​(1  + ​lf​  ​​)​ ​​​(​​1  + S%​)​​​ = _______ ​  f    ​​  ​Ph​  ​​​(1  + ​lh​  ​​)​ or: ​P​  ​​​(1  + ​lf​  ​​)​ ​S% = _______ ​  f    ​   − 1​ ​Ph​  ​​​(1  + ​lh​  ​​)​ However, since it was assumed initially that P​  ​​ h​​ = P ​ f​  ​​​ , they can be cancelled out, which leaves: (1 + ​lf​  ​​) ​S% = _____ ​     ​   − 1​ (1 + ​lh​  ​​)

16.1

Equation 16.1 represents the relationship between the exchange rate and inflation if PPP holds. It implies that if ​​lf​  ​​ > ​lh​  ​​​, then S% should be positive. That is, if inflation in the foreign country is higher than that in the home country, the home currency should appreciate. Similarly, if l​ ​​f​​ < l​h​  ​​​, then S% should be negative, that is, the home currency should depreciate. The following numerical examples illustrate the operation of the equation. Assume that the home country experiences inflation of 10.00 per cent per annum, while the foreign country has inflation of 4.00 per cent per annum. If PPP is maintained, then: (1 + ​lf​  ​​) S% = ​ _____    ​   − 1 (1 + ​lh​  ​​) ​(​​1  + 4.00%​)​​ __________ ​​ ​​       ​  − 1​       ​  = ​    ​ ​ ​​ )​​ ​(​​1  + 10.00%​ 1.04  ​ = ​ ____  ​  − 1 1.10 ​ = − 5.4545%

CHAPTER SIXTEEN REVIEW

which can be solved for the change in the exchange rate:

That is, the home currency should depreciate by 5.4545 per cent in response to the higher rate of inflation in the home country. As another example, assume that the home country rate of inflation is 2.50 per cent and that of the foreign country is 5.50 per cent. According to PPP, the exchange rate will adjust to the extent of: (1 + ​lf​  ​​) S% = ​ _____    ​   − 1 (1 + ​lh​  ​​) ​ ​​      ​  1.055  ​​​​ ​ = ​ _____  ​   − 1 1.025 ​ = 2.9268% That is, in response to the relatively lower rate of inflation in the home country, the home currency should appreciate by 2.9268 per cent. Therefore, if the spot exchange rate is AUD/USD0.7500, in the first example the exchange rate would be expected to fall to AUD/USD0.7090. In the second example the exchange rate would be expected to increase to AUD/USD0.7719. If the exchange rate did behave according to PPP and if, for example, the AUD/USD rate adjusted to the reported inflation differentials as calculated in the above examples, the real value of the currency—that is, the real exchange rate—would remain constant. The real exchange rate is an indicator of the purchasing power of a currency when it is converted into another currency. Real exchange rates can be used to test PPP. If an exchange rate adjusts to the inflation differential in accordance with PPP, the real exchange rate would remain constant. Having considered PPP within the context of inflation differentials, it is necessary to remember that there are several other important factors that will, from time to time, have an impact on an exchange rate. These were discussed earlier in Section 16.2 and include relative national income growth, relative interest rates, government or central bank interventions and market expectations. 535

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Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

The Reserve Bank of Australia publishes an index of commodity prices. Outline the nature and purpose of this index and explain how it can help us to forecast changes in the equilibrium value of the Australian dollar. (LO 16.1)

2

Draw a graph that depicts the AUD/EUR demand curve and supply curve. Plot the equilibrium exchange rate at AUD/EUR0.7000. If the spot exchange rate is AUD/EUR0.7500, what impact will that have on the demand and supply position in the FX markets? (LO 16.1)

3

Under a floating exchange rate regime, the exchange rate will always adjust so that the demand for, and the supply of, a currency in the FX market will be equal.

(a) Having regard to this statement, describe the mechanisms through which equilibrium is maintained in the event of a change in the demand or supply curves.

(b) Draw a diagram showing the appropriate demand and supply curves. (LO 16.1)

4

The Reserve Bank of Australia sometimes intervenes in the FX markets.

(a) Discuss the importance of the RBA trading under its own name during these periods.

(b) What is the rationale for the RBA targeting its interventions in the AUD/USD exchange market? (LO 16.2)

5

Draw a chart and explain in words what is expected to happen to the Indian rupee demand and supply curves (USD/INR) if there is a forecast increase in India’s inflation rate while the inflation rate remains stable in the USA. (LO 16.2)

6

Draw a chart and explain in words what is expected to happen to the New Zealand dollar demand and supply curves (USD/NZD) if there is a forecast increase in New Zealand’s national income relative to a stable growth rate in the USA. (LO 16.2)

7

Consider the following apparently contradictory statements:

An increase in the rate of growth in a country’s national income relative to that in the rest of • ‘the world will result in a depreciation of that currency.’ An increase in the rate of growth in a country’s national income relative to that in the rest of • ‘the world will result in an appreciation of the currency.’ (a) Outline the mechanisms through which forecasters responsible for the above comments see the change in national income affecting the FX markets.

(b) Is it possible to deem one or other of the forecasters to be correct? Explain your response. (LO 16.2)

8

Draw a chart and explain in words what is expected to happen to the Indonesian rupiah demand and supply curves (USD/IDR) if there is a forecast increase in Indonesia’s interest rates relative to interest rates in the USA. (LO 16.2)

9

Each of the following statements has been put forward as an explanation of exchange rate movements.

The increase in the value of a currency is because rates of interest in that country have • ‘risen relative to those in the rest of the world.’ The decrease in the value of a currency is because rates of interest in that country have • ‘risen relative to those in the rest of the world.’ Explain and reconcile these two statements. (LO 16.2)

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Scenario

iAUD (%)

iUSD (%)

Expected change in value of AUD (%)

1

5

2

−4

2

2

5

+4



(a) Under which scenario will an investor in the USA consider investing funds in the Australian money markets? Explain why this is so.



(b) Also, explain why the investor would not find the other scenario attractive. (LO 16.2)

11 Participants in the FX markets actively attempt to forecast changes in economic variables that should impact upon future exchange rates. Therefore, it may be argued that exchange rate expectations are of critical importance in determining the FX value of a currency.

(a) Identify and discuss factors that may be relevant when forming exchange rate expectations.



(b) Discuss the proposition that an economic indicator may be a suitable proxy for exchange rate expectations. In your answer examine the use of the Australian commodity price index. (LO 16.2)

12 The Reserve Bank of Australia has not intervened in the FX markets for more than a decade. Why are interventions so rare? What could prompt an intervention in the future? (LO 16.2)

CHAPTER SIXTEEN REVIEW

10 Consider the data in the two scenarios in the table below.

13 A market-determined exchange rate is affected by changes in relative inflation, relative national income growth rates, relative interest rate differentials, government or central bank intervention, and market expectations. Regression analysis is a statistical technique used in the analysis of exchange rate movements. If the regression analysis yields coeffcient values for the first three variables listed above of 0.7, 0.4 and –0.3, what does this tell us about the sensitivity of a currency to changes in these variables? (LO 16.3)

Extended learning questions 14 Briefly outline the basic contention of the purchasing power parity theory of exchange rate determination. (LO 16.4) 15 While the PPP theory has stood the test of time, it must be recognised that it has some identifiable inadequacies. List and explain the inadequacies of the PPP theory within the context of exchange rate determination. (LO 16.4)

KEY TERMS commodity price index  525

FX smoothing  526

regression analysis  529

dummy variable  529

purchasing power parity (PPP) 519

regression coefficient  529

embargo 526 equilibrium exchange rate  517

quota 526

tariff 526

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CHAPTER 17

Foreign exchange: risk identification and management CHAPTER OUTLINE 17.1 Foreign exchange risk policy formulation 17.2 Measuring transaction exposure 17.3 Risk management: market-based hedging techniques 17.4 Risk management: internal hedging techniques

Learning objectives LO 17.1

Formulate an FX policy document including FX objectives, management structure, authorisations, reporting systems, communications, performance evaluation, audit and review procedures.

LO 17.2

Outline methods that can be employed to measure a company’s FX transaction exposures, including net FX cash flows, currency standard deviations and correlation coefficients.

LO 17.3

Explain procedures involved in the implementation of market-based hedging techniques, in particular forward exchange contracts and money-market hedging.

LO 17.4

Consider the implementation of internal hedging techniques to minimise and manage FX risk, including invoicing in the home currency, creating a natural hedge, currency diversification, leading transactions, lagging transactions, mark-ups, counter-trade and offsets.

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CHAPTER SNAPSHOT Like interest rates, exposure to FX movements represents a significant risk factor for companies and financial institutions. A company that has to pay suppliers in a foreign currency faces the risk that the currency will appreciate in value against the company’s domestic (home market) currency. This will make the purchase price more expensive. Companies and financial institutions have risk management policies that are designed to ensure that FX exposure is appropriately monitored. Financial instruments, such as FX forward contracts that are used to lock in an exchange rate, can be used to manage FX exposures.

Introduction Market participants who have cash flows, assets or liabilities that are denominated in foreign currencies face the risk that the values of those items may change if the exchange rate between the local currency and the foreign currency changes. This chapter begins by looking at some of the issues involved in measuring the exposure of a corporation to FX risk. FX risk exposures can be classified in terms of their impact on a firm’s cash flows, balance sheet, competitive position and net value. These are defined as:

• • • •

transaction exposure translation or accounting exposure operational exposure economic exposure.

Transaction FX exposure derives from contractually binding, foreign-currency-denominated cash inflow and outflow transactions. It refers to the extent to which the value of a firm’s future cash flows may be affected by changes in the exchange rate. For example, an Australian toy retailer that has entered into a contract to import toys from China, where the contract is denominated in USD, is exposed to transaction risk. If the importer’s local currency (AUD) depreciates before payment is made, it will cost more of the local currency to purchase the same quantity of USD to pay for the imported toys. Therefore, exchange rate movements may lower, or remove, the profit expected by the toy importer. Translation FX exposure, or accounting exposure, measures the impact of exchange rate changes on the consolidated financial statements of a firm; that is, the balance sheet. The accounting consolidation and reporting of a firm’s financial position requires the financial statements of foreign operations or subsidiaries to be converted from foreign currency values into the home currency of the parent company. For example, if a company accumulates assets or liabilities overseas, these items will usually be denominated in a foreign currency. If the company later translates the value of those items onto its consolidated balance sheet at anything other than the original exchange rate, their value in local currency terms will be affected by fluctuations in the exchange rate. Corporations need to consider the appropriate accounting standards to ascertain specific translation requirements. Operating FX exposure measures the extent to which exchange rate volatility may affect a firm’s future operating cash flows—that is, the risk that changes in an exchange rate will affect future ongoing revenues and costs. For example, a company that has foreign operations or subsidiaries will need to pay its foreign employees and its day-to-day operating expenses in the currency of the foreign operation. If funding for these operating expenses is sourced in another country, such as from the parent company, then operating FX exposure exists. Economic FX exposure is a broad measure that attempts to capture the impact of unexpected exchange rate fluctuations on the net present value of the firm’s future cash flows. Economic exposure combines both transaction exposures and operating FX exposures, but extends further to recognise the impact of FX risk on the future value of a firm. For example, an Australian and a German company might manufacture a very similar product. Both companies sell the product into Europe. The Australian

Transaction FX exposure the risk that future foreign currency cash flows will vary due to exchange rate movements

Translation FX exposure the risk that the conversion and consolidation of foreign currency assets and liabilities will have an adverse impact on the balance sheet

Operating FX exposure the risk that day-to-day operating revenues and expenses will be affected by FX movements

Economic FX exposure the effect of exchange rate movements on the net present value of a firm’s future cash flows

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company is exposed to economic FX risk in that a change in the exchange rate between the euro and the Australian dollar will affect the future profitability of the firm. If the AUD appreciates against the EUR, the Australian company will need to put up the price of the product to maintain its profit margin. This will cause the company to become less competitive with the German company. If the company does not put up its price, it will have to cut its profit margin. This will affect the net present value of the firm, as its future cash flows generated from the product will be worth less. Clearly, an organisation conducting business in the international markets must recognise potential FX exposures and consider strategies that enable the measurement and management of such exposures. These strategies will vary between market participants. For example, historic data indicate that in commercial trade transactions importers and exporters typically use forward exchange contracts and currency options as FX risk management strategies; while in capital market transactions lenders and borrowers are more likely to use currency futures contracts and cross-currency swaps. The study of FX risk continues with a discussion on FX policy formulation, followed by a more detailed discussion of transaction risk, including internal and external techniques that a company may use to hedge against transaction exposures. Chapters 18 to 21 in Part 6 consider the use of derivative products—futures contracts, options and cross-currency swaps—for the management of both translation and transaction FX exposures.

REFLECTION POINTS

• • • • • LEARNING OBJECTIVE 17.1 Formulate an FX policy document including FX objectives, management structure, authorisations, reporting systems, communications, performance evaluation, audit and review procedures.

Chief executive officer (CEO) responsible to the board for the dayto-day financial and operational management of a company

Changes in exchange rates may affect a firm’s cash flows, balance sheet, competitive position and net value. Transaction FX exposure measures the impact of exchange rate movements on future foreigncurrency-denominated cash flows. Translation FX exposure measures the impact of a consolidation of foreign-currencydenominated assets and liabilities on a firm’s balance sheet. Operating FX exposure measures the impact of exchange rate volatility on a firm’s ongoing foreign revenues and expenses. Economic FX exposure measures the impact of exchange rate movements on the net present value of a firm.

17.1

Foreign exchange risk policy formulation

The owners of a publicly listed corporation are its shareholders—that is, investors who have purchased ordinary shares or common stock issued by the company. One of the principal rights attached to an ordinary share is the right to vote at a general meeting of a company. At an annual general meeting, shareholders will vote to elect the board of directors of the company. The role of the board of directors is to represent the interests of the shareholders within the context of the ongoing viability of the company. The role of the board of directors is also to establish the objectives and policies of the organisation. The objectives will determine what the company is going to do, while the policies will state how the company is going to achieve its objectives. The board of directors will also appoint the chief executive officer (CEO) of the company. The CEO will appoint managers and will take responsibility for the day-to-day financial and operational management of the company. The CEO will ensure operational procedures are developed that state how the business of the company is to be conducted within the context of the objectives and policies set by the board. The board of directors of a company should document and circulate specific policies in relation to all aspects of the company’s operations, including FX risk management. Executive management will

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then establish FX operational procedures that must be followed within the company. Aspects of FX risk management that should be incorporated into an FX policy document include:

• • • • • • •

foreign exchange objectives management structure authorisations exposure reporting systems communications performance evaluation audit and review procedures.

17.1.1

F OREIGN EXCHANGE OBJECTIVES

The FX objectives of an organisation will take account of the nature of the underlying business. For example, a company that carries out transactions in the international markets will be faced with FX risk exposures that need to be measured and managed. The policy will consider the nature, scope and scale of the business of the organisation in the international markets. This will include the type of products and services that the company will buy and sell in those markets, plus any financial securities issued to borrow funds or purchased as investments. The policy document will recognise financial and operational strategies that may be applied at various levels of the organisation, including strategies that can be used by local, regional and global offices of the company. The policy will specify those products and services that can be used by the organisation to manage FX risk exposures. For example, the policy may authorise the use of forward exchange contracts to manage FX cash-flow exposures, but specifically prohibit the use of cross-currency swap transactions. Swap transactions may be prohibited simply because the company does not have the expertise or skills to apply this form of risk management technique. Another company may authorise the use of swap transactions. The document will also indicate the style of risk management. This may take the form of active FX risk management strategies or defensive strategies. Active FX strategies require the company to analyse and forecast movements in the FX markets. The company will then apply strategies based on its forecast of future movements in an exchange rate over time. The company needs to have great confidence in its ability to change its strategy rapidly in response to the dynamics of the FX markets. On the other hand, a defensive FX strategy requires the company to hedge a defined percentage of its identified FX exposure at all times. For example, one company might always hedge 100.00 per cent of its FX exposures, while another company may hedge only 50.00 per cent. Essentially, FX objectives will be directed towards maximising shareholder value within the context of transactions conducted in the international markets. The policy will authorise management to proceed and develop business opportunities within the global markets. If at a later date a new market opportunity emerges that is not authorised under the policy document, approval is required from the board of directors before management can proceed.

17.1.2

Cross-currency swap the exchange of principal and associated interest payments denominated in different currencies

Active FX strategy hedging techniques are continually adjusted in response to forecast changes in exchange rates

Defensive FX strategy a defined percentage of an identified risk exposure is automatically hedged

M ANAGEMENT STRUCTURE

The board of directors must ensure that an appropriate management structure with expertise in the FX markets—in particular, the management of FX risk—is in place to manage the organisation’s exposures to FX risk. A budget allocation must be incorporated, with sufficient funds to ensure that personnel are appointed and infrastructure is established. For example, if the company’s policy allows the establishment of a treasury division, then complex systems and procedures need to be established and maintained, including an FX dealing room, back office support, technical support and administration. Specialist personnel will need to be appointed and the latest technology installed for use by those personnel.

Back office support treasury division functions of confirmations, settlements and reconciliation

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Centralised FX operation treasury FX policy and procedures are controlled from the main treasury management location

Decentralised FX operation treasury FX policy and trading are divested to regional offices

The policy document must state whether the organisation will operate a centralised or decentralised FX operation. For example, a large Australian-based multinational organisation may conduct FX transactions in, say, London, New York and Sydney. The policy document must detail how management decisions will occur. The company may establish a centralised FX operation, with a single FX function in one location from which all FX policy is developed and transactions occur. A decentralised FX operation may divest policy and trading to each regional office (e.g. London and New York). Perhaps the most prudent policy would be to centralise the FX policy function to the organisation’s main office, and decentralise the FX trading operations to the regions, but within the constraints of the centralised policy. The combined arrangement will allow the organisation to retain close control of policy development, but at the same time provide the scope for the regional offices to monitor their local situation and take advantage of trading opportunities within the different global time zones. Management authority, responsibility and delegation arrangements will also be contained in the policy document. A reporting hierarchy will be established that clearly states who has authority to conduct certain transactions, and who has the responsibility of ensuring that certain functions are carried out in accordance with policies and procedures. While a manager may be authorised to delegate tasks within the treasury FX operations, the manager cannot delegate responsibility. This means that even though the manager has requested someone else to carry out a task, the manager is still responsible for ensuring that the task is carried out as required by the organisation. The objective of a management structure is to ensure that organisational controls and reporting systems are in place and that the organisation appoints skilled personnel and has sufficient funding to meet its operational needs.

17.1.3 Treasury division responsible for balance-sheet funding, managing cash flows and financial risk management

It is important that the FX policy document specifies who in the organisation has the authority to do what. The FX function will be part of the organisation’s treasury division. The head of the treasury division will appoint specialist FX personnel and authorise those personnel to conduct defined transactions on behalf of the organisation. It was also noted earlier that FX functions include FX dealers, back office staff and other support personnel. In a large organisation there may be many FX dealers, each authorised to trade one or more foreign currencies up to a specified monetary limit. For example, limits will be established for:

• • • • • • • • Confirmations, settlements and reconciliation confirm FX dealer transactions, arrange financial settlement and reconcile FX position

A UTHORISATIONS

single transactions exposures to a particular client each currency FX products used by the organisation each individual FX dealer total exposures that may be taken during the business day FX exposures across time zones and at each settlement maximum FX exposures overnight.

In particular, the policy document must address the issue of task segregation within the treasury FX function. For example, an FX dealer must not be permitted also to carry out the back office tasks of confirmations, settlements and reconciliation. Treasury tasks of dealing, back office, technology support, administration and audit must be segregated. There is an enormous risk of financial loss from either fraud or mistakes if personnel conduct tasks across a number of treasury functions. A classic case study in this area is the loss suffered by Barings Bank in its treasury operation in Singapore. If you are interested, it is worth looking on the internet at one of the many papers written on the Barings Bank failure. Contributions can be found from many different discipline backgrounds. One that reflects some of the themes we have addressed throughout this book is Lynn Drennan’s ‘Ethics, governance and risk management: Lessons from Mirror Group Newspapers and Barings Bank’, published in volume 52 of the Journal of Business Ethics in 2004 (pp. 257–66).

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17.1.4

E XPOSURE REPORTING SYSTEMS

Management must maintain control of its FX transactions and trading position at all times. In the first instance, the authority to deal in FX is established under the policy document, which also establishes procedures that ensure management always knows its current FX open position. This will generally be achieved by imposing authorisations (discussed above) and by requiring periodic reports. The policy document will specify which reports are to be produced, how frequently they must be generated and who is responsible for acting upon them. For example, a company may require daily reports on each currency to which the company has a financial exposure, each counterparty or client, each country, the amount of each transaction and the FX dealer who carried out the transaction. The reports should be forwarded each day to a nominated manager who is required to analyse the information. Exception reports should be automatically generated by the computer system each time an authorisation is breached. For example, a nominated dealer may be authorised to carry out FX transactions up to USD1 million for any one client or client group. If the dealer exceeds this authorised limit, an exception report is generated, which should then be investigated by treasury managers. Reports should also be generated that allow trends in the FX markets to be observed and analysed. This facilitates the ongoing active management of FX risk exposures.

17.1.5

FX open position the net value of outstanding FX buy and sell transactions yet to be settled

Exception reports an automatic computergenerated report activated when an FX authority is breached

C OMMUNICATIONS

The policy document that governs FX management should specify how communication is to occur both horizontally (across the organisational structure) and vertically (up and down the organisational structure). This will apply, first, within the treasury division of which FX is a part and, second, within the overall organisation. When a business unit within an organisation carries out a transaction (e.g. the importing or exporting of goods) that will eventually require the provision or receipt of foreign currency, it must inform the treasury division so that financial arrangements can be made on the due date in relation to the payment or receipt of the FX. In another example, the treasury division of an organisation may have issued debt securities into the international capital markets denominated in USD. As the paper is sold, the USD funds may need to be converted into local currency and from time to time USD interest payments will fall due. These arrangements must be communicated to the responsible FX dealers within the organisation. Failure to complete ongoing USD interest payments when they fall due may result in significant financial penalties to the firm and loss of reputation in the capital markets. Another aspect of communications is the daily strategy meeting. Early each day, before the local market opens, FX dealers will meet to discuss the evolving news in the markets overnight. They will consider the implications of the news for the forthcoming day’s operations and develop specific trading strategies. Finally, communication systems to be applied in the event of a disaster should be incorporated in the policy document. If, for example, there is a fire in the building that houses the treasury and FX operations, what are the back-up and business recovery plans and strategies? In particular, how will FX dealers maintain communications with the markets, other business units within the organisation and their corporate customers?

17.1.6

P ERFORMANCE EVALUATION

An organisation must evaluate the performance of all its business units, including its FX operations. The performance of each unit must ‘nest’ or fit into the overall performance objectives of the organisation. Typically, the FX operations of an organisation will be carried out to support an underlying business 543

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SMART performance objectives should be specific, measurable, achievable, realistic and timely

transaction, such as the export or import of goods and services, or the borrowing or investment of funds in the capital markets. Performance objectives and evaluation must be SMART; that is, they must be Specific, Measurable, Achievable, Realistic and Timely. The policy document must state the organisation’s objectives in relation to performance measurement, which must cover all aspects of the business’s operation, ranging from performance objectives for each individual, team, business unit, section, department or division to the overall performance objectives of the total organisation. The sum of the performance objectives of the individual parts should equal the whole. The FX policy document will specify what is to be measured and how it is to be measured. The performance benchmarks set for personnel must be achievable and be seen as being realistic; if personnel feel that an objective is not achievable, they are less likely to be motivated to achieve that objective. Performance should be measured on a regular basis over defined time periods. Performance evaluation is an excellent policy tool that will enable an organisation to target desired behaviour from personnel and business units across the organisation. It allows managers to set challenging benchmarks that will lift work outcomes.

17.1.7

A UDIT AND REVIEW PROCEDURES

The audit role is critical in a treasury FX operation. The FX function should be subject to regular internal audit, as well as periodic external audit. Strict criteria for the conduct of an audit must be clearly stated in the policy document. The audit function should be segregated from all other treasury functions within the organisation. Internal audit reports must be forwarded to senior management for analysis and action. External audit reports should be forwarded to both executive management and the board of directors. Executive management should not have the opportunity to filter an external audit report before it goes to the board of directors. The external audit firm should be independent of the organisation so that there are no conflicts of interest between its task as an auditor and other services the firm may provide from time to time. The audit should cover all treasury functions. The reports generated from the audit must be used to review current objectives, policies and procedures of the organisation. The audit will assess the firm’s performance within the context of its policies and procedures, and ensure compliance with regulatory requirements. The audit report provides management with the opportunity to consider ways to improve efficiency and effectiveness. The policy document should also require structured processes to be established to ensure that all business functions are reviewed periodically. The financial markets, and in particular the FX markets, are dynamic, that is, things are always changing. Business operations will change in response to market changes. Business reviews allow management to consider change in a controlled and structured manner. The review process will lead to new policies and procedures, which must be authorised, documented and distributed to the appropriate personnel in the organisation.

REFLECTION POINTS

• •

The board of directors will establish objectives and policies relating to FX risk; management will set up and oversee operational procedures to achieve those objectives and policies. An FX policy document will include:

— Objectives: identify the nature and extent of a firm’s business within the international markets, the products and services offered or used and the management of FX risk exposures. — Management structure: appointment of personnel with FX expertise, budget allocations, centralised or decentralised treasury operation (dealing, back office and support) and reporting hierarchy. 544

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— Authorisations: establishes who is allowed to conduct FX transactions, including limits on types of transactions and exposures to currencies, products, counterparties and time zones; risk management products that can be used. — Exposure reporting systems: provide detailed reports relating to all FX exposures; who receives the reports, the frequency of specific reports, actions to be taken, exception reports; they should facilitate active FX risk management. — Communications: horizontal and vertical communication within the treasury business unit and throughout the organisation; FX transactions conducted, FX strategies and operational risk management. — Performance evaluation: covers all business operations and personnel; must be specific, measurable, achievable, realistic and timely; establish performance benchmarks that target challenging business and personnel outcomes. — Audit and review: internal and external audit requirements; audit reports sent to executive management and board of directors; periodic review of FX exposure and risk management policies and procedures.

17.2

Measuring transaction exposure

It was noted previously that FX risk is categorised as transaction exposure, translation exposure, operational exposure and economic exposure. This section focuses on the measurement of transaction exposures, using the example of an Australian company conducting transactions in USD. However, the same outcomes could easily be achieved by substituting a company from any other country where cash flows are exposed to changes in an exchange rate. The identification of the potential FX exposure for a firm with only one or two international transactions is quite simple. If an Australian company has a single export order from a US company, and the order is worth USD1 million paid in USD, the Australian company may consider its potential exposure to be USD1 million. If the exchange rate is AUD/USD0.7216 at the time the order is placed, the contract is then worth AUD1 385 809.31. The risk (or uncertainty) faced by the Australian company is that the AUD/USD rate will be different by the time the payment for its export order is received. If the AUD appreciates and the AUD/USD exchange rate rises to AUD/USD0.7452 by the payment date, the export order returns the Australian company AUD1 341 921.63. The appreciation of the AUD has resulted in an AUD43 887.68 reduction in the AUD value of the export order. The exchange rate movement may well have eroded most of the firm’s profit margin on the transaction. If, on the other hand, the AUD depreciates and the exchange rate falls, the firm will make an unexpected AUD gain on the transaction when the company converts the USD into AUD. With the above transaction, the US importing company is not directly exposed to FX risk as the transaction is denominated in its home currency. A major component of FX risk is uncertainty—in this case uncertainty as to the amount of AUD to be received by the firm at the actual value or settlement date, and therefore uncertainty as to the profitability of the export transaction. Risk does not imply that the amount to be received in the future will necessarily be less than the originally budgeted value of the contract. Risk has two directional elements:

• •

LEARNING OBJECTIVE 17.2 Outline methods that can be employed to measure a company’s FX transaction exposures, including net FX cash flows, currency standard deviations and correlation coefficients.

a downside exposure, where the amount to be received in the future is lower than the current projected amount, or where the amount to be paid in the future is higher than the current projected amount an upside exposure, where the amount received (paid) in the future is higher (lower) than the current projected amount. 545

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Hedging techniques strategies that allow a firm to protect against an identified risk exposure

Since risk makes accurate budgeting very difficult, and since it affects the estimation of the net present value of a firm, the firm may consider strategies to minimise FX risk (particularly its downside exposure) through the use of hedging techniques. Hedging is the implementation of specific strategies that will minimise or remove risk. These are discussed later in the chapter. The company in the above illustration is exposed to a single FX cash-flow exposure, but many multinational companies are typically exposed to much more complex FX cash-flow situations. Companies with multiple FX cash-flow exposures should:

• •

calculate the net amount of inflows and outflows in each foreign currency at specified points in time estimate the overall risk of exposure to those currencies. These steps are now discussed in turn.

17.2.1

N ET CASH FLOWS

It is important to collate all receivables and payables in each foreign currency rather than considering each individual transaction. The reason for this should be clear from the following data.

• •

An Australian company has an export order to the USA for USD1 million, with settlement due to be received on 3 July. The company also has an import order with a Japanese firm. The contract is also denominated in USD, with a value of USD1 million, and is payable on 3 July.

If the Australian company hedged both transactions, it would be acting as if it had an exposure of USD2 million and would therefore incur an unnecessary cost. In fact, the two transactions cancel each other, except for the difference between the bid and offer rates, giving the company essentially a zero net FX exposure. For example, an appreciation of the AUD during the period between the business transactions and the payments dates would result in an FX loss on the receipt of the USD payment for the export, but the loss would be offset by an FX gain on the payment for the import account, since the USD is now cheaper. This is illustrated in Table 17.1. Two important observations must be made regarding the calculation of the net exposure:

•

First, the receivables and payables should be collated according to the currency of the transaction rather than the country of the transaction. For example, if a contract is written with a company located in Japan, but denominated in USD, then the FX risk is with the USD.

Table 17.1 Net transaction exposure  

Inflow (+)

Outflow (−)

Today’s data: Export order

(+)USD1 000 000.00

 

Import order

 

(−)USD1 000 000.00

Expected value

 

 

(spot AUD/USD0.7234–37)

(+)AUD1 382 361.07

(−)AUD1 381 788.03

AUD/USD0.7815–18

(+)AUD1 279 590.53

(−)AUD1 279 099.51

FX gain (+)

(+)AUD102 770.54

 

3 July:

FX loss (−)

(−)AUD102 688.52

The net FX exposure equals $82.02, the difference between the gain and loss. This amount is not worth hedging and derives from the difference between the bid and offer rates.

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•

The second observation is that the company has an almost perfect hedge because its receivables and payables are identical, not only in amount and currency but also in time. Both the receipt and payment are due on 3 July.

Had there been a time discrepancy between the two payment dates, the natural hedge would not have been perfect. If the import payment had not been due until 27 July, and if the AUD had depreciated between 3 July and 27 July, the FX gain made on the payment of the import account would not have been as great as that shown in Table 17.1. It therefore would not have provided a perfect offset for the FX loss on the export receipt. Given the significance of the timing of the cash flows in estimating the exposure in each currency, it is important to record the expected inflows and outflows for specific time periods. A pro-forma record is presented in Figure 17.1. One of the features of the suggested recording procedure is that it is very time specific in the recording of the flows in the near future. The further into the future that the flows occur, the broader is the time-band. The tables in the pro-forma would be updated daily. Those transactions recorded on a monthly or quarterly time-band will, as time passes, be progressively broken down into weekly then daily observations. The pro-forma also provides for the conversion of net flows into the AUD-equivalent amounts at the current spot rates, in order to allow quick comparisons to be made between the various currency exposures. This helps determine whether or not it is necessary to put in place a hedging strategy.

Natural hedge the use of matching transactions to offset a potential risk exposure

Figure 17.1  Recording net transaction exposures Net exposures—Quarterly net inflows (+) / net outflows (–) (in local currency equivalent) USD

JPY

USD

EUR Net NZD GBP — exposures—Monthly net inflows (+) / net outflows (–) (in local currency equivalent) JPY

USD

—

EUR NetNZD GBP — exposures—Weekly net inflows (+) / net outflows (–) (in local currency equivalent) JPY

USD

—

EUR NZD GBP — Net exposures—Daily net inflows (+) / net outflows (–) (in local currency equivalent) JPY

EUR

NZD

GBP

—

—

—

The reporting pro-forma in Figure 17.1 will vary in complexity depending on the policies of a particular organisation. For example, an organisation that has large FX exposures may determine that more detailed reports are required beyond weekly, particularly if the FX markets are currently volatile. The pro-forma in Figure 17.1 is typically generated using a computer-based spreadsheet program. Smaller companies may develop their own simple report format, but larger corporations that conduct regular transactions in the international markets may purchase one of many sophisticated specialist 547

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software packages that enable a firm to identify, measure, manage and monitor its ongoing net FX exposures over time. Our understanding of risks associated with transaction FX exposures can be extended further by considering:

• •

currency variability currency correlations.

17.2.2

Standard deviation a statistical measure of the dispersion of a set of data around a central point

Mean the average of a set of observations; an indicator of central tendency

T RANSACTION EXPOSURES: CURRENCY VARIABILITY

Having determined the net FX exposure in each currency, it is then important to develop a view on the extent of the risk associated with each exposure. The higher the probability that the spot rate for a given currency will change between the contract date and the settlement date, the greater the risk associated with remaining exposed to the FX risk. If, on the other hand, there is a low probability of a change in a particular currency, there is a lesser risk associated with the exposure. The measurement of this probability and the magnitude of future changes in an exchange rate are therefore important. Standard deviation is one measure that is used. It is a statistical measure of the dispersion of a set of data around a central point. It measures the volatility and the degree of movement in each currency over a specified historic period. In a normal distribution, approximately two-thirds of observations will fall within one standard deviation of the mean. The mean is the average of the observations; that is, a statistical indicator of a central tendency of the data. FX exposures in currencies that have a low standard deviation against another currency involve less risk than exposures in currencies that have a higher standard deviation. There is a problem, however, in using the standard deviation to provide information on the future movement in an exchange rate. The standard deviation is calculated from—and thus reflects—historic data. The future may hold different patterns of currency movements. One way of obtaining a feel for the reliability of a standard deviation is to test for the stability of the standard deviation through various historic sub-periods. Past periods of stability provide some comfort in the use of historic data to provide a pointer to the ongoing future relationship. Table 17.2 provides hypothetical data on the standard deviation of some major trading currencies against the AUD. Four time periods indicate standard deviations in situations of FX stability, uncertainty, recovery and renewed stability.

