Paul Nguyen – Semester 1 – 2014

BF2000 – Financial Institutions and Markets

Week 1 – Overview
Roles of the Financial System (Markets, Institutions and Money)
 Facilitate the flow of funds
o The flow of funds in a financial system is from surplus spending units (SSUs) to
deficit spending units (DSUs).
o SSUs will buy financial instruments for funds. DSUs will sell financial instruments on
the markets in exchange for funds.
o There are three types of economic units – households, businesses and government.
o SSU – income > planned expenditure
o DSU – income < planned expenditure
o SSUs are mostly households (e.g. people putting money in their bank, people buying
shares and bonds). These funds flow to DSUs. Mostly business firms and
governments. This is a fundamental function of the financial system.
o There are two ways of financing. I.e. for funds to go from SSUs to DSUs.
 Direct Financing – SSUs lend money directly to DSUs and accept a financial
claim in return. This exchange occurs directly. The limitation of this method
is that DSUs generally want large denominations and SSUs generally want
smaller ones. Also, it might be hard for DSUs to find SSUs.
 Indirect Financing – financial intermediaries, e.g. a bank, will purchase direct
claims from SSUs and transform them to indirect claims and sell to DSUs.
 Provide the mechanism to settle transactions
o A payment system (e.g. cash, EFTPOS, credit card…etc.)
o A strong payment system is one that is efficient in terms of speed, cost and
stability.
o It also needs to have strong financial institutions and settlement mechanisms among
them.
 Generate and disseminate information
o Another key role of the financial system is to provide economic and financial
information to enable investors to make informed investment decisions.
o E.g. Credit history, financial statements, credit ratings.
 Provide the means to transfer and manage risk
o There are many different types of risks faced by financial institutions.
o Credit Risk – risk that a borrower will default on debt
o Interest Rate Risk – risk of interest rate movements
o Liquidity Risk – risk that a security cannot be traded quickly enough to prevent loss
o Foreign Exchange Risk – risk of movements in exchange rates
o Political Risk – risks due to political factors and change or events such as war
o Reputational Risk – risk due to loss stemming from damages to reputation
o Environmental Risk – risks on adverse effects to living organisms and environment
o Risk is reduced through diversification, careful credit analysis of borrowers,
monitoring of borrowers and using hedging strategies.
 Provide ways of dealing with incentive problems
o There are many incentive problems that can occur within a financial contract.
o Information asymmetry – transactions in which one party has more or better
information than the other.
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BF2000 – Financial Institutions and Markets

o Adverse selection – when there is information asymmetry, the bad products or

services are more likely to be selected. E.g. if a bank has one price for all of its
accounts, people who want low-balance or high-activity accounts will flock to that
bank – i.e. the least profitable people.
o Moral hazard – a situation where one party is more willing to take a risk knowing
that the risks will be borne (wholly or partially) by others. In other words, a lack of
responsibility.
o Agency problem – this is where decisions are being made by agents, e.g. financial
managers, for the benefit of others, i.e. the owners or shareholders.

Benefits of Financial Intermediation (Indirect Financing)

 There are generally five services which intermediaries play when transforming a direct claim
to an indirect one.
o Denomination divisibility – they facilitate the demand of large funds using many
small suppliers.
o Currency transformation – facilitate foreign exchange risk so that SSUs do not face a
loss in the case of a declining Australian dollar. In the case that the AUD increases,
however, the intermediary will benefit.
o Maturity flexibility – able to facilitate medium and long term funds using many
retail deposits.
o Credit risk diversification – since financial intermediaries have access to a large
range of investments, they can diversify and reduce risk.
o Liquidity – since they have a large pool of funds, they are able to provide liquidity
for both SSUs and DSUs.

Financial Intermediaries
 There are many different Australian financial intermediaries, including banks, building
societies, credit unions, insurers, money market corporations, superannuation entities…etc.
 Commercial banks – largest and most diversified intermediaries, Australian-owned
commercial banks hold more than $2 trillion in financial assets (end of ’09). Assets include
loans to consumers, businesses and governments. Their liabilities consists of deposit
accounts and other sources of funds. Also involved in other activities (e.g. underwriting –
helping businesses to find investors).
 NBFC (Non-Bank Financial Corporations) – provide many of the same products and services
as commercial banks – building societies, credit unions, money market corporations, and
finance companies.
o Building societies – financial institution owned by its members, usually mortgage
lending and savings accounts.
o Credit unions – people who have accounts in credit unions are its members and
owners. Their main aim is to provide financial services to its members including
credit at competitive rates. Credit unions are not-for-profit.
 Other financial institutions – life insurance, general insurance, superannuation funds,
managed funds, securitiesers.
 International organisations – Bank of International Settlements, World Bank, IMF, Asian
Development Bank
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BF2000 – Financial Institutions and Markets

Financial Markets
 Financial markets are the markets to buy and sell financial securities. They can be classified
in many ways, including the order and timing, type and time to maturity of the financial
securities.

Primary and Secondary Markets

 Primary markets are where financial claims are initially sold by the DSU, e.g. an IPO (initial
public offering) where shares are first sold to the public.
 Secondary markets are where previously issued securities are exchanged among investors.
 Once issued, the exchange of securities can take place on an organised exchange, such as
the ASX or over-the-counter (OTC). OTC markets have no central location.

Other Financial Markets

 Other financial markets include the futures, options, foreign exchange and international
markets.
 Futures market – market for selling futures contracts, i.e. a contract to buy a specific
quantity of security or commodity at a determined price for future delivery.
 Options market – market for selling options, contracts which give the buyer (i.e. owner) the
right, but not the obligation, to buy or sell an underlying asset at a specified strike price
before a specified date. The seller has an obligation to fulfil l the transaction if the owner
elects to exercise the option.
 International Market – e.g. the Eurocurrency markets and Eurobond markets where
domestic or overseas firms can borrow or lend AUD deposited in overseas banks.

Money Markets
 Financial markets usually fall under either money or capital markets.
 Money markets are for wholesale of short term securities (less than 12 months).
 The money market is where banks and businesses borrow to adjust their liquidity positions.
It consists of a collection of markets each trading different financial instruments.
 The main characteristics are – high liquidity, low default risk.
 Instruments traded on the money markets include:
o Treasury notes – government short term debt
o Commercial paper (promissory note) – unsecured short-term debt instrument
issued by corporation
o Commercial bills – longer-term debt instrument issued by a corporation
o Negotiable certificates of deposit – essentially a promissory note issued by a bank,
it is a time deposit that restricts the holder from withdrawing, though the owner can
withdraw with a penalty. Also called a term deposit.
o Secured and unsecured notes – financial security with a longer term than a bill, but
shorter than a bond. Notes are sold below par value and make regular interest
payments.
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BF2000 – Financial Institutions and Markets

Capital Markets
 On the capital markets, longer term securities are traded.
 Capital goods are financed with stock or longer-term debt instruments.
 Capital market instruments are less marketable, have varying default levels and maturities.
 Instruments traded on the capital markets include:
o Shares
o Corporate Bonds
o Government Bonds
o Mortgages (mortgage-backed securities)
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 2 and 3 – The Monetary Authorities, RBA and Interest Rate

The Monetary Authorities
 Central banks regulate a nation’s money supply and their financial institutions.
 The central bank aims to maintain a stable economic environment and effective payments
system.
 The functions of a central bank include developing and implementing monetary policy,
issuing currency, providing banking services for the government, overseeing the
operations of the financial system and facilitating the payments system.
 Australia has three independent agencies which perform the role of the monetary authority.
o Reserve Bank of Australia (RBA) – responsible for monetary policy, payment system
and financial system stability.
o Australian Prudential Regulation Authority (APRA) – responsible for prudential
supervision of financial institutions.
o Australian Securities and Investment Commission (ASIC) – responsible for
enforcement of company and financial services laws. Objective is to protect
consumers, investors and creditors. Also responsible for licensing and monitoring
financial markets and advisors as well as monitoring disclosure and conduct of
Australian companies.

The Reserve Bank of Australia (RBA)

 History – Established in 1911 as the Commonwealth Bank of Australia, CBA’s commercial
and central banking duties were separated in the 1950s. RBA was established in 1959.
Responsibilities of RBA were adjusted in light of the Campbell Committee (1979) and Wallis
Committee (1996).
 Roles of the RBA include:
o Determination and implementation of monetary policy
o Issuing Australian currency
o Overseeing payments system
o Banker to the government
o Issuing and providing the market for treasury securities – i.e. government debt
o Managing financial system liquidity and the government holding of foreign exchange

Monetary Policy
 Monetary policy is the management of short term interest rates.
 The objectives of monetary policy are to maintain:
o Stable currency
o Full employment
o Prosperity and welfare for Australians
 The principal medium-term objective of monetary policy is to control inflation.
 Inflation, thus, is a centrepiece of the monetary policy framework.
 RBA target inflation rate = 2 – 3% per annum.

Payments System
 The payments system is used to settle transactions.
 The RBA plays three roles:
o Promoting efficiency and stability of the payment system
o Providing the facilities for settlement
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BF2000 – Financial Institutions and Markets

o Acting in the payment system as the bank of the Australian government.

RBA Structure
 Overseen by the Reserve Bank Board – 9 members, including Governor and Secretary to the
Department of the Treasury
 Meets 11 times a year and its main business is monetary policy.
 Board is accountable to the federal parliament and produces an annual report for the
treasurer.
 The governor of the RBA also meets regularly with the treasurer.
 However, the RBA is not directly under the authority of the government.

Australian Prudential Regulation Authority (APRA)

 History – Established July 1st 1998 by Australian Prudential Regulation Authority Act 1998.
 Responsibilities – prudential supervision of financial institutions including banks, insurance
and superannuation companies.
 APRA’s specific functions include:
o Development, implementation and supervision of prudential regulation.
o Monitoring regulated entities to ensure they are complying with laws and policies.
o Advising the government on development of regulation and legislation affecting
regulated institutions and markets.
 Key role – supervise Authorised Deposit-taking Institutions (ADIs) in Australia. They wish
to control the risk taking of ADIs.
 It is important that ADIs do not take excessive risk for:
o Investor confidence
o Contagion – financial crisis from one country spreads to another
o Stability of the financial system
 ADIs must adhere to an 8% capital adequacy ratio (CAR). The ratio of capital to risk
adjusted assets must be > 8%.
 Governance – APRA is governed by the APRA board and it is accountable for its actions by
appearing before parliamentary committees, annual reports to parliament and audits by the
National Audit Office.

Australian Securities and Investment Commission (ASIC)

 History – Established in 1991. Australian Securities and Investments Commission Act 2001.
 Responsibilities – regulating financial markets, regulating securities, futures and
corporations, consumer protection in superannuation, insurance, deposit-taking and credit.
 Specific responsibilities include:
o Maintain, facilitate and improve performance of financial system and entities.
o Promote confident and informed participation by investors in financial system.
o Administer the law effectively with minimal procedural requirements.
o Act to enforce and give effect to the law.
o Receive, process, store information given to ASIC.
o Make information about companies and other bodies available to the public.
 ASIC’s Priorities
o Assist and protect retail investors and consumers.
o Build confidence in the integrity of Australia’s capital markets.
o Facilitate international capital flows and international enforcement.
o Manage the domestic and international implications of the global financial turmoil.
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BF2000 – Financial Institutions and Markets

o Lift operational effectiveness and service levels for all ASIC stakeholders.
o Improve services and reduce costs by using new technology and processes.

Other Central Banks Around the World

 Bank for International Settlements (BIS)
o International monetary authority based in Basel, Switzerland
o Facilitator of central banking cooperation, meeting place for central banks and is a
bank to the central banks, providing services related to their financial operation.
 Central Banking in China
o People’s Bank of China – responsible for monetary policy, currency regulation,
developing policy for financial markets and facilitating interbank borrowings.
o China’s Bank Regulatory Commission = APRA in Australia
 Central Banking in Hong Kong
o No central bank, principal regulator called the Hong Kong Monetary Authority
o Performs many of the functions of a typical central bank.
 Central Banking in the USA
o US Federal Reserve System – created in 1913.
o Consists of seven-member board of governors, twelve regional Federal Reserve
Banks, 3000 member commercial banks and the Federal Open Market Committee
(FOMC).
o Authority – rests with board of governors.
o Roles – 12 federal reserves clear and process payment orders, depository for banks
in their district, participate in making monetary policy.
o Roles – FOMC – consists of 7 board members, plus 5 presidents of the Federal
Reserve Banks – committee determines monetary policy and the Federal Reserve
Bank of New York implements the policy day-to-day.
 Central Banking in NZ
o Similar to Australia, however, there is no equivalent of ABRA.
o The Reserve Bank of New Zealand (RBNZ) is responsible for monetary policy,
systemic stability and prudential regulation.

What are Interest Rates and Determinants of Interest Rates

 For the borrower, interest is the penalty for consuming income prior to earning.
 For the lender, interest is the compensation for delaying of consumption.
 The fundamental determinant of interest rates is the interaction of investment (and
investors) and saving (and savers).
 Investors want as high a yield as possible. Consumers want to consume sooner and want as
low an interest rate as possible, so there is less penalty for consuming. The strength of these
opposing forces will be reflected by the interest rate.

