This new edition, while maintaining its accessible approach and style, encourages
students to understand, anticipate and challenge the complex and global nature
of finance today.
KEY FEATURES
▶ Currency Contemporary, reliable and authoritative commentary on modern and topical financial
systems, including discussion on ethics and the global financial crisis
▶ New financial case studies With the right balance of local and international examples, students can
understand the global nature of financial institutions through real-world cases
▶ Examples Integrated worked examples and short in-chapter exercises assist student learning by
bridging the gap between theory and application
▶ Pedagogical features An easy-to-read layout includes tagged learning objectives, chapter summaries
and extended learning sections that provide additional resources for self-assessment and study
Financial
Institutions
Instruments
& Markets
9TH EDITION
9e
VINEY • PHILLIPS
Connect is proven to deliver better results. Content integrates seamlessly with
enhanced digital tools to create a personalised learning experience that provides
precisely what you need, when you need it. Maximise your learning with SmartBook,
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McGraw-Hill SmartBook® visit www.mheducation.com.au/student-smartbook
Financial Institutions, Instruments & Markets
Now in its ninth edition, Financial Institutions, Instruments and Markets continues
to be one of the market leaders in financial institutions management. With a wellrespected author team at the helm, it is a comprehensive resource for all students
wanting to learn about the modern financial system, as well as those preparing for
a career in finance.
CHRISTOPHER VINEY
PETER PHILLIPS
www.mhhe.com/au/viney9e
spine: 26mm
FINANCIAL ABBREVIATIONS
ABS
ACCC
ADI
ADR
AFMA
AFR
AGPS
ANZ
AOFM
APRA
ARBL
ASIC
ASX
ATM
AWOTE
BAB
BBSW
BIS
CAR
CBA
CBOT
CD
CDI
CDS
CEDEL
CEO
CGS
CHESS
CLICK XT/ITS
CME
CMT
CP
CPI
CRA
CUFS
EBIT
ECP
EDI
EDR
EFIC
EFTPOS
EMU
EPS
ERM
ESA
ETP
EU
EUR
FDA
FEC
Fed
FRA
FRN
FTSE
FX
G-10
GDP
GDR
GICS
GNE
HPY
IBSA
IMF
IPO
IRR
IWT
L/C
LBO
LEPO
Australian Bureau of Statistics
Australian Competition and Consumer Commission
Authorised deposit-taking institution
American depositary receipt
Australian Financial Markets Association
Australian Financial Review
Australian Government Printing Service
ANZ Banking Group
Australian Office of Financial Management
Australian Prudential Regulation Authority
Assets repriced before liabilities
Australian Securities and Investments Commission
Australian Securities Exchange
Automatic teller machine
Average weekly ordinary time earnings
Bank accepted bill
Bank bill swap rate
Bank for International Settlements
Capital adequacy requirement
Commonwealth Bank of Australia
Chicago Board of Trade
Certificate of deposit
CHESS depositary interest
Credit default swap
Centrale de Livraison des Valeurs Mobilières
Chief executive officer
Commonwealth Government Securities
ASX Clearing House Electronic Sub-register System
ASX securities electronic trading system
Chicago Mercantile Exchange
Cash management trust
Commercial paper
Consumer price index
Credit rating agency
CHESS Units of Foreign Securities
Earnings before interest and tax
Eurocommercial paper
Electronic data interchange
Euro depositary receipt
Export Finance and Insurance Corporation
Electronic funds transfer at point of sale
European Monetary Union
Earnings per share
Exchange rate mechanism (European Union)
Exchange settlement account
Eligible termination payment
European Union
Euro
Fully drawn advance
Forward exchange contract
Federal Reserve Bank (USA)
Forward rate agreement
Floating rate note
Financial Times Stock Exchange
Foreign exchange
Group of ten central banks
Gross domestic product
Global depositary receipt
Global industry classification standard
Gross national expenditure
Holding period yield
International Banks and Securities Association
International Monetary Fund
Initial public offering
Internal rate of return
Interest withholding tax
Letter of credit
Leveraged buy-out
Low exercise price option
WORLD CURRENCIES
LIBID
LIBOR
LIFFE
LIMEAN
LME
LSE
M&A
MA
MBO
MSCI
MTN
NAB
NASDAQ
NBFI
NCD
NGF
NIC
NIF
NPV
NTA
NYSE
OBS
OBU
OECD
OPEC
OTC
P/E
PLC
P-note
PPP
PSBR
PV
PVCF
QIB
RBA
RBL
RBNZ
repos
RITS
ROE
ROI
RTGS
S&P
SEC
SFE
SGC
SIBOR
SIS
SMART
SME
SOMA
SPAN
SPI
SPV
SSP
SWIFT
T-bill
TLC
T-note
TWI
UK
USA
USCP
USSR
VaR
WBC
London interbank bid rate
London interbank offered rate
London International Financial Futures Exchange
London interbank mean rate
London Metals Exchange
London Stock Exchange
Merger and acquisition
Moving average
Management buy-out
Morgan Stanley Capital International index
Medium-term note
National Australia Bank
National Association of Securities Dealers Automated
Quotation System
Non-bank financial institution
Negotiable certificate of deposit
National Guarantee Fund
Newly industrialising country
Euronote issuance facility
Net present value
Net tangible assets
New York Stock Exchange
Off-balance sheet
Offshore banking unit
Organisation for Economic Cooperation and Development
Organization of Petroleum Exporting Countries
Over-the-counter
Price to earnings ratio
Publicly listed corporation
Promissory note
Purchasing power parity
Public sector borrowing requirement
Present value
Present value of cash flows
Qualified institutional buyers
Reserve Bank of Australia
Reasonable benefit limit
Reserve Bank of New Zealand
Repurchase agreements
Reserve Bank Information and Transfer System
Return on equity
Return on investment
Real-time gross settlement
Standard and Poor’s Credit Rating Agency
Securities and Exchange Commission (USA)
Sydney Futures Exchange
Superannuation guarantee charge
Singapore interbank offered rate
Superannuation Industry (Supervision) Act
Specific, measurable, achievable, realistic, timely
Small- and medium-sized enterprise
Surveillance of Market Activity system (ASX)
Standard portfolio analysis of risk
hare price index
Special-purpose vehicle
Special service provider
Society for Worldwide Interbank Financial
Telecommunications
Treasury bill
Transferable loan certificate
Treasury note
Trade-weighted index
United Kingdom
United States of America
United States commercial paper
Union of Soviet Socialist Republics
Value at risk
Westpac Banking Corporation
ARS
AUD
BRL
CAD
CLP
RMB
CZK
DKK
EUR
HKD
HUF
INR
IDR
ILS
JPY
MYR
MXN
NZD
NOK
PKR
PHP
PLN
RUB
SAR
SGD
ZAR
KRW
LKR
SEK
CHF
TWD
THB
TRY
UAE
GBP
USD
VND
spine: 26mm
Argentina
Australia
Brazil
Canada
Chile
China, People’s Republic of
• CNY (traded on-shore)
• CNH (traded off-shore)
Czech Republic
Denmark
European monetary union
• Austria
• Belgium
• Cyprus
• Estonia
• Finland
• France
• Germany
• Greece
• Ireland
• Italy
• Latvia
• Lithuania
• Luxembourg
• Malta
• The Netherlands
• Portugal
• Slovakia
• Slovenia
• Spain
Argentine peso
Australian dollar
Brazilian real
Canadian dollar
Chilean peso
Chinese renminbi (yuan)
Hong Kong
Hungary
India
Indonesia
Israel
Japan
Malaysia
Mexico
New Zealand
Norway
Pakistan
Philippines
Poland
Russia
Saudi Arabia
Singapore
South Africa
South Korea
Sri Lanka
Sweden
Switzerland
Taiwan
Thailand
Turkey
United Arab Emirates
United Kingdom
United States of America
Vietnam
Hong Kong dollar
Hungarian forint
Indian rupee
Indonesian rupiah
Israeli shekel
Japanese yen
Malaysian ringgit
Mexican peso
New Zealand dollar
Norwegian krone
Pakistani rupee
Philippine peso
Polish złoty
Russian rouble
Saudi riyal
Singapore dollar
South African rand
South Korean won
Sri Lankan rupee
Swedish krona
Swiss franc
New Taiwan dollar
Thai baht
Turkish lira
Emirati dirham
British pound
US dollar
Vietnamese dong
Czech koruna
Danish krone
Euro
FINANCIAL ABBREVIATIONS
ABS
ACCC
ADI
ADR
AFMA
AFR
AGPS
ANZ
AOFM
APRA
ARBL
ASIC
ASX
ATM
AWOTE
BAB
BBSW
BIS
CAR
CBA
CBOT
CD
CDI
CDS
CEDEL
CEO
CGS
CHESS
CLICK XT/ITS
CME
CMT
CP
CPI
CRA
CUFS
EBIT
ECP
EDI
EDR
EFIC
EFTPOS
EMU
EPS
ERM
ESA
ETP
EU
EUR
FDA
FEC
Fed
FRA
FRN
FTSE
FX
G-10
GDP
GDR
GICS
GNE
HPY
IBSA
IMF
IPO
IRR
IWT
L/C
LBO
LEPO
Australian Bureau of Statistics
Australian Competition and Consumer Commission
Authorised deposit-taking institution
American depositary receipt
Australian Financial Markets Association
Australian Financial Review
Australian Government Printing Service
ANZ Banking Group
Australian Office of Financial Management
Australian Prudential Regulation Authority
Assets repriced before liabilities
Australian Securities and Investments Commission
Australian Securities Exchange
Automatic teller machine
Average weekly ordinary time earnings
Bank accepted bill
Bank bill swap rate
Bank for International Settlements
Capital adequacy requirement
Commonwealth Bank of Australia
Chicago Board of Trade
Certificate of deposit
CHESS depositary interest
Credit default swap
Centrale de Livraison des Valeurs Mobilières
Chief executive officer
Commonwealth Government Securities
ASX Clearing House Electronic Sub-register System
ASX securities electronic trading system
Chicago Mercantile Exchange
Cash management trust
Commercial paper
Consumer price index
Credit rating agency
CHESS Units of Foreign Securities
Earnings before interest and tax
Eurocommercial paper
Electronic data interchange
Euro depositary receipt
Export Finance and Insurance Corporation
Electronic funds transfer at point of sale
European Monetary Union
Earnings per share
Exchange rate mechanism (European Union)
Exchange settlement account
Eligible termination payment
European Union
Euro
Fully drawn advance
Forward exchange contract
Federal Reserve Bank (USA)
Forward rate agreement
Floating rate note
Financial Times Stock Exchange
Foreign exchange
Group of ten central banks
Gross domestic product
Global depositary receipt
Global industry classification standard
Gross national expenditure
Holding period yield
International Banks and Securities Association
International Monetary Fund
Initial public offering
Internal rate of return
Interest withholding tax
Letter of credit
Leveraged buy-out
Low exercise price option
WORLD CURRENCIES
LIBID
LIBOR
LIFFE
LIMEAN
LME
LSE
M&A
MA
MBO
MSCI
MTN
NAB
NASDAQ
NBFI
NCD
NGF
NIC
NIF
NPV
NTA
NYSE
OBS
OBU
OECD
OPEC
OTC
P/E
PLC
P-note
PPP
PSBR
PV
PVCF
QIB
RBA
RBL
RBNZ
repos
RITS
ROE
ROI
RTGS
S&P
SEC
SFE
SGC
SIBOR
SIS
SMART
SME
SOMA
SPAN
SPI
SPV
SSP
SWIFT
T-bill
TLC
T-note
TWI
UK
USA
USCP
USSR
VaR
WBC
London interbank bid rate
London interbank offered rate
London International Financial Futures Exchange
London interbank mean rate
London Metals Exchange
London Stock Exchange
Merger and acquisition
Moving average
Management buy-out
Morgan Stanley Capital International index
Medium-term note
National Australia Bank
National Association of Securities Dealers Automated
Quotation System
Non-bank financial institution
Negotiable certificate of deposit
National Guarantee Fund
Newly industrialising country
Euronote issuance facility
Net present value
Net tangible assets
New York Stock Exchange
Off-balance sheet
Offshore banking unit
Organisation for Economic Cooperation and Development
Organization of Petroleum Exporting Countries
Over-the-counter
Price to earnings ratio
Publicly listed corporation
Promissory note
Purchasing power parity
Public sector borrowing requirement
Present value
Present value of cash flows
Qualified institutional buyers
Reserve Bank of Australia
Reasonable benefit limit
Reserve Bank of New Zealand
Repurchase agreements
Reserve Bank Information and Transfer System
Return on equity
Return on investment
Real-time gross settlement
Standard and Poor’s Credit Rating Agency
Securities and Exchange Commission (USA)
Sydney Futures Exchange
Superannuation guarantee charge
Singapore interbank offered rate
Superannuation Industry (Supervision) Act
Specific, measurable, achievable, realistic, timely
Small- and medium-sized enterprise
Surveillance of Market Activity system (ASX)
Standard portfolio analysis of risk
hare price index
Special-purpose vehicle
Special service provider
Society for Worldwide Interbank Financial
Telecommunications
Treasury bill
Transferable loan certificate
Treasury note
Trade-weighted index
United Kingdom
United States of America
United States commercial paper
Union of Soviet Socialist Republics
Value at risk
Westpac Banking Corporation
ARS
AUD
BRL
CAD
CLP
RMB
CZK
DKK
EUR
HKD
HUF
INR
IDR
ILS
JPY
MYR
MXN
NZD
NOK
PKR
PHP
PLN
RUB
SAR
SGD
ZAR
KRW
LKR
SEK
CHF
TWD
THB
TRY
UAE
GBP
USD
VND
spine: 26mm
Argentina
Australia
Brazil
Canada
Chile
China, People’s Republic of
• CNY (traded on-shore)
• CNH (traded off-shore)
Czech Republic
Denmark
European monetary union
• Austria
• Belgium
• Cyprus
• Estonia
• Finland
• France
• Germany
• Greece
• Ireland
• Italy
• Latvia
• Lithuania
• Luxembourg
• Malta
• The Netherlands
• Portugal
• Slovakia
• Slovenia
• Spain
Argentine peso
Australian dollar
Brazilian real
Canadian dollar
Chilean peso
Chinese renminbi (yuan)
Hong Kong
Hungary
India
Indonesia
Israel
Japan
Malaysia
Mexico
New Zealand
Norway
Pakistan
Philippines
Poland
Russia
Saudi Arabia
Singapore
South Africa
South Korea
Sri Lanka
Sweden
Switzerland
Taiwan
Thailand
Turkey
United Arab Emirates
United Kingdom
United States of America
Vietnam
Hong Kong dollar
Hungarian forint
Indian rupee
Indonesian rupiah
Israeli shekel
Japanese yen
Malaysian ringgit
Mexican peso
New Zealand dollar
Norwegian krone
Pakistani rupee
Philippine peso
Polish złoty
Russian rouble
Saudi riyal
Singapore dollar
South African rand
South Korean won
Sri Lankan rupee
Swedish krona
Swiss franc
New Taiwan dollar
Thai baht
Turkish lira
Emirati dirham
British pound
US dollar
Vietnamese dong
Czech koruna
Danish krone
Euro
Financial
Institutions
Instruments
& Markets
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ASSURANCE OF LEARNING
Many educational institutions today are focused on the notion of assurance of learning, an important element of some
accreditation standards. This ninth edition of Financial Institutions, Instruments and Markets is specifically created to support
assurance of learning initiatives designed to draw on and expand key knowledge and skill sets required by graduates such as:
communication, initiative and enterprise, self-management, life-long learning, problem solving, technology, teamwork, planning
and organising.1
Chapter learning objectives and pedagogical features throughout the text are developed to directly relate to the learning
outcomes for your course which may assist instructors in making the collection and presentation of assurance of learning data
easier.
AACSB STATEMENT
McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of
AACSB accreditation, Financial Institutions, Instruments and Markets 9e has sought to recognise the curriculum guidelines
detailed in the AACSB standards for business accreditation. A variety of pedagogical features in chapters are designed to
draw on the general knowledge and skill guidelines found in the AACSB standards: communication abilities, use of information
technology, ethical understanding, reflective thinking, critical analysis and diversity and multicultural understanding.2
The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school
and the faculty. While Financial Institutions, Instruments and Markets 9e and the teaching package make no claim of specific
AACSB qualification or evaluation, we have geared pedagogical features and online assessment tools towards some of the
general knowledge and skills areas.
1
2
DEST 2002, Employability skills for the future, Department of Education, Science and Training, Commonwealth of Australia,
www.employmentdirections.net.au/docs/employabilityframework.doc.
AACSB International 2008, Eligibility procedures and accreditation standards for business accreditation, www.aacsb.edu.
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Financial
Institutions
Instruments
& Markets
9TH EDITION
CHRISTOPHER VINEY
PETER PHILLIPS
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Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd
Additional owners of copyright are acknowledged in on-page credits.
Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their
apologies should any infringement have occurred.
Reproduction and communication for educational purposes
The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work,
whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational
purposes provided that the institution (or the body that administers it) has sent a Statutory Educational notice to
Copyright Agency and been granted a licence. For details of statutory educational and other copyright licences
contact: Copyright Agency, 66 Goulburn Street, Sydney NSW 2000. Telephone: (02) 9394 7600. Website: www.
copyright.com.au
Reproduction and communication for other purposes
Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Act, no part
of this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a database
or retrieval system, without the written permission of McGraw-Hill Education (Australia) Pty Ltd, including, but not
limited to, any network or other electronic storage. Enquiries should be made to the publisher via www.mheducation.
com.au or marked for the attention of the permissions editor at the address below.
National Library of Australia Cataloguing-in-Publication Data
Authors:
Title:
ISBN:
Christopher Viney, Peter Phillips
Financial Institutions, Instruments and Markets 9e
9781760422943
Published in Australia by
McGraw-Hill Education (Australia) Pty Ltd
Level 33, 680 George Street, Sydney NSW 2000
Portfolio lead: Jillian Gibbs
Content developer: Anne Harmer
Senior production editor: Claire Linsdell
Copyeditor: Julie Wicks
Proofreader: Annabel Adair
Cover design: Simon Rattray
Internal design: David Rosemeyer
Typeset in NimbusRomDOT 10.5/13 by SPi Global
Printed in Singapore on 70 gsm matt art by Markono Print Media Pte Ltd
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BRIEF CONTENTS
PART 1
FINANCIAL INSTITUTIONS ...............................................................................................................................
1
Chapter 1
A modern financial system: an overview..........................................................................................................3
Chapter 2
Commercial banks..................................................................................................................................................41
Chapter 3
Non-bank financial institutions............................................................................................................................87
PART 2
EQUITY MARKETS ...............................................................................................................................................129
Chapter 4
The share market and the corporation..............................................................................................................132
Chapter 5
Corporations issuing equity in the share market............................................................................................161
Chapter 6
Investors in the share market...............................................................................................................................191
Chapter 7
Forecasting share price movements..................................................................................................................222
PART 3
THE CORPORATE DEBT MARKET ..................................................................................................................257
Chapter 8
Mathematics of finance: an introduction to basic concepts and calculations.........................................259
Chapter 9
Short-term debt.......................................................................................................................................................287
Chapter 10
Medium- to long-term debt...................................................................................................................................315
Chapter 11
International debt markets....................................................................................................................................347
PART 4
GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND INTEREST RATES .......385
Chapter 12
Government debt, monetary policy and the payments system..................................................................388
Chapter 13
An introduction to interest rate determination and forecasting..................................................................417
Chapter 14
Interest rate risk measurement............................................................................................................................453
PART 5
THE FOREIGN EXCHANGE MARKET .............................................................................................................483
Chapter 15
Foreign exchange: the structure and operation of the FX market.............................................................485
Chapter 16
Foreign exchange: factors that influence the exchange rate......................................................................513
Chapter 17
Foreign exchange: risk identification and management...............................................................................538
PART 6
DERIVATIVE MARKETS AND RISK MANAGEMENT ..................................................................................563
Chapter 18
An introduction to risk management and derivatives....................................................................................565
Chapter 19
Futures contracts and forward rate agreements............................................................................................594
Chapter 20
Options......................................................................................................................................................................626
Chapter 21
Interest rate swaps, cross-currency swaps and credit default swaps.......................................................663
v
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CONTENTS
Preface�������������������������������������������������������������������������������� xx
Text at a glance��������������������������������������������������������������� xxv
About the authors������������������������������������������������������������ xxi
Connect�������������������������������������������������������������������������� xxviii
Acknowledgments������������������������������������������������������������ xxi
Exploring finance on the web���������������������������������������� xxx
Highlights of the ninth edition��������������������������������������� xxii
Careers in finance��������������������������������������������������������� xxxii
PART 1
1FINANCIAL INSTITUTIONS
CHAPTER 1
1
A MODERN FINANCIAL SYSTEM: AN OVERVIEW
3
1.1
Theory and facts in finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2
The financial system and financial institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.3
Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.3.1 Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.3.2 Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.3 Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.4
Financial markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.4.1 Matching principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4.2 Primary and secondary market transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4.3 Direct finance and intermediated finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.4.4 Wholesale and retail markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.4.5 Money markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.4.6 Capital markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.5
Flow of funds, market relationships and stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Case study: The next global financial crisis? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
CHAPTER 2
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning A: The global financial crisis of 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning B: The impact of the Asian financial crisis on the financial system . . . . . . . . . . .
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
30
32
35
38
39
COMMERCIAL BANKS
41
2.1
The main activities of commercial banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2.2
Sources of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.2.1 Current account deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.2.2 Call or demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.3 Term deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.4 Negotiable certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.2.5 Bill acceptance liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.2.6 Debt liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.2.7 Foreign currency liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.2.8 Loan capital and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
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Uses of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.3.1 Personal and housing finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.3.2 Commercial lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
2.3.3 Lending to government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.3.4 Other bank assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.4
Off-balance-sheet business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.4.1 Direct credit substitutes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4.2 Trade- and performance-related items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4.3 Commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4.4 Foreign exchange contracts, interest rate contracts and other
market-rate-related contracts ����������������������������������������������������������������������������������������������54
2.4.5 Volume of off-balance-sheet business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.5
Regulation and prudential supervision of commercial banks . . . . . . . . . . . . . . . . . . . . . . . . 56
2.6
A background to the capital adequacy standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
2.7
The Basel accords: evolution from Basel I to Basel III . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.7.1 Minimum capital adequacy requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.7.2 The definition of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.7.3 Basel III structural framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.7.4 Basel III and bank liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
2.8
Liquidity management and other supervisory controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
2.8.1 Other regulatory and supervisory controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Case study: Basel III reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
CHAPTER 3
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning A: The standardised approach to credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning B: Business continuity risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extended learning C: Corporate governance and ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
72
74
77
82
84
85
NON-BANK FINANCIAL INSTITUTIONS
87
3.1
Investment banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.1.1 Sources of funds and uses of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.1.2 Off-balance-sheet business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3.2
Managed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
3.2.1 Structure of the managed funds sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.2.2 Sources and uses of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
3.2.3 Capital guaranteed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.2.4 Capital stable funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.2.5 Balanced growth funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3.2.6 Managed growth or capital growth funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
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3.3
Cash management trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
3.4
Public unit trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.5
Superannuation funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.5.1 Sources of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
3.5.2 Defined benefit funds and accumulation funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
3.5.3 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
3.6
Life insurance offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
3.6.1 Life insurance policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.7
General insurance offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
3.8
Hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
3.9
Finance companies and general financiers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
3.7.1 General insurance policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
3.9.1 Sources of funds and uses of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
3.9.2 Sector structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
3.10
Building societies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
3.11
Credit unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
3.12
Export finance corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
Case study: The hedge fund sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Extended learning: Project finance and structured finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
PART 2
EQUITY MARKETS
CHAPTER 4
THE SHARE MARKET AND THE CORPORATION
4.1
129
132
The nature of a corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
4.1.1 Advantages of the corporate form of business organisation . . . . . . . . . . . . . . . . . . . . 135
4.1.2 Disadvantages of the corporate form of business organisation . . . . . . . . . . . . . . . . . 135
4.2
The stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
4.3
The primary market role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
4.4
The secondary market role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
4.5
The managed product and derivative product roles of a stock exchange . . . . . . . . . . . 141
4.5.1 Exchange traded funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
4.5.2 Contracts for difference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
4.5.3 Real estate investment trusts (REIT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.5.4 Infrastructure funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.5.5 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.5.6 Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
4.5.7 Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
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4.6
The interest rate market role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
4.7
The trading and settlement roles of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
4.8
The information role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
4.9
The regulatory role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
4.10
The private equity market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Case study: Development of industrial scale blockchain in Australia . . . . . . . . . . . . . . . . . . . . . . . 154
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
CHAPTER 5
CORPORATIONS ISSUING EQUITY IN THE SHARE MARKET
5.1
161
The investment decision: capital budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.1.1 Net present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.1.2 Internal rate of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
5.2
The financing decision: equity, debt and risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
5.2.1 Financial risk and the debt-to-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
5.2.2 What is the appropriate debt-to-equity ratio? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
5.3
Initial public offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
5.3.1 Ordinary shares: limited liability companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
5.3.2 Ordinary shares: no liability companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
5.4
Listing a business on a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
5.5
Equity-funding alternatives for listed companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
5.5.1 Rights issue or share purchase plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
5.5.2 Placements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
5.5.3 Takeover issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
5.5.4 Dividend reinvestment schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
5.5.5 Preference shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
5.5.6 Convertible notes and other quasi-equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Case study: Covenant-lite loans—risk implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
Extended learning: Australian Securities Exchange (ASX) listing rule requirements . . . . . . . . . . . 183
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
CHAPTER 6
INVESTORS IN THE SHARE MARKET
191
6.1
Share-market investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
6.2
Buying and selling shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
6.3
Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
6.4
Financial performance indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.4.1 Capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.4.2 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
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6.4.3 Debt servicing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.4.4 Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.4.5 Share price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.4.6 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
6.5
Pricing of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
6.5.1 Estimating the price of a share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
6.5.2 Cum-dividend and ex-dividend share prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
6.5.3 Bonus share issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
6.5.4 Share splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
6.5.5 Pro-rata rights issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
6.6
Stock-market indices and published share information . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Case study: Private equity firms, angel investors and exit strategies . . . . . . . . . . . . . . . . . . . . . . . 215
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
CHAPTER 7
FORECASTING SHARE PRICE MOVEMENTS
7.1
222
Fundamental analysis: the top-down approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
7.1.1 International economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
7.1.2 The rate of growth of an economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
7.1.3 Exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.1.4 Interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7.1.5 The balance of payments current account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7.1.6 Inflationary pressures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
7.1.7 Wages growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
7.1.8 Understanding the interrelationships of economic fundamentals . . . . . . . . . . . . . . . 229
7.2
Fundamental analysis: the bottom-up approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
7.3
Technical analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.3.1 Moving-averages models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.3.2 Charting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
7.4
Electronic trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
7.5
The random walk, efficient market and behavioural finance hypotheses . . . . . . . . . . . . 242
7.5.1 The random walk hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.5.2 The efficient market hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.5.3 The behavioural finance hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
Case study: The effects of scandals on the market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
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PART 3
THE CORPORATE DEBT MARKET
CHAPTER 8
MATHEMATICS OF FINANCE: AN INTRODUCTION TO BASIC
CONCEPTS AND CALCULATIONS
8.1
257
259
Simple interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.1.1 Simple interest accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
8.1.2 Present value with simple interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
8.1.3 Calculation of yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
8.1.4 Holding period yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
8.2
Compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
8.2.1 Compound interest accumulation (future value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
8.2.2 Present value with compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
8.2.3 Present value of an annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
8.2.4 Accumulated value of an annuity (future value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
8.2.5 Effective rates of interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
Case study: The retirement dream . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
CHAPTER 9
SHORT-TERM DEBT
287
9.1
Trade credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
9.2
Bank overdrafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
9.3
Commercial bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
9.3.1 Features of commercial bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
9.3.2 The flow of funds and bill financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
9.3.3 Establishing a bill financing facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
9.3.4 Advantages of commercial bill financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
9.4
Calculations: discount securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
9.4.1 Calculating the price where the yield is known . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
9.4.2 Calculating the face value where the issue price and yield are known . . . . . . . . . . . 299
9.4.3 Calculating the yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
9.4.4 Calculating the price where the discount rate is known . . . . . . . . . . . . . . . . . . . . . . . . 300
9.4.5 Calculating the discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
9.5
Promissory notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
9.5.1 Establishing a P-note issue program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
9.5.2 Underwritten P-note issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
9.5.3 Non-underwritten issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
9.6
Negotiable certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
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9.7
Inventory finance, accounts receivable financing and factoring . . . . . . . . . . . . . . . . . . . . 306
9.7.1 Inventory finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
9.7.2 Accounts receivable financing and factoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
Case study: The demise of LIBOR? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
CHAPTER 10
MEDIUM- TO LONG-TERM DEBT
10.1
315
Term loans or fully drawn advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
10.1.1 Term loan structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
10.1.2 Loan covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
10.1.3 Calculating the instalment on a term loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
10.2
Mortgage finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
10.2.1 Calculating the instalment on a mortgage loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
10.2.2 Securitisation and mortgage finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
10.3
The bond market: debentures, unsecured notes and subordinated debt . . . . . . . . . . . . 325
10.3.1 Debentures and unsecured notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
10.3.2 Issuing debentures and notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
10.3.3 Subordinated debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
10.4
Calculations: fixed-interest securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
10.4.1 Bond price/yield relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
10.4.2 Price of a fixed-interest bond at a coupon date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
10.4.3 Price of a fixed-interest bond between coupon dates . . . . . . . . . . . . . . . . . . . . . . . . 332
10.5
Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
10.5.1 Types of leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
10.5.2 Lease structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
Case study: The Kangaroo bonds and blockchain bond-i’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
Extended learning: Securitisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
CHAPTER 11
INTERNATIONAL DEBT MARKETS
347
11.1
The euromarkets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
11.2
Eurocurrency market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
11.2.1 Short-term bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
11.2.2 Eurocurrency standby facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
11.2.3 Medium- to long-term eurocurrency bank loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
11.3
Euronote market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
11.3.1 Euronote issuance facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
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11.3.2 Eurocommercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
11.3.3 Calculating the price of an NIF and an ECP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
11.4
Eurobond market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
11.4.1 Euro medium-term notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
11.4.2 Eurobonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
11.4.3 Issue and trading of eurobonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
11.4.4 Types of eurobonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
11.4.5 Calculating the price of fixed-interest euromarket securities . . . . . . . . . . . . . . . . . . 362
11.5
Markets in the USA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
11.5.1 Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
11.5.2 US foreign bonds (Yankee bonds) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
11.5.3 American depositary receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
11.6
Credit rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
Case study: Supervision of rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
Extended learning A: Novation, subparticipation and transferable loan certificates . . . . . . . . . . . 375
Extended learning B: Convertible bonds and warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
Extended learning C: US medium-term notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
Extended learning D: Standard & Poor’s credit rating definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
PART 4
GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS
SYSTEM AND INTEREST RATES
CHAPTER 12
GOVERNMENT DEBT, MONETARY POLICY AND THE PAYMENTS SYSTEM
12.1
385
388
The Commonwealth Government borrowing requirement . . . . . . . . . . . . . . . . . . . . . . . . . 390
12.1.1 The borrowing requirement: full financial year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
12.1.2 The borrowing requirement: within the financial year . . . . . . . . . . . . . . . . . . . . . . . . 391
12.2
Commonwealth Government securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
12.2.1 Treasury bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
12.2.2 Treasury notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
12.3
State government securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
12.4
Monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
12.4.1 Open market operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
12.4.2 Impacts on financial system liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
12.5
The payments system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
12.5.1 Exchange settlement accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
12.5.2 Real-time gross settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
12.5.3 Repurchase agreements (repos) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
Case study: The new payments platform (NPP) in Australia and the risk of fraud . . . . . . . . . . . . . 410
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
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Extended learning: Fixed-coupon Treasury bonds: price calculation using the
Australian Office of Financial Management (AOFM) formula . . . . . . . . . . . . . . . . . . . . . . . . . 413
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
CHAPTER 13
AN INTRODUCTION TO INTEREST RATE DETERMINATION AND FORECASTING
417
13.1
The macroeconomic context of interest rate determination . . . . . . . . . . . . . . . . . . . . . . . 419
13.2
The loanable funds approach to interest rate determination . . . . . . . . . . . . . . . . . . . . . . . 423
13.2.1 The demand for loanable funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
13.2.2 The supply of loanable funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426
13.2.3 Equilibrium in the loanable funds market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
13.2.4 Loanable funds—an expected increase in the level of economic activity . . . . . . . . 428
13.2.5 Inflationary expectations in the loanable funds approach . . . . . . . . . . . . . . . . . . . . . 429
13.3
The term structure of interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
13.3.1 The expectations theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
13.3.2 The segmented markets theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
13.3.3 The expectations approach versus the segmented markets approach . . . . . . . . . 437
13.3.4 The liquidity premium theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
13.4
The risk structure of interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
Case study: The Reserve Bank’s balancing act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
Extended learning: The yield curve and expectations theory calculations . . . . . . . . . . . . . . . . . . . 447
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452
CHAPTER 14
INTEREST RATE RISK MEASUREMENT
453
14.1
Interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455
14.2
Exposure management systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456
14.2.1 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
14.2.2 Strategies and techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
14.2.3 Management reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458
14.3
Assets re-priced before liabilities principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
14.4
Pricing financial securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460
14.4.1 Discount security pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460
14.4.2 Fixed-interest security pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
14.5
Re-pricing gap analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
14.6
Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464
14.7
Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470
14.8
Interest rate risk management techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
14.8.1 Internal techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
14.8.2 External techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475
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Case study: APRA and bear as risk management regimes in Australia . . . . . . . . . . . . . . . . . . . . . . 476
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482
PART 5
THE FOREIGN EXCHANGE MARKET
CHAPTER 15
FOREIGN EXCHANGE: THE STRUCTURE AND OPERATION OF THE FX MARKET
483
485
15.1
Exchange rate regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
15.2
Foreign exchange market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
15.2.1 Foreign exchange dealers and brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.2.2 Central banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.2.3 Firms conducting international trade transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
15.2.4 Investors and borrowers in the international money markets
and capital markets ��������������������������������������������������������������������������������������������������������� 490
15.2.5 Speculative transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
15.2.6 Arbitrage transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
15.3
The operation of the FX market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
15.4
Spot and forward transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493
15.5
Spot market quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
15.5.1 Asking for a quotation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
15.5.2 Two-way quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
15.5.3 Transposing spot quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
15.5.4 Calculating cross-rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
15.6
Forward market quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.6.1 Forward points and forward exchange contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.6.2 Some real-world complications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
15.7
Economic and Monetary Union of the EU and the FX markets . . . . . . . . . . . . . . . . . . . . . 505
Case study: Fixed exchange rates and currency misalignments . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
CHAPTER 16
FOREIGN EXCHANGE: FACTORS THAT INFLUENCE THE EXCHANGE RATE
16.1
513
The FX markets and an equilibrium exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
16.1.1 Demand for a currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
16.1.2 Supply of a currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
16.1.3 Equilibrium exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
16.2
Factors that influence exchange rate movements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
16.2.1 Relative inflation rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
16.2.2 Relative national income growth rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
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16.2.3 Relative interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
16.2.4 Exchange rate expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
16.2.5 Central bank or government intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
16.3
Measuring exchange rate sensitivity to changes in economic variables . . . . . . . . . . . . . 528
Case study: Terrorist attacks and FX movements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Extended learning: Purchasing power parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
CHAPTER 17
FOREIGN EXCHANGE: RISK IDENTIFICATION AND MANAGEMENT
538
17.1
Foreign exchange risk policy formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540
17.1.1 Foreign exchange objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
17.1.2 Management structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
17.1.3 Authorisations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
17.1.4 Exposure reporting systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
17.1.5 Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
17.1.6 Performance evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
17.1.7 Audit and review procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544
17.2
Measuring transaction exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545
17.2.1 Net cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
17.2.2 Transaction exposures: currency variability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548
17.2.3 Transaction exposures: currency correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549
17.3
Risk management: market-based hedging techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
17.3.1 Forward exchange contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
17.3.2 Money-market hedge to cover FX risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553
17.4
Risk management: internal hedging techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.4.1 Invoicing in the home currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.4.2 Creating a natural hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555
17.4.3 Currency diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
17.4.4 Leading and lagging FX transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556
17.4.5 Mark-ups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557
17.4.6 Counter-trade and currency offsets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 557
Case study: FX risk management: Do companies hedge or speculate? . . . . . . . . . . . . . . . . . . . . . 558
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562
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PART 6
DERIVATIVE MARKETS AND RISK MANAGEMENT
CHAPTER 18
AN INTRODUCTION TO RISK MANAGEMENT AND DERIVATIVES
563
565
18.1
Understanding risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
18.1.1 Operational risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
18.1.2 Financial risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568
18.2
The risk management process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
18.2.1 Identify operational and financial risk exposures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
18.2.2 Analyse the impact of the risk exposures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571
18.2.3 Assess the attitude of the organisation to each identified risk exposure . . . . . . . . 571
18.2.4 Select appropriate risk management strategies and products . . . . . . . . . . . . . . . . 572
18.2.5 Establish related risk and product controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572
18.2.6 Implement the risk management strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 572
18.2.7 Monitor, report, review and audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 573
18.3
Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574
18.4
Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576
18.4.1 Forward rate agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576
18.4.2 Forward foreign exchange contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
18.5
Option contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579
18.5.1 Call option profit and loss payoff profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580
18.5.2 Put option profit and loss payoff profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581
18.6
Swap contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
18.6.1 Interest rate swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583
18.6.2 Cross-currency swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584
Case study: Regulatory reforms and the ‘clearing’ of derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 586
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593
CHAPTER 19
FUTURES CONTRACTS AND FORWARD RATE AGREEMENTS
594
19.1
Hedging using futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596
19.2
Main features of a futures transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
19.2.1 Orders and agreement to trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598
19.2.2 Margin requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599
19.2.3 Closing out of a contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
19.2.4 Contract delivery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
19.3
Futures market instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601
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19.4
Futures market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.4.1 Hedgers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.4.2 Speculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.4.3 Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604
19.4.4 Arbitrageurs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 604
19.5
Hedging: risk management using futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
19.5.1 Hedging the cost of funds (borrowing hedge) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
19.5.2 Hedging the yield on funds (investment hedge) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607
19.5.3 Hedging a foreign currency transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608
19.5.4 Hedging the value of a share portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609
19.5.5 Hedging against volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610
19.6
Risks in using futures contracts for hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
19.6.1 Standard contract size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
19.6.2 Margin payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613
19.6.3 Basis risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614
19.6.4 Cross-commodity hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614
19.7
Forward rate agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615
19.7.1 Using an FRA for a borrowing hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617
Case study: SPI futures market acts as a market-maker facilitating price discovery
in the S&P/ASX 200 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625
CHAPTER 20
OPTIONS
626
20.1
The nature of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628
20.2
Option profit and loss payoff profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
20.2.1 Call option profit and loss payoff profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
20.2.2 Put option profit and loss payoff profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
20.2.3 Covered and naked options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634
20.3
The organisation of the market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636
20.3.1 International options markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636
20.3.2 The Australian options markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637
20.4
Factors affecting an option contract premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
20.4.1 Intrinsic value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
20.4.2 Time value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642
20.4.3 Price volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642
20.4.4 Interest rate levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 644
20.4.5 Cap, floor and collar: an options cost-minimisation strategy . . . . . . . . . . . . . . . . . . . 644
20.5
Option risk management strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
20.5.1 Single-option strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
20.5.2 Combined-options strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648
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Case study: The Black–Scholes option pricing model: The equation that can end
the world? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662
CHAPTER 21
INTEREST RATE SWAPS, CROSS-CURRENCY SWAPS AND CREDIT DEFAULT SWAPS
663
21.1
Interest rate swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 666
21.2
Rationale for the existence of interest rate swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670
21.2.1 Lowering the net cost of funds (comparative advantage) . . . . . . . . . . . . . . . . . . . . . 670
21.2.2 Gaining access to otherwise inaccessible debt markets . . . . . . . . . . . . . . . . . . . . . . 671
21.2.3 Hedging interest rate risk exposures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671
21.2.4 Lock in profit margins on business transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672
21.3
Cross-currency swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673
21.4
Rationale for the existence of currency swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676
21.5
Credit default swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 678
21.6
Credit and settlements risk associated with swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681
Case study: Naked credit default swaps: Two perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
Master before you move on . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 690
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712
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PREFACE
This book has achieved remarkable acceptance by academics and their students in a significant number of tertiary
institutions throughout Australia, New Zealand and Asia, and by professionals within the financial services industry. In this
ninth edition, we present once more a finance text for you that is authoritative and scholarly, and which at the same time
highlights the dynamic, exciting and global nature of financial institutions, instruments and markets.
As the global financial crisis and its aftermath fades into history, attention has turned to the financial services industry
itself, its culture and its values. In 2018, the Royal Commission into Misconduct in the Banking, Superannuation and
Financial Services Industry in Australia highlighted many areas of concern and highlighted the importance of strong
governance, codes of conduct and ethics within financial services firms. The findings of the Royal Commission will
continue to shape public opinion and trust in financial institutions for many years to come. New graduates in finance, as
well as their professors, are not powerless to ensure that this trust is restored sooner rather than later.
As the ninth edition was being finalised, financial markets in the United States were tentatively testing and retreating
from new highs against a backdrop of stronger economic activity and rising interest rates. In Australia, the challenge
of returning interest rates to more ‘normal’ levels without causing a major disruption to the housing market remained
perhaps the most significant challenge confronting the Reserve Bank of Australia.
Although political uncertainty has swept through Europe and the United States, it is important to recognise that
innovation, technological and otherwise, continues at pace. New companies with new products and new ideas are
forever emerging and will seek capital from the world’s debt and equity markets to fund their first (or next) steps. In the
financial markets, as for most aspects of life, we can never wait for the clouds of uncertainty to lift before trying to make
our way.
One thing is certain, change will occur. As students of the financial system you must keep yourself informed about
the structure and operation of financial institutions, instruments and markets. Importantly, you must think about and
anticipate future directions and change. Despite the continuous change that financial markets undergo, there are a set of
stable, underlying principles that govern decision-making across all markets and instruments. It is worth keeping in mind,
then, that a sound knowledge of the basics can take you much further than you might think.
With that said, we encourage you to accept every opportunity that comes your way and we wish you the best of
success.
Christopher Viney and Peter J Phillips
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ABOUT THE AUTHORS
CHRISTOPHER VINEY brings to this book a wealth of industry experience and academic
knowledge associated with the international financial markets. His appreciation of the nature
of both the theoretic and the applied functions and operations of the global financial system
is reflected in the clear and interesting presentation of issues in such a way that the reader is
motivated to learn.
Prior to moving into academia Chris spent 27 years in the commercial banking industry
including retail banking, corporate lending, risk management, personnel, property, policy and
administration. His academic career included appointments at Monash University and Deakin
University, Melbourne, Australia. He has taught in the areas of financial markets, financial
institutions management, corporate finance, treasury management and personal financial
planning. Chris has also taught in Singapore, Malaysia, Thailand, Indonesia and New Zealand.
He has received university awards for contributions to the internationalisation of teaching and
learning programs. As the director of the finance international study programs at Monash and Deakin Universities, Chris
has taken select groups of students overseas as part of their tertiary studies. He has also published research papers on
the capital markets, operational risk management, bureau de change, money laundering and education and training.
Following the passing of Michael McGrath with the first edition of the text, Chris has guided the evolution of future
editions of the book and it has now become a principal learning and reference source for undergraduate students,
postgraduate students and industry practitioners alike. Peter Phillips joined Chris ahead of the seventh edition and has
been Chris’s co-author since 2011.
PETER PHILLIPS has been teaching economics and finance at the University of Southern
Queensland (USQ) in Toowoomba, Australia, since 1998. Presently, he is an Associate
Professor in Finance at USQ. He has taught in the areas of financial markets and institutions,
portfolio management and corporate finance as well as several economics courses, including
macroeconomics and econometrics.
In 2003 Peter completed a PhD at USQ in financial economics. Since then he has
published a number of papers on the topic of Self Managed Superannuation Funds (SMSFs)
in which he and his co-authors explore various aspects of the portfolios chosen by SMSF
investors.
Acknowledgments
The challenge of maintaining the currency and relevancy of a book with the scope of financial institutions, instruments and
markets is enormous. This daunting task is tackled at many levels. At one level we are most appreciative of those users
of the book, including academics, practitioners and students, who provide ongoing feedback in the form of comment,
suggestion and discussion. We value your contributions immensely.
The quality of the production of the book is also dependent on the expertise and hard work of the people at McGrawHill Education (Australia). As authors, we have been very fortunate to have the dedicated editorial support of Jillian Gibbs.
We would also like to acknowledge and thank the team at McGraw-Hill, including Anne Harmer, Claire Linsdell, Marisa
Rey Bulen and Bethany Ng.
We would like to thank our case study contributor, Jaison Parackel Johnny (University of Southern QueenslandToowoomba). We would also like to thank Michael Baker (Flinders University), Sisira Colombage (Federation University
Australia) and David Spiers (Federation University Australia) for their detailed reviews of the material during development.
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HIGHLIGHTS OF THE NINTH EDITION
C HAPTER 1 A modern financial system: an overview
introduces the financial institutions, financial instruments
and financial markets that comprise domestic and global
financial systems and explains why a stable financial
system is important for economic growth
provides a concise context that assists the reader to
understand the relationships of the material in the
following chapters
discussion moves away from the global financial crisis and
broadens to describe how theories and ideas operate in
the discipline of finance. The framework is simple: risk and
reward, supply and demand
extended learning—the global financial crisis
extended learning—the impact of the Asian financial crisis
on the financial system
case study—the current possibilities of future financial
crises
C HAPTER 2 Commercial banks
contains a detailed discussion on the commercial bank,
including its role, products, off-balance-sheet business,
regulation and supervision
provides a concise explanation of the capital adequacy
and liquidity standards that apply to banks under Basel III
shifts the focus to Basel III, which was finalised in 2017,
but which will take several more years to fully implement.
Basel II is out, Basel III is in
outlines aspects of the regulatory response to the global
financial crisis
extended learning—the standardised approach to credit
risk
extended learning—business continuity risk management
extended learning—corporate governance and ethics
case study—Australian banking’s prompt response to the
new Basel requirements
C HAPTER 3 Non-bank financial institutions
a current examination of investment banks, managed
funds, superannuation funds, cash management trusts,
public unit trusts, life and general insurance offices, hedge
funds, finance companies, building societies, credit unions
and export finance corporations
extended learning—project finance and structured finance
case study—hedge fund managers, regulation, and
current hedge fund trends
C HAPTER 4 The share market and the corporation
new approach focusing on Basel III
considers the management structure of a publicly listed
corporation
discusses the important roles of a stock exchange in
facilitating the listing of a corporation’s shares on the
exchange (primary market role) and the ongoing trading
of existing shares (secondary market role) on the share
market
examines the managed products and derivative products
offered by a stock exchange, including exchange traded
funds, contracts for difference, real estate investment
trusts, infrastructure funds, options, warrants and futures
contracts
examines the interest rate market role, the trading and
settlements roles, the information role and the regulatory
roles of a stock exchange
case study—industrial-scale blockchain in Australia
C HAPTER 5 Corporations issuing equity in the share
market
introduces the capital budgeting investment decision
process; funding issues related to debt and equity;
initial public offerings, stock exchange listing rules and
alternative forms of equity issues
extended learning—current Australian Securities
Exchange (ASX) listing requirements
case study—covenant-lite loans and their risk implications
C HAPTER 6 Investors in the share market
considers the role of the investor in the share market;
risks associated with buying and selling shares
discusses taxation; financial performance indicators and
the pricing of shares
introduces share market indices and the interpretation of
share market information
case study—private equity firms, angel investors and exit
strategies
C HAPTER 7 Forecasting share price movements
examines fundamental analysis and technical analysis
approaches to share price forecasting
updated consideration of the impact of electronic trading
and technology on share prices
introduces the random walk hypothesis and the
efficient markets hypothesis (EMH) within the context of
forecasting share price movements
introduces behavioural finance as an alternative
theoretical framework to the EMH for understanding share
price movements
case study—the effects of scandal on the market
C HAPTER 8 Mathematics of finance: an introduction to
basic concepts and calculations
introduces the principles of mathematical calculations that
underpin financial market instruments, including simple
interest, compound interest, present value, future value,
yield, annuities and effective rates of interest
case study—the 4% rule and considering the feasibility of
early retirement
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C HAPTER 9 Short-term debt
examines the main sources and types of short-term
intermediated and direct finance available to a business
corporation, including trade credit, bank overdrafts,
commercial bills, promissory notes, negotiable certificates
of deposit, inventory finance, accounts receivable
financing and factoring
thoughtful analysis of the role of short-term debt in the GFC
calculation of prices and yields on discount securities
case study—the demise of the London Interbank Offer
Rate (LIBOR) and the rise of the Bank Bill Swap Rate
(BBSW) in the Australian economy
C HAPTER 10 Medium- to long-term debt
identifies the main types of longer-term debt available to
a corporation, including term loans, fully drawn advances,
mortgage finance, debentures, unsecured notes,
subordinated debt and leasing
calculation of prices and yields on fixed-interest securities
extended learning—securitisation
case study—Kangaroo bond markets and the
development of the blockchain bond
C HAPTER 11 International debt markets
explores the structure of the international debt markets,
in particular the euromarkets (eurocurrency, euronote and
eurobond markets) and the US money and capital markets.
examines the main generic products offered in the
international debt markets
considers the important role of credit rating agencies in
the international debt markets
extended learning—novation, subparticipation and
transferable loan certificates
extended learning—convertible bonds and warrants
extended learning—US medium-term notes
extended learning—Standard & Poor’s credit rating definitions
case study—the triggering role played by credit agencies
in the GFC, and how they operate in Australia today
C HAPTER 12 Government debt, monetary policy and
the payments system
examines why governments issue short-term and longerterm debt securities, the types of securities and the
pricing of those securities. It also considers the purpose
and implementation of monetary policy; the operation
of the payments system, exchange settlement accounts,
real-time gross settlement and repurchase agreements
bolstered by an updated treatment of the GFC and aftermath
extended learning—fixed-coupon Treasury bonds:
price calculation using the Australian Office of Financial
Management (AOFM) formula
case study—the New Payments Platform (NPP) in Australia
and the consequent rising risk of fraud
C HAPTER 13 An introduction to interest rate
determination and forecasting
examines the macroeconomic context and the loanable
funds approach to interest rate determination and the
impact of changes in related variables
considers the term structure and risk structure of interest
rates within the context of the expectations theory, the
segmented markets theory and the liquidity premium
theory
extended learning—the yield curve and expectations
theory calculations
case study—the RBA’s decision to hold interest rates in
Australia until 2020
C HAPTER 14 Interest rate risk measurement
identifies methods used to measure interest rate risk and
introduces an exposure management system
examines interest rate risk measurement models,
including re-pricing gap analysis, duration and convexity
considers internal and external interest rate risk
management techniques
case study—APRA and BEAR as risk management
regimes in Australia
C HAPTER 15 Foreign exchange: the structure and
operation of the FX market
examines the structure, participants, operation and
conventions in the global FX markets
discusses and calculates spot and forward FX quotations
considers the impact of the Economic and Monetary
Union of the European Union (EMU)
case study—fixed exchange rates and currency misalignments
C HAPTER 16 Foreign exchange: factors that influence
the exchange rate
introduces different exchange rate regimes used by
various nation-states
in the context of a floating exchange rate, considers
factors that affect the determination of an equilibrium
exchange rate, including relative inflation rates, national
income growth rates, interest rates, expectations and
central bank intervention
considers the application of regression analysis in the
measurement of exchange rate sensitivity
extended learning—purchasing power parity
case study—the relationship between terrorist attacks and
FX movements
C HAPTER 17 Foreign exchange: risk identification and
management
recognises FX risk and presents an organisational FX risk
policy structure
discusses the measurement of transaction FX exposures
xxiii
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Highlights of the ninth edition
examines internal and external market-based hedging
techniques using derivative products
case study—do companies hedge or speculate in FX risk
management?
C HAPTER 18 An introduction to risk management and
derivatives
introduces the fundamentals of understanding risk and
risk management
provides a concise introduction to generic derivative
products and markets, in particular futures, forwards,
option and swap contracts
case study—regulatory reforms and the ‘clearing’ of
derivatives in global banking
C HAPTER 19 Futures contracts and forward rate
agreements
examines the purpose, structure and operation of a
futures market, including structuring and calculating risk
management strategies
considers forward rate agreement contracts and the use
of an FRA to manage interest rate risk exposures
case study—defining the SPI futures price contract on the
S&P/ASX 200 Index, and its strengths and vulnerabilities
in the current market
C HAPTER 20 Options
examines the purpose, structure and operation of options
markets
introduces option contract strategies that may be applied
in a wide range of risk exposure scenarios
case study—the Black-Scholes option-pricing model
C HAPTER 21 Interest rate swaps, cross-currency
swaps and credit default swaps
examines the purpose of interest rate swaps (including
facilitating speculation) and considers the construction of
a swap to manage an interest rate risk exposure
in the context of international markets, considers the
construction of a currency swap to manage both an
interest rate exposure and an FX risk exposure
introduces the credit default swap and discusses the
structure of, and parties to, a CDS
case study—two perspectives on naked credit details swaps
xxiv
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TEXT AT A GLANCE
PART INTRODUCTIONS A short
overview of the material that is covered
in the following chapters is provided.
They are a helpful introduction to
how the key concepts, institutions or
instruments work together and show
how they fit within the larger picture.
PART Four
Government debt,
monetary policy, the
payments system and
interest rates
CHAPTER OPENERS Each chapter
begins with a short overview of the
information contained in the chapter,
providing not only an introduction to
the chapter, but also a useful study
reference.
12.2
Commonwealth Government securities
12.3
State government securities
12.4
Monetary policy
12.5
The payments system
Consider the reasons for the existence of government debt markets and the government
borrowing requirement.
LO 12.2
Outline features of the main debt instruments issued by the Commonwealth Government, that is,
the Treasury bond and the Treasury note, and describe the issuance process, participants and
complete relevant calculations.
LO 12.3
Describe the purpose and structure of state government central borrowing authorities.
LO 12.4
Outline the monetary policy techniques currently employed by the Reserve Bank through which
it influences the level of interest rates in Australia, including open market operations and the
impacts on system liquidity.
LO 12.5
Describe the purpose and operation of the payments system, including exchange settlement
accounts, real-time gross settlement and repurchase agreements.
An introduction to interest rate determination and forecasting
CHAPTER 14
385
11/27/1804:39PM
Consider the reasons
for the existence of
government debt
markets and the
government borrowing
requirement.
Commonwealth
government
the central government
of australia
Budget deficit
Consider the reasons for the existence of government debt markets and the government
borrowing requirement.
LO 12.2
Outline features of the main debt instruments issued by the Commonwealth Government, that is,
the Treasury bond and the Treasury note, and describe the issuance process, participants and
complete relevant calculations.
LO 12.3
Describe the purpose and structure of state government central borrowing authorities.
LO 12.4
Outline the monetary policy techniques currently employed by the Reserve Bank through which
it influences the level of interest rates in Australia, including open market operations and the
impacts on system liquidity.
LO 12.5
Describe the purpose and operation of the payments system, including exchange settlement
accounts, real-time gross settlement and repurchase agreements.
Untitled-4
Calculate the price of a bond using the AOFM formula.
388
11/27/1804:39PM
Chapter 12 Government debt, monetary policy and the payments system
Primary market transactions
ThesystemusedinAustraliafortheprimarymarketissueofTreasurybondsisknownasthetender
system.Thefederaltreasurerhasthepowertodecideonthetimingofeachtender,andonthematurities,
coupons and quantities of bonds to be marketed. This is currently managed through the Australian
Office of Financial Management (AOFM).
Withthetendersystem,theAOFMisconfidentthatinvestorswillalwayspurchaseanyTreasury
bondsonoffer.Thebondsareofferedwithafixedinterestrate,butatenderwillbelodgedtobuythe
bondsintermsoftheyieldtomaturity.Thatis,aninvestorwilloffertobuyatapremium,oradiscount,
tothefacevalue.
For example, if an issue is announced carrying a coupon of 5.75 per cent per annum but an
investorrequiresarateof6.00percentperannum,underthetendersystemtheserieswillstillbefully
subscribed.Buyerswillputinatenderwiththeirbidpricebeingsufficientlybelowthefacevalueofthe
bondsothattheexisting5.75percentfixed-couponpayments,plusthecapitalgainatmaturity,will
returnaneffectiveyieldof6.00percentonthepurchaseprice.Thatis,theinvestorwillbuythebond
Partforlessthanthefacevaluetoday,receivetheperiodicfixed-couponpaymentsandfinallyreceivethe
4 Government debt, monetary policy, the payments system and interest rates
facevalueofthebondatthematuritydate.
ThecurrentproceduresinvolvedinbiddingforbondsareavailableonthewebsiteoftheAOFMat
continued
www.aofm.gov.au.Fixed-couponTreasurybondbidconditionsincludethefollowing.
Tender system
investors bid a price on
government securities,
thus setting the yield;
allocated in order of
lowest yields
Australian Office
of Financial
Management (AOFM)
a body established to
manage commonwealth
government debt issues
• BidsmayonlybesubmittedelectronicallybyregisteredbiddersthroughtheAOFMtendersystem.
of same-day funds are surplus balances in banks’ exchange settlement accounts,
• Sources
TheAOFMtendersystemisaccessedviatheelectronicYieldbrokerDEBTSSystem.
Reserve Bank payments for market operations or repurchase arrangements with the Reserve
Bank.
CASE•• Theminimumbidmustbeforafacevalueof$1million,andthereafterinmultiplesof$1million.
STUDY Found
at the end of every chapter, each
Bidsaretobemadeintermsofyieldtomaturityuptothreedecimalplaces,notintermsofprice.
financial news case study
central bank requires high-value transactions in the payments system to be settled by real• The
time gross
settlement
(RTGS); that is, funds
must be available
in a bank’s
exchange settlement
contains
excerpts
from
financial
articles
that
provide
real-world
examples of
•
account immediately. The purpose is to reduce settlement risk and systemic risk.
support RTGS,
the Reserve
Bank provides
an intra-dayThey
liquidity facility
for same-day
funds or
• To
concepts
discussed
within
the
chapter.
are
followed
by
related
discussion
an overnight liquidity facility, known as a repurchase agreements (repo).
•
•
Reservethe
Bank willopportunity
provide a repo based on underlying
eligible securities. An intra-day
• The
questions
providing
for
self-assessment
and
putting
into
practice
repo must be unwound by the end of the day.
Table 12.1 Treasury bond series tender: bids and allotments
what has been learned.
The yield is calculated using the formula specified in the prospectus (see the Extended learning
sectionattheendofthechapter).
Bidsareacceptedinascendingorder;thatis,thelowest-yieldbid,whichcorrespondstothehighest
price,isacceptedfirstandthequantityofthatbidisallotted.Thenthesecondlowestofthetendered
yieldsisacceptedandsoon,untiltheissueisfullysubscribed.ThisisillustratedinTable12.1.
Biddersmaysubmitmultiplebids,atdifferentyields,fortheonebondseries.
TreasurybondpurchasesaresettledusingtheAustraclearsettlementsystem.
30
2
6.40
35
35
3
6.50
25
25
6.60
30
10
4
The Commonwealth Government
borrowing requirement
11/27/1804:39PM
Yield Competitive bids
Allotment:
Allotment: Reserve
(% p.a.)
($ millions)
competitive ($ millions) Bank ($ millions)
6.30
CASE
STUDY 30
THE NEW PAYMENTS PLATFORM (NPP) IN AUSTRALIA AND THE RISK OF FRAUD
In Chapter 12 we examined the establishment of a new payments platform in Australia that enables
5
6.65
25
nil
quick payments.
The
basic structure of
NPP includes a network to connect participants, a switch that
Weighted average yield
6.42messages between participants and an addressing
20
transfers
service with a simpler payment address
such as a phone number
or an email 100
address.
Totals
145
20
The government must manage its financial position, including the timing of its cash flows and the
platform
financing of capital expenditures. The matching principle (discussed in Chapter 1) alsoThe
applies
to is equipped with a faster payment service that enables real-time handling and settlement
Table 12.1 illustrates
hypothetical bond
tender where
the government
issues
$120the
million
of a
transactions,
regardless
of size.
The platform
uses
ISO of
20022 standard for electronic data
government; that is, the government funds any shortfall in short-term liquidity requirements
with
Weighted
average
Treasurybonds.TwentymilliondollarsoftheissueisallocatedtotheReserveBankattheweighted
interchange
data
than most of the other
the issue of short-term debt securities, and any shortfall in its long-term
capital
expenditures
and between financial institutions with the capability to convey more
issue yield
average
issue yieldannouncedfortherelevanttender.Theremaining$100millionisallottedaccording
messaging
formats (NPP Australia, 2018). Financial institutions and customers
are
expected to reap the
the average
of the
commitmentswiththeissueoflong-termdebtsecurities.
tothebidsthatarereceived.Intheexample,theAOFMreceivescompetitivebidsfromfiveparties
proportional yields
bid
benefits of the new platform; however, critics argue that the number of fraudulent
transactions
will rise.
Aliquidityshortfallmayoccurifthereisamismatchbetweenthetimingofgovernmentintra-year
totalling$145million,andthesehavebeenarrangedinascendingorderinthetable.Thefirstbidder
on a bond issue
expendituresandthereceiptofrevenues.Acapitalexpenditureshortfalloccurswhenabudgetisin
It is notable that most credit card frauds take place online or over the telephone and involve stealing
393
deficit,thatis,whencapitalexpendituresaregreaterthantaxandotherincomereceipts.Ifnecessary,
details (card numbers, names etc), not the plastic card itself. According to the Australian Payments
Network, almost 85 per cent of thefts involving credit cards occurred when the details were
theAustraliangovernmentissuestwomainformsofdebtsecurity:theshort-termTreasurynoteandthe
compromised.
longer-termTreasurybond.
Thissectionexamines,first,theCommonwealth Government’slong-term(orfull-year)borrowing
Untitled-4 393
The NPP enables instant transfer of money, and such transfers are deemed11/27/1805:36PM
to be irreversible. Each
requirements,and,second,thegovernment’sshort-termliquidityrequirements(thosethatexistwithin
financial institution could impose limits on the upper value of transfers, however, these are expected
afinancialyear).
to be higher than credit card limits and similar to limits on transfers using BSB numbers. According to
12.1.1
occurs when a
government’s
expenditures exceed
its revenues over a
fiscal year
LO 12.1
KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term
or concept is highlighted in the text at its first appearance, and the definition is
provided in the corresponding margin. A boxed list of these key terms appears at
the end of each chapter and each entry is followed by the page on which it first
appeared. All of the key terms, with their definitions, appear in the glossary.
Part 4 Government debt, monetary policy, the payments system and interest rates
LEARNING
OBJECTIVE
12.1
The payments system
CHAPTER SNAPSHOT This brief outline at the beginning of every chapter
launches the reader into the content, providing a helpful overview of what is to
come and placing the ideas in their broader context.
1
12.1
Monetary policy
12.5
LO 12.6
Calculate the price of a bond using the AOFM formula.
388
State government securities
12.4
Extended learning
Bid
Untitled-4
Commonwealth Government securities
12.3
Interest rate risk measurement
Extended learning
LO 12.6
The Commonwealth Government borrowing requirement
12.2
CHAPTER 13
Learning objectives
LO 12.1
12.1
Learning objectives
Government debt, monetary policy and the payments system
LEARNING OBJECTIVES These
numbered points clearly outline
what each reader should know
and be able to do by the end
of the chapter. They will also
assist in exam revision. Each
learning objective notes the
numbered section in which the
CHAPTER 12
learning objective appears in
Government
the chapter. debt,
They are directly
monetary
policy
and
linked to the
end-of-chapter
the payments system
summary, which systematically
CHAPTERthrough
OUTLINE
works
each learning
objective.
The Commonwealth Government borrowing requirement
CHAPTER OUTLINE
CHAPTER 12
Untitled-4
12.1
CHAPTER 12
Government debt,
monetary policy and
the payments system
critics, this is a potential problem.
The borrowing requirement: full financial year
Online fraud has almost doubled in the UK since a faster payment system was adopted. The system had
a payment limit of £100 000 in 2010 and £250 000 in 2015. In 2017, there was a notable case known
Aborrowingrequirementariseswhenagovernment’sexpendituresexceeditsrevenuesinanyparticular
as the ‘Friday afternoon fraud’, where a group of fraudsters hacked into the emails between solicitors
period.Overafullfinancialyearthissituationgivesrisetoabudget deficit.AscanbeseeninFigure12.1,
and their home-buying clients on the day money was to be transferred.
the Commonwealth Government’s financial position has changed quite significantly throughout the
The fraudsters impersonated the solicitor and communicated to the clients that the payment details had
last10years.
been changed and that the payments should be made to a different account. By the time the victims
realised, the money had been transferred (Worthington, 2018). Earlier, the banks had up to three days
Figure 12.1 Commonwealth Government budget outcomes ($ billions) to stop a transfer when a scam was detected, but with the transition to faster payments there was less
time to detect and stop fraudulent transactions such as these (Yeates, 2018).
30
26.7
28.1
20
14.2
10
2015–16
2016–17
2014–15
2013–14
–18.2
–33.2
410
Untitled-4
410
–14.5
xxv
2018–19
–37.4
–40.4
2017–18
–47.0
–23.5
2011–12
2010–11
2009–10
2008–09
2007–08
2006–07
2005–06
–10
–44.5
–52.0
2012–13
–56.5
–31.3
0
There is reason to be optimistic that advances in security will outpace the ingenuity of fraudsters.
Traditional security measures, like passwords, are on the decline. Knowledge-based passwords are
often compromised. Australian banks are planning to introduce biometrics, including voice recognition,
facial recognition and fingerprints. Last year, ANZ added a voice-ID function to its banking app that allows
customers to carry out high volume transactions without a PIN or a password. HSBC also experienced
success in detecting fraud by implementing biometrics. Approximately $7 million of attempted fraud
–20
vin22943_prelims_i-xxxiv.indd
xxv–30
–40
11/27/1804:44PM
01/21/19 11:13 AM
Text at a glance
REFLECTION POINTS Located after every major section
within each chapter, the reflection points highlight the
most significant material covered and provide regular
onlytomeettherepaymentsontheborrowedfunds,thelessorsgenerallyrelyontaxdeductionsfrom
summaries.
They are a useful tool for revision, helping
thedepreciationoftheequipmentandfromtheinterestpaidtothedebtpartiestoearntheirreturn.
Sinceleveragedleasingcanbequitecomplexandmayinvolvequiteafewpartiestothearrangement,
itiscommonforthearrangementstobehandledbyalease
manager.Theleasemanagerstructures,
students
to
identify
areas that
require further study.
negotiatesandplacestheleasetransaction,andmanagesthetransactionforthelifeofthelease.