Table 17.2 Standard deviations of currency movements (%) Period 1

Period 2

Period 3

Period 4

Currency

Stability

Uncertainty

Recovery

Stability

US dollar

5.69

13.37

7.29

4.32

Japanese yen

6.81

25.83

8.39

6.82

UK pound

6.73

17.76

7.51

5.09

Euro

8.88

23.53

9.76

5.12

NZ dollar

7.11

12.49

7.50

3.34

Taiwanese dollar

6.98

14.93

7.21

4.68

South Korean won

4.77

9.88

5.51

3.62

Singapore dollar

8.07

12.19

8.32

5.05

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The data presented in Table 17.2 demonstrate quite clearly the two points made above. First, standard deviations vary between currencies in the same time period, indicating that there are considerably different degrees of risk associated with exposures in different currencies. Second, standard deviations vary over time. For example, in periods of crisis, volatility in the FX markets increases significantly. As  the markets recover from a disturbance, it is to be expected that standard deviations (currency variability) will gradually return to more normal levels. In Table 17.2, the standard deviations in the renewed stability in period 4 are now actually lower than the earlier stability period. This may be the outcome of specific initiatives taken by governments or regulatory authorities as a result of the crisis evident in period 2.

17.2.3

T RANSACTION EXPOSURES: CURRENCY CORRELATIONS

The preceding approach is useful in assessing the risk of exposures in particular currencies. However, a firm that is considering whether or not to hedge an FX exposure must take a second measure into account: the correlation between the various currencies to which the firm is exposed. The correlation between currency movements is measured by their correlation coefficients, which indicate the degree to which currencies move in relation to each other. If two currencies are perfectly synchronised in their movements in relation to each other, they will have a correlation coefficient of either +1.0 or −1.0. A correlation coefficient of +1.0 indicates that the two currencies have a perfect positive correlation, which means that when one currency is appreciating (depreciating), the other currency will also be appreciating (depreciating) by an identical amount. On the other hand, a coefficient of −1.0 indicates a perfect negative correlation between the two currencies; that is, when one currency is appreciating (depreciating), the other currency is depreciating (appreciating) by an identical amount. A coefficient of zero indicates that there is no discernible pattern in the co-movements of the two currencies against each other. To demonstrate the use of correlation coefficients in determining whether or not to hedge an FX exposure, an Australian company whose net inflow and net outflow in AUD equivalent data are given in Table 17.3, and Figure 17.2 is used as an example. At date t + 6, the Australian company has exposures in two currencies, but based on the correlation coefficient between currency A and B there is little incentive to hedge the exposures. Historically, there is a high positive correlation (+0.96) between currency A (inflow) and B (outflow) that, if it continues, will give the company what is termed a natural hedge. In the event of, say, a depreciation of currency A against the AUD, the company would experience an FX loss on the net inflows in currency A, but this would be mostly offset by the expected FX gain made on the payment of its currency B outflow.

Correlation coefficients a statistical measure of the degree to which movements in variables are related

Positive correlation data that move in the same direction

Negative correlation data that move in the opposite direction

Table 17.3 Transaction exposure and currency correlations Net inflows (+) and net outflows (−) in AUD equivalents ($ millions) Date

Currency A

Currency B

Currency C

t+6

(+)$10.8

(−)$10.9

 

t+8

(−)$7.4

(−)$7.3

 

t+9

 

(−)$6.5

(+)$6.4

t + 11

 

(+)$5.2

(+)$5.5

Correlation coefficients

A:B = +0.96 (high positive correlation) B:C = −0.95 (high negative correlation)

 

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% monthly change in foreign currency against local currency

Figure 17.2  Currency movements

DEM deutschmark; the former currency of Germany before joining the EMU

Currency B Currency A

Time

Currency C

A quite different situation exists at t + 8. Though currencies A and B are again involved, the direction of the flow is the same for both currencies. In that situation, remembering the very high correlation between A and B, if an FX gain is made on one currency outflow, it will also be experienced on the other currency outflow. Similarly, if an FX loss is sustained on one flow, it will also be experienced on the other. Depending on the expected variability, or standard deviations, of the two currencies against the AUD, it may be appropriate to hedge the exposures. The net flows recorded at t + 9 and t + 11 demonstrate the implications of a set of foreign currency inflow and outflow exposures that are negatively correlated (B:C = −0.95). The flows at t + 9 should be hedged, depending on the standard deviations of the currencies against the AUD. If the flows are not hedged and currency B appreciates, currency C will depreciate. The company will experience an FX loss on its transaction in currency B and a further FX loss from receiving payment in currency C. In contrast, it would not be necessary to hedge the flows at t + 11, since a natural hedge exists. Given the strong negative correlation between currencies B and C, if currency B depreciated, then the FX loss experienced on the inflow of currency B would be more or less compensated for by the FX gain that would be realised through the appreciation of currency C. A diagrammatic representation of the correlation coefficient relationships between the currencies is shown in Figure 17.2. It is necessary to conclude this section with a caution: like standard deviations, correlation coefficients are calculated on historic data and therefore cannot be presumed to provide reliably accurate forecasts of future correlations. Nevertheless, historic coefficients can provide valuable insights for estimating a firm’s FX risk exposure. In common with standard deviations, more faith can be placed in the correlations if they have remained relatively stable throughout various historic subperiods. In addition to testing the stability of the correlations, it is important to be aware of the institutional arrangements relevant to various currencies. For example, until July 1997 Thailand fixed the Thai baht against a basket of currencies, predominantly the USD, JPY and DEM. Since that date, Thailand has adopted a floating exchange rate regime. Over the same period Indonesia moved from a currency regime in which the rupiah traded within a limited band, or range, to one in which the currency has been floated. On the other hand, the Hong Kong dollar (HKG) is currently linked to the USD. The introduction of the euro has resulted in the disappearance of many sovereign currencies, in particular the German deutschmark, the French franc and the Italian lira. These past changes, and any new future changes, in exchange rate regimes will clearly affect historic data outcomes.

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In applying any statistical technique it is important not to slavishly accept and follow the numbers that are generated. Statistics must be interpreted within the historic and institutional framework in which they are generated and applied; they cannot replace the need to be up to date and familiar with the economic, political and social environment that impact upon the financial markets.

REFLECTION POINTS

• • • •

A firm that carries out transactions that require future cash flows denominated in a foreign currency is exposed to FX transaction risk; that is, a movement in the exchange rate will change the amount of the future cash flows in terms of the local currency. A firm needs to calculate the net amount of cash inflows and outflows denominated in specific foreign currencies, based on the timing of the cash flows. This will identify natural hedges and the net FX risk exposures that may need to be hedged. Standard deviation may be used to measure the volatility and probability associated with exposures to foreign currencies; a weakness is that standard deviation is based on historic FX data. A firm that has FX exposures to a number of currencies needs to consider their correlation coefficients, including positive and negative correlations, when analysing FX risk exposures.

17.3

Risk management: market-based hedging techniques

Having calculated its net exposures in each currency, and having considered their standard deviations and correlation coefficients, a company may decide that the risk exposure associated with an FX position is too great and should be managed. Therefore, the company may decide to implement a strategy that reduces the identified FX risk exposure. This is defined as hedging the risk exposure. The company has a number of choices in relation to hedging strategies. Broadly, the company may implement one or a combination of so-called market-based hedging techniques or strategies. Market-based hedging strategies involve the use of specific financial products that are available in the financial markets. Alternatively, the company may decide to use so-called internal hedging techniques. These strategies reduce FX risk by actively managing FX cash flows within the organisation. These are discussed in Section 17.4. At this stage, we introduce an important market-based risk management financial product, the forward exchange contract (17.3.1), and an FX risk management technique known as a money-market hedge (17.3.2). Other market-based instruments that may be used to hedge FX risk, including futures contracts, options and cross-currency swaps, are examined in Part 6. Those chapters should be read in conjunction with this section on foreign exchange risk management.

17.3.1

LEARNING OBJECTIVE 17.3 Explain procedures involved in the implementation of market-based hedging techniques, in particular forward exchange contracts and moneymarket hedging.

F ORWARD EXCHANGE CONTRACTS

A forward exchange rate is an exchange rate set today that will apply to the delivery or receipt of a specified amount of a nominated currency at a future date. The forward exchange rate will be calculated as the spot rate plus or minus forward points. Chapter 15 discusses the calculation of forward points; briefly, this is the net interest rate differential between the countries of the two currencies involved in a transaction. A forward exchange contract facilitates the management of FX risk as it locks in an exchange rate today that will apply at a nominated future date. If an exchange rate is locked in today, then the uncertainty, or risk, of exchange rate movements has been removed. 551

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Forward exchange contracts are over-the-counter contracts provided by commercial, investment and merchant banks. The following example shows how a forward exchange contract could be used to hedge a foreign currency receivable. Assume that an Australian company has a USD1 million receivable, due in six months, and that the company is not prepared to accept any FX risk exposure. That is, it is not prepared to face the risk that the USD may be worth less in terms of the AUD by the time it is due to receive the USD. In order to fix the value of the USD, it could enter into a forward exchange contract today to sell the USD for forward delivery in six months, at a rate fixed today. In effect, this contract means the company is buying AUD for delivery in six months. The Australian company will contact its bank and conduct the steps shown in Figure 17.3.

Figure 17.3  Forward exchange contract: hedging a foreign currency receivable Today’s data Spot rate AUD/USD0.7256–62 Six-month forward rate AUD/USD0.7375–81 The Australian company has USD1 million receivable in six months. Transactions Today: The company enters into a contract to buy AUD six months forward. The contract rate is the dealer’s six-months’ forward offer rate, that is, 0.7381. The amount to be received in six months is: USD1 000 000/0.7381 = AUD1 354 829.97. In six months: The company receives USD1 000 000 from its commercial transaction. It supplies USD1 000 000 to the FX dealer, and receives AUD1 354 829.97.

Had the company not taken forward cover, then the value of the USD receivable, in terms of the AUD, would have been determined by the spot rate that prevailed in six months’ time. For example:

•

If the spot rate six months from today is 0.7543, then USD1 000 000 = AUD1 325 732.47. In this case, the USD depreciated more than was suggested by the forward rate; by taking the forward cover the company avoided an FX loss.

•

If the spot rate six months from today is 0.6865, then USD1 000 000 = AUD1 456 664.24. In this case, the USD appreciated but the forward exchange contract taken out by the company deprived it of the gain it would have made had it remained uncovered.

In the first example, the company is pleased that the hedging strategy worked because the USD had depreciated by the delivery date. In the second example, where the USD actually appreciated, the company may regret having put the forward exchange contract in place. Such judgments, however, are based on a misunderstanding of the nature and purpose of risk management. The main purpose of hedging is not to maximise cash flows and profits but to reduce variability and uncertainty about the value of future cash flows—that is, to reduce risk. However, in reality companies do take extraordinary FX risks from time to time, sometimes contrary to the organisation’s FX policy. Large FX exposures are often left open as managers seek to make large speculative profits, often with the intent of increasing their short-term performance outcomes and maximising their own performance payments or bonuses. Large open FX exposures that are not recognised by the firm increase the probability that it will suffer a significant financial loss and perhaps be forced into insolvency. The above example considered a foreign currency receivable transaction. Any company that is exposed to FX risk as a result of having a foreign currency payable due at a future date can also enter into 552

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a forward exchange contract with an FX dealer to buy a foreign currency (sell AUD) forward. Having implemented this strategy, the company knows exactly how many AUD the foreign currency payable is going to cost, no matter what happens to the exchange rate between today and the delivery date.

17.3.2

M ONEY-MARKET HEDGE TO COVER FX RISK

Another technique for hedging the risk associated with having an FX receivable or payable is the use of a money-market hedge, sometimes referred to as a BSI (Borrow, Spot Convert, Invest) hedge. The general principle behind any hedge strategy is to create a position opposite to the original situation that is exposed to risk. In the example in Figure 17.3, the Australian company had a USD1 000 000 receivable due in six months’ time. To hedge that receivable, it entered into a forward exchange contract in which it established a payable of USD1 000 000, also due in six months’ time. An alternative strategy is to hedge the FX exposure using a money-market hedge. The steps involved in a money-market hedge are shown in Figure 17.4, using the example of an Australian company that has

Money-market hedge strategy: borrow FX today, convert to local currency at spot rate, invest in money markets (BSI)

Figure 17.4  A money-market (BSI) hedge to cover a USD receivable Today’s data Spot rate: Money-market rates:

AUD/USD0.7430–35 2.75% p.a. in the USA 3.50% p.a. in Australia The company has a USD500 000 receivable due one year from today. Transactions Today: The company borrows USD such that it has to repay USD500 000 in one year; that is, borrow USD500 000/(1 + 0.0275) = USD486 618. The company buys AUD with the USD at the dealer’s spot sell rate; that is, USD486 618/0.7435 = AUD654 496.30. The company invests AUD654 496.30 for one year at 3.50% p.a.; that is, in one year it will receive AUD654 496.30 × (1 + 0.035) = AUD677 403.67. In one year: The company receives USD500 000 from its commercial transaction. The USD500 000 is used to repay its borrowing, being USD486 618 plus interest. The company also receives AUD677 403.67 from its money-market investment.

a one-year USD500 000 receivable. The spot rate is AUD/USD0.7430–35. Money-market interest rates are 2.75 per cent per annum in the USA and 3.50 per cent per annum in Australia. The strategy involves:

•

today—borrow USD486 618, being USD500 000 less the interest due in one year (500 000/(1 + 0.0275), then

• •

convert the USD486 618 into AUD at the AUD/USD0.7435 offer spot rate = AUD654 496.30, then invest the AUD654 496.30 today in the local money markets.

Hence the name ‘BSI hedge’: borrow, spot, invest. In one year’s time the company will receive AUD from the Australian money-market investment. At the same time it will repay the USD486 618 loan plus interest (486 618 × 1.0275) from the USD500 000 receivable that is due on that date. 553

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Had the company not taken the cover as shown in Figure 17.4, the value of its USD receivable, in terms of the amount of AUD received in one year’s time, would be uncertain. It would depend on the AUD/USD spot rate in one year’s time. Having hedged using the BSI strategy, the company is assured today that it will receive AUD677 403.67 in a year’s time. In the example shown in Figure 17.4, numerous simplifying assumptions have been made. For example:

•

There is only one rate of interest in each location, whereas in reality it is necessary to use the appropriate market bid/offer interest rates in the calculations.

•

It is assumed that both rates of interest are expressed in similar terms; that is, the US interest rate has been converted from a 360-day rate to its 365-day equivalent.

•

Taxation implications and any other transaction costs have been ignored.

In another example, if a business had an exposure that was a GBP payable on a date six months in the future, then the BSI hedge would have involved the following steps. Today:

•

Borrow sufficient AUD such that when converted into GBP and invested in the London money markets, the GBP principal plus interest will be sufficient to meet the future GBP payment obligation in six months.

• • • •

Convert the AUD into GBP at the current spot rate. Invest the GBP so that the investment matures on the same day that the initial GBP payable is due. In six months: Use the maturing London money-market deposit to meet the GBP payable commitment. Retire the AUD debt.

By following these steps, the Australian company knows today, with certainty, the AUD cost of its GBP payable. It is the amount of AUD that the company has to pay to retire its AUD debt, and that amount is immune from the effects of any change in the exchange rate that may occur between today and six months’ time. However, the company could have achieved the same position by simply entering into a forward exchange contract with an FX dealer.

REFLECTION POINTS

• • • •

FX risk exposures may be hedged using market-based techniques, including forward exchange contracts, money-market hedges, futures contracts, option contracts and cross-currency swaps. (Note: (1) futures, options and swaps are discussed in Part 6, and (2) internal risk management techniques are discussed below.) A forward exchange contract is an over-the-counter risk management product generally provided by commercial, investment and merchant banks. A forward exchange contract establishes an exchange rate today that will apply to the buying or selling of a foreign currency amount at a specified future date. The writer of the forward exchange contract will deliver the specified foreign currency on the specified date. Settlement occurs using the forward exchange rate determined today. A money-market hedge, or BSI (borrow, spot, invest) hedge, involves establishing an opposite position today to the future FX risk exposure. For example, to hedge a foreign currency receivable, borrow currency in the overseas money market today, convert the funds at the spot rate, invest in the local money market and use the future foreign currency receivable to repay the hedge strategy borrowing.

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17.4

Risk management: internal hedging techniques

There are a number of internal risk management techniques which firms may consider using in order to minimise their FX exposures and thus reduce the need to hedge FX exposures using market-based techniques. Internal hedging techniques offer firms an opportunity to manage FX risk exposures from within the business and thus, in part, avoid the explicit costs associated with using market-based hedging instruments. Six internal hedging techniques are discussed:

• • • • • •

invoicing in the home currency creating a natural hedge currency diversification leading and lagging FX transactions mark-ups counter-trade and offsets.

17.4.1

LEARNING OBJECTIVE 17.4 Consider the implementation of internal hedging techniques to minimise and manage FX risk, including invoicing in the home currency, creating a natural hedge, currency diversification, leading transactions, lagging transactions, markups, counter-trade and offsets.

I NVOICING IN THE HOME CURRENCY

This technique avoids FX exposure completely. If a business is able to arrange for all its international transactions to be denominated in its local currency, then, regardless of what happens to the exchange rate, the business has certainty about the value of its future cash flows. However, businesses do not generally follow this practice, even though by doing so they could avoid having to consider FX risk exposure, because it is most likely that other costs will be imposed as a result. By denominating all contracts in local currency, the firm effectively pushes the total FX risk onto the other party to the business transaction. The other party will factor in its increased FX risk into its pricing decision; it may charge a higher price if it is selling to the business, or it may only be prepared to pay a lower price if it is buying. The only businesses that could expect consistently to adopt a home currency invoicing strategy and not pay this penalty would be those that are in a dominant position in the market in which they are carrying out the transaction. It is not an option that is available to most businesses in the competitive international markets. In reality, the majority of trade transactions and international finance transactions are conducted in hard currencies such as the USD, the euro, GBP and Japanese yen. This does not mean that a company should not bother to try and invoice in its home currency; it should always explore the possibility, but the company needs to consider the cost implications.

17.4.2

C REATING A NATURAL HEDGE

A natural hedge is achieved by structuring business transactions so that foreign currency receivables are matched in currency, timing and amount with offsetting foreign currency payables. An exporter with receivables in, say, GBP could hedge the exposures by establishing payables in the same currency. This could involve a range of transactions, including:

• • •

sourcing production inputs, such as inventory and manufacturing equipment, from overseas and denominating the import invoices in GBP borrowing part of the firm’s debt requirements offshore in GBP, which establishes a commitment to pay interest and repay the principal in the currency in which it has foreign currency receivables due leasing equipment, with the lease payments denominated in GBP.

There are some problems associated with this approach to minimising FX exposures. First, it is unlikely that the cash flows associated with the hedge-motivated transactions will perfectly match the 555

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Overseas currency accounts a foreign currencydenominated account opened with a bank

size and timing of the underlying export income exposures. Even if this does not cause a problem, the business must consider the cost of the hedge-motivated transactions. Is there an extra interest cost associated with borrowing in markets in which the business may not be well known? Are the imported inputs or the lease agreements superior in quality or better priced than those obtainable from a third supplier in a currency that does not match the hedging requirements? Businesses that have significant involvement in international trade and investment may consider the establishment of overseas currency accounts with their bank. The individual cash flows will be held in this account and the net balance in the account may only need to be repatriated to the home currency at the end of the accounting period. Notwithstanding the possible limitations of natural hedge strategies, where possible businesses should always consider using natural hedge techniques for FX risk management in their commercial decision-making processes.

17.4.3 Currency diversification a strategy of spreading FX transactions across a number of currencies

As discussed earlier, an understanding of standard deviations and correlations can be used to reduce FX risk exposures. This can be achieved through currency diversification. Consider a company whose business is predominantly imports and exports, and assume that the company’s export revenue exceeds its import payments in each currency in which it is exposed. In this situation the company would be adversely affected by a strong local currency, since its net export receipts would convert into less of its local currency. The company’s risk exposure would be heightened if its transactions were concentrated in only one or two foreign currencies. If its receipts were spread over a larger number of currencies, there would be less damage to its profitability from a strong local currency. As the data in Table 17.2 indicate, each currency has a different standard deviation; that is, not all currencies will depreciate to the same extent over any particular period. If one or two of the currencies depreciated sharply, their impact on the company’s overall profitability would be less if they represented a smaller proportion of a wide range of foreign currency cash flows. The advantage of diversifying the currency spread of the business’s transactions is enhanced if the foreign currencies received do not have a highly positive correlation. Ideally, the company described above would have its net export receipts in a range of currencies that are negatively correlated. If that could be achieved, the variability of the local currency value of the foreign currency earnings would be reduced. If some currencies depreciated, others would appreciate, thus somewhat protecting the local currency value of the company’s earnings.

17.4.4 Leading changing the timing of FX transactions by bringing the cash flows forward

Lagging changing the timing of FX transactions by delaying future cash flows

C URRENCY DIVERSIFICATION

L EADING AND LAGGING FX TRANSACTIONS

Another commonly used internal technique involves the leading and lagging of cash flows. Leading refers to changing the timing of a cash flow so that it takes place prior to the originally agreed date. This would be a sensible strategy if, for example, a company had a USD payable and it anticipated that the USD would appreciate prior to the scheduled payment date. Similarly, it would be in the best interests of a company with a USD receivable if it could encourage its customer to lead its payment if a depreciation of the USD was anticipated. It is likely that in both cases there would be a cost involved in the strategy. In the former case, the company must consider the cost of the interest forgone as a result of the early payment. That cost must be compared with the expected gain to be obtained from leading its FX payment. In the latter case, the company may have to offer a discount for early payment. Again, the cost of the inducement must be compared with the expected benefit of the early payment. Lagging is the reverse of leading and involves delaying future FX cash flows. For example, a company may have a USD payable due in three weeks, but is also expecting a USD receivable of a similar amount in four weeks. The company may seek to lag the payable in order to match the timing of the receivable and thereby minimise its FX risk exposure.

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In addition to the explicit financial costs, there is one other potential cost that must be considered. If a company becomes unpredictable in its payments behaviour, it may develop a poor credit reputation in its commercial relationships. The supplier may begin to apply a higher invoice value to compensate for the interest paid on their bank overdraft for the lagged period of payment. Effectively, payment lagging could result in the imposition on the business of the equivalent of a risk premium. The company may also find that suppliers are no longer willing to give the company trade discounts or credit.

17.4.5

M ARK-UPS

Mark-ups are said to occur when a firm increases the price of a good or service to cover any potential future FX risk exposure. A finance manager might examine historical movements in a currency over the medium term and find that a worst-case scenario resulted in the exchange rate falling by, say, 10.00 per cent. Based on this scenario, an exporter could mark up the export price of goods sold by this amount. Similarly, an importer could mark up the domestic price of the imported goods. The biggest constraint to this FX risk management strategy is competition. In a competitive market a company that increases the price of its products or services to cover a possible FX risk exposure may well find that its revenues fall from reduced sales. This will particularly be the case where the company is selling goods and services into another country and is competing with a local company in that country. In that situation the local firm is not exposed to the same FX risk. Provided the exporter or importer is able to increase its price by 10.00 per cent and still remain competitive, the mark-up technique is a valid risk management alternative to be considered by a firm.

17.4.6

Mark-ups increasing prices to cover worst-case scenario changes in exchange rates

C OUNTER-TRADE AND CURRENCY OFFSETS

Counter-trade involves what might be described as a modern-day barter system. Two companies that are each exposed to FX risk may enter into an arrangement whereby they exchange one product for another product, rather than buying and selling the products with currency transactions. The removal of currencies from the counter-trade transaction also removes the direct exposure to FX risk. However, this strategy is limited by the likelihood that the companies will have matching needs. That is, the companies will need to exchange products of equal value and at the same time. Currency offsets are an important FX risk management technique. As discussed earlier in the chapter, firms must recognise the denominations and timing of all their FX cash inflows and outflows. In doing this, a firm is often able to offset one FX-denominated cash inflow against a cash outflow also denominated in the same currency. This risk management technique applies to the internal cash flows of a firm, plus FX-denominated cash flows between different firms. For example, company A may owe USD to company B for goods imported, but at the same time company B may owe company A a similar amount of USD for consulting services provided in relation to another project. If the matching USD cash flows are offset against each other, associated FX risk exposures are eliminated.

Counter-trade the exchange of product for product, rather than currencybased contracts

Currency offsets the recognition of the timing and amount of cash inflows and outflows in the same currency

REFLECTION POINT

•

Internal hedging techniques offer firms an opportunity to manage FX risk exposures from within the business. Internal FX risk management techniques include:

— Invoice goods and services in the home currency rather than a foreign currency. — Create a natural hedge. For example, borrow in a foreign currency to finance assets generating income in the same currency, then use foreign currency income generated from the asset to repay foreign currency loans (cash-flow timing is an issue). A multinational corporation may also establish an overseas currency account. continued

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— Currency diversification allows a firm to spread its FX risk exposures and attempt to benefit from different currency standard deviations and correlation coefficients. — Leading and lagging strategies afford a firm the opportunity to match the timing of foreign currency cash flows; leading involves bringing the cash flows forward; lagging involves delaying the cash flows. — The mark-up technique is a strategy whereby a firm increases the price of a product or service to directly cover a potential future FX risk exposure. This strategy may adversely affect the firm’s competitive position. — Counter-trade involves two international firms exchanging products to a specified value, rather than generating currency exposures by separately buying and selling the products. — Currency offset strategies recognise the amount and timing of foreign currency cash flows and the ability of a firm to offset those exposures to minimise its FX risk exposure.

CASE STUDY FX RISK MANAGEMENT: DO COMPANIES HEDGE OR SPECULATE? In their risk management policies, non-financial corporations usually set down strict rules for currency hedging activities. These include provisions to prevent speculation in the currency markets by those charged with the responsibility of hedging the company’s currency transactions. If a company expects to make or receive payments of particular amounts in particular currencies at particular times, hedging the company’s currency risk involves transactions in FX derivatives that offset or reduce exposure to changes in the value of those particular currencies during those particular times. The size of the position, of course, must be commensurate to the payments to be made or received. We would expect, then, that companies would not enter into FX derivatives positions that relate to different currencies, time periods or transaction values. That would be speculating, not hedging. In a recent study, the first to explore such an issue, Kim and Chance (2018) investigated the currency spot and derivatives positions of 101 large non-financial exporting companies operating in South Korea to see whether those companies followed their own FX risk management policies and engaged in hedging rather than speculation. Perhaps surprisingly but possibly not, they found that companies’ FX derivatives and spot positions agreed with the companies’ stated risk management policies less than one-third of the time. In many cases, companies are actively speculating rather than hedging. Interestingly, even when companies are hedging, they often try to ‘time’ the hedge. This is, of course, another form of speculating that is inconsistent with the risk management policies that most of these firms have in place. Further reading Kim, SF & Chance, DM 2018, ‘An empirical analysis of corporate currency risk management policies and practices’, Pacific Basin Finance Journal, 47, pp. 109–28.

Discussion point

•

Imagine an exporting corporation based in the USA that expects to receive quarterly payments expressed in Japanese yen. The next payment is due in three months’ time and the value of the transaction is $20 million (or at current exchange rates JPY2 224 520 000). The company’s FX risk management policy requires this transaction to be hedged and, of course, prohibits currency speculation. How would we tell whether the company’s FX risk management team are hedging or speculating?

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LEARNING OBJECTIVE 17.1 Formulate an FX policy document including FX objectives, management structure, authorisations, reporting systems, communications, performance evaluation, audit and review procedures.

• • • • • • • • • • • • • • • • •

FX risk is categorised as transaction exposures, translation exposures, operating exposures and economic exposures. Transaction exposures relate to the foreign-currency-denominated cash flows of an organisation, such as USD receivables or EUR payables. Translation exposure relates to the conversion to the home-currency value of balance-sheet items, that is, assets and liabilities that are denominated in foreign currencies. Operating exposures relate to the risk that day-to-day revenues and expenses will be affected by exchange rate movements. Economic exposures relate to changes in a firm’s competitive position that may derive from exchange rate movements. For example, the products of a manufacturer may be less competitive in price terms because of an appreciation of the currency of the exporter. An organisation needs to manage its exposures to FX risk. The risk management process should be driven from the top of an organisation. The board of directors should establish the objectives and policies of a company in relation to FX transactions. The objectives should state what the company is to do and the policies should state how the company is to achieve its objectives.

CHAPTER SEVENTEEN REVIEW

Master before you move on

Executive management implements the policies by developing appropriate FX strategies and procedures. The board of directors must document a comprehensive FX policy that includes the FX objectives of the organisation, management structure, authorisations, exposure reporting systems, communications, performance evaluation, audit and policy review. The FX objectives should establish the nature and form of the company’s FX dealings within the organisation, the FX products authorised for use and the strategies to be adopted. The policy should formalise budget allocations and infrastructure, the structure of FX dealing, back office and other support functions, and establish centralised or decentralised operations. The policy document will also establish authorisations—that is, who has responsibility for the various levels of the FX functions and who may delegate. It must set transaction limits and controls, establish clear reporting lines and detail the FX reports that are to be periodically generated in terms of currency, client, country and time zone. It will also establish exception report requirements. The policy will formalise communications both horizontally (across the organisation) and vertically (up and down the management structure). Performance evaluation criteria will be SMART and will target challenging work outcomes. Strict internal and external audit requirements will be documented in the policy. Internal audit reports will be forwarded to management for action. External audit reports will be forwarded to executive management and the board of directors. Finally, procedures will be established for the ongoing review of FX policy and procedures.

LEARNING OBJECTIVE 17.2 Outline methods that can be employed to measure a company’s FX transaction exposures, including net FX cash flows, currency standard deviations and correlation coefficients.

•

Since FX rates cannot be accurately forecast, businesses, governments and individuals who have transactions denominated in foreign currencies are exposed to FX risk. 559

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• • • •

In calculating its foreign currency exposure, it is important for a business to estimate its net exposure in each currency, with careful attention being paid to the timing of the future cash flows. Once the net exposures are calculated, and before deciding whether or not to hedge the exposure, the business should calculate the degree of risk associated with the exposure and make an informed decision on whether to hedge the exposure or not. The historic variability of foreign currencies against a local currency, as measured by the standard deviation, may be useful in estimating the risk associated with exposures to particular currencies. Where a business has exposures in a number of currencies, the correlations between the currencies’ movements should also be taken into account. For example, if the business has a net receivable in one currency and a net payable in another currency, and if the two currencies are strongly positively correlated, then the exposures taken together constitute a lesser risk exposure.

LEARNING OBJECTIVE 17.3 Explain procedures involved in the implementation of market-based hedging techniques, in particular forward exchange contracts and money-market hedging.

• • • • • • • •

After assessing the risk of the various exposures, a business may decide to implement hedging techniques to manage the identified FX exposures. Market-based hedging techniques include the use of forward exchange contracts and moneymarket hedging techniques. Other market-based strategies include futures contracts, options and cross-currency swaps (discussed in Part 6). A forward exchange contract locks in an exchange rate today that will apply to a specified amount of a foreign currency at a specified future date. A business will approach an FX dealer such as a commercial bank or investment bank to enter into a forward exchange contract. The FX dealer will quote bid and offer rates that lock in the exchange rate that will apply at a specified date in the future. This in effect allows the company to remove its FX risk exposure in that it has established with certainty the price of the foreign currency. Money-market hedging involves the same general principles as those used in the forward market. However, instead of using a forward exchange contract, the company carries out a set of transactions in both the domestic and foreign money markets that achieve the same outcome. A position is taken in the money market today that establishes a future obligation that is the opposite of the exposed underlying transaction.

LEARNING OBJECTIVE 17.4 Consider the implementation of internal hedging techniques to minimise and manage FX risk, including invoicing in the home currency, creating a natural hedge, currency diversification, leading transactions, lagging transactions, mark-ups, counter-trade and offsets.

•

Internal hedging techniques offer firms an opportunity to manage FX risk exposures from within the business. Internal FX risk management techniques include:



— Invoice import or export contracts in the home currency to remove any direct exposure to a foreign currency and FX risk.



— Establish contracts that generate cash inflows and cash outflows in the same foreign currency to create a natural hedge. To be completely successful, the timing and amount of the matched foreign cash flows need to be the same. May also establish an overseas currency account.



— Enter into contracts that are denominated in a range of diversified currencies in order to minimise FX risk exposures, using standard deviations and positive and negative correlations.

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Chapter 17  Foreign exchange: risk identification and management

— Change the timing of cash flows by leading (bringing forward) or lagging (delaying) foreign currency transactions.



— A firm may consider incorporating an FX risk component into the pricing, or mark-up, of goods and services.



— A less common practice is the use of counter-trade, where one good is traded for another good, thus removing the need for currencies.



— Currency offsets recognise the timing and amount of cash inflows and outflows denominated in the same foreign currency.

•

While each of these measures may reduce the risk associated with FX exposures, they may also result in additional commercial and marketing costs.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Wesfarmers is one of Australia’s largest companies. On its website, it states the following in reference to FX risk management: The Group’s policy is to protect the Group from currency fluctuations together with maintaining the integrity of business decisions and protecting the competitive position of the Group’s activities. The Group’s primary currency exposures are in US Dollars and arise from sales or purchases by an operating unit in currencies other than the unit’s functional currency.