Investment vs. Saving

 The higher the return on an investment, the more likely the producer is likely to undertake a
project. The minimum return on an investment is the required rate of return, i.e. the rate at
which the cost of financing is covered. At higher interest rates, a lot of projects can no longer
meet the required rate of return. Thus, lower interest rates -> higher demand for capital
(and vice versa).
 On the other hand, when interest rates are low, there is less incentive for people to invest,
rather, they will prefer to consume now, as they aren’t being compensated much for
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BF2000 – Financial Institutions and Markets

delaying. Thus, the supply of saving will be higher, the higher the interest rate (and vice
versa).

 Higher interest rates – more people want to invest, less people wanting to borrow
 Lower interest rates – more people wanting to borrow, less people wanting to invest
 Loanable Funds Theory - Interest rates are determined by the demand and supply of
loanable funds.

Price Expectation and Interest Rates

 The price level does not stay constant, it changes (i.e. inflation).
 This affects the realised return lenders receive on their loans and the price borrowers pay
for these loans.
 Thus, loan contracts must incorporate the impact of expected changes to the price level
otherwise there would be a transfer of purchasing power between borrowers and lenders.
 The equation which allows for price level changes is the Fisher Equation.
 Interest rates are made up of two parts – the real rate (i.e. no price changes) and the
expectation of the percentage change in the price level.
 𝑖 = 𝑟 + ∆𝑃𝑒
 If the actual inflation is higher at the end of the loan than expected inflation at the
beginning, the lender will have a lower realised rate of return. I.e. Borrower benefits from
more purchasing power.

RBA Influence on Interest Rates

 The RBA influences the interest rate structure by controlling the cash rate, the rate of
unsecured overnight interbank lending.
 The cash rate measures the return on the most liquid financial asset – bank reserves.
 It is integral to monetary policy because it reflects the available reserves in the banking
system, this will influence the banks’ decisions to issue loans.
 The cash rate is determined by supply and demand, the RBA manipulates the supply side to
ensure that the actual cash rate corresponds to the level it has decided is appropriate.

RBA Controls the Liquidity of the Financial System

 The RBA controls the liquidity of the financial system by managing the exchange
stabilisation funds (ESF) held by the banks at the RBA in exchange settlement accounts
(ESAs).
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BF2000 – Financial Institutions and Markets

 Exchange stabilisation funds are the funds used to settle obligations amongst institutions
and the RBA.
 Thus, when the RBA controls the ESF, it also controls the money supply.

Money Supply Changes

 The RBA can measure money supply through three definitions:
o M1 – currency, currency accounts at depository institutions.
o M3 – M1 + all other bank deposits of the private non-bank sector.
o Broad Money – M3 + borrowings from the private sector by non-bank financial
institutions (NBFIs) - currency and bank deposits of NBFIs.
 The money supply can change as a result of:
o Government tax and spending
o Government transactions in CGS (Commonwealth Government Securities) and
foreign exchange
 The ESA balances change continuously each day. The RBA manages the supply of ESA funds
in order to maintain equilibrium at the cash rate. If the RBA wants the cash rate to fall, it
increases supply and vice versa.
 Each day RBA staff estimate the likely net settlement between the ESA holders and the RBA.
The RBA decides what supply adjustment is needed to maintain the cash rate at the
targeted level. Then, the RBA will announce whether it wants to buy or sell securities and
dealers have 15 mins to communicate their offers to the RBA. These offers are ranked and
the best accepted to supply the required ESA funds or to soak up excess.

Objectives of Monetary Policy

 There are three main objectives of monetary policy:
o Currency (Price) stabilisation
o Maintenance of full employment
o Economic prosperity and welfare for Australians
 Price Stability
o Price stability is the stability of the average price of all goods and services in the
economy.
o Inflation is the continuous rise in the average price level.
o Monetary policy aims to keep the inflation rate between 2 and 3% per annum in
order to negate the effect of unintended transfers of purchasing power.
 Full Employment
o Full employment is that anybody who is of working age, who wishes to work, can
find employment.
o There is always a natural rate of unemployment due to the “buffer” of people
entering and leaving employment.
o The target unemployment rate is 5%.
o During the GFC, it peaked at 5.8%, much lower than feared.
 Economic Growth
o Economic growth is the expansion and development in an economy.
o The RBA manages its monetary policy so that it contributes to economic prosperity.
o Measured as the change (i.e. increase) of GDP.
 Conflict Amongst Goals
o There is a trade off in the short run between full employment and stable prices. As
unemployment decreases, inflation increases. Thus, RBA must balance.
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BF2000 – Financial Institutions and Markets

Monetary Policy Transmission and Economic Activity

 There are three basic mechanisms (expenditure channels) through which monetary policy
affects the economy.
o Business investment
o Consumer spending
o Net exports
 Business Spending
o High interest rates = increase in financing costs = increased required rate of return
on new plants and equipment.
o Thus, spending might fall.
 Consumer Spending
o High interest rates = more expensive to borrow, more expensive to serve payments
on existing loans.
o High interest rates = values of securities fall.
o Thus, spending may fall.
 Net Export
o Changes in the interest rate will affect the dollar.
o Higher rates = higher AUD
o This is because the demand for import increases and the demand for export
decreases
o As imports increase relative to exports, income decreases.
o Therefore, when interest rates increase, net exports fall and so does income.

Forecasting of Interest Rates

 Economic Modelling
o Economic modelling predicts interest rates by estimating the statistical relationship
between economic variables and the level of interest rates.
o Key assumption – causality among variables is stable.
 Flow-of-funds Account Forecasting
o Shows the movement of saving through the system.
o Analysts examine “pressure points”, points where the demand exceeds supply or
vice versa.
o These imbalances indicate the possibility of interest rate changes.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 4A – Regulation of Banking Industry

Reasons for Regulation
 Financial institutions are regulated because they provide goods and services that the
economy needs to do well.
 The industry in which financial institutions operate is characterised by asymmetric
information.
 The social costs of bank failures and the resulting economic problems are high, thus, banks
are heavily regulated.
o Regulation of banks aims to reduce the risk of a bank failure occurring, which is a
high cost occurrence.
o Furthermore, the failure of one bank can undermine confidence in all other banks.
Confidence may be maintained by the presence of a lender of last resort.
o Banks can fail due to illiquidity or inadequate capital.
 Ensuring banks have sufficient liquidity (especially in a crisis) is of the utmost
importance.
 Governments and RBA (in the past) have provided support in a liquidity
crisis.
 The strong prudential supervision of Australian banks contributed to the
stability of Australia’s financial system during the global financial crisis.

Regulators
 RBA – responsible for systemic stability
 ASIC – responsible for consumer protection and market integrity
 APRA – responsible for prudential regulation of ADIs, insurance and superannuation entities

Legislation
 Reserve Bank Act 1959
 Banking Act 1959
 Financial Sector (Shareholdings) Act 1998
 Financial Sector (Collection of Data) Act 2001
 Financial Services Reform Act 2001
 Legislation Amendment (Financial Claims Scheme and other Measures) 2008

APRA’s Methodology
 There are three key elements to APRA’s prudential supervision framework.
 Supervisory action plans
 Risk assessment and response tools (probability and impact rating system – PAIRS,
supervisory oversight and response system – SOARS)
o PAIRS is used to assess the probability that a regulated institution will fail. Based on
strength of an institution’s management, controls and capital base. PAIRS is based
on four main factors:
 Inherent risk of an institution in relation to business operations
 Management and control of the entity in terms of quality of the risk
management controls and systems and the ability of the entity to conduct
these.
 Net risk remaining after consideration of management and control.
 Capital support the entity has to buffer against unexpected losses.
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BF2000 – Financial Institutions and Markets

o SOARS is used to determine the supervisory response that APRA should take.
 Industry wide risk analysis

Prudential Regulation in Australia

Supervision of Bank Liquidity
 Liquidity – availability of sufficient funds to meet day-to-day requirements.
 Liquidity management of ADIs aims to ensure that ADIs have enough cash on hand to meet
their obligations. It is required for ADIs to have a liquidity management strategy.
 APRA maintains tight reporting controls, however, their choice of strategy is flexible.

Capital Adequacy
 Monitoring bank capital began in the 1970s.
 APRA regulations – ADIs must adhere to an 8% capital adequacy ratio (CAR).
 This means that the ratio of capital to risk adjusted assets must be at least 8%.
 The CAR is capital defined by prudential statements divided by risk adjusted assets
 Capital – Tier 1 capital + Tier 2 capital (Tier 1 must be > 50%)
 Risk adjusted assets – institution’s assets multiplied by a credit risk weightage (0, 20, 50 or
100%).
 To calculate a CAR:
o Estimate capital base (i.e. Tier 1 and 2 capital)
o Calculate total risk-weighted assets
o Calculate the total market risk-weighted assets
o Divide capital base by total risk-weighted assets
o Result must be > 8%

Other Prudential and Regulatory Controls

 In addition to liquidity management and CAR > 8%, there are additional requirements
placed on ADIs.
 Authorisation
o Companies who wish to conduct banking business must obtain approval from APRA.
 Ownership and control
o To ensure that management and the boards of ADIs represent all shareholders and
that no particular shareholder can influence the ADI’s operations, no individual or
group can own more than 15% of the voting shares of the ADI.
 Associations with nonbanks
o Equity associations of banks with nonbanks is also regulated.
o The association cannot exceed 50% of Tier 1 capital per association or 150%
collectively.
 Board certification
o Each year, ADIs must present a certification by management of the efficacy of the
institution’s risk management systems.
o Must come from CEO and endorsed by the board of directors.
 Exposure limits
o ADIs must report new exposures greater than 10% of the capital base.
o APRA must be consulted before exposures of more than 30% are undertaken.
 External reviews
o ADIs must submit data to APRA.
o Meetings and site visits must be conducted.
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BF2000 – Financial Institutions and Markets

o ADIs must be externally audited with an audit report going to APRA.

Consumer Protection Regulation

 There are regulations designed to protect consumers in their transactions with commercial
banks.
 The regulation hinges on the fact that consumers generally have unequal market power
compared to creditors and that consumer markets may not allocate credit in the most
socially desirable manner.

Consumer Credit Code

 Part of the consumer protection framework.
 Applies minimum standards to all types and suppliers of credit across Australia.
 Based on the principle of truth in lending – ensures that all consumers are given adequate
information to allow them to make informed decisions when purchasing credit.

Legislative Framework
 Relevant Legislation – Australian Uniform Credit Laws Agreement 1993.
 Ensures consumer credit laws are uniform in all states and territories and applies to all credit
transactions in Australia.
 Places requirements on credit providers in entering credit agreements with consumers.

Banking and Financial Services Ombudsman

 Established in 1989 - Independent dispute resolution service.
 Considers complaints made against banks and affiliates that operate in Australia.
 Alternative to court action.
 Consumers’ contact point - Financial Ombudsman Service (FOS)
 Cases which are not dismissed or cannot be resolved are subjected to investigation by the
BFSO.
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BF2000 – Financial Institutions and Markets

Week 4B – The Australian Banking System

Australian Banking Industry
 15 locally owned banks in Australia
 Big 4 banks account for 80% of total assets of the 15 banks. Thus, the industry is
characterised by a few large players and a group of smaller competitors.
 Consolidations through takeovers and mergers is the way banks grow quickly, diversify
operations and improve geographical spread.
 Australian banks have undertaken takeovers of foreign entities, however, the government
does not allow further consolidation of the local market. Four pillars policy – maintains
competition in the banking sector.

Bank’s Balance Sheet

 Balance sheet lists a business’s assets, liabilities and equity (capital).
 Assets = Liabilities + Capital

Source of Bank Funds

 The principal source of funds for banks is deposit accounts – demand, savings and term
deposits.
 Funds from deposits take precedence over funds sourced elsewhere in the event of a bank
failure.
 For large banks, borrowed funds are a more important source of funds than deposits.
Increased demands for loans has outpaced the growth of deposits. Thus, banks rely on
borrowed funds to finance their operations.

Deposit Accounts
 Transaction accounts – owners are entitled to receive funds on demand, transfer of
ownership is by cheque or EFTPOS.
 Savings accounts – interest bearing accounts of individuals and partnerships.
 Term deposits – legally due on a mature date, funds cannot be transferred to others.

Borrowed Funds
 Borrowed funds are short-term borrowings by commercial banks from the wholesale money
markets.
 Borrowings may include – banker’s acceptances, debt issues and loan capital (notes and
debentures).
 There are three types of borrowed funds – banker’s acceptance (a time draft accepted by a
bank and drawn on the deposits of a bank), debt issues (short term and long term
instruments that raise funds form the public debt issues) and loan capital (long term,
subordinated note instruments – subordinated means they get paid after other
debtholders).

Capital Accounts
 Bank capital is the ownership funds of the bank.
 Loan and security losses are charged against this account.
 Includes – share capital, retained profits, reserve accounts.
o Share capital is the direct investment into the bank in the form of stock
o Retained profits is the bank’s profits which was not paid out as dividends
o Reserve accounts are ones set up to cover expected losses on loans and investments
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BF2000 – Financial Institutions and Markets

Bank Uses of Funds

 Raised funds are used for issuing loans or for investment.
 Loans are a contract between a borrower and a bank and represent an ongoing relationship.
 Investments are contracts issued by large borrowers and purchased by banks. More
impersonal, resold by the bank on secondary markets.