Chapter 10 Medium- to long-term debt
Lease manager
the arranger and
ongoing manager of a
leveraged lease that
brings together the
lessor, debt parties and
the lessee
MASTER BEFORE YOU MOVE ON These chapter
summaries comprehensively review the topics covered
in each chapter and are linked directly to the learning
objectives, listing each learning objective and a summary
of the relevant material.
Part 1 Financial institutions
Master before you move on
Reflection points
•
•
•
•
•
•
•
•
A lease is a contract whereby the owner of an asset (the lessor) allows another party (the
lessee) to use that asset for an agreed period in return for lease payments. Major providers of
lease finance are banks and finance companies.
LEARNING OBJECTIVE 1.1
Understand the basic frameworks that underlie the facts that characterise financial institutions,
financial instruments and financial markets.
Advantages of lease financing are that it does not use up lines of credit, it provides 100.00 per
cent financing, payments can be matched with revenue generation, payments are generally tax
deductible, it may not breach existing loan covenants and assets can be leased for the actual
periods they are needed.
•
•
•
•
An operating lease is a full-service lease where an asset is leased for a relatively short period,
then returned to the lessor. The lessor maintains and insures the asset and leases it again
and again.
A finance lease is a long-term net lease where an asset is leased once. The lessee maintains
and insures the asset and makes periodic lease payments. The lessee is required to make a
lump-sum residual payment at the completion of the lease contract.
•
Sale and lease-back occurs when the original owner of an asset sells the asset and then enters
into an arrangement to lease back the asset.
The interconnected global financial system traces its origins to the introduction of money and
the development of local markets to trade goods.
Money is a medium of exchange that facilitates transactions for goods and services.
With wealth being accumulated in the form of money, specialised markets developed to enable
the efficient transfer of funds from savers (surplus entities) to users of funds (deficit entities).
Financial instruments incorporate attributes of risk, return (yield), liquidity and time-pattern
of cash flows. Savers are able to satisfy their own personal preferences by choosing various
combinations of these attributes.
By encouraging savings, and allocating savings to the most efficient users, the financial system
has an important role to play in the economic development and growth of a country. The real
economy and the financial system are connected.
A cross-border lease occurs when parties to a lease extend into another country; it involves
foreign exchange risk.
LEARNING OBJECTIVE 1.2
A direct finance lease involves two parties, the lessor and the lessee. The lessor retains
ownership of the asset and may also seek additional guarantees to support the lease contract.
Explain the functions of a modern financial system and categorise the main types of financial
institutions, including depository financial institutions, investment banks, contractual savings
institutions, finance companies and unit trusts.
A leveraged finance lease is an arrangement whereby the lessor borrows to fund the purchase
of an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such
as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease
manager will be responsible for the management of the contract.
•
•
•
•
CASE STUDY
•
•
THE KANGAROO BONDS AND BLOCKCHAIN BOND-I’s
Kangaroo bonds or Matilda bonds are Australian dollar-denominated bonds issued by non-Australian
issuers after complying with local laws and regulations. They represent the largest share of the Australian
domestic bond market after Australian Government Securities (AGS) and semi-government securities
(Semis) (Bergmann & Nitschke, 2018). The bond issuers are major banks and financial institutions of
high credit quality who participate in the Australian foreign exchange and derivative markets. The
experience of these firms in the Australian bond market also helps other countries develop their
domestic bond markets (Batten, Hogan & Szilagyi, 2008).
337
•
Untitled-5
337
Advantages of lease financing are that it does not use up lines of credit, it provides 100.00 per
cent financing, payments can be matched with revenue generation, payments are generally tax
deductible, it may not breach existing loan covenants and assets can be leased for the actual
periods they are needed.
11/27/1804:47PM
CHAPTER TEN REVIEW
A company normally enters a foreign market to gain access to better interest rates. Kangaroo bonds
are normally issued when interest rates in Australia are low relative to the domestic rate of the foreign
Chapter
10 Medium- to long-term debt
corporation. This will help to lower the interest expense and cost of borrowing for the issuer.
These
bonds, which are denominated in the local currency, form an attractive investment opportunity for
•
•
•
operating lease
is a full-service lease where
an asset
is leased for a relatively
short period
EXTENDED
LEARNING
The
extended
learning
sections
• An
and then returned to the lessor. The lessor maintains and insures the asset and leases it again
and again.
provide
an
additional
resource
for
self-assessment
and
lease is a long-term net lease where an asset is leased once. The lessee maintains
• Aandfinance
insures the asset and makes periodic lease payments. The lessee is required to make a
a variety
of
activities
designed
to address the more
lump-sum
residual
payment at the completion
of the lease contract.
and lease-back occurs when the original owner of an asset sells the asset and then enters
• Sale
into an arrangement
to lease of
back the
asset.chapter. These sections are
complex
aspects
the
cross-border lease occurs when parties to a lease extend into another country; it involves
• Aforeign
exchange risk.
accompanied
by extended learning questions which test
direct finance lease involves two parties, the lessor and the lessee. The lessor retains
• Aownership
of the asset and may also seek additional guarantees to support the lease contract.
students’
understanding
of the material.
A
leveraged
finance lease is an arrangement whereby the lessor borrows to fund the purchase
•
of an asset that is to be leased. Often a lessor partnership is formed for big-ticket items such
as ships and aircraft. Because of the complexity of leveraged leasing arrangements, a lease
manager will be responsible for the management of the contract.
Extended learning
A financial system encourages accumulated savings that are then available for investment
within an economy.
A modern financial system comprises financial institutions, instruments and markets that provide
a wide range of financial products and services.
A range of different financial institutions has evolved to meet the needs of financial market
participants and to support economic growth.
Depository institutions, such as commercial banks, building societies and credit unions,
specialise in gathering savings in the form of deposits and using those funds to provide loans to
customers.
Investment banks tend to specialise in the provision of advisory services to clients (e.g. merger
and acquisition advice).
Contractual savings institutions, such as insurance offices and superannuation funds, enter into
contracts in which they receive funds on the undertaking that they will pay a policyholder, or
member of a fund, a specified sum when a nominated event occurs.
Finance companies sell debt instruments directly to surplus entities and then use those funds to
provide loans and lease financing to borrowers.
Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and invested in
asset classes specified within the trust deed.
Commercial banks dominate in terms of their share of the assets of financial institutions.
LEARNING OBJECTIVE 1.3
Define the main classes of financial instruments that are issued into the financial system, that is,
equity, debt, hybrids and derivatives.
•
•
30
Financial instruments are central to any financial relationship between two parties.
Where the saver acquires an ownership claim on the deficit entity, the financial instrument is
referred to as equity.
END OF CHAPTER QUESTIONS A number of
different question types are included to test student
recall and understanding of the material covered in
the chapter.
Untitled-6
30
11/27/1805:49PM
The Essay questions provide the opportunity to put
the concepts that have been learned into practice,
highlighting students’ ability to analyse and
evaluate the material.
Part 1 Financial institutions
LEARNING OBJECTIVE 10.6
Understand the detailed process of financial asset securitisation.
•
Securitisation
Is there a large budget deficit and a lot of government debt outstanding?
The Extended
learning questions relate to the
•
•
in-depth extended
learning sections and require
•
•
students to• demonstrate a deeper understanding of
•
the concepts
• and theories presented in the chapter.
Is there loose monetary policy and high inflation?
Financial institutions and corporations accumulate financial assets and other entitlements, such
as accounts receivable, mortgage-backed housing loans, credit card receivables and utility rates,
which generate future cash flows over time. There are no secondary markets which specifically
trade in individual assets such as these, so the process of securitisation has evolved to allow the
sale of these types of non-liquid financial assets that have specified future cash flows associated
with them. For example, housing loans have future cash flows attached in the form of periodic
interest payments and principal repayment.
Is the domestic economy in, or at risk of, a recession?
Is there a large current account deficit?
Is there a large amount of foreign debt?
Is there an asset price boom (especially credit driven) occurring?
Are there a lot of bad debts in the banking system, or is there a poor system of bank supervision?
Securitisation is a form of financing in which the cash flows associated with existing financial
assets are used to service funding raised through the issue of asset-backed securities. For example,
the securitisation of mortgage loans involves the bundling together of a group of mortgage loans
with similar characteristics, such as term to maturity. The loan originator (e.g. bank) then sells the
bundle of mortgage loans to the trustee of a special-purpose vehicle (SPV). In order to be able to
pay for the purchase of the mortgage assets from the loan originator, the trustee of the SPV raises
the funds by issuing new securities to investors, particularly institutional investors.
•
Has there been a lot of unhedged foreign currency borrowing?
Are there poor accounting standards, few disclosure requirements or ambiguous bankruptcy
procedures?
These 12 points form a strong starting point for financial crisis analysis. However, you should be
aware that all of the factors will not always be evident, and that the existence of some factors does
not by itself imply an imminent crisis situation. Also, as with past financial crises, each future crisis
will have its own particular set of defining characteristics.
Institutional investors are attracted to this type of investment because, in theory, the level of
risk is relatively low because the securities issued by the SPV trustee are supported by the cash
flows and mortgages associated with the loans purchased from the originator. As the owner of
the mortgage loans, the trustee receives the future loan instalments paid by the housing loan
borrowers. The trustee uses these future cash flows to pay interest on the new securities issued to
institutional investors and repays those securities on maturity.
Questions
The diagrammatic representation of the securitisation process is shown in Figure 10A.1, and
may be summarised as follows:
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points you raise in relation to each question.
•
Essay questions
1
Financial assets (e.g. housing mortgage loans) accumulate and are funded on the balance sheet
by a loan originator, such as a commercial bank.
341
Untitled-5
341
11/27/1804:49PM
2
Describe the flow of funds that characterises any financial system. (LO 1.1)
3
Explain why an investor should consider the time-pattern of cash flows and the variability of
the cash flows associated with a multi-period investment, rather than simply assessing the
investment on the basis of the total cash flows received. (LO 1.1)
4
Risk preferences shape the decisions that people and businesses make when under conditions
characterised by risk and uncertainty. Outline the three ways in which economists categorise
decision makers and explain how each type of decision maker will choose differently when
confronted with a risky choice. (LO 1.2)
5
Identify and discuss three changes in the distribution of assets among the financial institutions
that have occurred during the period of the global financial crisis and Australia’s recovery from
it (2008 to 2018). The information required is presented in Table 1.1. (LO 1.2)
6
Financial instruments may be categorised as equity, debt or derivatives. Discuss each category.
In your answer, make sure you explain the differences between debt, equity and derivatives.
(LO 1.3)
7
During the GFC, the funding of longer-term assets with short-term borrowing was identified
as a point of weakness in the operations of financial institutions. Discuss this statement with
reference to the matching principle. (LO 1.4)
8
xxvi
The concepts of risk, reward, supply and demand underlie the complexity of financial
instruments. How could we use these concepts, for example, to explain the rate of return
expected by a shareholder in Telstra and the price at which Telstra shares change hands on the
stock market? (LO 1.1)
(a) What are the differences between primary market and secondary market financial
transactions?
(b) Why is the existence of well-developed secondary markets important to the functioning of
the primary markets within the financial system? (LO 1.4)
38
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38
01/09/1904:06PM
01/21/19 11:13 AM
Text at a glance
EXPLORING FINANCE ON THE WEB This updated
resource provides a comprehensive list of useful
finance websites including central banks, financial
institutions, government sites, exchanges and markets.
It also provides online learning tools such as financial
newspapers and magazines, currency converters,
background reading and suggested databases.
CAREERS IN FINANCE Introduces students to the
enormous career opportunities that exist in both local
and international economics. A list of web addresses
of select employers of finance graduates is a source of
organisation-specific career information. A useful guide
to preparing online applications is also presented.
EXPLORING FINANCE ON THE WEB
CAREERS IN FINANCE
A career in finance can be established in any country, economic sector, industry sector, business or government and the
range of career opportunities is enormous.
For example, commercial banking provides an enormous range of options including retail finance, corporate lending,
international banking, treasury and information technology, to name but a few. Investment banking also offers specialist
finance opportunities including mergers and acquisitions, project finance, securitisation, underwriting and venture capital.
For those interested in portfolio management, there are many fund managers, including superannuation funds,
operating in Australia. And those people interested in working directly with clients might find that personal financial
planning is another career opportunity to explore.
Small, medium and large businesses all require people skilled in finance to manage their assets, liabilities and cash
flows. Government departments and authorities also require finance graduates to assist with the financing of capital or
recurrent expenditures.
Finance is global and there are possibilities for working in a range of developing and advanced financial markets.
During your studies you may find certain areas of finance that particularly excite and interest you. Research the types
of organisations that provide career opportunities in your areas of interest; understand the structure and culture of
the organisations and carefully consider the organisation’s guidelines for graduate employment. Most large employers
include a link to this information on their website. Some examples include:
ANZ Banking Group – www.anz.com.au/about-us/careers
Commonwealth Bank – www.commbank.com.au/about-us/careers.html
National Bank of Australia – www.nab.com.au/about-us/careers
Westpac Banking Corporation – www.westpac.com.au/about-westpac/careers
Goldman Sachs – www.goldmansachs.com/careers
Macquarie Bank – www.macquarie.com.au/careers
Reserve Bank of Australia – www.rba.gov.au/careers
Australian Prudential Regulation Authority – www.apra.gov.au/aboutAPRA/workingatAPRA
Department of Treasury – www.treasury.gov.au/About-Treasury/recruitmentandcareers
Telstra Corporation – www.telstra.com.au/careers
BHP Billiton Limited – www.bhpbilliton.com/careers
KPMG – www.kpmg.com/au/en/careers
Ernst & Young – www.ey.com/au/en/careers
The following websites have been selected as useful and interesting sources of information relevant to financial
institutions, instruments and markets. As you continue your search of the internet you will find many more sites; this
is just the beginning! See your library’s subject page on finance/economics/business where there will be listings
of search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources
available to use/borrow, often with their call numbers and the general call numbers to look for your subject. These
pages may also list significant journals in your field as well as databases and newspapers.
BACKGROUND READING
FINANCE GLOSSARIES
Both Yahoo! and Google provide good entry points for
the latest news, facts and figures as well as providing
a gateway to other resources. Yahoo! has a specific
Australian and New Zealand site, www.yahoo.com.au/
finance. Google Finance has an international site, www.
google.com/finance.
This text includes a glossary of the main financial market
words referred to in the book. As you extend your
understanding of the financial system further, www.
investorwords.com provides online access to over 6000
words and 20 000 links. It is the biggest financial glossary
on the web.
DATABASES
This is a list of some of the suggested databases your
library may have access to that contain finance articles
and information. If your institution does not have access
to all the databases you may be able to get access
through another institution, so check with your library
about borrowing rights at other universities.
Proquest: Academic research library Covers finance,
has full text articles.
Connect4: Annual report collections Business provides
full text annual reports from various Australian companies
including some company financial statements.
APA Full Text (Australian Public Affairs full text) Lists a
large range of Australian periodicals with some access
to full text.
Proquest: Banking Information Sources International
database, full text article access. Covers banking and
industry and the financial services industry.
Expanded Academic ASAP Full text articles available,
international.
Factiva Full text available, covers most Fairfax
publications including Business Review Weekly, The
Australian Financial Review and The Age.
Science Direct Full text, international. Includes access to
journals such as Journal of Financial Markets, Journal
of International Money and Finance and Journal of
Banking and Finance.
You can find these databases by selecting your subject
(finance, business, economics) and searching the library
subject pages for relevant journal listings. Alternatively,
look them up in alphabetical order through the online
library catalogue to check for access. You may need a
password when accessing them off campus.
Tips for online applications
Before you start
•
WORLD CURRENCIES
http://en.wikipedia.org/wiki/List_of_circulating_currencies This site has a comprehensive list of the majority member
states of the United Nations with their ISO-4217 currency codes and abbreviations listed.
www.xe.com/currencyconverter provides a convenient foreign exchange currency converter.
xxx
FM.indd
–
Allow yourself plenty of time as each application
can take between two and four hours at a minimum!
Read the application instructions carefully, to
determine whether you:
– have the appropriate/minimum software and
hardware to undertake this process
– have the option of downloading a copy of the
application form to assist you in preparing all
relevant information and in filling out the form
– have to fill out the form in one sitting, or whether
you have the option of saving, exiting out and
returning to the form when you are ready
•
•
•
know what information you will be required
to include in the application form (course/unit
details, results etc.) so you can have this handy
when you are completing the forms
– know whether additional information (cover
letters, etc.) can be attached if desired.
Obtain a copy of your academic transcript.
Collect all the information you require, for example
course/unit details. Also have electronic access to
your résumé to cut and paste into the application
form.
If you need to use computer labs or library
computers, book ahead of time.
xxxii
xxx
11/27/1807:02PM
GLOSSARY This useful list of
definitions contains all of the key terms
and concepts as they appear in the
margin notes.
FM.indd
xxxii
Glossary
acceptance a bank puts its name on a bill issued by a
third party; bank accepts primary liability to repay the
face value of the bill at maturity
acceptor a bank that puts its name on the face of a
bill and takes primary liability to repay the holder at
maturity
arbitrage simultaneously taking advantage of buy and
sell price differences between markets
arbitrageur a party that simultaneously conducts buy
and sell transactions in two or more markets in order to
take advantage of price differentials between markets
accounting ratios measures of a company’s financial
and management performance, strength and efficiency
ARBL gap a positive ARBL gap exists when assets are
re-priced before liabilities, and a negative ARBL gap
exists when liabilities are re-priced before assets
accounts receivable an asset on the balance sheet
representing amounts due to the business
ascending triangles form an uptrend characterised by
increasing bottoms and horizontal tops
accounts receivable financing a loan obtained by
a firm using current accounts receivable debtors as
security to support the loan
ask price the price at which an FX dealer will sell the
base currency
accumulation index measures changes in share
prices, plus the reinvestment of dividends received
active ETFs a type of ETF that deploys strategies
designed to outperform a market index
active FX strategy hedging techniques are continually
adjusted in response to forecast changes in exchange
rates
active investment a portfolio structure based on share
analysis, new information and risk/return preferences
FINANCIAL ABBREVIATIONS This comprehensive list
covers all the major financial abbreviations used both
in the text and in the financial world, providing a quick,
easy-to-use reference point. It is helpfully located on the
inside front cover to make looking up terms easy.
11/27/1807:01PM
asset management a bank restricts growth in
its lending to the level of funds available from its
depositor base
asset portfolio a combination of assets, each
comprising attributes of return, risk, liquidity and timing
of cash flows
asset transformation the ability of financial
intermediaries to provide a range of products that
meet customers’ portfolio preferences
age pension a limited regular income stream paid by a
government to older retired persons
assets re-priced before liabilities (ARBL) a risk
management principle that ensures net margins and
profitability are protected
agency problem the conflict of interest that may exist
between shareholders and management of a corporation
assets test minimum level of assets to be held by an
entity seeking listing on a stock exchange
agent bank conducts the ongoing administration role
of an established syndicated loan facility
ASX Trade the electronic securities trading platform
used by the ASX to facilitate trading in equity securities
listed on the ASX
WORLD CURRENCIES Located
on
the inside
back
ASX Trade24
the electronic
securities trading
platformcover
used by the ASX to facilitate trading in futures, options
and contracts for
difference listed on
the ASX lists the
for ease of reference, this handy,
updated
table
at-the-money the physical market price and the option
American-type options options that can be exercised
price arecountries,
the same
at any time up to the expiration
currencies
of alldatethe world’sexercise
major
as well as
Austraclear an electronic clearing house for a range
amortised loan a loan that is progressively repaid
of financial instruments, including Treasury bonds
by regularcommon
equal instalments that
comprise interest
their
abbreviations.
payments and part-principal repayment
American depositary receipt (ADR) a security
(depositary share) issued by a US depositary bank
that is supported by shares held of a foreign listed
company
amortised loan instalments regular and equal
loan instalments that comprise the current interest
payment due, plus part repayment of the loan principal
outstanding
annuity a series of cash flows of equal amount,
equally spaced over time
annuity due periodic cash flows that occur at the
beginning of each period
Australian Office of Financial Management (AOFM)
a body established to manage Commonwealth
Government debt issues
Australian Securities and Investments Commission
(ASIC) the regulatory body responsible for the
supervision of the Corporations Act in Australia
authorised deposit-taking institution (ADI) financial
institution authorised by APRA to accept retail deposits
in Australia
691
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691
xxvii
01/09/1904:23PM
01/21/19 11:13 AM
McGraw-Hill Connect® is the only learning platform that continually adapts to you, delivering precisely
what you need, when you need it.
Proven effective
With Connect, you can complete your coursework anytime,
­anywhere. Millions of students have used Connect and the results are
in: research shows that studying with McGraw-Hill Connect will increase
the likelihood that you’ll pass your course and get a better grade.
Connect support
Connect includes animated tutorials, videos and additional
embedded hints within specific questions to helf you succeed.
The Connect Success Academy for Students is where you’ll find
tutorials on getting started, your study resources and completing
assignments in Connect. Everything you need to know about Connect is here!
Visual progress
Connect provides you with reports to help you identify what you
should study and when your next assignment is due, and tracks
your performance. Connect’s Overall Performance report allows you
to see all of your assignment attempts, your score on each attempt,
the date you started and submitted the assignment, and the date the
assignment was scored.
To learn more about McGraw-Hill Connect®, visit
http://www.mheducation.com.au/student-connect
vin22943_prelims_i-xxxiv.indd
xxviii
01/21/19 11:13 AM
LearnSmart Advantage is a series of adaptive learning products fuelled by LearnSmart—the most widely used
and adaptive learning resource proven to strengthen memory recall, increase retention and boost grades.
Adaptive learning
No two students are the same, so why should their ­learning
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SmartBook
Fuelled by LearnSmart, SmartBook is the first and only
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an initial preview of each chapter and key learning objectives,
students read material and are guided to the topics they most
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directs students to recharge and review important material
they are most likely to forget.
LearnSmart
LearnSmart maximises learning productivity and efficiency
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To find out more about SmartBook visit
http://www.mheducation.com.au/student-smartbook
vin22943_prelims_i-xxxiv.indd
xxix
01/21/19 11:13 AM
EXPLORING FINANCE ON THE WEB
The following websites have been selected as useful and interesting sources of information relevant to financial
institutions, instruments and markets. As you continue your search of the internet you will find many more sites; this
is just the beginning! See your library’s subject page on finance/economics/business where there will be listings
of search terms for the library catalogue and for databases, lists of subject-specific dictionaries and resources
available to use/borrow, often with their call numbers and the general call numbers to look for your subject. These
pages may also list significant journals in your field as well as databases and newspapers.
BACKGROUND READING
FINANCE GLOSSARIES
Both Yahoo! and Google provide good entry points for the
latest news, facts and figures as well as providing a gateway
to other resources. Yahoo! has a specific Australian and
New Zealand site, www.yahoo.com.au/finance. Google
Finance has an international site, www.google.com/finance.
This text includes a glossary of the main financial market words
referred to in the book. As you extend your understanding
of the financial system further, www.investorwords.com
provides online access to over 6000 words and 20 000 links.
It is the biggest financial glossary on the web.
DATABASES
This is a list of some of the suggested databases your
library may have access to that contain finance articles
and information. If your institution does not have access
to all the databases you may be able to get access
through another institution, so check with your library
about borrowing rights at other universities.
Proquest: Academic research library Covers finance,
has full text articles.
Connect4: Annual Report Collection Business provides
full text annual reports from various Australian companies
including some company financial statements.
APA Full Text (Australian Public Affairs full text) Lists a
large range of Australian periodicals with some access
to full text.
Proquest: Banking Information Sources International
database, full text article access. Covers banking and
industry and the financial services industry.
Expanded Academic ASAP Full text articles available,
international.
Factiva Full text available, publications include Business
Review Weekly, The Australian Financial Review and
The Age.
Science Direct Full text, international. Includes access to
journals such as Journal of Financial Markets, Journal
of International Money and Finance and Journal of
Banking and Finance.
You can find these databases by selecting your subject
(finance, business, economics) and searching the library
subject pages for relevant journal listings. Alternatively,
look them up in alphabetical order through the online
library catalogue to check for access. You may need a
password when accessing them off campus.
WORLD CURRENCIES
http://en.wikipedia.org/wiki/List_of_circulating_currencies This site has a comprehensive list of the majority member
states of the United Nations with their ISO-4217 currency codes and abbreviations listed.
www.xe.com/currencyconverter provides a convenient foreign exchange currency converter.
xxx
vin22943_prelims_i-xxxiv.indd
xxx
01/21/19 11:13 AM
Exploring finance on the web
FINANCE MEDIA
Although not all of these may be available from your
library (either in hard copy or through online access with
a password) it is worth investigating the possibilities
of interlibrary loans. Ask your subject librarian for
information about accessing the catalogues of other
libraries.
Wall Street Journal
http://online.wsj.com/public/asia
The Wall Street Journal has great information available
online without subscription.
MSN Money
www.money.msn.com
A useful site that has good coverage of financial events
in the ‘news’ section including video clips.
The Financial Times
www.ft.com/home/uk
Online access to full text articles from either the UK, US
or Asian editions of the paper.
Fortune Magazine
http:www.fortune.com
Fortune Magazine home, access to full text articles.
AUSTRALIAN AND INTERNATIONAL
INFORMATION PROVIDERS
INSTITUTIONS AND AUTHORITIES
Bloomberg – www.bloomberg.com
Dow Jones – www.dowjones.com
Thomson-Reuters – www.reuters.com
The Reserve Bank of Australia website www.rba.gov.au/links
provides direct link access to the websites of:
central banks
EMEAP members
other international organisations
Australian government departments and
­authorities
Australian legislation
Australian financial sector organisations
AUSTRALIAN MAJOR BANKS
ANZ Banking Group – www.anz.com.au
Commonwealth Bank of Australia – www.commbank.com.au
National Australia Bank – www.nab.com.au
Westpac Banking Corporation – www.westpac.com.au
SELECT INTERNATIONAL FINANCIAL
INSTITUTIONS
Allianz – www.allianz.com
Citibank – www.citibank.com
Credit Suisse – www.credit-suisse.com
Goldman Sachs – www.goldmansachs.com
ING Bank – www.ing.com
JPMorgan Chase & Co – www.jpmorgan.com
UBS Investment Bank – www.ubs.com
CREDIT RATING AGENCIES
Fitch Ratings – www.fitchibca.com
Moody’s Investors Service – www.moodys.com
Standard & Poor’s – www.standardandpoors.com
EXCHANGES AND MARKETS
Australian Securities Exchange – www.asx.com.au
New Zealand Stock Exchange – www.nzx.com
CME Group (Chicago Board of Trade and Chicago Mercantile
Exchange) – www.cmegroup.com
Hong Kong Exchange – www.hkex.com.hk
Euronext (formerly London International Financial Futures
Exchange) – www.euronext.com
London Metal Exchange – www.lme.com
London Stock Exchange – www.londonstockexchange.com
Lloyds of London – www.lloyds.com
NASDAQ – www.nasdaq.com
New York Stock Exchange – www.nyse.com
Shanghai Stock Exchange – http://english.sse.com.cn/
Singapore Exchange – www.sgx.com
ASX Trade24 (Futures) – www.asx.com.au
Tokyo Stock Exchange – www.jpx.co.jp/english/
CLEARING, SETTLEMENTS AND CUSTODIAN
SERVICES
Austraclear – www.asx.com.au
Clearstream – www.clearstream.com
Euroclear – www.euroclear.com
Reserve Bank Information and Transfer System – www.rba.
gov.au/payments-and-infrastructure/rits/
SWIFT – www.swift.com
xxxi
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01/21/19 11:13 AM
CAREERS IN FINANCE
A career in finance can be established in any country, economic sector, industry sector, business or government and
the range of career opportunities is enormous. For example, commercial banking provides an wide range of options
including retail finance, corporate lending, international banking, treasury and information technology, to name but a
few. Investment banking also offers specialist finance opportunities including mergers and acquisitions, project finance,
securitisation, underwriting and venture capital.
For those interested in portfolio management, there are many fund managers, including superannuation funds,
operating in Australia. And those people interested in working directly with clients might find that personal financial
planning is another career opportunity to explore.
Small, medium and large businesses all require people skilled in finance to manage their assets, liabilities and cash
flows. Government departments and authorities also require finance graduates to assist with the financing of capital or
recurrent expenditures.
Finance is global and there are possibilities for working in a range of developing and advanced financial markets.
During your studies you may find certain areas of finance that particularly excite and interest you. Research the types
of organisations that provide career opportunities in your areas of interest; understand the structure and culture of
the organisations and carefully consider the organisation’s guidelines for graduate employment. Most large employers
include a link to this information on their website. Some examples include:
ANZ Banking Group – www.anz.com.au/about-us/careers
Commonwealth Bank – www.commbank.com.au/about-us/careers.html
National Bank of Australia – www.nab.com.au/about-us/careers
Westpac Banking Corporation – www.westpac.com.au/about-westpac/careers
Goldman Sachs – www.goldmansachs.com/careers
Macquarie Bank – www.macquarie.com.au/careers
Reserve Bank of Australia – www.rba.gov.au/careers
Australian Prudential Regulation Authority – www.apra.gov.au/aboutAPRA/workingatAPRA
Department of Treasury – www.treasury.gov.au/About-Treasury/recruitmentandcareers
Telstra Corporation – www.telstra.com.au/careers
BHP Billiton Limited – www.bhpbilliton.com/careers
KPMG – www.kpmg.com/au/en/careers
Ernst & Young – www.ey.com/au/en/careers
TIPS FOR ONLINE APPLICATIONS
Before you start
•
Allow yourself plenty of time as each application
can take between two and four hours at a minimum!
Read the application instructions carefully, to
determine whether you:
–
have the appropriate/minimum software and
hardware to undertake this process
–have the option of downloading a copy of the
application form to assist you in preparing all
relevant information and in filling out the form
–have to fill out the form in one sitting, or whether
you have the option of saving, exiting out and
returning to the form when you are ready
–
know what information you will be required
to include in the application form (course/unit
details, results etc.) so you can have this handy
when you are completing the forms
–
know whether additional information (cover
letters, etc.) can be attached if desired.
•
•
•
Obtain a copy of your academic transcript.
Collect all the information you require, for example
course/unit details. Also have electronic access to
your résumé to cut and paste into the application
form.
If you need to use computer labs or library
computers, book ahead of time.
xxxii
vin22943_prelims_i-xxxiv.indd
xxxii
01/21/19 11:13 AM
Careers in finance
Working on the application
•
•
•
•
•
•
•
•
Print out the application form to use as a draft.
Complete responses offline and cut and paste into
the application.
Remember to fill out all the fields.
Save regularly as you progress through the application
form if possible.
Proofread your applications—not all online
application forms have spell checks.
Leave plenty of time to submit the applications
electronically. Typically, employer websites experience
a huge rush towards the application deadlines. You
may experience delays or be unable to submit due to
technical problems if sites are overloaded.
Make sure your email address and mobile phone
numbers are correct! All too often students
record these inaccurately—it is vital that you are
contactable, particularly if employers wish to
schedule you for testing/interviews. If they can’t
reach you, they won’t bother trying again, given the
numbers of applications they will be processing.
If you don’t receive acknowledgment, or you are
unsure whether your application has been received,
contact the relevant recruitment coordinator to
confirm receipt of your application.
If you are having any problems with the technology
or have questions regarding the form, contact the
graduate recruiter in that organisation as soon as
possible.
•
•
Print out a copy of the application for your records
(and make a note of any contact you have with
the organisation)—it will help if and when you are
invited to an interview.
In addition to proofreading, reread your application
before you hit the ‘send’ button. Does it present you
in the best possible way? You will not get another
chance to revise it!
Distinguish yourself from other applicants
Employers advise that the best way to make your
application stand out are the simple things:
• Fill out all the fields.
• Proper business language should be used as you
would for a paper-based application. Just because
it is an online form doesn’t mean that you should
use more informal or text language, or insert
symbols, for example smiley faces.
• Check your spelling, or get others to check it for
you—spell checks don’t pick up everything.
• Answers to in-depth questions should be carefully
thought out and tailored to each employer, not
a generic cut-and-paste answer. Use proper
paragraphs, not just a list of dot points.
These tips may seem obvious, but you’d be amazed
at the number of applications which are not successful
because they haven’t followed this advice!
xxxiii
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PART One
Financial institutions
CHAPTER 1
A modern financial system: an overview
CHAPTER 2
Commercial banks
CHAPTER 3
Non-bank financial institutions
vin22943_ch01_001-040.indd
1
01/09/19 09:18 PM
Financial institutions
This textbook discusses the structure, functions and operations of a modern financial system. You are going
to learn about financial institutions, financial instruments and financial markets. Although institutions,
instruments and markets are fundamentally alike, they may be differentiated by size, terminology, the level of
government regulation and prudential supervision. Despite this complexity, underlying all of the instruments
that are traded on the world’s financial markets are some basic ideas: risk and reward, supply and demand.
Internationalisation of the financial markets has, in part, occurred because of the development of
sophisticated technology-based information systems and product delivery systems. This has allowed new
products and markets to evolve, and an enormous increase in the volume and speed of the flow of funds
through the international financial markets. As will be seen, the combination of globalisation, deregulation,
technology and competition has encouraged enormous innovation and change within financial institutions,
instruments and markets.
Think of a financial system as a number of financial institutions and markets through which funds
move between lenders and borrowers. The institutions and markets that facilitate this flow of funds develop
the financial instruments and techniques that encourage savings and investment. The financial system also
provides the framework through which central banks and prudential regulators influence the operations of
participants in the financial system. Most importantly, a central bank, through its monetary policy initiatives,
affects the level of interest rates, economic activity and business performance.
A financial system is essential in facilitating economic growth and future productive capacity in a country.
The provision of finance to business allows economic growth to occur, which should lead to increased
productivity, increased employment and a higher standard of living. A modern, sound and efficient financial
system encourages the accumulation of savings that are then available for investment in productive capital
within an economy.
Chapter 1 presents an overview of a modern financial system and provides a context for the more
detailed studies that occur throughout the textbook. It introduces the main categories of financial
institutions, discusses the functions of financial markets and provides an overview of the types of instruments
that are created within the markets. At the end of Chapter 1, two extended learning sections are provided:
‘Globalisation of the financial markets’ and ‘The impact of the Asian financial crisis on the financial system’.
Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks. Commercial
banks are the largest financial institutions providing savings, lending and a wide range of other financial
services for their customers. The assets, liabilities and off-balance-sheet business of commercial banks are
analysed in detail. At the end of the chapter, three extended learning sections are provided: ‘The standardised
approach to credit risk’, ‘Business continuity risk management’ and ‘Corporate governance and ethics’.
Chapter 3 extends the discussion of financial institutions further and looks at the operations and
significance of other types of financial institutions. In particular the chapter considers investment banks,
managed funds, superannuation funds, cash management trusts, public unit trusts, life insurance offices,
general insurance offices, hedge funds, finance companies, general financiers, building societies, credit
unions and export finance corporations. At the end of the chapter, an extended learning section is provided:
‘Project finance and structured finance’.
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CHAPTER 1
A modern financial
system: an overview
CHAPTER OUTLINE
1.1
Theory and facts in finance
1.2
The financial system and financial institutions
1.3
Financial instruments
1.4
Financial markets
1.5
Flow of funds, market relationships and stability
Learning objectives
LO 1.1
Understand the basic frameworks that underlie the facts that characterise financial institutions,
financial instruments and financial markets.
LO 1.2
Explain the functions of a modern financial system and categorise the main types of financial
institutions, including depository financial institutions, investment banks, contractual savings
institutions, finance companies and unit trusts.
LO 1.3
Define the main classes of financial instruments that are issued into the financial system, that is,
equity, debt, hybrids and derivatives.
LO 1.4
Discuss the nature of the flow of funds between savers and borrowers, including primary
markets, secondary markets, direct finance and intermediated finance.
LO 1.5
Distinguish between various financial market structures, including wholesale markets and retail
markets, and money markets and capital markets.
LO 1.6
Analyse the flow of funds through the financial system and the economy, and briefly discuss the
importance of ‘stability’ in relation to the flow of funds.
Extended learning
LO 1.7
Appreciate the impact of the global financial crisis (GFC) on the world’s financial system and
economy.
LO 1.8
Appreciate the effects, consequences and relevance of the Asian financial crisis.
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CHAPTER SNAPSHOT
Financial institutions, instruments and markets cannot be separated from the ideas that have
been developed in financial economics about risk, reward, supply and demand, arbitrage
and the time value of money. Ideas originating in university departments of finance and
economics have shaped, and in some cases created, the institutions, instruments and
markets that we observe in the world today. Our very observation of them occurs through the
lens of modern finance theory.
INTRODUCTION
To say that finance can seem like a complex subject is, to some people, an enormous understatement.
Though it’s not something that we will have to worry greatly about for now, finance theorists, like
economists of certain schools, have come to rely more and more upon mathematics to express their
essential ideas. This is a rhetorical choice that need not deter us, though it may delay us, from developing
a deep understanding and appreciation of those ideas.
The great philosopher of science, Karl Popper, argued that all facts are theory-laden. It is not
possible to describe a set of facts or series of data without drawing on some theory or other. Often,
the theory will be hidden from view and the person who is drawing upon its ideas will be doing so
subconsciously. If traced to their ultimate source, however, we shall find that the ideas, though not
necessarily the practices, that prevail in the business and financial worlds find their origins in the
modern finance theories and economics that were developed in universities, mainly in America, during
the twentieth century.
As you read through this book, which is about financial institutions, financial instruments and
financial markets, you will come across a great many facts. A full appreciation of why these facts are
facts and, more to the point, a full understanding of their implications for us necessarily requires that
they be viewed from some theoretical perspective or other. While we cannot cover in a few pages the
results of a half-century of economic thought, we can provide a simple framework that will bring out
a good deal of the meaning of the facts that we present. This simple framework is: risk, reward, supply
and demand.
1.1
LEARNING
OBJECTIVE
1.1
Understand the basic
frameworks that
underlie the facts that
characterise financial
institutions, financial
instruments and
financial markets.
Theory and facts in finance
The primary challenge that a study of finance presents is its language. There are many new words to
learn and those words are used to convey new ideas. New words and new ideas all at once.
If we were to name four pieces of finance and economics that can help us organise our thoughts
and make it easier to understand how financial institutions, instruments and markets work, they
would be: (1) risk and reward; (2) supply and demand; (3) no arbitrage; and (4) the time value of
money.
The returns that investors expect to earn are positively related to the risk they must bear. We might
speak of shareholder returns, bond yields, interest rates or cash flows from a project. These are just
different names for the returns that can be earned by bearing some degree (perhaps zero) of risk. When
the risk is perceived to be greater, the returns that investors demand will be higher. Whatever we might
call them, the rewards from investing depend on the risk that the investor must bear. All investment
returns follow the same rules. If the risk is greater, the expected return is higher.
Later in the book, we introduce some financial instruments that appear rather strange and
mysterious. Of course, they also have some special language that is used to describe them. However,
whether we are talking about shares, bonds, options, futures or swaps, the price of these instruments
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Chapter 1 A modern financial system: an overview
depends ultimately on supply and demand. When the supply of a particular futures or options contract
goes up while demand remains the same (or falls), the price must decline, and vice versa. It can be
helpful to remember that, ultimately, supply and demand are fundamental determinants of the market
prices for everything.
Working alongside supply and demand is a rule that we might call ‘no arbitrage’. More generally,
we might say there are no free lunches. A trader cannot buy a financial instrument in one market at
a low price while simultaneously selling that same thing at a higher price in a different market. If this
were possible, the trader could earn infinite returns at zero risk. That would contradict the risk–reward
trade-off. Of course, traders look for such opportunities all the time. Their buying and selling activities
are the reason why such opportunities do not emerge or do not exist for very long when they do. ‘No
arbitrage’ helps us to understand that prices are just statements that must be consistent with each other.
Two different prices for the same thing is not a mystery. It is just an inconsistent statement that will
quickly be corrected.
Finally, have you ever wondered what interest is and why it exists? Interest is just the reward for
waiting. The difference in value between wine that is in a cellar now and the same wine in 10 years’
time is interest. The difference in value between saplings planted now and fully grown oak trees in
30 years’ time is interest. How much extra value an investor demands depends on his or her impatience
to consume now rather than later. This impatience determines the pure time value of money. This is the
interest rate on completely risk-free investments.
The pure time value of money is positive because people are generally impatient to consume now
and must be rewarded for waiting. If they weren’t, no wine would ever be stored and no commercial
forests would ever be planted. All of the rates of return that we observe on the financial markets consist
of the pure time value of money, plus a premium for risk, plus a premium for inflation. This is the case
for every rate of return we observe. Whether it is a shareholder’s return, a bondholder’s bond yield or a
conservative investor’s term deposit rate, the return is a sum of the pure time value of money, a premium
for risk and a premium for inflation. The risk premium may, of course, be zero for risk-free investments.
These simple rules underpin the now vast interconnections of the world’s financial markets. This
global financial system grew from relatively humble beginnings. Its development began the moment
that people first started to use money. The use of money has many advantages. For one, it makes it
easier for individuals to save their surplus earnings. Saving may be defined as deferring consumption
into the future. The funds saved by surplus units—those savers with current excess funds—can be put to
use by those whose current demand for goods and services is greater than their current available funds.
Such users of funds are called borrowers or deficit units.
Just as the exchange of goods and services can be carried out more efficiently through organised
markets, so too can the exchange of money or value between surplus units and deficit units. Financial
institutions and markets facilitate financial transactions between the providers of funds and the users
of funds.
When a financial transaction takes place, it establishes a claim to future cash flows. This is recorded
by the creation of a financial asset on the balance sheet of the saver. The financial asset is represented
by a financial instrument that states how much has been borrowed, and when and how much is to be
repaid by the borrower. For example, if you invested money in a term deposit with a bank, the bank
would issue a term deposit receipt to you. This is a financial instrument. The receipt would specify
how much you had invested, the rate of interest to be paid, when interest payments are due and when
the amount invested would be repaid by the bank. The interest payments and principal repayment are
claims to future cash flows.
Buyers of financial instruments are lenders that have excess funds today and want to invest and
transfer that purchasing power to the future. The sellers of the instruments are those deficit units
that are short of funds today, but expect to have a surplus amount in the future that will enable the
repayment of the current borrowing.
A principal role of financial institutions and markets is to bring together providers of funds (savers)
with users of funds (borrowers). The flow of funds and the relationship between savers and borrowers,
and the place of the financial markets in the flow, are shown in Figure 1.1. Like our fundamental ideas
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of risk, reward, supply and demand, it is possible to use this idea of a ‘flow of funds’ to cut through the
complexity of the financial markets in its entirety. Financial markets are processes that facilitate the
flow of funds between lenders and borrowers. Regardless of how many facts you are presented with
throughout this book, these basic frameworks can always be drawn upon to remind us that the picture,
beneath the surface at least, is a simple one.
Figure 1.1 Financial markets and flow of funds relationship
Suppliers of funds:
■
surplus (savings) units
Users of funds:
■
deficit units
are
are
Lenders:
■
■
■
■
Borrowers:
householders
companies
governments
rest of world
■
■
■
■
who
receive
funds
who
supply
funds
and
receive financial
instruments
householders
companies
governments
rest of world
Financial markets
and
issue financial
instruments
REFLECTION POINTS
•
•
•
A financial system encourages savings, provides funds for investment and facilitates
transactions for goods and services. The financial system and the financial markets are
inextricably connected with the real economy.
Although seemingly complex, financial institutions, instruments and markets adhere to
some simple rules and can be understood by drawing on basic frameworks of finance and
economics.
The modern financial system began humbly when people first started using money. Economic
and financial transactions are valued in money terms. Money is a universally acceptable
medium of exchange and a store of value. Money, most importantly of all, has a time value.
1.2
LEARNING
OBJECTIVE
1.2
Explain the functions of a
modern financial system
and categorise the
main types of financial
institutions, including
depository financial
institutions, investment
banks, contractual
savings institutions,
finance companies and
unit trusts.
The financial system and financial institutions
A financial system comprises a range of financial institutions, financial instruments and financial
markets which interact to facilitate the flow of funds through the financial system. Overseeing
the financial system, and sometimes taking a direct role, is the central bank and the prudential
supervisor.
The decision to save allows surplus units to transfer some of today’s income to the future, when it
can be used for consumption. Therefore, savings allow consumption in the future to be independent of
future levels of earned income. Surplus entities invest their savings through the purchase of financial
instruments that are expected to improve their overall wealth.
The expectation of the saver is to earn a positive rate of return. However, there are other factors
that savers should consider, otherwise all savers would only purchase financial instruments that offered
the highest rate of return. Providers of funds should consider their own particular needs when they
purchase or invest in assets. This will affect the expected rate of return. It is useful to think of an asset,
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Chapter 1 A modern financial system: an overview
whether it is a real asset such as an investment property or a financial asset such as a bank term deposit,
as being a package of four main attributes:
•
•
•
•
return or yield
risk
liquidity
time-pattern of cash flows.
With a real asset such as an investment in a residential unit, return is the regular rental or lease payments
received, plus any increase in the value of the property over time (capital gain). Risk relates to uncertainty
and probabilities, such as the failure of the tenant to make rental payments or the possibility that the
property may burn down. The liquidity of the residential unit is the ease with which it can be sold.
Finally, the time-pattern of the cash flows will vary depending on the frequency of the rental payments,
the cost of maintenance and the payment of other expenses such as insurance and rates.
In the case of a financial asset such as the purchase of shares in a corporation, return consists of
the dividends received and the capital gains or losses made through movements in the share price on
the stock exchange. Note that a dividend is the portion of corporation profits periodically paid to the
shareholder; a stock exchange is where corporation shares are bought and sold. Risk is measured by
the variability of the expected returns and, in the extreme, the possibility that the corporation may fail.
The liquidity of the shares relates to the ease with which they can be sold on the stock exchange at the
current market price. Finally, the time-pattern of the cash flows expected from the shares depends on
the profitability and dividend policy of the corporation. Typically, a profitable corporation will pay
dividends to shareholders twice a year.
It is reasonable to assume that the average person likes return and liquidity, dislikes risk
and prefers reliable cash flows. Fortunately, the preferences of savers with regard to these four
attributes are not identical. If they were, all savers would seek to place all of their savings with very
few borrowers. Since preferences are not identical, financial institutions and markets provide an
enormous range of investment opportunities that have different levels of return, risk, liquidity and
timing of cash flows.
Individuals and businesses may be categorised as being risk averse, risk neutral or risk takers. More
risk-averse individuals will accept lower expected returns for bearing lower levels of risk. If the level
of risk increases, they expect to be compensated with higher expected returns. It is usual to assume
that individuals and businesses are risk averse to some degree. They do not avoid risk entirely, but
they do demand a higher return for bearing higher risk. Furthermore, savers will accept various levels
of liquidity or different timings of cash flows associated with financial instruments. Participants in
the financial markets are therefore able to alter the composition of their financial asset portfolio by
changing their preferences in relation to the four attributes of return (yield), risk, liquidity and the
timing of cash flows. An asset portfolio is the list of assets held by a saver.
A major function of the financial system is to facilitate portfolio structuring and restructuring
through the buying and selling of a wide range of financial instruments. Financial institutions and
markets provide the potential suppliers of funds with the combinations of risk, return, liquidity and
cash-flow patterns that best suit each saver’s particular portfolio needs.
To support decisions taken by both the providers of funds and the users of funds, the financial
system is also a provider of financial and economic information to market participants. Information
affects price and investment decisions; therefore, the provision of timely and accurate information is
essential for an efficient financial system.
If a financial system is successful in creating a range of financial instruments that possess different
combinations of the four attributes valued by savers, this will encourage an increased flow of savings. By
encouraging savings, the financial system is important to economic growth, as the savings are available
for investment capital that can be used for the improvement of the productive capacity of an economy.
Not only can it be expected that a well-functioning financial system will increase the flow of
savings, but it can also be argued that an efficient financial system should ensure that savings are
Financial system
comprises a range of
financial institutions,
instruments and
markets; overseen
by central bank;
supervised by
prudential regulator
Financial instruments
issued by a party raising
funds, acknowledging
a financial commitment
and entitling the holder
to specified future cash
flows
Flow of funds
movement of funds
through a financial
system
Surplus units
savers or providers
of funds; funds are
available for lending or
investment
Rate of return
the financial benefit
gained from investment
of savings; expressed in
percentage terms
Return or yield
the total financial
benefit received
(interest and capital
gain) from an
investment; expressed
as a percentage
Risk
the possibility or
probability that an
actual outcome will
vary from the expected
outcome; uncertainty
Liquidity
access to cash and
other sources of
funds to meet dayto-day expenses and
commitments
Time-pattern of cash
flows
the frequency of
periodic cash flows
(interest and principal)
associated with a
financial instrument
Asset portfolio
a combination of
assets, each comprising
attributes of return, risk,
liquidity and timing of
cash flows
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Portfolio structuring
the buying and selling
of assets and liabilities
to best meet current
savings, investment and
funding needs
Monetary policy
actions of a central bank
that influence the level
of interest rates in order
to achieve economic
outcomes; primary
target is inflation
more likely to be directed to the most efficient users of those funds. This outcome further enhances
the rate of economic growth. Since typical savers will seek to maximise their return, subject to
their preferred level of risk, liquidity and the time-pattern of cash flows, they should be expected to
invest their funds with users that show a high probability of meeting those expectations, such as by
investing in corporations that use funds to produce goods and services that are in demand in the
marketplace.
Another important function of a financial system is its role in the implementation of monetary
policy. Monetary policy relates to the actions of a central bank that are taken to influence the level of
interest rates in the financial system. The current monetary policy stance of central banks in developed
countries is to maintain the level of inflation within a specified level. Inflation is the increase in the
price for goods and services within an economy. By targeting the level of inflation, a central bank
seeks to achieve a range of economic objectives, such as increased employment and the stability of the
exchange rate of the currency.
REFLECTION POINTS
•
•
•
•
•
•
•
Inflation
an increase in prices
of goods and services
over time; measured
by the consumer price
index (CPI)
Depository financial
institutions
accept deposits
and provide loans
to customers (e.g.
commercial banks,
credit unions)
Investment banks
specialist providers
of financial and
advisory services to
corporations, high-networth individuals and
government
A financial system comprises financial institutions, financial instruments and financial markets.
Overseeing a financial system are the central bank and prudential supervisor.
A financial asset incorporates four main attributes: return, risk, liquidity and time-pattern of cash
flows.
The wide range of financial products available in a financial system facilitates portfolio
structuring.
A financial system provides economic and financial information to the markets; that information
should be timely and accurate.
An efficient financial system rapidly absorbs and reflects new information into the price of
financial instruments.
An efficient financial system encourages savings and allocates those savings to the most
efficient users of funds.
The central bank uses the financial system to implement monetary policy in order to target the
level of inflation and achieve certain economic objectives.
Most of you have carried out transactions with one or more financial institutions. For example,
you may have opened a deposit account with your local bank, applied for a loan from that bank or
obtained a credit card facility. Also, you may have entered into an insurance contract for motor vehicle
insurance, medical insurance, travel insurance or life insurance with an insurance office.
There is a very wide range of financial institutions operating in the financial system. While some
institutions offer similar products and services, typically institutions tend to specialise in areas where
they have greater expertise. We will discuss the different types of institutions in detail in Chapters 2
and 3. In this chapter, we simply classify financial institutions into five categories based on the
differences between the institutions’ sources of funds and uses of funds.
1 Depository financial institutions obtain a large proportion of their funds from deposits lodged by
savers. Examples include deposits placed in demand deposit accounts or term deposit accounts
with commercial banks, building societies and credit cooperatives. A principal business of these
institutions is the provision of loans to borrowers in the household and business sectors.
2 Investment banks generally focus on the provision of advisory services for their corporate
and government clients. This includes advising clients on mergers and acquisitions, portfolio
restructuring and financial risk management. These institutions may provide some loans to clients
but are more likely to advise and assist a client to raise funds directly from the capital markets.
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Chapter 1 A modern financial system: an overview
3 Contractual savings institutions are financial institutions such as life insurance offices, general
insurers and superannuation funds. Their liabilities are mainly contracts which specify that, in
return for periodic payments made to the institution, the institution will make specified payouts
to the holder of the contract if and when an event specified in the contract occurs. The periodic
cash receipts received by these institutions provide them with a large pool of funds that they invest.
Payouts made by these institutions include payments for claims made on an insurance policy, or
payment to a superannuation fund member on their retirement from the workforce.
Contractual savings
institutions
4 Finance companies and general financiers raise funds by issuing financial instruments such as
commercial paper, medium-term notes and bonds in the money markets and the capital markets.
They use those funds to make loans and provide lease finance to their customers in the household
sector and the business sector.
borrow funds directly
from markets to provide
loans and lease finance
to customers
5 Unit trusts are formed under a trust deed and are controlled and managed by a trustee or responsible
entity. Unit trusts attract funds by inviting the public to purchase units in a trust. The funds obtained
from the sale of units are pooled and then invested by funds managers in asset classes specified
in the trust deed. Trusts generally specialise in certain categories of investments, including equity
trusts, property trusts, fixed-interest trusts and mortgage trusts.
offer financial contracts
such as insurance and
superannuation; large
investors
Finance companies
and general
financiers
Unit trusts
investors buy units
issued by the trust;
pooled funds invested
(e.g. equity trusts and
property trusts)
Table 1.1 shows the total assets of the various Australian financial institutions in June 1990, June
2008 and March 2018. The Australian financial system has rapidly evolved over this period in response to
significant changes that have occurred, including regulatory change, internationalisation of the financial
markets and the application of technology to the development of new financial products and information
systems. As can be seen, there has been an enormous growth in assets held within the financial system. This
is not restricted to the Australian market, as international markets have also shown considerable growth.
Table 1.1 Assets of financial institutions, Australia ($ billions)
Financial institution
Reserve Bank
1990
% total
assets
2008
% total
assets
2018
% total
assets
24.9
3.4
93.7
2.2
183.4
2.36
Commercial banks
325.8
43.8
2 239.5
52.0
4 224.4
54.49
Building societies
22.9
3.1
21.7
0.5
12.1
0.0015
8.7
1.2
41.6
1.0
37.1
0.0047
Money-market corporations
53.6
7.2
113.5
2.6
30.9
0.0039
Finance companies and
general financiers
55.5
7.5
130.7
3.0
153.7
1.98
Life insurance offices
85.3
11.5
184.8
4.3
176.1
2.27
Superannuation funds
80.8
10.8
752.2
17.5
2 208.2
28.48
Cash management trusts
4.7
0.6
46.2
1.1
35.5
4.57
Common funds
7.0
0.9
11.6
0.3
9.7
0.0012
Friendly societies
8.1
1.1
4.1
0.1
5.6
0.0007
Public unit trusts
27.7
3.7
272.1
6.3
326.7
4.21
General insurance offices
32.5
4.4
130.0
3.0
216.6
2.79
5.7
0.8
263.9
6.1
132.7
1.71
Credit unions
Securitisation vehicles
Total
743.2
4 305.6
7 752.7
SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.
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Some generalisations that emerge from Table 1.1 include:
•
Total assets of the financial institutions increased more than tenfold over the period, to $7752.7
billion.
•
Commercial banks account for the largest share of the assets of financial institutions, at 54.49 per
cent. However, this figure does not fully represent the full extent of commercial banks’ influence, as
these institutions also participate in a range of activities that are not recorded directly on the banks’
balance sheets (e.g. their managed funds activities).
•
The importance of building societies significantly declined as changes in regulation allowed most of
the larger societies to become commercial banks.
•
The activity of finance companies contracted as the impact of financial deregulation, greater
competition and the absorption of some finance companies into their parent banks took
effect.
•
The percentage of life insurance offices’ share of total assets declined over the period. However, this
was offset by significant increases in their managed funds activities, particularly superannuation
products.
•
Securitisation
non-liquid assets are
sold into a trust; the
trustee issues new
securities; cash flows
from the original
securities are used
to repay the new
securities
The percentage share of superannuation assets increased to 28.48 per cent. Factors influencing
this growth were an ageing population saving for retirement, the introduction of compulsory
superannuation and the introduction of taxation incentives for superannuation savings.
•
Securitisation vehicles showed enormous relative growth up until the onset of the GFC. The
ensuing severe tightening of the availability of credit in the capital markets—resulting, in part,
from problems with securitised assets that were backed by sub-prime mortgage assets—has seen
new securitisation issues subsequently almost disappear and the percentage share of securitised
assets decline to just 1.71 per cent. Securitisation is discussed in the extended learning section at
the end of Chapter 10, but can be briefly described as a process whereby an organisation, such
as a bank, sells existing balance-sheet assets, such as housing loans, thereby generating new cash
flows.
REFLECTION POINTS
•
•
•
•
•
•
Financial institutions may be classified into five categories based on their sources of funds and
uses of funds.
Depository financial institutions, such as commercial banks, gather savings from depositors and
provide loans to customers. (Commercial banks also provide a wide range of other financial
services.)
Investment banks do not have a depositor base; they specialise in the provision of advisory
services to clients (e.g. merger and acquisition advice).
Contractual savings institutions, such as insurance offices and superannuation funds,
gather savings from the sale of insurance contracts and from superannuation contributions
respectively, and make payouts on the occurrence of specified events (e.g. a car accident or
retirement from the workforce).
Finance companies raise funds directly from the money markets and capital markets, and
provide loans and lease finance to customers.
Unit trusts sell units in a trust and invest those funds in assets specified in the trust deed; for
example, an equity trust would invest in certain types of shares.
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1.3
Financial instruments
When a user of funds obtains finance from the provider of funds, the user must prepare a legal document
that clearly defines the contractual arrangement. This document is known as a financial instrument: it
acknowledges a financial commitment and represents an entitlement to future cash flows. The financial
instrument becomes a financial asset on the balance sheet of the provider of funds. If the financial
asset represents debt that will be repaid, then it also appears as a liability on the balance sheet of the
borrower; however, if it represents equity, it will appear as part of shareholder funds.
For example, if a bank customer deposits funds in a term deposit, the bank will acknowledge this
deposit and issue a receipt that will specify the amount of funds provided, the maturity date when the funds
will be repaid, the rate of interest to be paid and the timing of interest payments. The terms and conditions
specified in a financial security can vary significantly. For example, a loan agreement may include an
interest rate that is fixed for the term of the loan, while another loan may have a variable rate of interest
that can change on certain dates. One loan may require monthly payments of interest and principal, while
another loan may require half-yearly interest payments with principal only repaid at maturity. Savers, as the
providers of funds, will purchase financial assets that have attributes of risk, return, liquidity and cash flows
that meet their particular needs. In the financial markets, the saver is said to buy the ‘paper’ of the issuer.
Financial instruments may be divided into three broad categories: equity (including hybrid
instruments), debt and derivatives. These three categories reflect the nature and main characteristics
of financial instruments.
1.3.1
LEARNING
OBJECTIVE
1.3
Define the main classes
of financial instruments
that are issued into the
financial system, that
is, equity, debt, hybrids
and derivatives.
E QUITY
Equity can take a number of forms. For example, if you buy a new car by paying a deposit from your
own funds and borrowing the remainder from a bank, your equity in the car is the amount of the deposit
paid. As you progressively repay the loan to the bank, your level of equity in the car will increase. Equity
can therefore be described as an ownership interest in an asset.
Within the context of the discussions in this text, equity in a business corporation is represented
through the ownership of shares issued by a corporation. The principal form of equity issued by a
corporation is an ordinary share or common stock. As we will discuss in detail in Part 2, larger
corporations list their shares on the stock exchange. Ordinary shares have no maturity date; they
continue for the life of the corporation. However, as the shares are listed on the stock exchange, they
may be sold to other investors at the current market price.
An ordinary shareholder is entitled to share in the profits of the business. Shareholders generally
receive a portion of the profits of the company in the form of dividend payments. (This is discussed
in Part 2.) The value of a corporation’s shares may increase over time, representing a capital gain. In
the event of the failure of a corporation, however, shareholders are entitled to the residual value of the
assets of the corporation (if any remain), but only after the claims of all other creditors and security
holders have been paid.
The owners of ordinary shares have the right to vote at general meetings, in particular for the
election of members of the board of directors of the company.
Another form of equity is known as a hybrid security. A hybrid security may be described as having
the characteristics of both equity and debt (see below). Preference shares are an example of hybrid
securities. Preference shares, while being a form of equity finance, have many characteristics in common
with debt instruments. For example, the holders are entitled to receive a specified fixed dividend for a
defined period, similar to a fixed-interest payment. The fixed dividend must be paid before any dividend
is made to ordinary shareholders. Preference shareholders also rank ahead of ordinary shareholders in
their claim on the assets of the corporation should the company be wound up or placed into liquidation.
Equity
the sum of the financial
interest an investor
has in an asset; an
ownership position
Ordinary share or
common stock
the principal form of
equity issued by a
corporation; bestows
certain rights to the
shareholder
Dividend
that part of a
corporation’s profit
that is distributed to
shareholders
Hybrid security
a financial instrument
that incorporates the
characteristics of both
debt and equity (e.g.
preference shares)
Liquidation
the legal process of
winding up the affairs of
a company in financial
distress
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The issue of hybrid securities, or quasi-equity instruments, has become an increasingly important
means by which corporations raise additional equity funding. These instruments are discussed in detail
in Chapter 5.
The equity markets are discussed in much more detail in Part 2.
1.3.2
Debt instruments
specify conditions of a
loan agreement: issuer/
borrower, amount,
return, timing of cash
flows, maturity date;
debt must be repaid
Secured debt
a debt instrument that
provides the lender with
a claim over specified
assets if the borrower
defaults
Negotiable debt
instrument
a debt instrument that
can be sold by the
original lender through
a financial market
Derivative instrument
a synthetic security
that derives its price
from a physical market
commodity or security;
mainly used to manage
risk exposures
Futures contract
an exchange-traded
agreement to buy
or sell a specific
commodity or
financial instrument
at a specific price at a
predetermined
future date
D EBT
A debt is a loan that must be repaid. Debt instruments represent a contractual claim against an issuer,
and require the borrower to make specified payments, such as periodic interest payments and principal
repayments, over a defined period.
The types of debt instruments issued by a corporation include debentures, unsecured notes,
term loans, commercial bills, promissory notes, overdrafts and mortgage loans. These types of debt
instruments are discussed in detail in Part 3 of the text. However, when we discuss the financial markets
later in this chapter, we will introduce the money markets and the capital markets. Debentures and
unsecured notes are longer-term debt instruments issued into the capital markets, while commercial
bills and promissory notes are short-term instruments issued into the money markets. Term loans,
mortgage loans and overdrafts are generally provided by financial institutions.
Government debt instruments are Treasury bonds and Treasury notes (T-notes); these are examined
in Part 4.
Debt instruments entitle the holder to a claim (ahead of equity holders) to the income stream
produced by the borrower and to the assets of the borrower if the borrower defaults on loan repayments.
Debt can be divided into two subcategories on the basis of the nature of the loan contract: secured debt
and unsecured debt. A secured debt contract will specify the assets of the borrower, or a third party,
pledged as security or collateral. If the borrower defaults on the loan, the lender is entitled to take
possession of those assets to recover the amount owing. In other cases, a loan may be made on an
unsecured basis.
Another subdivision of debt is based on the transferability of ownership of the instrument.
Negotiable debt instruments are those that can easily be sold and transferred from one owner to another.
Commercial bills are an example of negotiable debt instruments that can be sold in the money markets
(Chapter 9). Non-negotiable instruments are instruments that cannot be transferred from one party to
another. A term loan obtained through a bank is generally non-negotiable.
Corporate debt is discussed in Part 3 and government debt in Part 4.
1.3.3
D ERIVATIVES
A third class of instrument has become significant in the financial markets: the derivative instrument.
Derivative contracts are primarily used to manage an exposure to an identified risk. For example,
a borrower might be concerned that interest rates on existing debt funding may rise in the future. The
borrower can accept this forecast risk, or seek to reduce that risk exposure by locking in an interest rate
today. One way the borrower can lock in an interest rate is through the use of derivative contracts.
There is a wide range of derivative contracts for the management of risk exposure related to
commodities (such as gold and oil) and financial instruments (such as interest-rate-sensitive debt,
currencies and equities). Therefore, financial derivatives may be used to manage risk exposures related
to both equity and debt.
There are four basic types of derivative contracts: futures, forwards, options and swaps:
1 A futures contract is a contract to buy (or sell) a specified amount of a commodity or financial
instrument at a price determined today for delivery or payment at a future date. Futures contracts are
standardised contracts that are traded through a futures exchange. Futures contracts are discussed
in Chapters 18 and 19.
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2 A forward contract is similar to a futures contract but is typically more flexible and is negotiated
over the counter with a commercial bank or investment bank. A forward foreign exchange contract
establishes a foreign currency exchange rate that will apply at a specified date. A forward rate
agreement is used to lock in an interest rate today that will apply at a specified date. Forward
contracts are discussed in Chapters 17, 18 and 19.
3 An option contract gives the buyer of the option the right—but not an obligation—to buy (or sell) the
designated asset at a specified date or within a specified period during the life of the contract, at a
predetermined price. The fact that the buyer is not obliged to proceed with the contract is valuable,
and therefore the buyer must pay a premium to the writer of the option. Option contracts are
discussed in Chapters 18 and 20.
4 A swap contract is an arrangement to exchange specified future cash flows. With an interest rate
swap there is an exchange (swap) of future interest payments based on a notional principal amount.
A currency swap is denominated in a foreign currency and fixes the exchange rate at which the initial
and final principal amounts are swapped. Ongoing interest payments are also swapped at the same
exchange rate. Swap contracts are discussed in Chapters 18 and 21.
Derivative instruments are different from equity and debt in that they do not provide actual funds for
the issuer. Funds need to be raised in either the equity or debt markets. Risks associated with equity or
debt issues may be managed using derivative contracts. For example, an investor might be concerned
that the value of shares held in an investment portfolio might fall. The investor might enter into a
derivative contract that gives the investor the option to sell shares at a specified date at a price that
is agreed today. If the share price does fall, the investor will exercise the option and sell at the agreed
higher price.
Forward contract
an over-the-counter
agreement that locks in
a price (interest rate or
exchange rate) that will
apply at a future date
Option contract
the right, but not the
obligation, to buy or sell
a commodity or security
at a predetermined
exercise price; the
option buyer pays a
premium to the option
writer
Swap contract
an agreement between
two parties to swap
future cash flows;
interest rate swaps and
currency swaps
REFLECTION POINTS
•
•
•
•
•
The principal form of equity issued by a publicly listed corporation is the ordinary share or
common stock.
Ordinary shares entitle the shareholder to share in the profits of the company, either through
the receipt of dividends or through capital gains, and provide certain voting rights.
A hybrid security, such as a preference share, incorporates the characteristics of both debt and
equity.
The basic characteristic of debt is that it must be repaid. The debt holder is entitled to receive
cash flows specified in the debt instrument (e.g. interest payments and principal repayment).
Debt may be secured or unsecured.
A derivative contract is designed to facilitate the management of risk (e.g. interest rate risk).
Types of derivative products are futures, forwards, options and swaps.
1.4
Financial markets
We now introduce the third component of a financial system, being the financial markets. You gained
a basic understanding of the financial institutions and instruments earlier in the chapter; now, once
you understand the structure of the financial markets, you should have a good grasp of the integrated
functions of the markets and the importance of the financial system to economic growth within a
country. In this chapter, we begin by categorising the markets according to the types of transactions
LEARNING
OBJECTIVE
1.4
Discuss the nature
of the flow of funds
between savers and
borrowers, including
primary markets,
secondary markets,
direct finance and
intermediated finance.