CHAPTER SEVENTEEN REVIEW



The Group requires all of its operating units to hedge foreign exchange exposures for firm commitments relating to sales or purchases or when highly probable forecast transactions have been identified. Before hedging, the operating units are also required to take into account their competitive position. Operating units are not permitted to speculate on future currency movements. What type of FX risk has Wesfarmers identified and what aspects of its FX risk policy formulation can be identified? (LO 17.1) 2

In 2017, the Sydney Morning Herald carried the provocative headline: ‘Aussie dollar strength a “phantom menace” for overseas earners’. The ensuing article refers to a stock-market sell-off of Australian companies exposed to USD earnings. Explain why exposure to USD earnings could lead to a decrease in the market value of companies such as CSL, Cochlear, Amcor, Brambles and others when the Aussie dollar strengthens. (LO 17.1)

3

Exposure to FX risk is a significant factor that must be considered when a company decides whether to raise funds in the international capital markets. Explain how a company that has borrowed overseas in USD might be affected if the local currency depreciates. (LO 17.1)

4

Google, an American company, is investing heavily in data-centres in Finland. Each centre is expected to generate cash flows in the cloud computing space. Google has evaluated the project in US dollar terms at the prevailing USD/EUR exchange rate. With reference to economic FX exposure, outline the implications for the net present value of the project and the market value of Google if there is a significant depreciation in the value of the euro. (LO 17.1)

5

The FX policy document of an organisation will include the FX objectives and management structure that will apply to the organisation. Discuss issues that you would expect to be incorporated in that part of the FX policy document. (LO 17.1)

6

In order to ensure that appropriate controls are in place, the board of directors will make certain that the FX policy document covers authorisations and exposure reporting systems. What issues 561

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relating to authorisations and exposure reporting systems should be included in the policy document? Explain your responses using examples where appropriate. (LO 17.1) 7

‘Performance evaluation provides management with a valuable tool in the management of FX risk exposures.’ Discuss and explain this statement. (LO 17.1)

8

As a result of recent high-profile corporate failures, the board of directors of a company is reviewing its FX policy document in relation to FX audit functions. Identify and explain important issues that the company must incorporate in its policy document in relation to the FX audit function. (LO 17.1)

9

Discuss why a company should calculate its time-specific net cash-flow exposures in each foreign currency rather than simply listing all foreign currency transactions in order to assess its FX risk exposure. (LO 17.2)

10 FX risk may be said to be two-directional. Within the context of a company borrowing in the international capital markets, explain the two-directional nature of FX risk, having regard to the ongoing cash flows associated with the debt facility. (LO 17.2) 11 Explain how foreign currency standard deviations and currency correlations may assist in assessing the risk associated with a company’s FX exposures. In your answer consider the strengths and weaknesses of these measures. (LO 17.2) 12 Describe in conceptual terms how a company could hedge its net foreign currency receivables using a forward exchange contract. (LO 17.3) 13 An Australian company is exporting electronic components to Sweden. The company has a receivable of SEK10 000 000 (Swedish krona) due in three months’ time. The company approaches its bank and enters into a forward exchange contract. Rates are quoted as AUD/ SEK6.16–19, forward points 8–5. Discuss the transactions that will take place today and in three months’ time. Show your calculations. (LO 17.3) 14 Explain how an Australian company could hedge its net HUF (Hungarian forint) payables using a BSI money-market hedging strategy. Illustrate your answer based on the company having a HUF200 million payable due in 180 days. Assume a spot rate of AUD/HUF206.90–99, a Hungarian interest rate of 8.00 per cent per annum and an Australian interest rate of 4.50 per cent per annum. (LO 17.3) 15 Identify and discuss eight internal hedging techniques that might be used by a firm to minimise FX exposures. Include in your discussion the advantages and disadvantages associated with each type of technique. (LO 17.4)

KEY TERMS active FX strategy  541

decentralised FX operation  542

money-market hedge  553

back office support  541

defensive FX strategy  541

natural hedge  547

centralised FX operation  542

DEM 550

negative correlation  549

chief executive officer (CEO)  540

economic FX exposure  539

operating FX exposure  539

confirmations, settlements and reconciliation 542

exception reports  543

overseas currency accounts  556

FX open position  543

positive correlation  549

correlation coefficients  549

hedging techniques  546

SMART 544

counter-trade 557

lagging 556

standard deviation  548

cross-currency swap  541

leading 556

transaction FX exposure  539

currency diversification  556

mark-ups 557

translation FX exposure  539

currency offsets  557

mean 548

treasury division  542

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PART Six

Derivative markets and risk management CHAPTER 18 An introduction to risk management and derivatives

CHAPTER 19 Futures contracts and forward rate agreements

CHAPTER 20 Options

CHAPTER 21 Interest rate swaps, cross-currency swaps and credit default swaps

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Derivative markets and risk management So far, we have looked at the operation of the financial system, which included the providers of funds and the users of funds. Also considered were major factors that impact on equity prices, interest rates and exchange rates. Within this context, borrowers, lenders and investors confront the following questions: In which direction might interest rates move? What about exchange rates? What will be the financial impact of a change in interest rates, exchange rates or share prices? Will a forecast movement in interest rates affect share prices or exchange rates? Should participants in the markets try to protect themselves against these and other risk exposures? How can this be done? Questions such as these are asked frequently, particularly in an environment of financial systems that have deregulated the money markets, capital markets and foreign exchange markets, and where there has been a marked increase in the speed of information transmission into the financial markets. While it can be argued that world financial markets have become more efficient, at times they also exhibit significant volatility. Therefore, modern management practice should include the identification, measurement and management of all risk exposures. Part 6 provides an insight into risk, risk management and the risk management products provided by the financial markets known as derivatives. Chapter 18 introduces risk management and derivatives. The chapter explains the nature of risk and provides an understanding of some of the major sources of risk that need to be managed by most organisations. Having gained knowledge about risk, the chapter presents a structured risk management process that should be applied by an organisation. Finally, Chapter 18 provides an introduction to the fundamentals of the generic derivative products—futures contracts, forward contracts, options contracts and swap contracts. The understanding of risk and derivative products is extended in Chapters 19 to 21 with a more comprehensive examination of derivative products, that is, financial instruments designed principally to allow the management of price risk. Price risk includes exposures to movements in commodity prices, interest rates, exchange rates and equity prices. Derivatives are financial instruments that can be bought and sold in the financial markets. They are not a means by which borrowers raise funds; they are a financial product that can be used to manage a risk exposure. Speculative trading in derivative products, in an attempt to profit from favourable price movements, provides further depth and liquidity to the exchange-traded derivatives markets. Derivatives are but one strategy through which risk exposures can be managed. Other methods of managing financial risk, such as matching the timing and denomination of future cash flows, have been discussed previously. The derivatives markets are dynamic and rapidly expanding as new, sophisticated risk management strategies evolve that use a combination of derivative products. There are four basic types of derivative products: futures, forwards, options and swaps. The basic product is known as a vanilla product, but an abundance of exotic products have been developed that are variations and combinations of the basic derivative types. Chapter 19 considers futures contracts and forward rate agreements, Chapter 20 focuses on options contracts and Chapter 21 discusses interest rate swaps, cross-currency swaps and credit default swaps. Note that forward exchange contracts were described in Chapters 15 and 17.

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CHAPTER 18

An introduction to risk management and derivatives CHAPTER OUTLINE 18.1 Understanding risk 18.2 The risk management process 18.3 Futures contracts 18.4 Forward contracts 18.5 Option contracts 18.6 Swap contracts

Learning objectives LO 18.1

Understand the nature and importance of risk and risk management, and explain the operational and financial risk exposures that a business must manage.

LO 18.2

Construct and analyse a structured risk management process that includes the identification, analysis and assessment of risk exposures, the selection of risk management strategies and products and the establishment of control, monitoring, audit and review procedures.

LO 18.3

Examine the basic fundamentals of futures contracts.

LO 18.4

Review the operation of forward exchange contracts and forward rate agreements.

LO 18.5

Understand the nature and versatility of option contracts.

LO 18.6

Consider the structure of an interest rate swap and a cross-currency swap.

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CHAPTER SNAPSHOT Financial innovation emerges because companies or institutions find themselves exposed to a risk that they would rather avoid or minimise. Such situations also represent opportunities for financial institutions to engineer new products and profit from doing so, either by charging fees or earning a ‘spread’ between a buy and sell price in a newly created market. Futures, forwards, options and swaps emerged to meet various needs of market participants seeking to manage risk or earn additional reward by bearing risks that others seek to avoid.

INTRODUCTION The management of risk exposures is an important part of managing a business. It may well be argued that the effective management of risk is essential to the long-term survival of an organisation. An organisation with the best products or services may still fail if risk exposures are ignored. The world markets are littered with examples of high-profile businesses that have failed because the board of directors did not establish adequate risk management objectives and policies, or management did not implement and monitor adequate risk management procedures and strategies. A business must identify, measure and manage the wide range of risks to which it is exposed. Some risk exposures will be common to most business organisations; others will vary depending on the nature and structure of the business. The common types of risk exposures will also vary in the extent of that exposure. For example, most businesses are exposed to interest rate risk. However, the extent of the exposure will vary depending on the amount of debt borrowed by the firm. Also, some firms will borrow debt with more, or less, fixed or variable interest rates. Each business organisation has a number of choices on how risk exposures may be managed. For example, Chapter 17 discussed the concept of internal and external risk management strategies for the management of foreign exchange (FX) risk. Internal strategies included invoicing in the home currency, creating a natural hedge, currency diversification, leading and lagging FX transactions, markups, counter-trade and currency offsets. External strategies incorporated the use of derivative products. A derivative is a financial asset that is primarily designed to manage a specific risk exposure. A derivative is based on an underlying commodity or financial instrument that is traded in the physical markets. For example, a commodity derivative may be based on gold, oil or wheat, while a financial instrument derivative may be based on shares, share indices, exchange rates or debt interest rates. Within the context of risk management, derivative contracts enable the management of risk associated with interest rates, credit, equity, commodities and foreign currencies. Derivative contracts are available in the major international financial markets. As a financial asset, a derivative has a price. The price of a contract is derived (hence the term derivative) from the price of the commodity or financial instrument in the physical market. The interest rate risk contracts derive their value from interest rate securities, such as discount securities and bonds that are issued in the money markets and capital markets. The equity contracts derive their value from shares in listed corporations or on stock-market indices. The price of a commodity derivative is based on a physical commodity such as gold, wheat, frozen orange juice, soy beans, oil or electricity, to name a few. Currency derivatives derive their value from the underlying foreign currency, such as the USD, EUR, GBP or JPY, or from a basket of nominated currencies. There are four basic types of derivative products: futures, forwards, options and swaps. The basic risk management function of a derivative product is that the derivative locks in a price today that will apply at a specified future date. For example, it is possible to enter into a derivative contract that locks in an interest rate, a share price or an exchange rate. By locking in a price today, an identified risk exposure is said to be hedged.

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This sounds quite easy, but identifying, measuring and determining appropriate risk management strategies within a large and often diverse organisation is not so simple. As a challenge, you might like to spend a few minutes writing down a list of the risk exposures to which you think a global mining company such as BHP Billiton might be exposed. In the next section we introduce some of these risk exposures.

REFLECTION POINTS

• • • • • • •

Risk is an integral part of any business organisation. All risk exposures must be identified, measured and managed. The board of directors should establish risk management objectives and policies; management should implement relevant procedures and strategies. Risk management strategies may be internal or external strategies. External risk management strategies incorporate the use of derivative products: futures, forwards, options and swaps. A derivative is a financial asset that derives its price from an underlying physical market commodity or financial instrument. A derivative risk management strategy locks in a price that will apply at a future specified date, such as an interest rate, exchange rate or share price.

18.1

Understanding risk

The basic definition of risk is the possibility or probability that something may occur that is different from what was expected. For example, interest rates and exchange rates change from time to time. In earlier chapters we discussed factors that affect interest rates and exchange rates. A risk manager is able to consider these factors and try to forecast whether interest rates might change over certain planning periods. The planning periods could be over the next month, three months and six months. Will interest rates rise, fall or remain unchanged? If they change, how much will they change? How frequently might they change? What impact will forecast interest rate changes have on the financial performance of the business? The above questions clearly introduce uncertainty into the forecasting process. For example, a business may be confident that the central bank will increase interest rates over the next six-month planning period. However, it will be far less certain when this may happen during the six-month period. Will the central bank increase rates by 25 basis points, or more? Will there be more than one change? Will lenders pass on the full monetary policy change to borrowers? What other factors may affect the cost of borrowing? The above interest rate example is categorised as a financial risk. We therefore begin by categorising risk as:

LEARNING OBJECTIVE 18.1 Understand the nature and importance of risk and risk management, and explain the operational and financial risk exposures that a business must manage.

1 operational risks 2 financial risks.

18.1.1

O PERATIONAL RISKS

Operational risks are those exposures that may impact on the normal commercial functions of a business, that is, any potential event that may affect the day-to-day ability of a business to deliver its

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products or services. The range and scope of operational risks will vary significantly depending on the nature of a business. For example, a commercial bank, such as Westpac Banking Corporation, is critically reliant upon its electronic product delivery and information systems. A major failure of its systems will cause large losses to the bank and may result in the collapse of the business. Alternatively, a mining corporation such as BHP Billiton is reliant on the continued operation of its smelters. If the company was required to close a number of its smelters for an extended period, it is likely that the share price would drop significantly and may leave the company exposed to takeover by a competitor. A smaller company may be exposed to the risk of loss of key personnel. If an individual or team of people is involved in the research and development of a new product for the company, the company may have difficulty completing the project if the key personnel leave. The future success of the company may be dependent upon bringing the new product to the market. It should be evident that operational risks are many and varied. To assist in our understanding of this form of risk, we can identify some of the main sources of operational risks as:

• • • • • • •

Technology—for example, the loss, failure or redundancy of electronic product delivery systems and information systems. Property and equipment—for example, the loss of access to the organisation’s buildings due to legionnaire’s disease, or severe damage to an oil drilling platform from a hurricane, or the destruction of a natural gas pipeline by terrorists. Personnel—for example, the death of a group of executive managers in a plane crash, or employees going on strike and forcing business operations to close down for an extended period. Also, the risk of fraud carried out by an employee is an operational risk. Competitors—for example, a competitor developing a new product that outperforms existing products offered by your company, or another competitor winning contracts put out to tender by your traditional clients. Natural disasters—for example, floods, fire, snowstorms and hurricanes may all cause damage such that an organisation is unable to maintain normal day-to-day business operations. Natural disasters can often be catastrophic in that they may result in loss of life for personnel as well as significant damage to physical assets. Government policy—for example, a nation-state may introduce legislation that requires all carbonemitting corporations to develop and install new technologies and equipment to lower overall carbon emissions of the organisation. Suppliers and outsourcing—for example, the bankruptcy of the main supplier of component parts for a major product produced by your company. Also, a supplier is exposed to all of the above risks; for example, an equipment failure may result in the supplier being unable to deliver under a contract. If a component of a larger business project or function is outsourced to another business, the company outsourcing the function is also exposed to the operational risk exposures of the outsourcing provider.

Clearly, operational risks can impact upon the operational and financial performance of an organisation and may result in its ultimate failure. It is beyond the scope of this chapter to consider strategies that may be implemented to manage operational risk exposures. However, Extended learning B at the end of Chapter 2 provides considerable insight into business continuity risk management.

18.1.2

F INANCIAL RISKS

Financial risks are those risk exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities. 568

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For example, a commercial bank is exposed to the risk that a larger percentage of customers will default on loan repayments in times of increased interest rates and an economic downturn. This will affect the cash flows of the bank as loan instalments are not received when expected. This may cause a liquidity problem for the bank in that it will have less cash available in that planning period. Further, the bank may need to write off the bad loans against capital (shareholder funds). This may adversely impact on the bank’s capital adequacy position (see Chapter 2 regarding the Basel capital accords). The above example introduced several of the major financial risks to which an organisation may be exposed. The example highlights an important issue that needs to be understood in relation to risks and risk management, namely that there are relationships between risks. That is, one risk will often have an impact upon another risk. Therefore, specific risks should not be considered in isolation. Risk managers need to be aware of both direct risks and consequential risks. Within the context of financial risks in the above example, the direct risk was the change in interest rates. The consequential risks were those risks that flowed from, or occurred as a result of, the direct risk. In this case they included credit risk, liquidity risk and capital risk. A more detailed analysis of the consequential risks would most likely identify additional risks, such as funding risk, regulatory risk and reputational risk. It is evident that the consequential risks can often be more significant than the initial direct risk exposure or event. Major financial risk exposures include:

•

•

•

• •

Interest rate risk—the risk of an exposure to movements in current market interest rates. A change in interest rates will affect both borrowers and investors. For example, a rise in interest rates may have a negative impact on share prices and therefore the value of shareholders’ investment portfolios. The negative outlook will be due, in part, to the increased cost of borrowing for corporations, plus an expectation that there will be a fall in business activity and lower profits generated by corporations in the near future.

Capital adequacy a requirement under the Basel II accord that banks hold a minimum level of capital

Direct risks the initial risk event that impacts on the operational or financial position of an organisation

Consequential risks risk exposures that eventuate as a result of an initial direct risk event

Foreign exchange risk—the risk that the value of one currency relative to another currency will change. This may have either a negative or a positive impact on importers, exporters, investors and borrowers in the international markets. For example, an appreciation of a local currency will reduce the competitiveness of exported products, but will make imported products cheaper relative to domestic products. A change in an exchange rate will affect future cash flows, plus the value of assets and liabilities denominated in a foreign currency. Liquidity risk—this risk has different aspects depending on the party concerned. A central bank will consider liquidity risk within the context of the amount of funds available within the financial system. On the other hand, liquidity risk for a corporation is related to the availability of funds to meet day-to-day commitments as they fall due. For example, a commercial bank must have access to sufficient cash to repay deposits and other liabilities when they are due, plus advance funds on loans approved to customers, plus meet normal operating expenses such as salaries, plus meet additional liquidity requirements dictated by the bank regulator.

Liquidity risk central bank—funds in the financial system; corporation—funds available to meet dayto-day commitments

Credit risk—the risk that borrowers will not repay commitments when they are due. For example, the global financial crisis (GFC) saw large numbers of mortgage borrowers default on interest payments and principal repayments on housing loans. The cumulative effect resulted in banks around the world being required to write off billions of dollars in bad debts against their capital base. Capital risk—in Chapter 5 we discussed the importance of capital and an appropriate debt-to-equity ratio. Capital risk is the risk that a corporation will not have sufficient capital to expand the business and maintain the desired debt-to-equity ratio. For example, a corporation’s capital base may be eroded if rapid business growth is funded with increased levels of debt. Alternatively, the capital base may be eroded from the increased write-off of bad debts associated with business activities.

Capital risk risk that a corporation will not have sufficient capital to expand the business or maintain its debt-to-equity ratio

The above list of financial risks is certainly not exhaustive, but represents some of the major financial risk exposures faced by a corporation. Later in this chapter we will introduce derivative products that may be used to manage financial risk exposures. First we need to understand the risk management process. 569

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REFLECTION POINTS

• • • • • •

Risk relates to uncertainty; the possibility or probability that an unexpected event may occur. Operational risks are those exposures that may impact on normal day-to-day functions of an organisation. Sources of operational risk include technology, property, equipment, personnel, competitors, natural disasters, government policy, suppliers and outsourcing. Operational risks may be managed using real option strategies. Financial risks are those exposures that may impact on the cash flows or the value of balancesheet assets and liabilities of an organisation. Sources of financial risk include interest rate risk, FX risk, liquidity risk, credit risk and capital risk. Financial risks are often managed using derivative contracts. An initial risk occurrence is a direct risk and the subsequent flow-on impacts on other risks are consequential risks.

18.2 LEARNING OBJECTIVE 18.2 Construct and analyse a structured risk management process that includes the identification, analysis and assessment of risk exposures, the selection of risk management strategies and products and the establishment of control, monitoring, audit and review procedures.

The risk management process

We have introduced the concept of risk and classified some of the major categories and sources of risk. In order to manage these risk exposures it is necessary to establish a structured risk management process. It is very important that a structured process is applied to the risk management function. In any organisation there are an enormous number of risks that need to be managed. As mentioned previously, the range of risks is quite diverse and will vary between organisations. Therefore, in order to manage risk it is necessary to have specialist knowledge of risk, the risk management process and risk management strategies. Intertwined with this is the essential need to understand the organisation and the business environment in which it operates. In order to gain some understanding of the complexity of a structured risk management process, we will consider the following model: 1 Identify operational and financial risk exposures. 2 Analyse the impact of the risk exposures. 3 Assess the attitude of the organisation to each identified risk exposure. 4 Select appropriate risk management strategies and products. 5 Establish related risk and product controls. 6 Implement the risk management strategy. 7 Monitor, report, review and audit.

18.2.1

I DENTIFY OPERATIONAL AND FINANCIAL RISK EXPOSURES

The first step in the process is to identify risk exposures. This sounds like a simple task, but it is not. The diversity of business operations within an organisation means that there will be an enormous number of risk exposures that need to be identified. This will only be possible if the people within the organisation responsible for this task fully understand the business, including its operations, personnel, competitors, regulators, legislative 570

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requirements, stakeholders, cash flows and balance-sheet structure. These are some of the important categories, but each of these categories will split into many more related sub-categories. It is also necessary to understand interrelationships and causal linkages between the above categories. For example, if a bank manager approves a loan to a customer, the treasury operation of the bank needs to ensure that the funds are available for the loan. Another section of the bank will need to maintain sufficient capital before the loan is given. If the borrower is late in making loan repayments or defaults on the loan, this will affect other sections of the bank. All these interrelated and causal linkages need to be understood so that they can be adequately managed.

18.2.2

A NALYSE THE IMPACT OF THE RISK EXPOSURES

Once risk exposures have been identified, it is necessary to analyse and measure the potential impact of each exposure. This should be completed through a business impact analysis. A business impact analysis will document each risk exposure and endeavour to measure the operational and financial impacts should the risk event occur. Let us continue the situation of a bank giving a customer a loan. The customer will have a choice on the interest rate structure of the loan; that is, will the loan have a fixed interest rate or a variable interest rate? Whichever interest rate structure is used, the bank will need to manage its new exposure to interest rate risk. To do this, it needs to measure or quantify that risk. The risk will be different depending on whether the loan is given a fixed interest rate or a variable interest rate. Further, the scheduled timing of interest rate reset dates on a variablerate loan will have different risk impacts. This particular task is further complicated because the bank will approve thousands of loans every day, while other existing loans are being repaid. In other words, the composition of the bank’s loan portfolio is dynamic in that it is continually changing in size and structure. The business impact analysis must measure all quantitative risks (as above), but also needs to recognise non-quantifiable risks. For example, the attitude of the bank manager towards the customer seeking the loan is important to the customer, but difficult to quantify. Similarly, the complexity of loan documentation that the bank requires to be completed can be most annoying to a customer, but is this measurable?

18.2.3

Business impact analysis measures the operational and financial impact of an identified risk exposure

A SSESS THE ATTITUDE OF THE ORGANISATION TO EACH IDENTIFIED RISK EXPOSURE

An organisation must determine the level of risk that it is willing to accept. While all risks must be identified and a business impact analysis carried out, an organisation will not seek to mitigate or remove all these risks. The nature of any business operation will entail a level of risk; the board of directors together with executive management need to consider and document the amount of risk the organisation will take. Therefore, the organisation must document which risks are to be avoided, controlled, transferred or retained. For example, a bank can avoid certain risks by not providing specified products or services—a small regional bank may decide to avoid increased FX risk by not acting as an FX dealer. The same bank will control risks associated with lending to customers by establishing procedures to be strictly followed by bank lenders when approving loans to customers. Part of the risk associated with providing residential housing loans to customers might be transferred by requiring certain customers to take out mortgage insurance, thus transferring part of the risk to the insurance office. The bank may also decide to retain specified risks, such as those associated with the wide distribution of credit card facilities. The bank may determine that this part of the business is sufficiently profitable, and attracts other business from customers, such that the initial risk exposure is worth retaining. Many smaller risks will also be retained because the cost of managing those risks may be greater than the potential risk itself. 571

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18.2.4

S ELECT APPROPRIATE RISK MANAGEMENT STRATEGIES AND PRODUCTS

Cost–benefit analysis the cost of a risk management strategy versus the risk management benefits to be gained

Now that the organisation has determined which risks need to be managed, it must analyse the risk management options that are available. This is an integrated process. The organisation will generally have several risk management strategy options, and may well use alternative strategies to manage various risks, or alternative strategies to manage the same risk at different times. The range of risk management strategies must be integrated into an overall strategy that is compatible with the organisation’s risk management objectives. When determining the most appropriate risk management strategy at a particular point in time, an organisation will, in part, conduct a cost–benefit analysis. A cost–benefit analysis will measure the costs associated with establishing and maintaining a particular risk management strategy versus the risk management benefits to be gained. For example, our small regional bank is exposed to a possible failure of its computer centre. One risk management strategy would be to build a back-up computer centre, but this would cost tens of millions of dollars. A cost–benefit analysis may indicate that a better strategy would be to outsource this computer function, or enter into a contract with a back-up computer centre provider. The outsourcing of certain business functions, as mentioned above in relation to computer operations, highlights one of the basic fundamentals of risk management. The management of one risk may well cause another risk. In the case of outsourcing, for example, the initial risk has been outsourced to another party, but a whole new range of risks has now been created that relate to the performance of the outsourcing provider. What will happen to the bank if its primary computer centre fails and the outsourcing company is unable to provide the service specified in the outsourcing contract? There are many unexpected reasons why this might happen, such as the provider going into liquidation.

18.2.5

E STABLISH RELATED RISK AND PRODUCT CONTROLS

Before an organisation can implement a risk management strategy, it must ensure that adequate controls have been established, documented and circulated to personnel. These controls will include procedural controls and system controls. Procedural controls will document the risk management products that can be used by the organisation (and those that cannot be used). It will also document who, within the organisation, has responsibility for a specific risk management task. The document will specify authorities in relation to decision making, delegation, monetary limits and reporting requirements. Systems controls will cover all the electronic product delivery and information systems as they relate to the identification, measurement, management and monitoring of risk management. For example, before a new risk management product can be used, the organisation needs to ensure that it is able to record associated transactions in its electronic systems and automatically generate periodic reports to management. The organisation also needs to ensure risk management personnel have the necessary understanding, skills and experience to implement and monitor a particular strategy. For example, a decision to use cross-currency swaps as an integrated risk management strategy to cover FX risk and interest rate risk associated with a corporation’s overseas borrowings should not be taken if existing personnel have no experience in the use of these products. Recent history has many examples of organisations that have suffered significant losses from this exact situation.

18.2.6

I MPLEMENT THE RISK MANAGEMENT STRATEGY

Before implementing the strategy it is necessary to ensure that written authority to proceed has been given. It is also necessary to check that time-lags between the commencement of this process and the implementation of the strategy have not impacted on the effectiveness of the strategy. Remember, many 572

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risks are dynamic, that is, they change over time, often rapidly. This is particularly evident with financial risks such as liquidity risk, FX risk and interest rate risk. Risk strategies will be developed for different planning periods. As such, changes in the business environment, market conditions and legislation will affect risk management strategies differently within short-, medium- and longer-term planning periods. Therefore, the risk management strategy about to be implemented must be flexible and robust. That is, the strategy can be refined, modified or changed as conditions change. Finally, the risk management strategy can be implemented.

18.2.7

M ONITOR, REPORT, REVIEW AND AUDIT

The risk management process is ongoing. Existing strategies must be continually monitored to ensure they are achieving the expected risk management objectives and outcomes. The organisation’s risk management document will specify the types of reports that need to be generated, how often they should be produced, who the reports should be forwarded to and what actions need to be taken by those responsible for monitoring and analysing the reports. For example, a commercial bank will require daily reports to be generated on FX transactions conducted by the treasury department FX dealers. The report will include currencies traded, quantities, customers or counterparties, dealer authorities and end-of-day open positions. The reports will be forwarded to treasury managers who will review the reports and take action; for example, if individual FX dealer authorities are breached or open FX positions are above the authorised limits. As mentioned above, risk is dynamic. Therefore, risk management strategies must be reviewed regularly. The review will analyse the appropriateness and effectiveness of the existing strategies and consider alternative strategies in the light of new information and the changed business environment. Most importantly, all risk management processes and strategies should be periodically audited. Auditors will ensure that the existing risk management strategies are within the scope of the risk management objectives and authorities issued by the organisation. With larger organisations, it could be expected that internal audits will regularly be carried out by specialist personnel in the organisation. In addition, external auditors should conduct audits as and when directed by the board of directors. Internal and external audit reports should be forwarded to executive management for review and action as required. Further, external audit reports should be forwarded, without amendment, to the board of directors and the board risk management committee.

REFLECTION POINTS

• •

A structured risk management process should be maintained by risk managers with specialist knowledge of risk, the risk management process and risk management strategies. A structured risk management process includes the following steps:

1 Identify operational and financial risk exposures. 2 Analyse the impact of the risk exposures. 3 Assess the attitude of the organisation to each identified risk exposure. 4 Select appropriate risk management strategies and products. 5 Establish related risk and product controls. 6 Implement the risk management strategy. 7 Monitor, report, review and audit.

•

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18.3 LEARNING OBJECTIVE 18.3 Examine the basic fundamentals of futures contracts.

Initial margin a deposit lodged with a clearing house to cover adverse price movements in a futures contract

Clearing house records transactions conducted on an exchange and facilitates value settlement and transfer

Marked-to-market the periodic re-pricing of an existing contract to reflect current market valuations

Maintenance margin call the top-up of an initial margin to cover adverse futures contract price movements

Futures contracts

The remainder of this chapter will introduce the four main categories of derivative contracts: futures, forwards, options and swaps. At the start of the chapter, derivatives were introduced as being financial instruments that enabled the management of identified risk exposures. The price of a derivative contract is based on a specified underlying commodity or financial instrument traded in the physical markets. For example, a derivative product such as a futures contract that is used to lock in the price of gold today for delivery at a future date is based on the actual price of gold in the spot or physical market. Similarly, the price of an interest rate futures contract may be based on a financial instrument such as the 90-day bank-accepted bill or the three-year or 10-year Australian treasury bonds. Futures contracts are standardised contracts traded through a formal exchange that enable the management of risk exposures associated with commodities and financial assets. A futures contract is therefore referred to as an exchange-traded contract. Later in this chapter the discussion will look at over-the-counter derivative contracts. A futures contract is an agreement between two parties to buy, or sell, a specified commodity or financial instrument at a specified date in the future at a price determined today. By being able to lock in a price today that will apply at a future date, a risk manager has managed an exposure to risk. For example, a fund manager may hold a portfolio for a client of shares issued by companies listed on the Australian Securities Exchange (ASX). The client may have indicated that she expects to sell a proportion of the shares in the near future to fund the purchase of an investment property. The fund manager has advised the client that a forecast slowing economy may reduce the profitability of these companies and that their share prices may fall over the next few months. After discussing various strategies with the fund manager, the client instructs the manager to proceed with a futures contract risk management strategy. If the portfolio comprises the shares of only a few companies, then the investor may decide to use futures contracts associated with those specific companies to manage the risk exposure. For example, ASX Trade24 offers futures contracts based on 1 000 shares of each of the major companies listed on the ASX, such as BHP Billiton Limited, National Australia Bank Limited and Woolworths Limited. However, if the portfolio comprises a large number of listed shares, the investor may decide to use a futures contract based on a share price index such as the S&P/ASX 50 index. This contract is based on the price of the top 50 companies listed on the ASX. In either case, the investor would adopt the following strategy. The investor must carry out an initial transaction in the futures market that corresponds with the transaction to be conducted in the physical market (share market) at a later date. The fund manager has been advised by the client that she will be selling shares in a few months; therefore, the initial futures transaction will be to sell a futures contract. The client will be required to pay an initial margin to the futures exchange clearing house. The margin will vary depending on the futures contract and current market volatility, but will generally range between 2.00 and 10.00 per cent of the value of the contract. The futures contract will be ­marked-to-market by the clearing house; that is, the clearing house will monitor changes in the price of a futures contract. Changes in the price of the underlying physical market asset will directly affect the price of the futures contract. If the futures contract price moves such that the initial margin paid is insufficient to meet the minimum percentage required, then a maintenance margin call will be made and must be paid by the client. The maintenance margin will top up the initial margin payment. When the futures contract is due to expire, the fund manager will reverse the strategy and close out the futures position by buying an identical futures contract. The fund manager is carrying out a zero-sum game; that is, the fund manager initially sold a contract and then three months later bought a contract, therefore the net result is zero contracts. The initial futures contract had a price as did the final futures contract. The difference between the prices of the two contracts represents either a profit or a loss made on the futures contract transactions. How has this strategy managed the risk that the share prices may fall?

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First, you need to remember that there is a positive correlation between the futures contract price and the share prices in the share market. In our example, there is a concern that share prices will fall. If they do fall, then the value of the futures contract will also fall. As the initial futures transaction was a sell contract, it will have a higher price than the final buy contract as the price of the buy contract has fallen because the share market prices have fallen. Therefore, the futures contract strategy has made a profit. This profit will be paid to the client. If the client decides to sell shares from her portfolio, she will only be able to sell them on the share market at the current lower share price. However, the profit she has made from the futures contract strategy will offset the lower price she will obtain from selling the shares. The net outcome is that the portfolio manager was able to use a futures contract risk management strategy to maintain the overall wealth of the client for the three-month period. Figure 18.1 provides a conceptual view of a futures contract risk management strategy.