Off-Balance Sheet Banking

 Off-balance-sheet banking has become popular over the last twenty years and earn a fee
income for the bank. These items are contingent assets or liabilities and include – loan
commitments, unrealised gains or losses on derivative securities. They are not kept on the
bank’s books.
 Contingent assets are assets which are now not on the balance sheet, but might ultimately
become on balance sheet assets.

Loan Commitments
 Loan commitments are an example of an off-balance sheet asset
 Loan commitments are formal promises by a bank to lend money according to certain terms.
 One of three types:
o Lines of credit – agreement under which a bank customer can borrow up to a
predetermined limit in the short term, it is a moral obligation, not legal, meaning
that the bank can renege on the deal. Examples - overdraft protection, credit
cards…etc.
o Term loans – formal agreement under which a bank will lend a customer a certain
dollar amount for a period exceeding a year. e.g. home loan
o Revolving credit facilities – customer pays a fee and has access to a loan at any
time, commitment fee and interest expenses must be paid.

Derivative Securities
 Banks participate in the markets for interest rate and currency forwards, futures, options
and swaps.
 Losses on derivative securities are an off-balance sheet liability. Gains on derivative
securities are an off-balance sheet asset.
 Purposes are:
o Hedging risks
o Speculation
o Serving as a counterparty for a customer

Bank Performance
Profitability
 Profitability of banks have generally increased over time.
 Measured in one of two ways – rate of return on average assets, rate of return on average
equity.
 Return on average assets measures the quality of bank management, return on average
equity is for the shareholders of the bank, and not for the assets the bank is given.
 Interest income on loans is the major source of income on banks.
 Other sources of income are fees (e.g. ATM fee, account management fee, cheque costs)
and returns on investments.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Profitability vs. Safety

 More risks = more rewards
 Thus, banks can increase profits by taking on more risks, however, this jeopardises bank
safety.
 Therefore, banks must balance the demands of shareholders, depositors and regulators.
 Balance must be achieved between profitability and solvency.
 Banks can fail in one of two ways, either through becoming insolvent or becoming illiquid.
o Liquidity is the ability to pay depositors on demand. Thus, if lots of people wanted to
withdraw money at the same time, the bank might not have enough cash at hand to
satisfy those withdrawals, this means that the bank is illiquid.
o Insolvency is where the bank suffers great losses on its investments or loans and
does not have the money it will need to pay back depositors.
o Note that a bank can be solvent, i.e. have enough money, but still be illiquid, i.e. it
doesn’t have the money on demand and cannot liquidate its assets quickly enough.

Liquidity Management
 Asset management – maintaining sufficient cash and non-cash assets that can be quickly
converted to cash (i.e. liquid assets).
 Liability management – acquiring liquidity from the liability side of the balance sheet.

Asset Management
 Bank assets classified into four groups – primary reserves, secondary reserves, bank loans,
investments.
 Primary reserves – immediately available to accommodate liquidity demands.
 Secondary reserves – additional liquidity whilst earning interest income.
 Bank loans – undertaken once the bank has satisfied its liquidity needs.
 Open market investments – undertaken once loan demand has been satisfied.

Liability Management
 Attracting additional funds by increasing the interest rate on interest sensitive securities.
 Sudden deposit outflows can be offset.
 Funds raised can meet increased loan demand.
 Funds raised can allow banks to engage in off-balance-sheet activities.

Bank Capital Management

 Provides a financial cushion
 Helps maintain public confidence
 Provides some protection to depositors
 Serves as a source of funds for expansion

Capital Adequacy and Risks

 Capital adequacy – does the bank have enough capital per unit of risk.

Basel Accord
 Basel I and Basel II (the Basel Accord) set capital guidelines that relate the bank’s capital to
risk profile, i.e. that to undertake riskier activities, the bank must have more capital.
o Basel I – Looks at credit risk and market risk in calculating the capital adequacy ratio.
o Basel II – Also takes into account operational risk.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 COMPARISON OF BASEL 1, BASEL 2 and BASEL 3

 BASEL 1:
o The Basel 1 accord mainly focused on capital requirements for banks.
 BASEL 2:
o The Basel 2 added supervision and market discipline to these capital requirements
through its "Three Pillars" concept. The first pillar sets the minimum capital
requirement, the second pillar discuses regulation and supervision while the third
pillar describes market discipline.
o Pillar 1: Regulatory capital requirement for credit risk, market risk and operational
risk
o Pillar 2: Supervisory review process
o Pillar 3: Market discipline – Disclosure of capital structure, risk exposures and capital
adequacy
 BASEL 3:
o The Basel 3 aims to improve risk management and governance as well as strengthen
transparency and disclosure of banks. This provides a framework to strengthen the
global capital rules and introduces a global liquidity standard.
o To strengthen the global capital framework:
 it raises the quality, consistency and transparency of the capital base (e.g.
common shares and retained earnings must be the main source of Tier 1
capital)
 enhances risk coverage (e.g. counterparty risk)
 introduces a supplementary measure to the risk-based capital requirement
(i.e. introduction of a leverage ratio)
 includes measures to reduce procyclicality and promotes countercyclical
buffers (e.g. forward-looking provisions)
o A new liquidity standard is introduced to promote a bank’s short-term resilience
(pursued by the liquidity coverage ratio, LCR) and to provide a sustainable maturity
structure of assets and liabilities (measured with the net stable funding ratio, NSFR).
 Prepared by Jyotir

Managing Credit Risk

 Primary risk that banks face – credit risk – the risk of loan defaults.
 The credit risk associated with an individual loan concerns the losses the bank may suffer if
the borrower defaults.
 In order to cover these losses, banks must set aside resources in provisional accounts.

Credit Risk of Individual Loans

 Banks must monitor a loan’s performance once it has been made.
 There are certain indicators which a bank may use in order to determine whether its loans
are becoming risky. Examples:
o Failure to make loan repayments
o Adverse changes in a customer’s credit rating
o Adverse changes in deposit balances, sales and earnings
o Delays in supplying financial statements
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Credit Risk of Loan Portfolios

 Loan portfolios – an all-in-one type loan which combines different loans, e.g. a home loan,
investment property loan and a line of credit.
 Risk is usually measured by internal credit risk ratings.
 These credit risk ratings are used to:
o Identify problem loans
o Determine the adequacy of loan reserves
o Analyse loan pricing and profitability
 CAMELS rating system to assess credit risk of a loan portfolio:
o Capital adequacy
o Asset quality
o Management
o Earnings
o Liquidity
o Sensitivity to market risk

Interest Rate Risk and Duration Gap Analysis

 Banks manage interest rate risk to ensure that they will always earn a spread between their
borrowing rates and the rates they earn on their investments.
 The sensitivity of bank earnings to interest rates can be measured by the gap between rate
sensitive assets and rate sensitive liabilities.
 Gap = RSA – RSL
 However, a more precise interest rate risk tool is duration gap analysis.

Duration Gap Analysis

 Duration gap analysis measures the difference between the duration of a bank’s assets and
its liabilities.
 Dg = DA – (MVL/MVA) x DL
o DA = weight duration of assets
o DL = weight duration of liabilities
o MVL = market value of liabilities
o MVA = market value of assets
 The duration of assets and liabilities is calculated by multiplying each asset/liability class by a
risk factor and then dividing it by the market value of total assets/liabilities.
 If the duration gap > 0, then if interest rates increase, the earnings will decrease and vice
versa. This is because the assets of the firm will be repriced before its liabilities, allowing the
assets to earn the firm the new higher interest rate, whilst the firm only pays the older,
lower interest rate on its liabilities.
 If the duration gap < 0, then if the interest rates increase, the earnings will increase and
vice versa. This is because the liabilities of the firm will be repriced before its assets,
meaning that it will have to pay the higher interest rate on its liabilities before it starts
earning the higher interest rate from its assets.

Value at Risk
 Another measure of interest rate risk is the Value at Risk (VaR) statistical model. It attempts
to estimate the maximum potential gains and losses that may be incurred by a portfolio in a
given time period and a given confidence interval.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 In other words, if there is a VaR of –$x at a confidence interval of 99%, over one trading day,
then that means that there is a 1/100 chance that on such day, the loss will exceed $x.

Managing Interest Rate Risk

 Interest rate risk must be controlled through hedging.
 Microhedging – through matched funding (fixed rate loans are funded with deposits or
borrowed funds of the same maturity).
 Macrohedging – use of financial futures, options on futures and interest rate swaps to
reduce the interest rate of the firm’s entire balance sheet.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 5A – Bond Markets

The Long Term Capital Markets (Bond Markets)
 The bond market allows firms to match the expected life of an asset with the maturity of a
debt. These debts are raised on the bond markets and allows firms and governments to
issue long term debt securities.
 With longer term debt, the cost of funds may be known for the life of the asset. Thus, there
are likely to be fewer refinancing problems.
 The largest purchasers of capital market securities are individuals and households.
 The largest issuers are the Commonwealth and State governments.

Commonwealth Government Securities (CGS)

 CGSs are treasury bonds and notes backed by the credit of the Commonwealth government.
 Treasury bonds are coupon instruments (i.e. bonds) whereas notes are discount securities
traded in the money market.
 Government surplus – reduce the need for bond issuing
 Government deficit – increases the need for bond issuing
 Long term securities – treasury bonds. Short term securities – treasury notes.
 Treasury notes are considered default risk free and are short term discount securities.

Treasury Bonds
 Treasury bonds (T-bonds) are considered to be default risk free, they are sold by tender and
have five and thirteen year maturities.
 They pay semi-annual coupons.
 New issues are sold through a tender system, i.e. a bidding system, and bids are expressed in
terms of YTM. The bid with the lowest YTM (i.e. the highest current price) is accepted first.
 The process of issuance is conducted by the RBA and bids are expressed in terms of yield to
maturity in multiples of 0.005%.

Treasury Indexed Bonds

 Treasury Indexed Bonds – not fixed principal bonds. They adjust with inflation and pay
quarterly interest and the principal amount changes with inflation.
 This means that their coupon is not fixed.
 The adjustment in the principal amount will take place before each coupon payment.
 At maturity, the investor will receive the greater of the final principal amount or the initial
par amount.
 Investors want them when inflation is high, governments want them when inflation is low.

Semis
 Semis are bonds which are issued by the state government.
 They are issued by the state financial authorities and are backed by the credit of the
particular state government.
 Unlike CGS, semis are not issued through a tender system, but rather to dealer panels. Most
semis currently issued are offshore.
 Semis trade at higher yields than CGS, they are not risk free, and have a liquidity premium.
This means that they are initially sold at lower costs.
 The liquidity premium comes from the fact that the market for semis is not as large as the
market for CGSs.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Corporate Bonds
 Debt contracts requiring payment of interest periodically and repayment of principal at
maturity.
 Usually issued in denominations of $1000 and pay coupon interest semi-annually.
 Two types:
o Unsecured Notes – no specified collateral attached to the bond
o Debentures – secured by specific asset of the corporation

Debentures
 Debentures are bonds secured by charges over the issuing firm’s assets.
 There are two forms of debentures:
o Fixed charge debenture holders have the right to the proceeds of the sale of the
assets, as specified in the debenture, should the bond default.
o Floating charge debenture holders have the right to the proceeds of sale of the
assets specified in the debenture that are not already pledged against a fixed charge
in any other debenture.
 Essentially, what this means is that floating charge debenture holders rank behind fixed
charge in case of a default.

Sinking Funds
 Sinking fund provisions requires the corporation to place funds with a trustee to retire a
portion of the debt issue each year. Unlike call provision, the issuer MUST retire.
 The trustee may retire the bonds by purchasing them on the market or calling for them if a
call provision is present in the contract.
 For sinking fund provisions, it benefits the investors by reducing their risk of default.
 A call provision is an option, which the issuer can choose whether to exercise or not to retire
the bonds before maturity. The issuer does not HAVE TO exercise.
 For call provisions, the advantage is that issuers and investors have to be compensated with
a call premium.

Hybrid Securities
 Hybrid Securities:
o Have both debt and equity characteristics.
o Have a set coupon rate and are convertible to equity at a set conversion date.
o It allows the debtholders of a company to benefit if it becomes successful.
o The reset date is the date the issuer can elect to change the term of the security (i.e.
next reset date or coupon rate).
o Investors can accept the new terms of choose to convert their securities into equity.
 Convertible Notes (Example of a Hybrid Security)
o Convertible notes are hybrids that can be converted into equity at the holder’s
discretion.
o This allows the holder to share in the good fortune of the firm if the stock price rises
above a certain level.
o It is to the investor’s advantage to convert when the market value of the stock
exceeds the market value of the notes.
 Other hybrid securities, apart from convertible notes are stapled securities (where equity
and bonds are stabled together, cannot be traded separately) and preference shares (shares
which have a more senior claim than ordinary stock).
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Primary and Secondary Market for Bonds

 Primary market – where new corporate bonds are bought to the market through public sale
or private placement.
o Public sales – made through investment banking firm, available to the general
public.
o Private placements – sold privately to a few investors - not very common in
Australia, used to issue bonds into the US.
 Secondary market – where existing bonds are sold on the ASX or through dealers.
o The secondary market for bonds is quite small compared with the markets of
money-market securities or corporate stock.
o This is because corporate bonds have features such as call provisions or sinking
funds which makes them hard to value.
o Corporate bonds are also long term, thus riskier and less marketable.