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that occur within each market. Later in the textbook we will discuss in detail the institutions and
instruments that prevail in each of the financial markets. This section considers:
•
•
•
•
•
•
the matching principle
primary and secondary markets
direct and intermediated financial flow markets
wholesale and retail markets
money markets
capital markets.
1.4.1
Matching principle
short-term assets
should be funded with
short-term liabilities;
longer-term assets
should be funded with
longer-term liabilities
and equity
Overdraft facility
a fluctuating credit
facility provided by a
bank; allows a business
operating account to
go into debit up to an
agreed limit
Bonds
a long-term debt
instrument issued
directly into the capital
markets that pays the
bondholder periodic
interest coupons and
the principal is repaid at
maturity
The matching principle is one of the fundamental reasons for the existence of a wide range of
financial instruments and markets. The principle contends that short-term assets such as working
capital and inventories should be funded with short-term liabilities. For example, if a company is
purchasing stock (asset) that will remain in the company for just a short period of time before the
product is sold, the company should need only a short-term loan (liability) to fund the purchase of
the stock. An example of a short-term loan that can be used for this purpose is an overdraft facility
(see Chapter 9).
The matching principle goes on to state that longer-term assets should be funded with equity
and long-term liabilities. For example, a company may purchase a new factory and manufacturing
equipment, and it is expected that these assets will generate income for the next 10 years. To
fund the purchase, the company should issue equity and/or long-term debt such as bonds (see
Chapter 10).
The money markets and capital markets trade short-term and long-term financial instruments
respectively, and therefore allow borrowers to apply the matching principle in relation to funding. A
borrower is able to match the cash flows associated with a source of funds (liabilities) closely with the
cash flows generated from the use of funds over the life of a particular asset.
While the matching principle may be regarded as a fundamental principle of finance, it is
interesting to note how often this principle is disregarded. For example, at the onset of the GFC,
short-term finance available through the money markets virtually ceased as a result of uncertainty in
relation to risk deriving from the so-called sub-prime market collapse. Quite a number of financial
institutions had been funding longer-term instruments with short-term finance in the money
markets. When this source of finance was suddenly no longer available, the institutions experienced
a significant liquidity problem and some institutions failed or were taken over. They forgot the
fundamentals!
1.4.2
Primary market
transaction
the issue of a new
financial instrument;
funds are obtained by
the issuer
Money
a commodity that is
universally accepted as
a medium of exchange
M ATCHING PRINCIPLE
P RIMARY AND SECONDARY MARKET TRANSACTIONS
The concept of primary markets and secondary markets is quite simple, but their role in ensuring the
efficiency of the financial markets is very important indeed.
A primary market transaction occurs when businesses, governments and individuals issue financial
instruments in the money markets and capital markets. For example, when a corporation issues
additional ordinary shares to raise equity funding for a proposed investment project, it is conducting
a primary market transaction in the capital markets. Similarly, if the government sells new long-term
bonds in order to finance spending on capital works, health or education, this is a primary market
transaction. Individuals who borrow money from a bank to finance the purchase of a house are also
participating in a primary market transaction. The distinguishing characteristic of a primary market
transaction is that it creates a new financial instrument. Primary market flows and relationships are
illustrated in Figure 1.2.
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Figure 1.2 Primary market transactions
Suppliers of funds
supply funds
(surplus units)
Users of funds
(deficit units)
Issue ‘new’ financial instruments
(debt or equity) to the suppliers of funds
Use funds to acquire
goods, services
or assets
In contrast, secondary market transactions involve transactions with existing financial instruments.
Instruments traded in the secondary markets are those that were initially created in primary market
transactions. For example, consider an investor who buys shares (equity) issued by a corporation.
These primary market flows are shown in Figure 1.2. If the holder of those shares now decides to sell
them, the sale of the shares is regarded as a secondary market transaction. Figure 1.3 illustrates the
flows involved in secondary market transactions.
Secondary market
transaction
the buying and selling
of existing financial
securities; transfer of
ownership; no new
funds raised by issuer
Figure 1.3 Secondary market transactions
Surplus entity 1
Holders of previously
issued financial
instruments
sell marketable
securities to
Surplus entity 2
Surplus entity n
and receive market value
Secondary market transactions have no direct impact on the amount of funding raised or available
to the company that was the initial issuer of a financial instrument; that is, the company receives no
extra funds from the secondary market transaction. A secondary market transaction is simply a transfer
of ownership from one party to another party.
However, the existence of well-developed secondary markets has important impacts on the
marketability of new primary market financial instruments or securities.
Secondary market transactions help overcome two potential obstacles that may stand in the
way of savers providing funds for the financing of long-term capital investment. These are the savers’
preferences for liquidity and their aversion to risk. Without an active secondary market, purchasers
of new-issue instruments would be required to hold those long-term instruments until they mature. In
the case of equity, the problem would be even greater as there is generally no maturity date. A deep
and liquid secondary market solves this problem by providing markets where these instruments can be
bought and sold. A deep and liquid secondary market is one where there are many buyers and sellers
in the market.
Economic growth (and the benefits, such as increased employment, that flow to the community
from that growth) is critically reliant on the existence of strong primary markets. Primary market
transactions allow corporations and governments to raise new funding that leads to increased capital
and productive investment. Secondary markets, while not directly involved in the process of channelling
funds from savers to users of funds, encourage both savings and investment because they enhance the
marketability and liquidity of primary-issue instruments, thus making them more attractive to savers.
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Securities
financial assets that
are traded in a formal
secondary market (e.g.
stock exchange)
It will be useful to introduce and explain some market terminology at this stage. A financial asset
has already been defined as an entitlement to future cash flows. A financial instrument is the more
general term used in the markets to describe instruments where there is no organised secondary market
where that instrument can be traded.
The market also describes a number of financial instruments as securities. A security is the term
used to describe a financial asset that can be traded in an organised secondary market such as a stock
exchange or a futures exchange. An example of a financial instrument is a bank term deposit, and an
example of a security is an ordinary share in a publicly listed company. Both are financial assets.
1.4.3
D IRECT FINANCE AND INTERMEDIATED FINANCE
The issue of new financial instruments generates a flow of funds through the primary markets from the
provider of funds to the user of those funds. This flow can occur in two ways:
•
•
The funds may flow through a direct relationship from the provider of funds to the user of funds.
The flow of funds may occur through a financial intermediary such as a bank.
Within the financial markets, each form of financial flow is an important source of finance.
Direct finance
Direct finance
funding obtained
directly from the money
markets and capital
markets
When funds are raised in the primary markets using direct finance, the contractual agreement is between
the provider of funds and the user of funds. The funds are not provided by a financial institution. The
relationships that exist between savers and the users of funds in the provision of direct finance are
shown in Figure 1.4.
Figure 1.4 Direct financial flows
Suppliers of funds
provide funds
(surplus units)
Users of funds
(deficit units)
Brokers and
dealers
Financial instruments
Broker
an agent who carries
out the instructions of
a client
Dealer
makes a market in a
security by quoting both
buy (bid) and sell (offer)
prices
Credit rating
the assessment by a
credit rating agency of
the creditworthiness of
an obligor to a financial
obligation
The ‘brokers and dealers’ included in Figure 1.4 may act as agents through which the instructions
of the providers of funds and users of the funds are carried out.
The broker does not provide the finance, but receives a fee or commission for arranging the
transaction between the two parties. The broker has no rights to the benefits that may flow from the
purchase of the security. It is not necessary for a broker or dealer to be involved at all in the transaction.
An investor seeking to purchase shares in a company will generally arrange the transaction through
a stockbroker. The stockbroker acts only as an agent to the transaction and, on behalf of a client,
facilitates the direct purchase or sale of shares by accessing the electronic share trading systems of the
stock exchange.
Examples of direct financing include share issues, corporate bonds and government securities.
These securities are discussed further in various chapters of the text.
The benefits and disadvantages of direct finance
Direct finance is generally available only to corporations and government authorities that have
established a good credit rating. A credit rating is an assessment of the creditworthiness of an issuer of
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paper. As the contractual relationship in direct finance is directly between the provider of funds and the
issuer of paper, the risk that the issuer may default is an important consideration. Therefore, borrowers
that do not have an established good credit rating generally are not able to borrow direct. The credit
rating process is discussed in Chapter 11.
The main advantages of direct finance are as follows:
•
•
•
•
•
•
•
•
It removes the cost of a financial intermediary. If a borrower obtains a loan from a financial
institution, the borrower will pay a profit margin to the intermediary. Should a corporation or
government authority have an investment-grade credit rating (e.g. Standard & Poor’s BBB and
above), it may well be able to raise funds directly from the domestic or international markets at a
lower total cost than borrowing through a bank.
It allows a borrower to diversify funding sources by accessing both the domestic and international
money and capital markets. This reduces the risk of exposure to a single funding source or market.
It enables greater flexibility in the types of funding instruments used to meet different financing
needs. More sophisticated funding strategies may be used to raise funds. For example, a corporation
may obtain a US dollar (USD) loan in the international capital markets and then use USD export
income to repay the loan.
An organisation may enhance its international profile by carrying out transactions in the
international financial markets. An increased profile in the financial markets may be beneficial in
establishing a reputation in the markets for the firm’s goods and services.
There are some disadvantages that may, at times, be associated with direct financing. These include:
There can be a problem of matching the preferences of lenders and borrowers. For example, a
lender may have a certain amount of funds available for investment, but this amount may not be
sufficient for the needs of the borrower, who would then need to seek out and enter into funding
arrangements with additional suppliers of funds. There may also be a mismatch in the maturity
structure of the funding as the borrower may need to borrow for a longer period than the risk-averse
investor is willing to lend.
The liquidity and marketability of a direct finance instrument may be of concern. How easy is it for
the holder of an instrument issued by direct finance to sell at a later date? Is there a deep and liquid
secondary market in that instrument? Not all financial instruments have an active secondary market
through which they may be sold.
The search and transaction costs associated with a direct issue can be quite high. These might include
advisory fees, the cost of preparing a prospectus, legal fees, taxation advice, accounting advice and
specific expert advice (such as a geologist’s report). On very large direct finance transactions the
fees and costs may run into millions of dollars.
It can be difficult to assess the level of risk of investment in a direct issue, particularly default risk.
Accounting and reporting standards may vary between nation-states, and information about an issuer
may be limited to the prospectus and the issuer’s credit rating.
Intermediated finance
The critical difference between direct and intermediated finance can be found in the relationships
that exist between the saver, the intermediary and the user of funds. With intermediated finance, as
illustrated in Figure 1.5, the intermediary has an active role in the relationship. The intermediary, in
providing finance to deficit units, acquires the ownership of the financial instrument that is created as
part of the transaction. It also obtains the rights to the benefits and risks associated with the ownership
of that asset. The benefits include the receipt of interest payments and the repayment of principal. On
the other hand, a significant risk accepted by the intermediary is default or credit risk—that is, the risk
that the borrower may not make all loan repayments.
Default risk
the risk that a borrower
may not meet financial
commitments such as
loan repayments when
they are due
Intermediated
finance
financial transaction
conducted with a
financial intermediary
(e.g. bank deposits and
bank loans); separate
contractual agreements
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Figure 1.5 Intermediated financial flows
Suppliers of funds
funds
(surplus units)
Intermediaries
Financial instrument
funds
Users of funds
(deficit units)
Financial instrument
In order to be able to provide loans to its customers, an intermediary obtains its funding from
savers. Savers receive financial instruments issued by the intermediary, such as a term deposit receipt
issued by a bank. A contractual agreement then exists between the saver and the intermediary in relation
to the term deposit. The intermediary creates a separate contractual agreement with the borrower (the
ultimate user of funds). The saver has no claim on the income or assets of the ultimate borrower. Those
entitlements reside with the bank as the intermediary. The saver only has a claim for the payment of
interest and the return of principal at maturity from the bank. On the other hand, under a separate
loan contract, the intermediary relies on the borrower for repayment of the loan. Failure of the bank
to recover the funds from the borrower does not change the contractual relationship the bank has with
its depositor.
The benefits of financial intermediation
Very often the portfolio preferences of savers and borrowers differ. For example, a risk-averse lender
may be prepared to receive a lower rate of return in exchange for maintaining funds at call. On the
other hand, a borrower may be prepared to pay a higher rate of return, but may want to have the funds
available for a number of years. It is likely that many savers and borrowers would find it difficult to meet
their investment and funding needs if only direct finance was possible.
An intermediary is able to resolve this problem and satisfy the preferences of both parties, and at
the same time make a profit. An intermediary is able to transform short-term deposit funds into longerterm loan funds. An essential economic role of an intermediary is to resolve the conflicting preferences
of surplus units and deficit units, and thus encourage both savings and productive capital investment.
In carrying out the role of offering instruments with varying financial attributes (risk, return,
liquidity, timing of cash flows), intermediaries perform a range of functions that are important to both
savers and borrowers. These are:
•
•
•
•
•
asset transformation
maturity transformation
credit risk diversification and transformation
liquidity transformation
economies of scale.
Asset transformation
Asset transformation
the ability of financial
intermediaries to
provide a range of
products that meet
customers’ portfolio
preferences
Financial intermediaries engage in asset transformation by offering their customers a wide range of
financial products on both sides of the balance sheet, including deposit, investment and loan products.
Without intermediation, surplus units that could generate only small levels of savings would not
have any incentive to save; and users of funds, such as individuals and small businesses, would find the
cost of obtaining loans too great to be worthwhile. Intermediaries specialise in the gathering of savings
and can achieve economies of scale in their operations. They can profitably receive small amounts from
many savers, pool them into larger amounts and make them available as loans to borrowers.
Financial intermediaries provide a range of deposit products which meet the varying preferences
and need of their customers. These include demand deposit accounts, current accounts, term deposits
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and cash management trusts. At the same time, financial intermediaries provide a range of loan
products, including overdraft facilities, term loans, mortgage loans and credit card facilities.
Maturity transformation
Most frequently, savers prefer great liquidity in their financial assets, while borrowers tend to
prefer a longer-term commitment in the funds they borrow. By managing the deposits they receive,
intermediaries are able to make loans of a longer-term nature while satisfying savers’ preferences for
shorter-term savings. This is referred to as maturity transformation.
Banks provide a good example of the maturity transformation function of intermediaries. The
deposits they receive are generally quite short term in nature (typically less than five years), yet a large
proportion of their lending is for home loans that frequently have a maturity of 30 years. The banks
therefore have a mismatch between the terms to maturity of a large proportion of their sources of funds
and their loan liabilities.
Financial intermediaries are able to perform such extremes of maturity transformation for two
reasons. First, it is unlikely that all savers would choose to withdraw their deposits at the same time.
Deposit withdrawals during any particular period are generally more or less matched by new deposits.
Second, and more importantly, financial intermediaries that engage in maturity transformation rely on
liability management.
Should a bank’s deposit base (liabilities) begin to decline below the level necessary to fund their
forecast loan portfolio (assets), then the bank may adjust the interest rates that it offers in order to attract
the necessary additional deposits. More probably, the bank will issue further securities (liabilities)
directly into the money or capital markets to raise the additional funds required.
Maturity
transformation
financial intermediaries
offer products with
a range of terms to
maturity
Liability management
when banks actively
manage their sources
of funds (liabilities) in
order to meet future
loan demands (assets)
Credit risk diversification and transformation
Credit risk transformation occurs through the contractual agreements of intermediation. A saver has an
agreement with the financial intermediary, and therefore the credit risk exposure of the saver is limited
to the risk of the intermediary defaulting. The financial intermediary has a separate loan agreement
with the borrower and is exposed to the credit risk of the borrower.
Financial intermediaries have two advantages over most individual savers in managing investments.
First, intermediaries specialise in making loans and therefore develop an expertise in assessing the risk
of potential borrowers. This expertise comes from the technical skills of the employees and systems in
assessing and monitoring loan applications, and also from the information that is acquired through
prior dealings with the borrower.
Credit risk
transformation
a saver’s credit risk
exposure is limited to
the intermediary; the
intermediary is exposed
to the credit risk of the
ultimate borrower
Liquidity transformation
Savers generally prefer more, rather than less, liquidity in their investments. One reason for this is
that the timing of a saver’s income and expenditure flows will not perfectly coincide. There are times
when income is higher than expenditure and savings are available for investment purposes. On the
other hand, there are times when expenditure exceeds income. In order to try and manage this timing
problem, savers will tend to hold at least some of their financial assets in a very liquid form that can
easily be converted to cash.
Liquidity transformation is measured by the ability to convert financial assets into cash at something
close to the current market price of the financial instrument. However, liquidity has another dimension:
the transaction costs associated with acquiring and disposing of the financial asset. Transaction costs
can often be quite high. However, a financial intermediary may have the capacity to lower transaction
fees by spreading fixed costs across a large number of transactions. The time involved in carrying out a
transaction may also be an important component of the total transaction cost.
Many intermediaries provide highly liquid accounts in which individuals may store some of
their wealth. For example, a demand (at-call) account with a bank represents complete liquidity. The
depositor has the right to withdraw funds without notice. There is zero risk that the value of the asset,
when it is converted into cash, will be less than the value of the deposit in the demand account. In
addition, the transaction costs associated with converting the credit balance into cash are limited to
Liquidity
transformation
measured by the ability
of a saver to convert
a financial instrument
into cash
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transaction fees imposed by the bank. Intermediaries such as commercial banks can offer highly liquid
assets to savers, which the ultimate users of funds would be most unlikely to be able to do.
Banks have further extended liquidity arrangements by adopting systems such as electronic
networks: automatic teller machines (ATMs) and electronic funds transfer at point of sale (EFTPOS)
arrangements.
Economies of scale
Economies of scale
financial and
operational benefits
gained from
organisational size,
expertise and volume of
business
Financial intermediaries gain considerable economies of scale due to their size and the volume of
business transacted, and therefore have the resources to develop cost-efficient distribution systems.
Banks maintain extensive branch networks as their primary distribution mechanism. At the same time
they also provide extensive technology-based distribution systems such as ATMs, EFTPOS, telephone
banking and internet banking.
The cost of the sophisticated computer and communication systems required to support such
distribution networks is spread over the millions of transactions processed.
Intermediaries also obtain cost advantages through effective knowledge management and the
accumulation of financial, economic and legal expertise. For example, a bank will typically use
standardised documentation for its deposit and lending products. The bank knows that these documents
will comply with regulatory and legal requirements. Other cost advantages include a reduction in search
costs for both savers and borrowers; that is, savers do not need to investigate the creditworthiness of the
ultimate borrower. The intermediary will have that data available before making a loan decision.
In a competitive market, financial intermediaries should pass on efficiency gains in the form of
reduced interest margins and fees.
1.4.4
LEARNING
OBJECTIVE
1.5
Distinguish between
various financial market
structures, including
wholesale markets
and retail markets, and
money markets and
capital markets.
Wholesale market
direct financial flow
transactions between
institutional investors
and borrowers
Retail market
financial transactions
conducted with financial
intermediaries mainly
by individuals and
small to medium-sized
businesses
W HOLESALE AND RETAIL MARKETS
Direct financial transactions between institutional investors and borrowers are described as
wholesale market transactions. Institutional investors include commercial banks, insurance offices,
superannuation funds, investment banks, fund managers, finance companies, building societies, credit
unions, government authorities and large corporations. Transactions conducted in the wholesale
markets typically range from the tens of thousands of dollars to the millions of dollars. For example,
a portfolio manager may purchase a $50 000 wholesale managed fund for a client while a financial
institution might sell $10 million worth of commercial bills into the money market.
The cost of wholesale funds is determined by a range of factors, such as the level of liquidity
(surplus funds) within the financial system, future interest rate expectations and the maturity structure
of investment opportunities. For example, large amounts of short-term funds are invested overnight in
the money markets. Generally, wholesale investors are able to accumulate large quantities of surplus
funds and use their market power and investment skills to obtain higher returns than would normally be
available in the retail market. At the same time, wholesale market borrowers are able to use their good
credit standing in the markets to obtain access to those funds.
The retail market, on the other hand, comprises transactions primarily of individuals and small to
medium-sized businesses. Transactions are principally conducted with financial intermediaries. Market
participants are price takers; that is, the financial intermediary is able to set both deposit and lending
rates of interest. Retail market participants are not totally excluded from the wholesale markets. They
are able to gain indirect access to the wholesale markets through managed investment products such as
cash management accounts and unit trusts. These are discussed in Chapter 3.
1.4.5
M ONEY MARKETS
The financial markets may be categorised according to the characteristics of the financial instruments
that are traded in the markets. Within the debt and equity markets, the two main market classifications
are the money markets and the capital markets. The money markets and the capital markets include
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Chapter 1 A modern financial system: an overview
a number of submarkets (see below). Other markets, such as the foreign exchange market and the
derivatives market, also form part of the financial system.
Money market transactions involve wholesale short-term-to-maturity securities of less than
12 months. As discussed below, medium- to long-term-to-maturity transactions are referred to as
capital-market transactions. Figure 1.6 depicts the structure of the money markets and the capital
markets. You will note that each market incorporates primary and secondary markets within both the
domestic and the international markets.
Money markets
wholesale markets
in which short-term
securities are issued
and traded
Figure 1.6 Structure of the money and capital markets
Financial markets
Money markets
Primary money
markets
Secondary money
markets
Capital markets
Primary capital
markets
(maturities to one year)
(residual maturities
to one year)
(new shares and longterm debt issues)
Domestic
short-term
money markets
International
short-term
money markets
Domestic
capital markets
Secondary capital
markets
(trading in existing
securities)
International
capital markets
The money markets bring together institutional investors that have a surplus of funds and those
with a short-term shortage of funds. The money markets are attractive to institutional investors for
short-term financing arrangements as the markets are (normally) highly liquid and the securities issued
in the market are standardised and have well-developed secondary markets.
The money markets allow institutional investors, such as commercial banks, insurance offices,
superannuation funds, investment banks, funds managers, finance companies, other finance
institutions, government authorities and large corporations to manage their short-term financing
needs. For example, a large retail sales store may accumulate surplus funds from sales. In order
to gain a return, the store needs to invest the surplus funds. However, the store may need to use
the funds in a few days to buy more stock. The store knows that it is able to purchase short-term
securities in the money markets today that can easily be sold again in a few days when the cash is
needed.
From the point of view of borrowers, one of the principal functions of the money markets is to
enable them to bridge the mismatch between their cash expenditures and their cash receipts. A large
corporation may need to raise short-term funds to cover its forecast working-capital requirements over
the next three months. The corporation could borrow the funds from a bank, but it may also find that
it is able to borrow at a lower yield by issuing short-term securities directly into the money markets. The
securities issued may be repaid as the company generates income from its products or services.
The money markets have no specific trading location. Money-market transactions are conducted
from the business offices of the market participants using computer networks. The money markets
Institutional investors
participants in the
wholesale markets
(e.g. funds managers,
insurance offices,
banks)
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operate both as primary markets in which new securities are issued and as secondary markets in which
existing securities are bought and sold. The major money-market participants and securities issued and
traded are listed in Figure 1.7.
Figure 1.7 Money-market participants and instruments
Market participants
Money-market instruments
Central bank
Exchange settlement account funds
Commercial banks
Treasury notes
Superannuation funds
Investment banks and merchant banks
Government bonds (less than 12 months to
maturity)
Finance companies
Commercial bills
Insurance offices
Promissory notes (commercial paper)
Funds managers (including unit trusts)
Deposits (11 am and 24-hour call)
Building societies and credit unions
Negotiable certificates of deposit
Cash management trusts
Interbank loans
Corporations
Repurchase agreements (repos)
Money-market submarkets
As indicated in Figure 1.7, the money markets comprise a number of submarkets, including:
•
•
•
•
•
central bank: system liquidity and monetary policy
interbank market
bills market
commercial paper market
negotiable certificates of deposit market.
Central bank: system liquidity and monetary policy
Central banks use the money markets to carry out transactions that will maintain, or change, the
amount of liquidity that is available within the financial system. The amount of daily liquidity in the
financial system is affected mainly by government budget surpluses or deficits, official foreign exchange
transactions and net sales of government securities. The amount of liquidity in the financial system
directly impacts on interest rates in the market. The central bank implements its monetary policy by
targeting the cash rate, hence the central bank carries out money-market transactions so that the cash
rate remains at its target level.
For example, in Australia the central bank is the Reserve Bank of Australia. The Reserve Bank
deals regularly, usually daily, in the money markets for the purpose of managing the supply of
liquid funds (cash) available to the financial system. The Reserve Bank deals in (buys and sells)
Commonwealth Government Securities (CGS) and certain other specified securities of up to one
year to maturity, and in repurchase agreements (repos). The Reserve Bank conducts these market
operations with members of the Reserve Bank Information and Transfer System (RITS), principally
commercial banks and other institutions that participate in the wholesale market for CGS. RITS is an
electronic settlement system.
Furthermore, the Reserve Bank is responsible for the implementation of monetary policy. Briefly,
the main monetary policy objective is to maintain an economic environment whereby inflation remains
within a desired range of 2.00 per cent to 3.00 per cent over time. To achieve this, the Reserve Bank seeks
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to influence the level of interest rates by targeting the cash rate in the money markets. In an efficient
market, it is expected that if the cash rate changes, then this will flow through over time to changes in other
interest rates. Changes in interest rates will then impact on economic activity and the level of inflation.
System liquidity and monetary policy issues are discussed in Chapter 12.
Interbank market
The interbank market facilitates the management of the short-term liquidity needs of the commercial banks.
Banks carry out transactions on behalf of their customers and also on their own behalf. Settlement of
transactions between the banks occurs through the payments system. In order to effect settlement, each
member of the payments system is required to maintain an exchange settlement account with the central bank.
An important role of the interbank market is the lending of surplus exchange settlement account
funds. These cleared settlement funds are known as same-day funds and are required by the banks to
maintain their exchange settlement accounts in credit. The introduction of real-time gross settlement
for the clearance of large-value transactions has increased the profile of the interbank market. The
operation of the payments system is discussed in Chapter 12.
Interbank market
the lending and
borrowing of very
short-term funds by
banks operating in the
payments system
Bills market
Bills of exchange are short-term discount securities. A discount security is issued today with a face value
that is payable at the maturity date. A discount security does not pay interest, but is sold to investors
at a price less than the face value. Therefore, the holders of these securities obtain their return on
investment from the difference between the price that they pay for the security and the price for which
they sell it, or the face value if held to maturity. For example, if a borrower issues a bill with a face value
of $1 million, payable in 90 days, and sells the bill today for $980 000, then the return to the investor
will be $20 000 if the bill is held to the maturity date. The issuer of the bill has effectively borrowed
$980 000 for 90 days at a cost of $20 000.
The commercial bills market is the largest component of the money markets, and involves the
trading of bank bills and non-bank bills. There is an active secondary market in commercial bills. This
allows market participants to manage their maturity preferences. For example, an investor can buy a 90day bill but sell it after seven days. The same bill might be sold several times during its short 90-day life.
Commercial bills are discussed in Chapter 9.
Discount securities
short-term securities
issued with a face value
payable at maturity;
they do not pay interest;
they are sold today at
a discount to the face
value
Bills market
an active money
market for the issue
and trading of bills of
exchange (discount
securities)
Commercial paper market
Another important segment of the money markets is the issue and trading of promissory notes. It is a
market convention to refer to promissory notes as commercial paper.
A promissory note is a discount security (similar to a commercial bill). It is issued with a face value
that is payable at maturity. As the promissory note does not pay interest, it is sold today for less than
the face value. Refer to the example given in the bills market (above).
The strength of this market tends to fluctuate with the overall performance of the economy. As
promissory notes are often issued on an unsecured basis, only corporations with a good credit rating
are able to issue into the market. However, a segment of the market comprises the issue of secured
commercial paper supported by asset-backed securities. As mentioned above, this segment of the
commercial paper market virtually ceased to operate as a result of the credit crisis associated with
the GFC. This occurred because a portion of the asset-backed securities turned out to be sub-prime
securities with a high risk of default. Promissory notes (commercial paper) are discussed in Chapter 9.
Commercial paper
promissory notes
(discount securities)
issued into the money
market by corporations
with a good credit
rating
Negotiable certificates of deposit market
Negotiable certificates of deposit, more commonly referred to as CDs, are short-term discount securities
issued by banks. An example of a discount security is given in the bills market (above).
The CD segment of the money markets is a source of liquidity funding for the banks. As a result
of increased levels of funds under management, the CD market has become an increasingly important
source of liquidity funding, giving the banks flexibility to manage the short-term maturity structure of
their balance sheets.
Negotiable certificate
of deposit
a discount security
issued by a bank
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1.4.6
Capital markets
markets for longerterm funding; includes
equity, corporate debt
and government debt,
and is supported by the
foreign exchange and
derivatives markets
C APITAL MARKETS
Capital markets channel savings to finance the longer-term investment plans of businesses, individuals
and governments. Therefore, financial instruments are defined as capital-market instruments if they
have an original term to maturity in excess of one year. Capital-market instruments include both debt
instruments and equity, and encompass both the domestic and international markets.
The capital markets are extremely large and offer a wide range of products to meet the needs
of both lenders and borrowers. For example, loans may be obtained through direct or intermediated
finance for periods ranging up to 30 years. Loans may be secured or unsecured, have a fixed interest
rate or a variable interest rate, and different repayment structures and timing of cash flows.
The development of domestic capital markets is extremely important for economic growth as they
provide the long-term funds necessary for productive investment. Further, the international capital
markets offer enormous opportunities for investing and borrowing funds in a range of countries,
markets and currencies. We will explore the diverse nature of the capital markets by looking at the
following markets:
•
•
•
•
•
equity market
corporate debt market
government debt market
foreign exchange market
derivatives market.
Equity market
Equity markets
facilitate the issue of
financial securities that
represent an ownership
interest in an asset (e.g.
stock market)
The principal characteristic of the equity market is that the provider of equity finance obtains an
ownership interest in an asset.
Within the context of a corporation, the main form of security issued is the ordinary share,
sometimes referred to as common stock. The shareholder has an entitlement to participate in the
profits of the business, by way of receiving either dividend payments or capital gains (losses) in the
value of the shareholding.
From the perspective of the business, equity provides a source of long-term funding that does not
have to be repaid. Equity is available to:
•
•
•
•
finance physical infrastructure such as buildings and equipment
provide creditor confidence in dealing with the firm
ensure the availability of funds to absorb abnormal losses
improve the liquidity of the business.
This text focuses mainly on equity issued by publicly listed corporations on a stock exchange.
Chapter 4 considers the share market and the corporation, Chapter 5 explores a range of issues that a
corporation needs to consider when issuing equity, Chapter 6 examines equity financing from the point
of view of an investor and Chapter 7 provides a detailed analysis of share prices. As you can see, there
is a lot to learn about the equity markets. However, it is easy to become addicted to the stock market,
particularly if you become an investor.
Corporate debt market
Longer-term debt is an important source of funding for the growth of business corporations. Capitalmarket debt represents a financial commitment that typically requires periodic interest payments to
be made during the term of the debt arrangement, and repayment of principal (amount borrowed).
The principal may be amortised—that is, repaid in periodic instalments over the period of the loan—or
repaid in a lump sum at the maturity date.
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Medium-to-longer-term debt instruments issued into the corporate debt market include:
•
•
•
•
•
•
•
term loans: provided by commercial and investment banks
commercial property finance: loans secured by a registered mortgage over the business property being
financed
debentures: a corporate bond, where security is given in the form of a charge over the assets of the
borrower
unsecured notes: a corporate bond with no security attached
subordinated debt: where the claims of the debt holder are subordinated against other debt lenders
lease arrangements: periodic lease payments made in return for borrowing an asset
securitisation: the sale of existing assets, such as mortgage loans, to generate new funds.
These capital market products are discussed in Chapter 10.
With the deregulation of the financial system, the international capital markets are also an
important source of funding for corporations with good credit ratings. Chapter 11 examines offshore
funding, focusing on the euromarkets and the US markets and the various instruments available within
those markets. While the types of products offered in the international markets are fundamentally the
same as those listed above, the main variable is the currency in which they are issued. For example, a
euromarket instrument is issued by a borrower into another country, and the instrument is denominated
in a currency other than the currency of the country in which it is issued. An example might be an
Australian company issuing corporate bonds into the Singapore market that are denominated in USD
(borrowing USD).
Government debt market
Governments also need to budget with regard to their cash flows and capital expenditures. A government
may budget for a surplus, a deficit or be in balance. If a budget is in deficit, the government will need
to borrow funds to cover the forecast deficit. If a budget is in surplus, the excess funds can be used to
repay existing government debt.
Governments fund budget deficits through long-term borrowings in both the domestic and the
international capital markets. If a government has a short-term liquidity funding need due to a mismatch
of cash inflows from taxation and cash outflows to meet commitments such as pension payments, this
may be managed by issuing short-term securities.
For example, if the Australian government has a short-term funding need, it will issue Treasury
notes. It issues Treasury bonds to raise longer-term funds. The Reserve Bank acts as banker to the
government and therefore issues government securities as required to meet the government’s funding
needs.
Treasury notes are discount securities issued in the money market with maturities up to six months.
Treasury bonds are issued in Australia with maturities ranging up to 10 years. They are mainly
issued as fixed-interest securities for which half-yearly interest payments are made for the term of
the bond and the principal is repaid at maturity. The bonds may be issued at a discount or premium
over face value, depending on the yield of the fixed-interest coupon relative to the issue tender price.
The bonds are sold periodically by tender to members of RITS. Government funding is discussed in
Chapter 12.
The extent of government borrowing has an impact on the private sector. If the government
increases its borrowing in the market, it will crowd out or reduce the amount of funds available to
corporate borrowers.
Foreign exchange market
The foreign exchange market forms an important component of the capital markets, especially since the
floating of exchange rates by the majority of nation-states and the deregulation of the financial systems
of the major economies of the world.
Corporate debt
markets
facilitate the issue
and trading of debt
securities issued by
corporations (e.g.
discount securities,
bonds)
Euromarket
instruments
financial transactions
conducted in a foreign
country in a currency
other than the currency
of that country
Government debt
government borrowing
for short-term liquidity
needs, or longerterm budget capital
expenditures (T-notes,
Treasury bonds)
Crowding out
government borrowing
that reduces the
net amount of funds
available for other
lending in the financial
system
Foreign exchange
markets
markets that facilitate
the buying and selling
of foreign currencies
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Corporations, financial institutions and governments all access funds in the international capital
markets, which provide a range of funding instruments and a diversity of funding sources that otherwise
may not be available within domestic capital markets.
Financial instruments issued in the international capital markets are usually denominated in a
foreign currency. Therefore, interest payments and principal repayments related to international debt
commitments require the borrower to purchase the necessary foreign currency in order to make those
periodic payments.
The foreign exchange market facilitates the buying and selling of foreign currencies necessary
for the conduct of international capital-market transactions. The exchange rate is the price of one
currency against another. Foreign exchange risk is the risk that the exchange rate between currencies
will change. Other issues that have an impact on the exchange rate—and therefore the cost of funding in
the international capital markets—are relative inflation, relative interest rates, relative national income
growth, government intervention and exchange rate expectations. The foreign exchange market is
discussed in Part 5.
Derivatives market
Derivatives markets
markets in synthetic risk
management products:
futures, forwards,
options, swaps
Within the context of the capital markets, the derivatives market provides a range of risk management
products that are available to borrowers to manage risks associated with capital-market transactions.
The principal risks to be managed include interest rate risk, foreign exchange risk and price risk. For
example, a borrower with an existing loan that has a variable interest rate might be concerned that the
rate will increase in the future. The borrower might use a derivative product to manage that risk. The same
principles apply for the risk that the exchange rate might change or that share prices may rise or fall.
Derivative products available to manage these risks are discussed in detail in Part 6. They include
futures contracts, forward rate agreements, forward foreign exchange contracts, options, interest rate
swaps and currency swaps. A brief introduction to the different types of derivative contracts was given
in Section 1.3.3.
The derivatives market, through the provision of a range of risk management products, supports
and encourages capital-market transactions. Risk management through the use of derivative contracts
is a complex area of finance and will represent a challenging part of your later learning.
REFLECTION POINTS
•
•
•
•
•
•
The matching principle contends that short-term assets should be financed by short-term
liabilities, and longer-term assets financed with longer-term liabilities and shareholder funds.
Within the context of financial markets, primary markets are those markets where new financial
instruments are issued.
Secondary markets are those markets where existing securities are bought and sold.
Direct finance occurs when a provider of funds contracts with a user of funds. Benefits can
include lower cost of funds, access to diverse funding sources and greater financing flexibility.
Disadvantages involve matching funding preferences, liquidity and marketability of instruments
issued, search and transaction costs and risk assessment.
Intermediated finance occurs when the provider of funds contracts with a financial intermediary,
such as a commercial bank, and the financial intermediary contracts separately with the user
of funds (borrower). Benefits include asset transformation, maturity transformation, credit risk
diversification and transformation, liquidity transformation and economies of scale.
Wholesale market transactions are large direct transactions carried out by institutional
investors. Retail market transactions are usually greater in number but smaller in size, and
are typically carried out with a financial institution by individuals and small to medium-sized
businesses.
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•
•
Money markets are direct finance wholesale markets for the issue of discount securities
such as bills of exchange, promissory notes (commercial paper) and negotiable certificates
of deposit. These short-term markets allow participants to manage their day-to-day liquidity
requirements.
The capital markets provide long-term finance, including equity, corporate debt and
government debt. The capital markets are supported by the foreign exchange market and the
derivatives markets.
1.5
Flow of funds, market relationships
and stability
A principal function of the financial system is to facilitate the flow of funds between suppliers of funds
and users of funds.
The flow of funds to deficit units involves the creation of financial instruments that are exchanged
for money in the primary markets. The flow may be direct—that is, directly between the lender and
the user. Alternatively, the flow can be indirect—that is, intermediated by financial institutions. With
intermediated flows, financial institutions gather together the savings of surplus units and provide loans
from the pooled savings to deficit units.
For a number of financial instruments issued in the primary markets there are secondary markets
in which those securities are traded. Transactions in the secondary markets do not provide additional
funding for the issuer, but rather they involve a flow of funds and a change of ownership between
the two parties concerned. A function of the secondary markets is to add marketability and liquidity
to primary market securities. In particular, this allows the holders of securities to restructure their
portfolios by buying and selling at current market prices. Most importantly, secondary market liquidity
makes the issue of new primary market securities much easier and reduces the returns that savers would
otherwise require if those securities were less liquid.
The discussion to date on the flow of funds relationships in the financial system has referred to two
major categories: the ultimate savers or surplus units, and the ultimate borrowers or deficit units. We
should now consider sectorial flows of funds in terms of the saving and borrowing patterns of the key
sectors of an economy.
The domestic economy can be divided into four sectors:
•
•
•
•
business corporations
financial corporations
government
household sector.
LEARNING
OBJECTIVE
1.6
Analyse the flow of
funds through the
financial system and the
economy, and briefly
discuss the importance
of ‘stability’ in relation to
the flow of funds.
Deficit units
borrowers or users of
funds
Sectorial flow of
funds
the flow of funds
between surplus and
deficit sectors in an
economy; the business,
financial, government,
household and rest-ofthe-world sectors
To these four sectors, the rest-of-the-world sector is added. This sector may be both a source of
surplus funds flowing into the domestic economy and an outward investment destination for surplus
funds within an economy.
Net borrowing and net lending of the major sectors of the economy vary between countries. The
flow of funds between sectors also varies from year to year, depending on factors such as government
budgetary actions, the level of economic activity and the state of the business cycle.
As a broad generalisation, the business sector will, on average, be a deficit sector. Most business
enterprises need to borrow in order to fund their business activities. The financial corporations sector
also tends to be a deficit sector; financial institutions fund the growth in their balance sheets by
borrowing in the capital markets. The government sector may fluctuate between being a deficit sector
and a surplus sector, depending on budget policy objectives, while the household sector is typically a
surplus sector—that is, a net saver of funds.
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Fiscal policy
the management of
annual revenues and
expenditures of a
government
Compulsory
superannuation
employers must
contribute minimum
specified amounts into
retirement savings for
employees (Australia)
World Bank
created along with the
International Monetary
Fund (IMF), the World
Bank is an organisation
of 189 member
countries tasked with
reducing poverty in
developing countries
International
Monetary Fund (IMF)
an organisation of 189
countries, created in
1945, to foster financial
stability, trade and
economic growth
A country that has a stable political environment and a domestic economy that is strong and
offers good growth potential would expect to attract savings from overseas investors. Deregulation of
the global capital markets has allowed the rest-of-the-world sector to become more sensitive to sudden
shifts in the flow of funds, as investors are able to move funds from one market to another quite quickly
and with relative ease.
A country’s government can impact the flow of funds between sectors by making policy decisions
that change its own deficit or surplus unit status. The most directly relevant policy is the government’s
fiscal policy. However, policy decisions on issues such as compulsory superannuation have an impact
on the levels of savings within the economy. Government policy decisions regarding guarantees on
bank deposits and bank borrowings, designed to increase confidence in the financial system, are also
important in shaping the flow of funds.
Worldwide, a set of global institutions can play a role in shaping and managing the flow of funds
across geographical boundaries. This can be particularly important in times of crisis. For example, the
World Bank and the International Monetary Fund (IMF) can play an important role in shaping the
flow of funds into and out of developing economies. As we shall soon see, the Bank for International
Settlements (BIS) has played a leading role in shaping banking regulations across the world. Changes
to these regulations, by requiring banks to hold more capital, for instance, shape the flow of funds
globally as well as within domestic economies.
The remainder of Part 1 is devoted to an examination of the main financial institutions. The
role of commercial banks in the flow of funds, and explanations for their importance in the financial
system, are considered in Chapter 2. The main non-bank financial institutions are examined in
Chapter 3.
REFLECTION POINTS
•
•
•
•
A modern financial system facilitates the efficient flow of funds from providers of funds to users
of funds.
A strong financial system will encourage savings and investment, which should lead to
economic growth.
The flow of funds in a domestic economy can be divided into four sectors: business
corporations, financial corporations, government and households. An additional sector is the
rest-of-the-world sector.
A sector may be a surplus sector or a deficit sector, depending on whether it is a net provider of
funds or a net user of funds.
CASE STUDY
THE NEXT GLOBAL FINANCIAL CRISIS?
The sub-prime lending crisis which originated from the US housing market and spread to insurance
and other sectors of the US economy became a world economic crisis (Dewatripont, 2010) in 2008,
resulting in massive unemployment after the loss of 8.7 million jobs worldwide (including 250 000 in
Australia) and a significant decline in world economic output (Claessens, 2014). Nations have adopted
various strategies and lending policies to ensure that the crisis is not repeated. Despite this, more than
10 years after the GFC, concerns have been raised about the seeds of a new crisis being sown in
different corners of the world.
Bill Gates, when asked on the possibility for the outbreak of another financial crisis, has stated that
there exists a high possibility. This opinion is also held by Gates’ friend, Berkshire Hathaway founder
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and well-known investor Warren Buffett (Frank, 2018). A growing number of experts, including Steve
Eisman, have also raised some alarms about a future crisis. Eisman predicted the GFC and influenced
the character played by Steve Carell in the Oscar-winning movie The Big Short.
Eisman has predicted a crisis to start in Italy, where banks have a high number of non-performing loans
(NPLs). These loans are to companies and households who have fallen behind in making repayments.
The books of Italian banks hold about €360 billion in NPLs, which have been written down to about
50.00 per cent of their original value. The real problem is that they are not worth even that amount.
When financiers buy NPLs from Italian banks, they value them at only 20.00 per cent of the book value.
That is, only 10.00 per cent of the original value of the loans.
Compared to Italy, Eisman sees the US economy as being in a safer position because the issue of subprime mortgages has been reduced following strong regulatory actions after 2008. He feels that the
European regulators are more lenient than US regulators and that this represents a risk to the European
economy (Collinson, 2018).
Another potential area for concern is the Chinese banking sector, where banks have enjoyed lending
growth over the past few decades that resulted in the creation of largely unregulated shadow banks
or credit unions who lend to property developers. These loans are funded in various ways, including
by ‘asset management products’, all of which have certain question marks regarding their levels of risk.
A collapse of one of these funding streams could lead to a financial crisis in China (David, 2018; John,
2017).
References
Chung, F 2018, ‘Bill Gates says another US financial crisis a certainty’, News.com.au, 2 March, viewed
15 October 2018, https://www.news.com.au/finance/economy/world-economy/bill-gates-says-anotherfinancial-crisis-a-certainty/news-story/364c28ad0c20696f399553d51900fe77
Claessens, S 2014, Financial crises: Causes, consequences, and policy responses, International
Monetary Fund, Washington, District of Columbia.
Collinson, P 2018, ’The Big Short: is the next financial crisis on its way?’, The Guardian, 19 November,
viewed 15 October 2018, http://www.theguardian.com/money/2016/nov/19/big-short-financial-crashsteve-eisman-italy-banks-risk
Dewatripont, M, Rochet, J and Tirole, J 2010, Balancing the banks: global lessons from the financial
crisis, Princeton University Press, Princeton and Oxford.
Mauldin, J 2017, ’One Of These 3 Black Swans Will Likely Trigger A Global Recession By End Of 2018’,
Forbes, 27 July, viewed 15 October 2018, http://www.forbes.com/sites/johnmauldin/2017/07/27/oneof-these-3-black-swans-will-likely-trigger-a-global-recession-by-the-end-of-2018#4cda7aef1875
Taylor, D 2017, ’Australia has the capacity to ride the wave, should a financial crisis make its way to
our shores’, ABC News, 16 March, viewed 15 October 2018, http://www.abc.net.au/news/2017-03-15/
david-taylor-can-australia-survive-another-financial-crisis/8353074
Discussion points
•
•
•
In the words of Steve Eisman, the ‘US economic system is in a safer seat when compared with
Europe’. Why?
According to Steve Eisman, what are the concerns with the Italian banking sector that could
trigger a crisis?
Describe how the Australian economy is set to deal with crisis situations, especially in light of a
financial threat from China.
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Master before you move on
LEARNING OBJECTIVE 1.1
Understand the basic frameworks that underlie the facts that characterise financial institutions,
financial instruments and financial markets.
•
•
•
•
•
The interconnected global financial system traces its origins to the introduction of money and
the development of local markets to trade goods.
Money is a medium of exchange that facilitates transactions for goods and services.
With wealth being accumulated in the form of money, specialised markets developed to enable
the efficient transfer of funds from savers (surplus entities) to users of funds (deficit entities).
Financial instruments incorporate attributes of risk, return (yield), liquidity and time-pattern
of cash flows. Savers are able to satisfy their own personal preferences by choosing various
combinations of these attributes.
By encouraging savings, and allocating savings to the most efficient users, the financial system
has an important role to play in the economic development and growth of a country. The real
economy and the financial system are connected.
LEARNING OBJECTIVE 1.2
Explain the functions of a modern financial system and categorise the main types of financial
institutions, including depository financial institutions, investment banks, contractual savings
institutions, finance companies and unit trusts.
•
•
•
•
•
•
•
•
•
A financial system encourages accumulated savings that are then available for investment
within an economy.
A modern financial system comprises financial institutions, instruments and markets that provide
a wide range of financial products and services.
A range of different financial institutions has evolved to meet the needs of financial market
participants and to support economic growth.
Depository institutions, such as commercial banks, building societies and credit unions,
specialise in gathering savings in the form of deposits and using those funds to provide loans to
customers.
Investment banks tend to specialise in the provision of advisory services to clients (e.g. merger
and acquisition advice).
Contractual savings institutions, such as insurance offices and superannuation funds, enter into
contracts in which they receive funds on the undertaking that they will pay a policyholder, or
member of a fund, a specified sum when a nominated event occurs.
Finance companies sell debt instruments directly to surplus entities and then use those funds to
provide loans and lease financing to borrowers.
Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and invested in
asset classes specified within the trust deed.
Commercial banks dominate in terms of their share of the assets of financial institutions.
LEARNING OBJECTIVE 1.3
Define the main classes of financial instruments that are issued into the financial system, that is,
equity, debt, hybrids and derivatives.
•
•
Financial instruments are central to any financial relationship between two parties.
Where the saver acquires an ownership claim on the deficit entity, the financial instrument is
referred to as equity.
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Chapter 1 A modern financial system: an overview
Where the relationship is a loan, the financial instrument is referred to as a debt instrument.
A financial instrument that incorporates the characteristics of both debt and equity is known as
a hybrid.
Another category of instruments is derivatives (futures, forwards, swaps and options). The main
use of a derivative is in the management of commodity and financial risks.
LEARNING OBJECTIVE 1.4
Discuss the nature of the flow of funds between savers and borrowers, including primary markets,
secondary markets, direct finance and intermediated finance.
•
•
•
•
•
•
•
•
•
Financial markets and instruments allow borrowers to meet the requirements of the matching
principle; that is, short-term assets should be funded by short-term liabilities, and longer-term
assets should be funded by longer-term liabilities and equity.
The markets in which new debt and equity securities are issued are known as primary markets.
Markets that facilitate the sale of previously issued securities, such as a stock exchange, are
called secondary markets.
CHAPTER ONE REVIEW
•
•
•
By providing a market for the trading of existing securities, secondary markets serve the most
important function of adding liquidity to financial instruments.
Where an active secondary market exists for a financial instrument, the instrument is usually
referred to as a security.
In the primary market, surplus entities may acquire assets directly from the issuer.
Alternatively, the flow of funds may be through a financial intermediary, in which case the surplus
entity establishes a financial relationship with the intermediary rather than with the ultimate borrower.
Intermediated flows are attractive to many savers since the intermediary provides a range of
financial attributes that may not otherwise be available.
The advantages of financial intermediation include asset transformation, maturity transformation,
credit risk diversification and transformation, liquidity transformation and economies of scale.
LEARNING OBJECTIVE 1.5
Distinguish between various financial market structures, including wholesale markets and retail
markets, and money markets and capital markets.
•
•
•
•
The financial markets are categorised as money markets (short-term securities) and capital
markets (longer-term securities).
Submarkets in the money markets include central bank transactions, the interbank market,
the bills market, the commercial paper market, the government securities market and the CD
market.
The capital markets include the equity market, the corporate debt market, the government debt
market, the foreign exchange market and the derivatives market.
Within the money and capital markets there are also the wholesale markets (institutional
investors) and the retail markets.
LEARNING OBJECTIVE 1.6
Analyse the flow of funds through the financial system and the economy, and briefly discuss the
importance of ‘stability’ in relation to the flow of funds.
•
•
Sectorial flow of funds may be observed within an economy.
Sectors include the business corporations sector, the financial corporations sector, the
government sector, the household sector and the rest-of-the-world sector.
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Part 1 Financial institutions
•
•
•
These sectors may be net surplus sectors (providers of funds) or net deficit sectors (users of
funds).
Factors that affect these sectors are government policy initiatives and economic performance.
A stable financial system is characterised by the smooth flow of funds between surplus and
deficit units.
Extended learning A
LEARNING OBJECTIVE 1.7
Appreciate the impact of the global financial crisis (GFC) on the world’s financial system and
economy.
The global financial crisis of 2008
Global financial
crisis (GFC)
the global
financial crisis
(GFC) refers to
the financial crisis
of 2008 that has
been traced to the
collapse of the
housing market in
the USA and the
consequences
of that collapse
for the market for
mortgage-related
securities
Sub-prime
mortgages
loans to
borrowers that,
under normal
credit assessment
standards, would
not have the
capacity to repay
The global financial crisis (GFC) has been described as the most significant economic crisis since
the Great Depression in the 1930s. In 2007, realisation that house prices in America had begun to
fall and mortgage defaults were increasing, particularly in sub-prime mortgages which had been
issued to low-income individuals who were sometimes without a documented ability to meet the
monthly repayments, initiated a liquidation of trading positions in the mortgage markets that quickly
evolved into a banking crisis. Uncertainty about the value of assets posted as collateral and the
solvency of counterparties significantly disrupted the financing arrangements upon which financial
institutions relied to fund their activities.
Uncertainty about the solvency of financial institutions flowed through the financial system.
Unable to fund their activities through the usual channels, some financial institutions were forced to
seek equity capital injections from investors or obtain emergency funding from central banks. Some
were bailed out by their sovereign government. Others were forced to sell themselves to stronger
financial institutions. Many others were forced to file for bankruptcy.
The effects of the crisis flowed into the ‘real’ economy. Economic growth in the USA slowed
considerably. According to the Bureau of Economic Analysis (www.bea.gov), from the second
half of 2008 through to the first half of 2009, the USA experienced four consecutive quarters
of negative economic growth (falling gross domestic product or GDP). Contributing to this were
severe declines in private investment, including back-to-back declines of 36.00 per cent and
42.00 per cent in 2009.
The Bureau of Labor Statistics (www.bls.gov) recorded a steep increase in the unemployment
rate in the USA, which doubled from 5.00 per cent in 2007 to just over 10.00 per cent in 2009.
Amid the uncertainty and economic turmoil, financial markets continued to reel. Share markets in
most of the advanced economies experienced precipitous falls and at the depths of the crisis had
recorded losses of more than 50.00 per cent. The US stock market alone experienced losses in
2008 of $8 trillion. Currency markets were not immune from the volatility. The Australian dollar
experienced depreciations of more than 30.00 per cent against the major currencies.
During the crisis, a number of prestigious Wall Street firms lost their independence or failed
completely. Bear Stearns was purchased by JPMorgan Chase & Co. for just $10 per share in March
2008, after trading at $150 per share a year earlier. In July, the mortgage broker IndyMac was placed
in ‘conservatorship’ by the US government. In September, two government-chartered mortgage
lenders, Freddie Mac and Fannie Mae, were similarly placed in the care of the US government.
Lehman Brothers collapsed in mid-September.
At the same time that Lehman Brothers tried in vain to arrange a bailout or takeover, Merrill
Lynch sold itself to Bank of America to avoid a Lehman-style collapse. The Lehman Brothers’
collapse created enormous market volatility as market participants struggled to predict the effects
of the investment bank’s failure on the intertwined network of trades that characterises the financial
markets. Governments and central banks desperately tried to stabilise the markets. Meanwhile,
other financial institutions found themselves under tremendous pressure. Washington Mutual was
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Chapter 1 A modern financial system: an overview
Banks and other financial institutions are always vulnerable to ‘runs’. These are situations
where, all at once, many customers demand their money back from a financial institution. Financial
institutions do not operate with 100.00 per cent reserves and cannot possibly meet all of these
demands.
Federal Reserve
the central bank
of the USA
Before the GFC, financial institutions became more vulnerable because of maturity mismatching
in their financing arrangements. Most financial institutions had become reliant on very short-term or
overnight financing to finance their operations. Repurchase agreements, or ‘repos’, are very shortterm funding arrangements and financial institutions had come to rely heavily on overnight repo
financing in the decade before the crisis.
During the crisis, when financial institutions became wary about the solvency of their
counterparties (and themselves), repo financing became either increasingly expensive or impossible
to secure. Without the overnight repo markets, financial institutions did not have the capital to sustain
their operations for any length of time. This was exacerbated by the redemption and withdrawal
requests being received from investors and depositors. Bear Stearns, for example, found that it was
unable to secure repo financing once doubts surfaced about its solvency. Although Bear Stearns
had more than $18 billion in capital, this fell far short of what was required to finance its day-to-day
operations. Bear Stearns was taken over by JPMorgan Chase & Co. just a few days after its repo
financing evaporated. With Bear Stearns gone, the financial markets awaited the next ‘domino’ to fall.
CHAPTER ONE REVIEW
placed in receivership. Wachovia was purchased by Wells Fargo. AIG was effectively taken over by
the Federal Reserve.
When the crisis hit, information about the market value of the securities traded among
financial institutions and the magnitude of financial obligations of particular institutions was
difficult or impossible to obtain. Collateralised debt obligations (CDOs), which are portfolios of
mortgages and other loans arranged into ‘tranches’ according to levels of risk, are complex by
nature because it is very difficult to determine the quality of the numerous individual loans in each
of the tranches.
This complexity and the absence of liquid secondary markets for the securities led to large writedowns in the estimated values of these securities when financial institutions realised that there
were no buyers willing to engage in transactions at prices even close to the previously recorded
selling prices. With prices falling, write-downs in the value of positions in these markets spiralled
downwards.
Uncertainty about which institutions held the riskiest CDO tranches contributed to financial
institutions’ unwillingness to extend financing to their counterparties. To make matters even
worse, buyers of CDOs had usually entered into credit default swaps (CDSs) with other financial
institutions. CDSs were designed to insure their buyers against default on bonds, tranches or by
institutions. As CDOs fell rapidly in value and financial institutions reeled, the large outstanding
liabilities potentially facing the ‘sellers’ of CDSs and the uncertainty over how much insurance had
been sold by which institutions contributed further to the spiral in valuations, balance sheet writedowns and the viability of financial institutions.
Although most of the drama and many of the popular accounts of the crisis focused on Wall
Street and its ‘blue-blood’ banking establishments, as time has passed the GFC came to be thought
of as having two main parts. The first, which we have just described, was the initial liquidation of
assets due to the trouble emanating from and engulfing the Wall Street banks. The second was
what has come to be known as the eurozone crisis or the sovereign debt crisis. This second
instalment of the GFC emanated from and engulfed the central banks of a number of European
countries. That is, in ‘part two’ it was country or government debt, otherwise known as sovereign
debt, that became ground zero as the crisis evolved.
The eurozone crisis can be traced to late 2009, when the new Greek government announced
that its deficit, understood by the world financial community to already be an astronomical 113.00
per cent of the country’s national income, was actually twice as large, or more than 220.00 per
cent of the country’s gross domestic product. There was a very great possibility that Greece would
fail to meet its obligations to investors in Greek sovereign debt (Greek government bonds). This
immediately precipitated panic in the international bond markets.
Eurozone crisis
or sovereign
debt crisis
the economic
and international
financial crisis
that followed the
GFC, which saw
multiple European
governments seek
bailouts from the
European Central
Bank (ECB) and
other stronger
European
countries
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Like any market, investors need to have confidence that they will receive the cash flows they
are entitled to and the issuer of the debt, whether it is a corporation or a government, will not
default on its obligations. It looked like Greece might do just that. The panic in the international
bond markets led to a collapse in bond prices and a spike in the cost of borrowing for governments
suspected of being in a similar position to Greece, especially Ireland, Spain, Portugal and Italy.
Government services and welfare programs became the victims of harsh austerity measures. As
the government sector of these economies was curtailed, national incomes fell rapidly and other
economic indicators deteriorated.
The economic booms in these countries had been fuelled by money coming from banks in
other European countries, particularly in northern Europe. These banks held trillions of dollars
in Greek, Irish, Spanish and Italian debt, which were consequently trading at substantially lower
prices. The trouble had spread north and west, like a virus. This had disastrous and far-reaching
economic consequences. National incomes fell precipitously in the worst affected countries and
unemployment soared. Most of the Eurozone, including relatively strong economies such as France
and Germany, soon found itself amid an economic malaise that only gradually abated.
A number of explanations for the GFC have been proposed. These include greed, irrationality,
fraud, the inherent instability of capitalism, the disproportionate size of the financial sector
compared to the manufacturing or ‘real’ sector of the economy, shadow banking, lax lending
standards, deregulation and free-market policies, over-reliance on badly designed mathematical
models for measuring risk, inappropriate incentive structures within financial institutions, ‘captured’
ratings agencies that were too lenient in rating mortgage debt, out-of-control financial innovation
and misguided government or central bank policy.
There are many different points of view and strong and convincing arguments can be made
for each of the possible explanations for the GFC. Whatever role each of these factors might have
played, the fundamental explanation for the GFC is quite straightforward. Throughout the early
2000s, central banks, particularly the US Federal Reserve, set interest rates at very low levels. This
created a boom in consumption, housing and other asset prices driven by easy credit available
throughout the economic system. In the absence of increasingly intense credit expansion, sooner
or later the credit-driven boom had to come to an end. The larger and longer the boom, the more
catastrophic must be the ensuing recession or depression. Despite the unique circumstances of
each individual case, all economic crises can be traced to this same root cause.
Following the onset of the crisis, governments and central banks around the world undertook
unprecedented interventions in the financial and economic systems. In the USA, for example, the
federal government arranged a $700 billion bailout plan and, as we have seen, even took ownership
of some financial institutions. In Australia, the federal government implemented a guarantee on
deposits with banks, building societies and credit unions to prevent ‘runs’ on these institutions by
their customers.
As the banking crisis gave way to concerns about economic growth, governments turned their
attention to fiscal stimulus to encourage economic activity and prevent recession. In Australia,
the government implemented two stimulus packages totalling more than $50 billion in late 2008
and early 2009. Various factors contributed to greater stability in Australia during the crisis and a
mitigation of its effects on the real economy. However, the effects of the GFC continue to be felt in
most parts of the developed world and, although Australia managed to navigate the crisis better
than other countries, dealing with the legacy of the GFC will present a challenge for many years to
come. Australia’s stock market in 2018 had yet to reach its pre-GFC highs set back in 2007.
Many lessons might be learned from the GFC. A stable financial sector is vital to the health of
the overall economy. Perceived mistakes by regulators, including allowing interest rates to remain
at very low levels for long periods of time as well as perceptions that the crisis was caused by a
financial sector that is out of control, have sparked calls for strong regulatory reforms.
Innovative financial products and securities, such as CDOs and CDSs, present a challenge to
regulators. New products do not always fall within the scope of existing regulations. The incentive
arrangements and governance within financial institutions are also factors that attracted the
attention of critics before, during and after the GFC. Regulations that limit compensation packages
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Chapter 1 A modern financial system: an overview
With the GFC, it appears that there was a lack of understanding of who was ultimately holding
risk and the impact on the markets if the ultimate risk holder failed. For example, CDOs simply
moved the risk exposure from one party to another party. Everyone made money along the way,
including the mortgage brokers, the banks, the credit rating agencies and the fund managers, but
the risk was still in the financial system. The process of risk shifting was also often made easier by
implicit or explicit guarantees given by governments, often with limited or no regulatory oversight.
To ensure the soundness and stability of a financial system, governments establish legislation
and regulatory authorities responsible for the prudential supervision of the financial system. The
soundness and stability of the financial system and the role of financial regulation are issues that
have acquired even more significance following the GFC.
The GFC produced a number of regulatory and policy responses. Some of these were
directed to the problem of managing the ensuing economic recession while others were directed
at specific parts or activities of the financial system. The response of governments and their
regulators to the GFC will be a topic of ongoing discussion for many years. Anyone who doubts
that this will be the case need look no further than the recent intense focus on the role of central
bankers’ responses to the collapse of the dot-com boom in 2000 in sowing the seeds for the GFC
almost a decade later. The reduction of interest rates and their maintenance at very low levels
following the dot-com collapse has been criticised for inflating values in the real estate market.
The subsequent decline in real estate prices from these over-inflated levels is widely viewed as
the proximate cause of the GFC.
CHAPTER ONE REVIEW
within the financial sector or realign incentive structures so they do not encourage large amounts
of risk taking represent attractive options to those who are critical of perceived excesses within the
financial sector. Finally, the way that risk is managed within financial institutions has emerged as a
very prominent subject. Risk is intertwined and interrelated. The existence of one risk will change
the dynamics of other risk exposures.
It would be wishful thinking to believe that another crisis will not eventually strike the financial
system. If that happens any time soon, there is no doubt that the US Federal Reserve’s years of
‘quantitative easing’ (credit easing), designed to encourage economic activity by pumping billions
of dollars into the financial sector following the GFC, will be heavily scrutinised. Of course, if
speculative banking practices once again lie at the heart of any such event, questions will be raised
about whether the response of regulators to the GFC was strong enough or whether the bailouts
of so many financial institutions, directly or indirectly, sent the wrong signals to market participants
and sowed the seeds for another crisis.
Extended learning B
LEARNING OBJECTIVE 1.8
Appreciate the effects, consequences and relevance of the Asian financial crisis.
The impact of the Asian financial crisis on the financial system
This chapter has recognised the importance of a modern, efficient and stable financial system as
a critical component of sustained economic and social growth. This fundamental principle applies
to nation-states, geographic regions and, ultimately, the global economy. The proposition is aptly
demonstrated by the so-called Asian financial crisis that became manifest from mid-1997.
While the Asian financial crisis occurred some time ago, it is an excellent learning case study
that attracted renewed interest in 2014 as weakness in some emerging markets started to exhibit
some worrying parallels with the Asian crisis of the late 1990s. The crisis was more than a financial
crisis; it extended into a major economic and social crisis as well. Nation-states and the global
financial system are periodically adversely affected by financial crises, the most recent being
the so-called sub-prime market crisis in the USA, which evolved into a global credit crisis. The
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Part 1 Financial institutions
interesting, but unfortunate, observation of financial crises is that they tend to repeat themselves
over time. The lessons learned from one crisis are eventually thought to be irrelevant to the current
market environment. This leads to an environment where a new crisis can grow. The reality is that
the fundamentals of risk management don’t change. Managers and regulators need to understand
risk and who is actually holding (or exposed to) risk. Within the context of the financial system, risk
needs to be identified, measured and managed.
Much has been written about the Asian financial crisis. Here, only a brief analysis and
discussion of events is provided. After gaining some understanding of the complexity of the
factors that precipitated the crisis, and of the inevitable flow-on effects that proceeded from it,
students are advised to read papers published on the topic. These include various issues of the
Reserve Bank of Australia’s RBA Bulletin, the Bank for International Settlements BIS 68th Annual
Report (1998) (www.bis.org) and papers published by the Federal Reserve Bank of New York
(www.ny.frb.org).
The 1980s and early 1990s were a period of enormous economic growth and prosperity within
what was often described as the ‘tiger’ countries of Asia, in particular Hong Kong, Singapore,
Malaysia, Thailand, South Korea and Indonesia. However, the late 1990s saw the ‘bubble’ burst,
and the region experienced severe economic, financial and social reversals.
Prior to mid-1997, Thailand maintained a fixed exchange rate regime whereby the Thai baht was
pegged to a basket of currencies, predominantly the US dollar, the Japanese yen and the German
deutschmark. The currency came under sustained pressure and the central bank of Thailand was
unable to continue to support the fixed exchange rate. On 2 July 1997, Thailand floated its currency,
and this essentially became the trigger for the Asian currency crisis, as other fixed exchange rate
regimes, including the Philippine peso, the Malaysian ringgit and the Indonesian rupiah, all fell
victim to the foreign exchange market.
The situation rapidly evolved into a financial and economic crisis, initially encompassing
Thailand, Indonesia, the Philippines and Malaysia but eventually extending to Japan, South Korea,
Russia and Brazil. The contagion effects of the ever-expanding crisis were not restricted to these
countries. Other countries in the region—Singapore, Hong Kong, Australia and New Zealand—all
experienced negative consequential effects of the crisis, as did the majority of global economies,
including the USA.
In order to understand the flow-on effects of the crisis, it is important to understand the
relationships that exist between risks associated with foreign exchange, interest rates, liquidity, price,
credit and capital. For example, there is a statistical relationship between interest rates and exchange
rates. Normally, if an exchange rate depreciates significantly, domestic interest rates will rise. The
rise in interest rates will affect the profitability of the business sector, and therefore stock prices will
fall. If asset price inflation has also been evident, then asset prices would be expected to fall. The
combined effect so far will cause a lack of confidence in the economy and a fall in business activity.
Higher interest rates and lower economic activity will lead to businesses defaulting on credit,
which will place pressure on the capital ratios of financial institutions. Also, as with the Asian crisis,
a large portion of a country’s debt may be denominated in unhedged foreign currencies, and
depreciation of the domestic currency will result in higher real interest and principal repayments.
While this is happening, liquidity in the market disappears as financial institutions and investors
withdraw. All these risk factors occurred with the Asian crisis.