Figure 18.1  Conceptualisation of a futures contract risk management strategy Physical market (e.g. share market)

Futures market

Today

Today

Concern relating to an identified risk exposure

Buy (or sell) futures contracts at current futures market price

Date of physical market transaction

Contract expiry

Conduct the planned physical market transaction at the current market price

Close out futures position. Sell (or buy) futures contract at current futures price

Use profit (or loss) from futures market to offset physical market transaction cost or return

Difference between contract buy and sell prices represents a profit or a loss

Net cost or return equals the risk managed or hedged position

In order to understand how futures contracts may be used to manage an identified risk exposure we considered a strategy that would hedge a risk exposure to a fall in share prices. In an opposite situation where an investor planned to buy shares in the future and was concerned that share prices might rise, the investor would initially buy a futures contract and at a later date close out the position by selling a futures contract. The profit, or loss, made in these transactions would be used to offset the change in the share prices in the share market. Another example of using futures contracts to manage risk relates to interest rates. A company that issues bank bills with a rollover facility may wish to lock in the cost of funding for the next 12 months. As the company is a borrower, the company is said to sell its paper when it issues the bank bills. Therefore, the company will initially sell a futures contract based on the 90-day bank-accepted bill. In 90 days the company will close out its position by buying another contract. The strategy and outcome are the same in principle as those that applied to the share price example above. As the company wished to cover its interest rates risk exposure for 12 months, it would not enter into a single 90-day contract, but rather would set up a series of 90-day contracts to cover the whole 12-month period. This is known as a strip. Pricing of the 90-day bank-accepted bills futures contract is calculated using the discount securities formula (Chapter 9). Similarly, the price of a Treasury bond futures contract is calculated using the bond pricing formula (Chapter 10). The price of a share-market index futures contract is simply the number of contracts, multiplied by the physical share-market index number, multiplied by $25.00. Examples of calculations are given in Chapter 19. 575

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REFLECTION POINTS

• • • • • • • •

A derivative contract enables the management of a specific risk exposure. A futures contract is an agreement to buy, or sell, a specified commodity or financial instrument at a specified date at a price determined today. A futures contract is a standardised, exchange-traded contract. A futures strategy requires the risk manager to conduct a transaction in the futures market today that corresponds with the transaction to be carried out in the physical market at a later date. The futures exchange clearing house will require the payment of an initial margin. The contract will be marked-to-market and a maintenance margin call may be made. At the end of the contract period the futures position is closed out by buying, or selling, an opposite contract to the initial futures transaction. The buy and sell transaction will result in a net profit, or loss, in the futures market. This amount is then used to offset the current price in the physical market. The pricing of interest rate futures contracts uses the underlying financial instrument formulae.

18.4 LEARNING OBJECTIVE 18.4 Review the operation of forward exchange contracts and forward rate agreements.

Forward rate agreement (FRA) an over-the-counter product used to manage interest rate risk exposures

FRA agreed rate the fixed interest rate stipulated in the FRA at the start of the contract

FRA settlement date the date when the FRA agreed rate is compared to the reference rate to calculate the compensation amount

FRA contract period the term of the interest rate protection built into the FRA

Reference rate a benchmark interest rate published daily and used for pricing variable-rate loans

Forward contracts

A forward contract is a financial instrument primarily designed to enable the management of a specified risk. Forwards are often an attractive risk management strategy as they are an over-the-counter product offered by financial institutions. As an over-the-counter product they are regarded as being more flexible than a highly standardised exchange-traded product such as a futures contract. It is possible to negotiate the various terms and conditions of a forward contract, such as the amount and timing of the contract. The two forward contracts introduced in this section are forward rate agreements and forward foreign exchange contracts.

18.4.1

F ORWARD RATE AGREEMENTS

A forward rate agreement (FRA) allows a borrower to manage a future interest rate risk exposure. An FRA may be likened to a futures contract in that it locks in an interest rate today that will apply at a specified future date. However, the FRA is more flexible to manage in that there is no requirement to make an initial margin or any future top-up margin payments. As such, a corporation entering into an FRA does not need to ensure it has sufficient liquidity to meet margin call cash flows. An FRA is a contractual agreement between two parties to lock in an FRA agreed rate at a future FRA settlement date based on a specified FRA contract period and a specified reference rate. Figure 18.2 shows the structure and timing of an FRA that locks in an FRA agreed rate today that will apply in two months’ time (the FRA settlement date). The reference rate is the three-month rate (contract period). This FRA example is expressed as 2Mv5M. That is, the settlement date is in two months and interest cover is for a three-month period. The agreed FRA rate is the fixed interest rate that is set at the beginning of the contract. The settlement date is the nominated date specified in the FRA when the parties to the contract will apply the specified reference rate. The contract period relates to the term of the interest rate protection being managed. For example, if the FRA is being used to manage the interest rate risk associated with a 90-day bank bill rollover facility, then a three-month contract period would apply. In this case the

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Figure 18.2  An FRA structure timeline (2Mv5M) End date

FRA settlement date

FRA agreed rate

Reference rate applied

3-month contract period

0

1

2

3

4

5

Months

appropriate reference rate, which is specified in the FRA, would be a three-month reference rate such as the three-month BBSW. While an FRA is an interest rate risk management product, it may be written in terms of a currency other than the domestic currency. For example, an Australian company may enter into an FRA based on USD or NZD. As with other derivative products, an FRA is not a means to raising or borrowing funds. Further, there is no commitment by a bank providing an FRA also to provide a loan facility in the future. If a bank does commit to a future loan commitment, it will be under a separate loan agreement. Financial institutions, particularly commercial banks and investment banks, will provide a twoway quote for an FRA. The market convention is to state a quote in terms of a start month and an end month and a date within the month that will be the settlement and maturity date; for example, a company may approach its bank on 17 June and request a quote to cover the period 22 August to 22 November, that is, three-month cover commencing in just over two months’ time. If the quote was obtained over the telephone, the bank dealer would state ‘2s/5s the 22nd’ which is pronounced verbally as twos fives the twenty-second. The dealer would then add the bid and offer interest rates. The FRA quote might be 2Mv5M(22) 9.25–8.75. The first interest rate in the quote is the dealer’s bid rate, that is, 9.25 per cent per annum. Therefore, 9.25 is the agreed FRA rate the dealer will give on a borrowing hedge; that is, the other party to the FRA wishes to manage risk associated with a loan. The second number in the quote is the dealer’s offer rate of 8.75 per cent per annum. The offer rate is the agreed FRA rate that the dealer will give on an investment hedge. An FRA is a compensation agreement in that one party to the contract will compensate the other party if the reference rate specified in the FRA is different from the agreed FRA rate. In the above example, the agreed rate on a borrowing hedge is set at 9.25 per cent per annum. If the specified reference rate (three-month BBSW) at the settlement date is 9.50 per cent per annum, then the bank would compensate the company for the increase in interest rates. The compensation amount will be the notional principal amount multiplied by the interest rate differential of 25 basis points, adjusted for the three-month period. (Remember, the interest rate quote is a per annum rate, but the cover is for three months only.) In Chapter 19 the actual calculations are shown. The calculation for the above example uses the discount security formula (Chapter 9). The formula is used twice; first, to calculate the price using the agreed FRA rate and, second, to calculate the price using the reference rate at settlement date. The difference between the two prices is the compensation payment. In the above example, interest rates increased and the bank compensated the company. If interest rates had fallen, the company would have been required to compensate the bank. 577

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18.4.2

F ORWARD FOREIGN EXCHANGE CONTRACTS

A forward foreign exchange contract, generally referred to as a forward exchange contract, facilitates the management of exchange rate risk exposures. A forward exchange contract locks in an exchange rate today for delivery of foreign currency at a specified future date. Exchange rates can, at times, be highly volatile. Even under normal conditions, exchange rates are constantly changing as new information comes into the market. As indicated in Part 5, the FX markets are enormous and many participants are exposed to FX risk, including exporters, importers, investors, borrowers, FX dealers and brokers, central banks, speculators and arbitrageurs. By using a forward exchange contract to lock in an exchange rate today, the risk manager has removed the uncertainty associated with a future foreign currency denominated cash flow. For example, an Australian company may be importing goods from overseas and the contract is denominated in USD. The company knows that it will need to pay USD1 million in three months’ time. The company contacts its bank and asks for a three-month forward rate. The bank FX dealer provides the following quote: AUD/USD0.7130–35 14:20. This would be given verbally as Aussie dollar seventyone thirty–thirty-five fourteen twenty. AUD/USD0.7130–35 is the spot rate and 14:20 are the forward points that determine the three-month forward exchange rate. As the forward points are rising, they are added to the spot rate: Spot rate Add forward points Forward rate

= AUD/USD0.7130 14 = AUD/USD0.7144 = AUD/USD0.7144–55

0.7135 20 0.7155

The calculation of forward points and an extended discussion on the forward FX market and forward exchange contracts is given in Chapter 15.

REFLECTION POINTS

• • • • • • • •

Forward contracts are over-the-counter risk management products. They are a more flexible risk management tool in that it is possible to negotiate specific terms and conditions. Forward rate agreements (FRAs) lock in an interest rate today that will apply at a specified future date based on a notional principal amount. An FRA incorporates an FRA agreed rate that is fixed at the commencement date, a contract period which relates to the term of interest rate cover sought, and a settlement date when the reference rate is applied and the compensation amount is paid. An FRA quote of 6Mv9M(10) 8.40–20 indicates a settlement date in six months with a threemonth interest rate cover. The dealer’s rate on a borrowing hedge is 8.40 per cent per annum, and on an investment hedge is 8.20 per cent per annum. The contract will be settled on the 10th of the specified month. The reference rate is normally the BBSW. The compensation amount is the difference between the FRA agreed rate and the reference rate. This is calculated using the discount security formula. A forward exchange contract locks in an exchange rate today that will apply for delivery of a specified currency at a specified date in the future. An FX dealer will normally quote the spot rate and the forward points for the period to delivery. If the forward points are rising, they are added to the spot rate; if they are falling, they are subtracted from the spot rate.

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18.5

Option contracts

An option contract gives the option buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a specified price on or before a specified date. The price established in the option contract is known as the exercise price or the strike price. The exercise price is the price determined today at which the buyer of the option is able to buy or sell the specified commodity or financial instrument at the exercise date. For example, if the buyer of an option entered into a contract to sell 1 000 shares in BHP Billiton Limited at $35.00 per share in six months, the exercise price is $35.00 per share. If, in six months, at the option expiry date, the price of BHP Billiton shares in the physical market has fallen to $32.00 per share, the buyer of the option would exercise the option and sell the shares at the higher exercise price. However, if the price of the shares had risen to $37.00 per share, the option buyer would let the option lapse and sell the shares directly into the physical market at the higher current market share price. From the definition of an option contract, it should be evident why it may, under certain circumstances, be an attractive hedging instrument. A unique characteristic of an option is that it need not be exercised if it is not in the option buyer’s best interest. An option buyer will not exercise a right to sell if the physical market price is above the exercise price of the option contract. Also, an option buyer will not exercise a right to buy if the physical market price is below the exercise price of the option contract on the expiration date. The buyer of an option contract is able to purchase a contract that gives the right to buy, or the right to sell, a commodity or financial instrument. These are known as call options and put options respectively:

• •

LEARNING OBJECTIVE 18.5 Understand the nature and versatility of option contracts.

Strike price the exercise price; the price specified in an option contract at which the option buyer can buy or sell

Call options give the option buyer the right to buy the commodity or financial instrument specified in the option contract at the exercise price. Put options give the option buyer the right to sell the commodity or financial instrument specified in the option contract at the exercise price.

Option contracts specify the time at which the rights contained in the option can be exercised. There are two contract types: European-type options and American-type options:

• •

European-type options give the option buyer the right to exercise the option only on the contract expiration date. American-type options give the option buyer the right to exercise the option at any time up to the contract expiration date.

Clearly, the American-type option is a more flexible risk management product, in that the option buyer can choose the best time to exercise the option and take advantage of favourable price movements. Consider the example above of the buyer of an option to sell BHP Billiton shares at $35.00 per share in six months. A European-type option would only allow the buyer to decide whether or not to exercise the option on the expiration date in six months, and the price would be locked in to that date. The buyer of an American-type option, on the other hand, can monitor the share price over the six-month period. If the price of BHP Billiton shares falls below the exercise price over the first four months, but then begins to rise, the buyer may decide to exercise the option immediately to take advantage of the higher option contract price. The option buyer could sell the shares at the higher option price, then could buy the shares back again in the physical share market at the lower market price in the expectation that the share price will continue to rise. For this reason, the cost of an American-type option will be higher relative to the price of the equivalent European-type option. The most important benefit of an option contract hedging strategy is that losses that may result from adverse price movements can be limited, while profits that may result from favourable price movements can be realised. To obtain such desirable cover, the buyer of the option must pay a premium to the seller, or writer, of the option. The premium is paid when the option is bought. The option writer receives the premium payment whether or not the option buyer eventually exercises the option.

European-type options options that can only be exercised on the specified date

American-type options options that can be exercised at any time up to the expiration date

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Profit and loss payoff profiles the potential gains and losses available to the buyer and writer of an option

Option contracts may be traded on an options exchange such as the ASX or the Chicago Board of Trade. These are called exchange-traded options. Exchange-traded option contracts are standardised contracts; that is, the terms and conditions of the contract are the same for all buyers and sellers of that particular type of contract. Option contracts are also available over the counter. It is possible for the buyer of an over-the-counter option to negotiate specific terms and conditions into the contract. For example, the buyer may wish to negotiate a non-standard quantity and contract expiry date. Potential gains and losses are quite different for the buyers and writers (sellers) of call options and put options. Sections 18.5.1 and 18.5.2 demonstrate the profit and loss payoff profiles for the buyers and sellers of both call options and put options.

18.5.1

C ALL OPTION PROFIT AND LOSS PAYOFF PROFILES

The potential gains or losses for the buyer, and the writer, of a call option are shown in Figure 18.3, where the underlying asset is a financial instrument, being shares in a listed company, ANZ Bank Limited. The exercise price is set at $20.00 per share, and the premium for the call option contract is $1.50 per share.

Figure 18.3 Profit and loss payoff profiles: call option—ANZ Bank Limited; exercise price $20.00, premium $1.50 (a) Buyer of option Profit

(b) Writer or seller of option Break-even

Profit

Break-even

+$1.50 Premium

$20.00 0

$21.50

Market price

0

$21.50

Market price

$20.00

Premium –$1.50 Loss

Exercise price

Loss

Exercise price

At the start of the contract the buyer pays the premium of $1.50 per share to the writer (seller) of the contract. In return the buyer obtains the right to buy 1 000 ANZ Bank Limited shares at an exercise price of $20.00 per share. If on the expiration date the actual price of the share in the stock market is less than $20.00, the buyer will allow the option contract to lapse. The call option buyer will allow the option to lapse because the shares can be purchased at a lower price in the stock market than is available from the option contract. In this situation, the total cost to the buyer of the call option is the initial $1.50 per share paid for the premium. On the other hand, the buyer will exercise the option to buy at $20.00 per share if the ANZ Bank share price is above $20.00. It is cheaper to buy the shares under the terms of the call option. If the share price on the stock market is between $20.00 and $21.50, the buyer will be able to use the profit made from exercising the option to offset the $1.50 premium that has already been paid. Once the share price moves above the break-even amount of $21.50, the buyer’s potential gain is unlimited. 580

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As the price of the share rises above $21.50 (the exercise price plus the premium), the buyer of the call option makes an outright profit by exercising the contract. The profit will continue to rise dollar for dollar with the share price as it moves above $21.50. This is illustrated in Figure 18.3(a) by the ascending 45° line. Should the share price remain below the $20.00 exercise price, the call option buyer’s losses are limited to the cost of the premium paid for the option, that is, $1.50. At the commencement of the call option contract the writer of the option will receive the $1.50 per share premium. This is the total potential gain available to the contract writer. However, the gain from the premium will be eroded if the share price begins to move above the $20.00 exercise price. As shown in Figure 18.3(b), the break-even point occurs at $21.50; that is, the writer of the call option has lost all of the original premium received. If the share price moves above $21.50, the losses are potentially unlimited for the contract writer. For example, if the share price moved to, say, $30.00, the option writer is required to deliver the shares when the buyer exercises the option. In this case the writer will make a net loss of $8.50 per share.

18.5.2

P UT OPTION PROFIT AND LOSS PAYOFF PROFILES

Assume that a wheat farmer has recently planted seed and is concerned that the price of wheat may fall before the crop is harvested. The farmer decides to buy a wheat put option with an exercise price of $6.00 per bushel. The farmer pays the writer of the option a premium of $0.70 per bushel. The potential profit and loss profiles for the buyer, and for the writer, of the put option are illustrated in Figure 18.4.

Figure 18.4 Profit and loss payoff profiles: put option—wheat farmer; exercise price $6.00 bushel, premium $0.70 (a) Buyer of option

(b) Writer or seller of option

Profit

Profit

Break-even

Break-even

+$0.70 Premium $5.30

0

$6.00

Market price

0

$5.30

$6.00

Market price

Premium –$0.70 Loss

Exercise price

Loss

Exercise price

The farmer has been able to lock in a minimum price for his wheat of $6.00 per bushel. If the price of wheat rises above $6.00 per bushel at the exercise date, then the farmer will allow the option to lapse and simply sell the wheat in the spot market. The net cost of the risk cover is the initial premium paid of $0.70 per bushel. If the spot wheat price is below $6.00, the farmer will exercise the put option. At the break-even spot price of $5.30 the farmer will recover all the cost of the premium. If the spot price falls even further, then the option has greater value. The profit and loss profile for the seller of the put option is shown in Figure 18.4(b). The writer of the option will receive the $0.70 premium at the beginning of the contract. If the spot wheat price remains at $6.00 or above on the expiry date, then the put option writer retains the full amount of the premium. 581

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However, should the spot wheat price fall below $6.00 a bushel, then the writer will begin to lose the premium when the contract is exercised. At the break-even spot price of $5.30, the net return on writing the contract is zero. A loss will occur if the price falls even further. The writer of the option will monitor the wheat spot price during the term of the contract. If the writer believes the spot price could fall near or below the break-even price, then the writer will implement a separate risk management strategy to minimise any potential loss. You should now have a sound understanding of the basic features of option contracts. A more comprehensive discussion is provided in Chapter 20, including a range of option risk management strategies.

REFLECTION POINTS

• • • • • • •

An option contract gives the option buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a specified price and date. A call option gives the option buyer the right to buy; a put option gives the option buyer the right to sell on the exercise date. A European option can only be exercised on the contract expiry date; an American option can be exercised any time up to the expiry date. The buyer of an option pays the writer of the contract a premium; the premium on an American option will be higher than the premium on a European option. Exchange-traded options are standardised contracts; the terms and conditions of over-thecounter options may be negotiated to meet specific risk management needs. Profit and loss profile of a call option: the buyer will exercise when the physical market price is above the exercise price; the break-even is the exercise price plus the cost of the premium. Profit and loss profile of a put option: the buyer will exercise when the physical market price is below the exercise price; the break-even is the exercise price less the cost of the premium.

18.6 LEARNING OBJECTIVE 18.6 Consider the structure of an interest rate swap and a cross-currency swap.

Intermediated swap a party enters into a swap with a financial intermediary

Direct swap two parties enter into a swap with each other without using a financial intermediary

Swap contracts

A swap is an over-the-counter financial product that has been developed by the financial markets to allow parties to enter into a contractual agreement to exchange cash flows. Two of the main types of swap contracts are:

• •

interest rate swaps cross-currency swaps.

Interest rate swaps and cross-currency swaps facilitate the management of interest rate and foreign exchange risk exposures. Swaps are not a source of funding for a borrower. A borrower must raise debt funding in the physical market by obtaining a loan from a financial institution or issuing debt securities direct into the money or capital markets. The borrower may choose to manage associated interest rate or foreign exchange risk exposures by also entering into a swap contract. Therefore, the underlying loan contract and the swap contract are two separate contractual commitments; each has its own terms and conditions that must be met. It is quite possible that a risk manager, such as a corporation, will enter into a loan contract and a swap contract with different parties. It is possible to enter into an intermediated swap or a direct swap. An intermediated swap is entered into with a financial institution, usually a bank. A bank is a market-maker in that it will be willing to enter into swap agreements with both borrowers and investors who wish to manage specific risk exposures. A direct swap may be contracted between two risk managers; for example, one corporation

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may enter into a swap with another corporation. Each corporation will be managing a specific risk exposure that the other corporation is willing to accept. While it is possible to enter into a direct swap, the majority of swaps are in fact intermediated swaps. There are two reasons for this; first, the banks are able to make a liquid market in swap contracts and, second, the counterparty to a swap is able to maintain commercial confidentiality by entering into a swap with a bank.

18.6.1

I NTEREST RATE SWAPS

Borrowers are exposed to interest rate risk. For example, a company that has a debt facility with a variable interest rate is exposed to the risk that interest rates on the facility might increase. Similarly, another company that has a debt facility with a fixed interest rate may be concerned interest rates are forecast to fall and that the company will not be able to take advantage of the forecast lower interest rate in the future. A further example of why a corporation might enter into a swap contract could relate to the nature of its business. For example, if the company had entered into a large fixed-price manufacturing contract, the company would be concerned that the cost of manufacturing might rise. A major cost component is the interest on debt. If the company has a variable-rate debt facility with its bank, an increase in interest rates will result in a reduction in the profit margin on its fixed-price manufacturing contract. It is possible that the company may make a net loss on the contract. In the above situation, the company may decide to lock in the cost of debt by entering into a swap contract with its bank, thereby locking in its profit margin. An interest rate swap is an agreement between two parties, such as a company and a bank, to exchange a series of interest payments based on a notional principal amount for a specified period. As the interest rate swap is based on a notional principal amount, no principal is actually swapped; only future interest payments will be swapped. The main type of swap is a fixed-for-floating interest rate swap contract, which is known as a vanilla swap. It is also possible to obtain a floating-for-floating interest rate swap, which is known as a basis swap. The basis is the difference between the two reference interest rates. Let us consider a vanilla swap whereby a corporation has a variable-rate loan with a bank and enters into a swap contract with the bank. The swap will be an agreement between the bank and the corporation periodically to swap interest payments due on a notional principal amount. In reality, the parties will swap the net difference between the interest amounts due. The netting-off of the transactions minimises the exposure to counterparty risk, that is, the risk that one party will not make a payment when it is due. With the vanilla swap, the fixed interest rate (the swap rate) will be set by the bank; the variable or floating rate will be based on a periodically published reference rate. Figure 18.5 shows the conceptual cash flows associated with a vanilla swap. The variable reference rate may vary from one swap contract to another. For example, in Australia an interest rate swap may use the BBSW as the reference rate, whereas in Singapore a similar swap may

Interest rate swap the exchange of interest payments associated with a notional principal amount

Notional principal amount the underlying amount specified in a contract that is used to calculate the value of the contract

Vanilla swap a swap of a series of fixed interest rate payments for variable interest rate payments

Basis swap a swap of a series of two different reference rate interest payments

Swap rate the fixed interest rate specified in a swap contract

Figure 18.5  Vanilla interest rate swap cash flows Fixed interest rate Corporation

Bank Variable interest rate

Variable interest rate

Debt facility

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Part 6 Derivative markets and risk management EURIBOR European interbank offered rate

use the SIBOR, in London it may use LIBOR, in Europe it may use EURIBOR and in the USA it may use USCP. The reference rate used will also depend on the swap reset periods. For example, if the swap variable interest rate is reset every three months, then the three-month BBSW would be used; if the swap is reset every six months, then the six-month BBSW would be applicable. With the vanilla swap, conceptually, at each reset date, the corporation will pay a fixed rate to the bank and the bank will pay a variable rate to the other party (the corporation). Therefore:

• • •

if the variable reference rate is higher than the fixed swap rate, then the corporation will receive a cash payment from the bank being the difference between the swap rate and the reference rate if the variable reference rate is less than the fixed swap rate, the bank will receive the net difference between the rates from the corporation if the rates are the same, then no amount is payable by either party.

Consider the situation where Bounty Limited has issued $1 million of floating rate notes with interest coupons payable half-yearly. The chief financial officer (CFO) at Bounty is concerned that interest rates could rise at some of the coupon dates, thus increasing the cost of the bond finance. The CFO approaches Mega Bank to establish a vanilla interest rate swap. They agree upon the terms and conditions of the swap, including setting the fixed swap rate at 7.00 per cent per annum and the reference rate as the six-month BBSW. If at the first reset date the BBSW is 8.00 per cent per annum, then Mega Bank will be required to make a net cash payment to Bounty of $5 000. The net difference between the interest rates at the reset date is 1.00 per cent per annum, therefore the net difference is 0.50 per cent for the half-year period. The amount paid is 0.50 per cent of $1 million, being $5 000. This is shown in Figure 18.6.

Figure 18.6  Interest rate swap—first reset date cash flows Fixed swap rate 7.00% p.a.

Bounty Limited

Net difference = $1 million × 1% ÷ 2 = $5000

Mega Bank

Six-month BBSW = 8.00% Variable interest rate = 8.00 p.a.

Floating rate note facility

In this case, the decision by Bounty to hedge their interest rate risk exposure proved beneficial. The company was able to lock in the lower cost of funds. However, had the six-month BBSW fallen to 6.00 per cent per annum, then Bounty would have been required to pay $5 000 to Mega Bank. In this situation you might think that the risk management strategy was not successful. If you consider the purpose of risk management, then you will see that the strategy did actually work. The purpose is to remove uncertainty; the company wished to remove the risk that interest rates might change. It achieved this by locking in the rate at 7.00 per cent, regardless of which way rates moved in the future.

18.6.2

C ROSS-CURRENCY SWAPS

As discussed in Part 5 of this text, the international money and capital markets are a major source of funds for borrowers, particularly financial institutions, large corporations and governments. Financial transactions conducted in the international markets generally involve a foreign currency. 584

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A borrower that issues debt securities into the international markets may well be exposed to two significant risks that can be managed using a swap: interest rates risk and FX risk. The swap contract is called a cross-currency swap. A cross-currency swap is an agreement between two parties, such as a bank and a corporation, to exchange a principal amount at the beginning of the swap, followed by the exchange of periodic interest payments during the term of the swap, plus re-exchange of the principal amount at the swap completion date. The swap will involve two currencies; therefore, the amount of the principal exchange and re-exchange, plus the interest payments, will be dependent on the exchange rate used. The exchange rate may be the spot rate at the time, or if the swap begins at a future date, a forward exchange rate may be applied. For example, if the swap is an Australian dollar–US dollar contract based on USD1 million and an exchange rate set at AUD/USD0.7245, then at the start of the contract one party would exchange USD1 million for AUD1 380 262.25. At each future interest payment date, interest payments would be calculated using the same exchange rate, that is, AUD/USD0.7245. Finally, at the swap completion date the original AUD and USD principal amounts will be re-exchanged; that is, USD1 million is reexchanged at AUD/USD0.7245. Therefore, a cross-currency swap is simply an interest rate swap, but incorporates two currencies. As such, it is necessary to determine an exchange rate that will be applied to the swap of cash flows, being the principal amounts and the periodic interest payments. With a cross-currency swap the exchange rate is locked in at commencement for all transactions. Figure 18.7 shows the cross-currency swap cash flows.

Figure 18.7  Cross-currency swap cash flows 1. Swap commencement—principal exchange USD principal Corporation

Bank AUD principal

USD debt facility

2. Periodic interest payments Fixed interest rate (AUD) Corporation

Bank Variable interest rate (USD)

Variable interest rate (USD)

USD interest payments

3. Swap completion—principal re-exchange AUD principal Corporation

Bank USD principal

Repay USD debt facility

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Now that you have a good understanding of interest rate and cross-currency swaps, you may wish to extend your knowledge further by reading Chapter 21. In Chapter 21 we consider the concept of comparative advantage when constructing a swap contract. Further, we discuss the advantages and disadvantages associated with using swaps as a risk management strategy. Finally, we introduce another swap product—the credit default swap.

REFLECTION POINTS

• • • • • • • • •

Interest rate swaps and cross-currency swaps may be used to manage interest rate risk and foreign exchange risk, respectively. Swaps are risk management products; they are not used to raise funds. The majority of swaps are intermediated swaps, but direct swaps are possible. An interest rate swap is an agreement between two parties to exchange a series of interest payments based on a notional principal amount for a specified period. The principal amount is not swapped. A fixed-for-floating interest rate swap contract is known as a vanilla swap; a floating-for-floating interest rate swap is a basis swap. A vanilla swap contract specifies a fixed swap rate plus a floating reference rate such as the BBSW or LIBOR. The net difference between the fixed swap rate and the floating reference rate is paid by one party to the other. A cross-currency swap is an agreement between two parties to exchange a principal amount at the beginning of the swap, followed by the exchange of periodic interest payments, plus the re-exchange of principal at the swap completion date. A cross-currency swap involves two currencies; therefore, the swap contract specifies the interest rates, plus the fixed exchange rate used in the swap cash flows.

CASE STUDY REGULATORY REFORMS AND THE ‘CLEARING’ OF DERIVATIVES Global banking regulations change the way in which certain markets operate. In the USA, for example, the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) introduced a requirement for swaps to be cleared through either a derivatives exchange or a clearing house. Formerly, swaps were traded solely over-the-counter (OTC), but regulations such as Dodd-Frank along with capital requirements for OTC derivatives have led to important changes in the marketplace. Some trades that were OTC before can only be undertaken through a clearing house. Other trades that can still be undertaken OTC have become costlier as banks need to adhere to larger capital reserve requirements and leverage ratios introduced as part of the Basel accords. One of the world’s premier providers of clearing house services is LCH Group. The British operation, which began its life as the London Clearing House in 1888, acts as the counterparty to trades in various markets. Like any clearing house, LCH is the intermediary between two parties and assumes

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the counterparty risk. Clearing houses protect themselves by requiring margin to be posted against all trades. It is easy to see why regulators feel more comfortable with trades cleared through a clearing house rather than undertaken OTC. Not only is there more transparency regarding the trades themselves, but there is a reduction of counterparty risk, which can cause instability during a crisis, particularly when doubts surface as to the solvency of counterparties. LCH has gradually widened its operations to clear products that previously traded solely OTC. In 2012, LCH launched ForexClear to clear foreign exchange derivatives, especially a contract called nondeliverable forwards (NDFs). NDFs are essentially forward contracts for difference (forward CFDs). With a NDF, two parties enter a foreign exchange contract with a face value calculated at the NDF (agreed) rate. Later, if the exchange rate has changed, the difference of some notional amount calculated at the prevailing spot rate is paid by one party to the other. The volume of NDF trades passing through ForexClear has grown significantly as margin and capital requirements on uncleared trades increased. Where NDFs were once traded solely OTC, the majority of trades are now cleared. Government regulations, laws and banking reforms have led to real changes in the marketplace, including new platforms, products and services (LCH Group, 2018). In the Australian economy, regulatory checks over the OTC derivatives market were strengthened after the outbreak of the GFC in 2008 and the focus was on interconnectedness of financial systems. The regulatory efforts directed financial markets towards a central counterparty (CCP) clearing house mechanism, which acts as a seller to every buyer, and buyer to every seller. The central counterparty is a financial institution that assumes credit risk between parties to a transaction and offers clearing and settlement services. This arrangement mitigates bilateral counterparty risk and limits all bilateral exposures to a single multilateral exposure with the CCP (Cox, Garvin & Kelly, 2013). The report submitted by a working group on the global financial system in July 2018 has indicated that the arrangement has reduced counterparty risk, especially between insurance companies and private pension funds (ICPFs) and the rest of the financial sector in Australia (Boyd, 2018). References Boyd, T 2018, ‘Central bankers determined not to repeat the financial crisis’, Financial Review, 6 July, retrieved from http://www.afr.com/brand/chanticleer/central-bankers-determined-not-to-repeat-the-financialcrisis-20180705-h12bs3 Cox, N, Garvin, N & Kelly, G 2013, ‘Central counterparty links and clearing system exposures’, research discussion paper, Reserve Bank of Australia LCH Group 2018, home page, retrieved from http://www.lch.com/

Discussion points

• •

Why would banking regulators view cleared trades more ‘leniently’ than OTC trades? Do you expect the trend towards cleared trades and away from OTC trades to continue? What is a central counterparty (CCP) clearing mechanism?

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Master before you move on LEARNING OBJECTIVE 18.1 Understand the nature and importance of risk and risk management, and explain the operational and financial risk exposures that a business must manage.

• • • • • • • • • • • •

Within the context of a corporation, the board of directors must establish objectives and policies in relation to the identification, measurement and management of risk exposures. It is the responsibility of the chief executive officer to ensure that appropriate risk management procedures and strategies are implemented throughout the corporation. Risk management strategies may be described as internal strategies or external strategies. Internal strategies use the organisation’s existing balance sheet, cash flows or physical assets to manage an identified risk exposure, such as matching foreign currency cash flows. External risk management strategies are sourced outside the organisation. Two examples are the use of derivative contracts (futures, forwards, options and swaps) or the outsourcing of specialised business functions (such as computer operations). Risk is the possibility or probability that an event, such as a change in interest rates, exchange rates or economic activity, may occur that is not forecast and is therefore unexpected. Broadly, risks may be categorised as operational risks or financial risks. Operational risks are risk exposures that impact on the normal day-to-day business functions of an organisation. For example, a loss of computer systems may severely disrupt an organisation. The range of potential operational risks is quite extensive, including technology, property, equipment, personnel, competitors, natural disasters, government policy, suppliers and outsourcing. These operational risks are generally managed by specialist business continuity risk managers. Financial risks are those exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities, thus impacting on shareholders’ funds. Several of the major financial risk categories include interest rate risk, FX risk, liquidity risk, credit risk and capital risk. It is important to recognise the relationships that exist between risk exposures; that is, a risk exposure should not be considered in isolation. A direct risk event will have consequential or flow-on impacts that are often more significant than the initial event.

LEARNING OBJECTIVE 18.2 Construct and analyse a structured risk management process that includes the identification, analysis and assessment of risk exposures, the selection of risk management strategies and products and the establishment of control, monitoring, audit and review procedures. order to manage risk successfully, an organisation must establish a structured risk management • Inprocess that will include: Identification of operational and financial risk exposures. – Analysis of the impact of the risk exposures. – Assessment of the attitude of the organisation to each identified risk exposure. – Selection of appropriate risk management strategies and products. – Establishment of related risk and product controls, including personnel and systems. –

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LEARNING OBJECTIVE 18.3 Examine the basic fundamentals of futures contracts.

• • • • • • • • • •

A derivative is a financial asset that derives its value from a specified underlying physical market commodity or financial instrument. For example, an interest rate derivative such as the 90-day bank-accepted bills futures contract is priced based on the value (or yield) on bank bills in the money market. As a risk management product, a derivate strategy locks in a price today that will apply at a specified future date. A futures contract is an agreement to buy, or sell, a specified commodity or financial instrument at a specified date at a price determined today. Futures contracts are standardised contracts that are traded on a formal futures exchange. To implement a risk management strategy using a futures contract, a risk manager will conduct a transaction in the futures market today that corresponds with the transaction to be carried out in the physical market at a later date. For example, if a company wishes to hedge interest rate risk on a debt facility (i.e. sell its paper to borrow funds), then it will first sell a futures contract. A futures transaction requires the payment of an initial margin (deposit) to the clearing house. The contract will be marked-to-market. If the value of the contract falls before maturity, a maintenance margin call will be made to top up the deposit paid.