Financial Guarantees and Credit Wrapping

 Financial Guarantee – unconditional offers from a private sector guarantor to cover the
payment of principal and interest to investors in debt securities in the event of a default.
 Bonds with financial guarantees attached – credit-wrapped bonds
 Credit wrapped bonds are issued by companies with lower credit ratings, usually companies
with predictable earnings but high gearing.
 Credit wrapping lowers yields, can represent interest savings for the issuer.

Securitisation
 Securitisation takes illiquid assets and turns them into liquid securities sold to investors on
the capital markets. Example – securitised residential mortgages.
 These created liquid securities are known as asset-backed securities.
 The securitisation process
o Special purpose vehicle (SPV) is created
o The SPV is separate from the loan originator and is controlled by a trustee.
o The loan originator sells the SPV from a pool of comparable assets (e.g. mortgages
from a particular city).
o The SPV then creates securities backed by the loans the SPV holds.
o These securities are sold to investors.

Offshore Bonds
 Offshore bonds issuance among Australian corporate entities increased from $60 billion to
more than $460 billion between 1994 and 2009.
 Most bonds are issued in major currencies, e.g. USD, EUR, JPY.
 Kangaroo bond – for an overseas company, issued in Australia for Australian investors, pays
in AUD.

Regulators
 ASIC – responsible for market integrity and consumer protection.
 APRA – responsible for prudential supervision of ADIs.
 RBA – responsible for stability of financial system and payments system.
 Corporation law – bond issue accompanied by a prospectus registered with ASIC.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 5B – Bonds and Bond Pricing

Bond Pricing
 Price of a bond is the PV of the bond’s future cash flows.
 Bond – series of regular interest payments + lump sum repayment of principle – i.e. annuity
with a lump sum.
 Coupon Rate – size of the coupon (interest payment)/face value.
 Term to maturity – the number of years over which the bond contract extends.
 Zero coupon bonds – do not pay coupons, sell at a discount, just discount the principal

Bond Yields
 The coupon rate is not necessarily a reflection of the actual rate of return the holder earns.
 This is dependent upon the credit or default risk, reinvestment risk and price risk.
o Default risk is the risk that the borrower fails to make coupon or principle payments
at the time agreed on.
o Reinvestment risk is the risk that, due to changes in the markets, the lender has to
reinvest coupon payments at interest rates less than the interest rate at the time the
bond was purchased.
o Price risk is the risk that the interest rate will change, changing the market value of
the bond, thus result in either gains or potentially losses.
 Yield to Maturity – yield promised if the bond is held to maturity and all coupons are
reinvested at the promised yield. Rate that equates the present value of the bond’s cash
flows with its price.
o There are two ways to understand the yield to maturity
o Firstly, we can get it from the bond formula.
o Secondly, we can also interpret it using the reinvestment of coupons idea. If all
coupons are converted to a future value using the interest i and we add together the
future values of all these coupons as well as the final principal value and then
discounting it by i, we can use the price of the bond today to find this interest rate,
which is the yield to maturity.
 Realised Yield – when the bond is sold before maturity, the actual return earned on a bond
given the cash flows actually received by the investor and assuming reinvestment at the
coupon rate.
 Expected Yield – yield investors would receive if interest rates changed, based on the
expected sale price. Unlike the realised yield, this is a prediction (i.e. an ex ante measure).

Bond Theorems
 Bond Prices and Yield
o As the market rate of interest declines, bond prices rise.
o As the market rate of interest rises, bond prices decline.
o This is because the coupon rate on a bond is fixed. The only way to change the
bond’s yield is to change its price. When interest rates are higher, the bond becomes
less attractive (cheaper) and vice versa.
 Bond Price Volatility and Maturity
o Bond price volatility – sensitivity of a bond’s price to changes in interest rates.
o The longer the term to maturity, the greater the price volatility.
o A measure of volatility is the percentage change in the bond’s price for a given
change in yield.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

𝑷𝒕 −𝑷𝒕−𝟏
o %∆𝑷𝑩 = ∗ 𝟏𝟎𝟎
𝑷𝒕−𝟏
 Bond Price Volatility and Coupon Rate
o The lower a bond’s coupon rate, the greater the sensitivity of the bond.

Interest Rate Risk

 Interest rate risk consists of price risk and reinvestment risk.
o Price risk – Inverse relationship between bond prices and interest rates
o Reinvestment risk – arises because interest rate changes cause fluctuations in
investors’ realised yield.
o Yields increase, bond prices fall, however, the rate at which coupons are
reinvested increases (and vice versa). Thus, price risk and reinvestment risk
offset each other.
 We need a measure of interest rate risk that accounts for both price risk and
reinvestment risk. This measure of risk is the duration of a bond.

Duration
 Duration is a measure of interest rate risk that considers both the coupon rate and the
maturity of the bond.
 Essentially, it is the weighted average of the number of years until each of the bond’s
cash flows is received, using annual compounding.
 Duration is used to measure price sensitivity, if the interest rate goes up by 1%, how
much will asset prices go down by. Alternatively, it can also be defined as the amount of
time it will take us to recover back our original capital.
 To calculate duration:
o Calculate the present value of all cash flows
o Multiply the PV of all cash flows by the number of years in which they will be
received.
o Add the values calculated and divide by the price.

 Properties of Duration:
o Higher sensitivity to interest changes (i.e. volatility), higher duration.
o Bonds with higher coupon rates have shorter durations. Think – duration
measures sensitivity. Thus, the higher the coupon rate, the less we will be
affected by changes in interest rate as per bond theorem. Alternatively, think
that higher coupon rate = getting money back sooner.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

o In general, there is a positive relationship between term to maturity and

duration, i.e. longer term to maturity = higher duration = higher sensitivity. This
is as per the bond theorem.
o Higher the market interest rate, the shorter the duration of the bond. This is
because higher rates lead to faster coupon reinvestment income accumulation.
o Single payment bonds – i.e. zero coupon – duration = term to maturity.
 Duration can be used to measure the sensitivity of a bond’s price to changes in interest
rates.
∆𝑖
o %∆𝑃𝐵 = −𝐷 (1+𝑖) ∗ 100

Managing Interest Rate Risk

 Zero coupon approach
o No coupons received, so there is no reinvestment risk.
o However, still exposed to bond prices changing due to interest rate (i.e. price risk).
 Maturity matching approach
o Matching when the cash flows of a bond are received to when cash flows must be
used.
o No price risk, as the bond is held to maturity.
o Interest rate might change, however, and thus, there is a reinvestment risk.
 Duration matching approach
o Most likely to reduce price and reinvestment risk.
o See below.

Duration Matching
 Duration matching can eliminate interest rate risk.
 If we want to invest in a bond and hold it for 2 years, we should find a bond that has a
duration of 2 years to invest in, not a maturity of 2 years.
 Essentially, we match our duration with our holding period.
 This ensures that capital gains and losses from interest rate changes are exactly offset by
changes in reinvestment income.
 For example, if there is an interest rate increase, bond prices will fall, however, the
increased amount at which coupons can be reinvested.
 Problem is that it is difficult to find a bond with the same duration as maturity.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 6 – Term Structure of Interest Rates

Term Structure of Interest Rates
 The term to maturity – amount of time until the principal amount borrowed becomes
payable.
 The relationship between yield and term to maturity is called the term structure of interest
rates.
 Often plotted as a yield curve. A normal yield curve is where investors believe there will be
no significant changes in the economy, i.e. no change in inflation, constant growth.
 The shape of the yield curve is known as the expectation theory. The shape of the yield
curve is determined by investors’ expectations of future interest rates. I.e. upward sloping
implies interest rate increases.

Term Structure Formula

 The term structure formula is the relationship between long-term and short-term interest
rates. It is used to ensure that investors cannot get “free lunch” by trading in securities with
different maturities.
 Specifically, the current long-term interest rate is a geometric average of the current short-
term interest rates and a series of expected short-term forward rates.
 The spot rate is the observed interest rate at which current transactions take place.
 The forward rate is the implied interest rate which will account for the difference between
the short-term and longer-term rates.
 Note – Essentially, it is “breaking down” an interest rate.
 In order to calculate the forward rate:

1  t Rn  / 1  t Rn 1 
n n 1
 1  t  n 1 f1
Example
 The current interest rate for a 5 year loan is 6.5% p.a. and for a 3 year loan is 8.0% p.a. What
is the forward rate for a 2 year loan starting in 3 years’ time?
 We need to consider that the interest rate for the 5 year loan is the geometric average of
the interest rate for the 3 year loan and the 2 year loan.

1.0655 = 1.083 (1 + 𝑟)2

Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

1.0655
𝑟=√ − 1 = 0.04289 = 4.29%
1.083

Other Theories of Term Structure

 Liquidity Premium Theory – investors require extra compensation for holding securities with
long term to maturities, as these securities take longer to produce returns.
 Market Segmentation Theory – investors have preferences for securities of a particular
maturity (due to investment goals) and consistently buy and sell securities with these
preferences in mind. Thus, the yield curve is determined by demand for securities at or near
a particular maturity.
 Preferred Habitat Theory – Investors only leave their preferred investment maturities if
compensated for taking on extra risk for investments not matching their goals. Preferred by
market participants.

Default Risk
 Risk that a borrower will not pay back the interest or principal.
 Since investors are risk averse, they will need to be compensated for taking on an extra
amount of risk. Thus, there is a default risk premium.
 The default risk premium is how much higher the risky investment pays over the risk free
yield. DRP = i - irf.
 During periods of prosperity, investors are more willing to hold securities with more default
risk, as the default risk during such periods is much lower.
 During recessions, investors switch to higher quality securities, causing their yields to
decrease, thus, the yields of lower quality bonds increase.
 During expansionary periods, investors seek higher returns and thus, the yields of riskier
bonds decrease.
 Thus, during recessionary periods, the default risk premium is higher.
 Calculating default risk, assessment of:
o Cash flows
o Contractual cash payments
o Profitability and variability of this profitability

Marketability
 Marketability refers to the cost and speed at which investors can resell a security.
 Higher demand -> greater marketability -> lower yield.
 Marketability depends upon:
o Costs of trade
o Costs of physical transfer
o Search and information costs.
 The more marketable a security is, the less the premium on the interest rate.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 7 – Money Markets

The Role of Money Markets
 Collection of markets trading short term securities.
 Trading takes place over the counter.
 Facilitated by dealers who offer buy/sell quotes to potential customers.
 Money markets are a wholesale market in which trades are typically more than $1 million.
 Open market – impersonal and competitive nature.
 Settlement usually takes place through Austraclear (clearing house) or the RBA’s Information
and Transfer System (RITS).
 Economic role of money markets is to provide a way for economic units (e.g. banks) to
undertake liquidity management.
 Allows economic units to manage the mismatches that occur between cash payments and
receipts, thus, thereby solve their liquidity problems.

Characteristics of Money Market Instruments

 Money Market Instruments have these characteristics:
o Low default risk
o High marketability and liquidity
o Large denominations
o Low per-dollar transaction costs
 The reason why these money market instruments have these characteristics:
o Investors are looking for safe, short-term investments, money market securities are
issued by economic units with the highest credit standing.
o Need to be highly marketable and liquid because money might be needed
unexpectedly.
o It only costs $3 in fees to trade a line of securities in Austraclear, could be worth up
to $100 billion.
 Main participants in the Money Market Instruments
o Commercial Banks
o RBA
o Commonwealth Government
o Corporations

Treasury Notes (T-Notes)

 Treasury notes are issued to finance the operations of the Commonwealth Government.
 Usually maturities of 1 year or less.
 When the government is in surplus, there are no issuance of T-notes.

Bidding for T-notes

 Auctioned by the Australian office of Financial Management (AOFM).
 Bids are usually by large investors and are submitted competitively.
 The bid with the lowest yield is accepted first and then remaining T-notes are sold to
subsequent bidders.

Pricing T-notes
 Discount security and pays no coupons.
 P = F/(1+yn), where n is in years, y is yield per annum.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

The Cash Market

 Cash market is the market for cash held in exchange settlement accounts (ESAs) at the RBA.
 This markets allow commercial banks to borrow or lend excess ESA balances.
 Relevant interest rate is the cash rate.
 Most of the cash market transactions are borrowing and lending transactions between
banks.
 When a transaction is made, ESA of one bank is debited, another is credited.
 The interbank borrowing and lending market is important because if banks stopped lending
to each other, e.g. during the GFC, the markets froze and interest rates skyrocketed.
 Such freezes will flow through the entire financial system.

Repurchase Agreements (Repos)

 Repurchase agreements are agreements involving the sale of a security with the condition
that the seller will buy it back at the predetermined price.
 Involved securities – CGS (Comm. Govt. Securities) and Semi-Government Bonds.
 Repos are usually made for one day and are no longer than a week.