In its 1998 annual report, the Bank for International Settlements identified the following
weaknesses that were common in the Asian crisis countries:
Moral hazard
the taking of
excessive risk
in the belief that
losses will be
diminished by
regulation or
insurance
•
•
•
Excessive bank credit was available, which encouraged over-investment in industrial capacity
(in particular, office buildings and condominiums) and an asset price boom and bust.
There was no recognition of the fragility of domestic financial systems because of historic
monetary and exchange rate stability, coupled with an extended period of economic growth. As
financial risks increased in the overheated economies, lending margins actually fell.
Moral hazard risk existed in that there was an expectation that government would always
support major financial institutions. Capital ratios were also relatively low.
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Chapter 1 A modern financial system: an overview
There was a reliance on potentially volatile external finance, particularly short-term funding. Much
of the external borrowing was not hedged against foreign exchange risk, as it was perceived
that such risk did not exist in the fixed exchange rate regime. Enormous capital inflows were
suddenly exposed to foreign exchange risk when currencies were floated. At the same time,
external investor confidence dissipated and there were significant capital outflows, as indicated
in Table 1B.1.
Table 1B.1 Net private capital flows, Asia* (USD billions)
1994
1995
1996
1997 (1st half)
1997 (2nd half)
24
38
77
62
−108
* India, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand.
SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p. 133.
Central banks in the region, in an effort to support their depreciating currencies and stem capital
outflows, raised overnight interest rates significantly. The effects on interest rates, stock market
prices and exchange rates are shown in Table 1B.2.
CHAPTER ONE REVIEW
•
Table 1B.2 Interest rates and exchange rates during the crisis
Interest
rates—
overnight
rate peak
Interest rates—
three-month
rate peak
Stock market indices—
falls between 1 January
1997 and 4 February
1998
Exchange rate
depreciation*—low
between July 1997
and March 1998
Hong Kong
100.0
25.0
−22.5%
0
Taiwan
−11.5
−9.8
Indonesia
300.0
27.7
−76.9%
−84.3
South Korea
−27.2
25.0
−54.6%
−54.6
Malaysia
−50.0
−8.8
−65.3%
−46.3
Philippines
102.6
85.0
Singapore
−50.0
10.3
−46.9%
−21.0
Thailand
−27.4
26.0
−62.8%
−55.0
n.a.
n.a.
−19.3
−41.8
* Percentage change in the US dollar/local currency exchange rate since July 1997.
SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p. 136.
The global financial crisis that resulted from the Asian financial crisis caused regulators,
government policy makers, academics and market participants to exercise their collective minds to
reconsider issues of signals, cause, effect, regulation and financial system architecture.
While changes in the structure, regulation and operation of the global financial system have
occurred, and will continue to occur, history indicates that change is usually a very slow process.
The lessons of the Asian financial crisis have prompted the Reserve Bank (RBA Bulletin, April 1998,
p. 2) to identify a list of questions to ask about a country’s financial system if there is the likelihood
of a currency crisis or a wider economic crisis.
•
•
•
Does the country have a fixed exchange rate and free movement of international capital?
Is the exchange rate overvalued?
Has a country with similar economic characteristics recently experienced a currency crisis?
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•
•
•
•
•
•
•
•
•
Is there a large budget deficit and a lot of government debt outstanding?
Is there loose monetary policy and high inflation?
Is the domestic economy in, or at risk of, a recession?
Is there a large current account deficit?
Is there a large amount of foreign debt?
Is there an asset price boom (especially credit driven) occurring?
Are there a lot of bad debts in the banking system, or is there a poor system of bank supervision?
Has there been a lot of unhedged foreign currency borrowing?
Are there poor accounting standards, few disclosure requirements or ambiguous bankruptcy
procedures?
These 12 points form a strong starting point for financial crisis analysis. However, you should be
aware that all of the factors will not always be evident, and that the existence of some factors does
not by itself imply an imminent crisis situation. Also, as with past financial crises, each future crisis
will have its own particular set of defining characteristics.
Questions
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points you raise in relation to each question.
1
The concepts of risk, reward, supply and demand underlie the complexity of financial
instruments. How could we use these concepts, for example, to explain the rate of return
expected by a shareholder in Telstra and the price at which Telstra shares change hands on the
stock market? (LO 1.1)
2
Describe the flow of funds that characterises any financial system. (LO 1.1)
3
Explain why an investor should consider the time-pattern of cash flows and the variability of
the cash flows associated with a multi-period investment, rather than simply assessing the
investment on the basis of the total cash flows received. (LO 1.1)
4
Risk preferences shape the decisions that people and businesses make when under conditions
characterised by risk and uncertainty. Outline the three ways in which economists categorise
decision makers and explain how each type of decision maker will choose differently when
confronted with a risky choice. (LO 1.2)
5
Identify and discuss three changes in the distribution of assets among the financial institutions
that have occurred during the period of the global financial crisis and Australia’s recovery from
it (2008 to 2018). The information required is presented in Table 1.1. (LO 1.2)
6
Financial instruments may be categorised as equity, debt or derivatives. Discuss each category.
In your answer, make sure you explain the differences between debt, equity and derivatives.
(LO 1.3)
7
During the GFC, the funding of longer-term assets with short-term borrowing was identified
as a point of weakness in the operations of financial institutions. Discuss this statement with
reference to the matching principle. (LO 1.4)
8
(a)
What are the differences between primary market and secondary market financial
transactions?
(b) Why is the existence of well-developed secondary markets important to the functioning of
the primary markets within the financial system? (LO 1.4)
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Chapter 1 A modern financial system: an overview
Explain the meaning of the terms ‘financial assets’, ‘financial instruments’ and ‘securities’. What
is the difference between these terms? Give examples of financial instruments and securities.
(LO 1.4)
10 Banks are the major providers of intermediated finance to the household and business sectors
of an economy. In carrying out the intermediation process, banks perform a range of important
functions. List these functions and discuss their importance for the financial system. (LO 1.4)
11 ‘The development of domestic capital markets is extremely important for economic growth as
they provide the long-term funds necessary for productive investment.’ Discuss this statement
using the equity market and the corporate debt market as examples. (LO 1.5)
12 Corporations often issue long-term debt instruments into the international capital markets to
raise funds. Explain the relationship between the issue of paper into the international capital
markets and the foreign exchange market and the derivatives market. (LO 1.5)
13 Discuss the sectorial flow of funds. In your answer, identify five sectors that are representative
of the sectorial flow of funds. Why is an understanding of the sectorial flow of funds important
for economic policy determination? (LO 1.6)
Extended learning questions
CHAPTER ONE REVIEW
9
14 The GFC has had a significant impact on the stability of international financial markets. Discuss
the implications of the crisis for the ‘real economy’ and evaluate the regulatory responses that
have been implemented in an attempt to stabilise the financial system. (LO 1.7)
15 The GFC is now thought of as having two parts or phases. Describe each part (or phase) and
outline some of the measures that have been taken by governments and central banks in
Australia, Europe and the USA in order to stem the effects of both phases of the crisis on their
respective real economies. (LO 1.7)
16 The Asian financial crisis provided some valuable lessons about the global financial system.
What are some of those lessons and why are they relevant for today’s emerging markets?
(LO 1.8)
KEY TERMS
asset portfolio 7
default risk 17
finance companies and general
financiers 9
asset transformation 18
deficit units 27
bills market 23
financial instruments 7
bonds 14
depository financial
institutions 8
broker 16
derivative instrument 12
fiscal policy 28
capital markets 24
derivatives markets 26
flow of funds 7
commercial paper 23
direct finance 16
foreign exchange markets 25
compulsory superannuation 28
discount securities 23
forward contract 13
contractual savings
institutions 9
dividend 11
futures contract 12
economies of scale 20
global financial crisis (GFC) 32
corporate debt markets 25
equity 11
government debt 25
credit rating 16
equity markets 24
hybrid security 11
credit risk transformation 19
euromarket instruments 25
inflation 8
crowding out 25
institutional investors 21
dealer 16
eurozone crisis or sovereign
debt crisis 33
debt instruments 12
Federal Reserve 33
intermediated finance 17
financial system 7
interbank market 23
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Part 1 Financial institutions
International Monetary
Fund 28
negotiable debt instrument 12
secondary market
transaction 15
investment banks 8
negotiable certificate of
deposit 23
liability management 19
option contract 13
secured debt 12
liquidation 11
securities 16
liquidity 7
ordinary share or common
stock 11
liquidity transformation 19
overdraft facility 14
sub-prime mortgages 32
matching principle 14
portfolio structuring 8
surplus units 7
maturity transformation 19
primary market transaction 14
swap contract 13
monetary policy 8
rate of return 7
time-pattern of cash flows 7
money 14
retail market 20
unit trusts 9
money markets 21
return or yield 7
wholesale market 20
moral hazard 36
risk 7
World Bank 28
sectorial flow of funds 27
securitisation 10
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CHAPTER 2
Commercial banks
CHAPTER OUTLINE
2.1
The main activities of commercial banking
2.2
Sources of funds
2.3
Uses of funds
2.4
Off-balance-sheet business
2.5
Regulation and prudential supervision of commercial banks
2.6
A background to the capital adequacy standards
2.7
The Basel Accords: evolution from Basel I to Basel III
2.8
Liquidity management and other supervisory controls
Learning objectives
LO 2.1
Evaluate the functions and activities of commercial banks within the financial system.
LO 2.2
Identify the main sources of funds of commercial banks, including current deposits, demand
deposits, term deposits, negotiable certificates of deposit, bill acceptance liabilities, debt
liabilities, foreign currency liabilities and loan capital.
LO 2.3
Identify the main uses of funds by commercial banks, including personal and housing lending,
commercial lending, lending to government and other bank assets.
LO 2.4
Outline the nature and importance of banks’ off-balance-sheet business, including direct credit
substitutes, trade- and performance-related items, commitments and market-rate-related
contracts.
LO 2.5
Consider the regulation and prudential supervision of banks.
LO 2.6
Understand the background and application of Basel III.
LO 2.7
Examine liquidity management and other supervisory controls applied by APRA in the context
of Basel III.
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Extended learning
LO 2.8
Understand the standardised approach to credit risk and compute the capital requirements for
particular transactions.
LO 2.9
Analyse business continuity risk and construct an education and training framework for
operational risk management for commercial banks.
LO 2.10
Discuss the importance of corporate governance and ethics in the context of Australian financial
institutions.
CHAPTER SNAPSHOT
Commercial banks take deposits and make loans. They also engage in billions of dollars of
trades in instruments such as interest rate contracts and credit derivatives, much of which
is recorded ‘off balance sheet’. The importance of commercial banks to the economic and
financial system and the damage that can be caused by banking crises has prompted the
Bank of International Settlements (BIS) to initiate a series of banking reforms known as
the Basel Accords. The final version of ‘Basel III’ was released at the end of 2017.
INTRODUCTION
In order to operate as a commercial bank within most developed countries, an institution generally must
obtain an authority from the prudential supervisor. A list of Authorised Deposit-taking Institutions
(ADIs) operating in Australia—Australian-owned banks, foreign subsidiary banks, building societies,
credit unions and branches of foreign banks—can be found on the website of the Australian Prudential
Regulation Authority (www.apra.gov.au). There are four major commercial banks in Australia.
Commercial banks control a significant proportion of the financial assets within the financial
system. As we saw in Chapter 1, commercial banks hold more than 50.00 per cent of the total assets
of financial institutions in Australia. Because of the absolute size of the commercial banks and their
importance as the principal institutions in the flow of funds between savers and borrowers, it is
important that we understand the functions and operations of commercial banks.
Perhaps one of the most interesting aspects of the operation of commercial banks is their ability
to ‘create’ money and liquidity. Commercial banks can lend out much more than they accept in the
form of deposits. If a bank receives a deposit of $100, it might lend out $90, which in turn is deposited
in another bank that lends out $81 and so on. The initial $100 deposit grows to a much larger amount.
Historically, this activity was somewhat restricted by a reserve requirement imposed by the central
bank. This was the case in Australia, as for many other countries. Most people probably assume that
these requirements are still in place and that they are quite stringent, if not 100.00 per cent. In fact, the
requirement for commercial banks to reserve some fraction of their deposits was removed in Australia
in 1988. Banks are not required to keep any fraction of their deposit liabilities in reserve.
This has played no small role in commercial banks amassing 50.00 per cent of the assets held by
all financial institutions. The big question is whether they can, in fact, create money without limit. The
answer, fortunately, is no. Banks face the requirement to keep a certain amount of capital, including
deposits, on hand. These capital requirements have become much more stringent as regulators recognised
the risks that unfettered lending can impose on the whole financial and economic system.
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Chapter 2 Commercial banks
Following a long phase of deregulation beginning in the 1980s, a review was undertaken during the
1990s to explore Australia’s experience with financial deregulation and identify areas for improvement. This
review, called the Wallis Report, recommended the establishment of APRA, which was founded in 1998.
Financial regulation in the 2000s has been dominated by the Basel III capital accords and their
implementation following the GFC. Arguably, these capital requirements are much more effective than
reserve requirements, even in jurisdictions where reserve requirements are still enforced. The Royal
Commission into Misconduct in the Banking, Superannuation and Financial Services Industry that
was undertaken during 2018 added an additional layer of scrutiny to the governance and culture of
financial institutions operating in Australia.
REFLECTION POINTS
•
•
•
Commercial banks are the main type of financial institution that operates within a financial
system.
The regulatory environment is subject to change.
The majority of developed economies began reducing banking regulations in the 1980s.
Following the GFC, financial regulations have been strengthened. The process of regulatory
reform is ongoing.
2.1
The main activities of commercial banking
Commercial banks take deposits from customers and then invest those deposits by making loans to their
customers. Although these two functions represent a large proportion of their activities, commercial
banks’ activities are much more complex than this, in that they provide a full range of financial services.
Commercial bank products and services include balance-sheet transactions and off-balance-sheet
transactions. Briefly, balance-sheet transactions are assets (e.g. loans), liabilities (e.g. deposits) and
shareholders’ funds (equity). Off-balance-sheet items are contingent liabilities; that is, they are transactions
that do not appear on the balance sheet.
In a highly competitive global market, banks must compete aggressively to obtain the funds
necessary to provide loans and other products and services. For example, bank customers request loans
from banks. The banks try to forecast future loan demand to ensure they have the funds available to
meet the forecast loan demand. As the banks lend hundreds of millions of dollars in a short-term
planning period, ensuring the availability of funds is a critical issue. To do this, the banks have moved
from a practice known as asset management to the practice of liability management.
In the highly regulated banking sector, asset management was the dominant practice. Because
of regulation, banks restricted their loan activity (assets) to match the available amount of deposits
they received from customers. It was not uncommon for a bank to run out of funds for lending by
the end of the month. It was expected that customers would come back next month to try again to
obtain a loan.
Liability management developed with the removal of restrictive regulation. It is the normal practice
today. Commercial banks now actively manage their sources of funds (liabilities) in order to ensure
they have sufficient funds available to meet loan demand and other commitments. If loan demand is
forecast to increase, banks enter the capital markets and borrow the necessary funds required to meet
their forecast loan demand. Banks are no longer dependent on their deposit base for lending. They
manage their liability base by borrowing directly from the domestic and international capital markets.
As the major banks typically have high credit ratings, they are able to borrow substantial amounts,
especially within the international capital markets.
LEARNING
OBJECTIVE
2.1
Evaluate the functions
and activities of
commercial banks
within the financial
system.
Asset management
a bank restricts growth
in its lending to the
level of funds available
from its depositor base
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Part 1 Financial institutions
Off-balance-sheet
business
transactions that
represent a contingent
liability and therefore
are not recorded on the
balance sheet
Banks also undertake a substantial volume of business that is not recorded as assets or liabilities
on their balance sheets. This is referred to as off-balance-sheet business. For example, commercial banks
have developed expertise in the provision of risk management products, using a range of over-the-
counter and exchange-traded derivative instruments. They also provide products and services that assist
their customers to carry out import and export business.
REFLECTION POINTS
•
•
•
A core function of commercial banks is to gather savings from depositors and investors, and
use those funds in the provision of loans to customers.
Commercial banks also conduct off-balance-sheet business. These are contingent liabilities
such as the promise to finance future trade transactions.
Banks compete in the global capital markets to raise funds in addition to their depositor base.
This is known as liability management, whereby a bank borrows sufficient funds (liabilities)
direct from the capital markets to meet forecast loan demand.
2.2
LEARNING
OBJECTIVE
2.2
Identify the main
sources of funds of
commercial banks,
including current
deposits, demand
deposits, term deposits,
negotiable certificates
of deposit, bill
acceptance liabilities,
debt liabilities, foreign
currency liabilities and
loan capital.
If the major part of a commercial bank’s business is the provision of loans to customers, then the first
question must be: where does the bank obtain the funds that it lends?
Sources of funds appear on a bank balance sheet either as liabilities that the bank will eventually
repay or as equity funds provided by shareholders.
In order to attract the savings of surplus entities, commercial banks offer a range of instruments
with different terms to maturity, liquidity, rates of return and cash-flow attributes. The main sources of
commercial bank funds considered in this section are:
•
•
•
•
•
•
•
•
current account deposits
call or demand deposits
term deposits
negotiable certificates of deposit
bill acceptance liabilities
debt liabilities
foreign currency liabilities
loan capital and shareholders’ equity.
2.2.1
Current account
deposits
liquid funds held in
a cheque account;
cheques drawn to
purchase goods and
services
Sources of funds
C URRENT ACCOUNT DEPOSITS
One of the most liquid instruments offered by a bank is a current account deposit. These funds are held
in a cheque account facility. Deposits in a cheque account provide liquidity in that they can be used
directly in payment for goods and services. The current account holder is able to write an order on a
cheque that instructs its bank to pay funds to the named payee. For example, a plumber may need to
pay a plumbing supplier for copper pipe and fittings. The plumber may write a cheque for the amount
due and give the cheque to the plumbing supplier. The plumbing supplier will lodge the cheque with
its bank, which will then obtain the funds from the plumber’s bank. This financial settlement occurs
through the payments system and is discussed in Chapter 12.
Even though current account deposits are liquid funds, they also provide a stable source of funds
for the banks. This stability occurs because current account deposits can be used to pay for goods
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Chapter 2 Commercial banks
and services. The dynamics of an economy means that individuals and businesses are continually
conducting transactions for goods and services and therefore current account deposits are always being
maintained for this purpose, thereby creating an ongoing funding source for the banks.
A business cheque account is usually referred to as its operating account. An operating account is
used by a business to pay periodic expenses as they fall due. (This is discussed further in Chapter 9.)
A cheque account will generally pay interest on credit funds in the account. The level of interest
paid is usually quite low and reflects the highly liquid nature of current account deposits.
2.2.2
C ALL OR DEMAND DEPOSITS
Call deposits are held in accounts other than a cheque account where the funds are available on
demand. These types of accounts are generally referred to as savings accounts. Call deposit account
holders usually receive interest payments, but the return on funds invested is low. As with the current
account, the low rate of return represents the highly liquid nature and low risk attached to this type
of account.
Banks typically charge transaction and account service fees on savings-type accounts. It may be
argued that the lower rates of return plus the fee structures tend to discourage customers from maintaining
excess funds in this type of account. Nevertheless, call or demand deposits have historically represented a
stable source of funds for the banks. This stability derives from individuals’ collective desire to hold some
funds in an account that can easily be used to meet forecast expenses and unexpected contingencies.
2.2.3
funds held in a savings
account that can be
withdrawn on demand
T ERM DEPOSITS
Term deposits are funds lodged in an account with a bank for a specified period of time. Such funds
receive a fixed rate of interest for the period of the investment. The saver nominates the term to maturity
at the time the funds are invested. Commercial banks typically offer term deposits that range from one
month through to five years to maturity.
Term deposits offer savers a higher rate of return than is available on current accounts or call
deposits. The higher return compensates the saver for the loss of liquidity with this type of deposit; that
is, the term deposit is fixed for the nominated period. Savers often use term deposits as an investment
alternative for surplus funds that are not immediately required for consumption.
The term deposit is a safe and stable investment that is particularly attractive to a conservative
investor. Term deposits are popular in countries that have an ageing population. Often these investors
seek secure investments that produce known income streams. History shows us that in times of volatility
in the financial markets investors tend to revert to the safe haven of the bank term deposit.
2.2.4
Call deposits
Term deposits
funds lodged in
an account for a
predetermined period
and at a specified fixed
interest rate
N EGOTIABLE CERTIFICATES OF DEPOSIT
Another source of short-term funding used by banks is the negotiable certificate of deposit, referred to
in the market as the CD. The CD is a certificate issued by a bank undertaking to pay to the bearer the
face value of the CD at the specified maturity date.
A CD is different from other forms of deposit in that a bank may issue a CD directly into the
money market. The CD does not include any interest payments. It is sold by the issuing bank to an
investor at a discount to the face value of the certificate. The CD is therefore known as a discount
security. The term to maturity of CDs typically ranges up to 180 days.
For example, if the face value of a 180-day to maturity CD is $100 000, the buyer may pay $96 755.38
to the issuing bank. On maturity of the CD, the holder of the certificate will receive $100 000 on
presentation of the CD to the issuer bank. Had the original owner of the CD held it until maturity, such
an investment would represent a dollar return of $3244.62, which is a yield of 6.80 per cent per annum.
The structure and pricing of a CD is discussed further in Chapter 9.
Negotiable certificate
of deposit
a discount security
issued by a bank
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Part 1 Financial institutions
Negotiable security
a financial instrument
that can easily be sold
into a deep and liquid
secondary market
Another feature of the CD that distinguishes it from other, more standard types of bank deposits is
that it is a negotiable security. In the money markets there is a deep and liquid secondary market in CDs.
The original purchaser of a CD may sell the CD in the secondary market to any other party, at any time
up to the maturity date. The subsequent owner similarly may sell the CD. At the maturity date, it is the
holder of the CD who receives the face value of the security from the issuing bank. The CD is a liquid
instrument, but the liquidity does not directly affect the amount of funds available to the issuing bank
because the CD is only repaid at maturity. Selling the CD during its term is simply a change of ownership.
Another attribute of the CD is that the yield offered on new CDs can be adjusted quickly as
the banks’ funding requirements change. CDs have become important in the liability management
approach of banks. Effectively, the rate of return can be changed from one transaction to another. This
flexibility is not as easily achieved on the more standard bank deposits.
2.2.5
Bill of exchange
a short-term moneymarket discount
security; face value
repayable at maturity
Acceptance
a bank puts its name on
a bill issued by a third
party; bank accepts
primary liability to repay
the face value of the bill
at maturity
Debenture
a form of security
attached to a corporate
bond; a fixed and/or
floating charge over the
assets of the issuer
Unsecured note
a corporate bond
issued without any form
of underlying security
attached
Collateralised floating
charge
security attached to a
loan; if the borrower
defaults, the lender will
take possession of the
borrower’s assets
B ILL ACCEPTANCE LIABILITIES
A business may seek to raise funds through the issue of a bill of exchange. A commercial bank may
take two different roles in this type of funding arrangement. First, the bank may act as acceptor to the
bill and, second, the bank may discount the bill. If a bank takes on the acceptance role, then the bill of
exchange is said to be a bank-accepted bill.
Bank bills are discussed in detail in Chapter 9; a brief description is provided here. A bill is a
discount security; that is, it is issued today and sold at a price that is less than the face value. The bill
does not pay interest. The face value of the bill is repayable at the maturity date. Therefore, the return
to the holder is the difference between the price at which the bill is bought and the price at which it is
sold before maturity, or the face value at maturity.
A business that issues a bill will sell the bill at a discount to the face value. In order to encourage
an investor to buy the bill, the issuer may ask a bank also to put its name on the bill. If a bank puts
its name on the bill, the bank is said to be the acceptor. The acceptor, on behalf of the issuer, will
repay the face value of the bill to the holder at maturity. By acting as the acceptor, the bank increases
the creditworthiness of the bill. The bank will have a separate arrangement in place to ensure that it
recovers the funds from the issuer on the maturity date. The bank charges a fee for this service.
The bank may also agree to discount and buy the bill from the issuer. Rather than hold the bill to
maturity, the bank is most likely to sell (re-discount) the bill immediately into the money market. In this
situation the bank has incurred a liability on its balance sheet because of the acceptance commitment, that
is, the agreement to repay the face value to the holder at maturity. By selling the bill into the money market,
the bank has been able to arrange finance for its business customer without having to use its own funds.
2.2.6
D EBT LIABILITIES
As part of their strategic management of liabilities, banks issue debt instruments into both the money markets
and the capital markets. The principal domestic money-market instrument—the negotiable certificate of
deposit (CD)—has been discussed above. However, the majority of banks’ assets are longer-term loans;
therefore, banks must actively borrow in the capital markets in order to fund part of their lending.
Medium- to long-term instruments issued by banks include debentures, unsecured notes and
transferable certificates of deposit.
Debentures and unsecured notes are bonds issued by corporations, including banks. Bonds pay a
regular interest coupon to the holder, usually semi-annually or annually. The principal is repaid at the
maturity date. The periodic interest payments may be a fixed interest rate, or based on a variable rate
that may change from time to time.
Debentures are bonds with a form of security attached. The security for a bank-issued debenture
is usually a collateralised floating charge over the assets of the institution. An unsecured note is a bond
with no security attached.
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Chapter 2 Commercial banks
Transferable certificates of deposit are long-term fixed-rate instruments typically issued with a
minimum face value of $100 000 and with terms to maturity of three to five years.
2.2.7
F OREIGN CURRENCY LIABILITIES
Deregulation of the financial system opened up enormous opportunities for commercial banks to
expand their activities and fund their balance sheets from international sources of funds. For example,
deregulation included the floating of the exchange rate of major currencies, the opening up of the foreign
exchange markets and the removal of most restrictions on the flow of capital in the international markets.
The large international capital markets are an important source of foreign currency liabilities for
commercial banks. Banks find it easier to raise substantial amounts of debt in the international capital
markets, often at a net lower cost, than in their traditional, transaction-based depositor base. For example,
the major Australian banks (National Australia Bank, Westpac Banking Corporation, Commonwealth
Bank and ANZ Banking Group) periodically issue debt instruments into the international capital
markets to raise amounts ranging from $500 million to $1 billion. These funds may then be used over
the next three to six months to fund the demand for loans from customers.
Chapter 11 will offer a more detailed study of the types of debt issued into the international capital
markets, in particular those issued into the euromarkets and the US markets. International debt issues
are typically denominated in a foreign currency such as the US dollar, the yen, the pound sterling or the
euro. The types of debt issued are essentially the same as those issued in the domestic markets and include
discount securities (Chapter 9), medium-term notes, debentures and unsecured notes (Chapter 10).
Globalisation means that the banks’ major corporate clients have become more internationalised.
This has increased business demand for financial services denominated in the currencies of their
commercial and financial transactions. That demand provides a further reason for the banks to seek
foreign currency liabilities.
2.2.8
L OAN CAPITAL AND SHAREHOLDERS’ EQUITY
Another source of funds, which has the characteristics of both debt and equity, is described as
loan capital or hybrid securities. For example, a bank may issue subordinated notes. These instruments
are subordinated, which means that the holder of the security will only be paid interest payments, or
have the principal repaid, after the entitlements of all other creditors (but before ordinary shareholders)
have been paid.
Commercial banks are listed corporations; that is, the institution issues equity securities such as
ordinary shares that are quoted on a stock exchange. Also, banks typically generate profits from their
business activities. Some of the profits are paid to shareholders as dividends; some are kept as retained
earnings, which increases shareholders’ funds. Equity is an important source of long-term funds for the
commercial banks. In fact, banks are required by the bank regulator to hold minimum levels of equity
(capital). Capital adequacy requirements for banks are discussed later in the chapter.
Foreign currency
liabilities
debt instruments issued
into the international
capital markets that are
denominated in another
currency
Euromarkets
debt markets where
instruments are issued
into another country, but
not denominated in the
currency of that country
Globalisation
the integration of
financial institutions,
instruments and markets
into an international
financial system
Loan capital
sources of funds that
have the characteristics
of both debt and equity
REFLECTION POINTS
•
•
Commercial banks are highly leveraged organisations; that is, a large percentage of their funds
is in the form of debt liabilities that must be repaid; the remainder is different types of equity.
Current account deposits are liquid funds held in a cheque account; a cheque is a written
instruction to the bank to pay the specified sum to the payee shown on the cheque. Businesses
use cheque accounts as their operating accounts.
continued
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continued
•
•
•
•
•
•
•
Call or demand deposits are liquid funds held in a savings-type account. They represent a stable
source of funds for banks. They typically pay a low rate of interest, and account fees may be charged.
Term deposits are savings lodged for a specified period of time that pay a fixed rate of interest.
The higher interest rate compensates for the loss of liquidity.
Negotiable certificates of deposit are short-term discount securities issued by a bank and sold
into the money market. They are issued today with a face value payable at maturity, and no
interest is paid.
Bill acceptance liabilities are a commitment by a bank, on behalf of the bill issuer, to pay the
face value of a bank-accepted bill to the bill holder at maturity.
Debt liabilities are longer-term debt instruments issued directly into the local capital markets.
They include interest-paying bonds such as debentures, unsecured notes and transferable
certificates of deposit.
Commercial banks issue foreign-currency-denominated debt securities into the international
capital markets to raise foreign currency liabilities.
Loan capital includes hybrid securities issued by a bank such as subordinated notes. The main
type of equity issued is ordinary shares. Shareholder funds are an important source of longterm funding.
2.3
LEARNING
OBJECTIVE
2.3
Identify the main uses
of funds by commercial
banks, including
personal and housing
lending, commercial
lending, lending to
government and other
bank assets.
Funds used by commercial banks appear as assets on their balance sheets. The majority of bank
assets are financial assets that create an entitlement to future cash flows; for example, if a bank gives a
customer a loan, then the amount outstanding on the loan will appear as an asset on the bank’s balance
sheet. The bank is entitled to receive periodic interest payments plus repayment of the principal in
accordance with the terms and conditions of the loan contract. A bank will also accumulate other
assets, such as branch premises and electronic systems.
In this section we categorise commercial bank assets into the following categories:
•
•
•
•
personal and housing finance
commercial lending
lending to government
other bank assets.
2.3.1
Housing finance
the provision of longterm funds to enable
the purchase of
residential property
Mortgage
a form of security
whereby a lender
registers an interest
over the title of a
property
Uses of funds
P ERSONAL AND HOUSING FINANCE
Banks are the principal providers of finance to individuals. The type and amount of bank lending to
individuals will vary between banks, and often between countries, and will reflect the specific priorities
of both lenders and borrowers. In Australia, for example, the largest form of bank lending is for owneroccupied housing. Other forms of personal finance include investment property finance, fixed-term
loans, personal overdrafts and credit card finance.
Housing finance, where the bank registers a mortgage over the property as security for the loan,
is an attractive form of lending as the risk of default by the borrower is normally low. In theory,
borrowers will always try and meet their housing loan commitments because if they don’t, the
bank will take possession of the house and sell it to recover the amount owing. The sale of a house
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under these circumstances certainly will not be in the best interests of the borrower. However,
these circumstances do not always hold. The GFC was precipitated by falling home values and
increasing rates of default on home loans. When house prices fell below the value of their loans,
homeowners, particularly in the USA, had weaker incentives to continue to meet their housing loan
commitments. Instead, many borrowers simply walked away because at that time they could leave
the liability with the bank. This had catastrophic effects for the value of mortgage securities and the
financial system.
Commercial banks have traditionally dominated the residential housing loan market. However, many
new providers of housing finance have entered the market, significantly increasing competition. For
example, insurance offices and superannuation funds now provide housing loan finance. Also, specialist
providers of housing finance, referred to as mortgage originators, have grown in the deregulated
financial market.
Both mortgage originators and commercial banks often use the process of securitisation to finance
their lending activities. Briefly, a lender may seek to obtain additional funds in order to provide new
housing loans by selling existing housing loans. Securitisation can be described as the selling of a class
of assets, such as housing loans, into a trust. The trustee, in order to raise funds to pay for the purchase
of these housing loan assets, will issue new securities to investors. The securities issued by the trustee
may be bonds that are secured by the housing loans held in the trust. Investors like the securities
because, under normal circumstances, they are lower-risk assets. The trustee will use the interest and
principal payments due from the housing loans held in the trust to pay interest and repay principal on
the new securities issued.
The term of a housing loan will vary quite considerably between countries. The major determinant
of the term of housing loans in a country is the average cost of housing coupled with the level of interest
rates. In countries where property prices are very high, the term of the housing loan will be longer. If
this was not the case, individuals would not be able to afford to repay their loan commitments. For
example, in Australia the average term of a housing loan is 30 years.
Housing loan repayment schedules may also differ. A typical owner-occupied housing loan will
require regular amortised loan instalments over the period of the loan. Each loan instalment with an
amortised loan comprises an interest component and a part repayment of principal component. Banks
offer housing loans with either a fixed interest rate or a variable interest rate. However, a fixed-rate loan
will usually be reset every five years or less. The interest rate on variable-rate loans will move from time
to time in accordance with changes in interest rates in the markets.
Another significant form of housing finance is known as investment property finance. In this
situation the bank provides funds to an individual investor who purchases a property for rental or
leasing purposes. Again, the bank will take a registered mortgage over the property as security for
the loan.
Individuals borrow for a range of reasons, such as to purchase a car or travel overseas. In these
circumstances, the bank may provide the borrower with a fixed-term loan. Typically, the term loan will
have a term to maturity of up to five years. As with housing finance, interest rates may be fixed or
variable. The bank will require some form of security, such as a guarantee, to support the loan. Housing
(mortgage) finance and term loans are discussed further in Chapter 10.
Banks provide personal overdraft facilities for individuals. The personal overdraft allows an
individual to put a nominated account into debit from time to time up to an agreed limit. Often,
individuals need to manage the mismatch in the timing of their cash flows and the personal overdraft
allows them to pay expenses when they are due by putting the overdraft account into debit. The bank
expects that the overdraft will be brought back into credit when the individual receives income.
A more flexible alternative to a personal overdraft is a credit card facility. A credit card typically is
used to conduct electronic transactions, such as using automatic teller machines (ATMs) or electronic
funds transfer at point of sale (EFTPOS), by drawing on a predetermined credit limit provided by the
card issuer. The bank as the credit provider will allow the card user to draw against a predetermined
credit limit. Credit cards typically have high interest rates on used credit, and a range of transaction and
other fees might also apply.
Mortgage originators
specialist mortgage
lenders that typically
refinance their lending
through securitisation
Amortised loan
instalments
regular and equal
loan instalments that
comprise the current
interest payment due,
plus part repayment
of the loan principal
outstanding
Investment property
finance
funding that enables a
borrower to purchase
property to rent or lease
to a third party
Fixed-term loan
a loan provided for a
predetermined period;
used to purchase
specified goods or
services
Credit card
a card facility that
provides access
to funds through
electronic distribution
systems: ATMs, EFTPOS
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2.3.2
Reference interest
rate
a benchmark interest
rate published daily
and used for pricing
variable-rate loans
BBSW
the average mid-point
of banks’ bid and offer
rates in the bank bill
secondary market
Overdraft
an arrangement with
a bank that allows a
business to place its
operating account
into debit up to an
agreed limit
Commercial bills
a bill of exchange
issued direct to raise
finance for a business;
a discount security; may
be sold into the money
market
Bank bills held
bills that have
been accepted and
discounted by a bank
and are held as a
balance-sheet asset
Rollover facility
an arrangement
whereby a bank
agrees to discount
new securities over
a specified period as
the existing securities
mature
Lease
an arrangement in
which the owner of
an asset, the lessor,
allows a lessee to use
the asset in return
for periodic lease
payments
C OMMERCIAL LENDING
Commercial lending represents bank assets invested in the business sector plus lending to other financial
institutions. Bank lending to business is essential if economic growth is to be achieved within a nationstate. Economic growth generates benefits such as increased production, higher levels of employment
and better living standards within a country.
In Chapter 1 we discussed the concept of direct finance and intermediated finance, and noted that
only those corporations with a good credit rating are able to raise funds through direct finance. Therefore,
in numeric terms, the majority of business borrowers do not have access to the direct finance markets.
These firms raise funds by borrowing from financial intermediaries. Commercial banks are the principal
lenders, particularly to small and medium-sized businesses. It is worth noting that larger corporations may
still borrow from the commercial banks, but they are also able to borrow direct from the markets.
The main type of loan provided by the banks to firms is the term loan. Typically, term loans are for
maturities ranging from three to seven years. Business borrowers negotiate the terms and conditions
of a loan with their bank. Conditions will include the period of the loan, the interest rate, security
provided to support the loan, and the timing of interest payments and the repayment of principal.
Commercial banks offer borrowers both short-term and long-term loans. Interest rates may be
based on a fixed interest rate or a variable rate set to a specified reference interest rate. For example,
in Australia a reference rate that is often used is the bank bill swap rate, or BBSW. The BBSW is the
average mid-point of banks’ bid and offer rates in the secondary bill market and is calculated and
published daily. International reference rates such as LIBOR and USCP are discussed in Chapter 11.
Loan instalments may be required monthly and may include both interest and part repayment of
principal outstanding. On the other hand, the borrower may be required to make only the interest payments,
and the principal is repaid in one lump sum at the maturity date. Loan repayments may be deferred for a
period before regular instalments commence. Term-loan financing is discussed in Chapter 10.
Banks provide overdraft facilities to businesses. The main purpose of an overdraft is to enable a
business to manage mismatches in the timing of its cash flows. Businesses typically need to pay out
funds for expenses before they receive funds back from their business operations.
An overdraft facility allows a business to place its operating account into debit up to an agreed amount.
While offering flexibility to the business, it should be noted that an overdraft is repayable upon demand
by the bank and therefore needs to be managed carefully. Of course, the bank charges fees and interest
for this very flexible funding arrangement. The bank also expects that the firm will bring the overdraft
back into credit as revenues are received by the business. Therefore, an overdraft will normally fluctuate
between being in debit and being in credit. The discussion of overdraft facilities is extended in Chapter 9.
Bills of exchange were discussed earlier in the chapter. Commercial bills are discount securities. We
noted above that a bank may act as an acceptor to a bill issued by a client, and that the bank will often
discount the bill (buy it at less than the face value). The bank will then generally sell the discounted
bills into the money market, but if the bank decides to hold the bills as assets on its balance sheet, these
are described as bank bills held.
Commercial bills are normally drawn for terms ranging from 30 to 180 days. In order to extend the
overall term of this type of short-term financing, a bank may provide a customer with a rollover facility. For
example, if a business has issued 90-day bills with a two-year rollover facility, the customer is able to redraw
new bills every 90 days for the next two years. When the new bills are drawn, the yield on the bills will change
to reflect current rates in the market. This means the bills are re-priced every 90 days, thus protecting the
bank from the risk that interest rates might change. The bank bills money market is deep and liquid. This
allows banks the flexibility initially to provide funding to business borrowers by discounting bills, but with the
option to sell those bills easily into the money market to generate more funds for further lending.
Another important category of bank finance is leasing. A lease is an arrangement whereby the
owner of an asset (the lessor) allows another party (the lessee) to use that asset subject to the terms and
conditions of the lease contract. A bank, as lessor, will finance the purchase of an asset and will enter
into a financial arrangement with the lessee whereby the lessee will make lease payments in return for
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the use of the asset. Essentially, the lessee is borrowing the asset rather than borrowing the funds to
purchase the asset. Leasing is discussed further in Chapter 10.
2.3.3
L ENDING TO GOVERNMENT
Governments generally borrow direct from the markets. Commercial banks lend to government directly
by investing in government-issued securities, such as Treasury notes, Treasury bonds and other public
sector securities. Banks may also provide some loans to government agencies in the form of term loans
and overdraft facilities.
Governments need to manage their short-term and longer-term cash flows. Short-term funds are
required to meet regular commitments such as social security benefits and the salaries of government
employees. Longer-term funding is required for capital expenditures such as building hospitals and
water storage facilities. If the timing of taxation and other income receipts does not cover intra-year
expenses, a government may issue short-term securities such as Treasury notes (T-notes) to raise the
necessary short-term funds. Longer-term budget capital expenditures will be funded through the issue
of Treasury bonds. Banks purchase a proportion of these securities issued by government. Government
borrowing and debt instruments are discussed further in Chapter 12.
Securities issued by governments are usually regarded as having a very low level of risk and therefore
yield a low rate of return. Why do banks invest in government securities when they could obtain a higher
return by giving more loans to other borrowers? There are a number of reasons. Government securities:
•
•
•
•
•
•
•
•
are an investment alternative for surplus funds that a bank is holding
are a source of liquidity as they can be easily sold in the secondary markets when funds are needed
for further lending
Treasury notes
(T-notes)
short-term discount
securities issued by the
government; face value
payable at maturity
Treasury bonds
medium- to long-term
securities issued by
the government; pay
regular half-yearly
interest, principal repaid
at maturity
provide income streams and potential capital gains, whereas holding cash does not
may be used as collateral to support the bank’s own borrowings in the direct finance markets
may be used for a repurchase agreement with the central bank in order to raise cleared funds for
payments system settlements (Chapter 12)
improve the quality of the balance sheet by holding a group of assets (government paper) with
lower-risk attributes
enable a bank to manage the maturity structure of its balance sheet by purchasing securities with a
range of maturities and cash flows
allow a bank to manage its interest rate risk by buying or selling securities with different interest rate
structures (fixed or variable interest rates).
Therefore, lending to government, particularly through the purchase of government securities,
provides a bank with the flexibility to actively manage its overall asset portfolio, while at the same time
lowering the overall levels of risk in its asset portfolio.
2.3.4
O THER BANK ASSETS
Bank lending is the core business of commercial banks and the largest allocation of their assets. However, banks
accumulate a range of other assets, including receivables, shares in and loans to controlled entities, goodwill,
property, plant and equipment and unrealised gains from their trading activities in derivative products.
Banks are highly dependent on their information systems and product delivery systems. Therefore,
they invest heavily in technology, property, plant and equipment. Nevertheless, there has been a shift
away from the accumulation of physical assets, including a contraction of branch networks. The
reduction in the branch networks has been offset by an increase in the use of electronic products
and service delivery systems, such as phone and internet banking, ATMs and EFTPOS. Apart from
direct branch closures, the divesting of physical assets has taken several other forms. For example,
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some banks have sold a proportion of their branch premises and entered into lease-back arrangements.
Others have outsourced their computer centre operations to specialist providers.
You can test your understanding of the sources and uses of funds by commercial banks by examining
the balance sheet of a major bank. The notes to the accounts reveal the details of the various sources
and uses of funds. Banks publish their financial statements on their websites; for example:
•
•
•
•
Australia and New Zealand Bank Group Limited at www.anz.com.au
Commonwealth Bank of Australia Limited at www.commbank.com.au
National Australia Bank Limited at www.nab.com.au
Westpac Banking Corporation at www.westpac.com.au
REFLECTION POINTS
•
•
•
•
•
•
•
•
•
•
•
The major business of commercial banks is the provision of loans to customers.
Personal finance includes housing loans, term loans and credit card facilities.
Housing finance is the provision of loans to purchase residential property. As security, the bank
will register a mortgage over the property.
Loan repayments may be amortised; that is, each loan instalment includes both interest and
principal repayments.
A bank may securitise part of its loan portfolio; that is, sell a group of loans into a trust in order
to raise additional funds for new lending.
Commercial lending is loans provided to the business sector, including overdrafts, term loans
and mortgage finance.
Loans may have a fixed interest rate, or a variable interest rate based on a reference rate such
as the BBSW.
Businesses establish overdraft facilities that allow a firm to put its operating account into debit up
to an agreed limit. This fluctuating facility allows a business to manage the timing of its cash flows.
Banks are providers of lease finance, whereby the bank purchases an asset that is leased to a
customer.
Banks mainly lend to government by purchasing government securities. These securities allow
banks to invest surplus funds and manage interest rate risk and maturity risk in the asset portfolio.
Banks also accumulate other assets such as physical infrastructure, for example, branches, and
electronic information and product delivery systems.
2.4
LEARNING
OBJECTIVE
2.4
Outline the nature
and importance of
banks’ off-balancesheet business,
including direct credit
substitutes, trade- and
performance-related
items, commitments
and market-rate-related
contracts.
Off-balance-sheet business
The focus of the previous discussion has been on the balance sheet—specifically, the acquisition and uses
of funds by the commercial banks. Such an emphasis understates the role of a modern bank. It was noted
at the beginning of the chapter that banks undertake a substantial volume of business that, by its nature,
is not recorded as an asset or liability on the balance sheet. Such off-balance-sheet transactions represent
an important source of income for the banks, and are most important in the financial life of businesses
and governments.
The main types of off-balance-sheet business conducted by commercial banks can be divided into
four major categories:
•
•
•
•
direct credit substitutes
trade- and performance-related items
commitments
foreign exchange contracts, interest rate contracts and other market-rate-related contracts.
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Direct credit substitutes and trade- and performance-related items generally involve the bank in
supporting or guaranteeing the obligation of a client to a third party. Normally the bank will make a
payment to that third party only if a specified event occurs. Commitments relate to a bank’s contractual
obligations to customers that are yet to be completed. Finally, market-rate-related contracts involve the
use of derivative products to manage financial risk exposures of the bank and its customers.
The large commercial banks also provide a wide range of advisory services to business and government.
These advisory services include risk management advice and portfolio restructuring advice. Much more
detail is provided on these types of advisory services in Chapter 3, Section 3.1.2 (‘Off-balance-sheet business’).
2.4.1
D IRECT CREDIT SUBSTITUTES
Direct credit substitutes are provided by a commercial bank to support a client’s financial obligations.
In this situation, the bank does not provide the finance from its own balance sheet. The direct credit
substitute effectively ensures that the client is able to raise funds direct from the markets.
For example, the direct credit substitute may take the form of a stand-by letter of credit. This is
an undertaking by a bank to make payment to a specified third party if the bank’s client fails to meet
its financial obligation to that party. With the bank undertaking in place, the client is able to issue
securities and raise funds directly in the markets, since the lender is assured that amounts due will be
repaid by either the borrower or the bank that issued the letter of credit.
Other examples of direct credit substitutes include guarantees, indemnities and letters of comfort
issued by a bank that have the effect of guaranteeing the financial obligations of a client. For example, a
bank’s client, when submitting tender documents for a major construction project, may need to provide,
with the tender documents, a formal assurance that it has the financial capacity to complete the project.
It would be expected that if the client wins the tender, the bank will provide finance for the project.
2.4.2
•
an undertaking
provided by a bank to
support the financial
obligations of a client
T RADE- AND PERFORMANCE-RELATED ITEMS
Trade- and performance-related items are also guarantees made by a bank on behalf of its client, but in
this case they are made to support a client’s non-financial contractual obligations.
The obligations may include trade-related undertakings or contractual agreements to provide goods
or services. In these circumstances, the bank provides a guarantee on behalf of its client that it will
make a payment to the third party subject to the terms of the specific commercial contract.
Examples of trade- and performance-related items include:
•
Direct credit
substitute
Documentary letters of credit (DLCs). These are where a bank substitutes its credit standing for that
of its client. The bank, on behalf of its client, will authorise payment to a named party against
delivery by that party of a shipment of goods (evidenced in specified documents). For example, an
exporter of goods will usually require the importer of the goods to arrange for its bank to provide a
documentary letter of credit to the exporter’s bank. Once the imported goods arrive in the country,
the associated documents are inspected and payment is made between the banks immediately. The
DLC will be irrevocable; that is, it cannot be cancelled.
Trade- and
performance-related
item
an undertaking
provided by a bank to
a third party promising
payment under the
terms of a specified
commercial contract
Performance guarantees. These are where a bank agrees to provide financial compensation to a third
party if a client does not complete the terms and conditions of a contract. For example, a client may
be deemed to have failed to complete the terms of a contract if inferior components are used in a
major computer system upgrade.
2.4.3
C OMMITMENTS
Commitments involve a bank in an undertaking to advance funds to a client, to underwrite debt and
equity issues or to purchase assets at some future date.
Commitments
the contractual financial
obligations of a bank
that are yet to be
completed or delivered
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Examples of commitments include:
•
•
•
•
•
Outright forward purchase agreements. These are where a bank contracts to buy a specified asset,
such as foreign currency, from its client at an agreed exchange rate on a specified date.
Repurchase agreements. A bank sells assets, such as government securities, on the understanding
that the bank will repurchase them at a specified date.
Underwriting facilities. A bank guarantees a client that, subject to a range of conditions, it will cover
any shortfall in funds received from a primary market issue of debt or equity securities.
Loans approved but not yet drawn down. For example, a bank has agreed to provide a borrower with
a loan at a future date upon completion of the loan documentation.
Credit card limit approvals that have not been used by card holders. For example, a bank may authorise
a credit card limit of $4000 for a client. If the client uses $1000 of the available credit, then that
amount will appear on the balance sheet as an asset (loan), and the remaining $3000 credit remains
as an off-balance-sheet commitment.
2.4.4
F OREIGN EXCHANGE CONTRACTS, INTEREST RATE CONTRACTS
AND OTHER MARKET-RATE-RELATED CONTRACTS
Market-rate-related
contracts
derivative products;
allow management of
exposures to interest
rate, foreign exchange,
equity and commodity
price risks
Hedging
implementing strategies
to protect against an
identified risk exposure
Foreign exchange, interest rate and other market-rate-related contracts principally involve the use of
derivative products—that is, futures, options, swaps and forward contracts.
These instruments are primarily designed to facilitate hedging against risk; for example, the effects
of movements in exchange rates, interest rates, equity prices and commodity prices. Derivative contracts
are also bought and sold by traders in an attempt to make profits from movements in contract prices.
Details of each of these instruments and their use for risk management are provided in Parts 5 and 6.
Examples of foreign exchange, interest rate and other market-rate-related contracts include:
•
•
•
•
•
•
Forward exchange contracts. A bank contracts to buy or sell at a future date a specified amount of a
foreign currency at an exchange rate that is set today.
Currency swap. A bank exchanges a principal amount and ongoing associated interest payments that
are denominated in a foreign currency.
Forward rate agreements. A compensation agreement between a bank and client based on a notional
principal amount. One party compensates the other party if interest rates move above or below an
agreed interest rate.
Interest rate futures contracts. These are exchange-traded agreements to buy or sell a specific security
at a specific price at a predetermined future date.
Interest rate options contracts. These provide the right, but not the obligation, to buy or sell a specified
financial instrument at an agreed date and price.
Equity contracts. These include futures and options contracts based on specified stock prices or
stock indices. These contracts lock in the equity price today that will apply at a specified future date.
2.4.5
V OLUME OF OFF-BALANCE-SHEET BUSINESS
There are two outstanding features of the banks’ off-balance-sheet business. The first is the magnitude
of the notional face value of the off-balance-sheet contracts written by banks. This will vary between
countries, but an examination of the volume of off-balance-sheet business within the Australian market
gives a good indication of the size of the markets.
In Australia, the face value of banks’ off-balance-sheet business as at December 2017 stood at
$37 341 981 (million) while the total value of banks’ assets stood at $4 125 764 (million). That is, the
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notional value of off-balance-sheet business is nine times the value of total assets held by the banks.
As described in Part 6, the notional value of many derivative products is significantly greater than the
actual associated cash flows. Comparing the notional value of derivatives with the value of balancesheet assets does overstate the relationship.
The second characteristic of the off-balance-sheet business is that it is mainly market-rate-related
contracts. The notional values of the various types of off-balance-sheet business are shown in Table 2.1.
Table 2.1 Bank off-balance-sheet business, Australia, as at December 2017
Off-balance-sheet business type
Notional amount ($ millions)
Direct credit substitutes
46 806
Trade- and performance-related items
66 945
Commitments
1 232 076
Interest rate contracts
Foreign exchange contracts
Credit derivatives
Other
27 356 300
8 305 871
42 312
291 667
Total
37 341 981
SOURCE: © Australian Prudential Regulation Authority 2018
The nature and size of market-rate-related contracts, combined with the volatility and speed at
which contracts are re-priced in the market, has resulted in a number of extraordinary losses being
incurred by both financial institutions and their clients. The threat to the stability of domestic and
global financial systems that may result from large losses in the derivatives markets has been the subject
of much discussion by regulators and prudential supervisors.
One high-profile example (which has since been depicted in the movie Rogue Trader) was the loss of
$1.5 billion by the UK bank Baring Brothers plc. Speculation on price movements of derivative contracts
on the Singapore and Osaka exchanges by one of its traders, Nick Leeson, brought about the loss, which
resulted in the eventual failure of the bank. Of course, during the GFC a number of institutions, including
Lehman Brothers and Bear Stearns, collapsed as the direct or indirect result of excessive trading in
mortgage-related derivatives. In the end, it is the responsibility of each bank to ensure that it establishes
and documents objectives, policies and procedures in relation to its use of derivative products.
REFLECTION POINTS
•
•
•
•
•
Direct credit substitutes are provided by a bank to support a customer’s financial obligations
to a third party (e.g. a letter of comfort written by the bank confirming that a customer has
sufficient funding in place to proceed with a project).
Trade- and performance-related items are guarantees given by a bank to support a customer’s
obligations; for example, a bank will execute a documentary letter guaranteeing that it will pay
for the importation of goods on behalf of its customer.
Commitments are yet-to-be-completed financial agreements made by a bank to its customers (e.g.
the approval to provide a loan in the future to purchase a house, or a credit limit on a credit card).
Foreign exchange, interest rate and other market-rate-related contracts are typically derivative
contracts, such as futures, forwards, options and swaps, used to manage risk exposures.
The notional value of the off-balance-sheet business of banks is much greater than the value of
balance-sheet assets.
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2.5
LEARNING
OBJECTIVE
2.5
Consider the regulation
and prudential
supervision of banks.
Bank regulation
constraints on banking
activities through
prescriptive legislation
and prudential
supervision
Prudential
supervision
the imposition and
monitoring of standards
designed to ensure the
soundness and stability
of a financial system
Regulation and prudential supervision of
commercial banks
We have highlighted the essential role that the financial system plays in facilitating financial transactions
that enable economic growth and prosperity. Therefore, governments and regulators have sought
to maintain the stability and soundness of the financial system in order to achieve both economic
objectives and social outcomes. The GFC cast a spotlight on the issue of regulation. In particular, the
leverage that characterised the financial system in the years before the crisis attracted much attention.
Many of the major financial institutions in the USA held assets with a value more than 30 times larger
than the banks’ underlying capital reserves. This leverage was supported by short-term financing and
innovative capital instruments that evaporated during the crisis.
Following the crisis, the primary regulatory response has been Basel III. We will discuss this in
detail in this chapter. However, concerns about the regulation of financial institutions did not just stem
from the crisis. In Australia, the housing finance provided by banks and the potential for a ‘housing
bubble’ raised questions about lending practices, and reports of poor treatment of customers eventually
resulted in the establishment in 2018 of the Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry. Evidence heard at the Royal Commission raised
additional questions about Australia’s financial regulatory frameworks.
The primary purpose of this section is to consider issues arising from bank regulation and
prudential supervision. This will vary between countries, but it is interesting to note that the principles
and functions of bank regulation and supervision have changed in similar ways and at a similar pace
in all developed economies. Much of the theory of bank regulation and supervision is the same
internationally; variations exist to a degree but mostly in the detail of the application.
It may be argued that a banking sector regulatory and supervisory framework should:
•
•
•
•
•
ensure a regulatory framework that is able to adjust regulation to maintain the cost effectiveness of
the financial system in a dynamic environment
provide a focused and accountable structure that facilitates community expectations for consumer
protection and financial safety
provide efficient and effective regulation of multinational financial conglomerates
establish consistent regulation and competitive neutrality across the financial system
contribute to effective monitoring and review with the aim of establishing more contestable, efficient
and fair financial markets.
An area of concern for regulators is that of maintaining the soundness and stability of the financial
system, and ensuring that savers have confidence in the institutions—in particular the commercial
banks—as safe repositories for their funds. Bank regulation no longer relies (as it once did) on heavily
prescribing the asset composition of a bank’s balance sheet. Rather, it now imposes guidelines that allow
the banks a wide range of options in their lending decisions, but forces those banks that adopt higherrisk lending strategies to support their activities with higher amounts of capital or shareholders’ funds.
Regulation directly influences the structure, scope and scale of financial institutions, instruments
and markets. The institutional framework for regulation and supervision of a financial system varies
between countries. In some countries, the central bank acts as the banking sector regulator and
supervisor; in other countries, the central bank has responsibility for the stability of the financial
system and the soundness of the payments system, while a separate authority has responsibility for the
regulation and supervision of financial institutions. Generally, other authorities will be responsible for
competition law, consumer protection and corporations legislation supervision.
By way of example, Australia has implemented a regulatory structure with the following features.
•
Overall responsibility for the maintenance of financial system stability, and soundness of the
payments system, is the responsibility of the central bank (Reserve Bank of Australia).
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•
Prudential regulation and supervision of authorised deposit-taking institutions (i.e. commercial
banks, building societies and credit unions), insurance offices, superannuation funds and friendly
societies is the responsibility of the Australian Prudential Regulation Authority (APRA).
•
Regulation and supervision of market integrity and consumer protection, within the context of the
Corporations Act 2001, is the responsibility of the Australian Securities and Investments Commission
(ASIC).
•
Authorised deposittaking institutions
financial institutions
authorised by APRA to
accept retail deposits in
Australia
Matters of competition policy (Competition and Consumer Act 2010) are the responsibility of the
Australian Competition and Consumer Commission (ACCC). Within this context, the government
has implemented a ‘four-pillars’ policy, which currently restricts mergers between the four major
commercial banks in Australia.
A basic principle of APRA’s approach to bank supervision is that the primary responsibility for a
bank’s sound operation rests with the bank’s own management and board of directors. However, there
are some aspects of banking operations where APRA is more intrusive and has implemented prudential
guidelines and standards, such as with the imposition of minimum capital requirements.
In the event of a threat to the stability of the financial system, the Reserve Bank is responsible for
determining whether, and how, it might provide emergency liquidity support to the financial system.
The Reserve Bank, however, does not regard its balance sheet as available to support the solvency of
an individual financial institution that may experience financial difficulty. Ultimately, each commercial
bank must rely on the strength of its own balance sheet.
Nevertheless, some depositor protection may be provided by the government. Deposit insurance,
in the form of a Financial Claims Scheme (FCS), was introduced in Australia in October 2008 during
the GFC. Under the FCS, $250 000 per person per institution is covered. More details are available at
www.apra.gov.au.
REFLECTION POINTS
•
•
•
•
•
The important role of the financial system, in particular the commercial banks, in supporting
economic growth means that each nation-state has established a regulator that sets prudential
standards for the supervision of the banking sector.
The GFC highlighted the importance of effective regulatory frameworks. The 2018 Royal
Commission into Misconduct in the Banking, Superannuation and Financial Services Industry
highlighted other areas for concern.
The regulator may be the central bank, a specialist supervisory authority or a combination of both.
In Australia, the central bank is the Reserve Bank of Australia, while the authority responsible
for financial institution supervision is APRA. The ACCC is responsible for competition and
consumer protection and ASIC is responsible for the Corporations Act.
Government guarantees may be provided for certain bank deposits.
2.6
A background to the capital adequacy
standards
According to APRA, capital is the cornerstone of a bank’s financial strength. This guides the most
important prudential standard, ‘capital adequacy’. The balance sheet of a corporation, including a
commercial bank, comprises a range of assets that are funded from liabilities and shareholders’ funds.
Shareholders’ funds represent equity and may be referred to as capital. The main assets accumulated by
commercial banks are its loans to customers. Typically, a percentage of borrowers will default on their
loan repayments. Under normal circumstances, these loan losses are written off against profit in the
LEARNING
OBJECTIVE
2.6
Understand the
background and
application of Basel III.
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relevant accounting period. However, if loan losses increase above the level of profits, then the losses
must be written off against capital. They cannot be written off against liabilities because the bank must
still repay its liabilities when due.
Capital has a number of important functions, including:
•
•
•
•
G-10
Belgium, Canada,
France, Germany, Italy,
Japan, the Netherlands,
Sweden, the UK and
the USA
Basel II capital accord
the standard that
defines the minimum
capital adequacy
requirement for a bank
Basel III capital
accord
an enhanced set of
capital, leverage and
liquidity standards
It is the source of equity funds for a corporation.
It demonstrates shareholders’ commitment to the organisation.
It enables growth in a business and is a source of future profits.
It is necessary in order to write off periodic abnormal business losses.
It is this last function of capital that is the basis upon which international capital adequacy
standards for banks have evolved.
Deregulation and globalisation of the international financial system, coupled with rapid advances
in technology and the development of sophisticated financial products, created an environment in
which there was the potential for instability or failure of the global financial system.
Therefore, the governors of the central banks of the major industrialised countries, who meet
monthly at the Bank for International Settlements (BIS) in Basel, Switzerland, established a new
standing committee in 1974 which is now known as the Basel Committee on Banking Supervision.
Currently, the committee’s members come from Argentina, Australia, Belgium, Brazil, Canada, China,
France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the
Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the
United Kingdom and the USA. However, the committee originally comprised only the senior bank
regulators of the G-10 group of countries, plus Luxembourg and Switzerland. Even in the early 1970s,
the committee recognised the problems involved in regulating internationally diversified banks and
recommended that such banks should be treated on a globally consolidated basis but should come
primarily under the regulatory powers of the home country.
The committee presented a paper to the governors of the central banks in which it expressed concern
about the erosion of banks’ capital bases and recommended that these should be rebuilt. The committee
continued to work on the adequacy of banks’ capital and on the development of a common minimum
standard of capital adequacy that international banks should maintain. The overriding purpose of the
committee’s work was to develop a framework that would maintain the soundness of the international
financial system and that would, at the same time, allow individual banks to make their own portfolio
choices and promote a greater competitive equality between banks in the international markets.
The committee’s work culminated in a document, The International Convergence of Capital
Measurement and Capital Standards (Basel Committee Publication No. 4, published in July 1988).
These capital adequacy requirements, currently referred to as the Basel I capital accord, were adopted
by most countries that have commercial banks operating in the global financial system.
The 1988 Basel I capital accord applied a standardised approach to the measurement of the
capital adequacy of banks. Basel I was successful in increasing the amount of capital held by banks and
therefore created a strong foundation to support the stability of the global financial system. However,
over time, it became apparent that Basel I did not fully account for the diversity, sophistication or
innovation of the changing financial markets. The committee conducted a major review of the capital
adequacy guidelines, which culminated in the Basel II capital accord guidelines.
Basel II capital adequacy guidelines were adopted by bank regulators in most major industrial
countries and implemented by commercial banks. In some countries, including Australia, other
regulated financial institutions were also required to meet the Basel II capital adequacy requirements.
In 2010, the Basel III capital accord guidelines were released. The goal of Basel III is to make financial
institutions more resilient to the economic shocks that occur periodically within an economic system
that is characterised by financial institutions that do not hold reserves that match their liabilities. Basel
III initially proposed enhancements to the quantity and quality of banks’ capital reserves, liquidity
ratios and leverage ratios. These have been reviewed over time. The Basel III bank capital framework
was finalised in December 2017.
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REFLECTION POINTS
•
•
•
•
An international capital adequacy standard for banks was developed to strengthen the global
financial system.
Banks need sufficient capital to expand their business and also periodically to write off
abnormal losses.
The Bank for International Settlements established a permanent committee, the Basel
Committee on Banking Supervision, to develop capital standards. The Basel I accord was
introduced in 1988 and strengthened by the Basel II capital accord.
The Basel III capital accord introduced enhanced capital requirements following the GFC. It was
finalised in December 2017.
2.7
The Basel accords: evolution from
Basel I to Basel III
Basel I developed a measure of capital adequacy that principally focused on the level of credit risk
associated with a bank’s balance-sheet and off-balance-sheet business. Credit risk is the risk that
counterparties to a transaction will default on their commitments. At the same time, bank supervisors
did not wish to restrict the asset choices of banks or to stifle banks’ participation in off-balance-sheet
business. An extension of the original guidelines introduced a capital requirement for market risk.
Market risk is the exposure of an institution’s trading book to changes in interest rates and foreign
currency exchange rates.
Basel II was a major extension of Basel I and much more sensitive to different levels of risk that
may exist within an institution and to the sophistication of modern risk management practice.
The Basel II approach focused on:
•
•
•
•
•
•
the credit risk associated with a bank’s balance-sheet and off-balance-sheet business
the market risks associated with a bank’s trading activities
the operational risk evident in a bank’s business operations
the form and quality of capital held by a bank to support these exposures
the risk identification, measurement and management processes adopted by banks
transparency, through the accumulation and reporting of related information and data.
LEARNING
OBJECTIVE
2.6
Understand the
background and
application of Basel III.
Credit risk
the risk that an obligor
will not make future
interest payments or
principal repayments
when due
Market risk
the exposure of a
bank’s trading book
to changes in interest
rates and exchange
rates
Basel III was primarily a response to the GFC but it has been revised and enhanced since then.
The focus has remained on the capital adequacy of financial institutions. The main objective of
Basel III is to increase bank liquidity and decrease bank leverage in order to support financial system
stability. While the Basel capital accords are developed by the Bank for International Settlements, it
is the responsibility of each country’s prudential regulator to implement the standards. We will look
at the application of Basel III in Australia by APRA. You can view updates on implementation at
www.apra.gov.au.
2.7.1
M INIMUM CAPITAL ADEQUACY REQUIREMENT
The Basel accords require that the ratio of a bank’s capital to its risk-weighted assets be set at some
minimum level. A bank’s capital, including equity and retained earnings, forms the numerator for the
capital ratio. A bank’s assets, including loans, forms the denominator. The assets are multiplied by a
risk factor or ‘weight’ to reflect their inherent riskiness. More risky assets attract a higher weight, which
reduces the capital ratio and requires more capital to be set aside to ensure that the capital ratio reaches
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the desired level. Minimum capital adequacy requirements apply to commercial banks and any other
institutions specified by a country’s prudential regulator.
In addition to a minimum total capital ratio to be maintained at all times, banks are required to
maintain a capital conservation buffer of 2.50 per cent. To act as a further safeguard, a counter-cyclical
buffer of between 0 and 2.50 per cent was also introduced to be applied when credit growth is judged to
have resulted in an undesirable increase in systemic risk. In Australia, APRA will determine the level of
the counter-cyclical buffer and bring it into effect when it deems it necessary to do so.
Immediately following the GFC, the focus of the capital adequacy requirements was on the
amount and nature of capital that would form the basis for determining a bank’s capital ratio.
A distinction was made between Tier 1 and Tier 2 capital to ensure that the capital that banks set
aside to meet their capital adequacy requirements contributed to financial strength in a real and
meaningful way.
Subsequent revisions to Basel III focused on the other half of the capital adequacy ratio. That is,
the way in which a bank’s risk-weighted assets should be calculated to avoid weaknesses in the financial
system emerging from dubious or inconsistent assumptions that banks might apply in developing their
own internal risk models.
2.7.2
Common Equity
Tier 1 capital
highest quality; core
capital for capital
adequacy purposes
Tier 2 capital
additional capital that
contributes to a bank’s
financial strength
T HE DEFINITION OF CAPITAL
Capital, within the context of Basel III, is measured in two tiers: Tier 1 and Tier 2.
Common Equity Tier 1 capital, or CET1, consists of the highest quality capital: common shares,
retained earnings and other reserves as set down by Australian Prudential Standard APS 111. APRA is
phasing in a requirement that banks in Australia have a Common Equity Tier 1 capital (CET1) ratio of
at least 10.50 per cent.