CHAPTER EIGHTEEN REVIEW

Implementation of the risk management strategy. – Monitoring, reporting, review and audit of the risk management process. –

At the end of the contract period the futures position is closed out by buying, or selling, an opposite contract to that of the initial futures contract. The net amount between the buy and sell transactions will represent either a profit or loss on the futures transactions. This amount is used to offset the cost or the return on the planned physical market transaction. The pricing of interest rate futures contracts uses the underlying financial instrument formulae.

LEARNING OBJECTIVE 18.4 Review the operation of forward exchange contracts and forward rate agreements.

• • • • •

Forward contracts are over-the-counter products. An FRA locks in a fixed FRA agreed rate today that will be compared to a published reference rate (e.g. the BBSW) on the settlement date. One party will compensate the other party for any movement in rates around the agreed rate. A forward exchange contract locks in an exchange rate today for delivery of a foreign currency at a specified future date. A dealer will quote the spot rate and the forward points.

LEARNING OBJECTIVE 18.5 Understand the nature and versatility of options contracts.

• • •

An option contract gives the option buyer the right, but not the obligation, to buy, or sell, a specified commodity or financial instrument at a specified price and date. A call option is the right to buy, while a put option is the right to sell. The buyer of the option must pay a premium to the writer of the option.

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• • • •

A European option is exercised on a specified date, but an American option can be exercised at any time up to the expiry date. With a call option, the buyer will exercise the option when the physical market price is above the option exercise price. The break-even is the exercise price plus the cost of the premium. The opposite situation applies for a put option.

LEARNING OBJECTIVE 18.6 Consider the structure of an interest rate swap and a cross-currency swap.

• • • • • • • •

An interest rate swap is the exchange of interest rate payments based on a notional principal amount. The majority of swaps are intermediated swaps arranged through a commercial or investment bank. A vanilla swap is a fixed-for-floating interest rate swap, while a floating-for-floating swap is a basis swap. At each interest payment date the net amount only is transferred. A cross-currency swap involves a principal amount and interest payments in two currencies. The principal amounts are exchanged at commencement, followed by a series of interest payments. The principal is re-exchanged at maturity. All transactions are based on an exchange rate fixed at the start of the swap contract.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Risk management is important to the long-term survival of a corporation.



(a) Define and explain the nature of risk.



(b) What is the purpose of risk management?



(c) Discuss who is responsible for the establishment of risk management objectives, policies, procedures and strategies in a corporation. (LO 18.1)

2

Heritage Bank is a medium-sized financial institution headquartered in Toowoomba, Queensland, Australia. Heritage has existing bonds on issue and is seeking to raise additional capital by a further bond issue. As global economic and political uncertainties abate, the treasury management team at Heritage have become increasingly concerned about the possibility of rising interest rates in Australia and the subsequent downward pressure that such a move may place on its key market (mortgages on homes).



(a) Define financial risk and identify five major financial risk categories.



(b) Discuss the interrelationships that are likely to eventuate between the five risk categories you identified in (a).



(c) What would you advise Heritage to do to manage the risks it confronts? (LO 18.1)

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Standard deviation and variance are two statistical measures for dispersion. They can be used to determine how variable or volatile a series of data is. Your best friend, Barry Markowitz, has argued that risk can be measured using either of these statistics. That is, if you want to know how risky a share or a currency is, for example, you would measure the standard deviation or variance of the share returns or the currency price over time. Is Barry correct? If so, why?  (LO 18.2)

4

Macquarie Bank relies upon its online trading platforms and communication systems to execute trades and maintain communication with customers.



(a) What category of risk best defines this type of risk exposure?



(b) Within the context of internal and external risk management, briefly discuss how the bank may consider managing this risk exposure. (LO 18.2)

5

According to CSL Limited’s statements: In 2017, the Board and Global Leadership Group adopted an internal ‘Risk Appetite Statement’, to be implemented throughout the CSL Group. CSL’s risk appetite is integral to the company’s overall risk management processes and the Risk Appetite Statement sets forth the types and extent of risk that CSL is willing to accept in pursuit of its global strategic objectives, while adhering to CSL’s core values and reinforcing its commitment to corporate responsibility. How does this Risk Appetite Statement fit within a structured approach to risk management? (LO 18.2)

6

The analysis of risk exposures is an important part of a structured risk management process.



(a) Outline the main features of risk analysis in the risk management process.



(b) What are some of the challenges that confront risk analysts? (LO 18.2)

7

Your financial adviser argues that you should take a position in the futures market that is the opposite of the position you have in the physical market. You are a farmer with wheat growing in the field. Should you take buy or sell wheat futures if you are worried about price declines between now and harvest time? (LO 18.3)

8

With two business partners, you manage a small financial services firm that actively manages $40 000 000 in superannuation funds. The markets have been particularly volatile and your analysis suggests that there is a strong chance of a significant market correction in the short to medium term. Explain to your partners how futures contracts might be used as part of a risk management strategy and outline the steps, including the transactions involved, that your firm should take in order to hedge against the risk of a market downturn. (LO 18.3)

9

At the completion of a futures contract risk management strategy, a risk manager will have made either a profit or a loss on the futures market transactions.



(a) How was the profit or loss in the futures market derived?



(b) Explain how making a loss with the futures market strategy can result in the risk manager hedging an identified risk exposure. (LO 18.3)

CHAPTER EIGHTEEN REVIEW

3

10 Pacific Brands has established a $5 million 90-day bank bill rollover facility with ANZ Bank. The company is concerned that interest rates may rise at the next rollover date. The company decides to manage this risk exposure with a forward rate agreement (FRA) with ANZ. The bank gives the following quote: 3Mv6M(21) 6.15–05. The reference rate is the Australian BBSW. Note: At the first rollover date BBSW is published as 6.10 per cent per annum.

(a) Explain each of the components of the above FRA quote.



(b) Draw and fully label an FRA timeline to show the structure of the above FRA agreement.



(c) In the above scenario the agreed rate will be 6.15 per cent per annum. The reference rate in three months is 6.10 per cent per annum. Who will be required to make the compensation payment?



(d) Has this been a successful risk management strategy for Pacific Brands? (LO 18.4)

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11 An importer has entered into a USD contract that will require payment of USD10 million in one month. The importer wishes to lock in an exchange rate today in order to protect its future profit margins. An investment bank gives the following quote: AUD/USD0.7340–33 12:17. Calculate the importer’s one-month forward exchange rate. (LO 18.4) 12 Dexus Property Group shares currently trade at $9.10. An investor enters into a call option on Dexus shares with an exercise price of $9.30 per share in two months, and a premium of $0.25 per share.

(a) Define an option and explain the premium and the exercise price.



(b) What is a call option?



(c) Draw a fully labelled diagram of the call option showing the profit and loss profile of the option buyer and the writer of the option (including the break-even price).



(d) At what minimum stock price will the option buyer exercise the option on the expiration date? (LO 18.5)

13 A superannuation fund is holding a large number of National Bank Limited shares in an investment portfolio and wishes to protect the value of the investment. The shares currently trade at $24.49. The superannuation fund buys a put option with an exercise price of $24.00 per share and a premium of $0.95 per share.

(a) What is a put option?



(b) By entering into this option strategy, explain whether the superannuation fund will exercise the option if the spot price is above or below the exercise price.



(c) Draw a fully labelled diagram of the put option showing the profit and loss profile of the option buyer and the writer of the option (including the break-even price). (LO 18.5)

14 Iluka Resources has recently issued $15 million in floating rate notes in order to fund the next stage of an exploration project. The notes pay an annual coupon of BBSW plus 150 basis points. The company approaches Commonwealth Bank to establish an intermediated vanilla swap. The swap contract sets a fixed rate of 7.60 per cent per annum and a reference rate of the 12-month BBSW.

(a) What is an intermediated vanilla swap?



(b) At the first interest payment date, the BBSW is 7.85 per cent per annum. Draw and fully label a diagram showing all the applicable interest rates at that date.



(c) Which party to the swap contract is required to make the first payment? How much is the payment? Why don’t both parties need to make a payment? (LO 18.6)

15 A state government borrowing authority is to issue USD bonds as part of the government’s capital funding program. The borrowing authority plans to establish an intermediated crosscurrency swap in order to convert the USD principal amount raised into AUD and, at the same time, manage the FX risk exposures attached to the future USD bond coupon payments.

(a) Draw and fully label a diagram of the flows at:



(i) the commencement of the swap



(ii) the first interest coupon payment date



(iii) the contract completion date.



(b) Explain how the cross-currency swap allows the borrowing authority to hedge its interest rate risk and FX risk exposures. (LO 18.6)

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American-type options  579

EURIBOR 584

liquidity risk  569

basis swap  583

European-type options  579

maintenance margin call  574

business impact analysis  571

marked-to-market 574

capital adequacy  569

forward rate agreement (FRA) 576

capital risk  569

FRA agreed rate  576

clearing house  574

FRA contract period  576

profit and loss payoff profiles 580

consequential risks  569

FRA settlement date  576

reference rate  576

cost–benefit analysis  572

initial margin  574

strike price  579

direct risks  569

interest rate swap  583

swap rate  583

direct swap  582

intermediated swap  582

vanilla swap  583

notional principal amount  583

CHAPTER EIGHTEEN REVIEW

KEY TERMS

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CHAPTER 19

Futures contracts and forward rate agreements CHAPTER OUTLINE 19.1 Hedging using futures contracts 19.2 Main features of a futures transaction 19.3 Futures market instruments 19.4 Futures market participants 19.5 Hedging: risk management using futures 19.6 Risks in using futures contracts for hedging 19.7 Forward rate agreements

Learning objectives LO 19.1

Consider the nature and purpose of derivative products and the use of a futures contract to hedge a specific risk exposure.

LO 19.2

Discuss the main features of a futures transaction, including orders and agreement to trade, calculations, margin requirements, closing out a contract and contract delivery.

LO 19.3

Review the types of futures contracts offered through a futures exchange.

LO 19.4

Identify the participants in the futures market, including hedgers, speculators, traders and arbitrageurs, and explain why they use futures contracts.

LO 19.5

Show how financial futures contracts may be used to hedge price risks, including a borrowing hedge, an investment hedge, an FX hedge and a share portfolio hedge.

LO 19.6

Identify risks associated with using a futures contract hedging strategy, including standard contract size, margin payments, basis risk and cross-commodity hedging.

LO 19.7

Describe, illustrate and calculate the use of a forward rate agreement (FRA) for hedging interest rate risk.

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CHAPTER SNAPSHOT Futures markets allow market participants to buy and sell now for delivery or settlement at some point in the future. A trader might believe that the oil price will increase between now and four months from now. He could buy a few million barrels of oil and store them in a warehouse until then. That will be expensive and tie up a lot of capital. Alternatively, he could take a long position (buy) in oil futures for settlement in four months’ time. If the price of oil increases, the value of his position increases. On the other side of this trade might be an oil company that will have oil to deliver in four months’ time and is concerned that the price will fall. The company can take a short position in oil futures that will increase in value as the oil price falls. In this way, futures markets can meet the needs of both speculators and hedgers (those seeking to avoid or minimise risk). There are futures markets for many different commodities, shares, share indices and, surprisingly, the weather.

INTRODUCTION The markets in derivative contracts have been among the most innovative and rapidly growing of all financial markets. Financial derivative contracts enable investors and borrowers to protect assets, liabilities and associated cash flows against the risk of changes in interest rates, exchange rates and share prices. Similarly, commodity derivative contracts allow risks associated with the movement in commodity prices, such as resource commodities and agriculture commodities, to be managed. A fund manager may use financial derivatives to protect the value of the portfolio that he manages. For example, if the manager expects markets to suffer losses, he can enter a short position in a financial futures contract that derives its value from S&P/ASX 200 Index. If the share market experiences losses, the value of the funds managed by the fund manager will fall. However, the value of the futures position will increase and act to offset some of the losses. A risk management strategy such as this essentially transfers the risk exposure to another party. The other party may have an opposite risk exposure that also needs to be managed, or may be a trader or speculator who has a view on future price changes and the extent of those price changes. Futures contracts are exchange-traded financial instruments. Exchange-traded contracts are traded on a formal exchange such as the Chicago Board of Trade (CBOT), ASX Trade24 and the NYSE Liffe. The contract specifications of exchange-traded contracts are standardised by the exchange on which the contracts are listed. Standard features include the underlying physical asset, the amount of a contract, how it is quoted, when it matures and how the contract is settled. The success and consolidation of the exchange-traded futures markets around the world eventually led to the development of an over-the-counter market, namely the forward market. The forward markets include the forward rate agreement (FRA) market and the forward exchange contract market. Both of these are discussed in this chapter, with particular emphasis on the FRA. As an over-the-counter product, the FRA has become a flexible global interest rate risk management product that is easily understood by users of the product. For example, the FRA does not include some of the complexities of the futures contract, such as margin payments. An FRA is negotiated and established with a financial institution such as a commercial bank or investment bank. The party entering into an FRA with a bank can negotiate contract features to meet their own particular risk management needs. The chapter begins with an examination of futures markets and contracts and the application of futures contracts to hedge risks.

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REFLECTION POINTS

• • • • •

Derivatives are primarily used to manage risk exposures associated with financial risks and commodity risks. The price of a derivative is based on an underlying commodity or financial instrument available in the physical market. The risk management function of a derivative contract is to lock in a price today that will apply at a specified later date. Futures contracts are standardised exchange-traded contracts. Most developed countries operate a formal futures exchange. An FRA is an over-the-counter derivative product; the terms and conditions of an FRA can be negotiated with the provider.

19.1 LEARNING OBJECTIVE 19.1 Consider the nature and purpose of derivative products and the use of a futures contract to hedge a specific risk exposure.

Hedging using futures contracts

A futures contract is a legally binding agreement between two parties to buy, or sell, a specified commodity or financial instrument at a specified date in the future at a price determined today. Risk incorporates uncertainty; therefore, if a futures contract locks in a price today that will apply at some date in the future, it has removed uncertainty from the price and the risk exposure has been hedged or managed. In Chapter 18 we discussed how a risk manager, or hedger, can use a futures contract to create a situation in which any change in the physical market price of a commodity or financial instrument is offset by a profit or loss derived from a corresponding change in the value of a futures contract risk management strategy. The following example illustrates the general principles and procedures involved in hedging through the futures market. Consider a farmer who grows wheat. The farmer is concerned that the price of wheat may fall before the wheat is ready for harvest and sale. The farmer would be happy to obtain the current price of wheat, but the wheat will not be ready to harvest for some months. The potential adverse effect of a fall in wheat prices can be hedged by selling futures contracts today equal in value to the current value of the expected wheat harvest. The futures contract is an obligation for the farmer to supply a specified quantity of wheat on a specified future date and at a price set today. When the specified future date arrives, the farmer has two options. The first is to deliver the wheat according to the terms of the futures contracts and receive the originally agreed upon price. However, this course of action (i.e. the physical delivery of the commodity) is not normally taken. The second option is for the farmer to sell the wheat through the usual grain market and, at the same time, buy a futures contract identical to the contract originally sold at the commencement of the hedging strategy. If the price for wheat in the grain market has fallen on the day that the farmer closes out the futures contracts, the price of the related wheat futures contracts will also have fallen in line with the price changes in the physical market. (Remember, the price of a derivative contract is derived from the underlying physical market product.) How does the fall in price affect the farmer? The wheat is sold at the current lower price in the spot grain market, but by hedging through the original sale and later purchase of wheat futures contracts, a profit has been made in the futures market. The farmer sold the futures contracts at one price and later bought them at a lower price. The profit made in the futures market transactions compensates the farmer for the loss made in selling the wheat at the current lower price in the spot grain market. The net outcome is that the farmer has effectively obtained the wheat price that prevailed at the beginning of the strategy. What would have happened if the price of wheat had risen in the grain market? The farmer would have made a profit from the sale of the wheat in the grain market. However, the original sale of the

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futures contracts at the then-prevailing price, and the repurchase of the contracts at the higher future price, would result in a loss from the futures market transactions. The futures market loss would be offset by the higher profit made in the spot grain market. The farmer may regret having entered the original sale of the futures contracts in this situation. However, the purpose of hedging is to provide certainty to future cash flows, and that is exactly what the farmer has achieved in both situations. The farmer is able to achieve cash-flow certainty because the pricing of a futures contract is directly based on the price of the underlying physical market price. As the price of wheat in the physical market fell, the price of the wheat futures contracts also fell. The farmer adopted a risk management strategy whereby futures contracts were sold in the first instance and this position was closed out at a later date by buying identical contracts. In the futures market transactions, the farmer sold high and bought low. The basic rule to be followed when establishing a hedging strategy is to conduct an initial transaction in the futures market today that corresponds with what is planned to be done in the physical market at a later date. The farmer initially sold a futures contract because he intended at a later date to sell wheat in the physical market. It is important to remember this buy or sell rule, as the sequencing of transactions will determine the success of a futures contract strategy.

REFLECTION POINTS

• • • •

A futures contract is an agreement between two parties to buy or sell a specified commodity or financial instrument at a specified future date and at a price determined today. A hedge is the implementation of a strategy to manage a risk exposure. Futures contracts allow the hedging of price risk by locking in a price today that applies in the future; for example, locking in a future interest rate. The futures contract hedging strategy rule is: conduct an initial transaction in the futures market today that corresponds with what you intend to do in the physical market at a later date. For example, if a firm intends to sell discount securities to borrow in three months, then sell a related three-month futures contract today. The open futures position is normally closed out (buy or sell an opposite contract) at maturity. The profit or loss made on the futures market transactions is offset against the physical market transaction.

19.2

Main features of a futures transaction

Futures are exchange-traded contracts. While futures contracts are standardised, the types of contracts vary between exchanges in different countries. Each futures exchange tends to offer contracts based on underlying commodities and financial instruments available in that country. For example, with government bond futures contracts, the CBOT offers US Treasury bond futures contracts, ASX Trade24 offers Commonwealth Treasury bond futures contracts and Eurex offers German government bond contracts. The convention adopted for the quotation of the price of a futures contract on a particular exchange may also vary. For example, in the US and European markets bonds are typically quoted on the basis of their clean price, being the present value of a bond less accrued interest, whereas in the Australian market bonds are quoted on the basis of their yield to maturity. It is not possible to look at all the futures exchanges around the world, but it is useful to obtain a clear understanding of at least one market. Therefore, this text focuses mainly on futures contracts, conventions and product specifications of the Australian futures markets—specifically contracts offered through ASX Trade24. The principles of futures contract transactions conducted on ASX Trade24 also apply to contracts offered in other international futures exchanges.

LEARNING OBJECTIVE 19.2 Discuss the main features of a futures transaction, including orders and agreement to trade, calculations, margin requirements, closing out a contract and contract delivery.

Clean price the present value of a bond less accrued interest

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19.2.1

O RDERS AND AGREEMENT TO TRADE

One of the contracts offered on ASX Trade24 is the Australian 10-year Treasury bond contract. This contract may be used as a proxy to hedge a longer-term interest rate risk exposure. Assume that there are two companies (company B and company S) wishing to conduct futures contract transactions. Company B wants to buy one 10-year Treasury bond futures contract and company S wants to sell one 10-year Treasury bond futures contract. Each company will place an order with a futures broker. An order normally specifies the following:

Market order an instruction to a broker to buy or sell at the current market price

Limit order an instruction to a broker to buy or sell to a specified price and within a certain time

• • • • •

whether it is a buy order (company B) or a sell order (company S) what type of contract (10-year Treasury bond contract) the delivery month, that is, the date on which the contract expires any price restrictions that may apply to the order; for example, the order may be a market order, that is, an order to buy or sell at the current market price; alternatively, it may be a limit order, that is, an order to buy at the lowest price up to a specified limit, or to sell at the highest price down to a specified limit a time limit on the order: the transaction must be completed by a nominated date or the order is to be withdrawn.

The brokers will enter their respective orders into the ASX electronic trading system. The system automatically matches corresponding buy and sell orders and demand and supply ‘determines’ the price. Where more than one buy or sell order is lodged on the system at the same price, the first order received is given priority in the matching process. The transaction (above) is completed when the electronic trading system matches the bid (buy) of company B with the offer (sell) of company S. The price of the transaction is based on the yield of the contract; however, a futures contract on ASX Trade24 is quoted as an index figure (100 minus the yield). The Treasury bond futures contract is quoted to three decimal places. Therefore, if company B and company S enter into contracts at a yield of 7.25 per cent per annum, the contract will be quoted as 92.750 (100 minus 7.25). Futures contracts are quoted at an index figure of 100 minus the yield so that a dealer can follow the basic principle of buy low and sell high. The price of the contract in the example is based on a 7.25 per cent yield. If this contract were to be sold at a later date at a yield of 6.50 per cent, then at first it seems that a loss would be made because the contract was bought at 7.25 per cent and sold at 6.50 per cent. If, however, we calculate the actual prices of the two contracts, we find that a profit would be made. Therefore, by adopting the index quote convention, if the dealer buys at 92.750 and sells at 93.500, it is apparent that a profit has been made. A bond futures contract is based on a bond traded in the physical market, so the pricing of the futures contract is based on the pricing of the actual bond. The price of the bond futures contract can be calculated using the bond formula given in Equation 19.1. For a review of the structure and use of the formula, refer back to the pricing of bonds in Chapter 10. Note that it is possible to write the bond formula in different ways. The formula below is used here as it clearly defines the pricing components, that is, the present values of the future cash flows, being the present value of the coupon stream plus the present value of the principal. 1 − (​ ​1 + i​)−n ​  ​   ​P = C​​ ​ _   ​ ​+ A ​​(​1 + i​)−n ​  ​ i [ ]

19.1

where:

i = the nominal interest rate per period expressed as a decimal n = the number of coupon periods C = periodic coupon payments A = the face value of the bond

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The Australian Treasury bond futures contract is based on a 6.00 per cent per annum fixed-interest bond with a face value of $100 000 and paying half-yearly coupons. Therefore, the futures contract entered into by company B and company S will be priced at $91 216.88; that is: ​i = 7.25% p.a. ÷ 2 = 3.625% = 0.03625 n = 10-year bond × half-yearly coupons = 20 C = 6.00% p.a. bond; half-yearly coupons = $100 000 × 0.03 = $3 000 A = $100 000​ 1 − (​ ​1 + 0.03625​)−20 ​  ​ ​P = $3 000​​ _________________ ​         ​ ​+ $100 000​​(​1 + 0.03625​)−20 ​  ​ 0.03625 [ ]

= $42 158.96 + $49 057.92 = $91 216.88​

Details of the transactions are entered into the computer of the clearing house ASX Clear (Futures)—the facility for recording transactions conducted through the exchange, ensuring the enforcement of the payment of margins (discussed below) and the value settlement of the transactions. ASX Clear (Futures) accepts and ‘novates’ submitted trades. This novation process makes it possible for one party to a contract to be substituted for another at any time and facilitates easy entry to and exit from the market. Once accepted and novated, a contract exists between each party and ASX Clear (Futures). While the contracts to buy and sell were made on behalf of the two companies, in effect the clearing house becomes the other party to each of the contracts.

19.2.2

M ARGIN REQUIREMENTS

An agreement to buy a futures contract is called a long position and an agreement to sell is known as a short position. When company B and company S enter into their positions (contracts), they do not need to pay the full price of the contract; instead they are only required to pay a deposit or initial margin. The initial margin will be set at a minimum percentage of the value of the futures contract. This will usually range between 2.00 and 10.00 per cent. The initial margin is held by the clearing house. Initial margins change from time to time, depending on the volatility of the price of the commodity or financial instrument underlying the futures contract. During periods of high price volatility, the percentage margin may be increased. The initial margin is similar to a performance bond or collateral that supports the value of the futures contract. The initial margin is imposed to ensure that brokers and their clients are able to pay for any losses incurred throughout the life of the contract, thus protecting the profits of the opposite party to the transaction. ASX Clear (Futures) uses a margining system developed by the Chicago Mercantile Exchange (CME), known as SPAN (Standard Portfolio Analysis of Risk). SPAN uses a set of predetermined parameters that are set by the clearing house in order to assess the maximum potential loss that can be expected on a specified portfolio over a one-day period. The margin will cover this potential loss amount. The value of the buy and sell contracts of companies B and S will change over time; if the value of one contract goes up, the value of the other contract will go down. If adverse movements in the price of a futures contract result in the amount of the initial margin paid no longer being sufficient to cover the percentage margin requirement, the company will be required to top up the margin held with the clearing house. This is achieved through a variation or maintenance margin call. Maintenance margins are imposed to ensure that parties to futures contracts do not default on their contracts if the price of the contract moves against them. For example, if the market price of the 10-year Treasury bond futures contract rises to 93.600, company B’s contract to buy at 92.750 would increase in value to $97 078.79. Conversely, if the market price of the contract fell to 92.500, the contract would then be worth only $89 577.84 and company B would have a loss on paper of $1 639.04. Company B’s futures contract would be out of the money. 599

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In this situation there is a risk that company B may default on its contract. To ensure that company B does not behave in this way, the value of futures contracts is marked-to-market on a daily basis. This means that all futures contracts are revalued by the clearing house every day at current market prices, and any difference between the current market value and the initial contract price is added to, or taken from, the margin account that is held with the clearing house. In company B’s case, if the market price fell to 92.500, the valuation loss of $1 639.04 would be debited to company B’s margin account. ASX Clear (Futures) requires members to maintain margins at least equal to that determined by SPAN. In the above scenario, the futures broker would therefore issue company B with a maintenance margin call and the company would have to add to the initial margin already held by the clearing house. The adjustments in the margin account for company S would be the exact opposite. Company S has a short position; that is, it sold one 10-year Treasury bond futures contract. Therefore, the movement in the contract price from 92.750 to 92.500 would result in a surplus balance in the margin account held with the clearing house.

19.2.3

Close out futures strategy: buy or sell a futures contract before maturity date that is opposite to the initial futures contract position

C LOSING OUT OF A CONTRACT

A futures exchange offers a market in which contracts are bought and sold. Company B and company S are therefore able to close out their open positions at any time by conducting an opposite futures contract transaction. Assume that company S now decides to close out its contract when the current market price is at 92.500. To close out its position, it would instruct its broker to enter into a contract that is exactly the opposite in direction, but identical in delivery date, to that of its initial futures contract. That is, company S initially entered a ‘sell one 10-year Treasury bond contract’. It would now enter a ‘buy one 10-year Treasury bond contract’ for delivery on the same date. This new contract would be conducted with a third market participant, perhaps company R. The net effect of the second contract is that it closes out the first contract. Company S no longer has an open position in the futures market as it has bought one contract and sold one contract, thus it no longer has any contract. Company S takes the $1 639.04 profit made by selling the contract at 92.750 and purchasing the contract at 92.500. The company is also able to withdraw its initial margin held with the clearing house since its market position has been closed out. Company B retains its agreement to buy a contract at 92.750 and has paid the additional maintenance margin call. Company R agrees to sell a contract at 92.500 and deposits its initial margin through its broker with the clearing house. The open positions at the clearing house remain unaltered by the transactions. There is still the same number of contracts at the contract delivery date. In effect, the clearing house is the counterparty to each contract. It becomes the buyer to each seller and the seller to each buyer. By serving this role, the clearing house makes it possible for one party to a contract to be substituted for another at any time. As we have explained, this process, known as novation, facilitates easy entry to and exit from the market. The clearing house is also able to guarantee all contracts because it is holding the funds in the margin accounts.

19.2.4

C ONTRACT DELIVERY

Most market participants who conduct futures contract transactions do so either to manage a risk exposure or to try and profit from changes in the price of the contracts. They do not wish actually to deliver or receive the underlying commodity or financial instrument specified in the futures contract. Therefore, as discussed above, the vast majority of financial futures contracts are closed out prior to the delivery date; that is, contract holders will either buy or sell an opposite contract on or before the expiry date in order to close out their open position. ASX Trade24 requires that financial futures positions that are still in existence at the close of trading in the contract month be settled with the clearing house. Depending on the particular futures 600

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contract, final settlement may be in the form of delivery of the actual underlying financial instrument, known as standard delivery, or may be by cash settlement. For example, the 90-day bank-accepted bills futures contract may be completed by standard delivery or cash settlement. Standard delivery may be by physical bank-accepted bills or bank-negotiable certificates of deposit (CDs), or their electronic equivalent, each of face value AUD1 million, maturing 85 to 95 days from settlement day. On the other hand, the three-year Treasury bond contract, the 10-year Treasury bond contract and the S&P/ASX 200 Index contract can only be completed by cash settlement. Futures contracts based on the shares of individual listed companies require standard delivery of 1 000 underlying shares per contract. Settlement details, including the calculation of cash settlement amounts, for each contract traded on ASX Trade24 are available on the exchange’s internet site at www.asx.com.au. The details that you will find include details regarding contract months and last trading days. The contract months for the S&P/ASX 200 Index futures contract, for example, are March, June, September and December up to six quarter months ahead. The last trading day for each contract is the third Thursday of the settlement month. On that day, trading in expiring contracts ceases at 12 noon.

Standard delivery futures contract—settled by physical delivery of the specified asset

Cash settlement futures contract—settled by cash payment at delivery date

Contract month the month in which a futures contract expires and settlement in cash or by physical delivery is required

Last trading day the day of the month on which a futures contract expires

REFLECTION POINTS

• • • • • • • • • •

A wide range of different futures contracts is available in global futures exchanges. Bond futures contracts may be quoted on a clean price basis (e.g. USA and Europe) or yield to maturity (e.g. Australia). A client may place a buy or sell order with a broker. Some exchanges operate by open outcry, but the majority have moved to electronic trading. ASX Trade24 quotes bond and bill futures contracts at an index figure of 100 minus the yield; for example, a futures contract yielding 5.75 per cent per annum would be quoted as 94.25. The price of a futures contract is calculated using the underlying physical market asset price formulae, such as the bond formula and the discount security formula. Transactions are recorded by the exchange’s clearing house; buying a futures contract is a long position, selling is a short position. A futures contract requires payment of an initial margin to the clearing house. Contracts are marked-to-market (re-priced) each day. Adverse price movement will require a maintenance margin call. The majority of futures contracts are closed out by buying or selling an identical contract before the original contract expiry date. Settlement of a futures contract may be by standard delivery (limited to certain contracts) or by cash settlement.

19.3

Futures market instruments

Futures markets can be established for virtually any commodity or financial instrument that has the following attributes:

• • • •

It is traded freely, generally without direct government controls over the prices. There is, at times, a considerable degree of price fluctuation or volatility. Its quality can be graded according to a universally accepted standard. There is a plentiful supply of the commodity or security, or cash settlement is possible.

LEARNING OBJECTIVE 19.3 Review the types of futures contracts offered through a futures exchange.

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Commodities that meet these requirements are remarkably varied in nature. They include resource commodities such as silver, gold, copper, oil and zinc, and agricultural commodities such as wool, frozen orange juice, cocoa, coffee, barley, butter, soy beans, pork bellies (bacon), corn, cotton, wheat and cattle. On the various futures exchanges around the world, it is possible to buy and sell contracts based on all major currencies, including the pound sterling, the Canadian dollar, the Japanese yen, the euro, the Swiss franc and the Australian dollar. Futures contracts based on financial instruments represent a significant part of the market. Contracts are available on interest rates, share-market indices and individual listed company shares. The interest rate contracts available globally include, for example, contracts based on short-term debt instruments such as US 90-day Treasury bills, three-month bank CDs, three-month eurodollar deposits, short-term UK gilt securities and Australian 90-day bank-accepted bills. Contracts based on longer-term interest rates include US 10-year T-notes, US 15-year Treasury bonds, US municipal bonds, UK longerterm gilt securities and Australian three-year and 10-year Treasury bonds. Examples of share price index futures contracts offered in the global futures exchanges include:

• • •

Chicago Mercantile Exchange: Standard & Poor’s 500 and Dow Jones Industrial Average Index (www.cme.com) Hong Kong Futures Exchange: Hang Seng Index (www.hkex.com.hk) Tokyo Stock Exchange: Tokyo Stock Price Index (TOPIX) (www.tse.or.jp/english).

In the Australian market ASX Trade24 currently facilitates trade in the financial futures contracts listed in Table 19.1. ASX Trade24 also offers a range of commodity futures contracts such as wool and  grain. ASX Trade24 also facilitates trade in option contracts on the majority of its futures contracts. Options are discussed in Chapter 20. Contracts are also available, in conjunction with other international futures exchanges, including the NYSE Liffe. The specifications of each of the ASX Trade24 futures contracts are available at www.asx.com.au.

Table 19.1 ASX Trade24 financial futures contracts, Australia and New Zealand Australian-based contracts

New Zealand-based contracts

30-day interbank cash rate

30-day official cash rate

90-day bank-accepted bills

90-day bank bills

3-year Treasury bonds

3-year government stock

10-year Treasury bonds

10-year government stock

S&P/ASX 50 Index

New Zealand/Australia 3-year bond spread

S&P/ASX 200 Index

New Zealand/Australia 10-year bond spread

S&P/ASX 200 VIX Index S&P/ASX 200 A-REIT Index

SX 15 Index

Select individual publicly listed company shares Australian/US 10-year bond spread 3-year interest rate swap 10-year interest rate swap 602

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REFLECTION POINTS

• • •

Futures contracts develop in markets in which an underlying asset is freely traded, the asset is easily standardised, but may experience price volatility from time to time, and the product is readily available or cash settlement is possible. Contracts tend to vary between international futures exchanges; contracts are often based on local commodities and financial instruments. Commodity futures contracts include gold, wool and frozen orange juice, and financial futures contracts include bonds, discount securities, currencies, shares and share indices.

19.4

Futures market participants

There are four main categories of market participants in the futures markets: hedgers, speculators, traders and arbitrageurs. Each category carries out an important role in the futures market; collectively, they help to maintain the depth and liquidity that is necessary within a market if it is to be efficient and successful, and to deliver competitive pricing.