Why are Repos Used?

 For the seller – source of short-term funds
 For the buyer – short-term investment
 E.g. f Bank A has an excess $1 mil and Bank B requires $1 mil, then bank A can make some
interest by lending $1 mil to Bank B.

Repo Yield
 Agreed upon by the two parties.
 Because repos are collateralised (i.e. secured loans), the yield is often less than the cash
rate.

Commercial Paper
 Commercial papers are unsecured promissory notes which are issued by large corporations.
 Firms of high credit rating issue commercial papers as an alternative to borrowing from a
bank.

Issuing Commercial Paper

 Firms issuing commercial papers can sell it through an underwritten or non-underwritten
process.
 Underwriting – guarantee that the issue will be taken up by investors.
 Non-underwritten – cheaper, because an underwriter does not have to be paid for.
Essentially the underwriter will purchase in the case that it cannot get investors to.

Commercial Paper Yields

 Commercial papers are discount securities.
 Thus, they follow the same formula as treasury notes.

Negotiable Certificates of Deposit

 A negotiable certificate of deposit (CD) is a term deposit which is negotiable.
 Used to attract large corporate deposits.
 Corporations buy CDs because they can earn a low risk return on excess cash. Banks in
Australia are very secure, e.g. they did not collapse in the GFC.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 A secondary market exists, meaning that CDs can be bought and sold on the markets.

Yields
 Yields are agreed upon between the buyer and the bank.
 The method of calculating the yield is similar to other short term money market securities.
 Also depends upon the default risk and liquidity of the CD.

Bank Accepted Bills (BABs)

 BABs are the most important instrument on the money market.
 They are a time draft drawn on and accepted by a commercial bank.
 The bank promises to pay the holder of the bill its face value at maturity.
 Thus, they trade as equals on the market.
 Essentially, they are when a company wants to borrow money and has backing of a
commercial bank to pay the bill in the case that the borrower or drawer defaults.
 Characteristics:
o Large denominations (>$100,000)
o Mature in 90, 120 or 180 days
o Can be sold and traded on the secondary market

Bank Accepted Bill Example

1. An Australian buyer of coffee wants to buy from a Colombian exporter. The Australian buyer
will go to a local bank and requests a letter of credit, a document which legally binds the
local bank to paying the exporter once certain conditions are met.
2. The letter of credit and the authorisation for a draft is sent to the Colombian exporter.
3. Colombian exporter will take the draft to a Colombian bank.
4. The Colombian bank will then pay him.
5. The Colombian bank provides the local bank with the draft and shipping documents.
6. The Australian bank will pay the Colombian bank.
7. The Australian buyer of coffee will now have to pay the Australian bank.

Interrelationship of Money Market Interest Rates

 They are all very similar, so their yields tend to move closely together in time.
 However, sometimes spreads do arise. Sophisticated traders woo remove abnormalities
from portfolios and eventually, they will reach normalcy again.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 8 – Equity Markets

Share Ownership in Australia
 Australia has one of the highest proportions of share ownership in the world.
 In 2007, 53% of Australians owned shares, down from 62% pre-GFC.

What are Shares?

Ordinary Shares
 Ordinary shares are the basic ownership claim in a company. I.e. if you own shares in a
company, you own part of that company.
 Shareholders share directly in the profits and losses of the corporation.
 However, it also means that if the firm is liquidated, then shareholders are paid last, i.e. they
have a residual claim on the company’s assets.
 The most a shareholder can lose is the amount of their investment in the firm, i.e. limited
liability. If the firm goes insolvent, shareholders, despite being owners of the firm, do not
have to pay the firm’s debt from their own pockets.

Dividends
 Dividends are corporate payouts to shareholders.
 Dividend imputation is the method of taxation which avoids double taxation. For example, if
the company pays tax on its earnings at the company tax rate of 30% and then we also pay
tax on the dividend at our personal tax rate, then we are essentially paying tax twice on the
same income. Thus, the shareholder only needs to “top-up” the tax.
 A dividend which has been taxed the corporate tax rate of 30% is called a fully franked
dividend.

Voting Rights
 Shareholders elect a board of directors who monitor the activities of the company’s
management.
 The voting takes place at an AGM (Annual General Meeting).

Preference Shares
 Preference shares also represents ownership of a company.
 However, if the firm is liquidated, preference shareholders rank above ordinary
shareholders.
 They normally have a fixed dividend, much like a corporate bond.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 Preference shares are also usually convertible to ordinary shares. They are usually issued at
$100 and have a set dividend for 5 years. After this time, they can either be redeemed at
face value, converted to ordinary shares, or the holders may accept the reset terms and
continue to hold preference shares.

Issuance of New Equity

 New issues of equity is sold on the primary market and the offering of shares for the first
time to the public is known as an initial public offering (IPO).
 The seller receives the proceeds of the IPO and investors will receive the shares.
 The IPO is not the only way to issue new shares, however, there are other ways to issue new
shares in the primary market including:
o Dividend reinvestment schemes, which allow dividends to be reinvested into shares
by shareholders at a discount, i.e. for less than the market price.
o Rights issues, the issuance of new shares to existing shareholders, also called a
seasoned equity offering (SEO).
 Book builds – a system for institutional investors to bid for a block of IPO, these bids are
used by the firm to determine its share price.
 Share splits – division of the entity’s shares into smaller denominations whilst the
capitalisation of the company stays the same. Share amalgamations – the opposite of share
splits, where shares are combined into bigger denominations whilst the capitalisation of the
company stays the same.

Secondary Markets
 After the equity has been issued on the primary market, it will be traded on the secondary
market.
 For example, investors might decide to sell the shares they have bought to other investors
on an exchange such as the ASX.
 When an investor is holding a particular share in their portfolio, they are said to be long on
those shares.

Short Sales
 If an investor who is holding a particular share in their portfolio is said to be long on those
shares, then the opposite position will be where an investor is in a short position.
 When investors think that share prices will fall, they may borrow shares and sell them
without actually owning them.
 This is known as a short position.
 Investors will have to buy back those shares again at a lower price at a later date.
 Short selling is strictly regulated and scrutinised.

Process of Short Selling

 Investors borrow stocks from dealers for a small fee and sell them at market price.
 If the stock price falls, then the investor can buy back those stocks at a lower price and
return them to the dealer, making a profit.

Covered Short Sale vs. Naked Short Sale

 A naked short sale is one in which the investor shorts a stock without first borrowing it. This
might occur when the inventory of a stock is limited and finding shares of the stock to
borrow might be difficult.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Equity Trading
The Australian Securities Exchange (ASX)
 Equity trading is usually conducted over an exchange, the largest of which is the ASX.
 All transactions are done electronically.
 Investors, when buying or selling shares, can choose to place either market or limit orders.
o A market order is an order to buy or sell at the best possible price available at the
time. Essentially, a market order will be executed immediately at whatever is the
best current price of the stock when the order is placed.
o A limit order is an order to buy or sell at a designated or better price. E.g. If buying a
stock and the current price is above the designated price, then the order will wait
until the stock price is at or below the designated price before executing.

Market Characteristics
 The essential functionality of secondary markets is to provide liquidity at fair prices – i.e.
providing a way for investors to buy and sell securities at fair prices.
 Liquidity is the ease with which an asset can be converted to cash without a loss in value.
 Characteristics which relate to liquidity include:
o Market depth – a feature of a secondary market if orders exist both above and
below the price at which a security is currently trading. This will lead to market
efficiency.
o Market breadth – a feature of markets where the orders that give the market depth
exist in significant volume. It is no good having scarce trades.
o Market resilience – a feature of a market if new orders pour in promptly in response
to price changes resulting from order imbalances. For example, if everybody
suddenly wants to sell a share, then the share will, of course, decrease in price. In a
resilient market, investors will jump onto those shares and buy them, thus, pushing
the price back up.

Regulation
 ASX is regulated by ASIC.
 Behaviour of companies listed on the ASX is regulated by the ASX itself. Companies who do
not behave and follow ASX requirements will have the trading of their shares suspended.

Equity Valuation
Earnings
 Dividend yield – dividend/stock price – expressed as a percentage.
 P/E ratio – price/earnings – i.e. how much we have to pay for $1 of earnings.

Share Valuation
 Covered in Corporate Finance
o Preference share valuation using the perpetuity model.
o Ordinary share valuation using the growing perpetuity model.
o Ordinary share valuation using the variable growth model.

Rights Issue Valuation

 Theoretical value of a right:
𝑁(𝑃𝑚 − 𝑆)
𝑅=
𝑁+1
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 Theoretical value of the shares after the rights issue:

𝑁𝑃𝑚 + 𝑆
𝑃𝑥 =
𝑁+1
o N is the number of shares required to be held to receive one right.
o Pm is the market price of the share.
o S is the subscription price – the price it costs to buy the share as part of the rights
issue.
 For example, let’s say that a company offers a 2:11 rights issue at $10.80 per share, with the
market value at $14. What this means is that we receive 2 rights for every 11 shares held.
We can calculate the theoretical value of one of these rights:
5.5(14 − 10.80)
𝑅= = $2.71
6.5
 Another way of thinking about this is to reason that a shareholder must own 11 shares
worth $154 (i.e. 14 x 11) in order to buy two shares at $21.60 (i.e. 10.80 x 2). Thus, the
shareholder will end up with 13 shares for a total of $175.60, meaning that each share is
worth $13.51. Since the subscription price is $10.80, the right is worth 13.51 – 10.80 = $2.71.
 We could have also used the formula to work out the ex-rights share price.
5.5 × 14 + 10.80
𝑃𝑥 = = $13.51
6.5
Equity Risk
 Covered mostly in corporate finance.
 The total risk is the sum of systematic and unsystematic risk.
 Systematic risk affects the entire market similarly and cannot be diversified away. Also
called diversifiable or business risk.
 Unsystematic risk is specific to individual securities and can be diversified away. Also called
market risk.

Portfolio Theory
 Since no two stocks have a correlation of +1, by combining more stocks into a portfolio, we
will always be reducing unsystematic risk.

Measuring Systematic Risk

 Systematic risk is measured by beta, which is the extent to which the share’s returns are
related to the risk of the market portfolio.
 Shares with beta < 1 have less systematic risk than the market portfolio.
 Shares with beta > 1 have more systematic risk than the market portfolio.

Security Market Line

 Plot of the expected return against systematic risk, i.e. beta.
 Y-intercept is the risk free rate.
 When beta is 1, the expected return is the expected return of the market portfolio.
 The slope is the risk premium, i.e. the expected return of the market minus the risk free rate.
 The equation which plots the SML is the CAPM equation:

𝐸(𝑅𝑗 ) = 𝑅𝐹 + 𝛽𝐽 (𝐸(𝑅𝑀 ) − 𝑅𝐹 )
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Share Market Indices

 Share market indices share summarise a lot of information generated by the buying and
selling of shares.

Price Weighted Index

 Sum the prices of the individual shares comprising the index.
 The sum is divided by a divisor to yield the base index value. The base value for the ASX200
is 31 December 1979 = 500.
 As the share prices change, the divisor remains constant.
 If, on average, share prices go up, the index will go up and vice versa.

Market-Value Weighted Index

 Calculate the total market value of all of the firms in the index.
 Calculate the total market value of all of the firms in the index on the previous trading day.
 The percentage change from one day to the next represents the change in the index.

Differences between Price Weighted and Market-Value Weighted

 The market value index would perfectly track capital gains on the underlying index, although
dividends would not be included.
 Price weighted indices track the returns on a portfolio composed of equal shares of each
company. Share splits will affect the price-weighted index, but not the market value index.
 The price weighted indices are most affected by the most expensive shares. Market value
indices are affected most by the largest companies by capitalisation.

Share Market and Economic Activity

 Changes in share prices may precede a recession. If a recession is expected, lower returns
are expected and investors will pay less for shares.
 Share price declines will reduce the wealth of investors and the confidence of consumers.
What happens is that people, as a whole, have less money to spend, thus, consumption
decreases, resulting in a decrease in GDP.
 Despite this logic, past data shows that the share market has not been very successful at
predicting recessions.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 9 – Derivative Markets

Derivative Markets
 A derivative is a security whose value is derived from some underlying security.

Forward Contracts
 A forward contract guarantees the delivery of an amount of goods on a specific day in the
future.
 It is an agreement between two parties, a seller (short position) and the buyer (long
position), for the buyer to purchase a set amount of goods from the seller at a pre-
determined price, called the forward price at a pre-determined date, called the settlement
date.
 The opposite of this is the spot market, where the sale is made immediate payment is made
for immediate delivery of securities at the spot rate.
 A forward contract is legally binding and must be adhered to by both parties. There is
however, a risk that the counterparty defaults.