Tier 2 capital is additional capital that contributes to a bank’s financial strength. Australian
Prudential Standard APS 111 sets down the characteristics that an instrument must have to qualify as
Tier 2 capital. Tier 2 capital includes subordinated debt and general loan-loss reserves.
2.7.3
B ASEL III STRUCTURAL FRAMEWORK
The Basel III capital accord framework is based on three integrated pillars:
•
•
•
Pillar 1: capital adequacy requirements, risk coverage and leverage ratios
Pillar 2: risk management and supervision
Pillar 3: the market discipline, incorporating disclosure and transparency requirements.
In the final version of Basel III, as mentioned previously, special focus was given to the methods
that banks use to compute their risk-weighted assets (the denominator in the capital adequacy ratio).
The mathematical models that banks use to compute the likelihood that they will suffer losses of
varying magnitudes have been scrutinised very closely. Basel III, in its final version, not only ensures
that banks set aside capital of appropriate quality but also ensures that the models used to compute
the risk that the bank bears in carrying a particular asset are calibrated correctly. Extended learning A
works through an example of the calculations involved.
Pillar 1
incorporates
components of credit
risk, operational risk
and market risk within
the Basel III framework
Pillar 1: Credit risk component
Pillar 1 incorporates three risk components: credit risk, operational risk and market risk.
Credit risk relates to the underlying counterparty to a balance-sheet asset or an off-balance-sheet
transaction. It is the risk that a counterparty is unable to meet its obligations. A bank’s risk-based
capital ratio is the ratio of capital to risk-weighted assets. A bank’s assets include cash, loans and
securities. The value of an asset is weighted by multiplying it by the appropriate risk weight. The safer
the asset, the lower the risk weighting.
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How does a bank determine the risk weights to be applied to different types of assets? Basel III
provides three alternative ways for a bank to measure credit risk:
1 the standardised approach (SA)
2 the foundation internal ratings-based approach (FIRB)
3 the advanced internal ratings-based approach (AIRB)
Globally, most banks use the standardised approach for credit risk. The standardised approach to
credit risk requires banks to assign each balance-sheet asset and off-balance-sheet item a risk weight
that is based on an external rating published by an approved credit rating agency, or is a fixed weight
specified by the prudential supervisor. This means that banks do not use their own internal models.
Off-balance-sheet exposures that give rise to credit risk are first converted into so-called balance-sheet
equivalents according to specified credit conversion factors prior to allocating the relevant risk weight.
With regard to market-related off-balance-sheet transactions, a bank has the choice of two methods
for determining the credit conversion factor: the current exposure method or the original exposure
method. The current exposure method (mark-to-market) is the sum of the current credit exposure and
the potential future credit exposure of a contract. The current credit exposure is defined as the sum
of the positive mark-to-market value (or replacement cost) of a contract. The potential future credit
exposure is determined by multiplying the notional principal amount by the relevant credit conversion
factor. Each of these market-related off-balance-sheet transaction methods has its own set of credit
conversion factors. The original exposure method applies a different set of credit conversion factors to
the notional value of the contract.
Larger commercial banks, under certain conditions, can use the internal ratings-based approach to
credit risk. These banks have the information systems and expertise that enable a more sophisticated
approach to the measurement and management of risk. In some cases, the bank’s estimate of the riskweighting to be applied to certain assets may be better informed than a risk-weighting determined by a
prudential supervisor. However, there are obvious incentives for a bank to understate the riskiness of
a particular asset. As such, Basel III places constraints on the use of internal models.
There are two internal ratings-based approaches available:
1 the foundation internal ratings-based approach (FIRB)
2 the advanced internal ratings-based approach (AIRB).
Under the FIRB approach, a bank must provide its own estimates of probability of default and
effective maturity, but must rely on supervisory estimates for other credit risk components, including
the loss given default estimates and exposure at default estimates. Under the AIRB approach, a bank
must provide its own estimates of all of the credit risk components. Basel III removes the option for
using AIRB to estimate the risk exposures to financial institutions. In addition, no internal models can
be used at all to compute the risk for equity exposures.
In Australia, APRA has decided to distinguish between authorised deposit-taking institutions
that use internal models and those that use the standardised approach. In the transition to full
Basel III implementation, those banks that use internal models will be required to meet a stricter
capital requirement than those banks that use a standardised approach. Those banks that are using
internal models to assess their credit risk will be required to meet a capital requirement that is
approximately 1.00 per cent (100 basis points) higher than banks that use the standardised approach.
This is an indication of the additional scrutiny that has been directed to internal risk models since the
GFC and which is reflected in the final version of Basel III.
Pillar 1: Operational risk component
In recent years, banks have gained a greater understanding and awareness of operational risks that
may result in the loss of business functions. The reality of disaster was particularly evident following
the terrorist attacks in New York on 11 September 2001. The US financial system was severely
tested as financial institutions and markets closed and struggled to recover their critical business
Standardised
approach to credit
risk
provides risk weights to
be applied to balancesheet assets and offbalance-sheet items
to calculate minimum
capital requirement
Current exposure
method
off-balance-sheet
capital calculation
based on the
current and potential
credit exposures’
mark-to-market
Original exposure
method
off-balance-sheet
capital calculation
based on the notional
contract value
multiplied by a credit
conversion factor
Mark-to-market
the revaluation of a
contract based on its
current quoted price on
an exchange
Internal ratings-based
approach to credit
risk
for capital calculations
a bank may use some
or all of its own risk
measurement model
factors; supervisor
approval required
Operational risks
exposures that may
impact on the normal
day-to-day business
functions of an
organisation
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operations. The direct and consequential operational and financial losses associated with that disaster
were significant.
The Bank for International Settlements categorises operational risk as:
•
•
•
•
•
•
internal and external fraud
employment practices and workplace safety
clients, products and business practices
damage to physical assets
business disruption and system failures
execution, delivery and process management.
The categorisation of operational risk is very wide ranging and indicates that all aspects of an
organisation’s day-to-day business activities are exposed to operational risk.
The Australian prudential supervisor, APRA, defines operational risk as the risk of loss resulting
from inadequate or failed internal processes, people and systems or from external events. This definition
includes legal risk, but excludes strategic and reputational risks.
The rapid advance in technology, together with globalisation of the international financial system,
has increased the time sensitivity of banks to operational risk. For example, a bank’s derivatives
transactions, foreign exchange trading and payments system settlements are clear examples of critical
business functions that are time sensitive within very short time-frames.
The loss by a bank of its critical business operations due to a disaster may severely challenge its
operational and financial survival. For example, such disasters may include the loss of computer or
communication systems, or severe damage from fire or earthquake. Further, operational risk contagion
is an extended risk to which a country’s financial system is exposed. It is possible that contagion effects
may result in instability within the global financial system.
Principally, the management of operational risk requires the development and maintenance of defined
strategies that will enable a bank to recover its functionality and resume critical business operations within
predetermined time frames. There are three overarching objectives of operational risk management:
1 Operational objectives. These are associated with the impact on a bank of the loss of business function
integrity and capability.
2 Financial impact objectives. These relate to direct losses incurred as a result of an operational risk
exposure, the cost of recovering normal business operations and consequential financial losses due
to reduced business effectiveness.
3 Regulatory objectives. These derive from prudential standards established by bank supervisors.
Business continuity
management
maintenance of
strategies to ensure the
continuance of critical
business functions
It might be argued that the prevailing risk management regime within a bank will ensure that
exposures to operational risk are identified and managed through a structured decision process.
However, it became apparent to bank regulators that theoretical drivers of risk management were often
impeded by operational and financial imperatives that limited the development of risk management
objectives, policies and practices. For example, failures within a bank’s operational risk management
process may result from a lack of understanding of this risk by the board of directors and executive
management, inadequate budget allocations, poor risk management leadership and procedures, and
weak or non-existent education and training programs.
It is within this context that the Basel Committee on Banking Supervision incorporated an
operational risk component into Pillar 1 of the capital accords.
The first, and most important, requirement is that commercial banks establish and maintain a
comprehensive risk management framework for operational risk. It must be clearly understood that the
provision of additional capital in the capital accord will not protect a bank from operational risk. The
capital will only support the survival of the institution and the stability of the financial system after an
event has occurred.
Business continuity management, or disaster risk management, is a significant component of
operational risk management. At the end of this chapter, Extended learning B provides a business
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continuity risk management structure consisting of a disaster recovery planning process and a disaster
recovery response process, and applies these processes to an education and training framework for
commercial banks. This is essential reading for those responsible for the management of business
continuity risk.
Basel III requires banks to hold additional capital to support their exposure to operational risk. The
final version of Basel III simplified the process of calculating the amount of operational risk capital that
a bank would be required to set aside by setting down a single standardised measurement approach.
Under this approach, a bank’s required operational risk capital is determined by the product of a
‘business indicator’ (BI) factor and an internal loss multiplier (ILM). APRA’s Prudential Standards
APS 114 and 115 will be revised in line with Basel III’s new approach to operational risk.
The calculation of operational risk capital under the new standardised approach is relatively simple.
The BI is a measure of income that increases with the size of the bank. The ILM is inferred from the
bank’s own history of losses. In its 2018 discussion paper on the revisions to the capital frameworks,
APRA presents an example that explains the calculation. The Basel III framework identifies ranges
of bank income: (1) up to $1 billion; (2) between $1 billion and $30 billion; and (3) greater than
$30 billion, along with coefficients of 12.00, 15.00 and 18.00 per cent, respectively. For example, if a
bank’s business indicator is $5 billion, then its BI factor would be $1 billion multiplied by 0.12 plus
$4 billion multiplied by 0.15, or $720 million. This BI factor is then multiplied by the ILM, which will
either increase or decrease the amount of capital required depending on the bank’s record of losses.
Basel III allows prudential supervisors some discretion in applying the specifics of the standardised
approach to calculating operational risk capital. APRA, if it decides, can disregard the ILM component.
In this case, the operational risk capital that a bank in Australia must set aside will be equal to its
business indicator. An important thing to note about the BI is that it increases non-linearly as the size of
the financial institution increases. This reflects the belief that operational risk not only increases with
the scale of the financial institution, but that it does so more than linearly. Larger banks will be required
to set aside more operational risk capital than smaller banks.
Pillar 1: Market risk component
Market risk is the third component of Pillar 1 and is defined as the risk of losses resulting from
movements in market prices.
Commercial banks that operate in the foreign exchange, interest rate, equity or commodities
markets may be exposed to potentially large swings in market prices and significant consequential
losses. Potential losses may arise from general market price movements and, in the case of interest rate
and equity instruments, from price movements specific to particular issuers.
An institution is required to divide its assets into either its banking book or its trading book. A
commercial bank must hold market risk capital against interest rate risks and equity risks arising from
positions held in its trading book. Also, market risk capital must be held against credit derivatives in the
bank’s trading book, as well as against all foreign exchange and commodity risks.
Market risk is split into two components: general market risk and specific market risk. General
market risk relates to changes in the overall market for interest rates, equities, foreign exchange and
commodities. Specific market risk is the risk that the value of a security will change as a result of issuerspecific factors, such as a change in the creditworthiness of the issuer. This is relevant only to interest
rate and equity positions.
It is the responsibility of the board of directors to ensure that an institution has documented a
trading book policy statement. The institution must ensure that it has in place adequate systems to
identify, measure and manage market risk.
Institutions have had a choice of two approaches to calculate their market risk capital requirements:
the internal model approach and the standardised approach. Basel III, and APRA’s interpretation of it,
place restrictions on the use of internal models. This step has been taken to ensure that the methods
used to compute risk exposures yield approximately the same results for comparable banks. When banks
are permitted to use their own tailored models, the risk exposure calculations can vary considerably
from bank to bank, even though the business characteristics are very similar.
General market risk
for capital adequacy
purposes; changes in
the overall market for
interest rates, equities,
foreign exchange and
commodities
Specific market risk
the risk that the value
of a security will change
due to issuer-specific
factors
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Value at risk (VaR)
a statistical probability
model that measures
financial risk exposures
based on historic
observations
The models that are used to measure risk exposure produce a measure of the value at risk (VaR)
from all market risks over a period of 10 trading days. To determine the amount of capital required, the
measure of VaR is multiplied by a factor set by the prudential supervisor. The factor will range from
3 to 5 according to the regulator’s view of the strength and reliability of the internal VaR model. Added
to this will be a plus factor of up to 1, depending on the ex-post performance of the model in back-testing.
Value-at-risk models (VaR)
VaR models endeavour to estimate maximum potential gains or losses that may be incurred on a
portfolio based on a specified probability over a fixed time period. APRA requires the VaR model
to include historical data observations for a minimum of one year. In times of high market volatility,
APRA may also require the banks to calculate VaR over a shorter time period to take account of the
increased risk associated with the volatility. The model data sets must be updated at least monthly.
The regulator requires a model to apply a 99.00 per cent confidence level over a 10-day holding
period. This assumption implies that, on average, trading losses from market-related contracts will
exceed the VaR estimate only once in every 100 trading days. However, VaR is calculated using historic
observations and therefore is not necessarily an accurate estimate of future losses, especially if an
extreme event occurs that impacts upon the financial markets.
The VaR model recognises the detailed structure of the balance-sheet and off-balance-sheet
items and—given specific assumptions on prices, values and volatility—determines a VaR estimate.
The sophistication of a VaR model used by an institution will vary, depending on the structure of its
balance-sheet and off-balance-sheet items, the risk management needs of the institution, the theoretical
and technical skills of its risk managers and the availability of computer hardware and software.
Simple VaR models:
Basis points
interest rates;
100 basis points equal
1.00 per cent
•
•
•
estimate the sensitivity of portfolio components to small changes in prices; for example, a 1 basis point
change in interest rates
assume that market price movements follow a certain statistical distribution, usually a normal or
log-normal distribution
enable inferences to be drawn about potential losses with a given degree of statistical confidence; for
example, a 99.00 per cent probability of a certain dollar amount loss.
More complex VaR models:
•
•
•
recognise correlations between different portfolio components; that is, the model allows for market
price changes that move together or offset each other
account for the effects of portfolio diversification
consider the liquidity of different portfolio instruments; that is, the ease or ability of an institution
to liquidate (sell) securities or close out an open risk position.
VaR represents an important tool available to risk managers and boards of directors for the
estimation of potential exposures to market-rate-related risks. However, VaR models are constrained by
some theoretical and statistical limitations; they:
•
•
•
•
•
are based on a limited set of historical data which may not be a correct reflection of future data
assume liquidity in all markets; that is, the ability of an institution to trade all components of its
portfolio. This will not always be the case, particularly in times of financial stress
assume that all instruments can be liquidated in one day. This is not possible. Contractual constraints
also mean that some items cannot be liquidated
do not include excessive intra-day price volatility; that is, unusually large short-term exchange rate or
interest rate movements
assume a normal distribution, when data indicate that in some markets prices may be volatile and a
normal distribution is not always evident.
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These limitations were on full display during the GFC. The historical data on which VaR models
were based simply did not include a housing market crisis of the proportions that precipitated the GFC.
A number of financial institutions significantly underestimated the amount of potential losses that they
could suffer and, in some cases, reported relatively low levels of potential losses just days before being
forced into bankruptcy. Because of these limitations, and as part of good risk management practice, banks
should back-test their VaR model estimates against actual outcomes. The model should be applied to a
range of scenario analysis situations, and particularly must be ‘stress tested’ for extreme market conditions.
Following the GFC, stress testing of financial institutions and their models attracted much attention.
APRA introduced a ‘stressed Value at Risk requirement’ that came into effect in January 2012. Among
other things, the stressed VaR must address illiquidity, price gapping, concentrated positions, one-way
markets, non-linear products, deep out-of-the-money positions and other risks that may not be captured
by VaR, including implied correlations and skew risk. For more information see APRA’s APS 116,
especially Attachment C (www.apra.gov.au). Perhaps one of the defining features of Basel III is the
‘output floor’ that limits the discrepancy that can emerge between a bank’s internal models and the
standardised approaches to measuring market risk. This places a limit on the incentives that exist for
banks to develop models that understate market risk.
Pillar 2: Risk management and supervision
The supervisory review process forms the second pillar of Basel III. The Basel Committee on Banking
Supervision advises that the supervisory review process is intended to:
1 ensure that banks have sufficient capital to support all the risk exposures in their business
2 encourage banks to develop and use improved risk management policies and practices in identifying,
measuring and managing risk exposures.
Banks have a responsibility to ensure that they hold adequate capital to support the overall risks of
the organisation beyond the core minimum requirements determined in Pillar 1. A bank’s supervisors
are expected to evaluate how well the bank is actually assessing its capital needs relative to its level
of risk. Under Basel III, particular emphasis is placed on the interest rate risk in the banking book
(IRRBB). Basel III expands the calculations that banks must perform while placing some restrictions
on the internal models that banks can use to estimate their IRRBB. APRA’s interpretation of this
aspect of Basel III is found in Prudential Standard APS 117.
The supervisory review process establishes a forum for dialogue between commercial banks and
their supervisors. Supervisors are expected to intervene when capital assessment by a bank is seen as
inadequate for its risk profile.
While capital adequacy is a key foundation in the support of sound risk management, it should not
be seen as the sole determinant. Pillar 2 encourages additional good risk management practice, such as:
•
•
•
•
Interest rate risk in
the banking book
(IRRBB)
the risk to earnings
and capital arising from
movements in interest
rates
developing risk management policies and procedures, including education and training (e.g. see
Extended learning A)
applying internal responsibilities, delegations and exposure limits
increasing provisions and reserves
strengthening internal control and reporting procedures.
Therefore, the Pillar 2 supervisory review process seeks to encourage banks to better understand
and account for:
•
•
•
risks that are not fully captured in Pillar 1, such as credit concentration risk; for example, lending
large amounts to a single borrower, industry or within a limited geographic region
those factors that are not taken into account by Pillar 1, such as interest rate risk in the banking
book, business risk and strategic risk
factors external to the bank, such as the effects of a changing business cycle.
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An essential component of the Pillar 2 supervisory review process is the assessment, by the supervisor,
of compliance by the banks with the minimum standards and disclosure requirements attached to the
capital accord. Supervisors are responsible for ensuring that these requirements are being met.
In order to establish an international benchmark for the application of Pillar 2, the Basel Committee
on Banking Supervision has identified four key principles of supervisory review.
Principle 1 states: ‘Banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels.’ The five main features of
a rigorous process are identified as:
1 board and senior management oversight
2 sound capital assessment
3 comprehensive assessment of risks
4 monitoring and reporting
5 internal control and review.
Principle 2 states: ‘Supervisors should review and evaluate banks’ internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory
capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result
of this process.’ To achieve these outcomes, supervisors would be expected to be involved with, or require:
•
•
•
•
•
on-site examinations and inspections
off-site reviews
discussions with bank management
reviews of work done by external auditors
periodic reporting.
Principle 3 states: ‘Supervisors should expect banks to operate above the minimum regulatory capital
ratios and should have the ability to require banks to hold capital in excess of the minimum.’ Reasons
why commercial banks should be required to maintain a capital buffer include:
•
•
•
•
•
•
Pillar 1 requirements represent only a minimum level of capital. Banks will require additional capital
in order to achieve business growth.
International banks will require a higher level of capital to enhance their credit ratings.
Fluctuations in capital requirements will occur as the dynamic business environment changes.
Obtaining additional capital on short notice is generally more costly.
Failure of a bank to maintain the minimum capital requirement may trigger legislative or supervisory
corrective action.
A bank may be exposed to specific risks that are not taken into account in Pillar 1, such as a large
exposure to a specific industry sector.
Principle 4 states: ‘Supervisors should seek to intervene at an early stage to prevent capital falling
below the minimum levels required to support the risk characteristics of a particular bank and should
require rapid remedial action if capital is not maintained or restored.’ These actions may include:
•
•
•
•
intensifying the monitoring of the bank
restricting the payment of dividends
requiring the bank to prepare and implement a satisfactory capital adequacy restoration plan
requiring the bank to raise additional capital immediately.
Pillar 3: Market discipline
Market disclosure forms the third pillar of Basel III. The purpose of Pillar 3 is to encourage market
discipline by developing a set of disclosure requirements that allow market participants to assess
important information relating to the capital adequacy of an institution.
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The Basel Committee on Banking Supervision states that such disclosures have particular relevance
under the capital accord because banks are given greater discretion in assessing their capital requirements
through the use of internal methodologies and models.
The key word associated with Pillar 3 is transparency, whereby the objective is to make banks’ risk
exposure, risk management and capital adequacy positions more transparent, or apparent, such that
market discipline can reinforce the regulatory process. For example, market discipline may be reflected
in a rise or fall in an institution’s share price if its risk profile is perceived to have changed.
It is to be expected that institutions will provide the prudential supervisor with all material relevant
to risk exposures, risk management and capital adequacy. Each nation-state supervisor will determine
what information is released for public consumption. Clearly, the general release of all information
would raise concerns relating to the maintenance of stability and confidence in the financial system, as
well as raise issues relating to proprietary and confidential information.
Prudential supervisors will determine the minimum disclosure requirements for institutions within
their jurisdiction. They will also determine the frequency of various reporting requirements.
The Basel Committee on Banking Supervision recommends that a range of qualitative and quantitative
disclosure reports be prepared that relate to the principal parts of Pillar 1 and Pillar 2. Within the context
of the Basel III capital accord, these will include reports on:
•
•
•
•
•
•
•
•
•
•
the scope of the application of the capital accord within an organisation
the capital structure of the institution
the methodologies, approaches and assessment of capital adequacy by the institution
the determination of all aspects of credit risk exposures
the application of credit risk mitigation
the determination of equity risk within the banking book
the impact of securitisation of assets
the determination of market risk exposures
the measurement of operational risk
the assessment of interest rate risk within the banking book (IRRBB).
2.7.4
B ASEL III AND BANK LIQUIDITY
In addition to the ‘three pillars’, Basel III sets down some liquidity standards. APRA has described these two
standards as the centrepiece of Basel III. The first is a liquidity coverage ratio (LCR) that aims to ensure that
financial institutions hold high quality liquid assets in sufficient volume to sustain them for a period of one
month during a period of ‘acute stress’. The second is a net stable funding ratio (NSFR) that aims to foster
longer-term stability by requiring financial institutions to fund their activities with stable sources of funding.
The LCR is supposed to ensure that banks have a ‘buffer’ that will help them to withstand a period
of acute financial stress for a period of one month. The LCR is the ratio between a financial institution’s
high quality liquid assets (HQLA) and net cash outflows over a 30-day (one month) period. Banks are
required to maintain a LCR of at least 100.00 per cent.
HQLA may be classified as Level 1 (highest quality) and Level 2 (lower quality). A bank’s total
HQLA must be at least 60.00 per cent of Level 1 (HQLA1). HQLA1 assets must, according to APRA,
be unencumbered, easily converted to cash with little or no loss of value during times of market stress
and be eligible for repurchase agreements with the RBA.
According to APRA, the assets that will be suitable for classification as HQLA1 are cash, deposits
with the RBA and marketable securities representing claims guaranteed by sovereigns, quasi-sovereigns,
central banks and multilateral development banks that have undoubted liquidity during periods of
stress and are assigned a zero risk weight under Basel III’s standardised approach to credit risk.
HQLA2 assets, which cannot exceed 40.00 per cent of a bank’s total HQLA holdings, may
comprise marketable securities representing claims on or by sovereigns, quasi-sovereigns, central banks
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and multilateral development banks, which are assigned a 20.00 per cent risk weight under the Basel
III standardised approach, and corporate bonds issued by corporations with a credit rating of at least
AA–. In effect, banks must maintain holdings of HQLA that match or exceed total net cash outflows
for a period of 30 days under stressful market conditions.
These quantitative requirements are complemented by several qualitative prudential requirements.
Primarily, liquidity risk management is identified as the responsibility of the board of a financial
institution. The board is responsible for setting the institution’s risk tolerance levels and clearly
articulating this information. The board must also approve a formal funding strategy. These measures are
designed to improve board oversight of liquidity risk management. APRA’s existing APS 210 prudential
standards, to which we turn our attention next, incorporate these Basel III enhancements of good
practice and governance.
REFLECTION POINTS
•
•
•
•
•
•
•
•
•
•
•
•
•
Banks must maintain a minimum risk-based capital ratio.
The Basel III capital accord comprises three integrated pillars:
—
Pillar 1: the capital adequacy minimum requirements, risk coverage and leverage
—
Pillar 2: the supervisory review of capital adequacy
—
Pillar 3: the market discipline, incorporating disclosure and transparency requirements.
Pillar 1 is divided into three components: credit risk, operational risk and market risk. Either a
standardised approach or a more advanced approach can be used to measure risk.
The credit risk standardised approach requires a bank to assign each balance-sheet asset and
off-balance-sheet item a risk weight. The risk weight is either based on an external credit rating
or is a fixed weight specified by the bank supervisor. Off-balance-sheet items are converted to
balance-sheet equivalents before applying a credit risk weight.
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people
and systems or external events (e.g. the failure of the computer system, employee fraud or
a major fire). Basel III requires banks to hold additional capital to support their exposure to
operational risk.
The standardised approach to operational risk set down in Basel III simplifies the process of
calculating the operational risk capital that a bank must set aside. Under Basel III, this is a
function of a business indicator (BI) and internal loss multiplier (ILM).
A bank is required to hold market risk capital against its trading book. Market risk is split into
general market risk and specific market risk.
Commercial banks have typically used an internal value-at-risk (VaR) model to measure their
market risk requirement. Basel III places restrictions on the use of internal models.
VaR models estimate potential gains or losses that may be incurred on a portfolio over a 10-day
holding period, based on a 99.00 per cent confidence level.
Pillar 2 establishes dialogue between banks and their supervisors. It also encourages good risk
management practices for those risks not covered in Pillar 1.
Pillar 3 aims to make banks’ risk exposure, risk management and capital adequacy positions
more transparent such that market discipline can reinforce the regulatory process.
Four key principles of supervisory review have been developed relating to the monitoring of a
bank’s risk management processes and minimum capital levels.
Basel III also introduced stricter capital requirements and enhanced liquidity requirements,
including the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR).
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2.8
Liquidity management and other
supervisory controls
Banks, in common with all organisations, must manage their day-to-day liquidity needs, such as paying
creditors and employees.
Liquidity is access to funds that enable an institution to meet its business operating commitments.
For example, if a bank approves a loan to a customer, it needs to be able to provide those funds at
settlement date. Should a depositor wish to withdraw funds from a demand account, the bank must
be able to make those funds available. Basel III introduced two new liquidity standards to ensure that
financial institutions do not find themselves short of funds. First, financial institutions must hold high
quality liquid assets in sufficient volume to sustain them for one month during a period of ‘acute stress’
and, second, financial institutions will be expected to fund their activities with stable sources of funding.
These reforms are warranted, given the liquidity problems to which the banking business is prone. The
nature of a bank’s business means that banks have special liquidity problems that they must manage.
The first problem relates to the mismatch in the terms to maturity of balance-sheet assets and
liabilities and the timing of associated cash flows. The majority of banks’ sources of funds are relatively
short term. For example, the longest term to maturity of a bank deposit product is typically five years.
On the other hand, banks provide housing loans to their customers with a term to maturity in excess
of 30 years. Banks must manage the fact that their sources of funds (liabilities) often need to be repaid
sooner than their loan assets; therefore, they have a liquidity risk exposure that has to be managed. Both
of the new liquidity standards aim to address this and related problems.
The second liquidity problem relates to the role of banks in the payments system. This is discussed
in Chapter 12, but it should be noted that banks need to have funds available for financial settlement of
the millions of financial transactions carried out by their customers each day. Value settlement of these
transactions occurs through the payments system.
In order to obtain liquidity, a bank must hold sufficient cash or have access to sources of liquidity.
Cash holdings do not provide a return on funds, therefore there is no incentive for a bank to hold
excess cash. A bank will invest surplus cash in securities that it will hold in its securities portfolio. The
securities held in the portfolio will provide a return on investment, but at the same time they can easily
be sold into the secondary markets to convert into cash as needed. For example, a bank may hold a
portfolio of government securities. There is an active secondary market in which these securities can be
sold immediately, if required, to access cash for liquidity purposes.
Liquid securities include cash, government securities, semi-government securities and moneymarket securities. Another liquidity contingency arrangement would be the provision of a stand-by
credit facility by an international bank. In this situation, the international bank must be able to provide
immediate liquidity support, subject to the stand-by credit facility terms and conditions.
In Australia, APRA applies a liquidity prudential standard, APS 210 Liquidity. Under APS 210, the
board of directors and management of a bank must implement and maintain a liquidity management
strategy that will ensure that the institution will be able to meet its operational liquidity demands as
they fall due. The liquidity management strategy must be reviewed at least annually, and a bank must
immediately inform the supervisor of any concerns about current or future liquidity. APRA will review
the adequacy and appropriateness of the liquidity management strategy.
APRA states that a liquidity management strategy must include the following elements:
•
•
•
•
•
LEARNING
OBJECTIVE
2.7
Examine liquidity
management and other
supervisory controls
applied by APRA in the
context of Basel III.
Securities portfolio
financial securities held
by an institution for
investment and trading
purposes
Liquidity management
strategy
an organisation’s
objectives, policies and
procedures as they
relate to cash flows and
liquidity
a liquidity management policy statement approved by the board of directors
a system for measuring, assessing and reporting liquidity
procedures for managing liquidity relevant to balance-sheet and off-balance-sheet activities on a
group basis
clearly defined managerial responsibilities and controls
a formal contingency plan for dealing with a potential liquidity crisis.
Contingency plan
a set of predetermined
strategies to be
implemented if a
designated event
occurs
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Prudential Standard APS 210 requires an institution’s liquidity management strategy to include
regular scenario analysis of domestic and foreign currency liquidity under a range of operating
conditions. The liquidity standard places great emphasis on a bank’s own internal management practices
for managing liquidity. Banks are able to adopt a range of strategies to manage liquidity, including:
•
•
•
•
•
•
•
•
setting limits on maturity mismatches between assets and liabilities
holding high quality liquid assets that can easily be sold to relieve unexpected liquidity pressures
diversifying liability sources to maintain a stable funding base
access to wholesale markets through the issue of money-market securities, or establishing stand-by
credit facilities
access to foreign currency markets for liquidity, particularly to meet foreign-currency-denominated
liquidity commitments
intra-group liquidity, whereby liquidity surpluses and shortfalls are identified, and any regulatory or
legal impediments are addressed
use of assets through sales, repurchase agreements and securitisation to provide liquidity
industry liquidity support arrangements through the provision of stand-by liquidity between banking
institutions.
2.8.1
O THER REGULATORY AND SUPERVISORY CONTROLS
Even though the operation of the financial system is often described as being deregulated, this
description is really only relative to previous periods. The capital adequacy and liquidity management
requirements of banks are supervised by the bank regulator, and there is a range of other regulatory and
supervisory controls with which banks must comply. The following are some of the controls placed on
Australian banks, many of which are similar to those applied in other countries.
•
•
•
•
•
Risk management systems certification. A bank is required to provide APRA with an annual attestation
from the chief executive officer, endorsed by the board of directors (or relevant senior officer outside
Australia in the case of foreign bank branches), of the efficacy of the bank’s risk management
systems. The chief executive officer and the board will attest that risks have been identified, that
systems have been designed to manage those risks and that those systems are working effectively.
Business continuity management. The board and senior management of a bank must ensure that
appropriate policies and procedures are in place to identify, measure and manage business continuity
risk. In particular, a bank must develop, implement and maintain a business continuity plan that
documents procedures and information that will enable the bank to respond to disruptions and
recover critical business functions (see also Extended learning A).
Audit (external auditors, on-site visits). APRA requires a commercial bank’s external auditor to inform
it of the reliability of statistical data provided to APRA, and of compliance with regulatory and
prudential requirements. In addition, each year external auditors are required to review a particular
area of a bank’s operation that is specified by APRA. They are required to provide APRA with an
analysis of the strengths and weaknesses of the risk management systems employed by the bank.
APRA also conducts a program of on-site visits to banks, focusing on bank systems used to measure
and manage risk. The Reserve Bank may also participate in the on-site visits.
Disclosure and transparency. As discussed above in the context of Basel III, bank supervisors expect banks
to improve the quality of publicly disclosed information. This assists market participants to exercise
their own disciplines on banks as a complement to supervision. For example, banks are encouraged to
upgrade information on asset quality and off-balance-sheet business, particularly derivatives activities.
Large exposures. Banks are required to report, for the consolidated group, exposures of greater than
10.00 per cent of the group’s capital base to an individual client or client group. Further capital
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requirements may be imposed on banks with such large exposures, due to the potentially increased
counterparty credit risk.
•
Foreign currency exposures. APRA requires banks to report their overnight foreign exchange positions,
and may establish currency exposure limits for individual banks.
•
Subsidiaries. A further prudential requirement is the establishment of transparency between banking
group subsidiaries such as funds management and securitisation entities. A bank must make a clear
disclosure that such investments do not represent deposit or other liabilities of the parent bank. Any
commitment of a subsidiary that creates recourse to the bank will require appropriate capital support.
•
Ownership and control. The Financial Sector (Shareholdings) Act 1998 provides that an individual,
entity or group is not permitted to have an aggregate interest of 15.00 per cent or more of the
nominal value of the voting shares of an institution. An exemption may be sought from the Treasurer
of the Commonwealth of Australia.
The ultimate responsibility for the sound and prudent operation of a commercial bank rests with
the board of directors. The board should comprise at least five directors who should be fit and proper
persons, capable of exercising independent judgment and widely representative of shareholders. The
chairperson and a majority of directors should be non-executive board members. The board also should
have regard to its responsibilities to depositors. Scrutiny of the effectiveness of the boards of financial
institutions in Australia was heightened during the 2018 Royal Commission into Misconduct in the
Banking, Superannuation and Financial Services Industry. Many commentators saw this as a warning
to directors to ensure that they perform their function effectively.
Non-executive board
members
board members
who are not part of
the management of
a corporation or its
subsidiaries
REFLECTION POINTS
•
•
•
•
•
Liquidity risk is a major risk exposure of commercial banks.
Banks need to have access to funds to meet day-to-day commitments, such as repayment of
deposits and loan settlements.
Banks hold liquid assets, such as money-market instruments, in their securities portfolio for
this purpose. These assets are easily sold in the secondary markets to raise cash as needed.
Bank supervisors require banks to maintain a liquidity management strategy, including access
to contingency liquidity in an extreme situation.
The bank supervisor imposes a range of other prudential requirements on banks, including risk
management certification, business continuity management, external audits, on-site visits, limits
on large credit and foreign currency exposures, subsidiary business operations and ownership
and control restrictions.
CASE STUDY
BASEL III REFORMS
The Basel Committee on Banking Supervision (BCBS) has agreed to a schedule for Basel III that involves
gradual implementation over the next decade. The Australian Prudential Regulation Authority (APRA) has
reaffirmed its expectation that ADIs will comply more quickly with the required capital ratios and expects
that compliance will be achieved by January 2020. This reflects a general perception that transitioning to
Basel III will be relatively smooth in Australia. This may not be the experience in other parts of the world.
In May 2018, the president of the association of German public banks stated in an annual press
conference that the impact of the Basel III reforms on the calculation of capital ratios will be to drag the
German system back to 2015 levels. He also adds that the regulatory efforts will prove to be in vain, like
an act of Sisyphus who pushes a boulder up the mountain, only to see it roll down again.
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In May 2018, The Financial Times reported that the CFO of Commerzbank of Germany, in talking
about Basel III, suggested that ‘the devil is in the detail’ and that the rule changes are difficult to
quantify. French lender Société Générale says it can assess the impact of some but not all of the
new rules while Dutch bank ABN Amro states that its capital requirements might jump by more
than one-third due to changes in definitions and measurement methodology as well as stricter
requirements.
Changes to the methodology applied to risk measurement and the acceptability of various assets that
can be used to meet capital requirements have real impacts on financial institutions. In some countries,
the adjustment process to Basel III may be tumultuous.
References
Bippart, G 2017, ‘Banks breathe a little sigh of relief as Basel III is completed’, Euromoney, 11 December,
viewed 15 October 2018, http://euromoney.com
Gorajek, A & Turner, G 2010, ‘Australian Bank Capital and the Regulatory Framework’, RBA Bulletin,
September 2010.
PricewaterhouseCoopers 2017, ‘Basel III Reforms (‘Basel IV’) Capital Floors’, viewed at http://www
.PricewaterhouseCoopers.com.au
Samuels, S 2018, ‘Confusion over Basel bank capital requirements fails us all’, Financial Times,
22 February, viewed at http://www.ft.com
Wittkowski, B 2018, ‘Basel IV throws German banking sector back by two years—VOeB’s president’,
25 May 2018.
Discussion points
•
•
•
Outline the positives for the Australian banking system in light of the Basel III reforms.
Describe the concerns regarding Basel III from the perspective of the German banking system.
What is the role of APRA in guiding the implementation of the Basel III reforms?
Master before you move on
LEARNING OBJECTIVE 2.1
Evaluate the functions and activities of commercial banks within the financial system.
•
•
•
Commercial banks are the largest group of financial institutions within a financial system and
therefore they are very important in facilitating the flow of funds between savers and borrowers.
The core business of banks is often described as the gathering of savings (deposits) in order to
provide loans for investment.
The traditional image of banks as passive receivers of deposits through which they fund their
various loans and other investments has changed since deregulation. For example, banks
provide a wide range of off-balance-sheet transactions.
LEARNING OBJECTIVE 2.2
Identify the main sources of funds of commercial banks, including current deposits, demand
deposits, term deposits, negotiable certificates of deposit, bill acceptance liabilities, debt liabilities,
foreign currency liabilities and loan capital.
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Banks now actively manage their sources of funds (liabilities).
They offer a diversity of products with different return, risk, liquidity and cash-flow attributes to
attract new and diversified funding sources.
Sources of funds include current deposits, call or demand deposits, term deposits, negotiable
certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency liabilities, loan
capital and shareholder equity.
LEARNING OBJECTIVE 2.3
Identify the main uses of funds by commercial banks, including personal and housing lending,
commercial lending, lending to government and other bank assets.
•
•
•
•
•
•
•
Commercial banks now apply a liability management approach to funding growth in their
balance sheets.
Under this approach, a bank will (1) encourage depositors to lodge savings with the bank,
and (2) borrow in the domestic and international money markets and capital markets to obtain
sufficient funds to meet forecast loan demand.
The use of funds is represented as assets on a bank’s balance sheet.
CHAPTER TWO REVIEW
•
•
•
Bank lending is categorised as personal and housing lending, commercial lending and lending
to government.
Personal finance is provided to individuals and includes housing loans, investment property
loans, fixed-term loans, personal overdrafts and credit card finance.
Banks invest in the business sector by granting commercial loans. Commercial loan assets
include overdraft facilities, commercial bills held, term loans and lease finance.
While banks may lend some funds directly to government, their main claim is through the
purchase of government securities such as Treasury notes and Treasury bonds.
LEARNING OBJECTIVE 2.4
Outline the nature and importance of banks’ off-balance-sheet business, including direct credit
substitutes, trade- and performance-related items, commitments and market-rate-related contracts.
•
•
•
•
Viewing banks only in terms of their assets and liabilities greatly underestimates their role in the
financial system. Banks also conduct significant off-balance-sheet business.
The national value of off-balance-sheet business is over four times the value of the accumulated
assets of the banking sector.
Off-balance-sheet business is categorised as direct credit substitutes, trade- and performance-related
items, commitments, and foreign exchange, interest rate and other market-rate-related contracts.
Over 94.00 per cent of banks’ off-balance-sheet business is in market-rate-related contracts
such as foreign exchange and interest-rate-based futures, forwards, options and swap contracts.
LEARNING OBJECTIVE 2.5
Consider the regulation and prudential supervision of banks.
•
•
•
One of the main influences of change in the banking sector has been the regulatory environment
within which banks operate.
Commercial banks are now said to operate in a deregulated market. Relative to previous
regulatory periods, this is a reasonable description; however, there still remains quite a degree
of regulation that affects participants in the financial markets, including the banks.
Each nation-state is responsible for the regulation and supervision of its own financial system.
In particular, central banks and prudential supervisors are responsible for the maintenance of
financial system stability and the soundness of the payments system.
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LEARNING OBJECTIVE 2.6
Understand the background and application of Basel III.
•
•
•
•
•
•
At the global level, the Bank for International Settlements takes an active interest in the stability
of the international financial system. To this end, the Basel Committee on Banking Supervision
has developed an international standard on capital adequacy for banks.
Basel III was finalised in December 2017. It is based on three pillars: capital adequacy, risk
management and supervision, and market discipline.
Basel III also contains additional liquidity requirements. In particular, banks are required to
maintain a ratio of high quality liquid assets (HQLA) to net cash outflows per month of at least
100.00 per cent. This is called the liquidity coverage ratio (LCR).
Minimum capital ratios are core to Basel III. The capital ratio of a bank is the ratio of its capital
(equity, retained earnings) to its risk-weighted assets (loans, securities).
In order to ensure that banks set aside ‘quality’ capital, Basel III categorises capital as either
Common Equity Tier 1 (CET1) capital or Tier 2 capital. Banks are required to maintain a minimum
quantity of CET1 capital.
In computing its capital ratio, a bank assigns risk weights to balance-sheet assets. The final
version of Basel III focused on the determination of risk weights and, in particular, restrictions on
the banks’ use of internal models to make the assessments.
LEARNING OBJECTIVE 2.7
Examine liquidity management and other supervisory controls applied by APRA in the context of
Basel III.
•
The Australian bank regulator, APRA, applies a number of important prudential controls on
commercial banks. These include liquidity management policies, risk management systems
certification, business continuity management, audit (external auditors, on-site visits), disclosure
and transparency, large credit exposures, foreign currency exposures, subsidiaries, and
ownership and control.
Extended learning A
LEARNING OBJECTIVE 2.8
Understand the standardised approach to credit risk and compute the capital requirements for
particular transactions.
The standardised approach to credit risk
The standardised approach to credit risk requires banks to assign each balance-sheet asset and offbalance-sheet item a risk weight. The risk weights reflect the view of regulators about credit risk on
a portfolio basis. The regulator emphasises that the risk weights should not be seen as a substitute
for the credit risk assessment of individual credit risk exposures. A bank has primary responsibility
to ensure that adequate systems are applied to measure credit risk, and that sufficient capital is
allocated to cover that risk.
The risk-weighted amount of a balance-sheet asset is calculated by multiplying its current book
value by the relevant risk weight. The risk weight applied may derive from an external rating grade
or a risk weight specified by the regulator.
An external credit assessment rating can only be obtained from regulator-approved external
credit assessment institutions. For example, in Australia, APRA recognises the ratings of Standard
& Poor’s Corporation, Moody’s Investors Service and Fitch Ratings. Credit rating agencies and
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Table 2.2 External long-term rating grades
External rating
grade
1
2
3
4
5
Standard & Poor’s
Corporation
Moody’s
Investors Service
Fitch Ratings
AAA
Aaa
AAA
AA+
Aa1
AA+
AA
Aa2
AA
AA−
Aa3
AA−
A+
A1
A+
A
A2
A
A−
A3
A−
BBB+
Baa1
BBB+
BBB
Baa2
BBB
BBB−
Baa3
BBB−
BB+
Ba1
BB+
BB
Ba2
BB
BB−
Ba3
BB−
B+
B1
B+
B
B2
B
B−
B3
B−
CCC+
CCC
6
CCC−
CC
C
D
Caa1
Caa2
Caa3
Ca
C
CHAPTER TWO REVIEW
the methodologies used are discussed in Chapter 11. A credit rating is the credit rating agency’s
opinion of the creditworthiness of an issuer of debt or equity. Credit ratings are represented by
alpha or alpha-numeric codes; for example, the long-term ratings of Standard & Poor’s range from
AAA (highest) to D (lowest). APRA’s APS 112 notes the external rating grades to these published
credit ratings (see Table 2.2).
CCC+
CCC
CCC−
CC
C
D
Sourced from the Federal Register of Legislation at 4 October 2018. For the latest information on Australian government
law please go to https://www.legislation.gov.au.
The external rating grades (1 to 6) are given a risk weight. For example, APS 112 Capital
Adequacy: Standardised Approach to Credit Risk requires that claims held in the banking book
for corporate counterparties and commercial public sector entities that have the following external
rating grade (as determined in Table 2.2) will need to use the relevant risk weight:
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External rating grade
Risk weight
1
20%
2
50%
3, 4
100%
5, 6
150%
SOURCE: Adapted from APRA Prudential Standard 112, Final,
July 2019, p.24.
It should be noted that APS 112 applies different risk weights to the various external rating
grades depending on the category of counterparty to a claim.
Clearly, there is a direct relationship between the level of credit risk and the amount of capital
required. If a bank provides a $1 million loan to a company that has an AA credit rating (external
rating grade 1), the amount of capital required is the book value × the risk weight × 8.00 per
cent capital adequacy requirement. That is, $1 million × 0.20 × 0.08 = $16 000. The remaining
$984 000 can be funded from bank liabilities.
Had the bank given a $1 million loan to a company that has a BB credit rating, the capital requirement
would have been $1 million × 1.0 × 0.08 = $80 000. Therefore, there is a significant difference in the
amount of capital a bank must use between the AA-rated company and the BB-rated company.
Risk weights specified by the regulator may range from zero to 400.00 per cent.
loan-to-valuation
ratio
the percentage
ratio of a loan
to the bank’s
valuation of the
property being
mortgaged
As mentioned earlier in the chapter, a large part of bank loan assets may be in the form of residential
housing loans (mortgage loans). With a standard mortgage loan, the risk weight is determined relative
to the loan-to-valuation ratio (LVR) and the level of mortgage insurance. The loan-to-valuation ratio is
simply the amount borrowed to purchase a residential property divided by the accredited valuation of
the property. For example, with a house valued at $400 000 where the buyer borrows $350 000, the
LVR is 87.50 per cent. Therefore, as indicated in Table 2.3, the risk weight is 50.00 per cent with no
mortgage insurance or 35.00 per cent with at least 40.00 per cent of the mortgage insured. It should
be noted that Basel III proposes some changes to risk weights for residential mortgage exposures.
Updates to APRA’s response can be found at: www.apra.gov.au.
Table 2.3 Risk weights for standard residential mortgages
Loan-tovaluation ratio
Risk weight (no
mortgage insurance)
Risk weight (at least 40% of the mortgage insured
by an acceptable lender’s mortgage insurer)
0–60.00%
35%
35%
60.01–80.00%
35%
35%
80.01–90.00%
50%
35%
90.01–100.00%
75%
50%
More than 100%
100%
75%
SOURCE: Adapted from APRA Prudential Standard 112, Final, July 2019, p.18.
In the above example, assuming that the borrower has taken appropriate mortgage insurance,
the capital requirement will be $350 000 × 0.35 × 0.08 = $9800.
Risk weights for balance-sheet assets are to be found on the website of a nation-state’s bank
supervisor. For example, the weights applied by the Australian bank supervisor, APRA, are listed in
Prudential Standard APS 112, Capital Adequacy: Standardised Approach to Credit Risk at www.
apra.gov.au. APRA may change some part of this risk-weighting structure in response to the final
version of Basel III.
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1
The notional amount of the off-balance-sheet transaction is converted into a balance-sheet
equivalent (the credit equivalent amount) by multiplying the amount by a specified credit
conversion factor.
2
The resulting credit equivalent amount is multiplied by the risk weight applicable to the
counterparty or type of asset.
Off-balance-sheet transactions are categorised as non-market-related transactions or marketrelated transactions. Non-market-related off-balance-sheet transactions are those items included
in the first three types of bank off-balance-sheet business discussed earlier in the chapter, namely
direct credit substitutes, trade- and performance-related items and commitments. Market-related
off-balance-sheet transactions are those included in the fourth type of off-balance-sheet business,
that is, foreign exchange, interest rate and other market-rate-related contracts. Again, the risk
weights applied by APRA are listed in Prudential Standard APS 112.
Let us consider the example of a non-market-related off-balance-sheet transaction. A company
arranges for its bank to provide a $1 million documentary letter of credit to support a trade
transaction. The company has a single B credit rating issued by Standard & Poor’s. Reference to
the website of the bank supervisor indicates that the credit conversion factor is 20.00 per cent
and that the external rating grade 5 represents a risk weight of 150.00 per cent. The capital
required by the bank to support this off-balance-sheet transaction is $1 million × 0.20 × 1.50 ×
0.08 = $24 000.
CHAPTER TWO REVIEW
The risk-weighted amount of an off-balance-sheet transaction that gives rise to a credit exposure
is generally calculated by means of a two-step process:
Extended learning B
LEARNING OBJECTIVE 2.9
Analyse business continuity risk and construct an education and training framework for
operational risk management for commercial banks.
Business continuity risk management
Business continuity risk management has an impact on a bank’s ability to maintain its day-to-day
business operations. It relates to the risk of direct, indirect or consequential operational and financial
impacts as a result of inadequate or failed internal or external processes, people, systems or events.
These may result, for example, from a natural disaster such as an earthquake or a physical disaster
such as a loss of computer or communication systems.
Business continuity risk management may be described as a dichotomy of:
1
a disaster recovery planning process, plus
2
a disaster recovery response process.
The two processes consist of a wide range of core components. Each component has implications
for, and must be incorporated in, business continuity risk management.
1. Disaster recovery planning process
The core components of the disaster recovery planning process are as follows:
•
The establishment of an organisational business continuity risk management structure that is
horizontally and vertically integrated throughout the bank using a top-down approach. The
management structure reports to the board of directors and includes a global risk committee,
a business continuity risk management group and divisional contingency planning units. The
global risk committee is made up of executive managers and implements strategic policy
initiatives to achieve the bank’s business continuity risk management objectives. The business
continuity risk management group will develop, implement, coordinate, monitor and maintain
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•
•
•
•
•
•
the bank’s overall business resumption plan. Divisional contingency planning units ensure the
relevancy of business continuity risk management within business units in each division of the
bank. This includes planning teams, emergency response teams and recovery teams.
Risk analysis and business impact analysis. These are processes of risk identification and
measurement using quantitative and qualitative methodologies. The risk analysis process
ensures that all risk exposures are identified and understood by the bank. This enables existing
procedures to be improved and thereby lessen the potential risk exposure. The business impact
analysis measures the operational and financial effects of a disruption to a business function,
particularly critical business functions.
Business function recovery prioritisation. When a large and diverse organisation such as a bank
experiences a major disruption to business operations, it is not possible to resume all functions at
the one time. This makes it necessary to establish a recovery prioritisation schedule. The business
impact analysis will be used to substantiate the prioritisation of business function recovery at the
divisional level, but within the constraints of the bank’s integrated business resumption plan.
Development of disaster recovery strategies. Bank personnel need to be aware of the range of
alternative strategies that may be put in place to maintain critical business functions. For example,
in order to ensure the resumption of computer operations, a bank may build a dedicated back-up
computer centre; alternatively, the bank may outsource that function to a specialist provider. To
facilitate these arrangements, a bank will enter into disaster recovery service agreements and
support agreements.
Education and training. This is a core component of business continuity risk management.
Education and training will directly affect the preparedness and capability of a bank and its
people to plan for and respond to a disaster situation. A business continuity risk management
education and training framework is provided later in the section.
Testing of disaster recovery strategies. A bank must be absolutely confident that its disaster recovery
strategies will be effective in the event of a disruption to critical business functions. Therefore, the
bank must establish a structured testing program that progressively tests all components of the
bank’s disaster recovery strategies. Testing should be integrated throughout the bank.
Plan maintenance. This includes the ongoing monitoring, review, reporting and auditing of
the bank’s business continuity risk management processes. This component will ensure that
changes in a bank’s systems, products and procedures are reflected in the disaster recovery
plan. Periodic auditing and review ensures that executive management and the board of
directors are appropriately informed.
2. Disaster recovery response process
Ultimately, the effectiveness of the disaster recovery planning process is dependent on the actions
taken by bank personnel in response to a disaster situation. The core components of the disaster
recovery response process include:
•
•
•
•
Plan activation. The disaster recovery plan specifies when a disruption to normal business
operations is to be declared a disaster. The disaster alert trigger point will activate notification
procedures, emergency response teams and recovery strategies.
Impact assessment and evaluation. Divisional recovery teams will conduct an initial analysis
of the operational impact of a situation. They will report to management and advise on which
recovery strategies need to be implemented, including the initial estimates of resources and
time required in order to recover primary business operations.
Recovery control centre. This is the location from which the disaster recovery response is
managed. Key personnel will report to the centre and direct recovery operations within the
context of the bank’s business resumption plan. The recovery control centre facilitates the
control, command and coordination management decision processes.
Communications and media liaison. The business continuity risk management group will
take control of a situation and communicate with executive management. Divisional recovery
planning teams must be able to communicate with their personnel. Communications will be
established with the providers of recovery facilities and service and support agreements.
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•
Implementation of prioritised business recovery. Back-up strategies, facilities, service
agreements and support agreements will be activated, but only within the constraints of
priorities established in the bank’s overall business resumption plan.
Performance evaluation, reporting and plan review. During the course of an event, the business
continuity risk management group will monitor and evaluate recovery progress and report to
executive management. When recovery is complete, it is necessary to analyse thoroughly, evaluate
and review performance outcomes and, as appropriate, revise the business continuity plan.
The purpose of business continuity risk management is to ensure that a bank and its personnel
are prepared to respond to an event that disrupts critical business functions and are able to recover
those functions effectively. Education and training is integral to achieving these objectives.
An education and training framework for business continuity risk management
The education and training framework provided below is designed to support the business continuity
risk management objectives of commercial banks, and improve the capability and preparedness
of institutions and their personnel to plan for, and respond to, an occurrence that may affect the
continuity of critical business functions.
CHAPTER TWO REVIEW
•
Media liaison personnel will establish communications with bank supervisors, government
authorities, the press, customers and other market participants.
Three business continuity risk management education and training programs have been developed:
1
Induction/awareness program
2
Contingency planning program
3
Executive program
All bank personnel and associated non-bank personnel should complete the induction/
awareness program. Participants in the contingency planning program will be specialist business
continuity risk management personnel, while the board of directors and executive management,
including global risk committee members and audit and compliance committee members, will
complete the executive program.
Each education and training program includes the rationale, participants, objectives, curriculum
framework, learning outcomes and performance indicators.
Program 1: Induction/awareness
The induction/awareness program should be completed by all bank personnel. A bank may also
provide the program to non-bank personnel from other organisations that provide critical services
to the bank.
This program recognises that the effectiveness of business continuity risk management is
dependent on the attitude and actions of personnel. All bank personnel must know and apply the
principles of risk management and want to participate in a corporate culture and practice of active
and positive disaster recovery planning and response.
The induction/awareness program curriculum framework incorporates the following issues and
learning outcomes.
1
What is business continuity? Why is business continuity risk management important? Participants
will be able to describe examples of physical and natural disasters and identify critical business
functions that may be exposed to such situations.
2
Organisation of business continuity risk management objectives, policies and procedures.
Participants will be able to explain why a bank needs to maintain the continuity of its critical
business functions. Participants will know how they can include business continuity risk
management in their day-to-day operational practice.
3
The bank’s business continuity risk management organisational structure. Participants will
be able to describe the bank’s business continuity risk management organisational structure,
emphasising the roles and responsibilities of individuals within business units.
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4
Risk and the disaster recovery planning process. Participants will be able to give a range of
examples of risk and demonstrate the practical application of the risk management process.
5
The disaster recovery response process. Participants will be able to explain through examples
why a bank implements a structured and prioritised disaster recovery process.
6
How to respond in a disaster situation. Participants will know their responsibilities in an emergency,
including disaster identification and reporting procedures, personnel safety, asset damage
mitigation and building evacuation procedures.
7
Applying learning to practice. Participants will return to their workplace knowing they have
the fundamental knowledge and skills to apply effective business continuity risk management
practices in their day-to-day business operations.
Program 2: Contingency planning
Although all bank personnel must incorporate business continuity risk management into their dayto-day practices, certain personnel will be responsible for core components of the disaster recovery
planning and response processes.
The contingency planning program will provide these personnel with the necessary specialist
knowledge and skills to complete those tasks effectively. Participants include organisational
business continuity risk management group members, divisional contingency planning unit
members and nominated global risk committee members.
The contingency planning program curriculum framework incorporates the following issues and
learning outcomes.
1
Construction of a contingency plan. Participants will appreciate the benefits that will derive from
contingency planning and develop a culture whereby contingency planning is incorporated into
normal business operations. Participants will be able to apply effectively the bank’s standard
contingency planning software and format to their business unit functions.
2
Risk analysis, business impact analysis and recovery prioritisation. Participants will be able to
identify risk exposures within their work environment and review procedures to minimise such
exposures. Participants will be able to apply quantitative methods and qualitative measures to
determine the operational and financial impact of a disruption to business functions. Based on
the risk analysis and business impact analysis, participants will be able to document a recovery
prioritisation schedule.
3
Disaster recovery strategies, service agreements and support agreements. Participants will have
acquired the knowledge and skills to identify, analyse, compare and evaluate recovery strategy
alternatives and be able to make recommendations to management based on a cost–benefit
analysis. Participants will be able to construct basic service agreements and support agreements.
4
Emergency response teams, divisional recovery teams and communications. Participants will be
able to perform the responsibilities of emergency response team members in a disaster situation—
that is, to ensure the safety of bank personnel, the implementation of disaster notification procedures
and the initial mitigation of damage to assets. Participants will also be able to describe the roles
and responsibilities of divisional recovery teams in implementing disaster recovery procedures
within the context of the organisational business resumption plan and the divisional recovery
plan. Participants will be able to demonstrate the application of communication procedures,
including activating 24-hour contact arrangements and establishing communications with the
recovery control centre, back-up facilities and service and support providers.
5
Disaster recovery plan testing. Participants will be able to develop and maintain a structured
and comprehensive recovery plan testing schedule. Participants will be able to apply a range of
testing methodologies, evaluate performance outcomes and report results to management.
6
Plan maintenance, monitoring and review. Participants will be able to maintain the currency of
a disaster recovery plan, including the application of procedures to ensure that new products
and services and changes in operational procedures are reflected in the disaster recovery
planning and response processes. Participants will be able to implement the bank’s policies in
relation to plan review and reporting requirements.
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The essential role of the board of directors and executive management in driving business continuity
risk management is recognised in program 3. This program addresses issues that will support the
board of directors and executive management in determining appropriate business continuity risk
management objectives, policies, strategies and procedures. The executive program curriculum
framework incorporates the following issues and learning outcomes.
1
Corporate governance and risk management. Participants will be able to critically review
corporate governance risk management policies and practices and shape new strategies to
improve the bank’s business continuity risk management corporate culture.
2
Business continuity and disaster risk management. Participants will be able to apply a structured
risk management process to the disaster recovery planning and response processes and
identify issues that must be the focus of the strategic decision maker.
3
Regulation and prudential supervision. Participants will be able to evaluate different
prudential supervisor approaches to business continuity risk management. They will also
be able to investigate the implications of the Basel Committee on Banking Supervision
application of a capital charge for operational risk and the recording of operational risk
occurrences.
4
Objectives, policies, procedures, budget and infrastructure. Participants will be able to
review current business continuity risk management objectives, policies and procedures and
recognise any divergence between policy and practice. Participants will also be able to identify
the bank’s critical business functions, and evaluate and review disaster recovery strategies and
infrastructure, budget allocations and testing programs.
5
Business continuity risk management organisational structure. Participants will be able to
identify and describe the scope, roles, responsibilities, authorities, reporting structures and
review procedures applicable to the business continuity risk management organisational
structure. Participants will also recognise the linkages between divisional contingency
planning units, the organisational business continuity risk management group and the global
risk committee.
6
Global best practice. Participants will be able to investigate and evaluate global best practice
in business continuity risk management, and analyse and compare the bank’s current practice.
Participants will be able to develop and implement policies and strategies that will enable the
implementation of best practice.
7
Disaster response: recovery control centre, communications, media liaison. Participants will be
able to demonstrate leadership in responding to a disaster situation. Participants will be able to
activate recovery control centre procedures, particularly the initiation of communications. They
will be able to command, control and coordinate the disaster recovery process. Participants
will also know their roles and responsibilities in relation to the bank’s policies and procedures
for media liaison.
CHAPTER TWO REVIEW
Program 3: Executive program
Summary
The business continuity risk management education and training framework for banks comprises
three specific programs that are directed towards identifiable groups of bank personnel:
•
•
•
an induction/awareness program for all bank personnel
a specialist contingency planning program
an executive program for strategic policy decision makers.
The curriculum framework within each program is designed to achieve learning outcomes that
will result in measurable performance indicators that reflect the business continuity risk management
culture and practice that derives from the bank’s related objectives, policies and procedures.
Figure 2A.1 presents the three business continuity risk management education and training
programs and the curriculum framework relevant to each program.
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Figure 2A.1 An education and training framework for disaster risk
management for banks
■
■
Program 1
Business continuity
risk management:
Induction/awareness
■
■
■
■
■
■
■
Program 2
Business continuity
risk management:
Contingency planning
■
■
■
■
■
Program 3
Business continuity
risk management:
Executive
■
■
■
■
■
■
What is a disaster? Why is disaster risk management important?
Organisational disaster risk management objectives, policies
and procedures
Bank disaster risk management organisational structure
Risk and the disaster recovery planning process
The disaster recovery response process
How to respond in a disaster situation
Applying learning to practice
Construction of a contingency plan
Risk analysis, business impact analysis and recovery prioritisation
Disaster recovery strategies, service agreements and support
agreements
Emergency response teams, divisional recovery teams and
communications
Disaster recovery plan testing
Plan maintenance, monitoring and review
Corporate governance and risk management
Business continuity and disaster risk management
Regulation and prudential supervision
Objectives, policies, procedures, budget, infrastructure
Disaster risk management organisational structure
Global best practice
Disaster response: recovery control centre, communications,
media liaison
The overall success of the education and training programs will become evident through a
positive change in a bank’s commitment to business continuity risk management and the corporate
culture. Some of the learning outcomes and performance indicators specified for each program will
be immediately measurable on completion of a program; others will be sustained over time as bank
personnel progressively apply their business continuity risk management knowledge and skills to
their day-to-day business practice.
The objective of business continuity risk management is to establish policies and procedures
that will ensure that a bank is able to maintain the continuity of its critical business functions and
resume normal operations within defined time parameters in the event of a crisis. Education and
training is essential in achieving this outcome.
Extended learning C
LEARNING OBJECTIVE 2.10
Discuss the importance of corporate governance and ethics in the context of Australian financial
institutions.
Corporate governance and ethics
It would be unusual today for someone to complete a business or commerce degree without hearing the
words ‘corporate governance’. The Australian Securities Exchange (ASX) defines corporate governance
as: ‘The framework of rules, relationships, systems and processes within and by which authority is
exercised and controlled in corporations. It encompasses the mechanisms by which companies, and
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The corporate scandals of the late 1990s and early 2000s, as well as the tremendous volatility
arising from the GFC, have gradually increased the prominence of corporate governance within the
business and regulatory communities as the need to demonstrate good governance to regulators,
customers and investors has grown. Needless to say, however, some managers and boards of
directors have not been so acutely attuned to these developments. The 2018 hearings of the Royal
Commission into Misconduct in the Banking, Superannuation and Financial Services Industry once
again thrust corporate culture and ethics into the spotlight.
Each Australian company is responsible for developing its own appropriate governance
frameworks, but the regulators have provided guidance in the form of principles and minimum
standards. For Australian listed companies, the ASX has developed its Corporate Governance
Principles and Recommendations to articulate the core principles of good and effective corporate
governance. It contains seven principles or recommendations:
1
Lay solid foundations for management and oversight.
2
Structure the board to add value.
3
Promote ethical and responsible decision making.
4
Safeguard integrity in financial reporting.
5
Make timely and balanced disclosure.
6
Respect the rights of shareholders.
7
Recognise and manage risk.
8
Remunerate fairly and responsibly.
CHAPTER TWO REVIEW
those in control, are held to account. Corporate governance influences how the objectives of the
company are set and achieved, how risk is monitored and assessed, and how performance is optimised.’
It is a requirement of the ASX’s listing rules that each listed company discloses whether it is
following the guidelines and recommendations the ASX has set down. The approach is an ‘if not,
why not’ approach that aims to gradually increase governance reporting and quality, and enhance
transparency for shareholders.
For authorised deposit-taking institutions (ADIs), APRA oversees compliance with Prudential
Standard APS 510, Governance. This prudential standard sets down the minimum standards for
good governance of institutions regulated by APRA. All regulated institutions must comply. The
requirements include prescriptions on board size and composition, the independence of the board
and chair, and the establishment of a Board Audit Committee. These requirements are designed to
ensure the prudent management of ADIs and promote a culture of good governance within ADIs.
The ultimate responsibility for the prudent management of all companies, including ADIs, rests with
the board of directors. A strong governance framework will help to ensure that the board functions
effectively and good outcomes are obtained for all stakeholders, including shareholders.
Unfortunately, in the Australian banking sector, the 2018 Royal Commission uncovered many
unethical practices that should not have occurred if strong governance frameworks were in place.
The failure to uphold a culture of ethical behaviour has seen the reputation of a number of banking
and financial services firms tarnished and has done considerable damage to the already poor public
perception of bankers and financial services providers.
One of the most important issues to be discussed before the Royal Commission is the provision
by a bank of financial advice on its own products. The corporate regulator, ASIC, had already
identified the problems with this behaviour in a January 2018 report entitled Financial Advice:
Vertically Integrated Institutions and Conflicts of Interest. The report noted that in 75.00 per cent of
the customer files reviewed by ASIC, ‘...the adviser had not demonstrated compliance with the best
interests duty and related obligations’. The full report can be found at: http://download.asic.gov.au/
media/4632718/rep-562-published-24-january-2018.pdf
The Royal Commission came at a time when Australian banks were already facing up to other
instances of poor and, in some cases, illegal behaviour. The Commonwealth Bank was facing a
lawsuit brought against it by the Australian Transaction Reports and Analysis Centre (Austrac) for
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breaches of money laundering and terrorism financing laws. Also, as reported by The Guardian in
April 2018, the Federal Court of Australia had imposed fines totalling $20 million on ANZ and NAB
for attempted manipulation of the bank bill swap rate (BBSW).
With the ABC running stories with titles like ‘Banking Royal Commission: Does this mean that
Banks are Not an Ethical Investment?’ (May 2018), the Royal Commission provides a stark reminder
to the boards of directors of financial institutions that there are real consequences for failures of
governance. They might also be reminded that their behaviour reflects poorly not only on the
finance industry, but on the finance discipline (i.e. the body of knowledge accumulated in finance
theory and research). The responsibility is not one that should be taken lightly.
Further reading: Gareth Hutchens (2018), ‘Banking Royal Commission: All You Need to Know
So Far’, The Guardian, 20 April.
Questions
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points you raise in relation to each question.
1
‘Deregulation has changed banking practices in Australia.’ Discuss this statement with reference
to banks’ asset and liability management. (LO 2.1)
2
‘Decades after the commencement of deregulation in the financial markets, the international
capital markets remain a relatively unimportant source of funds for commercial banks.’ Analyse
and discuss this statement. (LO 2.1)
3
A customer has approached your commercial bank seeking to invest funds for a period of six
months. The customer is particularly worried about geopolitical risk following recent tensions in
the Middle East and elsewhere. Explain the features of call deposits, term deposits and CDs to
the customer, and provide advice on risk-reward trade-offs that might be associated with each
product. (LO 2.2)
4
Discuss the four main uses of funds by commercial banks and identify the role that the purchase of
government securities plays in commercial banks’ management of their asset portfolios. (LO 2.3)
5
Commercial banks are the principal providers of loan finance to the household sector. Identify
five different types of loan finance that a bank offers to individuals. Briefly explain the structure
and operation of each of these types of loans. (LO 2.3)
6
ABC Limited plans to purchase injection moulding equipment to manufacture its new range of
plastics products. The company approaches its bank to obtain a term loan. Identify and discuss
important issues that the company and the bank will need to negotiate in relation to the term
loan. (LO 2.3)
7
The off-balance-sheet business of banks has expanded significantly and, in notional dollar
terms, now represents over nine times the value of balance-sheet assets.