19.4.1

H EDGERS

Hedgers use the market in an attempt to manage price risks such as exposures to changes in interest rates, exchange rates and share prices. For example, a fund manager may have forecast a general fall in the stock market within the next three months and will be concerned about the adverse impact this will have on the value of the share portfolio. The fund manager may decide to hedge this risk by selling S&P/ASX 200 share price index futures contracts. Other examples of the use of futures contracts as a means of reducing financial risk include:

• • • • •

LEARNING OBJECTIVE 19.4 Identify the participants in the futures market, including hedgers, speculators, traders and arbitrageurs, and explain why they use futures contracts.

A borrower can lock in the cost of borrowing by selling futures contracts in order to protect against the risk of rising interest rates. An investor can lock in the yield on an investment, and protect against the effects of falling interest rates, by buying futures contracts. An importer with FX payables, or a company having to make interest payments to foreign lenders, can lock in the price of the required foreign currency by buying FX futures (selling AUD futures). An exporter will take an opposite strategy. An investor who expects to buy shares in the future, but who also expects the share market to rise before buying the shares, can obtain protection by buying specific company share futures contracts now. An investor who anticipates a large amount of market volatility in the coming month can hedge exposure to that volatility by buying S&P/ASX 200 VIX futures.

19.4.2

S PECULATORS

Speculators attempt to make a profit by purposely taking risks. They enter the market in the expectation that the market price will move in a favourable direction for them. For example, company S (from the example used previously) may have been speculating. Its futures contract may have had nothing to do with a business exposure to interest rate risk. Its sale of the 10-year Treasury bond futures contract may simply have been based on its expectation that bond prices were going to fall. With that expectation, it sold a contract today at 92.750, and obtained a profit when it closed out its position by buying a 603

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Straddle buying and selling of contracts with different delivery dates to benefit from price variances

Spread position buying and selling of related, samedelivery-date contracts to benefit from price variances

contract at 92.500 at a later date. Speculators who expect prices to rise would take a long position and buy the contract now; those who expect prices to fall would take a short position and sell the contract now. A long position occurs when an asset is bought forward; a short position occurs when entering into a contract to sell an asset that is not held at that time. More complex strategies are also employed. For example, a speculator may construct a straddle or a spread position. In a straddle, the speculator may simultaneously buy a contract for delivery in a particular month and sell an identical contract with a later delivery date. This strategy is motivated by an expectation of a change in the price differential between the two contracts. A spread position is similar to the straddle, but involves the simultaneous buying and selling of contracts that are related rather than identical in the anticipation of a change in the price differential (or spread) between the two contracts. For example, a speculator might buy a 90-day bank-accepted bill contract and simultaneously sell a three-year Treasury bond contract in anticipation of a change in the yield curve. The expectations behind this spread position are as follows:

• •

The price of the 90-day bank-accepted bill futures contract will rise; that is, yields on 90-day bills are expected to fall. Therefore, the speculator will go long and buy. The price of the three-year Treasury bond contract will fall; that is, interest rates on three-year Treasury bonds are expected to rise. Therefore, the speculator will sell now, or go short.

This spread position is based on an expectation that the normal yield curve will become steeper in shape, or move from flat to normal, or move from steeply inverse towards a flat or normal yield curve. Speculators are important to the efficient operation of the futures market; they perform the useful role of being the counterparty to a position that a hedger wants to take. Speculators often take on the risks that hedgers seek to avoid. Without them, trading volumes in the market would be much lower. Speculators also provide information to market participants on the expected future direction of the price of physical market commodities and financial instruments. It is in the interests of the speculators to gather all available information relevant to factors that will affect the prices of the underlying commodities and financial instruments of the futures contract in which they trade. Collecting and processing this information enables the speculator to forecast future price trends. On the basis of these forecasts, speculators will take a position in the futures market and this will affect the prices of the contracts in which they are active. The resulting price fluctuations are an indicator of the direction in which the prices of the underlying physical market assets are expected to move. This is valuable information to those who deal in the physical markets, regardless of whether or not they intend to transact in the futures market.

19.4.3 Traders buy and sell contracts, typically very short term, on their own account

T RADERS

Traders conduct transactions on their own account, not on behalf of clients. Traders may be described as a special class of speculator; they trade futures contracts based on very short-term changes in price. Traders may buy and sell virtually identical contracts a number of times during the trading day. On futures exchanges that continue to operate with open-outcry trading on the floor of the exchange, such as the CBOT, trading may be expected to form a very large proportion of the transactions of local floor members. Traders contribute to the operation of the exchange in the same way that speculators do. By being prepared to buy or sell when prices move intra-day, traders add depth and liquidity to the market and have the effect of narrowing the spread between bid and offer prices.

19.4.4

A RBITRAGEURS

Arbitrageurs use the markets to make a profit without taking any risk. Arbitrageurs attempt to make a profit by taking advantage of price differentials between different markets, such as when a futures contract price is out of equilibrium with the physical market spot price of the underlying commodity or financial instrument. 604

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For example, it may be possible to make an arbitrage profit by buying a low-priced bank bill in the physical market and simultaneously selling a 90-day bank-accepted bill futures contract in the relatively higher-priced futures market. This is profitable if the gap between the two prices is greater than the opportunity cost and transaction costs involved in buying the bank bill and holding it through the relevant time period. Arbitrage transactions can be much more complicated than this simple example; some may require trading in several markets simultaneously. For example, Chapter 15 explains that there is a very strict relationship between the spot and forward rates of exchange between two currencies and the interest rates available in the two countries. An arbitrage profit may be available by trading in the forward exchange market and simultaneously trading in bank bill futures on ASX Trade24 and eurodollar interest rate futures on the Singapore Exchange (SXG). Arbitrageurs, through their transactions, bring about price changes in the markets such that the price of a physical market commodity or financial instrument and the associated futures contract are brought into equilibrium with one another.

REFLECTION POINTS

• • • •

Hedgers use the futures market to manage identified risk exposures; for example, a company that has borrowed and is exposed to an increase in interest rates may sell a futures contract to hedge that risk exposure. Speculators buy and sell futures contracts to try and make profits on price movements; for example, a speculator might anticipate a fall in a physical market price and therefore take a short position in futures to profit from such a fall if it occurs. Speculators increase price efficiency and liquidity in the futures market. Traders conduct transactions on their own account or for clients. They tend to conduct a large number of very-short-term trades with the intention of making small margins on each trade. Arbitrageurs try to make profits by conducting simultaneous transactions to take advantage of any price differentials that might appear between markets.

19.5

Hedging: risk management using futures

Futures contracts allow a wide range of risk exposures to be managed. This section introduces a number of strategies that may be applied to hedge an identified risk exposure using a futures contract; specifically:

• • • •

hedging the cost of funds (borrowing hedge) hedging the yield on funds (investment hedge) hedging a foreign currency transaction hedging the value of a share portfolio.

19.5.1

LEARNING OBJECTIVE 19.5 Show how financial futures contracts may be used to hedge price risks, including a borrowing hedge, an investment hedge, an FX hedge and a share portfolio hedge.

H EDGING THE COST OF FUNDS (BORROWING HEDGE)

Borrowers are exposed to the risk of an increase in the cost of funds (the risk that interest rates will rise). Consider a situation in which a corporate treasurer knows that in three months’ time the company will need to borrow approximately $1 million to fund working capital. To raise the funds, the company plans to issue 90-day bank bills (discount securities sold today at less than their face value; face value repayable at the maturity date). The treasurer has forecast that yields will rise before the bank bills are issued. A hedging strategy using the futures market is shown in Table 19.2. Note that the same strategy could also be adopted 605

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if the treasurer had no view about the future direction of interest rates, but simply wished to lock in the cost of funds. By implementing this strategy, the treasurer has hedged the company’s interest rate risk exposure.

Table 19.2 Hedging the cost of funds (borrowing hedge) Cash or physical market

Futures market

Today

Today

The company expects to borrow approximately $1 million in three months. The current rate of interest is 8.00% p.a. but is forecast to rise.

Sell one ($1 million) 90-day bank bill contract at 91.50; yield of 8.50% p.a. (​​Value of contract = $979 471.35​)1​

In three months’ time

In three months’ time

Issue a bank bill with a face value of $1 million at a yield of 9.00% p.a.

Buy one 90-day bank bill contract at 91.00 (close out futures market position).

​(​Value of bill = $978 290.00​)​

​(​Value of contract = $978 290.00​)​

Futures contract profit of $1 181.35 offsets the additional cost of borrowing at 9.00% in the cash market.

​ rofit on closing out futures P contract = $1 181.35​

1 The pricing of a futures contract is based on the underlying physical market product; therefore the same formula is used to calculate the value of both the futures contracts and the physical market security. Recall from Chapter 9 that bills are discount securities; thus the value of the futures contracts and the amount borrowed when the bill is issued (discounted) will be less than the face value. The discount formula was given as:

365 × face value _____________________________ ​             ​ 365 + ​(​yield / 100 × days to maturity​)​

In this example, a $1 million, 90-day bank bill futures contract offering a yield of 8.50 per cent p.a. would be discounted for: 365 × $1 000 000 = _______________ ​       ​ ​ ​   ​  365 + ​(​0.085  × 90​)​​ = $979 471.35

Recall the rule in hedging transactions: ‘conduct a transaction in the futures market today that corresponds with the transaction to be carried out in the physical market at a later date’. Therefore, the treasurer wishes to borrow in three months’ time by selling bank bills, so they will begin the strategy by selling a futures contract today. Three months later the treasurer will close out the open position by buying an identical futures contract. It is generally not possible to obtain a perfect hedge because prices often vary between the cash market and the futures market. This occurs because market participants have already begun to build an expectation of an interest rate rise into the price of the futures contract. This is known as basis risk. In Table 19.2 there is initial basis risk evident; the futures contract sells at a yield of 8.50 per cent, which is 50 basis points above the current bills market rate of 8.00 per cent. Even though the treasurer is unable to lock in the current market rate of 8.00 per cent, the company will still use the futures contract strategy to try and lock in the cost of funds because interest rates may rise even further. In the example, interest rates rose as the treasurer forecast. When the treasurer discounted the bills in three months’ time, the cost of borrowing had increased by $2 365.56. However, the higher cost of funds incurred when drawing the bills in the money market was partly offset by the profit of $1 181.35 made in closing out the futures position. The company had initially sold a contract at 91.50 and then closed out that position by buying a contract at 91.00. The profit made from selling high and buying low was $1 181.35. The success of the hedge strategy can be confirmed by calculating the effective cost of borrowing. This is done by dividing the net cost of funds by the total amount of funds that were available to the company. This is then adjusted for the number of days the funds were available. The relevant cash flows are as follows: ​Net cost of funds = discount amount minus the futures contract profit (Note: The discount amount = face value minus discounted value of bill.) = (​ ​$1 000 000 − $978 290.00​)​− $1 181.35 ​​= $20 528.65 ​ 606

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Total funds available = discounted value ​(​price​)​of bill plus futures profit



= $978 290.00 + $1 181.35



= $979 471.35​​



$20 528.65 __ × ​  ____ Therefore: = ​ __________   ​  ​   ​ 365 ​  $979 471.35 × 90



= 8.50% p.a.​

19.5.2

H EDGING THE YIELD ON FUNDS (INVESTMENT HEDGE)

Here it is assumed that a fund manager anticipates having a $2 million surplus of funds in three months’ time and intends using the funds to buy additional corporate bonds for a fixed-interest investment portfolio. Yields on corporate bonds are currently at 7.00 per cent per annum, but are expected to fall by the time the funds are available for investment. Table 19.3 shows how the investment manager might use the futures market to hedge the interest rate risk exposure. The strategy would also be appropriate for the risk-averse investor who does not have a view on the future movements in rates, but wants to secure a known rate of return on the investment.

Table 19.3 Hedging the yield on funds (investment hedge) Fixed-interest market

Futures market

Today

Today

A fund manager expects to have funds to invest in three months’ time and plans to buy $2 million corporate bonds; current yield 7.00% p.a.

Buy 20 three-year Treasury bond futures contracts1 at 93.500; yield of 6.50% p.a. (​​Value of contract = $1 973 137.05​)​

In three months’ time

In three months’ time

The company buys $2 million corporate bonds at yield of 6.84% p.a.

Sell 20 three-year Treasury bond futures contracts at 93.250 (6.75% p.a.).

​(​Price = $1 955 122.29​)​​

​(​Value of contract = $1 959 871.24​)​

Loss of $13 265.81 on futures market reduces current yield on bonds. Effective yield 6.59% p.a.

Loss of $13 265.81 from closing out of futures position.

Each contract has a face value of $100 000; therefore to hedge $2 million use 20 contracts. Use the bond price formula (Equation 19.1) to calculate the price of the Treasury bond futures contract (using half-yearly coupons). 1

The fund manager will begin the strategy by buying a futures contract; that is, the fund manager who wishes to buy bonds in three months’ time will conduct a corresponding futures market transaction today. Three months later the manager will close out the open position by selling an identical bond futures contract. The outcome of the hedge strategy can be determined by calculating the effective return on investment, being 6.59 per cent per annum. The fund manager initially bought at 6.50 per cent in the futures market and closed out the position at 6.75 per cent. The manager then purchased corporate bonds at 6.84 per cent; that is, 6.50 minus 6.75 plus 6.84 = 6.59 per cent per annum. In the above strategy the fund manager made a loss on the futures market transactions. Was the fund manager unwise to enter into the hedging strategy? The fund manager was hedging a forecast risk exposure, being the possibility that investment yields may fall. The manager wished to remove the uncertainty by locking in a yield of around 6.50 per cent. The fund manager was unable to obtain a hedge closer to the original 7.00 per cent per annum return because of basis risk and cross-commodity hedging. The basis risk existed because the futures market pricing had already built in an expected fall in interest rates. The cross-commodity hedging occurred because the fund manager was using a Treasury 607

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bond futures contract to hedge risk associated with corporate bonds. These risks are examined in more detail in Sections 19.6.3 and 19.6.4. While interest rates did not fall as far as the fund manager had forecast, the fund manager had achieved the principal objective of hedging a known risk exposure. When establishing a hedging strategy using futures contracts, it is not important whether a profit or loss is made. Either way, a profit or loss will simply offset the change in price in the physical market.

19.5.3

H EDGING A FOREIGN CURRENCY TRANSACTION

Importers, exporters, borrowers, investors, FX dealers, central banks and speculators that carry out transactions in the international markets may be exposed to foreign exchange risk. Futures contracts are available that facilitate the management of foreign exchange risk exposures. This section considers an example of an importer who is exposed to an appreciation of a foreign currency. Note that the hedging strategy applied by the other participants listed above will only vary depending on whether the foreign currency is being bought or sold in the physical market. In this example, an Australian company has entered into a USD85 000 contract to import goods. Payment in USD is due in three months’ time, so the importer is exposed to adverse FX movements over that time. While the importer may not have a view on the future direction of the exchange rate, recent volatility in the FX markets is of concern. The importer will incur an additional cost of importing the goods if the USD appreciates against the AUD. A risk management strategy using futures contracts is one possible strategy available to the importer; another strategy may be to enter into a forward exchange contract with a bank. (This strategy is discussed in Chapters 15 and 17.) The importer decides to use an AUD/USD futures contract available through the Chicago Mercantile Exchange (CME). Table 19.4 shows the futures FX hedging strategy. The futures position was established today and closed out three months later. The initial futures market transaction required the importer to sell one contract at AUD/USD0.7400. The importer was not able to hedge at the spot market rate of AUD/USD0.7500, in part because the futures market has already priced in an expectation of a depreciation in the Australian dollar. The futures position is closed out with a buy contract at AUD/USD0.7200, resulting in a profit of USD2 000 on the futures market strategy. The profit from closing out the futures position is used to offset the additional cost due to the appreciation of the USD (depreciation of the AUD) in the spot market. The importer was not able to obtain a perfect hedge due to the initial and final basis risk caused by different rates in the spot market and the futures market.

Table 19.4 Hedging the cost of foreign currency Spot market

Futures market

Today

Today

Australian importer buys goods at a cost of USD85 000 and agrees to pay in USD in three months; spot AUD/USD0.7500. (Spot = AUD100 000)

Sell one futures contract at AUD/USD0.7400.1 (Face value of contract = AUD100 000) (Value of contract = USD74 000)

In three months’ time

In three months’ time

Spot AUD/USD0.7190. Importer pays USD85 000 at a cost of AUD118 219.75. (Net cost of USD funds equals AUD118 219.75 – AUD2 781.64 = AUD115 438.11)

Close out futures position by buying one contract at AUD/USD0.7200. (Value of contract = USD72 000) (Profit from closing out position = USD2 000; AUD value = USD2 000/0.7190 = AUD2 781.64)

1 Note: Initial basis risk is evident between spot rate AUD/USD0.7500 and futures rate AUD/USD0.7400. Futures market price implies the spot FX rate is expected to fall by the contract maturity date. Also, intra-day FX movements have resulted in final basis risk (Section 19.6.3).

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Similarly, futures may be used to hedge the risk associated with borrowing offshore. For example, if foreign interest rates are lower than domestic rates, it may be attractive to borrow funds offshore. However, in so doing, the borrower is exposed to the risk that the foreign currency may appreciate by the time the debt is to be repaid. The risk can also be reduced by selling AUD futures contracts. If the AUD does fall in value against the foreign currency, the profit obtained when the futures position is closed out will, at least partially, offset the additional cost when the foreign currency is bought in the FX spot market.

19.5.4

H EDGING THE VALUE OF A SHARE PORTFOLIO

An investor who holds a share portfolio, or intends to purchase shares in the future, is exposed to changes in share prices over time. An investor may decide to use a contract to hedge this risk. One futures contract often used to hedge the risk on a diversified share portfolio in Australia is the S&P/ASX 200 Index futures contract. We can use as an example an investment fund that has $41 million in a well-diversified portfolio of Australian shares. The fund manager has formed the view that the share market will come under selling pressure over the next four months. The S&P/ASX 200 Index futures contract could be used to cover the value of the portfolio against a forecast fall in share prices. The hedging strategy is shown in Table 19.5. In this example the loss in the share market was mostly, but not completely, offset by the gain made from closing out the futures position. The share portfolio is not completely hedged because the value of the portfolio today cannot be exactly matched in the futures market. Notice in Table 19.5 that today the ‘sell 292 contracts’ order has a contract value of $40 880 000 and not the $41 million valuation of the portfolio in the physical market. In the futures market strategy, the fund manager achieved a profit of $2 920 000 which was then available to offset the 7.14 per cent fall in the value of the share portfolio. Because of the constraint of the standard contract size, a net valuation loss of $7 400 was still incurred.

Table 19.5 Hedging the value of a share portfolio Stock market

Futures market

Today

Today

A fund has a diversified portfolio with a current market value of $41 million. (The S&P/ASX 200 Index is currently 5 600, but is forecast to fall.)

Sell 292 S&P/ASX 200 Index futures contracts at 5 600. C ​ ontract value = 292 × 5 600 × $25 = $40 880 ​000​1​  ​

In four months’ time

In four months’ time

The S&P/ASX 200 Index has fallen to 5 200; the fund’s portfolio has fallen in value.

Close out futures position; buy 292 contracts at 5 200.

% fall in the market = 7.14%

Contract value = 292 × 5 200 × $25 = $37 960 000

Value of portfolio = $38 072 600 Loss in portfolio value = $2 927 400

Profit at close-out = $2 920 000

Profit from futures market $2 920 000 Net valuation loss = $7 400 The dollar value of one S&P/ASX 200 Index futures contract is $25 multiplied by the physical market index. To determine how many contracts the portfolio manager needs in order to hedge the portfolio, divide the portfolio value of $41 000 000 by the index value, multiplied by the dollars per index point (i.e. 5 600 x $25 = $140 000). So, $41 000 000 / $140 000 = 292 contracts (approx.). 1

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Therefore, the manager may have preferred to ‘over cover’ the physical position by selling 293 contracts, and changing the futures position to ​293 × 5 600 × $25  =  $41 020 000.​ Given the assumptions in Table 19.5, the excess cover would be a profitable position for the company to take. The value of the ‘buy 293’ at 5 200 would be $38 090 000. The profit made on closing out its position would be $2 930 000. The net profit would be $2 600 as opposed to the $7 400 loss reported in Table 19.5. The fund manager would need to be confident with the forecast of a fall in the share market, otherwise the excess risk cover will result in an adverse outcome if the share market does not fall as expected. Financial futures contracts can be used in a much greater variety of situations than those illustrated in the preceding examples. For example, financial institutions may consider using the market to hedge the cost of making fixed-interest loans to their clients when the loans are financed by variable-interest rate funds. If a lender’s cost of funds is tied closely to the bank bill rate, the lender can potentially secure the cost of funds by selling bank-accepted bill futures contracts at the time it advances fixedinterest loans to customers. Then, if the cost of funds increases, the profit made by closing out the futures position would, at least in part, offset the reduced margin between the cost of funds and the fixed rate the lender receives on its loans to customers.

19.5.5

H EDGING AGAINST VOLATILITY

In 2013, the ASX introduced the S&P/ASX 200 Volatility Index or VIX and an associated futures contract, S&P/ASX 200 VIX Futures. The Volatility Index is constructed from the stock-market volatility implied by prices on index options. As we shall see in the following chapter, volatility is a core component of the standard options pricing models. A trader can attempt to estimate volatility and input that value into the options pricing formula to determine a price or if a trader observes the market price and solves the formula for volatility, he or she can figure out what volatility is implied by the current market price for the option. Because the option’s price implies a volatility for the underlying security, market expectations about volatility can be extracted from the option’s prices. By applying a particular ‘methodology’ to the ‘near’ and ‘next’ term index options on the S&P/ASX 200, the Volatility Index or VIX can be constructed. Its value will go up and down as the expectations of market participants and their trading behaviour changes. One of the most interesting features of the VIX is its interpretation by traders as a ‘fear’ or ‘sentiment’ index. Because options can be used to hedge portfolios against large swings in the prices of shares, the prices of options tend to reflect how risk averse people are feeling by how much they are willing to pay to ‘insure’ their portfolios. When share prices fall and risk aversion increases, index options should become more expensive. They will also imply higher volatility. When markets become calm and risk aversion decreases, index options should become less expensive and imply lower volatility. These changes in volatility are encompassed in the VIX. One way to interpret the VIX, apart from the basic ‘higher = more fear’ interpretation, is that a VIX value of 50, which is quite high, implies that the options markets are pricing in a strong chance of a one-monthly change in the value of the S&P/ASX 200 Index of plus or minus 14 per cent (50 multiplied by the square root of 1/12). By contrast, a lower VIX value of 10 implies a strong chance of a one-monthly change in the value of the S&P/ASX 200 of plus or minus just 2.88 per cent (www.asx.com.au/products/sp-asx200-vix-index.htm). The ASX has introduced a futures contract on the VIX that allows traders to speculate on and hedge against future movements in volatility. Some of the features of the S&P/ASX 200 VIX futures contract are as follows:

• • •

The underlying index is the S&P/ASX 200 VIX. The contract price is $1 000 multiplied by the VIX value. Contracts are available on the next two months.

The VIX futures contract can be used for hedging and speculating. Because implied volatility is asymmetric (it goes up by more when share prices fall than when they rise), there is an inverse relationship between share prices and the VIX value. As such, a fund manager may use the VIX futures 610

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contract to protect the portfolio from volatility and, in particular, price declines. The fund manager would take a long position in VIX futures.

Table 19.6 Hedging with VIX futures Stock market

Futures market

Today

Today

A fund has a portfolio that tracks the ASX 200.

Buy VIX futures.

The portfolio’s value is $50 million.

Buy one futures contract for each $100 000 of market exposure.

The ASX 200 stands at 6 000 but is forecast to fall as volatility increases. The VIX currently stands at 15.

For a $50 million portfolio, buy 500 VIX futures contracts. The futures position is initially worth 500 × $1 000 × 15 = $7 500 000.

In a month’s time

In a month’s time

The ASX 200 Index has fallen to 5 500; the VIX has risen to 25.

Close out the futures position; sell 500 contracts at 20.

Since the ASX 200 Index has fallen by 8.3 per cent, the portfolio is now valued at $45.83 million.

The futures position is closed out at 500 × $1 000 × 25 = $12 500 000

Loss in portfolio value = $4 166 666

Profit at close-out = $5 000 000

Profit from futures market = $5 000 000 Net valuation profit = $833 333 The dollar value of one VIX futures contract is $1 000 multiplied by the VIX Index value. 

As for speculation, ‘shorting volatility’ can be a sound trade. Historically, we know that markets do calm down as whatever crisis is troubling market participants subsides. The trouble is that this may happen more slowly than expected and there is nothing to say that markets might not become more volatile in the meantime. The trader who is short the volatility will normally be right. Unfortunately, by the time he or she is proven correct, he or she might also be insolvent.

REFLECTION POINTS

•

Futures contracts can be used to manage a wide range of risk exposures, including:

— hedging the cost of borrowing — hedging the yield on investments — hedging foreign currency transactions — hedging the value of a share portfolio and future share transactions — hedging against the possibility of increased stock market volatility.

• •

A hedger needs to consider the physical market risk exposure to be managed and the necessary transactions to be carried out in the futures market, including the transaction conducted today and the closing out of that position by the futures expiry date. Basic hedging rule: conduct a transaction in the futures market today that corresponds to the transaction to be carried out in the physical market at a later date (at which time the open futures position is closed out). 611

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19.6 LEARNING OBJECTIVE 19.6 Identify risks associated with using a futures contract hedging strategy, including standard contract size, margin payments, basis risk and crosscommodity hedging.

Risks in using futures contracts for hedging

As shown in some of the hedging strategies in Section 19.5, it is often not possible to hedge a risk exposure perfectly. The underlying objective of managing risk using derivative products is to lock in a price today that will apply at a specified later date. If a risk manager can lock in a price today that exactly matches the current price in the physical market, then a perfect hedge has been achieved. However, this is generally not possible. Risk managers must gain a complete understanding of the risk management products and strategies that are available, and the implications of using different products and strategies. Some of the important constraints in achieving a perfect hedge when using futures contracts to hedge risk include:

• • • •

standard contract size margin payments basis risk cross-commodity hedging.

19.6.1

Standard contract size

The first potential constraint in using futures contracts to hedge a risk exposure is caused by the standard size of a futures contract. With an exchange-traded contract it is not possible to change the contract specifications to meet non-standard risk management needs. For example, Table 19.7 shows the standard contract size of selected financial futures contracts traded on ASX Trade24.

Table 19.7 Selected ASX Trade24 futures contract sizes Contract

Contract size

90-day bank-accepted bills

$1 000 000 in face value of bills

Three-year Treasury bonds

$100 000 in face value of bonds (6% coupon)

10-year Treasury bonds

$100 000 in face value of bonds (6% coupon)

S&P/ASX 200 Index

Share price index multiplied by $25, expressed in dollars

S&P/ASX 200 VIX

VIX Index value multiplied by $1 000, expressed in dollars

Listed company shares

1 000 shares

In the case of the share portfolio hedge shown in Table 19.5, for example, it was not possible to match exactly the actual share-market exposure with the futures market position. As a result of this mismatch, a perfect hedge was not possible and there was a net loss of $7 400. Mismatch problems also exist with the other futures contracts. Consider the implications of the standardised contract size in the bank bill market. Ninety-day bank-accepted bill futures contracts are available only with a face value of $1 million (two contracts for $2 million and so on). In the examples in Tables 19.2 and 19.3, the amounts to be hedged matched the starting values of the futures contracts. If, however, the company in Table 19.2 needed to borrow, say, only $650 000, a complete match in the physical bank bills market and the futures market would not be possible. Similarly, if the fund manager in Table 19.3 expected to purchase commercial paper with a face value of $1 250 000, it would also be unable to match its money-market position with its futures market position. It would therefore be unable to hedge exactly the expected value of its investment. 612

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A further example of the constraint of the standardised futures contract is illustrated in Table 19.8, where the mismatch in the contract size between the futures market and the physical market has resulted in a net loss to the investor. In this situation, an investor with a risk exposure of $1.5 million uses one futures contract to hedge that exposure. In the example, interest rates had fallen by 50 basis points. Had the rates fallen further, the hedge would have been less effective.

Table 19.8 Hedging a rate of return on an amount of a non-standard contract size Cash or physical market

Futures market

Today

Today

A fund manager will have $1.5 million to reinvest in bank bills in three months’ time; current yield is 7.00% p.a. (equivalent price today $1 474 548.88).

Buy one bank bill futures contract at 93.00. (Value of contract = $983 032.59)

In three months’ time

In three months’ time

The company buys a 90-day $1 500 000 bank bill at 6.50% p.a. (Price of bill = $1 476 338.14)

Sell one bank bill futures contract at 93.50. (Value of contract = $984 225.43)

Fall in yield of 50 basis points.

Profit from close-out of futures position = $1 192.83

Additional cost of bill of $1 789.26 is offset by the futures market profit of $1 192.83. Net loss from contract size mismatch = $596.42

In the above example the problem of the mismatch between the risk required to be covered and the standardised contract size is relatively small given an interest rate environment where rate changes are not excessive over the risk management period. The effect of standard contract size will vary depending on the contract and the volatility of the relevant physical market. For example, the FX market can, at times, be quite volatile. It may be argued that the mismatch problem becomes less significant as the size of the physical market exposure becomes larger. For example, a mismatch of a few thousand dollars when the cash position is in multiples of millions may well be of little concern to a risk manager. This was demonstrated in Table 19.5, where the mismatch problem resulted in a loss of $7 400 on a portfolio valued at $41 million.

19.6.2

M ARGIN PAYMENTS

A futures exchange requires buyers and sellers of futures contracts to pay an initial margin when entering into a contract. This can range between 2.00 and 10.00 per cent of the contract face value. The initial margin may need to be topped up when the contract is marked-to-market each day. For ease of learning, margin payments were ignored in the previous examples. This omission simplified the hedging illustrations, but initial margin and maintenance margin requirements must be considered when assessing the use of futures contracts as a hedging strategy. There is an opportunity cost associated with paying the margin upfront. If prices move adversely over the period of a futures contract, there will be maintenance margin calls to be met, involving further cash flows. If the contract holder fails to meet a margin call, the futures exchange clearing house will automatically close out the open position and the hedging strategy will no longer be in place. The funds held in the margin account will be used to offset any futures contract loss. The opportunity costs and cash-flow risks associated with initial margin and maintenance margin calls must be assessed prior to entering into a futures contract hedging strategy. 613

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19.6.3 Basis risk a situation where pricing differentials are evident between financial markets

Initial basis risk when basis risk exists at the start of a hedging strategy

Final basis risk where basis risk exists at the completion of a hedging strategy

In the context of the futures markets, basis risk describes the difference between the price of a commodity or financial instrument in the physical market and the price of the related futures contract. Where futures contracts are used to hedge a position for a period that does not end with an actual futures delivery date, basis risk will be present. Whereas the primary purpose of hedging is to obtain certainty about the value of future cash flows and the value of assets and liabilities, basis risk introduces a degree of uncertainty. A pricing differential between the physical market and the futures market at the commencement of a hedging strategy is known as initial basis risk. When a pricing differential appears at the completion of a hedging strategy, this is referred to as final basis risk. Typically, initial and/or final basis risk will be evident between the markets; therefore, it is normally not possible to set up a perfect hedging strategy. Initial basis risk will be evident when the market generally expects that prices in the physical market will change. For example, if a company with a loan that is due to be rolled over in three months is concerned that interest rates may rise in that time, then in all probability other market participants will also have that view. The forecast rise in interest rates will be reflected in a rise in yields in the futures market; and the extent of the change will be reflected in the pricing of futures contracts. In this situation the interest rates quoted in the physical market will be the current rates, whereas the rates quoted in the futures market will reflect the forecast change in rates, thus creating initial basis risk. Final basis risk will also occur if the pricing in the futures market is not exactly matched with pricing in the physical market. For example, while a company may use a 90-day bank-accepted bill futures contract to hedge a borrowing exposure, basis risk will occur if the company is unable to borrow short-term funds at exactly the same yield used to price the futures contract. One reason that there may be a difference between the actual cost of borrowing and the price of the futures contract is the level of risk attributed to the borrower. A lender will add a margin for the borrower’s credit risk and this will result in final basis risk between the prices quoted in the futures market and the actual cost of borrowing. The impact of basis risk can be seen in a review of Table 19.3, in which both initial basis risk and final basis risk are evident. Today, current yields were 7.00 per cent per annum, yet on the same date the yield in the futures market was 6.50 per cent per annum. The futures market had already factored in a fall in rates and therefore initial basis risk existed, and the investor was not able to hedge at the current yield. Three months later, yields in the futures market were 6.75 per cent per annum, while the actual yield on the corporate bonds in the capital market was 6.84 per cent per annum. Part of this price differential is final basis risk, but part is a result of the next constraint: cross-commodity hedging.

19.6.4 Cross-commodity hedging using a futures contract to hedge risk associated with a different underlying asset

B ASIS RISK

C ROSS-COMMODITY HEDGING

Cross-commodity hedging refers to the use of a futures contract that is based on one commodity or financial instrument to hedge a risk exposure associated with a different commodity or financial instrument. The necessity for cross-commodity hedging occurs because each futures exchange offers only a relatively small number of futures contracts that are based on a limited range of commodities and financial instruments. When futures contracts are used to hedge a share portfolio, an element of cross-commodity hedging is almost certainly introduced. For example, few investors would hold a portfolio of shares that perfectly reflects the composition of the S&P/ASX 200 Index futures contract. The matching of a physical share portfolio against a share price index contract is even more problematic when the share portfolio is internationally diversified. Should futures contract positions be established in the FTSE 100 Index, Standard & Poor’s 500 Index and the Nikkei Index to cross-hedge the British, US and Japanese shares included in a diversified share portfolio? Investors with a debt securities portfolio, and borrowers who have issued debt securities into the money and capital markets, are exposed to interest rate movements. If either party intends to use futures

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contracts to hedge that interest rate risk exposure, they must decide which type of futures contract to use. For example, within the Australian futures market, the surrogate short-term interest rate futures contracts are the 30-day interbank cash rate contract and the 90-day bank-accepted bills contract; the medium-term contract is the three-year Treasury bond contract and the longer-term contract is the 10-year Treasury bond contract. Therefore, an investor or borrower may need to:

• • •

use the 90-day bank-accepted bill futures contract to hedge a promissory note or commercial paper issue use the three-year Treasury bond futures contract to hedge a loan facility with a term to maturity from, say, two to seven years use the 10-year Treasury bond futures contract to hedge investments in semi-government bonds, or the issue of long-term debentures or unsecured notes.