Forward Price
 The forward price for an asset is the price that makes the forward contract have a zero NPV.
 Example of calculating the forward price:
o Hilary wishes to buy one-month Treasury notes in two months. The total face
amount of securities she plans to buy is $5 million. The current price for one-month
T-notes is $992,537 per $1 million face amount. If the current effective annual risk-
free rate over the two months is 3%, the rate for two months is 0.5%. The fair
forward price is $992,537 * 1.005 = $997,500.
o Thus, the total price Hilary should pay is $4,987,500 (i.e. $997,500 * 5).
 Essentially, what was done above was us calculating how much Hilary should pay for the
bonds in 2 months’ time. Of course she should pay more, because in the meantime, she can
invest her cash in other securities.
 For securities which require storage costs, e.g. commodities, the forward price will be higher
to offset these costs.
 For securities which pay income, e.g. dividends on shares, the forward price will be lower to
compensate the buyer.

Example of a Forward Contract

 Most common forward contract is in the foreign exchange forward market.
 These markets let people guarantee a currency exchange rate at some specific forward
point.
 For example, an importer needs to pay an overseas supplier for delivery of merchandise. It
would benefit both the importer and the supplier for them to lock in an exchange rate.
 The risk of default on forward exchange contracts is small and by undertaking this forward
contract both parties will reduce the risk inherent in future dealings. It is very difficult to
predict future foreign exchange spot rates.
 Forex dealers make their money on the spread between buying and selling prices for foreign
exchange.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Futures Markets
 Futures contracts are similar to forward contracts, in that they have similar key
characteristics, however, they also have many differences.

Futures Markets vs. Forward Markets

 Futures trade on organised exchanges such as the ASX.
 Futures contracts are standardised in quantities, delivery periods and grade of delivered
products.
 In a futures contract, parties hold contracts with the exchange (or clearinghouse), not with
each other. This reduces the risk involved. It is technically called novation. Thus, parties do
not need to worry about the creditworthiness of the counterparty.
 Futures exchange is protected from default risk by requiring daily cash settlement of all
contracts, called marking to market. What this means is that profits and losses are settled
each day through margin money rather than at the end of the period as with forward
contracts.

Futures Markets Terminology

 Contract unit – standard quantity of a good in a futures or options contact.
 Contract/delivery month – month in which delivers are made or contracts terminated.
 Last trading day – the last day on which trading occurs in a particular contract.
 Deliverable contracts – contracts in which the goods involved may be delivered or
purchased.
 Mandatory-settled contracts – contracts which are non-deliverable and are settled in cash.
 Cash settlement price – the price at which an open futures contract is settled in lieu of
delivery or physical purchase.

Margins
 Let’s say a firm wants USD in 2 months’ time and sells an AUD contract (AUD contracts are
standardised at $100,000 AUD) for $80,000 USD. If the spot exchange rate rises and the firm
can get $90,000 USD with $100,000 AUD, then it would make sense for them to just forget
the futures contract and buy their USD on the spot market. Why don’t firms do this?
 The answer lies in the margin requirements system.
 In order to minimise the risk of default, the clearinghouse requires the posting of a margin.
 Essentially, this is a deposit which ensures the completion of the contract. The clearinghouse
will manage the margin requirements continuously.
 When the trader experiences a loss, they may need to post additional margin in their
account, this is called marking to market.
 The margin is a bond to ensure that both parties will adhere to the contract, much like
property bonds are to ensure tenants pay their rents and don’t wreck the property.
 If payments are not received on time, then the clearing house will close out (cancel) a
contract, meaning it will take out a sell contract for the same goods so that the two
contracts cancel out and the margin account of the defaulting trader is decreased by the loss
represented by the difference between the open position and the closing-out value.
 The clearing house will ensure that the margin account is sufficiently funded at all times, so
that they won’t be at a loss if they need to cancel a contract.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Uses of Financial Futures Markets

Reducing Systematic Risk
 The SPI 200 is a share index futures contract which is based on the ASX200.
 It allows investors to alter the systematic risk of their portfolios.
 By having a long position in shares and a short position in the SPI futures, an investor can
offset the systematic risk of their portfolio.
 Example:
o An investor has an $11 million portfolio with a beta of 1. The portfolio moves in lock-
step with the ASX200.
o The SPI future contract is selling at 4400. $25 per point, so one contract is worth
$110,000. This means the investor needs to short 100 contracts to get the same
effect as selling $11 million in shares with a beta of 1.
o The investor is long shares and short futures. The net effect is a portfolio with a
beta of 0.
 If the investor has a portfolio with a beta greater than 1, then the investor will need to
purchase more futures contracts. If the investor has a beta of 1.2, for example, then 20%
more futures contracts will need to be purchased.
 Hedging against the SPI is a strategy for portfolio insurance. If an investor believes that the
market will fall, they will short SPI futures, protecting them from a fall, but at a cost of
reducing any potential gains.

Arbitraging
 Arbitraging is to attempt to exploit small differences in prices between different markets
(e.g. the stock market and the futures market) to make a profit, less transaction costs.
 Example – SPI futures are selling at 4400 and expire in 3 months. The underlying shares in
the ASX200 are selling for an equivalent price of 4200 right now. Arbitrageurs can buy the
shares and sell futures short, thus guaranteeing a riskless 4.7% gain, less transaction costs.
The arbitrageur might gain even more through the accrual of dividends during this period.
 When share-index futures prices rise too far above share prices, arbitrageurs sell the futures
index and quickly buy great amounts of shares that replicate the price movement of the
underlying share index, driving the share market up sharply.
 Another tactic would be if an investor wants to earn a return equal to or greater than a
specific share index. If both share indices and the equivalent futures index sold at 4400, the
portfolio manager could buy the futures and sell the shares. The proceeds from the sale can
be invested in short-term, low-risk securities to earn a small return. For example, if the
return earned was 1.5% every quarter, then the share fund would have $4466 for every
$4400 of shares sold. But since the investor owned a futures contract purchased at a price of
4400, he will be able to reinvest in the same shares for a net price of 4400 when the futures
expired.
 Index arbitrageurs try to profit by either:
o Earning a riskless return slightly greater than the risk free rate
o By selling shares and investing in bills to beat the share market
 Whenever the value of a share-index futures contract is not equal to the value of its
underlying shares, they will buy and sell huge quantities of shares. By doing so, they keep
the share-index futures prices in line with the value of the underlying shares.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 Example – CBA’s futures are selling at 52000 and expire in 3 months. The current market
price of CBA is $54 per share. This can be exploited by buying the futures contract and
shorting 1000 shares in CBA at $54 each, thus, making a risk-free return of $2,000.

Guaranteeing Cost of Funds

 Sometimes a corporation might plan to make a major investment and commit itself to major
cash outlays for several years in the future. There is always a risk that interest rates will rise,
thus the firm will have to pay more than it anticipated.
 This risk can be hedged by selling bond futures.
 If interest rates rise, the bond futures price falls, compensating the increase in the interest
the firm has to pay.
 However, of course, should interest rates fall, the firm will not benefit of making less interest
payments as the price of the bond futures will rise.
 For example, if a firm wishes to borrow $10 million now and $10 million in a year’s time, the
firm can issue $10 million worth of bonds now and sell three-year government bond futures
with a market value of $10 million for delivery in one year’s time. Thus, the firm will be able
to obtain a known interest rate for issuance of bonds in one year’s time. Changes in the
interest rate will be offset by the increase in price of the government bond futures prices.

Hedging a Balance Sheet

 Financial institutions can use the futures market to hedge against interest rate risk.
 For example, if an institution holds fixed-rate mortgages in its portfolio, if the interest rate
increases, their mortgages will be worth less and vice versa.
 By hedging against government bond futures, the financial institution can hedge against
interest rate risk. The institution will short government bond futures, so if interest rate
increases, the futures contracts will now be worth less, thus the institution will make a gain
from the short position.

Risks in Futures Markets

 Basis risk – risk that derives from the failure of the spot price to always keep the same price
relationship with futures contracts. For example, the fall in share prices in the spot market
might not be the same as the fall in price of SPI 200 futures. Basis risk is amplified by cross-
hedging, where a traded futures contract does not exactly match the hedger’s risk
exposure.
 Related-contract risk – sometimes a bank might hedge its loans and interest rates fall, this
causes a loss on the sale of futures contracts and then borrowers proceed to repay loans
early, thus, the bank loses on the futures contracts, but does not make the amount back in
interest revenue.
 Margin risk – the risk that parties have illiquid assets and cannot continue to post
maintenance margin funds.

Options Markets
 Options give the firm the ability to hedge against losses, but not eliminate gains if prices
move favourably.
 ASX trades options on share indices and many individual shares. SFE trades options on many
of the futures contracts there.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Options Basics
 Refer to BFC3140.

Options vs. Futures

 For futures gains and losses can vary virtually without limit.
 For example, a fund manager things interest rates will decline. To take advantage of the rate
decline, the manager might want to buy long-term bonds which would increase in value as
the rates declined.
 In order to shield her from the risk that rates increase instead, she can sell bond futures. If
rates increase, she is safe. However, if rates fall, any gains she makes from the bonds will be
lost on the futures contract.
 Thus, the fund manager might prefer to buy a bond put option. If bond prices fall, the put
option will rise in value and offset the loss on the bond portfolio. However, if rates fell, as
predicted, the option would not be exercised. Thus, only the premium will be lost.

Regulation of Futures and Options Markets

Australian Regulators
 ASX is partly self-regulated but also joins with ASIC
 ASIC and RBA are co-regulators of clearing and settlement.
 Similar regulatory arrangement occurs at the ASX.

International Regulators
 US Commodity Futures Trading Commission
 Securities and Exchange Commission
 UK Financial Services Authority
 Hong Kong’s Securities and Futures Commission

Swap Markets
 Swap markets involve the exchange of payment obligations on two underlying financial
liabilities where principal amounts are the same, but payment patterns are different.

Notional Principle
 Swap transactions only involve a net transfer of funds.
 If one party in a swap owes the other 6% on a notional principal of $1 million and the other
party owes the first 5%, then the first party pays the second party $10,000 per year.
 The principal actually never changes hands.

Fixed-for-Floating Swaps
 The most standard swap is one which allows a floating-rate borrower to become a fixed-rate
borrower and for a fixed-rate borrower to become a floating rate-borrower.
 This does not mean that they agree to take over the other’s interest obligations, both still
remain liable for the payments of their own loans.
 The reason why parties would want to enter into a swap is to take advantage of credit risk
differentials and to hedge interest rate risk by exchanging fixed rate payments for floating
rate payments.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Comparative Advantage
 There is usually a difference between the fixed borrowing rate and the floating borrowing
rate. Swaps enable two borrowers to take advantage of this situation and for both parties to
reduce borrowing costs.

Example
 Firm AA can borrow fixed at 7% and floating at BBSW (bank-bill swap rate) + 0.1%.
 Firm BB can borrow fixed at 9% and floating at BBSW + 1.7%.
 Let’s say Firm AA wants to borrow floating and BB wants to borrow fixed.
 Instead of AA paying BBSW + 0.1% and BB paying 9%, these parties can enter into a swap.
 AA takes out a fixed loan at 7%, BB takes out a floating loan at BBSW + 1.7%, the opposite of
what they were both after.
 They then organise a swap, such that AA pays BB the BBSW rate and BB pays AA 7.1%.
 The net result of this is that AA is borrowing at a rate of BBSW – 0.1% and BB is borrowing at
a rate of 8.8%, both are 0.2% better off than they were before the swap.
 The reason why this situation can occur is because the markets have misjudged the risk
premiums for fixed and floating rate loans for the two companies. AA’s floating rate is too
high and BB’s fixed rate is too high. Thus, they do a swap to take advantage of AA’s lower
fixed rate and BB’s lower floating rate.

Swap Dealers
 Swaps are arranged with dealers in an OTC market.
 These dealers earn a spread between the paying and receiving rates.
 When fixed rate > floating rate, the spread is between the paying and receiving fixed rates.
 When floating rate > fixed rate, the spread is between the paying and receiving floating
rates.
 Dealers enter swaps with both parties.
 Swap payments are subject to default risk, but the potential losses are small compared to
the nominal value of swaps.

Hedging Using Swaps

 Banks with a gap between rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs) can
use swaps to hedge those gaps and limit their interest rate exposure.

Regulation of Swap Markets

 Less regulated than other markets.
 No central clearinghouse.
 APRA plays regulatory role.
 Defaults on swaps are low, but banks are required to apply risk-adjusted capital
requirements to swaps.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 10 – International Markets

Difficulties of International Trade
 Companies and individuals who engage in international trade expose them to two risks
which are not present when trading within Australia:
o Currency risk – the risk that the changes in foreign exchange values affects the
returns on loans or investments which are in other currencies.
o Country risk – the risk that is tied to political developments in a country that affects
the return on loans or investments.
 The difficulty of trading internationally comes from two main sources:
o The fact that the different countries use different currencies can lead to currency
and country risk.
o The laws might be different in a foreign country, thus, meaning that there might be
no system such as the courts in order to settle disputes. Furthermore, credit ratings
and such information might not be reliably available.
 In order to facilitate these transactions and minimise these issues, there exists two distinct
international markets - the international money and capital markets (for lending and
borrowing) and the foreign exchange markets (for payment).
 The three main purposes of the FX markets are to:
o Facilitate cross-currency payments
o Reveal the value of currencies
o Allow traders to manage their FX risk
 It is impossible to send funds across international borders without using the FX market.