(a) Define what is meant by the off-balance-sheet business of banks.
(b) Identify the four main categories of off-balance-sheet business and use an example to
explain each category. (LO 2.4)
8
Following the GFC, the off-balance-sheet activities of commercial banks attracted a great deal of
attention among commentators. With reference to the size and composition of commercial banks’
off-balance-sheet activities, outline some of the possible reasons for this concern. (LO 2.4)
9
Bank regulators impose minimum capital adequacy standards on commercial banks. APRA
has stressed the importance of CET1 capital. Explain what this is and why APRA places such
emphasis upon it. (LO 2.5)
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11 Provide an overview and rationale for the two new liquidity standards introduced by
Basel III. (LO 2.6)
12 The final version of Basel III, released in 2017, focuses more attention on the denominator of
the minimum capital ratios that banks must maintain. Discuss this statement. (LO 2.7)
13 The second pillar of Basel III, risk management and supervision, addresses the management of
a bank’s interest rate risk in the banking book (IRRBB). Explain what is meant by IRRBB and the
new expectations regarding how it should be managed (LO 2.7)
Extended learning questions
14 The Basel III capital accord comprises a framework of three pillars. Pillar 1 established the
minimum capital required by a commercial bank and incorporates three risk components: credit
risk, operational risk and market risk.
(a) Define credit risk.
(b) What approaches may be used to measure the credit risk capital adequacy component of
Pillar 1?
(c)
CHAPTER TWO REVIEW
10 Basel III simplifies the process of computing the amount of operational risk capital that a bank
must set aside. Briefly explain the process. (LO 2.6)
Using the standardised approach to credit risk, explain how a commercial bank will use
this method to calculate its minimum capital requirement. (LO 2.8)
15 Commercial banks are exposed to the very real risk that at some point their critical business
operations could fail. Business continuity risk management may be said to incorporate a
disaster recovery planning process and a disaster recovery response process.
(a) Define business continuity risk management.
(b) Identify and briefly explain the core components of a disaster recovery planning process.
(c)
Identify and briefly explain the core components of a disaster recovery response
process. (LO 2.9)
16 An essential element of business continuity risk management is education and training.
(a) Why is education and training important in the context of business continuity risk
management?
(b) Identify three discrete education and training programs that a bank should provide.
(c)
Briefly discuss what issues should be incorporated in each of the three education and
training programs. (LO 2.9)
17 (a) Discuss the nature of corporate governance and its relationship with ethics. (LO 2.10)
(b) Discuss the importance of corporate governance and ethics for Australian ADIs, both
in terms of complying with regulations and effectively meeting the expectations of
stakeholders. (LO 2.10)
KEY TERMS
acceptance 46
bank bills held 50
BBSW 50
amortised loan instalments 49
bank regulation 56
bill of exchange 46
asset management 43
Basel II capital accord 58
authorised deposit-taking
institutions 57
Basel III capital accord 58
business continuity
management 62
basis points 64
call deposits 45
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collateralised floating charge 46
commercial bills 50
commitments 53
Common Equity Tier 1
capital 60
internal ratings-based approach
to credit risk 61
operational risks 61
interest rate risk in the banking
book (IRRBB) 65
overdraft 50
investment property finance 49
contingency plan 69
lease 50
credit card 49
liquidity management
strategy 69
credit risk 59
current account deposits 44
current exposure method 61
debenture 46
direct credit substitute 53
euromarkets 47
fixed-term loan 49
foreign currency liabilities 47
G-10 58
general market risk 63
globalisation 47
loan capital 47
loan-to-valuation ratio 76
market risk 59
market-rate-related contracts 54
mark-to-market 61
mortgage 48
mortgage originators 49
negotiable certificate of
deposit 45
negotiable security 46
hedging 54
non-executive board
members 71
housing finance 48
off-balance-sheet business 44
original exposure method 61
Pillar 1 60
prudential supervision 56
reference interest rate 50
rollover facility 50
securities portfolio 69
securitisation 000
specific market risk 63
standardised approach to
credit risk 61
term deposits 45
Tier 2 capital 60
trade- and performance-related
item 53
Treasury bonds 51
Treasury notes (T-notes) 51
unsecured note 46
value at risk (VaR) 64
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CHAPTER 3
Non-bank financial institutions
CHAPTER OUTLINE
3.1
Investment banks
3.2
Managed funds
3.3
Cash management trusts
3.4
Public unit trusts
3.5
Superannuation funds
3.6
Life insurance offices
3.7
General insurance offices
3.8
Hedge funds
3.9
Finance companies and general financiers
3.10
Building societies
3.11
Credit unions
3.12
Export finance corporations
Learning objectives
LO 3.1
Describe the roles of investment banks, with an emphasis on the nature of their off-balance-sheet
business, in particular mergers and acquisitions.
LO 3.2
Explain the structure, roles and operation of managed funds and identify factors that have
influenced their rapid growth.
LO 3.3
Discuss the purpose and operation of cash management trusts and public unit trusts.
LO 3.4
Describe the nature and roles of superannuation funds, including the primary sources of
superannuation funds and the different types of fund.
LO 3.5
Define life insurance offices and general insurance offices, and explain the main types of
insurance policies offered by each type of insurer.
LO 3.6
Discuss hedge funds, including their structure, investors, investment strategies and risk.
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LO 3.7
Explain the principal functions of finance companies and general financiers, and the changes that
have had an impact on finance company business.
LO 3.8
Outline the roles and relative importance of building societies and credit unions, and analyse the
significant changes that have occurred in these sectors.
LO 3.9
Describe the unique role of export finance corporations.
Extended learning
LO 3.10
Understand project finance and structured finance, and the related roles of investment banks.
CHAPTER SNAPSHOT
Operating alongside commercial banks are a range of non-bank financial institutions. These
include superannuation funds and other funds management operations, insurance companies,
investment banks and hedge funds. The tools and strategies that are deployed within these
operations draw heavily on modern finance theory and mathematics, especially in the hedge
fund world. The seeming complexity of the strategies, however, should not lead us to overlook
the role that fundamental concepts such as risk and reward and supply and demand play in
determining whether or not these institutions are successful.
INTRODUCTION
In this chapter the focus moves away from the commercial banks to the wide range of other financial
institutions that operate in a modern financial system. For convenience, the market refers to the collective
group of financial institutions other than the commercial banks as ‘non-bank financial institutions’.
The institutions examined in this chapter are:
•
•
•
•
•
•
•
•
•
•
•
investment banks
managed funds
superannuation funds
cash management trusts
public unit trusts
life insurance and general insurance offices
hedge funds
finance companies and general financiers
building societies
credit unions
export finance corporations.
Why do so many different financial institutions exist? In a deregulated and competitive market
it might be argued that the financial strength and enormous size and expertise of commercial banks
would create an environment in which other non-bank financial institutions would struggle to compete.
In part this may be true. For example, in Australia there has been a significant reduction in the building
society sector since the commercial banks were largely deregulated in the 1980s. With increased
competition between commercial banks and building societies, the building societies responded by
merging with other institutions and many changed to become commercial banks.
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However, other financial institutions have thrived by specialising within segments of the financial
markets. For example, investment banks have used their particular expertise to expand their off-balancesheet business, including providing financial advice to corporate clients on areas such as mergers and
acquisitions. As the insurance business of life insurance offices has declined, these institutions have
moved into, and taken a prominent position in, superannuation and managed funds products. To
meet the retirement savings needs of an ageing population, there has been an enormous expansion in
managed funds, in particular superannuation and public unit trusts.
The financial system as a whole is constantly evolving. Non-bank financial institutions have
developed in response to the different regulatory environments that have existed from time to time, and
to the changing preferences of market participants.
The chapter opens with an examination of the exciting world of investment banking, in particular
the investment banks’ off-balance-sheet activities.
REFLECTION POINTS
•
•
A wide range of non-bank financial institutions can compete within a modern financial system
(e.g. investment banks, life insurance and general insurance offices, superannuation funds,
finance companies, building societies, credit unions, cash management trusts and unit trusts).
Non-bank financial institutions tend to specialise in areas of the financial markets in which
they have a particular strength or expertise; for example, investment banks specialise in the
provision of financial advisory services.
3.1
Investment banks
Investment banks have always been regarded as financial innovators, at the leading edge of the financial
system. Today, these institutions continue to specialise in sophisticated areas of finance that are both
challenging and exciting.
Investment banks grew strongly in the USA, in particular as specialist facilitators of financial transactions
rather than providers of finance. Investment banks established a reputation as financial innovators and
were often responsible for the development of new financial products and services that met the changing
needs of market participants. Investment banks are organised around risk taking, risk measurement and
operational controls. The activities that take place within an investment bank are normally described as
front office (including trading, investment banking, research and investment management); middle office
(including risk measurement, risk management and reporting); and back office (accounting, bookkeeping,
audit and compliance). These features and other aspects of investment banking are discussed in the context
of the GFC by Mark Williams in his book Uncontrolled Risk (2010). As Williams points out, the relative
power and prestige of the activities, especially risk taking versus risk management, depends critically on
organisational culture. A culture of risk taking will place proportionally more power and prestige in the
hands of front office personnel and make it more difficult for the middle office to ensure that risks are
being managed appropriately. This may generate substantial profits when markets are moving in the right
direction, but leave an investment bank particularly vulnerable when market conditions change.
The relative size and importance of investment banks is significant, especially within the major financial
centres of London and New York. Outside these two financial centres, these banks often selectively focus
on other jurisdictions, such as Asia, Australia, South America, Western Europe and Eastern Europe.
3.1.1
Sources of funds and uses of funds
Investment banks provide financial services to their corporate clients, high-net-worth individuals and
government clients.
LEARNING
OBJECTIVE
3.1
Describe the roles
of investment banks,
with an emphasis on
the nature of their offbalance-sheet business,
in particular mergers
and acquisitions.
Front office
the name given to
those activities within
an investment bank
that involve client
relations, especially
trading, investment
banking, research
and investment
management
Middle office
the name given to
those activities within
an investment bank
that do not involve
client relations but may
complement or monitor
front office activities;
risk measurement and
reporting are examples
Back office
the name given
to those functions
within an investment
bank that are most
removed from client
relations; accounting
and compliance are
examples
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Unlike commercial banks, these institutions do not have a depositor base from which to acquire
assets. Their liabilities or sources of funds are usually raised through the issue of securities into the
international money markets and capital markets. Under normal market conditions, the high-profile
reputation of many of the investment banks affords them easy access to the international capital markets.
Investment banks will provide some limited lending to clients, but usually on a short-term basis.
They tend to sell any loans into the secondary markets rather than hold them on their balance sheet. They
are primarily focused on advisory services; for example, they will advise their clients on all aspects of
raising funds directly from the money and capital markets. In fact, the relative size of financial assets
held by investment banks has diminished over time. For example, in Australia the financial assets held by
investment banks represent less than 1.00 per cent of the total assets of financial institutions. However,
this figure completely misrepresents the importance of the investment banks.
The decline in asset share does not indicate the demise of these institutions; rather, it shows the
significant change that has occurred in their functions and operations. They now mainly focus their
activities on specialist off-balance-sheet advisory services.
3.1.2
Off-balance-sheet business
Investment banks have established a reputation as financial innovators. Much of that financial innovation
has been in the development of sophisticated off-balance-sheet products and advisory services. Therefore,
the principal income of these banks is fee income associated with their off-balance-sheet activities.
Examples of their off-balance-sheet business include:
1 Operating as foreign exchange dealers. Within a global market, importers, exporters, investors,
borrowers, central banks, speculators and arbitrageurs conduct a range of transactions that are
written or denominated in a foreign currency. Investment banks that operate as foreign exchange
dealers quote both bid (buy) and offer (sell) prices on all major currencies. As we will discuss in
Chapter 15, the foreign exchange markets are enormous, and at times quite volatile.
2 Advising clients on how, where and when to raise funds in the domestic and international capital
markets. Investment banks understand the global financial markets and how to access funds in
those markets. They provide advice and expertise on the types and structures of securities that can
be issued, interest rate risk and exchange rate risk, and the preparation of documentation, including
legal, accounting, taxation and regulatory matters, associated with a securities issue.
Underwriter
an institution that
supports the issue of
securities by a client
and agrees to buy any
securities not bought by
investors
3 Acting as the underwriter of new share and debt issues. In order to ensure funds are raised from an
equity or debt issue, the issuing corporation may pay a fee and enter into an underwriting agreement
with an investment bank, whereby the underwriter agrees, subject to the terms of the contract, to
purchase any securities that are not purchased by investors. By having an underwriting agreement
in place, the issuer is confident that they will raise the total funds they need for their business
operations.
4 The placement of new issues with institutional investors. A corporate client may wish to raise additional
debt or equity by issuing new securities. One relatively simple way to do this is to offer the securities
to institutional investors. Investment banks have a large corporate client list and also have access to
institutional investors such as funds managers. They are able to approach these investors and offer
them the opportunity to purchase large parcels of securities to be issued by clients. Placements are
discussed in Chapter 5.
5 Providing advice to corporate clients on balance-sheet restructuring. A balance sheet is dynamic in that
a corporation should always be considering the most effective funding of its assets. This will change,
for example, as the asset structure of the business changes, as interest rates are forecast to move, as
the economy or business cycle is expected to shift or as the exchange rate changes. An investment
bank will provide a client with advice on all these issues and assist the client to issue new securities
in order to restructure the balance sheet.
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6 Evaluating and advising a corporate client on mergers and acquisitions. See the section on mergers and
acquisitions below.
7 Conducting feasibility studies and advising clients on project finance and structured finance undertakings.
Project finance is long-term finance for projects such as building a tollway or a power station. The
financing of the project is based on the future expected cash flows that will be generated by the
project once it has been built. As the project will only generate cash flows once it is completed, and
often has only limited asset value before completion, this is a specialist area of high-risk lending
(refer to the Extended learning section at the end of this chapter for a detailed discussion on project
finance and structured finance).
8 Identifying client risk exposures and advising on risk management strategies. Corporations and
governments are exposed to a wide range of financial and operational risks. Risks that may affect
the value of assets, liabilities or shareholder funds, or cash flows generated by the business, include
interest rate, foreign exchange, liquidity, credit, investment, fraud and disaster risk exposures.
Investment banks have the expertise to provide sophisticated solutions that allow the identification,
measurement and management of risk exposures. Risk management strategies often involve the use
of complex financial products, such as derivatives.
9 Advising on, and partial provision of, venture capital. Venture capital, also known as risk capital, is
funding provided for new start-up businesses where there is a high level of risk attached to the future
success of the business but the potential for high returns. The size of the funding requirement,
plus the high level of associated risk, means that funding is often provided by a group or syndicate
of investors. An investment bank may take on the role of lead manager of a syndicate and bring
together a large group of other investment and commercial banks who will all provide funding for
the project.
This list of off-balance-sheet business carried out by investment banks demonstrates that they
operate in the more innovative and exciting areas of the financial markets. Many of the types of offbalance-sheet business conducted by investment banks, including advisory services, foreign exchange,
underwriting, equity and debt issues, risk management and derivatives, are discussed in various parts
of this text.
At this stage one important function that is carried out by investment banks, mergers and acquisitions,
is considered.
Mergers and acquisitions
Advising corporate clients on mergers and acquisitions—in which one company gains control over
another—is a significant fee-generating service provided by investment banks. There seems to be a
direct correlation between sustained economic growth and the level of merger and acquisition activity.
Interestingly, in recent years investment banking deals have been dominated by spin-offs, whereby a
company breaks itself into pieces and the pieces become separately listed public companies. In this
process, previous mergers and acquisitions are undone or divisions that have grown to a substantial
size within the company are spun off to begin an independent existence. When companies cannot
find buyers willing to pay a desirable price for the division that it wishes to sell, the company spins
off the division and becomes two separate companies: parent and child. Often, the combined market
value of the two new entities exceeds the market value of the parent company before the spin-off. This
provides an incentive for companies to investigate the possibility and for investment banks to initiate
deals. Mergers, acquisitions and spin-offs are important examples of the balance-sheet restructuring
facilitated by investment banks.
Typically, merger and acquisition strategies are categorised as horizontal, vertical or conglomerate
takeovers. For example, if a toy manufacturer purchases another toy manufacturer, the acquisition may
be described as a horizontal takeover.
A horizontal takeover occurs when the target company conducts the same type of business as the
takeover company.
Merger and
acquisition
takeover company
seeking to gain control
over a target company
Spin-off
a situation where a
part of a company is
separated from the
whole and begins
an existence as an
independent company
Horizontal takeover
when two companies
involved in a merger
and acquisition are in
the same business
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Vertical takeover
when the target
company in a merger
and acquisition
operates in a business
related to that of the
takeover company
Conglomerate
takeover
when the business of a
merger and acquisition
target company is
unrelated to the
existing business of the
takeover company
Hostile takeover
when the target
company rejects the
merger and acquisition
proposal of the
takeover company
A vertical takeover occurs when the takeover company acquires a company that normally operates
within a related business area (e.g. a toy manufacturer purchases an electronic components supplier).
A conglomerate takeover is said to occur when the takeover company diversifies its business
activities by acquiring a company that operates in a business area unrelated to the existing business of
the takeover company (e.g. a toy manufacturer purchases a media company).
A company interested in pursuing a merger or acquisition will seek the services of an investment
bank in its efforts to complete the transaction. The target of the acquisition may also seek the services of
an investment bank to advise the company on how best to resist what it might see as a hostile takeover.
A hostile takeover is one in which the actions of the takeover company are actively resisted by the
board of directors of the target company.
Investment banks generate significant fee income from their mergers and acquisitions business. They
are not, therefore, passive players in the market; that is, they do not wait until they are commissioned
by a client on either side of a merger transaction. Rather, investment banks actively seek out, analyse
and evaluate potential takeover opportunities for clients, then approach the client and try to sell them
the takeover idea.
There should be value added in a merger. That is, the value of the merged entity should be greater
than the sum of the two original companies on a stand-alone basis. This additional value could be
gained from synergies that may be present in the merger. Synergy benefits may be achievable from:
•
•
•
•
Economies of scale. For example, a company might gain operating advantages from a better use
of productive capacity and a lowering of the overall cost of production. Financial gains can also
be made from reductions in overhead expenses associated with administrative and management
structures within the merged business.
Finance advantages. A merged corporation should be able to leverage its larger balance sheet; that is, the
merged company may have a greater capacity to extend its debt funding. The enhanced reputation of
the larger organisation may enable it to access new debt markets, particularly the international capital
markets, and at a lower average cost of funds. The merged corporation will seek to maximise potential
tax advantages that may be available; for example, through the possible offsetting of capital losses.
Competitive growth opportunities. A takeover company can achieve immediate growth by acquiring the
existing business operations of another company. The cost of acquisition is typically more certain, and
much quicker, than the cost of internally generated growth. For example, it may be easier for a business
to purchase a company that has the production facilities it requires rather than build new facilities.
Business diversification. A corporation may extend its business operations into the international
markets through acquisition. Another firm may diversify its business functions through a conglomerate
takeover. In either situation, the takeover company will diversify its sources of revenue and will try to
protect itself from a downturn in a single economic market that might occur from time to time.
In advising a corporate client on a merger and acquisition opportunity, an investment bank must
consider the economic, legal, accounting and taxation implications of the proposal, often across a
number of jurisdictions. For example, anti-trust or competition regulations can vary quite significantly
between countries. Although most major countries apply international accounting standards, variations
do exist. This is noticeable in the stringent regulatory reporting requirements of the Securities and
Exchange Commission (SEC) in the USA. Taxation regimes also vary between nation-states, particularly
in relation to the treatment of tax issues arising from merger and acquisition activity.
A brief description of a range of issues that an investment bank would bring to the attention of a
corporate client when considering a merger and acquisition proposition is provided below.
•
•
Analysis of the target company. Is the company a strategic fit? Issues to consider include the company’s size,
geographic position, business mix, operational capacity, financial strength and availability for takeover.
Valuation of the company. Quantitative models will be used that incorporate net asset values
(liquidation value), net present values of incremental cash flows and future earning power. The
value of the combined entity should be greater than its pre-merger parts.
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•
Establishment of contacts. Confidentiality is essential if a successful merger is to be achieved at a
reasonable price. If the market becomes aware of a potential merger, the price of the target company
will be pushed higher on expectation of a takeover premium. Contacts need to be established with
the investment bank and senior representatives of the target company.
•
Transaction structures. Principally, this will include the development and evaluation of acquisition
and purchase methods. For example, should the deal involve a cash offer, a share offer, an asset
swap or a combination thereof? Other transaction issues include legal, taxation and accounting
structures, and future organisational and management structures.
•
Negotiation. Negotiation skills are essential when a dominant company is making a takeover bid for a
target company. If negotiations are conducted properly, there will be no perceived winners or losers.
Negotiators must resist taking positions, and should separate people from the business issues; that is, the
takeover should not be about personalities and personal gain, but rather about benefiting the business.
•
Due diligence. This involves the detailed and careful analysis of the financial and operational
condition of the target company. Clearly, information gained in the due diligence process will
determine whether a proposal should proceed and at what offer price.
•
Nature of the takeover. If an offer is made, will it be resisted by the board of directors of the target
company? If so, what are the strategic, financial and operational implications of proceeding with a
hostile takeover? If an unsolicited friendly merger is possible, what concessions will need to be made?
•
Communication with the market. This includes regulatory communication requirements to keep the
market informed, plus strategic communication with the media and specific market participants
such as investment analysts.
•
Project management and integration. Development of a merger and acquisition proposal will, at times,
be influenced by issues of speed versus accuracy of information, confidentiality versus transparency
of information provided to stakeholders, and the robustness versus the efficiency of the transaction
structure.
The merger and acquisition advisory role of an investment bank provides enormous opportunities
for the institution to offer a range of further services to its corporate client. Once it has advised on
a merger proposal, the investment bank will seek to facilitate the transaction on behalf of the client.
Other additional services may include providing advice and facilitating funding requirements for debt
and equity, underwriting arrangements, balance-sheet restructuring and risk management. All these
functions are discussed in detail in other parts of this textbook.
Reflection points
•
•
•
•
•
Investment banks are providers of innovative financial products and services to corporations,
high-net-worth individuals and government.
These institutions do not have a depositor base; they raise funds in the international financial
markets.
Investment banks provide some lending products to clients, but are more likely to assist a client
to borrow directly from the money and capital markets.
The structure of investment banks is characterised by a division of activities among front-office,
middle-office and back-office employees. The front-office activities are the most prominent
activities within an investment bank and usually involve direct relations with clients.
Investment banks specialise in the provision of off-balance-sheet products and advisory
services, such as:
continued
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continued
•
•
•
LEARNING
OBJECTIVE
3.2
Explain the structure,
roles and operation of
managed funds and
identify factors that
have influenced their
rapid growth.
•
—
operating as foreign exchange dealers, quoting bid and offer prices on a range of currencies
—
advising clients on how to raise funds in the local and international capital markets
—
acting as underwriters and assisting clients with the placement of new equity and debt
issues
—
advising clients on balance-sheet restructuring, having regard to the forecast business
environment
—
evaluating and advising on corporate mergers and acquisitions, and spin-offs
—
conducting feasibility studies and advising clients on project finance and structured finance
—
providing risk management advice, products and services
—
advising clients on accessing venture capital within the capital markets.
A merger and acquisition is a situation in which one company seeks to take over another
company. The merger may be friendly or hostile, and strategically may be a horizontal
takeover, a vertical takeover or a conglomerate takeover.
A spin-off is a situation where an independent company is formed from a part of the existing
company. For example, a division that manufactures and sells one of the company’s products may
be spun off to form an independent company (for example, Wesfarmers’ decision to spin off Coles).
The merger will seek to achieve synergy benefits such as economies of scale, finance
advantages, competitive growth opportunities and business diversification.
An investment bank would assist a client with analysis and valuation of the target company, and
provides expertise in relation to contracts, transaction structures, negotiation, due diligence,
communication with the market, project management and integration.
3.2
Managed funds
Managed funds
investment vehicles
through which the
pooled savings of
individuals are invested
Mutual funds
managed funds that
are established under
a corporate structure;
investors purchase
shares in the fund
Trust fund
managed funds
established under a
trust deed; managed by
a trustee or responsible
entity
Trust deed
document detailing
the sources, uses and
disbursement of funds
in a trust
Responsible entity
the trustee and
manager of a trust in
Australia
Over time, there has been an amazing growth in the managed funds industry on an international
scale. For example, growth in the amount of funds invested in mutual funds in the USA has had a
significant impact on the flow of funds into the US domestic capital market and other international
capital markets.
In the USA, a mutual fund is established under a corporate legal structure; that is, a fund will be
operated by an investment company. Investors purchase shares issued by the investment company, and
funds managed by the mutual funds are invested using professional fund managers.
An alternative structure, used in countries such as the UK and Australia, is a trust fund. In this
situation, managed funds are established under a trust deed. A trust deed specifies the parameters
under which the trust will operate. The investor in the trust obtains a beneficial right to the assets of the
fund and an entitlement to share in the income and capital gains (losses) derived from the fund.
Traditionally, managed funds have maintained a dual protective structure for investors by
separating the roles and responsibilities of the custodian or trustee and the fund manager. For example,
a mutual fund is required to use the services of a mutual fund custodian. A mutual fund custodian is a
commercial bank or trust company that provides safekeeping of the fund’s investment securities, and
controls cash flows to and from shareholders. With a trust fund, the fund is controlled by a trustee,
within the constraints of the trust deed. For example, in Australia a trust must have a responsible
entity. The responsible entity is both the trustee and the manager of the trust fund, and is responsible
for all aspects of its operation, including the appointment of professional fund managers and the
administration and safe custody of the trust’s assets.
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Managed funds use the services and skills of professional investment managers or fund managers.
The fund managers seek to maximise the return they can achieve on investment portfolios and therefore
move very large volumes of investment funds around the globe, as if they were playing a game of
monopoly.
The driving forces behind the growth of managed funds have been:
•
•
•
•
deregulation of the flow of funds in the international capital markets
a more affluent population
an ageing population where individuals are enthusiastically saving for their retirement from the
workforce
more highly educated investors with increased financial knowledge, which leads them to seek more
diverse and sophisticated investment opportunities.
3.2.1
Structure of the managed funds sector
Managed funds provide a range of investment structures and opportunities for an investor. Managed
funds gather the savings of individuals and then invest the accumulated amount of funds in various
asset classes in the domestic and international money markets and capital markets. The main categories
of managed funds are:
•
•
•
•
•
•
•
Cash management trusts (see Section 3.3)
Public unit trusts (see Section 3.4)
Superannuation funds (see Section 3.5)
Statutory funds of life offices (see Section 3.6)
Hedge funds (see Section 3.8)
Common funds. These are operated by trustee companies. They combine the funds of beneficiaries
into an investment pool and invest those funds in specified asset classes. Common funds are
different from unit trusts in that they do not issue units to investors. Solicitor firms often offer
mortgage trusts through a common fund.
Friendly societies. A mutual organisation that provides investment and other services, such as
insurance, sickness and unemployment benefits, to its members. Friendly societies’ investment
products include the issue of bonds that invest in a range of asset classes, such as cash, fixed-interest
trusts, equity and property.
3.2.2
Sources and uses of funds
A managed fund is not a financial intermediary, but rather provides direct access to a wide range
of investment opportunities, including the wholesale investment markets. Wholesale markets were
discussed in Chapter 1.
Managed funds derive their funding from the specific contractual commitments of investors. These
may be in the form of either periodic payments into the fund (e.g. superannuation) or, alternatively, a
single payment or premium (e.g. an insurance policy).
A large managed fund will typically allocate a portion of its total asset portfolio to several
professional fund managers. This is both a risk management and a performance management strategy.
Risk is diversified between a number of fund managers; therefore, if one manager experiences a poor
investment return for the fund, other managers should offset that poor performance. Similarly, each
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fund manager will have a competitive incentive to achieve higher returns; otherwise the services of
the fund manager may be dispensed with.
Each professional fund manager will:
•
•
•
•
•
•
invest in asset types authorised under the trust deed for the particular fund. For example, a fund
may be authorised to invest in commercial property
balance investments within their portion of the fund. For example, a fund manager will usually
maintain a diversified portfolio of assets (such as shares) within the asset class authorised in the
trust deed
reinvest income and any capital gains in the fund
restructure the asset portfolio based on forecast changes in the financial markets and the economy.
For example, an expectation that interest rates might change may cause the fund manager to sell
assets that could adversely be affected by an interest rate change
provide financial advice to the fund trustee
periodically report to the fund trustee.
Table 3.1 demonstrates the remarkable growth that has occurred in managed funds in Australia.
Managed funds have increased from $345 billion in March 1995 to $3171 billion at the end of 2017.
Table 3.1 Managed funds, Australia ($ million, December 1995, 2010 and 2017)
1995
2010
2017
124 183
241 013
242 070
91 330
206 771
192 812
155 992
1 087 458
2 520 130
44 217
308 534
356 033
Cash management trusts
7 455
39 313
35 695
Common funds
4 884
10 005
10 776
Friendly societies
8 300
6 252
7 263
Total of all funds
345 031
1 692 575
3 171 967
Statutory funds of life offices
Statutory funds (superannuation)
Superannuation funds
Public unit trusts
SOURCE: © Commonwealth of Australia
There are a number of different types of managed funds. These types of funds are defined by the
nature of the assets held in the fund:
•
•
•
•
capital guaranteed funds
capital stable funds
balanced growth funds
managed growth or capital growth funds.
Managed funds offer members a choice of investment strategies to meet their particular risk and
liquidity preferences. For example, it might be reasonable for a person nearing retirement to want to
minimise risk exposure and adopt a conservative investment strategy in order to protect their funds. On
the other hand, a young person may wish to take a more aggressive risk strategy to try and maximise
the return over the longer term. Therefore, managed funds may be categorised by the investment risk
profile of the different types of funds on offer. In some cases, however, there may be a marked difference
between what the fund is called and the nature of the risks that are borne by investors.
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3.2.3
Capital guaranteed funds
A capital guaranteed fund aims to provide investors with positive returns while protecting their
investment from downside losses. Despite being ‘capital guaranteed’, the investor’s capital is at risk and
the Australian Securities and Investments Commission (ASIC) has undertaken an analysis of these
products to determine whether the terms used to describe the funds are subject to misinterpretation
by investors. The structure of these products can be quite complex, and can involve sophisticated
derivatives investments and dynamic hedging strategies layered on top of investments in low-risk assets
such as bonds. During periods of market volatility, there is the risk of capital losses and investors may
not always achieve the outcome they expected, particularly if they fail to understand the nature of
the product in which they have invested. Sometimes, products such as insurance or savings annuities
are advertised as capital guaranteed or capital protected. These are not to be confused with a capital
guarantee fund offering the type of product described above.
3.2.4
the capital invested
exhibits low variability
because the fund
invests mainly in lowrisk securities
Balanced growth
fund
investments target
longer-term income
streams supported by
limited capital growth
Managed growth or capital growth funds
A managed growth fund is designed to maximise the return from capital growth; that is, funds managers
are looking for an appreciation in the value of assets held in an investment portfolio. The proportion of
equity in a managed growth fund portfolio is considerably higher than it is in the balanced growth funds,
and the equity segment also includes a greater range of risk securities. While the risk of the portfolio
is higher than for any of the other types of funds, managed growth funds provide the opportunity of
potentially higher returns. Investors in managed growth funds will generally have a higher propensity to
accept risk and will usually have a longer-term investment horizon.
Now that we understand the purpose and function of managed funds, we will look at the following:
•
•
•
•
Capital stable fund
Balanced growth funds
A balanced growth fund aims at delivering a longer-term income stream and some capital appreciation
or growth. The investment strategies of this type of fund are more aggressive than for a capital stable
fund, with assets diversified across a greater risk spectrum. Their portfolios include money-market
instruments, some government securities, property and a relatively high proportion of domestic and
foreign equities. On average, the assets of the balanced growth funds are subject to greater market
fluctuations. An investor in this type of fund typically has a longer-term investment horizon, or is
willing to accept a higher level of investment risk.
3.2.6
a fund that offers the
potential of positive
returns while putting
in place strategies
to protect investors’
capital from downside
losses
Capital stable funds
A capital stable fund aims to at least secure contributors’ investment, but the fund does not provide an
explicit or implicit capital guarantee. Capital stable funds will invest in defensive assets that have low
volatility and lower expected returns. A small portion of the portfolio may be invested in riskier assets
such as shares.
3.2.5
Capital guaranteed
fund
Managed growth
fund
invests to obtain
greater return through
capital growth; lower
income streams
cash management trusts
public unit trusts
superannuation funds
life insurance and general insurance offices.
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REFLECTION POINTS
•
•
•
•
•
Managed funds include cash management trusts, public unit trusts, superannuation funds,
statutory funds of life insurance offices, common funds and friendly societies.
Financial market deregulation, ageing populations, a more affluent population and more highly
educated investors have driven growth in this sector.
Managed funds accumulate savings (e.g. superannuation contributions or investors buying units
in a trust). The funds are invested using professional fund managers.
Fund managers invest funds in authorised assets, balance their portfolios, reinvest income and
capital gains, provide advice and periodically report to the fund.
Types of managed funds are categorised by their investment risk profile, being capital stable
funds, balanced growth funds, managed or capital growth funds.
3.3
LEARNING
OBJECTIVE
3.3
Discuss the purpose
and operation of cash
management trusts and
public unit trusts.
Cash management
trust (CMT)
invests the accumulated
savings of individuals
mainly in wholesale
money-market
securities
Cash management trusts
A cash management trust (CMT) is a mutual investment fund, often managed by a financial intermediary
within the terms of a specific trust deed. The trust deed sets out the rules under which the CMT is to be
managed, including the manager’s responsibility for the day-to-day operation of the trust, and provides
for a trustee to be responsible for the supervision of the trust. The deed also specifies the maximum
management fees that may be charged.
The CMT deed defines the types of assets in which the trust may invest. The assets are generally
restricted to short-term money-market instruments. Some funds specialise in short-term-to-maturity
government and semi-government securities, while others have a broader portfolio, including bills of
exchange, promissory notes and certificates of deposit (these securities are discussed in Chapter 9).
Table 3.2 shows the main types of investments held by cash management trusts in Australia.
Table 3.2 Cash management trusts (Australia): Assets as at December 2017
$ million
Cash and deposits
Bills of exchange
26 310
0
Other assets
9 385
Total assets
35 695
SOURCE: © Commonwealth of Australia
Cash management trusts provide a high degree of liquidity for the investor. Investments are
primarily in bank deposits and money-market securities. It is to be expected that the weighted average
maturity of investments held in a CMT will be measured in days.
The money markets provide a range of short-term investment opportunities; however, the money
markets are essentially a wholesale market—that is, most transactions are high value and are carried
out by institutional investors such as fund managers. The CMT provides an opportunity for the smaller
individual investor to obtain indirect access to money-market investments. The CMT gathers the savings
of investors and invests those accumulated savings in money-market securities.
A significant growth area in the use of the CMT has been within the stockbroking industry. With
the introduction of electronic settlement arrangements for the sale and purchase of securities traded on
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a stock exchange, the CMT has generally been adopted as the account through which settlement occurs.
Investors hold surplus funds in a CMT with their stockbroker in anticipation of conducting future
transactions on the stock exchange. Also, when a shareholder sells shares, the funds will be credited to
the CMT held with the stockbroker. Typical features attached to a CMT held with a stockbroker include:
•
•
•
•
•
no entry, exit or account-keeping fees
24-hour electronic access
personalised cheque book
free periodical payment service
direct crediting of dividends and unit trust distributions.
REFLECTION POINTS
•
•
•
•
A cash management trust (CMT) typically invests the majority of its funds in money-market
securities such as bills and commercial paper.
A CMT provides retail investors with access to the wholesale money markets.
Funds invested in a CMT are very liquid and normally can be withdrawn on 24 hours’ notice.
Stockbrokers quite often provide CMT accounts for their clients to enable the value settlement
of share trading transactions.
3.4
Public unit trusts
A public unit trust is an investment fund established under a trust deed whereby the trust sells units in the
trust to investors. The trustee, known as the responsible entity, is responsible for the management of the trust
and the investment of the pooled funds of the unit holders in accordance with the specified asset classes
listed in the trust deed. The trustee will normally appoint several fund managers who will be authorised to
invest funds on behalf of the trust. The trust will also specify how unit holders may sell their units in the trust.
The four main types of public unit trusts are defined by the assets accumulated in the fund:
•
•
•
•
property trusts
equity trusts
mortgage trusts
fixed-interest trusts.
Property trusts invest in industrial, commercial, retail and residential property. A particular trust may
invest only in residential rental properties, while another may invest in shopping centres, another in hotels
and another in central business district properties. The potential investment choices are quite wide, and
the nature of the unit trust, whereby investors purchase a limited number of units in the trust, means that
the investors gain access to investment opportunities that they may not be able to afford to purchase direct
from the market. For example, an individual person generally cannot afford to buy a shopping centre
complex; however, individuals are able to buy units in a trust that invests in shopping centres.
Similarly, an equity trust may invest in different equity markets, including the local share market or any
number of international share markets. The fund may invest in particular industry sectors, such as stocks in
the banking sector or the mining sector. One fund may invest only in industrial stocks, while another may
invest in resource stocks. Funds will generally specify if they are income or growth funds. Income funds invest
in stocks that produce higher dividend returns, while growth funds seek to achieve greater capital gains in
the value of the portfolio. Equity trusts are particularly useful for investors wishing to gain access to the
international share markets. Generally, an individual investor will not have the same level of knowledge about
the international share markets as they may have about their local share market. The trustee of an equity trust
will appoint fund managers who have an intimate knowledge of particular international markets.
LEARNING
OBJECTIVE
3.3
Discuss the purpose
and operation of cash
management trusts and
public unit trusts.
Public unit trust
investors purchase units
in a trust; the pooled
funds are invested in
asset classes specified
in the trust deed
Property trusts
invest in different types
of property specified in
the trust deed; includes
industrial, commercial
and retail property
Equity trust
invests in different
types of shares listed
on stock exchanges
(e.g. industrial,
resources, emerging
markets)
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Mortgage trust
invests in mortgages
registered as loan
securities over land
Fixed-interest trust
invests in a range of
debt securities such
as government and
corporate bonds
Listed trust
the units of a trust are
listed and traded on a
stock exchange
Unlisted trust
to sell units, a unit
holder must sell them
back to the trustee after
giving the required
notice
Mortgage trusts invest in mortgages issued by borrowers. A mortgage is a registered security taken
by a lender over the land of a borrower. The majority of mortgages will be ‘first mortgages’, where the
mortgagee has first claim over the title to the land in the event that the mortgagor defaults on the loan.
Fixed-interest trusts invest in a range of bonds issued by governments or corporations. For
example, a fund may purchase Treasury bonds issued by the government or debentures issued by listed
corporations. These instruments are discussed in Chapters 12 and 10 respectively. The funds may also
invest in securities issued in the domestic capital markets and the international capital markets.
There has been an enormous growth in public unit trusts. Table 3.3 compares the situation in
Australia in 1995 and 2017. The amount invested in public unit trusts has increased from about
$40 billion to approximately $350 billion.
Table 3.3 categorises property and equity unit trusts as listed trusts and unlisted trusts. With a listed
trust, the units of the trust are listed and traded on a stock exchange. A unit holder who wishes to sell
units held in a listed trust simply sells them through their stockbroker on the stock exchange at the
current market price. With an unlisted trust, a unit holder who wishes to dispose of units held in a trust
is required to sell them back to the trustee, after giving the required notice of intention to sell under the
terms of the trust deed. With the unlisted trust, it is possible that the trustee may not be able to obtain
enough liquidity to buy back the units, particularly in a volatile falling market.
Table 3.3 Public unit trusts (Australia): Assets as at December 2017 ($ million)
Type of trust
1995
2017
17 000
183 037
2 129
7 273
1 079
55 362
• unlisted
16 571
88 264
Mortgage trusts
1 904
194
Other trusts (including fixed-interest trusts)
5 534
21 903
44 217
356 033
Property trusts
• listed
• unlisted
Equity trusts
• listed
Total
SOURCE: © Commonwealth of Australia
The distinction between listed and unlisted trusts is important. For example, this was highlighted
in Australia during the late 1980s when, in an environment of falling property prices, the valuations
of most property trusts were marked down. This caused a significant demand for withdrawals by unit
holders who wanted to exit the trusts before they experienced further write-downs. The unlisted trusts
were generally unable to meet the demand for a large number of simultaneous withdrawal requests
as, quite reasonably, the trusts did not hold cash reserves to the extent of the withdrawal demand.
Many trusts began to impose a withdrawal notice period, which had the effect of stopping immediate
withdrawals. It also served to signal to investors what should have been obvious all the time: that
unlisted property trusts should not be seen as highly liquid investments.
As a result of that experience, a majority of property trusts are now listed on the stock exchange.
With a listed trust, the market determines the value of the units issued by a trust. The listed unit trust is
not involved with trading in existing units and therefore is not exposed to the demand for liquidity that
may be necessary for an unlisted trust.
It is interesting to compare the use of listed property trusts against the proportion of listed equity trusts
in Table 3.3. The value of listed equity trusts is relatively small. This reflects the liquidity characteristics
of the underlying assets. Because property typically is not a liquid asset, it is desirable to list the units on
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a stock exchange, thus creating a more liquid financial security. On the other hand, shares held by equity
trusts are generally highly liquid and therefore it is not as necessary to list the equity trust itself.
The growth in public unit trusts over the past two decades is not surprising. Professionally managed
public unit trusts represent an attractive investment option for an ageing population, as well as the
growing number of more educated, affluent investors.
REFLECTION POINTS
•
•
•
•
•
•
•
•
•
A public unit trust is formed under a trust deed.
The trustee, known as the responsible entity, manages the trust and ensures the pooled funds
are invested according to the terms of the trust deed.
The trust deed specifies the types of assets in which the trust will invest.
A property trust will invest in specified types of property, such as residential property, hotels
and shopping centres.
An equity trust will invest in specified shares listed on local or international stock exchanges,
such as industrial or emerging market shares.
A mortgage trust will invest in mortgages registered over land and the property thereon.
A fixed-interest trust will invest in debt securities such as government bonds or corporate bonds.
With a listed trust, the units are listed on a stock exchange and may be sold by the unit holder
through the exchange at the current market price.
With an unlisted trust, a unit holder must sell their units back to the trustee. The trust needs
sufficient liquidity to meet this demand.
3.5
Superannuation funds
In the international markets, financial institutions and financial instruments are sometimes referred
to by different names, even though they are very similar. Superannuation funds, pension funds and
provident funds are terms used in different countries to describe essentially the same type of institution.
For example, the market convention in the USA is to use the term pension fund, while in Singapore
the market might refer to the Central Provident Fund. In Australia, the convention is to describe the
institution as a superannuation fund.
Superannuation refers to specific savings accumulated by individuals in order to maintain their
lifestyle after retirement from work. When people leave the workforce they typically no longer receive
the regular income streams that have been a pattern of their working lives. This is a significant and often
traumatic change that should be planned for over an extended period prior to retirement. Depending on
the age at retirement, an individual may reasonably expect to live more than 30 years in retirement.
In some countries individuals must fund their own retirement, while in other countries, such as
Australia, age pension entitlements are available from the government. However, these entitlements are
restrictive and generally are not sufficient to allow an individual to live in the manner to which they
may have been accustomed. With many countries experiencing an ageing population, it is probable that
governments may provide less support for retirees into the future. Therefore, superannuation savings
will be essential for younger people currently in the workforce.
For most individuals the secret to accumulating sufficient retirement funds is progressive longterm savings. However, for young people entering the workforce, retirement seems a long way off and
thus saving for retirement is not seen as a priority. Therefore, many countries have introduced different
compulsory superannuation savings schemes.
While compulsory-superannuation-type schemes are an excellent government policy decision, most
schemes will not provide sufficient retirement incomes to fund existing lifestyles. Additional savings
will be required.
LEARNING
OBJECTIVE
3.4
Describe the nature and
roles of superannuation
funds, including the
primary sources of
superannuation funds
and the different types
of fund.
Superannuation
savings accumulated
by an individual to fund
their retirement from
the workforce
Age pension
a limited regular
income stream paid by
a government to older
retired persons
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Superannuation funds gather long-term savings and are increasingly important in providing a
significant proportion of funds that are available within the financial system for investment within
an economy. Such long-term investment facilitates economic growth, which in turn leads to positive
economic and social outcomes such as a higher standard of living and higher levels of employment. Using
Australia as an example, Table 3.4 shows the contribution of superannuation savings. Superannuation
assets of around $1700 billion represent a significant and growing level of savings within the context of
a small, open economy such as Australia.
Table 3.4 Superannuation assets and entities (Australia) as at December 2017
Superannuation fund classification
Entities with more than four members
Pooled superannuation trusts
Assets ($ billion)
1 696.4
207
147.1
39
2.1
2 079
Small APRA funds
Self-managed superannuation funds
721
Balance of life office statutory funds
592 658
56.1
2 614.5
Total
Number of entities
595 014
SOURCE: © Australian Prudential Regulation Authority [2018]
In Table 3.4, APRA classifies superannuation funds as:
•
•
•
•
•
Entities with more than four members: regulated superannuation entities with more than four members.
Pooled superannuation trusts (PSTs): trusts in which regulated superannuation funds, approved
deposit funds and other PSTs invest.
Small APRA funds: superannuation entities regulated by APRA with less than five members.
Self-managed superannuation funds: superannuation funds regulated by the Australian Taxation
Office that have fewer than five members, all of whom are trustees.
Balance of life office statutory funds: assets held for superannuation or retirement purposes in statutory
funds of life insurance companies. The balance of life office funds includes annuities and assets
backing non-policyholder liabilities. These products are regulated under the Life Insurance Act 1995.
3.5.1
Sources of funds
Superannuation funds accept and manage contributions from their members. As superannuation
represents long-term savings for retirement, the majority of fund members make regular periodic
contributions to their superannuation fund over an extended working life. The superannuation funds
invest the accumulated contributions. Income derived from investing those contributions is also added
to the superannuation savings. Although APRA does not separate retail, corporate, industry and public
sector superannuation funds, we find it useful to segment regulated superannuation entities with more
than four members based on their sources of funds. We therefore consider the following groups of
superannuation funds and sources of funds within the superannuation system:
•
•
•
•
•
corporate funds, industry funds and public sector superannuation funds
compulsory superannuation funds
retail superannuation funds
self-managed superannuation funds
rollover funds.
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Corporate funds, industry funds and public sector superannuation funds
A corporate superannuation fund provides benefits to employees of a particular corporation. Industry
superannuation funds had their origins in providing benefits to employees working within a particular
industry and public sector superannuation funds provide benefits to government employees.
These superannuation funds may be contributory or non-contributory. With a contributory fund,
both the employer and the employee make specified contributions to the fund. With a non-contributory
fund, only the employer makes payments into the fund on behalf of the employees. Often, government
employers do not make direct contributions to public sector superannuation funds, but rather meet
ongoing superannuation commitments from future taxation receipts.
For example, universities in Australia offer contributory superannuation schemes whereby the
university (employer) contributes the equivalent of 17.00 per cent of an academic’s salary, and the
academic contributes a further 7.00 per cent from their salary. On the other hand, a corporation is
more likely to offer a non-contributory scheme, with the corporation only contributing the required
9.50 per cent compulsory contribution.
Corporate
superannuation fund
Compulsory superannuation funds
a governmentsponsored fund
established for the
benefit of government
employees
In many countries around the world the average age of the population is increasing. An ageing
population presents a twofold problem:
an employer contributes
to a fund established
for the benefit of an
employee; employee
may also contribute to
the fund
Industry
superannuation fund
similar to a corporate
fund, but the fund
is established for all
employees in a specific
industry
Public sector
superannuation fund
1 More people will be retiring from the workforce in the near future, and improved living standards
mean that they will live much longer than in the past. These people will require access to funds in
order to maintain a reasonable lifestyle.
2 Many governments have traditionally provided support for the aged from taxation receipts. However,
as the aged leave the workforce, the proportion of the total population still actively working and
contributing to the tax base will fall. At the same time there will be increased demand for aged
support services such as hospitals and nursing homes. At some time in the future governments may
not be able to fund directly all the necessary services.
A number of countries have implemented compulsory superannuation schemes in an attempt to
deal with this problem in the longer term. Compulsory superannuation schemes differ considerably
between countries; for example, in Singapore the current scheme requires employers to contribute the
equivalent of 20.00 per cent of an employee’s earnings and employees a further 16.00 per cent.
In Australia, the current compulsory superannuation scheme is known as the superannuation
guarantee charge (SGC). The scheme was implemented on 1 July 1992 and phased in over a 10-year
period; it is designed to encourage an increase in the level of retirement savings and gradually to reduce
the burden of an ageing population on the social security system, by ensuring that employers provide a
required level of superannuation support to their employees. Employers who pay the required level of
superannuation into a complying superannuation scheme do not need to pay the SGC to the Australian
Taxation Office. The SGC is therefore a penalty taxation charge made on employers who do not
contribute to their employees’ superannuation.
From 1 July 2002, employer contributions on behalf of employees were set at the equivalent of
9.00 per cent of an employee’s wages or salary. This has had an ongoing impact on the flow of funds
through the financial system and on the amount of funds available for capital investment. As shown
in Table 3.4, total superannuation funds are currently more than $2 trillion. However, for a number of
years there has been debate about the adequacy of the 9.00 per cent SGC. In late 2011, the government
introduced the Superannuation Guarantee (Administration) Amendment Bill. The amendments to the
legislation proposed the gradual increase in the SGC from 9.00 per cent to 12.00 per cent by 2019. In
2014, the government opted to slow the growth of this change by keeping the SGC constant at 9.50 per
cent for the years between 2014 and 2021. Only after 2021 would the increase resume, finally reaching
12.00 per cent in 2025 or six years later than originally proposed.
In Australia, the government has also introduced taxation incentives that make it attractive
for individuals to contribute additional funds into superannuation. For example, contributions and
Superannuation
guarantee charge
(SGC)
the compulsory
superannuation scheme
operating in Australia
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earnings of a superannuation fund are taxed at a concessional 15.00 per cent taxation rate. When a
superannuation fund member reaches age 60 and the fund operates in pension mode, earnings and
withdrawals are tax free.
Perhaps the greatest incentive to the large numerical increase in private superannuation funds is
the concern that compulsory superannuation will not be sufficient to fund a comfortable lifestyle in
retirement; additional savings are required.
Retail superannuation funds
Retail superannuation funds are operated by financial institutions and membership is open. Anyone
can join a retail superannuation fund. These funds are run ‘for-profit’ by the financial institutions who
charge a fee on capital invested and take a percentage of the investment earnings. This distinguishes
them from industry funds, which are often run on a ‘not-for-profit’ basis on behalf of the fund’s members.
Retail funds are a popular choice for many individuals and account for around one-fifth of Australia’s
superannuation savings. Individuals seeking to exercise their freedom of choice in the superannuation
sector may transition out of an industry or corporate fund and into a retail fund or a self-managed
superannuation fund. Their superannuation contributions and those of their employer will now be
directed to the retail fund or the self-managed fund.
Self-managed superannuation funds
Approximately 30.00 per cent of Australia’s superannuation savings are managed in self-managed
superannuation funds (SMSFs). These funds are regulated by the Australian Taxation Office (ATO),
which also collects and publishes statistics that provide an overview of some of the more interesting
characteristics. The most eye-catching fact about self-managed superannuation is the large amount of
money that resides in SMSFs. This is more than $700 billion and a substantial proportion, more than
$150 billion, is invested in cash. This has proven to be a useful buffer against financial crises and
stock-market crashes but one might question whether the portfolios are, on average, too conservative.
Although there has been substantial growth in the SMSF sector, an overly conservative asset allocation
may lead us to expect SMSFs to make up a smaller and smaller percentage of the total superannuation
savings over time if the earnings in other fund types compound faster during market uptrends than
SMSFs, despite SMSFs being competitive at protecting the invested capital during periods of crisis
through substantial cash allocations.
SMSF investors are not completely averse to risk. More than $200 billion is invested in shares
listed on the ASX and a further $20 billion is invested in listed trusts. In fact, despite presumably being
set up to afford the investor more control over the investment decisions, SMSFs invest approximately
$100 billion in listed and unlisted trusts and other managed investments. About $110 billion is invested
in residential and non-residential property. Collectables, government bonds and other debt securities
and overseas-based investments do not figure prominently in the asset allocations of SMSFs. The
aggregated picture reflected by the ATO’s statistics and confirmed by academic research is that SMSFs
invest predominantly in shares and cash, with most of the remainder of the portfolios allocated to
managed investments and property.
Most SMSF trustees are the trustees of their own superannuation funds and are middle-aged
or older. Less than one-fifth of the almost 600 000 SMSFs are managed by people aged 44 or less.
Half of the trustees are over 55. This tends to explain the somewhat conservative asset allocation profile
that characterises the SMSF sector. Investors who are closer to retirement must take steps to protect
their retirement savings. This is particularly the case for those individuals who are on lower-to-medium
incomes. The taxable income of approximately one-quarter of SMSF members is less than $20 000.
More than half of SMSF members report taxable income of less than $60 000. Of course, these figures
reflect the age distribution of SMSF members, many of whom are possibly already in some form of
retirement from the workforce.
SMSFs have enjoyed an uncontroversial existence. There has been no major scandal associated
with SMSFs and some might be willing to conclude that this is adequate demonstration that people
are capable of looking after their own affairs when their retirement incomes are at stake. This being
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said, SMSFs do present both regulatory and policy issues. The portfolios are conservative but some
evidence suggests that they are not well managed. In particular, there is evidence to suggest that the
equity component of SMSF portfolios contains too few investments in too few industrial sectors to be
considered well diversified. As a consequence, SMSFs may be exposed to individual company-specific
risks that could be avoided by better managing the portfolios’ diversification. SMSFs also represent a
significant potential customer base for the financial services industry. The portfolio management of
SMSFs and innovations in the products that are specifically offered to SMSF trustees are two areas that
may present challenges to regulators and policy makers.
Rollover funds
An individual who changes jobs or retires early may need to retain accumulated superannuation
entitlements in a prescribed superannuation arrangement. Such prescribed arrangements are set by the
government to ensure that individuals retain their superannuation savings until retirement age, and also
to ensure the continuation of the concessional taxation environment for superannuation funds. The
vehicle through which these benefits may be preserved is called a rollover fund.
For example, in Australia an individual who moves from one job to another may roll over their
existing superannuation as an eligible termination payment (ETP). An ETP includes a payout from
a superannuation fund if a person withdraws from that fund, plus other amounts directly related to a
person’s termination of employment, such as a financial inducement paid for early retirement and
retrenchment benefits.
3.5.2
Defined benefit funds and accumulation funds
Superannuation funds offer members a choice of investment strategies to meet their particular
risk and liquidity preferences. For example, it might be reasonable for a person nearing retirement
to want to minimise risk exposure and adopt a conservative investment strategy in order to protect
their accumulated superannuation balances. On the other hand, a young person may wish to take a
more aggressive risk strategy to try and maximise the return over the long term. The different types of
managed funds were discussed in Section 3.2 and included capital stable funds, balanced growth funds
and managed growth funds.
The net amount of funds paid to a fund member is also dependent upon the type of superannuation
fund. Superannuation funds are described as either defined benefit funds or accumulation funds.
A defined benefit fund is a superannuation fund that may be offered by an employer to employees.
As the name implies, a defined benefit scheme is one in which the amount of the benefit paid to a
member on retirement is calculated based on a formula stated at the time the member joins the fund.
The final superannuation payout is normally calculated on the basis of the specified factor times the
employee’s average salary over the final year, or few years, of employment, multiplied by the number of
years of fund membership.
Should the performance of the investments in the defined benefit fund not be sufficient to meet
the defined payout, the employer must make good the shortfall. With this type of fund the investment
risk falls directly on the employer. In recent years many employers have transferred this risk exposure
by encouraging employees to move to, or only offering, accumulation funds (also known as defined
contribution schemes).
An defined contribution fund gathers in the contributions of the employer and the employee and
invests those funds on behalf of the superannuation fund member. At retirement, the total amount
of superannuation funds available to the member is the accumulated sum of contributions plus
investment earnings, minus expenses and taxes. There is no defined payout; the amount received
depends totally on the investment performance of the fund. In other words, the investment risk lies
with the fund member. Defined contribution schemes are the predominant type of superannuation
fund today.
Rollover fund
holds existing eligible
termination payments
within the regulated
superannuation
environment
Eligible termination
payment (ETP)
superannuation funds
due on termination
of employment, plus
related redundancy
payments
Defined benefit fund
the amount of
superannuation paid
to an employee on
retirement is based on
a defined formula
Defined contribution
fund
the amount of
superannuation funds
available at retirement
consists of past
contributions plus
earnings, less taxes and
expenses
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3.5.3
Regulation
By the early 1990s, the Commonwealth Government had developed a retirement income policy to
address a range of issues, including low levels of national savings, an ageing population and declining
labour participation rates. Legislative initiatives were implemented to raise retirement savings and reduce
future dependence on social security age pensions. In 1992, the current compulsory superannuation
arrangements were implemented (these were discussed above).
The Superannuation Industry (Supervision) Act 1993 (Cwlth) (SIS) and the Income Tax Assessment
Act 1936 are the two principal pieces of legislation that directly affect the operation of superannuation
funds. The SIS is the governing legislation for the regulation of complying superannuation funds that
receive concessional taxation treatment. APRA has responsibility for the prudential supervision of
superannuation funds, while ASIC has an associated responsibility for market integrity and consumer
protection, which includes superannuation products.
Superannuation funds are trusts established under a trust deed. The trustee is the responsible entity
and as such has a fiduciary duty of care to ensure that the fund is managed for the benefit of its members.
The Superannuation Industry (Supervision) Act establishes an overarching test that must be applied
to superannuation investments: the sole purpose test. The sole purpose test requires a superannuation
fund to invest in a range of assets that seek to achieve the member’s established risk and liquidity
preferences. The purpose is to provide the member with funds for retirement.
The concessional taxation treatment of complying superannuation funds relates primarily to a
15.00 per cent tax rate applied to fund contributions, earnings and realised capital gains. There are,
however, limitations on the amount an individual can contribute to a superannuation fund annually.
Superannuation fund members can withdraw their superannuation funds as a pension, or in a lump
sum, tax free once they reach age 60.
REFLECTION POINTS
•
•
•
•
•
•
•
Superannuation funds, provident funds or pension funds accumulate retirement savings of
individuals.
Superannuation funds may be classified as corporate funds, industry funds, public sector funds,
retail funds, small regulated funds and self-managed funds.
Superannuation savings come from a number of sources, including employer contributions,
employee contributions, compulsory superannuation contributions, personal contributions and
eligible rollover funds.
Many countries are experiencing a demographic shift to an ageing population. Some have
introduced compulsory superannuation schemes to ensure people fund at least part of their
own retirement.
In Australia, employers are required to pay the equivalent of 9.50 per cent of an employee’s
wage or salary into a superannuation fund in the employee’s name.
A fund may be a defined benefit fund or a defined contribution fund. At retirement, a defined
benefit fund pays a lump sum or pension based on a predetermined formula, whereas
a defined contribution fund pays the accumulated contributions and earnings of the fund, less
expenses and taxes.
Superannuation funds in Australia are supervised by APRA. A concessional taxation rate of
15.00 per cent applies to contributions and earnings of a fund. Funds may be withdrawn tax
free after age 60.
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3.6
Life insurance offices
Life insurance offices are contractual savings institutions. The liabilities of insurance offices are
defined by contracts in which, in return for the payment of specified periodic cash flows, the
policyholder will be entitled to a determinable benefit following the occurrence of a specified future
event or condition.
The main contract offered by a life insurance office is described as an insurance policy. The cost of
an insurance policy is the premium paid. The premium is usually paid annually until the policy matures
or is terminated. Typically, in return for payment of the premium, a policyholder or a beneficiary will
receive a payment upon death or disablement, or at a nominated maturity date, subject to the terms and
conditions of the insurance policy.
From an economic point of view, insurance premiums represent a form of savings. The accumulated
savings derived from the premium payments received by a life office are invested in a wide range of asset
classes. The return received on those investments is used to make payment to an insured policyholder
or beneficiary if an event specified in the insurance policy occurs. For example, a specified event may
be the death of the insured.
Life insurance offices are also providers of superannuation or retirement savings products, and
therefore accumulate and invest the superannuation savings of individuals. In Australia, superannuation
represents over 87.00 per cent of the assets of life insurance offices’ statutory funds. Statutory funds
are funds established within a life insurance office that hold, and therefore separate, the assets backing
policyholder liabilities from the other assets of the life insurance office.
The inflow of funds to a life insurance office is typically regular, relatively predictable and long
term. This gives the life insurance offices, in aggregate, a very stable source of funds. Their payment
flows to policyholders and superannuation fund members can be reasonably well predicted on an
actuarial basis and generally are not subject to erratic, seasonal fluctuations. Therefore, life insurance
offices are able to invest a large proportion of their funds in long-term securities. For example, as
indicated in Table 3.5, life insurance offices in Australia are large investors in equities, unit trusts, longterm securities and property, in both the domestic and international markets, with over $240 billion in
total funds invested.
LEARNING
OBJECTIVE
3.5
Define life insurance
offices and general
insurance offices, and
explain the main types
of insurance policies
offered by each type of
insurer.
Premium
the amount paid by the
buyer of a contract,
such as an option or an
insurance policy
Policyholder
the person who takes
out an insurance policy
that covers a defined
risk event
Beneficiary
the party who is entitled
to receive payment
under the terms of an
insurance policy
Table 3.5 Life insurance offices (Australia): Statutory funds as at December 2017
Statutory funds
$ millions
Cash and short-term investments
14 552
Long-term securities
21 243
Equities and unit trusts
Land and buildings
180 275
81
Overseas assets
14 742
Other assets
11 178
Total assets
242 071
SOURCE: © Commonwealth of Australia
Each country has its own legislative and regulatory supervision requirements for life insurance
offices. In Australia, the prudential supervisor of life insurance offices is the Australian Prudential
Regulation Authority (APRA). As the prudential supervisor of insurance offices, APRA regulates
them in the same manner as it does the commercial banks, particularly with regard to capital
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adequacy requirements and liquidity management (discussed in Chapter 2). The principal
legislation is the Life Insurance Act 1995 (Cwlth). This legislation covers the licensing and control
of life insurance offices.
3.6.1
Life insurance policies
As the name implies, a life insurance policy provides a named beneficiary with a financial payment in
the event of the death of the policyholder. Alternatively, the policyholder may receive payment if some
other defined event occurs, such as a permanent disability. As discussed below, some life insurance
policies also make a payment if the policyholder survives to a nominated age, such as 65 years.
In a competitive market, each life insurance office offers a range of different policies that will
incorporate a selection of terms and conditions. The basic insurance policy products offered by a life
insurance office include:
•
•
•
•
•
•
whole-of-life policy
term-life policy
total and permanent disablement policy
trauma policy
income protection policy
business overheads insurance policy.
Whole-of-life policy
Whole-of-life policy
a life insurance policy
that incorporates a risk
component and an
investment component,
thus accumulating
bonuses and a
surrender value
Investment
component
allows periodic bonuses
to accumulate on a
whole-of-life insurance
policy
Risk component
the cost of the actual
life insurance cover
as determined by an
actuary
Term-life policy
life insurance cover for
a fixed amount and a
predetermined period
The whole-of-life policy is a long-term life insurance policy. The policy will pay the sum insured, plus
bonuses, on the death of the policyholder.
The whole-of-life policy incorporates a special feature—an investment component—that affects
the amount paid on the death of the policyholder. The life insurance office invests the periodic
premiums paid by the policyholder. The returns on investment will, typically, be higher than the
risk component of the policy and therefore a surplus is accumulated in the life insurance office
statutory fund. The surplus is returned to the policyholder in the form of bonuses that are attached
to the policy.
Therefore, the policy will pay both the sum insured and the total bonuses attached to the policy.
Should the policyholder get into financial difficulty and not be able to pay the premiums on the policy,
the accumulated bonuses may be used to offset the outstanding premium payments due.
A whole-of-life policy, over time, acquires a surrender value—that is, an amount that will be paid if
the policy is cancelled by the policyholder.
Term-life policy
The term-life policy pays a specified benefit to a nominated beneficiary on the death of the insured, if
that death occurs during the term of the policy. The term-life policy is for a predetermined period and
does not include an investment component.
The term-life policy is often more attractive than the whole-of-life policy. It allows the policyholder
to obtain financial protection for the nominated beneficiary over that period in the policyholder’s life
when personal debt commitments are high. For example, a married couple with children may have
outstanding debts on their house and car, and are planning to send their children to private schools. If
the main income earner died during this period, the surviving family members may experience severe
financial hardship. The amount of insurance cover taken with a term-life policy should be at least
sufficient to cover these and any other forecast debt exposures.
Premium payments are made by the policyholder to the life office during the term of the policy. The
policy may require regular, periodic fixed premium payments for the term of the policy. Alternatively,
the premiums may be stepped over time, whereby the premium increases progressively during the term
of the policy. This form of premium reflects more closely the increasing level of risk of death over time.
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A feature that is available with a term-life policy is the indexation of the sum insured. Generally,
the policyholder is given the option to increase the amount of life cover each year during the term
of the policy.
A prospective policyholder should clearly understand exclusions that are incorporated in a termlife policy. For example, cover will not be extended to the insured in the event of suicide occurring
within a specified period from the commencement of the policy. Also, a policyholder is required to
advise the insurer of any pre-existing health and physical conditions and may be required to undergo a
medical examination. The insurer may not cover those conditions. Similarly, if the policyholder dies as
a result of an undeclared pre-existing condition, coverage may be excluded. If a policyholder is injured
or dies as a result of a riot, a terrorist act or war, the cover may be limited or unavailable.
Total and permanent disablement insurance
Total and permanent disablement insurance is often taken as an extension to a life insurance policy. It
would seem prudent and logical to cover the situation in which death does not occur but serious injury
results. This is quite often the case, for example, in a car accident. The injury suffered may be such that
the policyholder is no longer able to work.
A total and permanent disablement policy will pay a specified amount, either as a lump sum or
as an annuity, if an injury causes total and permanent disablement to the policyholder. Therefore, the
definition of a total and permanent disablement is critical in determining whether an insurance claim
will be paid or not. The definition is, at best, very restrictive. Before taking this type of insurance,
one should be aware of the limitations associated with disablement insurance. The restrictiveness of a
policy will vary between insurers. It is necessary to read a policy proposal very carefully.
In general terms, a total and permanent disablement will be determined within the constraints of either:
•
•
Total and permanent
disablement
insurance
insurance policy
covering loss of limbs
or total inability to
resume an occupation
Annuity
a series of cash flows of
equal amount, equally
spaced over time
the total and permanent loss of the use of a combination of two of the following: hands, feet and/or
eyes; or
total and permanent disablement resulting from an injury, accident or illness whereby the insured
is unable to carry out the normal functions of their usual occupation. This measure will usually be
subject to a range of conditions.