While the prices of each of these pairings may be reasonably correlated, the spread—or difference in prices—may not be constant through time. Changes in the spread introduce cross-commodity hedge risk. The combination of basis risk and cross-commodity hedge risk means that a perfect hedge can seldom be achieved using futures contracts. Constraints in using futures contracts as hedging instruments, such as standard contract size, margin payments, basis risk and cross-commodity risk, have seen market participants develop other risk management products. One product that most directly addresses these problems in relation to interest rate risk is the forward rate agreement.

REFLECTION POINTS

• • • •

Futures contracts are standardised by amount, underlying asset and term to maturity. A hedger may only be able to partly hedge a risk exposure that falls outside the standard futures contract specifications. While a futures contract is highly leveraged in that full payment is not made, a hedger still needs liquidity to be able to make initial margin and maintenance margin calls. Basis risk is evident when differences occur between prices in the futures market and prices in the physical market. There is initial basis risk and final basis risk. Basis risk means that a hedger is unlikely to be able to obtain a perfect hedge using a futures strategy. Cross-commodity hedging occurs when a hedging strategy uses a futures contract based on one underlying asset to hedge a risk associated with a different asset. This occurs if there is no futures contract based on the underlying asset that needs to be hedged (e.g. using a bank-accepted bill futures contract to hedge a promissory note exposure).

19.7

Forward rate agreements

A forward rate agreement (FRA) is an over-the-counter contract that is specifically designed to manage interest rate risk exposures. An FRA is a non-standardised contract typically offered by commercial banks and investment banks; that is, it is a contract where it is possible to negotiate specific terms and conditions to meet the particular risk management needs, such as the term and the amount of the FRA. The FRA is a contractual agreement between two parties that effectively allows the parties to lock in a rate of interest that will apply at a specified future date, based on a notional principal amount. The agreement relates to the interest rate only; no exchange of principal takes place. Contract settlement occurs when one party compensates the other party by paying the monetary value of the difference between the FRA agreed interest rate and the reference interest rate. The FRA agreed rate is set at the start of the FRA and the reference rate is established at the FRA settlement date. The structure and timeline of an FRA is shown in Figure 19.1.

LEARNING OBJECTIVE 19.7 Describe, illustrate and calculate the use of a forward rate agreement (FRA) for hedging interest rate risk.

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Figure 19.1  An FRA structure and timeline (3Mv9M) End date

FRA settlement date

FRA agreed rate

Reference rate applied

6-month contract period

0

1

2

3

4

5

6

7

8

9

Months

The FRA will specify:

• • • • •

the FRA agreed rate, fixed at the start of the FRA the notional principal amount of the interest cover the FRA settlement date when compensation is paid the contract period on which the FRA interest rate cover is based (end date) the reference rate to be applied at settlement date.

An FRA is a risk management product whereby one party will compensate the other party for any movement in interest rates. In order to calculate the compensation amount to be paid at the FRA settlement date, the FRA will specify a notional principal amount. The FRA interest cover will be for a specific FRA contract period (generally for either three or six months) and begins at a nominated date in the future. The contract period represents the actual term of the interest cover and may begin at a date up to two years hence. For example, the FRA may cover six-month interest rates, but will begin in three months (Figure 19.1). This will be written as 3Mv9M, that is, the six-month interest rates beginning in three months. The contract must specify two interest rates. The first is the FRA agreed rate. This is the fixed rate of interest noted in the agreement set at the start of the FRA and is the benchmark against which changes in interest rates will be measured. For example, one party wishing to protect itself against a rise in six-month interest rates in three months’ time may use an FRA (3Mv9M) as a borrowing hedge. A second interest rate is required to calculate the compensation amount. The second interest rate is a variable or floating reference rate, and is a published reference interest rate which allows both parties to the contract to be certain of the interest rate that will be used to measure the compensation amount. If the contract period is six months, the reference rate will be the market rate for six-month money. If the contract period was for a different period, say three months, then the three-month reference rate would be used. The main reference rates used in the international markets are LIBOR and USCP, while in Australia the main reference rate is the bank bill swap rate (BBSW)—the average rate for bank bills on a particular day. Reference rates are published daily through the Thomson-Reuters electronic information system. On the FRA settlement date, any difference between the FRA agreed rate and the published reference rate on six-month money is settled by a cash payment. For example, if the borrower has entered into an FRA with a bank and set the agreed rate at 8.00 per cent per annum with an FRA contract, 3Mv9M, and, in three months’ time, the BBSW reference rate is 9.00 per cent per annum, the bank would compensate the other party 1.00 per cent of the notional principal amount for the six-month period of cover. 616

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The formula used in calculating the settlement amount is simply the discount securities formula used in Chapter 9, rewritten to reflect FRAs: FRA settlement rate − FRA agreed rate × P  × P   ​  ​___________      ​ ​ ​ 365    ​  − ___________ ​  365   365 + ​(D × ​is​ ​)​ 365 + ​(D × ​ic​ ​)​

19.2

where: is = the reference rate specified in the FRA contract expressed as a decimal ic = the fixed FRA agreed rate expressed as a decimal D = the number of days in the contract period P = the FRA notional principal amount

19.7.1

U SING AN FRA FOR A BORROWING HEDGE

A company that identifies that it is exposed to a potential change in interest rates on a loan or debt issue may decide to use an FRA strategy to create a borrowing hedge. For example, on 19 September this year, a company may wish to lock in the interest rate on a prospective borrowing of $5 million for a six-month period beginning 19 April of next year to 19 October of the same year. In this example the FRA is established on 19 September, with the settlement date set as 19 April of the following year, and the end date is 19 October, giving a contract period of six months. The reference interest rate is specified as the six-month BBSW. When the company asks an FRA dealer for a price on the contract, the dealer quotes a two-number price: ‘7Mv13M(19) 13.25 to 20’. This means that in seven months’ time the dealer is prepared to lend six-month money at 13.25 per cent per annum, or to borrow at 13.20 per cent per annum. The company wishes to hedge a borrowing and so the relevant rate is 13.25 per cent per annum. (Note: In the quote 7Mv13M, the 7M denotes that the FRA starts in seven months; the quote relates to six-month money, so 13M is the sum of 7 plus 6 months. The (19) in the quote identifies the settlement date in the month.) On 19 April, both parties refer to Thomson-Reuters to ascertain the published reference rate and note that the six-month BBSW is 13.95 per cent per annum. As interest rates have risen over the period, the FRA dealer will compensate the company for the higher cost of funds in the physical market. On the other hand, had the reference rate fallen below the FRA agreed rate, the company would have made the compensation payment to the FRA dealer. The settlement compensation payment in the example is calculated as follows: FRA settlement rate − FRA agreed rate × P  × P   ​       ​ ___________ ​ ​ 365    ​  − ___________ ​  365   365 + ​(D × ​is​ ​)​ 365 + ​(D × ​ic​ ​)​ where:

is = 0.1395 (on 19 April) ic = 0.1325 (on 19 September) D = 183 days (from 19 April to 19 October) P = $5 000 000

365 × 5 000 000 ​Settlement = ​ __________________       ​  − _________________ ​  365 × 5 000 000       ​ 365 + (183 × 0.1395) 365 + ​(​183 × 0.1325​)​ = $4 673 154.46 − $4 688 533.65 = − $15 379.19​ The settlement paid by the FRA dealer to the company is $15 379.19. Had the borrowing company not established the FRA, the increase in interest rates would have increased the company’s cost of funds. The FRA has locked in the cost at 13.25 per cent per annum. 617

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However, the company will still have to raise its six-month funds in the marketplace on 19 April and pay the market borrowing rate available to it at that time. The company may be able to borrow at the equivalent rate to the BBSW 13.95 per cent per annum rate, or it may well have to pay a margin over the reference rate. The margin over the BBSW reflects the fact that the BBSW is an average reference rate, not an actual borrowing rate offered by all lenders. The actual rate at which the company will borrow is affected by a range of issues (discussed in Chapters 9 and 10), one of the most important of which is the creditworthiness of the company. The cash settlement of $15 379.19 received by the company from the FRA dealer is used by the company to offset against the actual higher cost of borrowing. The effect of this FRA hedging strategy is a lower net cost of funds for the company. Figure 19.2 provides a diagrammatic representation of the above borrower hedge process using the FRA. The value to the company (in this case the net cost of borrowing) is locked in at 13.25 per cent. Subsequent movements in interest rates result in the additional cost of borrowing in the physical market being offset by the compensation payment of $15 379.19 that is made to the company by the provider of the FRA.

Figure 19.2  Borrowing hedge using an FRA Change in financial position of company Risk (FRA) market

Compensation $15 379.19 paid by bank 13.25%

13.95%

Change in interest rates (cost of funds)

Increased cost of borrowing offset by compensation payment

Physical (borrowing) market

Strip of FRAS a series of consecutive forward rate agreements over time

In the above example, interest rates increased and the company was compensated by the bank as the writer of the FRA. If, however, the BBSW had fallen below the FRA agreed rate, the company would then have compensated the bank. In either circumstance the company has removed interest rate uncertainty and locked in at the agreed rate. This example was a relatively straightforward application of an FRA to hedge interest rate uncertainty. Much more complex strategies can be devised. For example, it would be possible to lock in a series of interest rates over a series of dates through the use of a so-called strip of FRAs. Strip hedging is the combination of a number of consecutive FRA contracts over an extended period. Such a strategy may be appropriate if a company is funding its working-capital requirements through a bill facility that has a rollover every three months. An FRA can also be used to manage FX risk in that it is possible to obtain an FRA denominated in any major currency. The main advantages of an FRA include the following:

• •

An FRA is a tailor-made, over-the-counter contract. It is not standardised like a futures contract. It possesses great flexibility with respect to the contract period and the amount of each contract. An FRA, unlike a futures contract, does not have associated margin payment requirements.

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•

The main disadvantages of an FRA are: There is a risk that the settlement amount might not be forthcoming; that is, there is some credit risk involved between the parties to an FRA. This risk is overcome in futures market transactions by the existence of the clearing house and the requirement for margin calls.

•

There is no formal market. This is in contrast to the futures markets. The main concern is that it is not as easy to close out an FRA position as it is in the futures market. However, although in the FRA market there is no clearing house to facilitate the novation of contracts, participants in an FRA can effectively close out an agreement by entering into another FRA that is the opposite of the original agreement.

The FRA borrowing hedge strategy shown above equally applies to an investment hedge strategy. That is, an investor can use an FRA to hedge a forecast fall in yields on investments. The FRA therefore provides a flexible alternative to interest rate risk management that is available to both investors and borrowers.

REFLECTION POINTS

• • • • • • •

A forward rate agreement is a non-standardised, over-the-counter product offered by banks and is used to manage interest rate risk exposures. The FRA locks in an interest rate (agreed rate) that will apply to a notional principal amount at a specified date. At maturity the agreed rate will be compared with a nominated reference interest rate. One party will compensate the other party for the difference between the two rates. With a borrowing hedge, if on the settlement date the reference rate is higher than the agreed rate, the bank will compensate its customer; if the reference rate is lower than the agreed rate the customer will compensate the bank. The reference rate will be based on a published indicator rate such as the BBSW or LIBOR. The bank will quote a two-way price, for example 1Mv4M(7) 6.50–25; this means that the FRA relates to the interest rate on three-month money in one month’s time; 6.50 per cent is for a borrowing hedge and 6.25 per cent is for an investment hedge. The contract will be settled on the 7th of the month. The formula used to calculate the settlement amount on the FRA is the discount securities formula, being the FRA settlement price (based on the reference rate) minus the FRA agreed price. A strip of FRAs may be put together consecutively to extend a hedging strategy over time.

CASE STUDY SPI FUTURES MARKET ACTS AS A MARKET-MAKER FACILITATING PRICE DISCOVERY IN THE S&P/ASX 200 INDEX Each morning on the news, the market report contains information about the SPI futures price. As you know from reading this chapter, this is the futures contract on the S&P/ASX 200 Index. It is the contract that facilitates speculation and hedging over the broad portfolio of 200 stocks that make up the index. The purpose of mentioning the SPI futures price on the news each morning is to give some indication of the direction in which the S&P/ASX 200 Index may move when the market opens. The S&P futures market acts as a market-maker for the S&P/ASX 200 Index, facilitating price discovery. For instance, the price of the SPI futures index today is indicative of tomorrow’s opening index value (Lepone & Yang, 2013). 619

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Since futures trading takes place around the clock, relevant events that occur after the markets close in Australia (such as movements in the American markets) will be reflected in the SPI futures price. If the SPI futures price is trading at a discount to the previous closing value of the S&P/ASX 200 Index, the index value is expected to fall when the markets open and vice versa. This is pretty good. An indication of where the markets will be heading when they open at 10 am Sydney time. And it is an accurate indicator about 60.00 per cent of the time (Commins, 2017). In October 2017, however, the Sydney Morning Herald ran a story with the headline, ‘The Australian dollar could be behind why the futures can’t pick the ASX’. The story was referring to the fact that the futures market and the stock market had become disconnected during September and October of that year. In fact, prediction accuracy had fallen by a third to around 40.00 per cent. The explanation, according to the traders interviewed for the article, can be found in the short selling behaviour of overseas hedge funds. Sensing weakness in the Australian dollar, the hedge funds were short selling both the Aussie dollar and the top 20 Aussie stocks. This unusually high amount of short selling could lead to weakness in the S&P/ASX 200 that was not reflected in the SPI futures contract value on any given day. References Lepone, A & JY Yang 2013, ‘Informational role of market makers: The case of exchange traded CFDs’, Journal of Empirical Finance, 23, pp. 84–92. Commins, P 2017, ‘The Australian dollar could be behind why the futures can’t pick the ASX’, Sydney Morning Herald, 5 October, retrieved from http://www.smh.com.au/business/markets/the-australiandollar-could-be-behind-why-the-futures-cant-pick-the-asx-20171005-gyur1e.html

Discussion points

• •

Why is the SPI futures contract an indicator of the expected movement in the S&P/ASX 200? Discuss the accuracy of daily predictions based on SPI futures contract.

Master before you move on LEARNING OBJECTIVE 19.1 Consider the nature and purpose of derivative products and the use of a futures contract to hedge a specific risk exposure.

• • • • • • •

A derivative is a risk management product that derives its value from an underlying commodity or financial instrument. A futures contract is a derivative product that may be used to manage risk exposures to interest rates, exchange rates, share prices and commodity prices. The risk management function of a derivatives-based strategy is to lock in a price today that will apply at a future date. A futures contract is an agreement between two parties to buy, or sell, a specified commodity or financial instrument at a specified date in the future, at a price that is determined today. The contracts are standardised by the contract size, the underlying commodity and delivery dates. Basic futures strategy rule: conduct a transaction in the futures market today that corresponds with the proposed physical market transaction due at a later date. For example, if a risk manager intends to buy at a later date in the share market, then they would buy a share-based futures contract today. The open position is closed out at the maturity date.

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Discuss the main features of a futures transaction, including orders and agreement to trade, calculations, margin requirements, closing out a contract and contract delivery.

• • • • • • • • • • • •

Futures contracts are standardised exchange-traded contracts available on futures exchanges such as the Chicago Board of Trade (USA) or ASX Trade24 (Australia). Each exchange offers a set of futures contracts which are often based on underlying commodities and financial instruments available in the local physical or spot markets. Most exchanges use electronic trading, although some open-outcry exchanges still operate. Buy or sell orders are placed through a broker. ASX Trade24 quotes bond and bill futures contracts at an index of 100 minus the yield; for example, a Treasury bond futures contract yielding 7.00 per cent is quoted at 93.000. Transactions are conducted through the exchange’s clearing house. An initial margin payment is paid to the clearing house. Contracts are marked-to-market each day. Maintenance margin calls may be required. An open position is closed out by buying or selling an identical contract, but opposite to the initial futures contract. The exchange will specify if settlement is by standard delivery or by cash payment. By conducting two transactions—buy and sell—the party will make either a profit or a loss on those transactions.

CHAPTER NINETEEN REVIEW

LEARNING OBJECTIVE 19.2

If the intent of the hedging strategy was to protect against a rise in prices, the positive correlation between the futures market and the physical market will ensure that if prices in the physical market rise a profit will be made with the futures market transactions. This profit can then be used to offset the increased cost associated with the price rise in the physical market.

LEARNING OBJECTIVE 19.3 Review the types of futures contracts offered through a futures exchange.

• • •

Futures contracts develop in markets in which an underlying asset is freely traded, the asset is easily standardised, but may experience price volatility from time to time, and the product is readily available or cash settlement is possible. Contracts tend to vary between international futures exchanges; contracts are often based on local commodities and financial instruments. Commodity futures contracts include gold, wool and frozen orange juice, and financial futures contracts include bonds, discount securities, currencies, shares and share indices.

LEARNING OBJECTIVE 19.4 Identify the participants in the futures market, including hedgers, speculators, traders and arbitrageurs, and explain why they use futures contracts.

• • • •

Hedgers use the futures market to manage identified risk exposures; for example, if a borrower is exposed to an increase in interest rates, they may sell a futures contract to hedge that risk exposure. Speculators buy and sell futures contracts to try and make a profit on price movements; for example, a speculator might anticipate a rise in a share price and take a long position in futures to try and make a profit. Speculators increase price efficiency and liquidity in the futures market. Traders conduct transactions on their own account or for clients. They tend to conduct a large number of very-short-term trades with the intention of making small margins on each trade. Arbitrageurs try to make profits by conducting simultaneous transactions to take advantage of any price differentials that might appear between markets. 621

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LEARNING OBJECTIVE 19.5 Show how financial futures contracts may be used to hedge price risks, including a borrowing hedge, an investment hedge, an FX hedge and a share portfolio hedge.

• • • • • •

The basis of a hedging strategy is to open a futures position today that corresponds with the transaction to be carried out in the physical or spot market at a later date. With a borrowing hedge, the risk manager will sell relevant futures contracts today. At a later date it will close out its futures market position by buying an identical futures contract. The profit or loss made on the futures transactions will offset the net cost of borrowing. Similarly, with an investment hedge, the hedger will buy a futures contract today, and then close out the position at the maturity date. Exposures to FX risk can also be hedged by either buying or selling a futures contract in the required foreign currency. Share portfolio risk can also be hedged by buying or selling futures contracts based on specific listed companies, or on a range of share-market indices. Exposures to volatility can be hedged using VIX futures. 

LEARNING OBJECTIVE 19.6 Identify risks associated with using a futures contract hedging strategy, including standard contract size, margin payments, basis risk and cross-commodity hedging.

• • •

While futures contracts are useful in hedging, it is important to recognise that a perfect hedge may not be possible. Where the dollar value of a risk exposure is not perfectly matched by the standardised dollar value of the futures contract, a small risk exposure will remain. A more significant risk arises from the fact that price movements in the physical market may not be perfectly matched by price movements in the futures market. The difference in prices between the two markets is referred to as basis risk. Initial basis risk may occur at the implementation of the futures hedging strategy, while final basis risk may occur when the futures position is closed out and the related physical market transaction takes place. Cross-commodity risk arises when, due to the limited range of futures contracts, the hedger uses a futures contract based on an underlying financial instrument that is different from the security associated with the risk exposure that needs to be managed. For example, a borrower may need to use a 90-day bank-accepted bill futures contract to hedge an exposure to changes in the yield on commercial paper in the money markets.

LEARNING OBJECTIVE 19.7 Describe, illustrate and calculate the use of a forward rate agreement (FRA) for hedging interest rate risk.

• • • • • •

A forward rate agreement (FRA) is an over-the-counter contract. Unlike futures contracts, FRAs do not have a standard contract size or delivery date; nor are margin calls a feature of the FRA market. A borrower or investor can use an FRA to lock in an interest rate on a specified date, based on a specified notional principal amount. As with the futures contract, the FRA is not a product that facilitates the borrowing or investing of funds, but rather is a risk management tool. At the start of the contract, the FRA specifies a fixed FRA agreed rate that will apply on either three-month money or six-month money at a future date. The FRA agreed rate will be compared with a nominated reference rate to determine the compensation amount payable on the settlement date, and which party will make that payment.

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Chapter 19  Futures contracts and forward rate agreements

•

The reference rate may be LIBOR, USCP or the BBSW. At the settlement date, one party to the FRA will compensate the other party for any movement in interest rates between the FRA agreed rate and the reference rate. In a borrowing hedge, the writer of the FRA will compensate the buyer if the reference rate is higher than the agreed rate. The compensation received will offset the current higher cost of borrowing in the physical debt market. The compensation amount is calculated using the discount security formula.

Questions Essay questions Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words the points you raise in relation to each question. 1

Oil Search notes in its annual reports that it is exposed to the risk of falling oil prices, increasing interest rates and changes in the exchange rates of various foreign currencies. How can Oil Search use derivative products to manage these risks? (LO 19.1)

2

Explain why it is not usually possible to perfectly hedge a position using futures contracts. (LO 19.2)

3

For investors and borrowers considering setting up a risk management strategy using futures contracts, there is a basic rule that determines the timing of the various buy/sell transactions. Specify and explain this rule, giving examples from an investor’s and a borrower’s viewpoint.  (LO 19.2)

4

(a) Outline the procedure involved in buying a futures contract.



(b) Indicate the implications of being long in a futures contract.



(c) Indicate the implications of being short in a futures contract.



(d) What are the procedures for closing out these positions prior to delivery? (LO 19.2)

5

On ASX Trade24 the quotation of the three-year Treasury bond futures contract is such that traders can easily follow a ‘buy low sell high’ rule. Construct an example that shows how this works. (LO 19.2)

6

‘In 2017, the average daily turnover in the Australian bond futures markets was 207 000 contracts for the three-year and 162 000 for the 10-year. This indicates an undesirably high level of speculation in the bond futures markets in Australia.’ Discuss the validity of this statement. (LO 19.2)

7

Distinguish between hedgers and speculators. Show how a hedger could use 90-day bankaccepted bill futures contracts to hedge interest rate uncertainty. Show how a speculator may use the same futures contracts in an attempt to make a profit. (LO 19.4)

8

A business plans to borrow approximately $40 million in short-term funding through the issue of commercial paper in three months’ time. The business does not have a view on what is likely to happen to interest rates over the next three months, but it would be very satisfied if it could obtain its funding at the current yield.



(a) Using the following data, show how 90-day bank-accepted bills futures contracts can be used to hedge the interest rate risk to which the business is exposed. Show the calculation and timing of all transactions and cash flows (ignore transaction costs and margin requirements).

CHAPTER NINETEEN REVIEW

• • •

Today’s data:

(i) current commercial paper yields 6.00 per cent per annum



(ii) 90-day bank-accepted bills futures contract 93.75.

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Data in three months:

(iii) commercial paper yields 7.00 per cent per annum



(iv) 90-day bank-accepted bills futures contract 93.25.



(b) What is the effective cost of funds achieved with this hedging strategy? What would the cost of funds have been had the hedge not been put in place? Explain your answer, showing your calculations. (LO 19.5)

9

A fund manager forecasts that it will need to invest $100 million in approximately 90 days. The manager wishes to receive a return as close as possible to the medium-term interest rates currently available, but expects that rates will have fallen by the time the funds are available for investment.



(a) Outline what the manager would do today in the financial futures market in order to secure a return that is close to current medium-term market rates.



(b) Calculate the price of a three-year Treasury bond futures contract quoted at 96.50.



(c) Outline how the fund manager would close out the futures market position.



(d) Outline and explain the factors that will determine how successful this strategy will be in securing an effective return that is close to today’s market rates. (LO 19.5)

10 A fund manager currently manages a diversified Australian share portfolio valued at $250 million. The manager decides to use the S&P/ASX 200 Index futures contract to manage an exposure to a forecast decline in share prices. The S&P/ASX 200 Index is currently at 5 500. In three months’ time the S&P/ASX 200 is at 5 150.

(a) Today: set up a hedging strategy to manage the risk exposure.



(b) In three months’ time: close out the open position.



(c) Show the net valuation effect of the hedging strategy. (LO 19.5)

11 A fund manager currently holds a well-diversified portfolio of Australian shares valued at $250 000 000. The global political context is unstable and the fund manager anticipates a period of unusually high market volatility. The S&P/ASX 200 VIX currently stands at 22. The S&P/ASX 200 Index stands at 6 500.

(a) Explain how the manager can use VIX futures to hedge exposure to the anticipated volatility.



(b) Determine the net valuation of the strategy if the position is closed out when the S&P/ASX 200 Index stands at 5 700 and the corresponding VIX stands at 38.  (LO 19.5)

12 While financial futures contracts may be used to hedge the risk of fluctuations in the prices of the underlying securities, the use of futures contracts often entails some risk. What are the sources of risk arising from the use of futures contracts in risk management? List, explain and demonstrate the implications of each type of risk. (LO 19.6) 13 (a) Define the forms of basis risk and explain why it is important for a hedger to understand this risk prior to dealing in derivative products. Use examples to explain your responses.

(b) When hedging risk, what is cross-commodity risk? In your answer, provide examples to explain cross-commodity risk within the context of interest rate risk and share price risk. (LO 19.6)

14 (a) What is a forward rate agreement?

(b) What are the main features of an FRA? Explain how a corporation that needs to borrow funds in seven months can use an FRA to fix the cost of funds today.



(c) What are the main differences between an FRA and a futures contract? (LO 19.7)

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Chapter 19  Futures contracts and forward rate agreements

   6Mv7M(23) 10.35 to 25    7Mv13M(23) 10.50 to 20 You enter into an FRA with the dealer:

(a) What will be the FRA agreed rate?



(b) If the reference rate on the settlement date is 9.75 per cent per annum, what is the compensation amount?



(c) Which party to the FRA will make the compensation payment? (LO 19.7)

KEY TERMS basis risk  614

final basis risk  614

standard delivery  601

cash settlement  601

initial basis risk  614

straddle 604

clean price  597

last trading day  601

strip of FRAs  618

close out  600

limit order  598

traders 604

contract month  601

market order  598

cross-commodity hedging  614

spread position  604

CHAPTER NINETEEN REVIEW

15 You know that in seven months’ time your company is going to borrow $5 million for six months. You obtain the following quotes from an FRA dealer:

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CHAPTER 20

Options CHAPTER OUTLINE 20.1 The nature of options 20.2 Option profit and loss payoff profiles 20.3 The organisation of the market 20.4 Factors affecting an option contract premium 20.5 Option risk management strategies

Learning objectives LO 20.1

Understand the structure and operation of option contracts, and describe the types and component parts of option contracts available in the global markets.

LO 20.2

Explain the profit and loss payoff profiles of call option and put option contracts, and consider the requirements of covered option contracts.

LO 20.3

Describe the structure and organisation of the international and Australian options markets, including examples of the types of option contracts available.

LO 20.4

Identify and explain important factors that affect the price of an option contract, including intrinsic value, time value, price volatility and interest rates.

LO 20.5

Develop options strategies that are appropriate to hedge price risk, including single-option strategies and combined-option strategies, and discuss the advantages and disadvantages of option contracts for the management of risk.

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Chapter 20   Options

CHAPTER SNAPSHOT The futures markets have a reputation for being a bit risky. This is because a futures contract represents an obligation to buy or sell. If the price moves against a speculator or hedger, losses are incurred. For example, a farmer might take a short position in wheat futures to lock in a selling price and avoid the risk of a price decline only to witness an unexpected increase in the wheat price that causes him or her to regret having taken out the futures position. Options emerged to meet the demand of hedgers and speculators for an instrument that could allow them to hedge and speculate but which would not represent an obligation to buy or sell. That is, if things turn in an undesirable direction, as they did for the wheat farmer, the hedger or speculator need not follow through with the contract because it would represent a right but not an obligation to buy or sell. This is the niche in the financial markets filled by options.

INTRODUCTION One of the possible disadvantages of hedging with a futures contract (Chapter 19) is that it not only protects a hedger against losses, but also eliminates the opportunity to benefit from a positive move in the price of the underlying asset in the physical market. Consider the case of a company that expects to borrow short-term funds in three months’ time through the issue of 90-day bank bills. The borrower is exposed to the risk that interest rates might increase before it issues the bills. Therefore, the company may adopt a risk management strategy where it sells a 90-day bank-accepted bill futures contract today to lock in the cost of funds in three months. With this strategy, the company is not concerned about interest rates rising or falling; it has locked in an interest rate using a futures contract. However, it could be argued that the company may have been wiser only to hedge the risk that interest rates might increase. In that situation, if interest rates did happen to fall, then the company could take advantage of the lower interest rate when it borrows in the debt market. The financial markets are very innovative and have developed option contracts that are designed to allow the buyer of an option contract not only protection against an adverse price movement, but also the opportunity to take advantage of any positive price movement. In the above example, the company issuing bills would be able to protect itself against a rise in the yield on the bills to be issued, but should the yield actually fall by the issue date, it is not locked in to the option and can issue the bills at the lower yield in the money market. Similarly, an investor may be concerned that global demand for resources is falling and therefore the investor’s holding of BHP Billiton Limited shares might fall in value. The investor could buy an option contract that allows the sale of the shares at a price and date specified in the option contract. If the value of the shares does fall on the stock market, the investor can sell the shares at the higher, predetermined price in the option contract. However, if the share price does not fall, or increases, the investor is not required to sell the shares at the lower option contract price. The investor will allow the option contract to lapse. For this reason, option contracts have become popular as a hedging instrument.

REFLECTION POINTS

• • •

While a futures contract strategy allows a hedger to lock in a price to manage a risk exposure, such a strategy protects against downside risk, but does not allow any advantage to be taken if prices actually move to the benefit of the hedger. An option contract allows a hedger to cover the downside of a risk exposure, but still take advantage of any possible upside in price movements. This important attribute of an option contract has resulted in options becoming a popular risk management strategy. 627

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20.1 LEARNING OBJECTIVE 20.1 Understand the structure and operation of option contracts, and describe the types and component parts of option contracts available in the global markets.

The nature of options

An option contract gives the option buyer the right, but not the obligation, to buy or sell a specified commodity or financial instrument at a predetermined price on or before a specified date. The price established in the option contract is known as the exercise price, or the strike price. The exercise price is the price determined today at which the buyer of the option is able to buy, or sell, the specified commodity or financial instrument. For example, if the buyer of an option entered into a contract to sell 100 ounces of gold at USD1200 per ounce in six months, the exercise price is USD1200. If in six months the price of gold in the physical market has fallen to USD1150, the buyer of the option would exercise the option and sell the gold at the higher exercise price. However, if the price of gold was USD1275 per ounce on the exercise date, the option holder would let the option lapse and sell the gold directly into the physical market at the higher current price. From the definition of an option contract, it should be evident why it may, under certain circumstances, be the preferred hedging instrument. A unique characteristic of an option is that it need not be exercised if it is not in the option buyer’s best interest. Therefore, an option buyer will not exercise a right to sell if the physical market price is above the exercise price of the option contract. Similarly, an option buyer will not exercise a right to buy if the physical market price is below the exercise price of the option contract on the exercise date. The buyer of an option contract is able to purchase a contract that gives the right to buy a commodity or financial instrument or, alternatively, purchase an option contract that gives the right to sell a commodity or financial instrument. These are known as call options and put options. Call options give the option buyer the right to buy the commodity or financial instrument specified in the option contract at the exercise price. Put options give the option buyer the right to sell the commodity or financial instrument specified in the option contract at the exercise price. The buyer of a call option benefits if the price of the underlying asset is above the exercise price when the option is exercised. For example, a call option that gives the right to buy a company share at $12.00 per share will be exercised if, at the exercise date, the price of the company share is above $12.00 in the stock market. The buyer of a put option gains if the price of the underlying asset is below the exercise price when the option is exercised. For example, a put option that gives the right to sell a company share at $12.00 per share will be exercised if the share price falls below the $12.00 exercise price. An essential term specified in an option contract is the date on which the option can be exercised. The two most common arrangements are known as European-type options and American-type options. European-type options give the option buyer the right to exercise the option only on the contract expiration date. American-type options give the option buyer the right to exercise the option at any time up to the contract expiration date. Therefore, deciding which type of option contract to buy is an important consideration for both the buyer of an option contract and the writer (seller) of an option contract. It would initially seem that the American-type option would be a much more attractive product than the European-type option because the option buyer can select the most opportune time to exercise the option and maximise the advantage of any favourable price movements. This can be seen with the example (above) of the put option to sell gold at USD1200 per ounce in six months. A Europeantype option would only allow the buyer to decide whether or not to exercise the option on the expiration date in six months, and the price would be locked in to that date. The buyer of an American-type option, on the other hand, can monitor the price of gold over the six-month period. For example, if the price of gold falls over the first four months but then begins to rise, the buyer may decide to exercise the option immediately to take advantage of the higher option contract price. The option buyer could sell the gold at the higher option price, then buy the gold again in the physical market at the lower market price in the expectation that it will continue to rise. For this reason, the cost of an American-type option will be higher relative to the price of the equivalent European-type option. An option contract certainly is an attractive risk management product; however, there is a cost to the flexibility attached to an option contract. The writer, or seller, of an option contract is accepting

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Chapter 20   Options

a higher level of risk than the counterparty to a futures contract. Therefore, the writer of the option contract charges a premium that must be paid by the buyer of an option contract. The buyer must pay the premium when the option contract is bought. Therefore, the option writer will receive the premium whether or not the option buyer eventually exercises the option.

REFLECTION POINTS

• • • • •

An option contract gives the option buyer the right, but not the obligation, to buy or sell a specified asset at a predetermined price (the exercise price) at a specified date. A call option gives the option buyer the right to buy an asset, while a put option gives the buyer of the option the right to sell an asset. A European-type option can only be exercised on the specified contract expiration date, whereas an American-type option can be exercised at any time up to the expiry date. Because the buyer of an option contract has the right but not the obligation to conduct a transaction, the writer (seller) of an option will charge the buyer a premium. The option premium payment is made by the contract buyer at the commencement of the contract, whether or not the option is eventually exercised.