Exchange Rates
 An exchange rate is the rate at which one currency can be exchanged for another at the
present time.
 There is a very specific way that exchange rates are quoted. When we quote exchange rates,
we quote the base currency (also called the commodity currency) in terms of the terms
currency. Thus, if we are quoting the price of the USD in terms of the AUD, i.e. much is the
cost of 1 USD in AUD, then the USD is the base currency and the AUD is the terms currency.
 The base currency is the currency we want to have one unit of. The terms currency is the
currency which is used to express how much that one unit of base currency is worth.
 If we wanted to write that the cost of 1 USD is 1.3333 AUD, then we will write USD/AUD –
1.3333. The base currency is the first, the terms currency is the second.
 When we obtain a quote, we can obtain a direct (price) quote or an indirect (quantity)
quote.
 A direct quote gives us how much of other currencies we can buy with our currency. For
example, we might have direct quotes for USD, JPY and EUR – these quotes will tell us how
much AUD a unit in those currencies will cost.
 An indirect quote is the opposite, it gives us how much 1 AUD is worth in other currencies.
For example, we might have indirect quotes for USD, JPY and EUR – these quotes will tell us
how much USD, JPY and EUR it will cost to buy 1 AUD. This is the more natural way of
informing Australians of the value of their currency.
 When exchange rates change, the cost of buying a product from another country changes.
For example, if we were buying steel from the UK, we will have to convert our AUD to GBP. If
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BF2000 – Financial Institutions and Markets

the value of the GBP suddenly decreases, then the cost of the steel will decrease despite it
still being the same product and despite that the steel still costs the same amount in the UK.

The Equilibrium Exchange Rate

 As with goods, the price for currency is dictated by supply and demand. The supply and
demand for a particular currency will determine its value.
 Before looking at the graphs, we need to define appreciation and depreciation.
o Appreciation – when a currency is now worth more in another currency than it was
before. For example, if 1 USD can now buy MORE AUD, then we will say that the
USD has appreciated against the AUD.
o Depreciation – this is the opposite, when a currency is now worth less in another
currency than it was before. For example, if 1 USD can now buy LESS AUD, then we
will say that the USD has depreciated against the AUD.

 GBP is the commodity currency and the AUD is the terms currency, i.e. indirect quotes.
 On the graph on the right, we can see the demand and supply curve for the GBP from
Australia. The downward sloping demand curve shows that the lower the price of the GBP,
the more Australians want to buy GBP, it will be cheaper to buy the same goods from the
UK. Supply is opposite, when the exchange rate is low, less people in the UK want to sell GBP
for AUD.
 In this situation, supply and demand will reach an equilibrium point of GBP/AUD – 2.00. In
order for this equilibrium to be disturbed, there needs to be a change in the demand or
supply.
 The demand will go up if there is a sudden surge of Australians wanting to buy GBP, this can
happen when the incomes increase in Australia, it encourages foreign spending and
investment. When this happens, Australians buy more GBP and as a result, the price of the
GBP is pushed up to $2.50 AUD.
 On the other hand, there can also be a change in supply, i.e. when the Brits want more/less
AUD. If they wanted more, then the GBP will the GBP will depreciate against the AUD.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Currency Quotations
 In the interbank spot FX market, the spot rate is always quoted as a 2 way price.
 The buying price is called the bid price and is on the LHS and the selling price is the offer
price which is on the right hand side.
 For example, if an interbank dealer quotes spot AUD/USD as 0.7850/0.7860,
o This means that the dealer is willing to buy AUD at $0.7850.
o On the other hand, they are willing to sell AUD at $0.7860.
 The spread is the difference between the buy price and the sell price, here it is $0.0010, or
10 pips (or points). A pip or a point is the last decimal place a currency is quoted in.

Currency Quotation Example

 The USD/SGD bid and offer prices are 1.7570 – 1.7580. This means that the dealer will buy
USD or sell SGD at 1.7570 USD/SGD, but, sell USD or buy SGD at 1.7580 USD/SGD.
 The bank which gives the quote is known as the quoting bank.
 On the other hand, however, the bank which requests the quote and receives it is called the
calling bank. It is important to note that for the calling bank, it is selling USD or buying SGD
at the bid rate of 1.7570 USD/SGD and buying USD or selling SGD at the offer rate of
1.7580 USD/SGD.
 The spread is 10 pips, thus for every USD bought using 1.7570 SGD and then subsequently
sold for 1.7580 SGD, 0.0010 SGD is made.
 Thus, if 1M USD is bought and then sold, a profit of 1,000 SGD will have been made.

Operations of the Foreign Exchange Markets

 There are two types of foreign exchange transactions – outright transactions and swap
transactions.
 Outright transactions can be made with spot rates for immediate payment (2 days) or with
forward rates for future payments.
 Swaps are where we buy and sell one currency against another currency for different
maturities.

Spot Transactions
 These are the most basic and involve exchanging one currency for another at an agreed rate
for delivery two days after the contract date (the date on which the transaction took place).
 The delivery date is the date where settlement occurs, i.e. when the cash actually moves (i.e.
2 days after the contract date).
 If we are given a spot rate of AUD/USD 0.7170/80, this means that we can sell AUD for
0.7170 USD or buy AUD for 0.7180 USD. If the contract date is the 4th of April 2006, then the
delivery date will be the 6th of April 2006.

Forward FX Transactions
 The forward rates are the buy and sell rates which apply when the deal is made now, but
delivery is in the future. For example a 1 month forward rate will deliver on the 8th of May if
the contract was agreed on the 4th of April (1 month + 2 days).
 The forward FX market is used to hedge against speculation by locking in an exchange rate
now. If a business in Australia wishes to buy goods from the UK for payment in a months’
time, both parties might want to lock in a forward rate now, rather than be exposed to the
risk of the spot market.
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BF2000 – Financial Institutions and Markets

Swap Transactions
 Swap transactions are when we purchase and sell a given amount of foreign exchange for
two different value (delivery) dates.
 Both the purchase and the sale are conducted with the same counterpart.
 Example – spot against forward swap – the dealer buys a currency in the spot market and
sells the same amount of currency back to the same dealer/bank in the forward market, of
course at a different price.

Balance of Payments
 The balance of payments is a set of accounts which summarises a country’s international
balance – i.e. how much it receives and how much it pays out to foreigners.
 Australia, for a long time, has always had a deficit in its balance of payments, meaning that
we have consistently paying out more money than we are receiving.
 The balance of payments must balance – i.e. the Current Account Balance + Financial
Account Balance + Change in Official Reserve = 0.
 Of course, there are unreported transactions, timing problems and errors, thus, a balancing
item called errors and omissions is added to the balance of payments.

The Current Account

 The current account summarises foreign trade plus investment income or gifts and grants
made to other countries.
 Australia usually has a current account deficit meaning that our imports exceeds our
exports.

The Financial Account

 The financial account represents the flow of capital. Thus, foreign investment in Australia
brings in money and Australian investment in foreign countries takes money out.
 Australia usually has a financial account surplus, meaning that foreigners invest more in
Australia than Australians invest overseas.
 This is how we pay for our current account deficit, the other way of paying for the current
account deficit is to borrow abroad. The downside of having a surplus financial account is
that a lot of Australian assets such as iconic brands and real estate are being sold to foreign
investors.

International Trade and Exchange Rates

 The classical theory of international trade says that nations produce the goods and services
for which they have a comparative advantage and they trade with foreigners to obtain other
goods and services.
 Thus, factors which can affect the demand of these imports and exports can affect the
foreign exchange rates.
 These factors include:
o Relative prices – relative costs of the factors of production varies between
countries, e.g. Labour is very cheap in China, thus, goods which are labour intensive
to produce will be cheaper if produced there. Therefore, as a result of people buying
from China, the Yuan has appreciated due to the increased demand.
o Barriers to trade – sometimes taxes and tariffs can be imposed by the government
on imports to persuade people to buy locally. For example, if there was to be a tariff
on Japanese cars, then the JPY will depreciate against the AUD due to less demand.
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BF2000 – Financial Institutions and Markets

o Resource endowments – different parts of the world have different sorts of

resources, e.g. the Middle East has a lot of oil, the US has a lot of capital, China has a
lot of labour…etc. Depending on the relative balance of trade between these goods,
the currencies of these countries will be affected. E.g. if oil suddenly becomes more
important, then the value of the Saudi Riyal will appreciate.
o Tastes – demand for products from particular places in the world due to consumers.
The higher the demand for products from a particular country, the more the local
currency there will appreciate.
o Productivity – this can also affect the level of imports and exports of a country. If
Australia finds a new method of producing solar panels that makes them more
productive, they will be able to supply goods for a lower cost, thus, appreciating the
AUD.

Purchasing Power Parity

 This is an economic concept which says that the purchasing power of a currency should be
equal in every country if goods, services, labour, capital and other resources can flow freely
between countries.
 However, because there are impediments to free trade (e.g. shipping costs), power parity
conditions do not hold. Thus, goods often cost more in one country than in another.
 Essentially, what this means is that if a Big Mac is 3 USD in the US and 330 JPY in Japan, then
purchasing power parity exists if the exchange rate is USD/JPY 110. If the exchange rate is
higher than this, then the JPY is undervalued or USD overvalued and vice versa.
 Different items have different purchasing power parities. Goods which are easily
transportable, e.g. computer parts, have high purchasing power parity. Other goods such as
Big Macs will have low purchasing power parity due to it being perishable.

Capital Flows and Exchange Rates

 There is a belief that since Australia has run a deficit on its current account for many years
that foreigners will begin to increase their holdings of AUD, thus, selling them to obtain their
local currency and depreciating the AUD.
 However, this hasn’t happened, the AUD has remained very strong.
 This is due to foreign investment in Australia. When foreign investors buy Australian capital
assets, goods and services, the demand for the AUD goes up.
 The demand for investments in Australia is very strong, strong enough to support the AUD
even when Australia runs a current account deficit.

Eurocurrency Markets
 A Eurocurrency is a currency deposited in a bank outside its country of origin, e.g. depositing
USD in an Australian bank.

Features of the Euro-Market

 Unregulated market – i.e. no reserve requirements, less stringent disclosure requirements
 Competitive rates and finer margins
 Less transaction costs – because conversion of currency costs money
 Less exchange risk

Eurocurrency Debt
 Eurocurrency debt allows multinational firms to borrow different currencies at very
competitive rates.
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BF2000 – Financial Institutions and Markets

 It also allows firms with excess liquidity or banks to earn a competitive rate of return.
 It helps to facilitate international trade.
 The relevant interest rate for worldwide overnight borrowing is the London Interbank
Offered Rate (LIBOR), which is usually 10 to 20 basis points higher than the US Federal
Reserve rate.
o The LIBOR is the average interbank interest rate at which a selection of the banks on
the London money market are prepared to lend to one another at.
o 8 different maturities – from overnight to 12 months, 5 different currencies
o Official interest rates are announced once per working day at ~ 11.45 AM.

Eurobonds
 Eurobonds are bonds issued into a particular market that is of a different currency. For
example, a US borrower issues USD bonds into the Australian bond market.
 There are many benefits for firms to issue Eurobonds:
o Attractive to investors who wish to qualify for tax exemption
o Underwritten by an international syndicate of banks, meaning greater volume
o Can borrow at lower rates than just locally

Globalisation of Financial Markets

 The globalisation of business and financial markets has proceeded at a rapid pace over the
last 30 years due to several key changes.
 The demise of the Bretton Woods system of fixed exchange rates has made way for a
floating exchange rate. Deregulation of financial markets have also helped
internationalisation.
 With the floating exchange rates, there is increased demand for foreign exchange and
hedging services due to the need for protection against exchange rate movements.
 In the 1980s, the US had a massive trade deficit which required them to borrow money from
foreigners on an unprecedented scale, this led to the US treasury security market becoming
a global bond market.
 Improvements in computers and telecommunications have also facilitated large scale capital
movements.
 Since people wish to trade in stable, widely accepted currencies, many countries have
moved to the USD as a medium of exchange, so that they don’t face currency risk. Two
thirds of all outstanding US currency is actually held outside the USA.
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 11 – Part A – Investment Banks

Relationship between Commercial and Investment Banking
Investment Banks vs. Commercial Banks
 Investment banks specialise in helping businesses and governments sell securities on the
primary markets – e.g. through IPOs or SEOs.
 After the securities are sold, investment bankers make secondary markets for the securities
as brokers and dealers.
 Commercial banks, on the other hand, specialise in accepting deposits and making loans.
 Traditionally, investment banks have also been referred to as money-market corporations.
 In Australia, commercial banks can enter into investment banking activities and investment
banks, given they acquire ADI status, can conduct commercial banking activities.
 This has led to competition in the financial services sector.

Competition between Commercial and Investment Banks

 Commercial banks usually don’t make very large margins, thus, many pursued investment
banking operations in order to make more margins.
 Investment banks also gradually moved towards providing services which were more the
domain of commercial banks such as short-term financing.

The Future
 Commercial banks entering investment banking can use their names to build strong
businesses, however, the larger investment banking firms are likely to maintain their
dominance.
 Investment banking has been growing strongly in Australia, total assets have grown from
$23 billion in 1985, to $120 billion in 2008, before the GFC. They now sit at around $68
billion in 2010.