Trauma insurance
Another type of insurance policy that can be attached to a life policy is trauma insurance. With trauma
insurance, the life insurance office will make a lump-sum payment to the insured in the event of a
specified trauma occurring. Examples of trauma events include cancer, heart attack, HIV, major body
parts failure and terminal disease or illness. Again, as with all insurance, the extent of coverage of
a policy, definitions of events and terms and conditions need to be examined with great care. For
example, at what point is a heart attack a trauma event under a policy?
Trauma insurance
a lump-sum payment
made if a specified
trauma event, such as a
stroke, occurs
Income protection insurance
Serious injury, illness or redundancy may result in an individual being unable to work for an extended
period of time. Income protection insurance offers a periodic payment of an amount up to 75.00 per cent
of average pretax income, for a predetermined period. The amount paid will be offset by any other related
payments received, such as workers’ compensation, and will be confined to the length of time specified in
the policy. Again, this type of policy will vary between insurers. Given the nature of this type of policy, a
policyholder must ensure that a policy includes a guarantee of policy renewal by the life insurance office.
Business overheads insurance
An extension of an income protection policy may be necessary where an individual runs their own
business. Business overheads insurance provides coverage for strictly defined, normal day-to-day
operating expenses such as telephones, electricity, insurance premiums, bank interest and fees, office
cleaning and administrative personnel.
Income protection
insurance
payment of a limited
income stream if the
insured is unable to
work in the event of
illness or accident
Business overheads
insurance
coverage of specified
day-to-day operating
expenses in the event
of business disruption
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REFLECTION POINTS
•
•
•
•
•
Life insurance offices are contractual savings institutions; that is, their liabilities are defined by
insurance contracts that provide a determinable payout if a specified event occurs. The cost of
the policy is the periodic premium paid.
Life insurance offices are large investors in the financial markets, particularly in longer-term
debt and equity securities.
A whole-of-life policy is a long-term life insurance policy that pays a beneficiary the sum
insured, plus bonuses derived from an investment component, on the death of the policyholder.
The policy may accrue a surrender value.
A term-life policy also pays the sum insured but does not incorporate an investment
component. This is a fixed-term policy that is used to cover that period of a person’s life when
they have high personal debt commitments.
Life insurance offices provide a range of other insurance policies, including total and permanent
disablement, trauma, income protection and business overheads insurances. Policyholders
need to understand the policy exclusions and limitations.
3.7
LEARNING
OBJECTIVE
3.5
Define life insurance
offices and general
insurance offices, and
explain the main types
of insurance policies
offered by each type of
insurer
General insurance offices
General insurance policies cover specified risks and provide a promise to pay the insured a predetermined
amount in the event that the peril that is insured against occurs. These funds include medical insurance,
motor vehicle insurance, travel insurance, public liability insurance and house and contents insurance.
Since insurance premiums are paid in advance, general insurers have substantial amounts of
funds to invest. However, because of the uncertain nature of the risks that are underwritten in general
insurance policies, claims are less predictable than those of life insurance offices. Thus, general insurers
tend to invest a larger proportion of their assets in shorter-term, highly marketable securities. They will
typically invest significant amounts in money-market assets such as bills of exchange, commercial paper
and certificates of deposit. These are very liquid assets that can easily be sold should the insurance
company need to raise cash to meet claims against insurance policies.
3.7.1
General insurance policies
General insurance offices provide a wide range of risk insurance products. Policies offer protection to
individuals in the retail market and to businesses in the commercial market. This section considers two
of the principal insurance policy types:
•
•
house and contents insurance
motor vehicle insurance.
House and contents insurance
Co-insurance clause
if an asset is underinsured, the policy
will cover only the
proportional value
insured
House insurance provides financial protection to the insured in the event of loss or damage to a
residential property. Typically, a policy will provide insurance cover up to a specified amount.
The insured must ensure that the amount of the cover is sufficient to replace or rebuild the
property covered in the policy. Under-insurance is a significant issue. Policies generally incorporate
a co-insurance clause, which means that the general insurance office will pay a claim only up to the
proportional insurance coverage.
For example, if a house is insured for $400 000 but the replacement cost is determined to be
$500 000, then under a co-insurance clause the house is covered for only 80.00 per cent of any loss.
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If an event occurs that is covered under the policy that causes, say, $100 000 damage to the property,
the general insurance office will pay only $80 000. The policyholder is said to have self-insured
for the remaining 20.00 per cent of the damage. Under-insurance can therefore be very expensive.
The range of events covered under a policy varies between insurers. The following is a list of perils
that an insurer may include in house and contents insurance policies:
•
•
•
•
•
•
fire or explosion
natural disasters such as lightning strike, flood and earthquake
malicious acts, riots, civil commotion
theft by persons other than residents
external impact
storm and water damage.
Contents insurance policies usually provide new-for-old replacement value. Specified items and
items over a certain value may need to be listed in a schedule attached to the policy. For example,
valuable paintings or antiques may need to be catalogued and listed on the schedule. Expert written
valuations of the items will usually be required.
House insurance policies typically incorporate public liability insurance coverage up to a specified
amount. Public liability insurance covers injury or death to a third party visiting the named property
that may result from negligence on the part of the property owner or occupier. For example, if, in
the dark, a visitor to a house falls down steps leading from the house, and if it can be shown that the
lighting was defective, the visitor may have a claim against the property owner.
Motor vehicle insurance
Accidents do happen, particularly when it comes to road transport. The owner or driver of a vehicle
has the choice of a number of motor vehicle insurance policies, each providing a different level of cover.
The highest level of cover is provided by a comprehensive insurance policy. A comprehensive motor
vehicle policy covers damage to the named vehicle, as well as damage to any third-party vehicles and
property. Motor vehicles are generally covered for market value, although it is possible to negotiate a
higher cover if necessary.
A lesser level of cover is available with a third-party, fire and theft policy. With this type of policy,
the named vehicle is covered only for damage or loss associated with fire or theft of the vehicle. Damage
to any third-party vehicles and property is covered.
A third-party policy only covers damage or loss to a third-party vehicle or property, but does not
cover the vehicle of the insured.
The cost, or premium, for the above motor vehicle insurance policies reduces as the level of
coverage or protection reduces. Also, the more expensive the vehicle owned, the more prudent it is to
take higher insurance cover.
Finally, within the Australian market there is compulsory third-party insurance. All vehicle owners
must pay for this insurance cover when they pay their annual vehicle registration. The policy covers
any legal liability for bodily injury caused by a motor vehicle accident. The cover varies between states;
some require proof of driver negligence, while others are on a no-fault basis.
Public liability
insurance
covers injury or death
of a third party due
to negligence of a
property owner or
occupier
Comprehensive
insurance
policy covers damage
to the insured vehicle,
plus third-party vehicle
or property damage
Third-party, fire and
theft policy
policy covers only fire
or theft of the insured
vehicle, plus third-party
vehicle or property
damage
Third-party policy
policy covers only
third-party vehicle or
property damage
Compulsory thirdparty insurance
covers legal liability for
bodily injury resulting
from a motor vehicle
accident
REFLECTION POINTS
•
•
General insurance provides financial protection against an insured event (e.g. travel or medical
insurance).
House and contents insurance protects against loss or damage to a residential property, up
to a specified amount, caused by a range of perils specified in the policy, such as fire, flood or
theft. The policy will include a co-insurance clause. The policy should also include public liability
insurance, which covers negligent injury to third parties.
continued
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continued
•
Motor vehicle insurance includes (1) comprehensive insurance, which covers damage to the
named vehicle, plus damage to third-party vehicles or property, (2) third-party fire and theft,
which covers damage to the named vehicle from fire or theft, plus damage to third-party
vehicles or property, and (3) third-party policy, which does not cover the named vehicle, but
covers damage to third-party vehicles and property.
3.8
LEARNING
OBJECTIVE
3.6
Discuss hedge funds,
including their structure,
investors, investment
strategies and risk.
Hedge funds
invest in exotic
financial products
mainly for high-networth individuals and
institutional investors
Hedge funds
A hedge fund typically uses so-called sophisticated investment strategies and exotic investment
products to try and achieve higher returns on investments. Therefore, a hedge fund investment
is generally regarded as a higher-risk asset in an investment portfolio. Hedge funds will tend to
specialise in different types of financial instruments. These include equity, foreign exchange, bonds,
commodities and derivatives. The hedge fund sector is generally divided into (1) single-manager
hedge funds and (2) fund of funds. The main difference is that the fund of funds invests in a number
of single-manager funds; that is, the fund of funds attempts to diversify its fund investments across a
number of funds.
Hedge funds may be offered and managed by individual managers or financial institutions, particularly
investment banks. Individual managers usually have a very high profile and an established reputation in
the financial markets.
Similarly, investment banks employ individuals with specialist skills, but offer the extra protection
of operational transparency; that is, they keep investors informed. Hedge funds use their reputation
to attract funds, as investors perceive the manager (individual or investment bank) to have superior
skills, particularly in relation to sophisticated investment strategies and the use of exotic investment
products.
Hedge funds obtain their funds from institutional investors, high-net-worth individuals and
retail investors. In particular, superannuation funds and life insurance offices are a major source
of institutional funds. Institutional investors seek to manage the risk and return structure of their
investment portfolios by adding hedge fund investments to a portfolio. Retail investors may invest
in hedge funds in some countries, such as Australia, but are excluded from this type of investment
in the USA. If a hedge fund makes an offer to retail investors in Australia, the fund must meet the
same regulatory requirements that are applicable to any other type of retail fund, such as an equity
unit trust.
A hedge fund may choose to list on a stock exchange. This will provide a secondary market that will
allow a hedge fund investor to buy and sell units in the fund. As such, a listed fund may be much more
liquid in that the price of the units in the hedge fund will move with current market valuations.
An expectation of investors is that hedge funds will achieve positive returns in both an upward- and
a downward-moving market. This is in contrast to the traditional funds management outcome where a
portfolio, on average, increases with an upward-moving market, but decreases with a downward-moving
market. While this expectation is possible, clearly it will be dependent on the skills of the hedge fund
manager to outperform the market.
A hedge fund may seek to leverage investment opportunities by borrowing large amounts of debt,
over and above the funds lodged by the hedge fund investors. Also, a typical hedge fund will leverage
a position by using derivative products. Derivative products—such as options, forward and futures
contracts—may be bought or sold to take either a short or a long position in the equity market or the
foreign exchange market. For example, a hedge fund that takes a short position will either sell forward
shares, or use a derivative such as an option or futures contract that it forecasts will fall in price.
Alternatively, the fund may buy shares it forecasts will rise in price by using either borrowed funds or
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derivative products. Note that with a derivative product, the fund may only need to pay a premium for
an option contract, or a deposit margin for a futures contract; that is, the full value of the shares does
not need to be paid during the term of the contract. If the share price moves up or down as forecast, the
fund will take a profit and not have to pay the full amount at all. (The operation of derivative contracts
is discussed in detail in Part 6.)
In the above examples, the profit potential to the hedge fund is multiplied by the high level of
leverage taken. Of course, the level of risk is also much higher.
REFLECTION POINTS
•
•
•
•
•
A hedge fund seeks to achieve above-average returns using sophisticated investment
strategies and exotic investment products.
Funds are often highly leveraged by using borrowed funds or derivative products, and are
invested in equities, foreign exchange, bonds, commodities and derivatives.
Single-manager funds or fund of funds may be managed by a high-profile individual or a
financial institution such as an investment bank.
Hedge fund investors may be institutional investors, high-net-worth individuals or retail
investors.
Hedge funds should be regarded as a higher-risk investment.
3.9
Finance companies and general financiers
Finance companies and general financiers borrow funds in the domestic and international financial
markets in order to provide loans to their customers. They do not accept deposits from the
general public.
Finance companies emerged largely in response to regulatory constraints that existed in the
previously highly regulated banking sector, where interest rate ceilings and lending directives
were often imposed on commercial banks by regulators. Constraints placed on banks created an
opportunity for the development of institutions that could conduct business outside the regulated
banking sector.
In order to circumvent regulatory ceilings placed on bank deposit and lending interest rates, and
constraints on their ability to lend to higher-risk borrowers, the banks took a major role in the ownership
and funding of finance companies.
3.9.1
LEARNING
OBJECTIVE
3.7
Explain the principal
functions of finance
companies and general
financiers, and the
changes that have had
an impact on finance
company business.
Sources of funds and uses of funds
There is a direct correlation between the rise and fall in the relative importance of finance companies
and general financiers and the process of deregulation of the banking sector. For example, in Australia
in 1955 these institutions represented only 3.00 per cent of the total assets of financial institutions,
but by 1980 their market share had risen to 13.00 per cent. However, with the deregulation of the
interest rate and portfolio restrictions on commercial banks, the finance companies’ share of total
assets declined continuously, and in 2017 stood at less than 2.00 per cent.
The main sources of funds of these institutions are from borrowings from related corporations,
loans from banks and borrowing direct from the domestic and international money markets and capital
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markets. The high level of funding obtained from related corporations derives from the fact that a
number of finance companies are subsidiaries of a parent company. For example, as mentioned above,
many finance companies are subsidiaries of commercial banks. Other finance companies have parent
companies that are manufacturers, such as motor vehicle manufacturers. In both instances, the parent
company may provide a large amount of the funds required by the finance company from its own balance
sheet. Another significant source of funds has been the increased use of offshore funding following
deregulation of capital flows in the international markets and the floating of the exchange rates of major
currencies.
On the asset side of the balance sheet, the main categories of business of the finance companies
and general financiers are:
•
•
•
•
loans to individuals
instalment credit to finance retail sales by retail stores
lease financing
loans to business, including bills finance, term loans, wholesale financing or floor plan financing,
factoring and accounts receivable financing.
These lending products are discussed in detail in Chapters 9 and 10.
3.9.2
Sector structure
Clearly, the finance company and general financier sectors of the market have experienced considerable
change. There has been an enormous contraction in finance companies in particular. Participants in
the market can be classified into one of three broad categories:
1 diversified finance companies that provide a wide range of lending products
2 manufacturer-affiliated companies whose business is almost exclusively involved with the financing
of the sale of the parent manufacturers’ products; for example, motor vehicles
3 niche specialists, which tend to be relatively small independent companies that have developed an
expertise in one aspect of lending, such as lease financing (see Chapter 10).
Examples of finance companies that operate in Australia include:
•
ESANDA: owned by the Australia and New Zealand Banking Group; a leading provider of vehicle
and equipment finance solutions and fixed-interest investments.
•
MyFord Finance: owned by Ford Motor Company; mainly provides financing for products of the
parent company.
•
RACV Finance Limited: a vehicle roadside service organisation that has diversified into the
provision of financial products.
A full list of registered financial corporations operating in Australia may be found at www.apra.gov.au.
REFLECTION POINTS
•
•
•
These institutions borrow funds in the local and international money and capital markets and
use those funds to provide loans and lease financing mainly to individuals and small and
medium-sized businesses.
The finance company sector has contracted as commercial banks have become more
competitive in the deregulated environment.
A number of finance companies specialise in niche areas of the market, such as motor vehicle
financing and lease financing.
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3.10
Building societies
Building societies are an example of a niche financial institution that evolved to meet a specific market
need during the period of heavy regulation of commercial banks. This type of institution is not found
in all countries; rather, it is found in certain countries where there is a large demand for finance to buy
residential property and the demand is not able to be fully met by the banking sector.
The main activities of building societies are to accept deposits from individuals and to provide
mortgage finance primarily for owner-occupied housing; that is, building societies gather in savings
from their depositors and provide loans to their customers to purchase residential property.
In Australia as at December 2017, the building society sector held $12.1 billion in balance-sheet assets.
Over 80.00 per cent of liabilities required to fund the balance sheet came from deposits from customers.
Residential lending represented 73.00 per cent of total assets. However, since 2007 there has been a significant
decline in the number of building societies operating in Australia (from 14 to 4). This is due to consolidation
within the sector and the fact that many building societies have re-branded themselves as mutual banks.
It is interesting to consider the changes that have occurred in the building society sector in Australia,
as it demonstrates the direct impact of changing regulation on the structure of the financial system.
Originally, the growth of building societies resulted from portfolio and interest rate restrictions
imposed by the Reserve Bank on the activities of savings (commercial) banks, which were the major
providers of residential mortgage finance. Building societies were not regulated by the Reserve Bank and
were able to offer—and charge—more market-related interest rates than could the commercial banks. The
market rates paid on deposits by the building societies increased their liability base, thus providing more
available funds for mortgage lending. With the progressive deregulation of product and interest rate
controls over the banks, building societies came under greater competitive pressure and lost substantial
market share. Their responses to the increased competition from the banks include the following:
•
•
•
LEARNING
OBJECTIVE
3.8
Outline the roles and
relative importance
of building societies
and credit unions, and
analyse the significant
changes that have
occurred in these
sectors.
Building societies
authorised deposittaking institutions that
primarily give loans
to customers to buy
residential property
Smaller building societies merged with a view to rationalising administrative and other costs.
Improved technology was adopted with the aim of reducing costs and improving services to customers.
Diversifying the products and services offered to members, such as an increase in lending to small
businesses, credit card facilities and personal term loans.
•
The most important response of many building societies was to seek regulatory approval and become
a commercial bank. This final response has had a significant impact on the building society sector
and is largely responsible for the overall decline in total assets of the sector. The largest building
societies progressively converted to banks, and now form a large proportion of the regional bank
sector in Australia. A number of other building societies that converted to banks have subsequently
been taken over by larger commercial banks.
Building societies are authorised deposit-taking institutions (ADI) and as such are regulated and
supervised by APRA. Essentially, APRA applies the same prudential and reporting standards to the
building societies as to the commercial banks. These requirements were discussed in Chapter 2—in
particular, the capital adequacy and liquidity management requirements.
REFLECTION POINTS
•
•
•
Building societies accept deposits from customers and provide personal finance to individual
borrowers, particularly housing finance, but also term loans and credit card finance.
In Australia, the building society sector contracted significantly as the banking sector
was deregulated. Many building societies merged and eventually converted into commercial
banks.
Building societies are authorised deposit-taking institutions that are regulated by APRA.
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3.11
LEARNING
OBJECTIVE
3.8
Outline the roles and
relative importance
of building societies
and credit unions, and
analyse the significant
changes that have
occurred in these
sectors.
Credit unions
authorised deposittaking institutions that
accept retail deposits
and provide loans to
members
Common bond of
association
members are drawn
together from a
common background
of work, industry or
community
Credit unions
Credit unions provide deposit and loan products for their members. The strength of credit unions
derives mainly from a common bond of association of its members. The common bond of association
may be based in employment, industry or the community. For example, the Shell Employees’ Credit
Union is an employer-based credit union; the Maroondah Credit Union is a community-based credit
union; and the Industries Mutual Credit Union is an industry-based institution.
Credit unions obtain the majority of their funds from deposits lodged by their members. To a
limited extent, they supplement their deposit base by borrowing from other credit unions, or issuing
promissory notes and other securities into the financial markets. Many credit unions are able to attract
deposits inexpensively through automatic customer payroll deductions. This is an arrangement whereby
an employee authorises an employer to forward part of their salary each pay day to an account held
with a nominated credit union.
On the asset side of their balance sheets, credit unions provide loans to members for residential
housing, personal term loans, credit card facilities and limited commercial lending to small businesses.
Another attraction offered to members is an automatic bill payment facility against the member’s credit
balance.
The credit union sector in Australia has more than $38 billion in assets (December 2017). Like
building societies, the 10 years up to 2017 saw a significant decline in the number of credit unions
operating in Australia. This was due to consolidation in the sector and to the re-branding of credit
unions as banks. In 2007, there were 141 credit unions in Australia. At the end of 2017, there were 54.
Over the same period, the number of domestic banks in Australia increased from 9 to 28.
Credit cooperatives are authorised deposit-taking institutions and as such are regulated and
supervised by APRA. The regulator applies the same prudential and reporting standards to credit unions
as to banks and building societies. These requirements were discussed in Chapter 2—in particular, the
capital adequacy and liquidity management requirements.
REFLECTION POINTS
•
•
•
LEARNING
OBJECTIVE
3.9
Describe the unique
role of export finance
corporations.
Export finance
corporations
government authorities
that provide finance
and insurance support
and services to
exporters
Credit unions accept deposits from their members and provide loans to those members, including
housing loans, term loans and credit card finance.
Members of a credit union tend to have a common bond of association. This may be based
on the members’ employer, the industry in which they work or the community in which
they live.
In Australia, credit unions are authorised deposit-taking institutions and are regulated
by APRA.
3.12
Export finance corporations
Nation-states generally support economic growth by encouraging increased exports of goods and
services. Many countries have therefore established export finance corporations. These organisations
are government authorities that provide financial support and services to exporting corporations in a
nation-state.
In Australia, the official export credit agency is the Export Finance and Insurance Corporation
(EFIC). The role of EFIC is to facilitate and encourage Australian export trade through the provision
of trade insurance and other trade-related financial services and products. EFIC is constituted under
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the Export Finance and Insurance Corporation Act 1991 (Cwlth). Through its charter, EFIC encourages
Australian international trade by:
•
•
•
insuring Australian suppliers of goods and services against non-payment
guaranteeing trade finance for the purchase of Australian goods and services
insuring Australian firms that invest in enterprises overseas against the political risks associated
with such investments
•
lending directly to overseas borrowers in support of particular classes of capital goods and services
transactions
•
indemnifying financial transactions of insurers that provide bonds or guarantees to overseas buyers,
and providing performance bonds in support of Australian export contracts
•
insuring Australian suppliers of goods and services against the unfair calling of such bonds or
guarantees.
There is a continual demand for export credit. This is particularly true for the export of
capital and semi-capital goods, where the terms of payment and financing facilities can be just as
important as price. To be successful in international markets, exporters need access to payments
insurance, guarantees and bonding, and loan facilities that compete with those available to overseas
competitors.
Exporters wishing to compete successfully in overseas markets sometimes need to offer deferred
payment terms; however, this increases the risk exposure to non-payment. EFIC provides protection
against this risk. Where applicable, EFIC makes loans for export sales of capital equipment and
services at concessional rates of interest. An EFIC loan is usually made to the buyer or to its
financier in the buyer’s country. For government and public sector buyers in countries that are
recipients of Australian aid, mixed credits may be made available—that is, EFIC finance combined
with aid funds.
REFLECTION POINTS
•
•
•
Export finance corporations typically encourage export trade through the provision of trade
insurance and financial services and products to corporations.
Export finance corporations are often able to provide exporters with innovative trade finance
solutions that may not be available through other financial institutions.
In Australia, the official export credit agency is the Export Finance and Insurance Corporation
(EFIC).
CASE STUDY
THE HEDGE FUND SECTOR
In Chapter 3, we discussed different types of managed funds, among which are the famously secretive
hedge funds. The first hedge fund manager, Alfred Winslow Jones, started a business with $100 000
and began generating extraordinary profits through the 1950s and 1960s (Mallaby, 2010). Ever since,
the industry has captured interest and generated curiosity.
The annual rich list of top hedge fund earners published by Institutional Investors features four
hedge fund managers who made more than $1 billion in 2017, with other top hedge managers
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earning more than 65 times the median pay of CEOs from the top 100 US companies (Frank, 2018).
Investors are often mesmerised by these figures and take a plunge into the sector, relying on the
stature and profile of these managers, which are often enhanced by the complexities of hedge fund
strategies.
The role of regulators has always been crucial in determining the development of the industry.
The scant regulation was one of the main elements that paved the way for the development of
the industry.
According to industry estimates in 2008, the hedge fund industry’s assets under management had
grown to $2.5 trillion, actually performing well during the GFC. Regulatory bodies have moved to tighten
their hold over the sector due to fears that a collapsing fund may damage the entire financial system.
Frauds and Ponzi schemes that emerged after the GFC, such as the Madoff investment scandal in late
2008, prompted further regulatory attention (Cumming, 2010).
Apart from the regulatory changes, the acceptability of exchange-traded funds and index funds
proved detrimental to the hedge sector. In the words of Jack Bogle, investor and founder of Vanguard,
‘In hedge fund investments, people have been paying very high fees for poor performance, which
resulted in disenchantment, especially among institutional investors’. The dissatisfied customers
were lured into the Exchange Traded Fund (ETF) industry which offered better returns with lower fees
(Chris, 2017).
Despite the fact that the hedge fund sector is glorified by the large incomes earned by its most prominent
fund managers, the overall trend is not positive, with the withdrawal of major investors including major
pension funds such as Calpers. The legendary investor Warren Buffett, who has always been a strong
critic of hedge fund managers and their promises of outperforming the market, made a bet with the fund
manager Protégé Partners in 2007 that his S&P 500 index fund would beat a basket of hedge funds.
Buffett’s index fund earned 7.10 per cent per annum over 10 years, beating a return of 2.20 per cent
per annum earned by the basket of hedge funds, winning a million dollar bet (to be donated to charity)
in 2017 (Akin, 2018).
References:
Cumming, D & Dai, N 2010, ‘Hedge fund regulation and misreported returns: Hedge fund regulation
and misreported returns’, European Financial Management, 16(5), 829-857. doi:10.1111/j.1468036X.2010.00576.
Frank, R 2018, ‘These hedge fund managers made more than $3 million a day last year’, CNBC, https://
www.cnbc.com/2018/05/30/these-hedge-fund-managers-made-more-than-3-million-a-day-last-year.
html
Mallaby, S 2010, More money than God: Hedge funds and the making of the new elite, Bloomsbury, UK.
Newlands, C 2017, ‘Jack Bogle: ETFs have beaten hedge funds’, Financial Times, 4 March, https://www.
ft.com/content/68123fe6-ff68-11e6-96f8-3700c5664d30
Oyedele, A 2018, ‘Warren Buffett has won his $US1 million bet he made against the hedge fund
industry 10 years ago’, Business Insider Australia, 3 January, viewed 15 October 2018, https://
www.businessinsider.com.au/warren-buffett-wins-million-dollar-bet-against-hedge-funds-20181?r=US&IR=T
Discussion points
•
•
•
Highlight the reasons behind the success of hedge funds at the time of the sub-prime
mortgage crisis.
What are the aspects that necessitated strong regulatory involvement in the hedge fund
industry?
What are the factors that are causing a downturn for the hedge fund industry?
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LEARNING OBJECTIVE 3.1
Describe the roles of investment banks, with an emphasis on the nature of their off-balance-sheet
business, in particular mergers and acquisitions.
•
•
•
•
•
•
A wide range of non-bank financial institutions has evolved within the financial system in
response to changing market regulation and to meet particular needs of market participants.
Investment banks play an extremely important role in the provision of innovative products and
advisory services to corporations, high-net-worth individuals and government.
The structure of investment banks is characterised by a division of activities between front
office (trading, investment banking, investment management, research), middle office (risk
measurement, risk management) and back office (accounting, audit, compliance).
Investment banks raise funds in the capital markets, but are less inclined to provide intermediated
finance for their clients; rather, they advise their clients and assist them in obtaining funds
directly from the domestic and international money markets and capital markets.
Investment banks specialise in the provision of off-balance-sheet products and advisory
services, including operating as foreign exchange dealers, advising clients on how to raise
funds in the capital markets, acting as underwriters and assisting clients with the placement
of new equity and debt issues, advising clients on balance-sheet restructuring, evaluating and
advising on corporate mergers and acquisitions, identifying and advising on potential spin-offs,
advising clients on project finance and structured finance, providing risk management services
and advising clients on venture capital.
CHAPTER THREE REVIEW
Master before you move on
An investment bank may advise a corporation on all aspects of a merger and acquisition
proposal. This is a situation in which one company seeks to take over another company. The
merger may be friendly or hostile, and strategically may be a horizontal takeover, a vertical
takeover or a conglomerate takeover. The merger will seek to achieve synergy benefits, such
as economies of scale, finance advantages, competitive growth opportunities and business
diversification.
LEARNING OBJECTIVE 3.2
Explain the structure, roles and operation of managed funds and identify factors that have
influenced their rapid growth.
•
•
•
Managed funds are a significant and growing sector of the financial markets due, in part, to
deregulation, ageing populations, a more affluent population and more highly educated investors.
The main types of managed funds are cash management trusts, public unit trusts, superannuation
funds, statutory funds of life offices, common funds and friendly societies.
Managed funds may be categorised by their investment risk profile, being capital stable funds,
balanced growth funds or managed or capital growth funds.
LEARNING OBJECTIVE 3.3
Discuss the purpose and operation of cash management trusts and public unit trusts.
•
•
•
•
Cash management trusts are highly liquid funds that allow individual retail investors to access
the wholesale money markets.
Public unit trusts allow investors to purchase units in a trust that is controlled by a trustee under
the terms of a trust deed. The trustee (responsible entity) arranges for the pooled funds of the
trust to be invested by selected fund managers in specified asset classes.
Public unit trusts include property trusts, equity trusts, mortgage trusts and fixed-interest trusts.
Unit trusts may be listed on the stock exchange or they may be unlisted.
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LEARNING OBJECTIVE 3.4
Describe the nature and roles of superannuation funds, including the primary sources of
superannuation funds and the different types of fund.
•
•
•
•
•
•
•
•
Superannuation funds facilitate savings by individuals for their future retirement.
Types of superannuation funds include corporate funds, industry funds, public sector funds,
retail funds, small regulated funds and self-managed funds.
Sources of superannuation savings include employer contributions, employee contributions,
compulsory superannuation contributions, personal contributions and eligible rollover funds.
Many countries are experiencing a demographic shift to an ageing population.
Some countries have introduced compulsory superannuation schemes to ensure people fund at
least part of their own retirement.
In Australia, employers must contribute the equivalent of 9.50 per cent of an employee’s wage
into a superannuation account in the name of the employee. The superannuation funds receive
concessional taxation treatment.
A defined benefit scheme pays a superannuation amount on retirement based on a defined
formula, while a defined contribution fund pays the accumulated balance.
APRA is the prudential supervisor of most superannuation funds.
LEARNING OBJECTIVE 3.5
Define life insurance offices and general insurance offices, and explain the main types of
insurance policies offered by each type of insurer.
•
•
•
•
•
•
•
•
•
•
Life insurance offices are contractual savings institutions. They generate funds primarily from
the receipt of premiums paid for insurance policies written.
Life insurance offices are also major providers of superannuation savings products.
Whole-of-life insurance policies include an insurance risk component and an investment
component. The policy will accumulate a surrender value over time.
A term-life policy provides life insurance cover for a specified period. If the policyholder dies
during that period, a predetermined amount is paid to the named beneficiary.
Related insurance policies include total and permanent disablement insurance, trauma
insurance, income protection insurance and business overheads insurance.
The regulator of life insurance offices is APRA.
General insurance offices also generate funds from premiums paid on insurance policies.
General insurance policies include house and contents insurance.
Policyholders need to be aware of the co-insurance clause and the amount of public liability cover.
Motor vehicle insurance includes comprehensive, third-party fire and theft, third party only and
compulsory third-party insurance.
LEARNING OBJECTIVE 3.6
Discuss hedge funds, including their structure, investors, investment strategies and risk.
•
•
•
•
A hedge fund seeks to achieve above-average returns using sophisticated investment strategies
and exotic derivative investment products; as such, they are higher-risk investments.
Hedge funds are often highly leveraged by using borrowed funds or derivative products; they
invest in equities, foreign exchange, bonds, commodities and derivatives.
Single-manager funds, or fund of funds, may be managed by a high-profile individual or a
financial institution such as an investment bank.
Hedge fund investors may be institutional investors, high-net-worth individuals or retail investors.
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CHAPTER THREE REVIEW
LEARNING OBJECTIVE 3.7
Explain the principal functions of finance companies and general financiers, and the changes that
have had an impact on finance company business.
•
•
•
Finance companies provide loans to individuals and businesses, including lease finance, floor
plan financing and factoring.
Deregulation of commercial banks has resulted in a significant decline in finance companies.
Many finance companies are now operated by manufacturers, such as car companies, to finance
sales of their product.
LEARNING OBJECTIVE 3.8
Outline the roles and relative importance of building societies and credit unions, and analyse the
significant changes that have occurred in these sectors.
•
•
•
The majority of building society funds are deposits from customers. Residential housing is the
main form of lending.
Credit unions’ funds are sourced primarily from deposits of members. Housing loans, personal
loans and credit card finance are available to their members.
A defining characteristic of a credit union is the common bond of association of its members,
usually based on employment, industry or community.
LEARNING OBJECTIVE 3.9
Describe the unique role of export finance corporations.
•
•
Government agencies play an important role in providing financial services to the corporate
sector to support the export of goods and services.
The official Australian agency is the Export Finance and Insurance Corporation (EFIC), which
provides trade insurance and trade-related financial services and products.
Extended learning
LEARNING OBJECTIVE 3.10
Understand project finance and structured finance, and the related roles of investment banks.
Project finance and structured finance
Project finance
Project finance is an interesting and complex area of finance. Project finance supports economic
growth within a country in that it enables important developments and infrastructure projects to
proceed. Such projects include the building of power stations, toll roads and tunnels, the extraction
of minerals, heavy industry and processing plants, tourist resorts and casinos.
Investment banks have developed expertise in the provision of advisory services for their
corporate and government clients on the structuring and financing of major projects. The possible
finance and ownership structures and the range of risks associated with project finance are quite
extensive. This extended learning section will give you an understanding of the main features of
project finance and structured finance.
Project finance
financing large
projects where
loan repayments
are based on the
future cash flows
of the completed
project
Distinguishing features
The key difference between project finance and most other forms of lending is that, with project
finance, the lenders determine their participation primarily on the basis of the expected future cash
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Part 1 Financial institutions
flows and assets of the project. There is only a secondary reliance on the balance sheets and
financial positions of the project sponsors. Figure 3A.1 provides a simplified conceptual framework
that diagrammatically represents a basic project finance structure.
As indicated in Figure 3A.1, a corporation or syndicate of corporations that implements a project
is known as the project sponsor.
Figure 3A.1 Conceptual project finance structure
Comp
Sponsors
Equity
letion
guara
ntees
Dividends
Debt
Project company
Syndicate lenders
Loans repayments
Cash flows
Project
Project sponsors
the originators
and equity
providers of a
project
Contractors, suppliers, buyers
Project sponsors, as the project originators, take an equity position in the project. For example,
the sponsors may form a project company to build, own and operate the project. The sponsors
will inject equity into the project company by buying shares in the company. The remainder of
the funding for the project will come from loans provided by a syndicate of lenders. The debt will
eventually be repaid from the future cash flows that the completed project will generate.
Within the context of the simple structure in Figure 3A.1, a number of acronyms have evolved
which describe different structures that may be used in project finance. These include ‘build, own,
operate and transfer’ (BOOT) structures, ‘build, own and operate’ (BOO) structures and ‘build,
operate, lease and transfer’ (BOLT) structures.
A BOOT structure may be a project such as a toll road; a project company builds the road and
operates the toll road for a specified number of years, at which date the road is transferred back
to the government. A BOO structure may be used for a project such as a power station; the project
company builds the station and continues to operate the station for the productive life of the facility.
A BOLT structure will include capital leasing arrangements.
A number of projects are completed in partnerships between the public sector and the private
sector. These are referred to as ‘public-private partnership’ structures.
Characteristics that distinguish project financing from more traditional methods include the
following:
•
•
•
•
The project company is established as a separate legal entity, and it relies very heavily on
debt financing. Project financing generally provides up to 75.00 per cent of the total capital
requirements. The remainder of the funding consists of equity and subordinated debt contributed
by the project sponsors.
The debt of the project company is separate from the project sponsors’ other business obligations.
The lenders’ security is usually limited to the assets of the project company, and does not include
the assets of the project sponsors. However, sponsors generally provide various completion
and performance guarantees.
Commitments from related third parties are sought as credit support for the project. Support
may be in the form of specific performance guarantees. Third parties may include suppliers,
intending purchasers of the project’s output and government authorities.
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Chapter 3 Non-bank financial institutions
Project finance loans are generally for a considerably longer term than is usually available
through finance provided by banks and other intermediaries.
Debt is on a ‘limited recourse’ or ‘non-recourse’ basis.
The recourse provisions are important, because they specify the rights of the lenders from
project commencement up to the time when the project is built and begins to generate positive
cash flows. Under non-recourse lending, lenders are totally dependent on the project’s future cash
flows for interest payments and the eventual repayment of the debt. During the total life of the loan
the lenders have no recourse to other repayment sources, including the project’s sponsors. Nonrecourse lending is most unlikely to be provided by banks. In so far as it is available, it has been
from major corporate investors.
Where bank finance is involved, it is almost always limited recourse lending. While the particular
recourse arrangements vary widely, lenders typically have very tightly defined and restricted access
to the sponsors for loan repayments prior to project completion. Once the project is complete, the
lenders have recourse only to the project’s cash flows and assets.
Non-recourse
lending
the lender is
totally reliant on
future project
cash flows for
loan repayments
Limited recourse
lending
Completion is said to occur when construction is finished, the project is operational and
specified cash-flow levels are achieved. For example, with a toll road, completion is said to occur
when the road has been built, is open for public use and is generating a required level of revenue
from vehicle tolls.
lenders have
certain claims on
the assets of the
project sponsors if
project cash flows
fail to achieve
specified levels
Participants
Project
completion
Projects are typically very large and extend over many years before completion. Often they require
hundreds of millions of dollars in finance. Given their size, most project undertakings are jointly
owned and controlled. Some of the advantages of joint ownership include:
point at which a
project is built and
is generating a
prescribed level
of cash flows
•
•
•
The project development risk is shared between the joint owners. This is particularly important
where the sponsors have provided completion guarantees to the project lenders.
CHAPTER THREE REVIEW
•
•
Joint ventures between parties bring different sets of skills to the project. These include both
specialist operational skills and specialist financial skills.
The project size may well require a greater financial and managerial capability than can be
provided by a single sponsor. Greater sponsor expertise and commitment will encourage project
lenders.
In addition to the project sponsors, the investment banks are essential in that they will facilitate
syndicated loans, partly through bill acceptance facilities, term loans and overdraft facilities. More
importantly, the investment banks will assist the project company with the issue of debt securities
directly to the capital markets.
The size of a project will normally require a syndicate of lenders, whereby several financial
institutions form a syndicate to share the risk of providing project finance. The syndicate of banks will
use the standing of the banks in the financial markets to access funds in the domestic and international
capital markets. Syndicates are also able to raise loans in currencies that match the currencies that
will be earned once the project cash flows are positive. This minimises the foreign exchange (FX) risk
exposure of the project’s earnings. (Chapter 17 discusses FX risk exposure and its management.)
Where the development and operation of a project involves the leasing of assets, lessor
partnerships form another party to the project. The key suppliers of equipment to the project may
also be important providers of funds. Indeed, the availability and terms of funding associated with a
lease may determine the ultimate choice of equipment used for the project.
Project finance is a highly specialised task. Both financial and technical expertise is required by
the lending syndicate to assess the potential productive capacity of the project and the length of
the development period before a positive cash flow can be expected, and to establish appropriate
guarantees from other participating parties. In order to achieve this, the syndicate of investment
banks will bring together the specialist engineers, environmentalists, marketing consultants,
financial consultants, auditors, accountants, taxation experts and legal counsel necessary when
drafting the project ownership agreements and loan documentation.
Syndicated loan
the provision
of loan funds
by a group of
financiers for a
single project
Leasing
the borrowing
of an asset in
return for lease
payments, rather
than borrowing
the funds to
purchase the
asset
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Structured finance
Structured
finance
funding provided
for major
infrastructure
projects
Structured finance is the term applied by the market to complex infrastructure funding arrangements;
essentially, it is a specialist area of project finance. However, there are a number of characteristics
of structured finance that tend to differentiate it from other forms of project finance. These include:
•
•
•
•
•
Infrastructure provides the essential major connectors for economic capital and activity, such as
power, water and roads.
Infrastructure supports economic growth and activity within an economy; for example, railway
networks efficiently carry goods from suppliers to markets.
Facilities such as hospitals are maintained for the public good.
Infrastructure projects tend to represent natural monopolies (e.g. the reticulation of water).
The projects are capital intensive (e.g. the construction of a water storage dam or an electricity
generating plant).
In the past, governments have primarily been responsible for infrastructure development and
finance. However, in recent years a change in political ideology has seen an enormous increase in
private sector infrastructure developments. Factors that have influenced private sector infrastructure
finance include:
•
•
•
•
the current preference of governments to maintain budget surpluses, resulting in fiscal
constraints being imposed on the ability of governments to fund large infrastructure projects
the granting of tax concessions to qualified infrastructure projects in order to encourage private
sector investment
policy initiatives to create market competition within economic sectors that were previously
monopolised by government
the privatisation of existing government authorities and enterprises.
The above initiatives have encouraged new infrastructure projects, often referred to as
greenfield projects. Infrastructure projects often retain a monopoly position within the market, and
also retain very stable and predictable cash flows. For example, retail electricity users will continue
to buy similar quantities of electricity regardless of the supplier.
Embedded
options
specific
performance
guarantees
included in a
project contract
Consumer price
index
a measure of
changes in the
price of a basket
of goods and
services
Subordinated
junior debt
claims of these
security holders
are subordinated
after all other
creditors
Infrastructure projects may well incorporate embedded options; that is, government may
legislate or contract to provide various guarantees such as revenue streams, anti-competition
advantages and periods of monopolistic advantage. However, government may also restrict
commodity price rises for a specified period of time; for instance, product price rises may be limited
to movements in the consumer price index.
Project and structured financing incorporate equity and debt funding techniques. These were
introduced in Chapter 1 and will be discussed in greater detail in later chapters. Equity includes
ordinary shares and hybrids such as preference shares and convertible notes. Debt ranges from
bank overdrafts to commercial paper facilities, medium-term note issues and longer-term bond
issues. Debt contains different priority rankings, from senior debt to subordinated junior debt,
and incorporates different interest rate structures, such as fixed and variable rates, and repayment
structures. Debt may also be denominated in a number of major currencies. The role of the
investment bank is to advise on funding structures and participate in syndicated lending and
underwriting agreements.
Risks associated with project finance
For providers of debt finance, particular importance is attached to the project reaching the
completion stage. It is at that point that the limited recourse provisions expire, and both limited
recourse and non-recourse lenders become dependent on the project’s future income stream
for repayment of their loans. As a result, lenders must carefully assess the risks associated with
achieving project completion, and the subsequent risk that may adversely impact upon the project’s
income streams, such that they may not be sufficient to provide for the repayment of debt.
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Chapter 3 Non-bank financial institutions
For example, in the case of a resource development project, one of the risks that must be taken
into account is the amount of recoverable resources. Will they be sufficient to cover commitments
to the debt providers, particularly if resource prices fall? To cover themselves against this risk, debt
providers typically seek an assurance that the proven reserves that are accessible under current
technologies are well in excess of those necessary to meet the debt-servicing requirements. A 2:1
ratio of accessible reserves to necessary sales is not uncommon. In projects where the object is the
development of infrastructure, such as the development of electricity-generating facilities, usage
and revenue guarantees may be sought from the relevant government authorities.
Given the significance of completion, lenders will typically seek non-completion covenants from
the project sponsors. The forms of the covenants are varied and may include some of the following.
•
•
•
Guarantees from the sponsors that they will repurchase the debt, or convert it on specified terms
into obligations of the sponsoring corporations, if the completion conditions are not achieved.
Guarantees from the sponsors that they will provide the appropriate management expertise and
additional funding (including equity funding) to ensure that the completion conditions will be met.
Guarantees from the sponsors that they will meet any working capital shortfall during the
development phase.
The definition of completion is also of significance. From the lenders’ point of view, the preferred
definition of completion would include a benchmark for performance criteria. The performance
criteria may include the performance of the project at design specification standards for a specified
period following the physical completion of the project, or the attainment of a predetermined cash
flow or a minimum level of sales.
Non-completion
covenants
specific loan
conditions
enforceable
against project
sponsors if a
project is not
completed
CHAPTER THREE REVIEW
There are a host of risks that can be identified. Most of them are also relevant to the assessment of
the risk of a borrower seeking any loan. However, the risks are more critical in the case of project finance
because the project (the borrower) often has no other assets that can be secured by the lenders. As a
result, it is likely that, when quantifying the risks, the lenders will be more conservative in their calculations
than they would be if they were assessing the risk for the purposes of making a secured loan.
Working capital
finance required
by a firm to fund
its day-to-day
operations
In addition to these risks, the debt providers must also calculate the risks associated with the
management of the project beyond completion, the impact of future changes in the regulatory
environment and financial risks such as the impact of changes in interest rates and exchange rates.
The complexity and sophistication of project financing should now be evident. Managers of
corporations typically are not experienced in these aspects of finance and therefore seek the
expertise and advice of investment banks. Fees earned on a project by an investment bank may
run into millions of dollars.
Questions
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points that you raise in relation to each question.
1
The ‘middle office’ is a less glamorous part of an investment bank but serves some of the most
important functions. Discuss this statement. (LO 3.1)
2
A number of the advisory services investment banks provide for their corporate clients are
defined as off-balance-sheet business. One service is placing new issues with institutional
investors. Outline the nature of this service and explain why it might be sought after by large
corporations. (LO 3.1)
3
Hostile takeovers rose to prominence during the 1980s and remain a part of the mergers and
acquisitions landscape. Explain the rationale for a hostile takeover and discuss the roles that
investment banks may play in both ‘offence’ and ‘defence’. (LO 3.1)
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Part 1 Financial institutions
4
Typically, an investment bank will act on behalf of a company involved in a merger and acquisition.
What are the main areas to which the investment bank will draw the client’s attention? (LO 3.1)
5
Managed funds are often categorised by the type of investments purchased by the fund. These
include capital stable funds, balanced growth funds and managed capital growth funds. For
each of these funds, discuss the types of investments the fund might accumulate and explain
the purpose of the investment strategies. (LO 3.2)
6
Provide an overview of the changing nature of public unit trusts between 1995 and 2017. (LO 3.3)
7
Identify and discuss three classes of assets in which public unit trusts may invest funds. Extend
your discussion by distinguishing between listed and unlisted trusts. (LO 3.3)
8
Superannuation savings for retirement is a growth area and represents a significant proportion
of the assets accumulated in the financial system.
(a) Why has there been such growth in superannuation savings?
(b) Self-managed superannuation funds (SMSFs) are a popular choice among investors.
Outline the size of the SMSF sector relative to other parts of the superannuation industry
and list some reasons that may explain the popularity of SMSFs. (LO 3.4)
9
One of the functions of a life insurance office is the writing of life insurance policies for individuals.
(a) How does the life insurance office derive income from this function?
(b) Describe the basic characteristics of the two main types of life insurance policies.
(c)
Briefly describe one other type of related insurance policy that an individual may
purchase. (LO 3.5)
10 In recent years in Australia and in other parts of the world, households have suffered significant
damage to their property as a result of floods and storms. Many households found, to their
dismay, that their policies did not cover them for some types of damage. The clauses that are
embedded within insurance policies are of obvious importance. Outline the consequences that
may result from a combination of under-insuring property while overlooking the presence of a
co-insurance clause. (LO 3.5)
11 You have purchased a motor vehicle and been advised that you should consider insuring the vehicle.
You contact an insurance office and receive advice on three forms of cover that are available.
(a) Explain the three different levels of motor vehicle cover that you can choose from.
(b) If the vehicle that you purchased is valued at $45 000, which level of insurance might you
decide to take? Why? (LO 3.5)
12 A friend has suggested that you should consider investing in an equity hedge fund because the
fund may achieve returns higher than the share market.
(a) Describe how a hedge fund is structured, including the manager, investors and types of
investment.
(b) Explain how a hedge fund may use leverage strategies to achieve higher returns. Give an
example. (LO 3.6)
13 Because hedge funds are usually only accessible to high-net-worth individuals, hedge funds
should not be regulated. Discuss this statement. (LO 3.7)
14 Building societies are no longer as significant as they once were. What are some of the main
reasons for this decline? (LO 3.8)
Extended learning questions
15 Project finance is largely based on forecast future cash flows.
(a) Draw a diagram showing the flow of funds that occurs in a basic project finance structure.
Referring to your diagram, explain the nature of project financing, why this type of funding
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Chapter 3 Non-bank financial institutions
(b) A form of project finance is described as structured finance. Identify some of the factors
that have influenced the growth in structured finance. What are the characteristics of
structured finance that tend to differentiate it from other forms of project finance? (LO 3.10)
KEY TERMS
age pension 101
export finance corporations 116
public liability insurance 111
annuity 109
fixed-interest trust 100
back office 89
front office 89
public sector superannuation
fund 103
balanced growth fund 97
hedge funds 112
public unit trust 99
beneficiary 107
horizontal takeover 91
responsible entity 94
building societies 115
hostile takeover 92
risk component 108
business overheads
insurance 109
income protection
insurance 109
rollover fund 105
capital guaranteed fund 97
industry superannuation
fund 103
structured finance 124
cash management trust
(CMT) 98
investment component 108
superannuation 101
leasing 123
co-insurance clause 110
limited recourse lending 123
superannuation guarantee
charge (SGC) 103
common bond of
association 116
listed trust 100
syndicated loan 123
managed funds 94
term-life policy 108
comprehensive insurance 111
managed growth fund 97
compulsory third-party
insurance 111
merger and acquisition 91
third-party fire and theft
policy 111
middle office 89
third-party policy 111
mortgage trust 100
total and permanent
disablement insurance 109
capital stable fund 97
conglomerate takeover 92
consumer price index 124
corporate superannuation
fund 103
credit unions 116
defined benefit fund 105
defined contribution fund 105
eligible termination payment
(ETP) 105
mutual funds 94
non-completion covenants 125
non-recourse lending 123
policyholder 107
premium 107
project completion 123
project finance 121
embedded options 124
project sponsors 122
equity trust 99
property trusts 99
spin-off 91
CHAPTER THREE REVIEW
structure is established, the major participants and the guarantees that the lenders will
request from the project sponsors to support their loans.
subordinated junior debt 124
trauma insurance 109
trust deed 94
trust fund 94
underwriter 90
unlisted trust 100
vertical takeover 92
whole-of-life policy 108
working capital 125
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PART TWO
Equity markets
CHAPTER 4
The share market and the corporation
CHAPTER 5
Corporations issuing equity in the share market
CHAPTER 6
Investors in the share market
CHAPTER 7
Forecasting share price movements
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Equity markets
The prices of shares and other securities traded in the domestic and international share markets are always
changing and are, from time to time, quite volatile. The following have all raised public awareness of sharemarket price volatility: the great bull run of the mid-1980s, followed by the stock-market crash of October 1987;
the subsequent extended period of growth (particularly in technology stocks); the negative flow-on effects
of the Asian financial crisis from mid-1997; the collapse of the technology stock market; another period of
recovery and growth; the effect of the 11 September 2001 terrorist attacks in the USA, and the subsequent
strong recovery; the significant fall in share prices due to the initial global financial crisis (GFC) in 2007–08;
the extension of the GFC into a sovereign debt crisis that stretched well into 2011–12; and, finally, the monetary
stimulus-backed recovery in US stock prices to new record highs.
Nevertheless, investor participation in share-market investments has increased in many countries.
Important factors that have led to this increase include:
•
•
•
•
•
•
•
globalisation of the financial markets
a reduction in regulations restricting the flow of investment funds into the international markets
greater understanding of investment opportunities as a result of, among other things, higher education
levels and access to financial advice
an ageing population saving for retirement
increased savings levels, such as the implementation of compulsory superannuation savings in some
countries
the evolution of new risk management products and strategies, including the use of derivatives
privatisation of government enterprises; for example, in Australia a number of large government-owned
enterprises such as the Commonwealth Bank of Australia, Telstra Corporation and Qantas Airways have
been sold and their shares listed on the stock exchange. In 2014, privatisation once again emerged on the
political agenda with proposals to privatise Medibank Private and other state-owned assets.
The performance of the local and global share markets is reported daily in the press, on radio and in
television news broadcasts and specialised business programs. Some of the general features of the share
market and its role in the financial system were introduced in Part 1. The purpose of Part 2 is to examine the
share market in more detail.
While the fundamental purpose of a share market is the same worldwide, there may be operational
differences between countries. In order to study the share market, it is necessary at times to look specifically
at a modern and efficient market to focus on a particular issue. When this is necessary, the Australian share
market and the operation of the Australian Securities Exchange will be considered. If you need to find out
particular details relating to the stock exchange of another country, simply refer to its website, where you will
find a wealth of information.
The distinguishing feature of equity, in particular shares or stock, is that the provider of equity finance to
a business obtains a share in its ownership. This text focuses on the type of corporation known as a publicly
listed corporation, that is, a company whose shares are listed on a stock exchange. Private companies and
other business forms are not considered.
As a part-owner of a public corporation, the shareholder has the right to participate in the profits of
the business (should there be any) but receives no guaranteed income stream. Why then are individuals
and institutions prepared to provide equity funding? This issue is taken up in Chapter 4, which explores the
advantages that accrue to publicly listed companies or corporations.
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Chapter 4 examines the operation of a stock exchange as a primary market and as a secondary
market for securities issued through the exchange. In facilitating its primary market and secondary market
functions, a stock exchange enables the offering of a range of securities, including equity, interest rate
and hybrid or derivative products. Importantly, stock exchanges facilitate the flow of information that is
essential in an efficient marketplace. This flow of information is crucial to both investors and companies
issuing securities. Finally, in order to maintain integrity and fairness in the market, a stock exchange will
monitor the behaviour of market participants and also ensure compliance with the regulatory requirements
of the nation-state supervisor.
Following the general discussion of the share market and the corporation in Chapter 4, the remaining
chapters in Part 2 examine the equity markets, first from the point of view of companies seeking to raise
funds in the equity markets and, second, from the point of view of investors.
Chapter 5 explores the stock exchange rules that apply to a company seeking to be listed as a public
company on a stock exchange. The chapter also considers various forms of equity funding that may be
available to companies. A distinction is drawn between those companies that are raising equity through the
share market for the first time and those that have already issued shares and are issuing additional shares
to obtain more equity in order to expand the business. The latter group of companies has a wider range of
equity funding alternatives.
Chapter 6 examines companies listed on a stock exchange from a potential investor’s point of view.
It examines major indicators of the financial structures, risk and profitability of listed companies. The
chapter also analyses issues that affect the price of shares. Chapter 6 concludes with a discussion on sharemarket indices.
Chapter 7 discusses techniques employed by market analysts and fund managers in their selection of
particular shares for inclusion in an investment portfolio. The chapter examines the fundamental analysis
and technical analysis approaches that may be used in the share investment decision process. Within the
context of fundamental analysis, macro and micro factors are identified that will have an impact on share
values. Two technical analysis forecasting models are considered: moving-averages models and charting.
The chapter also provides a discussion on market efficiency and considers the implications for investors of
various tests of the efficiency of a share market.
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CHAPTER 4
The share market and
the corporation
CHAPTER OUTLINE
4.1
The nature of a corporation
4.2
The stock exchange
4.3
The primary market role of a stock exchange
4.4
The secondary market role of a stock exchange
4.5
The managed product and derivative product roles of a stock exchange
4.6
The interest rate market role of a stock exchange
4.7
The trading and settlement roles of a stock exchange
4.8
The information role of a stock exchange
4.9
The regulatory role of a stock exchange
4.10
The private equity market
Learning objectives
LO 4.1
Understand the structure of a corporation and identify advantages and disadvantages of being a
publicly listed corporation.
LO 4.2
Consider the origins and purpose of a stock exchange.
LO 4.3
Understand the primary market role of a stock exchange through which corporations raise new
funding.
LO 4.4
Discuss the secondary market role of a stock exchange through which existing securities are
bought and sold.
LO 4.5
Examine the managed product (exchange traded funds, contracts for difference, real estate
investment trusts and infrastructure funds) and derivative product (options, warrants and futures
contracts) roles of a stock exchange.
LO 4.6
Examine the interest rate market role of a stock exchange.
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Chapter 4 The share market and the corporation
LO 4.7
Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for sharemarket transactions by the Australian Securities Exchange (ASX).
LO 4.8
Recognise the importance of information flows to the efficiency and integrity of stock exchanges.
LO 4.9
Identify the principal regulators that affect the behaviour of participants in the Australian share
market.
LO 4.10
Explain the structure and purpose of the private equity market.
CHAPTER SNAPSHOT
The equity markets represent one of the main hunting grounds for institutions such
superannuation funds, investment banks and hedge funds. With more than $1.5 trillion of
equity capital on the Australian Securities Exchange (ASX) alone, these institutions find both
trading and financial services provision opportunities in abundance. The ASX oversees and
provides the framework for the almost continuous auction that takes place in determining the
market price for securities such as shares in companies and units in managed funds and real
estate investment trusts.
INTRODUCTION
A stock exchange is a place where a range of listed financial assets is bought and sold. The share market
refers to that part of a stock exchange where companies are listed on the exchange and are known as public
corporations. The shares of listed public corporations are issued and traded through the share market.
The financial systems of countries with developed economies will include at least one stock
exchange on which public corporations list their ordinary shares, or common stock, plus other securities
such as preference shares, some debt securities and derivative products. The best-known stock exchange
is probably the New York Stock Exchange (NYSE). Another exchange in the USA, the NASDAQ,
lists mainly technology stocks. In Australia, the principal stock exchange is the Australian Securities
Exchange (ASX).
A publicly listed corporation is a legal entity formed under the provisions of the corporations
legislation of a nation-state and listed on a formal stock exchange. Listing on a stock exchange requires
the corporation to comply with the rules of that exchange as well as the Corporations Act 2001.
A corporation usually lists its shares on the exchange of its home country, although some large
multinational corporations may choose to list on their home exchange and an international stock
exchange such as the London Stock Exchange and/or the NYSE. Dual listing is discussed further
in Chapter 5.
The main class of financial asset quoted and traded on a stock exchange is the ordinary share, or
common stock. In some countries, such as the USA, it is the convention to use the term ‘common
stock’, while in other countries, such as Australia, the term ‘ordinary share’ is used. Both terms refer to
the main type of equity issued by a publicly listed company.
A share represents a financial claim to a fraction of the assets of the corporation given by the
accounting equation Equity = Assets − Liabilities; that is, a shareholder may benefit from the net
profits of the organisation after all other claims have been paid as this represents the increase in the
value of equity. The fractional benefit will relate to the number of shares that the shareholder has
purchased in the company. Other claims include those of employees (wages and salaries), debt holders
(interest and principal), suppliers of business inputs (cost of goods and services used) and taxes.
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Part 2 Equity markets
Corporation
a legal entity formed
under corporations
legislation; main source
of equity is ordinary
shares
Shares have an additional dimension that distinguishes them from other financial claims. As equity,
they represent a share in the ownership of the corporation, and provide the shareholder with a right
to vote in the affairs of the corporation. In particular, a shareholder has the right to vote for the board
of directors of the company. The shareholder can also vote on resolutions put to a general meeting
of the company. The relationships between the rights of shareholders, the board of directors and the
managers of a company give some insight into the nature of a corporation.
REFLECTION POINTS
•
A stock exchange is a formal market within a nation-state that lists a range of securities issued
by publicly listed corporations; the largest component of a stock exchange is its share market.
•
•
•
Publicly listed
corporation
a company whose
shares are listed and
quoted on a stock
exchange
A publicly listed corporation is a company whose shares are listed on a stock exchange.
The ordinary share, or common stock, is the main type of equity security issued by a corporation.
A share is a financial asset; that is, a security that entitles a shareholder to share in the net
profits of the company and to vote for the board of directors, and any resolutions put by the
board to shareholders at general meetings.
4.1
LEARNING
OBJECTIVE
4.1
Understand the
structure of a
corporation and
identify advantages
and disadvantages of
being a publicly listed
corporation.
A corporation is a company that is a legal entity established under the corporations legislation of a
nation-state. The shares of a publicly listed corporation are listed on a stock exchange and the main
source of equity funding, the ordinary share, is quoted in the share market. There are a number of
features that distinguish a corporation.
•
•
Objectives and
policies
what a company
intends to achieve
and how that will be
achieved
Board of directors
elected by
shareholders;
determine the
objectives and policies
of the corporation
Limited liability
company
the claims of creditors
against shareholders
are limited to the issue
price of their fully
paid shares
•
Ownership is generally widely dispersed among a large number of shareholders and shares issued
by a company can be readily bought and sold in the share market without directly affecting the
continuing existence of the business.
Shareholders, as owners of a company, do not have a right to participate directly in the ­day-to-day
operation and management of the business. The objectives and policies of a corporation are
determined by a board of directors, the members of which are elected at a general meeting of
shareholders. Directors have a legal responsibility to ensure that the corporation operates in the
best interests of the shareholders. The board of directors appoints an executive management group
that is responsible for achieving the specified objectives and policies of the organisation through
the management of the day-to-day financial and operational affairs of the company. Executive
management is responsible to the board of directors. The board of directors reports to shareholders.
The liability of shareholders for the debts of the business is limited. If a sole proprietorship, a
partnership or an unlimited company fails to meet its obligations to creditors, the creditors have a legal
right to take possession of the personal assets of the owners in order to recover any amount owing. The
rights of creditors against shareholders in a publicly listed company (i.e. a limited liability company or
a no liability company) are significantly less. These are defined more fully in Chapter 5, but, by way of
summary, in the event that a publicly listed company is liquidated, the following applies:
—
The liability of shareholders in a limited liability company is limited to the issue price of the
share. Providing the shareholder has paid the full issue price of the share (i.e. there is no
uncalled amount due on the share), the shareholder cannot be required to make any further
payment to the company or its creditors.
—
With a no liability company, where the shareholder has purchased partly paid shares, there is no
legal requirement for the shareholder to meet a future call for payment of any unpaid amount;
however, in that event the shareholder would forfeit their partly paid shares in the company.
No liability company
shareholders may
decide not to pay
calls on partly paid
shares, but will forfeit
such shares
The nature of a corporation
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Chapter 4 The share market and the corporation
4.1.1
Advantages of the corporate form of
business organisation
A publicly listed corporation has important advantages over other forms of business organisation. They
include the following:
•
•
•
•
•
•
Large amounts of equity funding can normally be obtained more easily, through access to a wide
pool of investors in the market. These investors are willing to purchase shares because the stock
exchange provides an active secondary market for the sale of those shares. It is said that the share
market is normally deep and liquid; that is, there are usually buyers willing to purchase shares at the
current market price.
Shareholders can reduce the risks of share ownership by holding a diversified portfolio of share
investments. The ability of shareholders to spread risk through diversification, and also readily to
transfer ownership by buying and selling share holdings in a deep and liquid market, reduces risk
and therefore enables listed corporations to raise capital on more favourable terms.
Share market
a formal exchange that
facilitates the issue,
buying and selling of
equity securities
The separation of ownership (shareholders) and control (managers) of a business means that
the corporation can appoint specialised and skilled personnel to run the business. For example,
a business may employ personnel with specialist skills in manufacturing, engineering, marketing,
accounting, risk management and taxation. The same option is often not available to a sole
proprietorship or a partnership, where the owners are also the managers.
The corporation as a legal entity allows for the continuation of the business. A change in shareholders,
that is, the ability to trade a corporation’s shares, enables ownership to change without significant
disruption to the firm’s day-to-day operations. The corporation has the potential to exist indefinitely.
This legal right is known as the right of perpetual succession.
The corporate form is almost essential for large-scale undertakings. Generally, only publicly listed
corporations, with a credit rating, have access to the wider range of equity and debt sources of funds
that are available in the capital markets. Listed corporations attract investors from both the local
and international markets.
Right of perpetual
succession
a corporation continues
to operate regardless of
changes in ownership
The separation of ownership and control allows a corporation to plan and implement strategic
decisions more effectively over both short-term and longer-term planning periods.
4.1.2
Disadvantages of the corporate form of
business organisation
The above advantages available to the corporation are clearly significant and explain why the majority
of large business organisations become publicly listed corporations. However, there are some potential
disadvantages that cannot be ignored.
The main problem that may be associated with a publicly listed company relates to the separation
of ownership and control. This may seem strange, since separation has also been identified as an
advantage of the corporate form. It is, however, possible for separation to be both an advantage and a
disadvantage.
Since the managers who control the day-to-day operation of the business do not own the company,
they will not necessarily have a strong incentive to act in the best interests of the shareholders. Managers
may be tempted to run the business for their own personal benefit rather than for the benefit of the
shareholders. This conflict of interest between owners (principals) and managers (agents) is known as
the agency problem.
In theory, an efficient share market should minimise the concern about conflicts between
the interests of owners and the interests of managers. Owners can express their satisfaction, or
Agency problem
the conflict of interest
that may exist between
shareholders and
management of a
corporation
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Part 2 Equity markets
Share options
the remuneration of a
manager may include
an option to purchase
shares in the company
at a specified price
Corporate
governance
policy and practice that
define the relationship
between shareholders,
the board and
management
dissatisfaction, with the performance of management through the purchase or sale of shares.
When management pursues a course that is not in the interests of the owners, it is argued that
shareholders will eventually begin to sell their shares and the share price will fall. If share prices in
similar firms are not falling, the share market will be signalling that the corporation’s owners are
not satisfied with management’s performance. This is clearly not in the interests of the managers,
since such a public judgment lowers the managers’ reputations and reduces their employability
elsewhere. Should the share price fall sufficiently, another corporation may buy the lower-priced
shares and assume control of the company. The threat of takeover and the consequent loss of
control by the current management group should serve to discipline managers and encourage them
to act in a manner consistent with maximising shareholder value. However, it may be argued that
managers are mobile and may implement a short-term maximisation strategy knowing that they will
move to another more lucrative job before the adverse impact of their current strategies becomes
evident.
One typical strategy used by many corporations in an attempt to align the interests of shareholders
with those of management is to incorporate performance incentives such as share options in the
management compensation package. A share option scheme may allow managers to obtain the right to
buy shares in the company at a discounted price. Managers with share options have a strong incentive
to manage the company so that the share price increases, thereby increasing the value of their share
options as well.
Recent history demonstrates that the agency problem still exists in corporations. In order to deal
with this problem, boards of directors, and regulators, have moved towards more rigorous corporate
governance requirements. Corporate governance relates to the relationships between the shareholders,
the board of directors and management. A company must implement corporate governance processes
that put policies and procedures in place to ensure that accountability and transparency become
an integral part of the corporate culture. Clear responsibility and reporting structures need to be
established to facilitate the long-term survival of the organisation and the maximisation of shareholder
value.
REFLECTION POINTS
•
•
•
•
•
•
•
Members of the board of directors of a corporation are elected by shareholders at a general
meeting.
The board determines the objectives and policies of the firm, and appoints executive managers,
who are responsible for managing the day-to-day business operations and for reporting back to
the board.
With a limited liability company, the liability of a shareholder is limited to the fully paid issue
price of the shares.
With a no liability company, a shareholder holding any partly paid shares cannot be forced to
make further payment, but may instead forfeit the shares.
Advantages of the corporate form of business include access to a large pool of equity funds
through the stock market, the separation of ownership (shareholders) and control (managers),
the continuity of business operations, the ability to conduct large-scale operations and the
opportunity for investors to hold a diversified share portfolio.
A potential disadvantage of the corporate form is the agency problem, whereby managers may
try to run the business for their own benefit rather than for the shareholders’ benefit.
The board of directors should establish strong corporate governance practices to ensure
accountability and transparency.
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Chapter 4 The share market and the corporation
4.2
The stock exchange
The origins of the modern stock exchange can be traced back to as long ago as 1553 with the
establishment in England of the Muscovy Company. The company was established to find the north-east
trade route to China and the Orient. The venture was a ‘joint stock’ company. A number of merchants
and suppliers of capital became part-owners of the venture, and jointly shared the risks and the returns
of the venture. Another feature which shares in the Muscovy Company had in common with the shares
of today was that they were freely transferable.