20.2

Option profit and loss payoff profiles

It is clear from our discussion so far that a change in the price of an underlying asset will impact on the buyer and the writer of an option contract quite differently. The buyer of an option contract seeks to manage a risk exposure and the net outcome of that strategy will depend on the price, in the physical market, of the asset specified in the option contract at the exercise date. On the other hand, the only return to the writer, or seller, of the option contract is the premium received. If the physical market price of the underlying asset moves against the writer, then the writer will begin to lose part of the premium previously received. If the price moves far enough, the writer may lose the full amount of the premium, and could actually make a loss on writing the contract. In Chapter 18 we introduced the concept of the profit and loss profiles associated with a call option and a put option. This section extends our understanding of the profit and loss payoff profiles for the buyers and sellers of both call options and put options.

20.2.1

LEARNING OBJECTIVE 20.2 Explain the profit and loss payoff profiles of call option and put option contracts, and consider the requirements of covered option contracts.

C ALL OPTION PROFIT AND LOSS PAYOFF PROFILES

Understanding the profit and loss profiles associated with a call option and a put option highlights the risk management attributes and cash-flow characteristics of an option contract. Figure 20.1(a) shows the profit and loss profile of the long-call party (the buyer) of a call option, while Figure 20.1(b) shows the short-call party (the writer) of a call option. The example in Figure 20.1 is based on a call option that gives the buyer of the option the right, but not the obligation, to buy a specified listed company share at an exercise price of $12.00 per share. At the start of the contract, the buyer pays a premium of $1.50 per share to the writer (seller) of the option contract. In return the buyer obtains the right to buy the specified shares at an exercise price of $12.00 per share. If on the expiration date the actual price of the share in the stock market is less than $12.00, the buyer will allow the option contract to lapse. The call option buyer will allow the option to lapse because the shares can be purchased at a lower price in the stock market than is available from the option contract. In this situation, the total cost to the buyer is the initial premium of $1.50.

Long-call party the buyer of a call option buys forward the underlying asset

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Figure 20.1  Profit and loss payoff profiles: call options (a) Buyer or holder (long call) Profit

(b) Writer or seller (short call) Break-even

Profit

Break-even

1.50 Premium (P ) 0 Premium (P)

12.00

13.50

Market price of asset (S)

0

12.00

13.50

Market price of asset (S)

–1.50

Exercise price (X) Loss

Loss

Exercise price (X )

However, the buyer will exercise the option to buy at $12.00 if the share price is above $12.00. In this situation it is cheaper to buy the shares under the terms of the option contract. If the share price on the stock market is between $12.00 and $13.50, the buyer will be able to use the profit made from exercising the option to offset the premium that has already been paid. Once the share price moves above $13.50, the buyer’s potential gain is unlimited. As the price of the share rises above $13.50 (the exercise price plus the premium), the buyer of the call option makes an outright profit by exercising the contract. The profit will continue to rise dollar for dollar with the share price as it moves above $13.50. This is illustrated in Figure 20.1(a) by the ascending 45° line. Should the share price remain below the $12.00 exercise price, the option buyer’s losses are limited to the cost of the premium paid for the option, that is, $1.50. Finally, if the current share price is exactly $12.00 at the expiration date, the buyer will be indifferent to exercising the contract. At the commencement of the option contract, the writer of the option will receive the $1.50 premium. This is the total potential gain available to the option writer. However, the gain from the premium will be eroded if the share price begins to move above the $12.00 exercise price. If the share price moves to $13.50, the writer will lose all of the premium payment. If the share price moves above $13.50, the writer’s loss is potentially unlimited. For example, if the share price moves to, say, $20.00, the option writer must deliver the shares when the buyer exercises the option. In this case the writer will make a net loss of $6.50 per share. Table 20.1 will assist in the understanding of the two panels of Figure 20.1. For the buyer or holder of the long call, the value (V) of the option depends on:

• • •

the market or spot price (S) of the underlying physical asset (in Figure 20.1 this is the company share) the exercise price (X) of the option the premium (P) paid for the option. It may be tempting to write, as a first approximation, that the value of the option is: ​V = S − X − P​

However, since the option will not be exercised if the spot price is below the exercise price, the algebraic expression for the value of the option has to be constrained. The algebra has to read that the option has value only when the spot price is greater than the exercise price. One way of expressing this is: ​max​(​S − X, O​)​ 630

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Chapter 20   Options

Table 20.1 Profits and losses: call option (exercise price $12.00, premium $1.50) (1) Spot price

(2) Value of long call V = max (S − X, 0) − P

(3) Exercise long call? S > X ?

(4) Value of short call V − P − max (S − X, 0)

$10.00

−$1.50

No

 $1.50

$11.00

−$1.50

No

 $1.50

$12.00

−$1.50

Indifferent

 $1.50

$13.00

−$0.50

Yes

 $0.50

$13.50

$0.00

Yes

 $0.00

$14.00

$0.50

Yes

−$0.50

$15.00

$1.50

Yes

−$1.50

This reads as: select the maximum value from the two terms: S − X and zero. That is, if the price of the physical asset is less than the exercise price, the holder of the call would choose to acquire the asset in the physical market rather than pay the higher exercise price. In this situation, the value of the option is zero. Recall, however, that the long-call party has paid the premium in order to acquire the option. The value of the option in this example would then be negative to the extent of the premium. The foregoing may be expressed algebraically in Equation 20.1 as: ​V  = max(S − X, O ) − P​

20.1

It is this expression that has been used to derive the values in column 2 of Table 20.1. For example, with the spot price at $10.00, an exercise price of $12.00 and a premium of $1.50: V = ​max​(​$10.00 − $12.00,0​)​ − $1.50​ ​  ​​​  ​  =​ ​ 0 − $1.50     ​​ ​    ​ ​  = − $1.50 If, on the other hand, the physical market price moved to $15.00 per share, then: V = ​max​(​$15.00 − $12.00,0​)​ − $1.50​ ​ ​​​ ​  =​ ​ $3.00 − $1.50          ​ ​​​ ​  = $1.50 Column 3 of Table 20.1 states the decision of the holder of the call option on whether or not to exercise the option. When the spot price is below the exercise price, it makes sense not to exercise the option. It would be cheaper to acquire the security in the physical market at the spot price. On the other hand, when the physical market spot price is above the exercise price, it is sensible to exercise the option and thus acquire the security at a price lower than the current spot price. The one range of prices where the decision may need some explanation is in the region where the security price is between $12.00 and $13.50. Consider the situation where the spot price of the security is $13.00. Column 2 indicates that the option has a negative value, −$0.50. The decision rule will be to exercise the option. By exercising the option with an exercise price at $12.00, the long-call party acquires a share with a physical market value of $13.00. The profit of $1.00 then goes some way towards reimbursing the $1.50 premium that was initially paid to buy the option. The result of this strategy is that the long-call party has experienced a net cost of $0.50. Had the party not exercised the option, the $1.50 premium could not be retrieved and the $1.00 profit available from exercising the option would have been forgone, and this certainly does not make sense. 631

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Short-call party the writer (seller) of a call option

Column 4 of Table 20.1 corresponds to Figure 20.1(b); that is, it reflects the position of the writer of the call option. Just as the profit and loss line for the writer of the call option is the mirror image of that for the holder of the call, so too is column 4 the mirror image of column 2. The value of the option to the writer (the short-call party) depends on the same variables that were identified for the long-call party: the exercise price, the spot price of the underlying asset in the physical market and the premium. The maximum profit that can be made by the writer is the premium that is received when the option is sold. If the option is in-the-money (see Section 20.4.1), and the buyer of the option chooses to exercise the option, the writer’s profit from having written the option is reduced, or turned into a loss. The relationship between the profit and the other variables is given algebraically by: ​V  = P − max(S − X, 0 )​

20.2

Equation 20.2 shows that the maximum profit that can be obtained by the writer of the call is limited to the premium. Once the spot price exceeds the exercise price (that is, S > X), the longcall party will exercise the option at the expense of the writer’s profits. In the example illustrated in Figure 20.1, where S = $12.00 and P = $1.50, the maximum profit that can be obtained by the writer is $1.50. That will be obtained only if the spot price of the asset in the physical market is less than or equal to the exercise price of $12.00. Once the spot price rises above $12.00, the writer’s profit is reduced or is converted into a loss. For example, at a spot price of $13.50: V = 1.50 − max($13.50 − $12.00,0) ​ ​​​ ​   =​  $1.50 − $1.50          ​ ​​​ ​    = 0 Should the spot price be, say, $16.00, the writer would experience a loss of $2.50 on the option. That is: V = ​$1.50 − max​(​$16.00 − $12.00,0​)​ ​ ​​​ ​   =​   $1.50 − $4.00  ​​        ​ ​ ​    = −$2.50 If the spot price were even higher, the loss sustained by the option writer would also be higher. The loss potential for the writer of a call option is, theoretically, unlimited. However, it is to be expected that the option writer would immediately close out a negative position by implementing a new risk management strategy, such as buying an opposite option contract, or maintaining a covered position (discussed below) by buying and holding the actual shares in the physical market before their price rose above $13.50.

20.2.2

P UT OPTION PROFIT AND LOSS PAYOFF PROFILES

The potential profit and loss profiles for the buyer and for the writer of a put option are illustrated in Figure 20.2. The profit and loss profile for the buyer (the holder of the long put option) is illustrated in panel (a). The main features of the long put are:

• • • • • •

Profits are made from exercising the option when the spot price falls below the exercise price of $12.00. The further the spot price falls below the exercise price, the greater is the value of the option. A net loss is sustained if the spot price is greater than the break-even price of $10.50. The net loss diminishes as the spot price falls from the exercise price to the break-even price. The maximum potential loss is the premium that was paid to buy the option. The profit and loss profile for the seller (the writer of the short put option) is illustrated in panel (b). The main features of the short put are:

•

The full amount of the premium is retained if the spot price remains above the exercise price of $12.00.

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• • • •

Even if the spot price exceeds the exercise price, the maximum profit is limited to the premium paid. The profit diminishes as the spot price falls from the exercise price down to the break-even price of $10.50. A loss is made when the spot price is below the exercise price less the premium. The maximum extent of a loss potential is the amount of the exercise price, that is, when the value of the underlying asset reaches zero value in the physical market.

The derivation of the two profit and loss profiles in Figure 20.2 is based on the calculation of the value of the option, at various spot prices, using formulae very similar to those presented for the calculation of the value of call options.

Figure 20.2  Profit and loss payoff profiles: put options (a) Buyer or holder (long put)

(b) Writer or seller (short put)

Profit

Profit

Break-even

Break-even

1.50 Premium (P) 10.50

0 Premium (P)

12.00

Market price of asset (S)

0

10.50

12.00

Market price of asset (S)

–1.50

Exercise price (X) Loss

Loss

Exercise price (X)

The long-put party will exercise the option when the exercise price is higher than the spot price. The option therefore has a positive value when X > S. The magnitude of the positive value, however, has to be adjusted downwards by the amount of the premium paid when the option was acquired. Should the exercise price be lower than the spot price (X > S), the option will not be exercised and thus the value of the option is negative to the extent of the premium. This can be shown in Equation 20.3 as: ​V  = max(X − S, 0 ) − P​

20.3

It is this expression that is used to derive the values in column 2 of Table 20.2 and the profit and loss profile in Figure 20.2(a). For example, given the same assumptions that were used in Figure 20.1, that is, P = $1.50 and X = $12.00, if the spot price (S) is $14.00, the value of the long put is: V = ​max​(​$12.00 − $14.00,0​)​ − $1.50​ ​ ​​​ ​  =​  0 − $1.50     ​​ ​    ​ ​  = −$1.50 Similarly, if S = $9.00, the value of the long put is: V = max($12.00 − $9.00,0 ) − $1.50 ​ ​​​ ​  =​  $3.00 − $1.50          ​ ​​​ ​  = $1.50 The value of the option for the short-put party, or the option writer, is at its maximum when the holder of the put option does not exercise the option. This will be the situation when S > X. In this situation the option has a value equal to the premium received for writing the option. The value 633

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Table 20.2 Profits and losses: put options (exercise price $12, premium $1.50) (1) Spot price ($)

(2) Value of long put V − max (X − S, 0) − P

 $9.00

 $1.50

Yes

−$1.50

$10.00

 $0.50

Yes

−$0.50

$10.50

 $0.00

Yes

 $0.00

$11.00

−$0.50

Yes

 $0.50

$12.00

−$1.50

Indifferent

 $1.50

$13.00

−$1.50

No

 $1.50

$14.00

−$1.50

No

 $1.50

(3) Exercise long put? X > S?

(4) Value of short put V = P − max (X − S, 0)

is reduced, and may turn negative, when the holder exercises the option. This may be expressed in Equation 20.4 as: ​ V = P − max(X − S, 0 )​

20.4

This expression was used to derive column 4 of Table 20.2 and the profit and loss profiles in Figure 20.2(b). For example, if the spot price of the underlying asset is $14.00, the value of the short put is: V = $1.50 − max($12.00 − $14.00,0 ) ​ ​​​ ​  =​   $1.50 − 0      ​    ​​​ ​   =  $1.50 Should the spot price be $9.00, the value of the option to the writer is: V = ​$1.50 − max​(​$12.00 − $9.00,0​)​ ​ ​​​ ​  =​  $1.50 − $3.00  ​​        ​ ​ ​  = −$1.50 Note that the profit (loss) made by the writer has its exact counterpart in the loss (profit) sustained by the holder of the option.

20.2.3

Covered option an option writer holds the underlying asset or provides a financial guarantee

C OVERED AND NAKED OPTIONS

The potential loss that may be incurred by the writer of an option contract could extend well beyond the amount of the premium received. Therefore, with an exchange-traded option, the writer will typically need to meet margin requirements unless a so-called covered option is written. An option is covered when there is a guarantee that the writer of the option can complete the contract should the holder choose to exercise the option. The writer of a call option would be considered to have written a covered call option if the writer owned sufficient of the underlying asset to meet the requirements of the option contract in the event that it is exercised. For example, if the call option gave the right to the option holder to buy shares in JB Hi-Fi Limited, the option would be covered if the writer held enough of those shares to meet the requirements under the option. Under an alternative arrangement, an option writer would be covered if a third party, such as a securities custodian, provided a guarantee that the option writer could borrow the underlying security on or before the option contract settlement date.

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A call option writer would also be covered by simultaneously being the holder of a call option in the same asset, but with a lower exercise price. To illustrate how this alternative provides cover, consider the following situation: Contract 1

• • •

Party A writes a call option on shares in JB Hi-Fi Limited with an exercise price of $23.00. Party B buys a call option on shares in JB Hi-Fi Limited from party A with an exercise price of $23.00. Party A does not own any shares in JB Hi-Fi Limited and is initially uncovered.

Contract 2

• • •

To obtain cover, party A buys a call option on shares in JB Hi-Fi Limited from party C with an exercise price of $22.00. Party C writes a call option on shares in JB Hi-Fi Limited with an exercise price of $22.00. Party C also holds shares in JB Hi-Fi Limited.

Should the spot price of shares in JB Hi-Fi Limited rise above $23.00, party B would exercise the call option it holds, and thus will acquire the shares at less than the current spot price in the stock market. As party A does not currently own the shares, it will acquire them by exercising its long-call option against party C. By simultaneously writing a call at one exercise price and buying a call at a lower exercise price, party A guarantees its ability to meet its contractual obligations. Before incorrectly jumping to the conclusion that the strategy outlined guarantees a profit to party A, it must be recalled that the illustration ignores the premium that would be paid by A when it buys the call option. The exercise price on the long-call option bought by party A is lower than the exercise price on the short call written. Therefore, it is to be expected that the premium paid by party A will be higher than the premium received on the short call. A writer of a call option who does not have the cover outlined above is said to have written an uncovered or naked call option. If the spot price of the asset rises above the exercise price, the holder of the call option will exercise that option, yet the naked option writer may not have the asset to deliver. How is the performance of the writer guaranteed? What is to stop the writer from walking away from the contract? When a naked call option is written on an exchange-traded option contract, the writer is required to deliver an initial margin payment to the brokerage firm. If the price of the underlying asset moves towards the exercise price, additional maintenance deposits are required.

Naked call option a call option writer does not hold the underlying asset

REFLECTION POINTS

• • • • •

Profit and loss payoff profiles show the potential gains and losses that are available to both the writer and the buyer of an option contract. The writer of an option receives the premium at the start of the option contract. With a call option, the writer retains the full premium so long as the current market price remains below the exercise price. If the market price goes above the exercise price, the writer begins to lose the premium. If the market price rises above the exercise price plus the premium (the break-even price), the writer is in a loss position. With a put option, the writer retains the full premium so long as the current market price remains above the exercise price. If the market price goes below the exercise price, the writer begins to lose the premium. If the market price falls below the exercise price less the premium (the break-even price), the writer is in a loss position. A covered option is an option where the writer provides a guarantee that the writer can complete the contract if the option is exercised. For example, an option is covered if the writer is holding sufficient of the underlying asset, or is able to borrow the underlying asset before settlement date. Exchange-traded options are covered options. 635

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20.3 LEARNING OBJECTIVE 20.3 Describe the structure and organisation of the international and Australian options markets, including examples of the types of option contracts available.

The options markets have become a major part of the international financial markets. Option contracts are available on an extremely wide range of commodities and financial instruments, either as exchangetraded contracts or over-the-counter contracts. Prior to 1973 and the creation of the Chicago Board Options Exchange (CBOE), option contracts were private contracts between two parties. Since the contracts were generally not standardised, there was little secondary market activity. However, market trading in options was stimulated by the establishment of the CBOE and the adoption of formal trading practices, and similar exchanges developed quite rapidly. Options exchanges now operate in the major financial centres around the world. Over-the-counter option contracts are also a major part of the overall market, particularly in relation to interest-rate-related option contracts. The commercial banks and investment banks are active participants in providing over-thecounter option contracts for their clients. The organisation of the market for exchange-traded options is similar to that of the futures market. All exchange-traded options contract transactions are recorded by an exchange’s clearing house. When a buyer and a seller of a particular contract enter into a trade, the clearing house breaks the deal into two option contracts: one between the buyer and the clearing house acting as seller, and one between the seller and the clearing house acting as buyer. This process of novation is discussed in Chapter 19. Once the clearing house has entered as the counterparty to both the seller and the buyer of the option, the original seller and buyer have no further responsibility to each other. Their relationships are now with the clearing house. If options buyers exercise an option, they rely on the clearing house rather than the original sellers for performance of the contract. The options clearing house thus guarantees the performance of all contracts. The role played by the clearing house allows either party to close out its position by selling contracts held without affecting the other party to the contract. The options clearing house also handles the assignment of option contract exercise notices submitted by buyers. In the event of the option holder electing to exercise the option, the holder simply notifies its brokerage firm of its intention. The broker in turn notifies the clearing house. The contract writer is informed that it has been assigned the responsibility of delivering the underlying asset (for a call writer) or the obligation to buy the underlying asset (for a put writer), at the exercise price. As mentioned above, exchange-traded options will be covered options, thus ensuring that the clearing house is able to guarantee completion of every contract.

20.3.1

Open outcry dealers conduct faceto-face transactions using verbal and handsignal conventions

The organisation of the market

I NTERNATIONAL OPTIONS MARKETS

Listed options markets can be found all around the world, and they are growing quickly, with contracts being added and deleted quite frequently. For example, the US market includes the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME), both of which are enormous exchanges that trade futures and option contracts on a vast range of commodities and financial instruments. In the UK and throughout Europe, the NYSE Liffe is a major derivatives exchange. Typically, an exchange in a particular country will specialise in option contracts that are directly related to physical market or futures market products also traded in that country. However, the largest exchanges, such as the CBOT and CME, offer option contracts based on a range of international commodities and financial instruments. Trading on international exchanges varies. While most exchanges around the world now operate as electronic exchanges, open-outcry exchanges still survive. For example, the CBOT and the CME still retain open-outcry trading on the floor of the exchange. The CME, for example, has between 4 000 and 5 000 people on the floor of the exchange. Visitors to Chicago should take the opportunity to visit the CBOT or the CME and witness firsthand the amazing spectacle of so many people trading futures and option contracts in the one location. Electronic trading is also conducted. Unfortunately for the spectator, open-outcry trading is disappearing around the world as exchanges move to electronic

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trading in order to become more efficient and competitive within a global market. One reason for this is the cost. The CME spends approximately $30 million each year to maintain traditional open-outcry floor trading alongside its electronic trading platforms (www.bloomberg.com). International links have also developed between various exchanges, allowing around-the-clock trading in options. The extent and diverse nature of option contracts is apparent in Figure 20.3, which shows a selection of the enormous range of financial option contracts traded on one (albeit very large) international exchange, the CME.

Figure 20.3  Selected financial option contracts traded on the CME CME equity options

CME commodity options

CME E-mini FTSE/Xinhua China 25

CME Class III Milk

CME E-mini NASDAQ-100

CME Live Cattle

CME S&P 500

CME Lean Hogs

CME NASDAQ-100

CME Feeder Cattle

CME iShares Russell 2000®

CME Frozen Pork Bellies

CME foreign exchange options

CME interest rates options

CME Euro FX

CME Eurodollar

CME Canadian Dollar

CME LIBOR

CME British Pound

CME Euroyen

CME Japanese Yen

CME 13 Week US T-Bill

CME Swiss Franc

20.3.2

T HE AUSTRALIAN OPTIONS MARKETS

The Australian options market is highly developed and provides a diverse range of option contracts that are available in exchange-traded and over-the-counter markets, including:

• • • • •

options on futures contracts share options low-exercise-price options warrants over-the-counter options.

Within the Australian market, the principal options exchange is operated by the Australian Securities Exchange (ASX). The trading platform is called ASX Trade24, which offers 24-hour trading on futures, options and contracts for difference. More information can be found on the ASX website at www.asx.com.au.

Options on futures contracts Options based on underlying futures contracts are listed on the ASX Trade24 trading platform. When an option contract is taken on a futures contract, such as the SPI 200, the buyer of the futures option has the right to buy (call) or sell (put) a specified futures contract that is also traded on 637

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the exchange. If the option is exercised, the writer of the option pays the buyer the difference between the current price of the futures contract and the exercise price of the option. Options on futures contracts traded on ASX Trade24 include the:

• • •

90-day bank-accepted bills futures contract ASX SPI 200 Index futures contract three-year and 10-year Treasury bonds futures contracts.

Futures contracts are discussed in detail in Chapter 19. A full list of contracts offered and detailed contract specifications are provided at www.asx.com.au.

Equity options: company issued and exchange traded Equity options are created in two ways. Most commonly, a speculator or hedger will write a call or put option over shares that trade on the exchange. These are exchange-traded options. Options can also be company issued. Companies might issue options to raise funds or as part of executive compensation. These are not issued over existing shares but over as yet un-issued shares. Company-issued options give their holders the right to purchase new shares on or before some date. Share option contracts are based on the ordinary shares of specified companies listed on the ASX. For each company share option, there are usually a number of contracts traded with the same expiration date, but with the options distinguished by different exercise prices. Typically, there are numerous options series on the particular share, with the options being distinguished by the expiration date. At the time each options series is initiated, contract expiry dates usually range from six months to three years. Options on Australian company shares have a contract size of 100 shares. The option premium is multiplied by 100 in order to find the total contract value. Options typically expire on the last Thursday before the last business Friday of the expiry month. To ensure that option writers meet their obligations under the option contract, the clearing house maintains a system of deposits and maintenance margins. Therefore, the writer either must write a covered option, where shares are deposited with the clearing house, or must be ‘cash covered’ by meeting deposit and maintenance margin requirements. The exercise price of a share option is generally set reasonably close to the actual market price of the share at the time of issue and may have expiry dates out to three years. If the option is exercised, settlement occurs with the delivery of the underlying shares by the option writer. Individual company share option contracts traded on ASX Trade are American-type options: the buyer of the option may exercise the option at any time up to the expiry date. Option contracts based on certain share-market indices are also offered through ASX Trade. These contracts are usually Europeantype contracts that can only be exercised at the expiry date.

Low-exercise-price options ASX Trade facilitates trading in an option contract known as a low-exercise-price option (LEPO). The seller of a LEPO undertakes to deliver the underlying shares at the expiry date in return for receiving the exercise price and the premium. A LEPO is a highly leveraged option on individual stocks, with an exercise price of one cent, plus a premium. Because of the low exercise price, the premium is comparable to the price of the underlying stock. A small amount of initial collateral or margin is required from both the LEPO buyer and the LEPO seller. Mark-to-market margins are subsequently settled in cash on a daily basis. Margin is required on both sides of the trade because the buyer does not pay the full premium upfront. The seller, of course, lodges an initial margin because he or she is exposed to the risk that the underlying share price might increase. The LEPO is a deliverable contract, with a European-type expiry; that is, it can only be exercised on the last trading day. Each contract covers 1 000 shares in a specified listed corporation on the ASX. If the holder elects to exercise at expiry, it will take delivery of those 1 000 shares from the writer. LEPO contracts are available over a range of high-liquidity stocks. 638

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Apart from their exercise price of one cent, LEPOs differ from standard equity options in other ways. Most importantly, the buyer of a LEPO does not pay the full option premium upfront. Instead, a margin based on the total premium is lodged. This might be 5.00 per cent or 10.00 per cent of the total premium. If the total premium is, for example, $20 000, the LEPO buyer might lodge a $2 000 margin with the clearing house. This is different from standard equity options where the buyer parts with the full $20 000 when the options are purchased. Contract specifications are provided at www.asx.com.au.

Warrants A warrant is simply an option contract. The warrant conveys a right to the buyer (the holder) of the warrant, but the holder is not obliged to exercise the warrant. It is necessary to distinguish between:

• •

equity warrants that are attached to debt issues made by companies seeking to raise funds through primary market debt issues, and warrants that are issued as financial products principally designed for investment and the management of an exposure to price movements in the markets.

Equity warrants are discussed in Chapter 5, and are essentially an option attached to a debt issue such as a corporate bond. The attachment of the equity warrant is often attractive to investors because it bestows on the equity warrant holder the option to convert the warrant into ordinary shares in the issuing company at a specified date and a predetermined price. This section focuses on the rapidly expanding range of other warrants that are issued through the ASX. These products are not issued by companies wishing to raise additional capital, but by financial institutions as investment and financial risk management products. The buyer of a warrant will pay a premium for the right to exercise the warrant. Settlement of contracts occurs through the clearing house. Warrants issued and traded through the ASX may be American-type or European-type contracts. Before the GFC, the monthly turnover of warrants had grown steadily from about $400 million to more than $1 billion. During the GFC, turnover fell by half, but as the crisis abated there was a strong upward surge to new record levels of almost $2 billion in monthly turnover. Warrant contracts offered in the market include:

•

• •

MINIs. MINIs are a type of warrant that may be issued over a number of different types of assets, including shares, share indices, currencies and commodities. MINIs may be either MINI longs or MINI shorts. One of the distinguishing characteristics of MINIs is their stop-loss feature. A holder of a MINI long, for example, profits when the price of the underlying asset increases and suffers losses when the price falls. The MINI long is equipped with a ‘barrier’ set somewhere above the exercise price. When the fall in the price of the underlying asset breaches the barrier, the stop-loss is triggered, terminating the MINI long and ensuring that the MINI long holder does not lose more than their initial investment. Commodity warrants. These are warrants where the underlying asset is a commodity such as gold, silver, copper, oil or gas. Commodity warrants share many of the features of equity warrants. Interestingly, however, when a commodity warrant is exercised for delivery, that delivery might entail either cash settlement or physical delivery. If physical delivery is called for, the holder will take delivery of a specified amount of the underlying asset. Index warrants. These are issued over a specified S&P/ASX share price index or an overseas stock index. The contracts enable investors to benefit from overall stock-market price movements. As it is not generally possible to deliver the actual shares on a broad-based index such as the S&P/ASX 200 Index or the S&P 500 Index, settlement is usually by cash payment if the warrant is exercised. The amount paid at settlement is calculated by multiplying the difference between the exercise level and the closing index to convert the points to cash. The index warrant may also have a barrier feature, whereby if a nominated index level is breached the warrant will automatically terminate. The barrier is usually triggered only if the warrant is deep out-of-the-money, and no money will be paid to the warrant holder. 639

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• • • •

•

Basket warrants. These contain a group of shares from different companies listed on the exchange. The group of companies may be categorised within certain market industries such as mining or manufacturing. Therefore, the buyer of the warrant is able to benefit from, or cover an exposure to, the select group of companies or a particular industry sector. If the warrant is exercised, settlement will usually require delivery of the underlying shares in proportion to the basket structure. Capped warrants. These are low-exercise-price warrants, set at one cent. The distinguishing feature is the cap applied to the upside profit available to the warrant holder. It is a European-type warrant where settlement, if exercised, is the lower of the current market value of the underlying shares or the capped value of the warrant. Instalment warrants. These give the warrant holder the right to buy the underlying shares by payment of a number of instalments during the term of the warrant. The warrant holder has the right not to make an instalment payment. Non-payment constitutes the lapse of the warrant. Capital plus warrants. These are usually issued for approximately $1 000 each and are based on a basket of listed shares. The issuer provides a guarantee that, at the expiration date, at least the initial issue value will be returned to the warrant holder. Capital plus warrants are typically long-term warrants issued for approximately five years. They are European-type warrants, and the value of the warrant on the exchange will fluctuate in line with the current price of the underlying shares. These warrant holders are not entitled to receive dividend payments. At settlement, a gearing ratio of between 10.00 per cent and 30.00 per cent is applied to any increase in the value of the basket of shares; that is, the holder will receive the current value of the basket of shares plus a percentage of the increased value of the basket of shares. The holder may elect to receive delivery of either the underlying shares or a cash payment. If the value of the basket of shares has fallen below the issue price, the holder is guaranteed return of the initial investment. Endowment warrants. These do not have a fixed exercise price, but rather an outstanding amount. The endowment usually has a long-term expiry date out to 10 years. A reference interest rate, such as the bank bill swap rate (BBSW), is applied to the outstanding amount of the warrant, and this is generally determined at issue date. The outstanding amount will usually reduce over time as dividend payments are received in relation to the underlying shares. Franking tax credits are also applied to the balance. When the outstanding amount is paid out in full, the warrant holder becomes the owner of the underlying shares. If the outstanding amount has not been reduced to zero from the receipt of dividends, franking credits and interest payments by the expiry date, the holder will need to make a final residual payment.

Over-the-counter markets Tailor-made over-the-counter options are also a large part of the overall options market, despite the apparent advantages of standardised expiration dates, exercise prices and contract sizes that are associated with exchange-traded option contracts. The popularity of the over-the-counter market results from the demand for products that will manage risk exposures associated with instruments that do not have options traded on formal exchanges, such as semi-government securities and other money-market instruments, or securities whose maturities are different from those that can be covered using exchangetraded options. In particular, over-the-counter interest rate options are a very flexible risk management product. They can be tailored to meet individual needs in terms of the amount, term, interest rate and price. These options also allow the setting of interest rate caps and floors, or the implementation of costminimisation strategies using collars. Caps, floors and collars are discussed at the end of Section 20.4. Banks are significant providers of over-the-counter option products, particularly contracts that allow their corporate customers to manage financial risk exposures associated with importing, exporting, borrowing and investing.

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REFLECTION POINTS

• • •

The options markets are categorised as exchange-traded markets or over-the-counter markets. Exchange-traded options are standardised contracts where the clearing house places itself between the option buyer and the option seller through the process of novation. Over-thecounter options are non-standardised contracts negotiated between the buyer and the seller (the seller usually being a commercial or investment bank). An enormous range of option contracts are available on exchanges around the world; each exchange tends to specialise in options on certain asset classes. Exchange-traded option contracts available in the Australian market include:

— options on futures contracts offered through the ASX and listed on ASX Trade24 — share options on specified shares and indices on the ASX — low-exercise-price options over shares listed on the ASX (high premium, low exercise price) — warrants, including MINIs, commodity, index, basket, capped, instalment and capital plus warrants.

•

An over-the-counter interest rate option may be a cap, a floor or a combination called a collar.

20.4

Factors affecting an option contract premium

The price of an option is the premium paid by the buyer of the option. The premium is determined by the writer of the option. The premium should reflect the level of risk accepted by the option writer. Risk inherent within an option contract is quite complex and will vary considerably depending, in part, on whether the option is a European-type contract or an American-type contract. With a European-type contract risk is primarily evident on the option expiry date; however, with an American-type option risk is always evident as the contract can be exercised at any time up to the expiry date. A number of theoretical and applied models have been developed to facilitate the calculation of the value of an option contract; that is, the premium. The model often used is that formulated by Black and Scholes. It is beyond the scope of this text to examine the Black–Scholes model, or derivations of that model. However, to extend our understanding of option contracts further, we consider four important factors that affect the amount of the premium paid on an option:

LEARNING OBJECTIVE 20.4 Identify and explain important factors that affect the price of an option contract, including intrinsic value, time value, price volatility and interest rates.

1 intrinsic value 2 time value 3 price volatility 4 interest rates. Each of these factors is discussed below. The section concludes with a discussion on how the cost of the premium paid on an interest rate option can be offset through the use of an options strategy known as a collar.

20.4.1

I NTRINSIC VALUE Intrinsic value

The relationship between the current market price of the underlying asset and the exercise price of an option determines whether or not the option would actually have a value if it were exercised immediately. This value is referred to as the intrinsic value of the option. If the option was exercised immediately and

the market price of an underlying asset relative to the option exercise price

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Part 6 Derivative markets and risk management In-the-money an option that has a positive intrinsic value; buyer will exercise

At-the-money the physical market price and the option exercise price are the same

Out-of-the-money an option that has a negative intrinsic value; buyer will not exercise

a profit made, the price of the option could be expected to equal the intrinsic value of the option. The greater the intrinsic value of the option, the more the option is worth, therefore the larger the premium. The relationship between the price of an asset and the option exercise price determines whether an option is in-the-money or not. An option is defined as being in-the-money if it can be exercised at a profit; that is, if it has a positive intrinsic value. If the exercise price is equal to the price of the asset in the physical market, the option is said to be at-the-money. In the situation where a loss would be made if the option were to be exercised (not that an option holder would choose to exercise under such a condition), the option is described as being out-of-the-money. Table 20.3 identifies the money position of both put and call options.

Table 20.3 The money position of an option Situation

Call option

Put option

In-the-money

S>X

S