Regulation of Investment Banking Activities in Australia

Banking Act 1959
 Investment banks must be an ADI and be regulated by APRA under the Banking Act 1959 if
they wish to engage in commercial banking services, like all providers of commercial banking
services.

Financial Sector (Collection of Data) Act 2001

 If the investment bank only engages in investment banking, it will be regulated by ASIC
under the Financial Sector (Collection of Data) Act 2001.
 This Act requires non-bank financial institutions to register with and provide data to APRA.
However, APRA has no power to supervise their operations unless the institution becomes
an ADI.

Primary Services of Investment Banks

 Initial Public Offerings (IPOs)
 Underwriting
 Trading and Brokerage
 Project Finance
 Mergers and Acquisitions (M&A)
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BF2000 – Financial Institutions and Markets

Initial Public Offerings (IPOs)

 The IPO is where new securities are brought to the market, either by corporate or
government clients.
 New issues of stocks and bonds are known as primary offerings. If a company has never
offered securities to the public before, then this is known as an initial public offering (IPO).
 There are two ways that a firm can offer its securities to the market – a best-effort basis,
where the investment bank tries its best to get a good price or a firm commitment
(underwritten) basis, where the investment bank guarantees that the firm will get a certain
price on their securities.
 The process of bringing securities to the market consists of:
o Origination
o Underwriting
o Distribution

Origination
 During origination, the banker helps the issuer:
o Analyse the feasibility of the project
o Determine the amount of money to raise
o Decide on the type of financing required
o Design the characteristics of the securities
o Provides advice.
 Once these decisions have been made, the banker helps the client prepare the official sale
documents.

Underwriting
 Underwriting involves the investment bank bearing risk. The investment banker guarantees
to buy the new securities for a fixed price.
 The risk is that the securities will be sold at a price less than this amount.
 Underwriters form underwriting syndicates in order to have broader reach and contacts as
well as to decrease the risk.

Distribution
 Once the investment banker has purchased the securities, they must be resold to investors.
The objective is to sell the securities as quickly as possible at the offering price.
 If the securities are not sold within a few days, the syndicate disbands and members sell the
securities at whatever price they can get.

Trading and Brokerage

 Investment banks provide services as brokers and dealers for existing securities.
 This is where they bring buyers and sellers together and earn a commission.
 Dealing involves making a market and seeing the banker stand ready to buy or sell the
security.
 There are two types of brokerage firms.
 Full service brokerage firms attend to all of a customer’s needs, apart from buying and
selling securities, they also offer storage, execution of trades, investment advice, margin
credit and cash management services.
 Discount brokerage firms are a more recent type of brokerage firm who offer fewer services
and pass the savings onto clients. All they do is simply take orders.
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BF2000 – Financial Institutions and Markets

Project Finance
 Another service investment banks provide is giving advice and services in regards to the
financing of large projects.
 Project financing differs from other lending in a number of ways:
o The project itself, not the company involved, is financed.
o Finance is usually on a limited recourse basis.
o Syndication is involved to share the risk amongst the financiers.

Mergers and Acquisitions

 Investment banks also assist companies with mergers and acquisitions and it is a high-profit
business for investment banks.
 Services include:
o Identifying candidates for M&A
o Pricing the deals
o Providing advice and negotiating the deal
o Obtaining funds to finance the acquisition
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 11 – Part B – Other Financial Institutions

Insurance Companies
 Insurance is the transfer of a pure risk (a risk where there are only two possible outcomes –
loss or no loss) to an entity that pools the risk of loss and provides payment if a loss occurs.
 Insurance policies are contracts between the insurer and the insured to cover the loss that
may be suffered. In return, the insurer receives a fee, called the insurance premium.

Objective Risk
 The risk that insurers face once they have accepted the risk from the insurance purchasers is
known as objective risk. This is essentially the deviation between actual losses and expected
losses.
 The insurance premium is set so that expected losses and expenses are covered.
 If losses are as predicted, the insurance mechanism will work well.
 There are ways in which insurers reduce their objective risk:
o Law of large numbers
o Careful underwriting
o Co-insurance
o Careful pricing
o Restrictive covenants
o Reinsurance

Privately Insurable Risks

 Certain conditions must be met before a private company can insure risk:
o There must be similar exposure units so that the risk can be predicted using the law
of large numbers.
o Losses should be accidental and unintentional.
o Losses must not be catastrophic.
o Losses should be determinable and measurable.
o The change of loss should be calculable.
o The premium for insurance must be affordable.

Regulation
 Insurance is regulated by APRA, who are responsible for the prudential regulation of
insurance companies and monitors capital requirements and liquidity management.

How Insurance Companies Make Money

 Insurance companies generate profits by collecting premiums. These premiums are then
pooled and used to pay claims on policies.
 If the premiums collected > claims made, then the company has made an underwriting
profit.
 The insurance company also earns investment income on the pooled premiums.
 The insurer must change a premium that is high enough to cover claims and administrative
expenses, but low enough so that they will be competitive.
 Essentially, pricing is a statistical exercise, relying on the probability of insured events
occurring.

Relevance of Interest Rate Risk

 For commercial property and liability insurance, interest rates are important.
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BF2000 – Financial Institutions and Markets

 When interest rates are high, companies will tend to write a lot of businesses. They get lots
of premiums and invest those premiums at the higher rate.
 When interest rates fall unexpectedly, however, insurance companies might get in trouble.

Types of Insurance
 Life insurance – to provide financial support to dependants in the case of premature death.
 General policies – insure a variety of risks, e.g. property, liability, motor vehicle, travel.
 Health insurance – insure against the medical costs associated with illness and injury.

Issues Faced by Insurance Companies

 Adverse selection – those who are most likely to suffer a loss are most likely to insure.
 Moral hazard – when those insured are more complacent of engage in inappropriate
activities.
 The viability of insurance companies, HIH collapsed in 2001.
 Complexity of insurance contracts – leads to implications for consumer affairs.
 Redlining – refusal to insure certain geographical areas.
 Patents – patenting of insurance products to protect from competitors.
 Securitisation of risk – transfer of risk to capital markets through creating of a financial
instrument.

Investment Companies
 Investment companies gather funds from savers and then invest those funds in capital
markets, money markets or real estate.
 Investors pay a variety of fees in return for enjoying the opportunity to use these investment
products.
 Advantage of investment products is that they provide investors with a diversified portfolio
of assets, reducing risk.

Importance of Investment Companies

 Lots of public interest – grown since the 1990s.
 Assets of life and super funds grew by almost 500% between 1990 and 2009.
 Other managed funds grew by almost 600%.
 Decrease in assets since the GFC.

Open vs. Closed End Funds

 A closed-end investment company sells its shares to the public to obtain cash and then
operates with a fixed number of shares outstanding.
 An open-end investment company stands ready to buy or sell their shares or units at net
asset value at any time. New units in the fund are created when an investment is made and
existing units are redeemed when a withdrawal is made.

Fund Strategies
 Growth and income – balanced return of capital gains and current income.
 Growth – focus on capital gain.
 Aggressive growth – focus on high profits from capital gain.
 Balanced funds – hold a portfolio with fixed proportion of stocks and bonds.
 Income-equity – focus on stocks with high dividend yields.
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BF2000 – Financial Institutions and Markets

 Socially responsible investment (SRI) funds – considers both social and environmental
consequences of investments.

Superannuation
 Government controlled investment strategy aimed at providing resources that can be used
in retirement.
 Ageing population will place a significant burden on public expenditure – social security can’t
be the only source of retirement income.
 Types of superannuation funds:
o Defined benefit – employer states benefit employee will receive at retirement.
o Accumulation fund – where amount received at retirement depends on
contributions made by the employee and earnings on those funds.
 Self-managed superannuation (SMSF) – have fewer than five members and are controlled by
the fund’s trustee. Regulated by ATO. During 2009, became largest category of
superannuation fund.

Cash Management Trusts (CMTs)

 Managed funds which invest in wholesale money-market securities.
 Allows access to money markets with relatively little invested cash.
 Low interest rates -> decrease in popularity of CMTs.

Public Unit Trusts

 Public unit trusts are investment funds governed by a trust deed.
 Units in the trust are sold to investors and the funds are invested in accordance with the
trust deed.
 There are many types of unit trusts – e.g. equity, fixed interest, mortgage, property…etc.

Hedge Funds
 Investment pools that aim to provide consistent, above market rates of return whilst
reducing risk of loss.
 Hedge funds operate by making use of sophisticated financial models to generate buy/sell
decisions.
 Different strategies:
o Fixed income arbitrage
o Index arbitrage
o Closed-end fund arbitrage
o Convertible arbitrage
o Risk arbitrage
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BF2000 – Financial Institutions and Markets

Lists
Week 1
Financial System Roles
 Facilitate flow of funds
 Provide a secure, reliable, cheap mechanism for settlement of transactions
 Mechanism for transfer of risk
 Generation of information – e.g. credit ratings
 Reduction of information asymmetry

Benefits of Intermediation
 Denomination divisibility
 Currency transformation
 Credit risk diversification
 Maturity flexibility
 Liquidity

Types of Risk
 Credit risk
 Interest rate risk
 FX risk
 Liquidity risk
 Political risk
 Reputational risk
 Environmental risk

Efficiencies
 Allocational – funds are allocated to the best use
 Informational – price of securities reflect all known information about them
 Operational – lowest transaction cost possible

Week 2 & 3
Roles of the Reserve Bank
 Monetary policy – i.e. interest rate setting
 Systemic policy
 Payments system
 Banker for Australian government
 Issuance of currency
 Issues Commonwealth government securities
 Maintains foreign exchange reserves

RBA Charter
 Maintaining stability of Australian currency (average price of goods doesn’t blow up)
 Maintaining full employment (everyone who can work and wants to can get a job)
 Maintaining economic prosperity and welfare of Australians (expansion and development)

Payments System
 Payments clearing – see if the payee has sufficient funds in account
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

 ESAs – account financial institutions hold with RBA to transfer funds to settle transactions

APRA
 Regulates the risk taking of financial institutions.
 Aims to manage safety of depositors’ funds.
 Develops and implements prudential regulation, monitors regulated entities.
 Advise government on legislation affecting financial institutions and markets

ASIC
 Regulates financial markets, securities and corporations.
 Consumer protection in superannuation, insurance, deposit taking and credit.

Measures of Money Supply

 M1 – financial assets people use to buy things – currency + current accounts at depository
institutions.
 M3 – M1 + bank deposits of the private nonbank sector (NBFI).
 Broad money – M3 + borrowings from private sector by NBFI less currency and bank
deposits of NBFIs.
 Money base – value of currency held by private sector + value of deposits made by banks
with RBA and other liabilities to the private sector held by RBA.

Changes in Money Supply

 Increase in ESA <-> Increase in money supply. Vice versa.
 Taxes paid, ESA decrease, money supply decrease.
 Government expenditure, ESA increase, money supply increase.
 Issuance of CGS, ESA decrease, money supply decrease.
 RBA sells AUD, increase AUD in circulation, ESA increase, money supply increase. Vice Versa.
 ESA increase, interest rates fall. Vice versa.

Cash Rate
 Cash rate – rate for unsecured overnight loans between banks.
 Signals how monetary policy is proceeding.
 Important because:
o Measures return on most liquid asset
o Integral to monetary policy
o Directly relates to available reserves.
 RBA manipulates supply side, called open market operations

Monetary Policy Transmission (Also vice versa)

 Business investment – interest rate up, more investment
 Consumer spending – interest rate down, more spending
 Net exports – interest rates up, AUD more valuable, more imports, less exports

Realised Rate of Return

 Realised rate higher than expected, i.e. underestimation, borrower benefits
 Realised rate lower than expected, i.e. overestimation, lender benefits
Paul Nguyen – Semester 1 – 2014
BF2000 – Financial Institutions and Markets

Week 4
Reasons for Bank Failure
 Illiquidity – bank cannot liquidate its assets quickly enough to pay depositors
 Inadequate capital – the assets the bank has is too risky relative to the capital base, if the
investments decline, the bank might become insolvent.

APRA’s PAIRS and SOARS

PAIRS – Probability and Impact Rating System

 Inherent risk of an institution

 Management and control of risk – i.e. risk management
 Net risk remaining after consideration of risk management
 Capital support the entity has as a buffer

SOARS – Supervisory Oversight and Response System

 Combines impact and probability ratings to determine the supervisory response that APRA
should take.

Estimating CAR
 Estimate capital base (T1 and T2 capital)
 Calculate total credit risk-adjusted assets for on and off balance sheet items
 Calculate total capital requirements for market and operational risk
 Calculate CAR by dividing 1 by the sum of risk-adjusted assets in 2 and 3, must be > 8%.

Other Prudential and Regulatory Controls

 Banks must be authorised, must demonstrate integrity, prudence and competence
 Regulations on % ownership
 Must provide an annual certification by management of the efficacy of risk management
 Required to report to APRA any new exposures greater than 10% of capital base
 External reviews:
o Requirement to submit various data to APRA
o Direct contact with the institution (meetings, site visits)
o External auditors