By the end of the seventeenth century there was substantial dealing in the shares of about 140 joint
stock companies in London. The merchants who owned shares (or their agents) met in the coffee houses
of London to carry out their transactions. These coffee-house markets gradually evolved into formal stock
exchanges, as rules were developed to govern share transactions and the behaviour of businesses seeking
to raise funds through the sale of shares. Indeed, the London Stock Exchange, believed to be the world’s
first stock exchange, was opened in 1700 in Jonathon’s Coffee House near Change Alley in London.
Today, stock exchanges compete within an international market that is characterised by the rapid
and continuous flow of information to the markets within a regulatory environment that allows capital
to move almost instantaneously around the world.
In a globalised market, the principal functions of a modern and efficient stock exchange are:
•
•
•
•
•
LEARNING
OBJECTIVE
4.2
Consider the origins
and purpose of a stock
exchange.
establishment of markets in a range of financial securities
provision of a securities trading system
operation of a clearing and settlements system
regulation and monitoring of the integrity of the exchange’s markets
provision of a well-informed market, to secure the confidence of all participants.
The remainder of this chapter will consider the role of a modern and efficient stock exchange. We
will focus on the primary market role, the secondary market role, the managed products and derivative
products roles, the interest rate market role, the trading and settlements role, the information role and
the regulatory role of a stock exchange.
Where necessary, we will refer to the operations of the ASX, as it is regarded internationally as a
modern and efficient stock exchange. The ASX is the principal stock exchange in Australia. The ASX,
until 2016, held a monopoly position when the Australian government legislated to allow competition
in the Australian market. To date, two exchanges are operating in competition with the ASX. These are
the National Stock Exchange of Australia (NSX) and Chi-X Australia.
It is common practice in the markets to use the terms share market, stock market and stock exchange
interchangeably. Market participants refer to the main equity security issued by listed corporations as
shares or stock, hence the use of the terms share market and stock market.
A deep and liquid share market is important to a corporation. The development of the stock
exchange was necessary to facilitate the formation of the publicly listed corporation and the creation
of a deep and liquid share market. Stock exchanges have facilitated the rise in the importance of the
corporation as the dominant business form in developed economies. The stock exchange provides the
primary market through which new share capital is issued by a listed corporation, and also provides the
market structure through which the ownership of existing shares can be bought and sold by investors.
While the principal security quoted on a stock exchange is an equity instrument, other securities
are also quoted. These are typically government bonds, corporate bonds and hybrid securities. A further
role of a stock exchange is the provision of derivative products that enable investors to (1) purchase
equity-based securities rather than purchasing ordinary shares directly, (2) manage risk exposures
associated with their investment portfolios or (3) synthetically restructure or leverage their portfolios.
A principal determinant of an efficient market is the speed at which new information flows to the
market, and the speed at which that information is absorbed and then reflected in share prices. A stock
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Part 2 Equity markets
exchange facilitates this rapid flow of information to all market participants. Other determinants of
an efficient market are the securities trading system and the transaction settlement system, that is,
the procedures for buying and selling shares, and the transfer of ownership and funds associated with
those transactions. The final role addressed in this chapter is the regulatory role of an exchange. Market
confidence in the integrity of the share market is essential and must be maintained. The stock exchange
plays a very important role in prescribing and monitoring the activities of market participants.
REFLECTION POINTS
Primary market
the issue of new
financial securities such
as ordinary shares
World Federation of
Exchanges
trade association
representing 64
publicly regulated
stock, futures and
options exchanges
•
•
•
•
•
The origin of stock exchanges dates back to 1553 in England.
Today, stock exchanges compete within the international markets, where there are continuous
flows of information.
A stock exchange facilitates the listing of corporations and price quotations, for the buying and
selling of listed securities.
An exchange operates a securities trading system and a transaction settlement system.
Stock exchanges, and regulators, seek to maintain the efficiency and integrity of the market.
4.3
LEARNING
OBJECTIVE
4.3
Understand the primary
market role of a stock
exchange through
which corporations
raise new funding.
New float or initial
public offering (IPO)
the initial listing of
the securities of a
corporation on a stock
exchange
Rights issue
the issue of additional
shares to existing
shareholders on a prorata basis
The primary market role of a stock exchange
The primary market role of a stock exchange is to ensure the efficient and orderly sale of new-issue
securities, and includes all of the support facilities that are required to enable this to happen. Although
the focus of Part 2 is on equity markets and equity securities, major stock exchanges also list fixedinterest debt instruments and units in listed trusts. The fixed-interest debt securities may be Treasury
bonds issued by government or corporate bonds, such as debentures issued by corporations. Units
in a public unit trust are issued by the trustee and are quoted and traded on the stock exchange.
(See Chapter 3 for a discussion of unit trusts.) Also, a stock exchange may list a range of derivative
products (Section 4.5).
Table 4.1 provides data on the number of listed companies, new listings, market capitalisation, new
capital issues, the level of the S&P/ASX200 index and the World Federation of Exchanges ranking for
the principal stock exchange in Australia, the Australian Securities Exchange (ASX).
Table 4.1 The ASX market statistics as at 8 May 2018
Number of listed companies
2 279
Domestic market capitalisation
$1.9 trillion
World Federation of Exchanges ranking
16th
SOURCE: ASX Limited, ASIC, 2018.
Placement
additional ordinary
shares are sold by a
corporation to selected
institutional investors
Dividend
reinvestment scheme
allows shareholders
to reinvest dividends
by buying additional
shares in the company
In May 2018, there were 2 279 companies listed on the ASX. The market capitalisation of the
share market—that is, the current value of shares issued—was $1.9 trillion, with 60 new listings since
January 2017. New companies listed on a stock exchange are referred to as a new float or an initial
public offering (IPO); almost $3 billion in initial capital was raised in the first four months of 2018.
Equity capital issued included ordinary shares issued with IPOs, rights issues, placements and
dividend reinvestment schemes. A rights issue is the issue of additional shares to existing shareholders
on a pro-rata basis of, say, one additional share for every five shares held. Placements are the issue of
new shares to selected institutional investors such as fund managers. Dividend reinvestment schemes
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Chapter 4 The share market and the corporation
give shareholders the opportunity to reinvest dividend receipts back into the company by buying
additional shares in the company. Rights issues, placements and dividend reinvestment schemes are
discussed in Chapter 5.
The main participants involved in the primary issue of equity securities are illustrated in Figure 4.1.
In a central position in the figure are corporations, which receive the proceeds from the issue of new
equity. The stock exchange is the institutional structure that facilitates the listing of the shares. With an
offer to issue new shares to the public, the application form must be attached to the issue prospectus.
Prospectus
document prepared by
a company stating the
terms and conditions of
an issue of securities to
the public
Figure 4.1 Participants in a primary market issue of shares
Advisers
Underwriters
Sub-underwriters
Corporations
Purchase
unsold shares
Stock exchange
Brokers
Flow of ownership rights
Flow of funds
Individuals
Institutions
Rest of world
Key
Flow of ownership rights
Flow of funds
Investors in new-issue shares can be individuals, institutional investors such as insurance companies,
superannuation funds, unit trust funds managers, other corporations and overseas investors. Other
groups, such as investment banks, involved in the primary issue of shares are the advisers to the
corporation, and the underwriters and sub-underwriters of the share-selling program. The roles of these
groups are discussed in Chapter 5.
REFLECTION POINTS
•
•
The primary market role of a stock exchange relates to the issue of new securities by listed
corporations or other entities.
The listing of a new company is known as a float or an initial public offering (IPO).
continued
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Part 2 Equity markets
continued
•
•
•
•
•
•
•
The main form of equity issued by a corporation is the ordinary share (common stock).
Primary market issues of ordinary shares raise equity capital for corporations. Equity capital is
typically used to enable a firm to grow.
Shareholders may receive dividends and/or capital gains (or losses).
Existing corporations may issue additional equity through rights issues, placements and
dividend reinvestment schemes.
A stock exchange may also list debt instruments, units in public trusts and derivative products.
An issue of equity or debt to the public requires the preparation of a prospectus.
2 279 companies were listed on the ASX as at May 2018. The ASX was ranked 16th globally
by the World Federation of Exchanges.
4.4
LEARNING
OBJECTIVE
4.4
Discuss the secondary
market role of a stock
exchange through
which existing
securities are bought
and sold.
The secondary market role of a
stock exchange
Secondary market transactions in a stock exchange involve the buying and selling of existing financial
securities, principally ordinary shares. The participants associated with secondary market transactions
in existing shares are shown in Figure 4.2. We noted in Figure 4.1 that ownership of shares flows to
individuals, institutions and the rest of the world. If any of these shareholders decide to sell their shares,
they will carry out a secondary market transaction.
Figure 4.2 Participants in a secondary market share transaction
Individuals
Individuals
Transfer of ownership
Institutions
Brokers
Stock
exchange
Brokers
Institutions
Transfer of funds
Rest of world
Sellers of existing shares
Rest of world
Buyers of existing shares
As indicated in Figure 4.2, a shareholder will normally issue a sell order to a stockbroker. The
stockbroker will enter the order into the stock exchange securities trading system. Another broker will
have entered a buy order on behalf of another client. The stock exchange securities trading system will
match the orders and facilitate the sale of the shares, transfer of ownership and payment for the purchase.
It is important to recognise that the corporation whose shares are being traded does not feature in the
flow of funds. Secondary market transactions have no direct impact on the cash flows of the corporation.
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The corporation receives the proceeds of the primary market issue, but the flow of funds associated with
the secondary market trade in existing shares is between the buyer and the seller of the shares; that is,
in the secondary market there is a transfer of ownership and a settlement of value for that transfer.
This does not mean that the price behaviour of the corporation’s shares in the secondary market,
and the secondary market itself, are of no consequence to the corporation. The existence of a welldeveloped secondary market is of great significance to a corporation that may be seeking to raise new
equity finance in the future. The relationship between the primary and secondary markets is extremely
important. Corporations normally seek to raise additional equity in order to expand the business. Equity
funding and therefore economic growth come from companies raising funds in the primary market.
The existence of an active, liquid and well-organised secondary market in existing shares encourages
investors to buy new shares issued in the primary markets.
In Part 1 it was argued that savers can be assumed to have a preference for more, rather than less,
liquidity in the various forms in which their savings may be invested. Liquidity in the share market
means that participants can buy and sell shares without unduly disturbing current market prices of
the shares that are being traded. The standard measure of market liquidity is the ratio of the value of
turnover to market capitalisation, where market capitalisation is calculated by multiplying the number
of shares on issue by the current market prices.
The depth and liquidity of a share market are important to investors and corporations alike.
Corporations are able to raise equity at a lower cost and investors are able actively to manage and
lower their risk exposures. Stock exchanges in many countries have entered into memorandums of
understanding and established reciprocal arrangements with international stock exchanges in order to
increase their market liquidity. For example, there is a longstanding arrangement between the Singapore
Exchange (SGX) and the ASX.
Market liquidity
the ratio of the value
of share turnover to
market capitalisation
Market capitalisation
the number of shares
issued by listed
corporations multiplied
by current share prices
REFLECTION POINTS
•
•
•
•
•
The secondary market role provides a market structure for the buying and selling of existing
listed securities.
Buy and sell orders are lodged through a stockbroker that has access to the exchange’s trading
and settlement platforms.
Secondary market transactions do not raise additional equity for the original issuing
corporation—they are a transfer of ownership for value.
Market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market
encourages investors.
Market capitalisation is the number of issued shares multiplied by the share price.
4.5
The managed product and derivative
product roles of a stock exchange
In support of their primary and secondary market roles relating to the issue of ordinary shares and
hybrid securities, stock exchanges may provide a market for the trade of specific equity-based managed
products and derivative products. These products derive their value from the value of an underlying
security or group of securities listed on a stock exchange. The underlying securities trade in the socalled physical market, being the stock exchange.
Equity-based managed products provide investors with the opportunity to gain a diversified
exposure to a market, or a market sector, through a single investment product rather than directly
purchasing all the individual securities represented in the basket of securities held in the managed
product. For example, an investor is able to buy an exchange traded fund (ETF) which is based on
20 major stocks listed on the ASX and representing the main sectors in the Australian equity market.
Derivative
a risk management
product that derives
its value from an
underlying commodity
or instrument
Physical market
a market in which a
commodity or financial
instrument is issued or
traded
LEARNING
OBJECTIVE
4.5
Examine the managed
product (exchange
traded funds, contracts
for difference, real
estate investment
trusts and infrastructure
funds) and derivative
product (options,
warrants and futures
contracts) roles of a
stock exchange.
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Exchange traded
contracts
standardised financial
contract traded on a
formal exchange
Over-the-counter
contracts
non-standardised
contract negotiated
between a writer and
a buyer
Hedge
implement a strategy
that manages or
protects against an
identified risk exposure
Exchange traded
funds (ETFs)
units sold in a managed
investment scheme that
tracks the performance
of a specified stock
exchange index,
foreign currencies or
commodities
Exchange traded
products (ETPs)
group of products
that includes ETFs,
managed funds and
structured products
The value of the ETF is based on the value of the underlying shares held by the fund and the value
moves as the market value of the underlying shares moves.
In the case of an equity-related derivative product, the price of the derivative will be directly
correlated with the price of the corresponding equity security quoted on the stock exchange. For
example, on the ASX, an investor may buy an option contract (derivative) that provides the right to
purchase 100 Crown Resorts Limited shares at a certain price, on or by a predetermined date. The price
of the option will be based on the current price of Crown on the share market (physical market). The
value of the option contract will change over time as the price of the share changes on the share market.
The derivative products available through a stock exchange are described as exchange traded
contracts. The main feature of an exchange-traded contract is the standard terms and conditions of each
contract. For example, an exchange-traded contract is based on a standard product, for a fixed amount
and will mature on a predetermined date. Alternatively, over-the-counter contracts that are available
from other financial institutions and fund managers are not standardised across a market, and terms
and conditions are negotiated between the writer and the buyer of a contract.
It should be noted that the types of contracts traded, and the standard terms and conditions of
those contracts, will vary between stock exchanges in different countries.
Why do stock exchanges offer a range of managed products and derivative products? The managed
products allow investors to invest in asset classes that otherwise may be complex to manage or difficult to
access directly. For example, the exchange-traded contracts offered by the ASX give individual investors
the opportunity to access a broad range of international shares within a single product listed on the
exchange. Other products provide access to the real estate markets and the infrastructure markets.
Derivative products, in part, give investors the opportunity to manage, or hedge, a risk exposure in
their investment portfolio. For example, an investor might be exposed to the risk that share prices may
fall in the future. The investor might consider using a derivative product that gives the right to sell those
shares at a future date, but at a price that is set in the contract today. In entering into such a contract,
the investor has hedged, or managed, the risk that the share price will fall in the future.
Derivatives also enable an investor to synthetically restructure an investment portfolio, such as by
buying an option that gives the right to buy or sell a certain stock at a specified price at a predetermined
date. If at the exercise date in the future the investor still wishes to buy or sell the stock, the investor is
able to proceed at the known price.
The scope of managed products and derivative products quoted on an exchange is limited only
by the depth of the market, the sophistication of market participants, the regulatory environment and
competition. In this chapter, we briefly consider:
•
•
•
•
•
•
•
exchange traded funds
contracts for difference
real estate investment trusts
infrastructure funds
options
warrants
futures.
Derivative contracts are discussed in much more detail in Part 6.
4.5.1
E XCHANGE TRADED FUNDS
Exchange traded funds (ETFs) offered through a stock exchange such as the ASX generally invest in a basket
of securities listed on the ASX, securities listed on an international stock exchange, foreign currencies or
commodities. ETFs are part of a class of investments called exchange traded products (ETPs).
Typically, the ETF will be a registered managed investment scheme. Investors purchase units in an
ETF. The fund manager of an equity-based ETF seeks to track the performance of a benchmark stock
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exchange index, such as the S&P/ASX200, by using the funds raised from the sale of units in the ETF
to purchase a securities portfolio that replicates the specified index. For example, the ETF would hold
all or the majority of shares included in the S&P/ASX200 index.
ETFs are distinguished from other types of ETPs. While an ETF traditionally tracks the
performance of an index, other types of ETPs involve active management strategies. Active ETFs try
to outperform an index rather than merely tracking it. ETPs also include structured products (SPs).
SPs are instruments that involve a company promising an investor a rate of return that is based on the
movement in the price of an underlying asset, such as an index. SPs are quite different in nature from
both ETFs and active ETFs.
By purchasing units in the ETF an investor gains access to a diversified portfolio of securities. The
extent of diversification will depend on the benchmark index specified in the ETF. For example, an
ETF that replicates the S&P/ASX200 provides exposure to the top 200 shares listed on the ASX. The
risks involved in ETFs include exposure to the ups and downs in the underlying benchmark index.
Should an investor wish to gain a diversified exposure to the international markets, then an ETF
such as the iShares S&P500 gives exposure to the US markets, while iShares S&P Europe350 provides
exposure to major European corporations listed on a number of European exchanges. The list of ETFs
offered by a stock exchange will be found on their website. The risks involved with ETFs that track
overseas indices include exposure to the volatility of those indexes and currency risks if the investments
are denominated in a foreign currency.
Most ETFs are open-ended funds; that is, the number of units offered by a fund is not fixed. For
example, if demand for units in a particular fund increases, the fund manager can increase the number
of units on offer. This ensures that units in the ETF trade at or near the net asset value of the securities
held in the fund.
Units in an ETF are bought and sold through a stock exchange in exactly the same way that ordinary
shares of listed corporations are bought and sold. There has been strong growth in the ETF sector
in Australia. Assets under management reached $25 billion in 2018. Most ETFs in Australia invest
in Australian equities and international equities. However, some venture into fixed income securities
and commodities. The innovation in the types of products offered as ETFs or ETPs provides more
opportunities for investors but also raises concerns about how well those investors understand the risks
that are involved.
4.5.2
Active ETFs
a type of ETF that
deploys strategies
designed to outperform
a market index
Structured products
(SPs)
instruments that
promise a rate of
return based on the
movement in the price
of some asset
C ONTRACTS FOR DIFFERENCE
A contract for difference (CFD) is a contract listed on a stock exchange that is an agreement between a
buyer and seller to exchange the difference in the value of a CFD. The difference in value is calculated by
subtracting the value of the CFD contract at the start date from the value of the contract at the close date.
The CFD may be based on a nominated security listed on a local or international stock exchange,
stock exchange indices, foreign currencies or commodities. For example, a CFD may be based on BHP
Billiton Limited shares listed on the ASX. The value of the CFD is directly correlated with the value of
the underlying BHP shares at the start and close date specified in the CFD contract.
A CFD provides a high level of leverage for an investor as the buyer of a CFD only pays a deposit
or initial margin; that is, the investor does not pay the full value of the underlying shares. This means
that an investor may be able to take a much larger exposure to the market in that more of the underlying
security can be bought or sold because full payment is not required to be made by the purchaser upon
execution of the CFD.
However, the risks associated with leverage are much higher as the full gain or loss associated with
the underlying security will be made when the CFD is closed out. Therefore, investors must understand
the upside and the downside risk associated with a leveraged investment such as a CFD.
An investor may use a CFD to go long in a rising market, or go short in a falling market.
For example, if an investor believes BHP Billiton shares are going to rise in value, the investor
might take a long position by buying 1000 BHP Billiton CFD at $43.25 per share. The value of the
Contract for
difference (CFD)
an agreement between
a buyer and seller,
based on an underlying
security, to exchange
the difference between
the contract start and
close values
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CFD is $43 250, but the investor would only pay, say, a 10 per cent deposit of $4325.00. If BHP Billiton
shares are trading at $45.76 on the CFD close date, then the investor would make $2510 profit. This is
a 58.00 per cent return on the initial capital investment.
If an investor believes that the market is going to fall, then the investor may decide to sell a CFD;
that is, take a short position. If the underlying security of the CFD falls, then the investor will make a
profit, but if the security rises in value, the investor will make a loss. A CFD has no expiry date so the
position has to be closed by conducting a reverse trade.
4.5.3
Real estate
investment trust
(REIT)
managed funds that
provide investors with
the opportunity to
invest in a range of
property categories
such as industrial,
hotels and retail
R EAL ESTATE INVESTMENT TRUSTS (REIT)
A real estate investment trust (REIT) purchases property and holds the assets within a trust. Units in
the REIT may be listed on a stock exchange and traded in the same way as ordinary shares in listed
corporations. Because investors are buying units in the listed trust, they gain access to a diversified real
estate portfolio that otherwise would not be possible for the average investor. For example, an investor
may purchase units worth $5 000 in a REIT, whereas, with that small amount, the investor could not
purchase property directly.
The type of property held in a REIT will be specified in the fund’s trust deed. The categories of
property that a REIT may purchase include:
•
•
•
•
industrial—such as warehouses, factories and industrial parks
hotel and leisure—including hotels, theme parks and cinema complexes
retail—in particular major shopping centres
office—such as multi-storey office buildings.
Investors may benefit from both capital gains on the property assets as well as rental income
generated by the properties. Also, units in a listed REIT are much more liquid than the underlying
property; that is, it is easier to sell the units than it is to quickly sell the property held in the trust.
4.5.4
Infrastructure fund
managed fund that
provides investors
with the opportunity to
invest in infrastructure
assets such as toll
roads and utilities
Call option
gives the buyer the
right, but not the
obligation, to buy a
specified commodity or
financial instrument at a
specified price and date
I NFRASTRUCTURE FUNDS
An infrastructure fund is a managed fund that may be listed on a stock exchange and enables investors
to gain access to investment opportunities in large-scale infrastructure projects such as toll roads.
Infrastructure projects are normally multi-million dollar projects and therefore beyond the investment
capacity of the average investor. The infrastructure fund accepts funds from a large number of investors to
create a significant pool of funds. This enables the fund manager to then invest in these types of projects
or assets. Returns to investors may take the form of capital gains and income generated from the project.
For example, a toll road will generate income from the toll charged for vehicles travelling on the toll road.
The categories of infrastructure assets held in a fund might include:
•
•
•
utilities—such as power stations, electricity transmission lines and gas pipelines
transport and materials handling—including railway lines, airport terminals, port and dock facilities
communication facilities—such as broadcasting and communication towers and networks.
The income earnings from many infrastructure assets are quite predictable as they are often
regulated or guaranteed by government. Also, infrastructure projects typically have high barriers to
entry (costs, technology, regulation) and therefore low levels of competition.
Put option
gives the buyer the
right, but not the
obligation, to sell a
specified commodity or
financial instrument at a
specified price and date
4.5.5
O PTIONS
An option contract gives the buyer of the option the right, but not the obligation, to buy (call option)
or sell (put option) a specified security at a predetermined price, on or before a predetermined date.
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The buyer of the option must pay a premium to the writer, or seller, of the option; that is, the writer of
the option is selling a right to the option buyer.
For example, an investor who holds Santos Limited shares in an investment portfolio might be
concerned that the share price will fall in the near term but does not want to sell the shares at this time.
The investor may implement an options strategy to protect against the risk. The investor may decide to
buy a put option, which gives the investor the right to sell, say, 1000 Santos shares at an exercise price of
$7.00 per share within the next three months. The premium paid to the option writer is quoted at $0.20
per share. Assume that the share price actually falls to $6.00; the option buyer will then exercise the
option and sell the shares at $7.00, or receive a cash settlement from the option writer. The investor has
protected the investment portfolio to the amount of the exercise price minus the current market price less
the premium paid, multiplied by the number of shares; that is, 1 000 ($7.00 − $6.00 − $0.20) = $800.
An interesting feature of an option contract is that if the investor decides not to sell the shares,
perhaps because the price in the share market has actually risen, there is no obligation to proceed. In
this case, the cost to the buyer of the option is the initial premium paid to buy the option contract.
A stock exchange may quote on a range of different types of option contracts, including stock
options, index options, flexible options and low-exercise-price options. To find out more about the
various option contracts offered on the ASX, you can look on the internet at www.asx.com.au. Option
contracts are derivative contracts and are discussed in greater detail in Chapter 20.
4.5.6
the price specified in
an options contract at
which the option buyer
can buy or sell
W ARRANTS
Another derivative product quoted on a stock exchange is the warrant. A warrant issuer, such as a bank,
must be authorised by the stock exchange to write warrant contracts. The warrant issuer is able to
determine the terms and conditions that will apply to a specific warrant series, but the warrant is then
quoted and traded on the stock exchange.
Warrant issuers are required by the exchange to make a market; that is, they must quote both buy
and sell prices on their warrant series. Call and put warrants are quoted; a call warrant holder will
benefit from an upward price movement in the underlying physical market share price or index, while a
put warrant holder will benefit from a downward movement in prices.
An equity-based call warrant gives the warrant holder the right to buy the underlying security at a
particular price, on or before a predetermined date. Similarly, a put warrant gives the right to sell.
Instalment warrants are often attractive to investors as they give the warrant holder the right to buy
the underlying shares by payment of a number of periodic instalments, but still be entitled to receive
any dividend payments and franking credits. Generally there are only two instalments on ASX quoted
instalment warrants: an initial part payment and an optional final payment.
A stock exchange may list a number of different types of warrant contracts. (A range of warrant
contracts is discussed in Chapter 20.) You can obtain further information on warrant contracts offered
on the ASX at www.asx.com.au. Similarly, other nation-state exchanges also provide details of their
particular contracts on their websites.
4.5.7
Exercise price
Warrant
a financial instrument
that conveys a right in
the form of an option
Warrant issuer
a third party, such as a
bank, authorised by a
stock exchange to write
warrant contracts
F UTURES CONTRACTS
Another type of derivative product that may be quoted on a stock exchange is the futures contract.
A futures contract is a contract between two parties to either buy or sell a specified commodity or
financial instrument at the expiry date of the contract. The value of the contract at commencement, and
at the expiry date, will relate to the price of the underlying physical market price at each of those dates.
Settlement of the contract will be specified in the contract, and may be by delivery of the underlying
security, such as a share, or by payment of a cash equivalent. The underlying security of a futures
contract may be a particular share of a listed company or a stock-market index. Stock-market indices are
discussed in Chapter 6. Futures contracts are discussed in detail in Chapters 18 and 19.
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Not all stock exchanges offer all the above products. Stock exchanges will offer managed products
and derivative products only if there is sufficient demand and liquidity for a particular product. Also, in
some countries the regulator may restrict the types of products offered. In Australia, the ASX provides
all the above products.
REFLECTION POINTS
•
•
•
•
•
•
•
•
Stock exchanges may list a range of managed products and derivative products. These
standardised products are known as exchange-traded contracts.
Exchange traded funds (ETFs) usually invest in a basket of securities listed on the local
or international exchanges, foreign currencies or commodities. ETFs provide access to a
diversified portfolio of securities. ETFs are just one type of exchange traded product (ETP).
Other ETPs include active ETFs and structured products (SPs).
A contract for difference (CFD) is an agreement to exchange the net difference in value
between the start date and the close date of a CFD. The CFD is based on a specified security.
Only a deposit is paid initially, therefore the CFD is highly leveraged (increased risk).
A real estate investment trust (REIT) issues units in the trust in order to raise funds to purchase
property, including industrial, hotels and leisure, retail and office. Assets generate rental income
and (hopefully) capital gains.
Infrastructure funds enable investors to gain access to large-scale infrastructure projects, such
as utilities, transport, materials handling and communications facilities.
An option contract gives the buyer the right, but not the obligation, to buy (call option) or sell
(put option) a specified security at a predetermined price and date. The writer of the option
receives a premium payment from the option buyer.
An equity warrant gives the holder the right to buy (or sell) the underlying security at a specified
price on or before a nominated date. Stock exchanges list a wide range of warrant contracts.
A futures contract is an agreement between two parties to buy (or sell) a specified commodity
or financial security at a specified date in the future. The value of the futures contract moves as
the price of the underlying asset in the physical market moves. Settlement may be for delivery
of the asset or cash.
4.6
LEARNING
OBJECTIVE
4.6
Examine the interest
rate market role of a
stock exchange.
Interest rate market
listing, quotation
and trading in debt
securities
The interest rate market role of a
stock exchange
Corporations fund their business operations with a combination of equity and debt. It has already been
noted that the principal function of a stock exchange is to facilitate primary and secondary market
transactions in shares of listed corporations. Another, lesser function of a stock exchange is the listing
of some of the debt issues of corporations, financial institutions and government.
An interest rate market is a market that facilitates the issue of debt securities and the subsequent
trading of those securities on a formal exchange. Just as a corporation issues a prospectus to prospective
shareholders, an issuer of debt similarly prepares a prospectus for potential investors. A prospectus
issued by a corporation is a document stating the terms of its public equity issue or debt raising. The
prospectus must meet the requirements of the stock exchange and the nation-state regulatory authority
in the provision of information to potential investors. If a debt issuer chooses to list the issue on a
stock exchange, the price of the issue will be quoted by the exchange and trading in the securities can
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occur. Trading will take place using the same procedures as those used when buying and selling shares
(discussed in Section 4.7).
The provision of an interest rate market by a stock exchange may be said to add value to issued debt
and new debt issues in three ways:
1 Transparency. An exchange provides access to information about the price, yield, maturity, credit
rating and other characteristics of debt securities. Information is the life-blood of the financial
markets. An efficient stock exchange ensures that an informed market exists.
2 Ease of entry and exit. By using a stock exchange’s electronic trading system, investors are able to
place orders through their stockbroker to buy or sell debt securities at a minimum cost, with little
delay and at the current market price.
3 Liquidity. Quotation of debt issues on a stock exchange provides access to a much wider investment
market. The formal market increases the negotiability of listed debt securities, as it brings buyers and
sellers together and facilitates the transfer of ownership from the seller to the buyer. Traditionally,
large debt issues have been made direct into the wholesale markets to institutional investors.
However, listing on a stock exchange provides access to the broader retail market. Therefore, the
stock exchange enhances the liquidity of debt securities.
Fixed-interest securities listed on a stock exchange are typically long-term instruments. The main types
are straight corporate bonds, floating rate notes, convertible notes and preference shares.
•
A straight corporate bond is a fixed-interest security. The interest payment is called a coupon.
The bond issuer pays a specified coupon rate that will not change for the term of the bond. The
face value of the bond is repaid to the holder at maturity. A corporate bond may be secured or
unsecured. A secured bond is known as a debenture, the security being a charge over the assets
of the issuing corporation. An unsecured bond is called an unsecured note. Since the interest
paid on a corporate bond is fixed, the price of the bond will change along with interest rates
for new issues of similar types of securities to reflect movements in the interest rate market (see
Chapter 10).
•
A floating rate note (FRN) is also a corporate bond, but it pays a variable rate of interest. Interest
coupon payments usually occur quarterly, half-yearly or annually. Interest rate changes will be based
on a reference rate published in the market by Reuters (see Chapter 10).
•
A convertible note is a hybrid security. It is a fixed-interest debt instrument that includes an option
to convert the note at a future date into ordinary shares of the issuer company (see Chapter 5).
•
Redeemable convertible preference shares are also a hybrid security. They pay a fixed dividend
(similar to a fixed interest payment) for a specified period, at which point the holder will have
the option to redeem the preference shares for cash or convert them into ordinary shares in the
company (see Chapter 5).
Stock exchanges therefore facilitate transactions in equity securities, hybrid securities and debt
securities. In order to do this, an exchange must maintain a securities trading system and a transaction
settlement system.
Straight corporate
bond
a long-term debt
instrument paying a
fixed interest coupon;
principal repayable at
maturity
Coupon
the periodic interest
payment attached to a
bond issue
Floating rate note
(FRN)
a corporate bond that
pays a variable rate
of interest; principal
repayable at maturity
Convertible note
a hybrid fixed-interest
debt security that
includes an option to
convert to ordinary
shares at a specified
date
Preference shares
a hybrid security
that combines
characteristics of
both equity and debt;
preference shares
usually pay a fixed
dividend and offer
the right to convert
to ordinary shares
at a future date (also
known as a redeemable
convertible preference
share)
REFLECTION POINTS
•
•
Corporations fund their operations from a combination of equity and debt.
Debt issues may be listed on a stock exchange and provide investors with transparency,
liquidity and ease of entry and exit.
continued
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continued
•
•
•
•
A straight corporate bond is a fixed-interest security that pays a periodic coupon. The principal
is repaid at maturity. A secured bond is known as a debenture; an unsecured bond as an
unsecured note. As the interest rate is fixed, the value of the bond will change as interest rates
in the current market change.
A floating rate note (FRN) is a corporate bond that pays a variable coupon rate, which will be
based on a published reference rate.
A convertible note is a hybrid security that pays a fixed interest rate and includes an option to
convert the note at a future date into ordinary shares.
A redeemable convertible preference share is a hybrid security that pays a fixed dividend.
It has an option at maturity to redeem to cash or convert to ordinary shares at a specified
price.
4.7
LEARNING
OBJECTIVE
4.7
Explain the electronic
trading (ASX Trade)
and settlement
(CHESS) platforms
used for share-market
transactions by the
Australian Securities
Exchange (ASX).
ASX Trade
the electronic securities
trading platform used
by the ASX to facilitate
trading in equity
securities listed on
the ASX
ASX Trade24
the electronic securities
trading platform used
by the ASX to facilitate
trading in futures,
options and contracts
for difference listed on
the ASX
The trading and settlement roles
of a stock exchange
People often talk about the good old days. Well, in the good old days trading on a stock exchange
occurred by open outcry. Participants in the market would gather on the floor of a designated exchange
and actively call out their buy and sell orders.
For example, in the stock exchange in Melbourne, stockbrokers and their staff would meet in a very
large room. At one end of the room was a raised platform, behind which was a large blackboard with the
code and price for each company listed on the exchange. Down on the floor of the exchange, brokers’
clerks would scream out buy and sell orders. On the platform, stock exchange staff would take those
verbal orders and run to the blackboard to change the relevant company information. Entries were
made and altered in chalk; thus, these exchange employees were known as chalkies. Needless to say,
when the market was hot, noise levels rose and everyone had to scream louder to catch the attention of
a chalkie. Sadly, those days have mostly gone. Some open-outcry markets still remain, the best examples
being the Chicago Board of Trade and the Chicago Mercantile Exchange. These institutions are worth
visiting to get a taste of the intensity of an open-outcry market.
Trading and settlement systems used by stock exchanges vary across the international markets.
However, the systems are becoming more compatible as stock exchanges in nation-states seek to
establish reciprocal trading arrangements with international exchanges. For example, the ASX uses
electronic trading platforms known as ASX Trade and ASX Trade24. These platforms are used by other
international stock exchanges, in particular the NASDAQ exchange in the USA.
ASX Trade is an integrated trading platform that allows the stock exchange to trade all listed
securities, including equities, derivatives and interest rate securities, using a single trading platform.
ASX Trade24 facilitates global trading in derivative contracts.
The buying and selling of listed securities on the stock exchange is initiated through authorised
stockbrokers who have access to the ASX electronic trading and settlement systems. The ASX Trade
trading platform allows stockbrokers to execute a client’s buy or sell order through computer-based trading
from the broker’s office while the client waits on the telephone, or through a computer-based trade
instruction given via the internet. In a liquid market, orders are confirmed almost instantly.
Figure 4.3 shows the process for buying and selling shares. Buyers and sellers independently
provide instructions to their stockbrokers on the quantity and price of a particular share they wish to
buy or sell. The broker inputs the order into ASX Trade. The orders are electronically transmitted to the
ASX host computer where the orders are recorded in price and time priority order. ASX Trade matches
corresponding buy and sell orders based on the bid (buy) and offer (sell) prices and the time the order
was received.
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Figure 4.3 Buying and selling shares on the ASX
Buying shares
Selling shares
Buyer instructs broker to buy
specific shares, including
quantity, price
Seller instructs broker to sell
specific shares, including
quantity, price
Operator enters buy order
on ASX Trade
Operator enters sell order
on ASX Trade
ASX Trade records instructions
in priority order based on
price and time of receipt
ASX Trade matches buy/sell
orders and executes the
trade
Stockbroker sends contract
note to buyer confirming
transaction
Stockbroker sends contract
note to seller confirming
transaction
Buyer forwards amount direct,
or credits funds to a cash
management account held by
broker
Seller advises the sponsor
broker of the required
uncertificated holder
information
Shares transferred electronically by
selling broker to buying broker through
CHESS and share registry notified
Share registry records new ownership
details and issues holding statements
to both buyer and seller
At the same time, settlement funds are
transferred between brokers via CHESS
With the ASX, the actual share certificate is no longer issued to the shareholder. An electronic record is
maintained of share ownership. Therefore, shares listed on the ASX are known as uncertificated securities.
On completion of the trade, each stockbroker will forward a contract note to the buyer and seller,
confirming the transaction details. The trading transaction is completed through the Clearing House
Electronic Sub-register System (CHESS). The buyer will arrange payment, usually by authorising the
broker to draw on credit funds held in a cash management account held with the broker or other
financial institution. Settlement, that is, the transfer of ownership and value payment, occurs through
CHESS. The ASX plans to replace CHESS with a new system in 2021.
ASX Trade provides a fast and efficient trading system, delivering data latency down to 250
microseconds; in addition, it disseminates information to the main market participants. The electronic
system allows brokers to monitor the market constantly, to enter bid and offer orders and to monitor
and adjust outstanding orders if necessary.
Certain trading principles apply during normal business hours: overlapping bids and offers are
executed at each price level in the order in which they were entered into the system. At the opening of
Uncertificated
securities
electronic record of
share ownership;
original share certificate
is not issued
Contract note
sent by a stockbroker to
a client advising details
of a share transaction
CHESS
the electronic securities
transaction settlement
platform used by the
ASX
Bid and offer
bid is an order to buy;
offer is an order to sell
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Settlement risk
the possibility that one
party to a financial
transaction will not
deliver value
trade, if there are bids and offers with overlapping prices, the trades are shared between all parties who
had lodged orders, provided there is sufficient stock available.
It is imperative for an efficient market to develop a secure settlement procedure in order to minimise
the risk of failed settlement by a party to a buy/sell transaction. This risk is known as settlement risk.
In volatile market conditions, the risk of non-settlement increases directly with the time that elapses
between the execution of an order and the value settlement of the transaction.
CHESS, the electronic settlement system used by the ASX, has two major functions:
1 It facilitates the settlement of transactions conducted through ASX Trade.
Electronic sub-register
a computer-based
system that records
securities ownership
T+2
settlement of a share
transaction will occur in
two business days
CHESS sponsor
market participant such
as a stockbroker that
has access to CHESS
2 It provides an electronic sub-register that records the ownership of listed securities.
Currently, the ASX requires settlement of trades to occur two business days after the transaction
(T + 2). In order to achieve this standard, all companies must issue uncertificated securities, so that
electronic transfer of ownership and settlement can occur quickly. After a transaction, a shareholder
will receive a holding statement from the CHESS sub-register or, alternatively, on the sub-register of
individual companies.
A shareholder who wishes to trade uncertificated shares must conduct the transaction with
a CHESS sponsor. Participants with direct access to CHESS are sponsors and are able to facilitate
transactions of other shareholders. Stockbrokers, most large institutional investors, custodian nominees
and trustee companies all act as sponsors. CHESS maintains a record of all CHESS-sponsored
transactions and changes in ownership, and that information is transferred electronically to the share
sub-registry. Holding statements will be issued on behalf of companies to uncertificated shareholders
who are sponsored by brokers or institutions that participate in CHESS. A separate statement is issued
for each security held. The linking of CHESS to the Australian bank payments system provides for
cleared funds settlement between the brokers of the buyer and the seller of shares.
The above information relates to just one trading system and settlements system, and it is worthwhile
to compare it with other systems. The internet provides an easy means of doing this. A recommended
starting point is the New York Stock Exchange system, which can be accessed at www.nyse.com.
REFLECTION POINTS
•
•
•
•
•
•
LEARNING
OBJECTIVE
4.8
Recognise the
importance of
information flows to the
efficiency and integrity
of stock exchanges.
To support the primary market and secondary market roles, an exchange must provide trading
and settlement platforms. Major exchanges use high-speed, robust technology-based systems.
ASX uses ASX Trade, which is an integrated system that allows the stock exchange to trade all
listed securities. ASX Trade24 facilitates global trading in derivative contracts.
Authorised stockbrokers have access to the ASX platforms. Investors lodge buy and sell orders
with their stockbroker, generally using the internet.
The broker will issue a contract note, which provides full details of the transaction.
Settlement will normally occur in T + 2 business days when transfer of ownership and financial
settlement will be processed through CHESS.
CHESS will issue a holding statement on the uncertificated shareholding.
4.8
The information role of a stock exchange
Information moves share prices. In Chapter 7 important approaches to analysing and explaining
share price movements are considered: fundamental analysis, technical analysis, the random walk
hypothesis and the efficient market hypothesis. In particular, the hypotheses imply that the current
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price of a share will reflect all available information in the market, and that any change in the
share price will be in response to new information coming to the market. Clearly, the role of a
stock exchange in facilitating the flow of information to the market is critical for the efficiency and
integrity of the market.
Legislative and stock exchange requirements for the provision of information to the markets vary
between countries. In this text, some of the requirements of the ASX are considered. The ASX has
a number of specific listing rules that relate to the provision of information, in particular continuous
disclosure rules that are designed to ensure a well-informed market. As new information is received
by the ASX, it disseminates this information to market participants. For example, if you go to the
home page of the ASX (www.asx.com.au), you will see a Price sensitive announcements box which lists
the company code and time of the last 20 announcements. Click the ‘View all recent’ box to see all
announcements.
Any information concerning a listed entity that a reasonable person would expect to have a material
effect on the price or value of the entity’s securities must immediately be given to the ASX. In Australia,
the Corporations Act (Cwlth) states that a reasonable person would consider information to be material
if it would be likely to influence persons who commonly invest in securities in deciding whether or not
to subscribe to, or buy or sell, the securities.
To give some idea of the extent of information that flows into the market, the following is a selection
of material information relevant to a listed corporation that would require disclosure:
•
•
•
•
•
•
•
•
•
a change in the corporation’s financial forecasts or expectations
the appointment of a receiver, manager, liquidator or administrator
a recommendation or declaration of a dividend or distribution
notice of a takeover bid or an intention to buy back issued shares
a proposal to restructure the capital base of the corporation
a notice of general meetings of shareholders, including motions to be put to the meeting and the
outcomes of those motions
a change in the chairperson, directors or auditors
copies of any documents forwarded to shareholders
disclosure of directors’ interests.
Listed corporations and other entities are also required periodically to report their financial
statements to the exchange. (Note: the ASX listing rules are discussed in detail in Chapter 5.)
The rapid flow and dissemination of information into the markets is essential to maintaining
market efficiency and retaining the confidence of market participants. A stock exchange must establish
rigorous rules and be vigilant in monitoring information flows to the exchange. Market participants
that breach the stock exchange’s information rules will be subject to disciplinary action by the exchange
and ASIC. In certain situations this might include the delisting of the company.
Listing rules
specific criteria that
must be met by an
entity seeking listing on
a stock exchange
Continuous
disclosure
a listed entity must
promptly advise the
stock exchange of
any material changes
relating to the
corporation
Liquidator
a party appointed to
manage the winding up
of a company
Directors’ interests
assets, contracts and
other items in which a
director has a beneficial
interest
REFLECTION POINTS
•
•
•
Share prices move as demand and supply for shares change. Demand and supply changes as a
result of new information coming to the market.
Stock exchange listing rules require continuous disclosure of information that may impact upon
investment decisions and share prices. This is in addition to prescribed reporting requirements,
such as the lodging of periodic financial statements.
A stock exchange will monitor information flows to ensure the market is fully informed in order
to maintain the integrity and confidence in the market.
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4.9
LEARNING
OBJECTIVE
4.9
Identify the principal
regulators that affect
the behaviour of
participants in the
Australian share market.
Australian Securities
and Investments
Commission (ASIC)
the regulatory body
responsible for the
supervision of the
Corporations Act in
Australia
Delisting
removal from quotation
on a stock exchange
of the securities of an
entity
The regulatory role of a stock exchange
Given the importance of the share market in encouraging and facilitating the raising of risk capital
or equity finance, it is important that the participants in the market have confidence in the integrity
of its operation. Each nation-state is responsible for the regulation and supervision of its own stock
exchanges. The methods vary from country to country; however, all developed countries maintain a
government-appointed regulator to supervise the country’s corporations legislation, and each stock
exchange assumes an important regulatory role over entities listed on its exchange.
Here we consider the regulatory structure applied to the Australian equity market. In line with
the more reputable of the international share markets, the operation of the Australian share market
is quite heavily regulated and supervised. The two major supervisors are the Australian Securities and
Investments Commission (ASIC) and each stock exchange itself. In 2009, the Australian government
announced a policy initiative that allows increased competition in the securities market; that is, it is
now possible for new stock exchanges to seek approval to operate in competition with the current
principal stock exchange, the ASX.
ASIC has responsibility for the supervision of real-time trading on Australia’s domestic licensed
markets, including responsibility for the enforcement of laws against misconduct in the markets and the
supervision of financial services licence holders.
ASIC has an integrated market surveillance system to support its commitment to market integrity
and a fair, orderly and transparent market. ASIC has established market integrity rules that apply
to market operators, market participants, other prescribed entities and financial products traded on
the relevant markets. ASIC is responsible for supervising compliance with these rules. ASIC is also
responsible for the market disciplinary panel. This panel is the main forum for disciplinary action for
breaches of the market integrity rules.
Stock exchanges within Australia have a responsibility for the oversight of listed entities under the
exchange’s listing rules. The exchange is also required to monitor and enforce compliance by market,
clearing and settlement participants with its operating rules. For example, the ASX has a wholly owned
subsidiary company, ASX Compliance, which is charged with these responsibilities.
As mentioned above, the ASX has continuous disclosure provisions in its listing rules.
ASX surveillance monitors market trading to identify situations where trading volumes or price
movements indicate the market may not be fully informed. For example, a sudden increase in price
and volume of a particular company share may be the result of information that has not been
publicly announced to the market. The surveillance systems automatically generate an alert. If
necessary, the relevant company will be asked to explain. If the explanation is not satisfactory,
further action may be taken, such as a detailed investigation, the imposing of financial penalties,
suspension or delisting from the official list of the exchange, and formal reporting to ASIC for
further action.
Another important participant in the regulatory structure in Australia is the Reserve Bank of
Australia (RBA). The RBA is responsible for the monitoring and assessment of licensed clearing and
settlement platforms and systems; for example, CHESS which is operated by the ASX. In particular, the
RBA ensures participants comply with its Financial Stability Standards in order to reduce systemic risk
within the financial system.
REFLECTION POINTS
•
•
Each nation-state is responsible for the regulation and supervision of its own stock exchanges.
Usually this role is shared between government-appointed regulatory authorities and the actual
exchange itself.
In Australia, the Australian Securities and Investments Commission (ASIC) has responsibility for
the supervision of real-time trading in the domestic licensed markets.
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•
•
•
•
ASIC is responsible for enforcement of laws against misconduct, and the supervision of
financial services licence holders.
ASIC maintains an integrated surveillance system. Breaches of rules are enforced by a
disciplinary panel.
ASX also monitors continuous disclosure through its own compliance subsidiary. It may
impose penalties, suspend or delist a corporation and forward a formal report to ASIC for
further action.
The Reserve Bank (RBA) monitors the licensed clearing and settlement platforms and systems
in order to ensure financial stability and reduce systemic risk in the financial system.
4.10
The private equity market
In this chapter we have focused on the stock market, as it is the major source of equity funding for
corporations. However, in a competitive global market where there are only limited restrictions on
the flow of capital, there has been considerable growth in another source of equity funds, namely, the
private equity market.
Private equity is an alternative equity funding source for those companies that are unable to, or
choose not to, access equity funding through a public issue in the share market. For example, small
unlisted companies may need to raise additional equity to support a new and growing business.
Alternatively, a listed corporation may find itself in financial difficulty and seek to restructure the
organisation by selling some of its non-core business to private equity investors.
Typically, private equity funding is provided to higher-risk companies. Having regard to the
direct relationship between risk and return, private equity providers are seeking to gain higher
returns on their investment. Quite often, companies seeking private equity do not have adequate
collateral or profit performance to attract investors within the normal share market or banking
sources of funds.
Private equity market funding is usually directed towards:
•
•
•
•
LEARNING
OBJECTIVE
4.10
Explain the structure
and purpose of the
private equity market.
start-up funds for new companies to allow the business to develop its products and services
business expansion funds that allow a company to grow the current business operations
recovery finance for companies that are currently experiencing financial difficulty
management buy-out financing where the existing company managers seek to buy the existing
business funded, in part, with private equity.
The majority of private equity is provided through funds that are established for this purpose; that
is, funds which specialise in seeking out and analysing potential private equity opportunities or targets.
Within Australia, the major providers of funds for the private equity funds are superannuation funds
and life insurance offices. These institutional investors seek to increase the overall return on their large
investment portfolios by including a proportion of higher-risk investments.
The nature of equity is long-term finance; however, the investment horizon of private equity
investors is often for a shorter period, usually less than five to seven years. As private equity has limited
liquidity—that is, it cannot be sold through the share market—a principal objective of private equity
investors is to improve the profit performance of the company significantly so that the company can be
listed on a stock exchange through an initial public offering (IPO) or sold to a trade buyer. Alternatively,
the investors may seek to break up the company and sell the component parts in order to achieve a
return on investment.
Private equity funding tends to grow in times of sustained economic growth. On the other hand, in
times of an economic downturn, new private equity funding will fall significantly.
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REFLECTION POINTS
•
•
•
•
•
Private equity is an alternative source of equity funding for a company.
Private equity may be provided for start-up companies, business expansion for existing
companies, recovery finance for corporations in financial difficulty or management buy-outs.
Specialist private equity funds obtain the majority of their funds from institutional investors.
Private equity funding is regarded as a higher-risk investment.
The principal objectives of private equity funds may be to improve company performance in
preparation for an IPO or trade sale, or the break-up of a company so that the component parts
may be sold separately.
CASE STUDY
DEVELOPMENT OF INDUSTRIAL SCALE BLOCKCHAIN IN AUSTRALIA
Digital currencies like bitcoins are based on blockchain technology, regarded as one of the most
innovative and exciting developments in finance. The blockchain is envisioned to be the new internet
with data integrity, authenticity and accuracy that enable development of future applications (Mermer,
2018). What is more interesting is that the world’s first industrial-scale blockchain will start operations
towards the end of 2020 at the ASX in Australia.
The ASX has revealed that the new technology will automate various corporate actions, streamline the
processes and reduce costs. The current system used by the ASX, also known as CHESS (Clearing
House Electronic Sub-register System), was extremely successful; however, the fact that more than 20
years have passed since its creation necessitated a change. It is expected that the new Distributed
Ledger Technology (DLT) will be able to clear and settle cash worth $2 trillion in the Australian equities
market (Eyers, 2018).
According to the ASX, the benefits of such a transition could include the following;
1. Greater control to issuers and investors by offering high security and simplified access to the
registers.
2. Smooth integration with upstream and downstream businesses globally with flexible technology.
3. An increase in user confidence in the system by making it traceable and secure.
4. The removal of paper-based processes and a reduction in the chances of manual errors because of
new streamlined functions and workflows (Chohan, 2017).
The traditional settlement mechanism, where participating organisations needed to send details of
financial transactions to a clearing house for recording in a centralised registry, has proved to be timeconsuming. Industrial scale blockchain has captured the interest of such organisations, with its capability
to reduce transaction time and costs while keeping security intact. In simple terms, blockchain is a data
structure that creates digital transaction ledgers that will be shared among a network of participating
organisations without a central authority. The major Australian banks, such as the Commonwealth,
Westpac and NAB, commenced operations with DLT from late 2015 by joining Hyper Ledger project
developed by IBM.
When it comes to blockchain or any other technology with digital back-up, the primary concern revolves
around the issue of security and opportunities for manipulation. It is notable that there exist two types
of blockchain technology based on permissions. The public blockchain technology is subject to the risk
of manipulation, whereas private blockchain is considered to be safe due to the extreme difficulty in
addition or removal of data. While adding or removing a block of data to the registry, the majority of the
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Chapter 4 The share market and the corporation
References:
Chohan, UW 2017, Blockchain and Securities Exchanges: Australian Case Study, 8 December 2017,
SSRN: https://ssrn.com/abstract=3085631 or http://dx.doi.org/10.2139/ssrn.3085631
Eyers, J 2018, ‘ASX blockchain to go live at end of 2020’, Financial Review, 27 April, viewed 15 October
2018, https://www.afr.com/technology/asx-blockchain-to-go-live-at-end-of-2020-20180427-h0zcgx
Gregory, M 2016, ‘Blockchain is here to stay’, The Australian Business Review, 18 May, viewed 15
October 2018, http://www.theaustralian.com.au/business/technology/opinion/blockchain-is-here-tostay/news-story/3199981db8accb21c18e3811195ff907
Mermer, GB, Zeydan, E & Arslan, SS 2018, ‘An overview of blockchain technologies: Principles,
opportunities, and challenges’, In 2018 26th Signal Processing and Communications Applications
Conference (SIU), May 2018, IEEE.
Discussion points
•
•
Why did ASX vote for a transition from CHESS (Clearing House Electronic Sub-register System)
to DLT (distributed ledger technology)?
CHAPTER FOUR REVIEW
participating organisations have to validate such changes, making it acceptable and safe for business
organisations and governments (Gregory, 2018).
In the eyes of ASX, what could be the potential benefits of DLT?
Master before you move on
LEARNING OBJECTIVE 4.1
Understand the structure of a corporation and identify advantages and disadvantages of being a
publicly listed corporation.
•
•
•
•
•
•
•
Members of the board of directors of a corporation are elected by shareholders at a general
meeting.
The board determines the objectives and policies of the firm, and appoints executive managers,
who are responsible for managing the day-to-day business operations and reporting back to the
board.
With a limited liability company, the liability of a shareholder is limited to the fully paid issue price
of the shares.
With a no liability company, a shareholder holding any partly paid shares cannot be forced to
make further payment, but may forfeit the shares.
Advantages of the corporate form of business include access to a large pool of equity funds
through the stock market, the separation of ownership (shareholders) and control (managers),
the continuity of business operations, the ability to conduct large-scale operations and the
opportunity for investors to hold a diversified share portfolio.
A potential disadvantage of the corporate form is the agency problem, whereby managers may
try to run the business for their own benefit rather than for the shareholders’ benefit.
The board of directors should establish strong corporate governance practices to ensure
accountability and transparency.
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LEARNING OBJECTIVE 4.2
Consider the origins and purpose of a stock exchange.
•
•
•
•
•
The origins of stock exchanges date back to 1553 in England.
Today, stock exchanges compete within the international markets where there are continuous
flows of information.
A stock exchange facilitates the listing of corporations and the quotation, buying and selling of
listed securities.
An exchange operates a securities trading system and a transaction settlement system.
Stock exchanges, and other regulators, seek to maintain the efficiency and integrity of the market.
LEARNING OBJECTIVE 4.3
Understand the primary market role of a stock exchange through which corporations raise new
funding.
•
•
•
•
•
•
•
•
•
The primary market role of a stock exchange relates to the issue of new securities by listed
corporations or other entities.
The listing of a new company is known as a float or an initial public offering (IPO).
The main form of equity issued by a corporation is the ordinary share (common stock).
Primary market issues of ordinary shares raise equity capital for corporations. Equity capital is
typically used to enable a firm to grow.
Shareholders may receive dividends and/or capital gains (or losses).
Existing corporations may issue additional equity through rights issues, placements and dividend
reinvestment schemes.
A stock exchange may also list debt instruments, units in public trusts and derivative products.
An issue of equity or debt to the public requires the preparation of a prospectus.
2 279 companies were listed on the ASX as at May 2018.
LEARNING OBJECTIVE 4.4
Discuss the secondary market role of the stock exchange through which existing securities are
bought and sold.
•
•
•
•
•
The secondary market role provides a market structure for the buying and selling of existing
listed securities.
Buy and sell orders are lodged through a stockbroker that has access to the exchange’s trading
and settlement platforms.
Secondary market transactions do not raise additional equity for the original issuing corporation—
they are a transfer of ownership for value.
Market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market
encourages investors.
Market capitalisation is the number of issued shares multiplied by the share price.
LEARNING OBJECTIVE 4.5
Examine the managed product (exchange traded funds, contracts for difference, real estate
investment trusts and infrastructure funds) and derivative product (options, warrants and futures
contracts) roles of a stock exchange.
•
Stock exchanges may list a range of managed and derivative products. These standardised
products are known as exchange traded contracts.
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•
•
•
•
•
•
Exchange traded funds (ETFs) usually invest in a basket of securities listed on the local or
international exchanges, foreign currencies or commodities. ETFs provide access to a diversified
portfolio of securities. ETFs are a type of exchange traded product (ETP). ETPs include active
ETFs, where a manager deploys strategies to outperform a benchmark, and structured products
(SPs), which promise to pay a rate of return based on the movement in the price of an underlying
asset.
A contract for difference (CFD) is an agreement to exchange the net difference in value between
the start date and the close date of a CFD. The CFD is based on a specified security. Only a
deposit is paid initially, therefore the CFD is highly leveraged (increased risk).
A real estate investment trust (REIT) issues units in the trust in order to raise funds to purchase
property, including industrial, hotels and leisure, retail and office. Assets generate rental income
and (hopefully) capital gains.
Infrastructure funds enable investors to gain access to large-scale infrastructure projects, such
as utilities, transport, materials handling and communications facilities.
An option contract gives the buyer the right, but not the obligation, to buy (call option) or sell
(put option) a specified security at a predetermined price and date. The writer of the option
receives a premium payment from the option buyer.
An equity warrant gives the holder the right to buy (or sell) the underlying security at a specified
price on or before a nominated date. Stock exchanges list a wide range of warrant contracts.
CHAPTER FOUR REVIEW
•
A futures contract is an agreement between two parties to buy (or sell) a specified commodity or
financial instrument at a specified date in the future. The value of the futures contract moves as
the price of the underlying asset in the physical market moves. Settlement may be for delivery
of the asset or cash.
LEARNING OBJECTIVE 4.6
Explain the interest rate market role of a stock exchange.
•
•
•
•
•
•
Corporations fund their operations from a combination of equity and debt.
Debt issues may be listed on a stock exchange, which provides investors with transparency,
liquidity and ease of entry and exit.
A straight corporate bond is a fixed-interest security that pays a periodic coupon. The principal
is repaid at maturity. A secured bond is known as a debenture; an unsecured bond as an
unsecured note. As the interest rate is fixed, the value of the bond will change as interest rates
in the market change.
A floating rate note (FRN) is a corporate bond that pays a variable coupon rate, which will be
based on a published reference rate.
A convertible note is a hybrid security that pays a fixed interest rate and includes an option to
convert the note at a future date into ordinary shares.
A redeemable convertible preference share is a hybrid security that pays a fixed dividend. It has
an option at maturity to redeem to cash or convert to ordinary shares at a specified price.
LEARNING OBJECTIVE 4.7
Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for sharemarket transactions by the Australian Securities Exchange (ASX).
•
•
•
To support the primary market and secondary market roles, an exchange must provide trading
and settlement platforms. Major exchanges use high-speed, robust technology-based systems.
ASX uses ASX Trade, which is an integrated system that allows the stock exchange to trade all
listed securities. ASX Trade24 facilitates global trading in derivative contracts.
Authorised stockbrokers have access to the ASX platforms. Investors lodge buy and sell orders
with their stockbroker, generally using the internet.
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•
•
•
The broker will issue a contract note, which provides full details of the transaction.
Settlement will normally occur in T + 2 business days when transfer of ownership and financial
settlement will be processed through CHESS.
CHESS will issue a holding statement on the uncertificated shareholding. The ASX plans to
replace CHESS in 2021.
LEARNING OBJECTIVE 4.8
Recognise the importance of information flows to the efficiency and integrity of stock exchanges.
•
•
•
Share prices move as demand and supply for shares change. Demand and supply change as a
result of new information coming to the market.
Stock exchange listing rules require continuous disclosure of information that may impact upon
investment decisions and share prices. This is in addition to prescribed reporting requirements,
such the lodging of periodic financial statements.
A stock exchange will monitor information flows to ensure the market is fully informed in order
to maintain the integrity and confidence in the market.
LEARNING OBJECTIVE 4.9
Identify the principal regulators that affect the behaviour of participants in the Australian share
market.
•
•
•
•
•
•
Each nation-state is responsible for the regulation and supervision of its own stock exchanges.
Usually this role is shared between government-appointed regulatory authorities and the actual
exchange itself.
In Australia, the Australian Securities and Investments Commission (ASIC) has responsibility for
the supervision of real-time trading in the domestic licensed markets.
ASIC is responsible for enforcement of laws against misconduct, and the supervision of financial
services licence holders.
ASIC maintains an integrated surveillance system. Breaches of rules are enforced by a
disciplinary panel.
ASX also monitors continuous disclosure through its own compliance subsidiary. It may impose
penalties, suspend or delist a corporation and forward a formal report to ASIC for further action.
The Reserve Bank (RBA) monitors the licensed clearing and settlement platforms and systems in
order to ensure financial stability and reduce systemic risk in the financial system.
LEARNING OBJECTIVE 4.10
Explain the structure and purpose of the private equity market.
•
•
•
•
•
Private equity is an alternative source of equity funding for a company.
Private equity may be provided for start-up companies, business expansion for existing
companies, recovery finance for corporations in financial difficulty or management buy-outs.
Specialist private equity funds obtain the majority of their funds from institutional investors.
Private equity funding is usually regarded as a higher-risk investment.
The principal objectives of private equity funds may be to improve company performance in
preparation for an IPO or trade sale, or the break-up of a company so that the component parts
may be sold separately.
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Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points you raise in relation to each question.
1
The ‘publicly listed corporation’ is viewed as one of the most important innovations in the
history of economic and financial development. Outline the advantages and disadvantages of
the publicly listed corporation. (LO 4.1)
2
Smiles Inclusive Ltd is one of the newest public companies to list on the Australian Securities
Exchange. Identify and discuss the rights, roles and responsibilities of Smiles Inclusive’s
shareholders, board of directors and executive management now that it is a publicly listed
company. (LO 4.1)
3
(a) Briefly explain the concept of corporate governance within the context of a corporation.
(b) What is the relationship between corporate governance and the so-called agency
problem? (LO 4.1)
4
Most developed or developing countries seek to establish modern and efficient stock exchanges.
CHAPTER FOUR REVIEW
Questions
(a) Identify and discuss the five principal functions of a modern and efficient stock exchange.
(b) Why is it important to maintain modern and efficient stock exchanges? (LO 4.2)
5
Discuss why a strong primary market is important for economic growth within a country and
explain how each of the main participants in the primary issue of securities interacts with each
other during the share issuance process. (LO 4.3)
6
(a)
Discuss the secondary market role of a stock exchange and its importance to the
corporation. Illustrate your answer by using examples.
(b) What is meant by the liquidity of the share market? Explain why liquidity in the secondary
market is important both to shareholders and to corporations. (LO 4.4)
7
Explain the difference between an ETF and an active ETF. (LO 4.5)
8
With a CFD it is possible to lose many times the initial investment amount. Explain why this
circumstance can arise. (LO 4.5)
9
An investor with a small amount ($15 000) to invest wants to gain exposure to the commercial
property market in Australia. What sort of investment product is appropriate? (LO 4.5)
10 An investor currently holds shares in Amcor Ltd. The investor is worried about a decline in the
price of the shares. What sort of instrument can the investor use to hedge the investment? (LO 4.5)
11 Woodside Petroleum Limited is considering issuing debentures in the capital markets and
having the debt debentures quoted on the fixed interest market of the ASX.
(a) As the chief financial officer for Woodside you have been invited to explain the issue to a
group of investors. Prepare a list and explain the advantages to both Woodside and the
potential investor in having the debentures listed.
(b) Briefly describe the main characteristics of a debenture. (LO 4.6)
12 (a)Using the example of the trading and settlement platforms used by the ASX, explain the
process whereby one investor places a buy order for 1 000 Rio Tinto Limited shares and
another investor places a sell order for 1 000 Rio Tinto Limited shares; both orders at
market price. (LO 4.7)
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(b) Within the context of the above Rio Tinto share transaction, define and provide examples
of the following:
•
•
•
•
uncertificated shares
share contract note
settlement risk
T + 2 business days. (LO 4.7)
13 (a)It may be argued that information is the life-blood of an efficient stock market. Explain this
proposition.
(b) Within the context of the ASX, explain the requirements and purpose of continuous
reporting.
(c)
Identify, using examples, five different pieces of information that are regarded as being
material and therefore should be reported to the stock exchange. (LO 4.8)
14 Outline the regulatory structure and the responsibilities of the main supervisors of market
integrity and market participants’ behaviour in Australian stock exchanges. (LO 4.9)
15 The private equity market is an alternative source of equity funding for business. Explain how
this market typically operates. (LO 4.10)
KEY TERMS
active ETFs 143
dividend reinvestment
scheme 138
physical market 141
agency problem 135
ASX Trade 148
electronic sub-register 150
preference shares 147
ASX Trade24 148
exchange-traded contracts 142
primary market 138
Australian Securities and
Investments Commission
(ASIC) 152
exchange traded funds
(ETFs) 142
prospectus 139
bid and offer 149
exchange traded products
(ETPs) 142
put option 144
board of directors 134
exercise price 145
call option 144
floating rate note (FRN) 147
CHESS 149
hedge 142
right of perpetual
succession 135
CHESS sponsor 150
infrastructure fund 144
rights issue 138
continuous disclosure 151
interest rate market 146
settlement risk 150
contract for difference
(CFD) 143
limited liability company 134
share market 135
liquidator 151
share options 136
contract note 149
listing rules 151
straight corporate bond 147
convertible note 147
market capitalisation 141
structured products (SPs) 143
corporate governance 136
market liquidity 141
T + 2 150
corporation 134
uncertificated securities 149
coupon 147
new float or initial public
offering (IPO) 138
delisting 152
no liability company 134
derivative 141
objectives and policies 134
directors’ interests 151
over-the-counter contracts 142
placement 138
publicly listed corporation 134
real estate investment trust
(REIT) 144
warrant 145
warrant issuer 145
World Federation of
Exchanges 138
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CHAPTER 5
Corporations issuing
equity in the share market
CHAPTER OUTLINE
5.1
The investment decision: capital budgeting
5.2
The financing decision: equity, debt and risk
5.3
Initial public offering
5.4
Listing a business on a stock exchange
5.5
Equity-funding alternatives for listed companies
Learning objectives
LO 5.1
Understand issues related to the capital budgeting investment decision.
LO 5.2
Identify issues relevant to a corporation’s funding choice between debt and equity.
LO 5.3
Examine the listing and flotation or initial public offering (IPO) of a business on a stock exchange,
including equity-funding alternatives that are available to a newly listed corporation.
LO 5.4
Consider important issues associated with listing a business on a stock exchange.
LO 5.5
Explore equity-funding alternatives that are available to an established listed corporation,
including rights issues, share purchase plans, placements, takeover issues, dividend
reinvestment schemes, preference shares, convertible notes and other quasi-equity securities.
Extended learning
LO 5.6
Explain the listing requirements of the Australian Securities Exchange.
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CHAPTER SNAPSHOT
Besides the trading opportunities that the equity markets present to investors and institutions,
the equity markets represent a deep pool of potential capital to be sourced by corporations
seeking to raise funds to manage and expand their existing operations. A company that has
reached a certain stage of development may seek to access this pool of capital by listing on
the ASX and becoming a publicly traded company. To do so, the company’s owners decide
to undertake an initial public offering (IPO). With the help of advisers (investment banks),
working on a fee-for-service basis, the company’s owners hope to sell part of their stake in the
company at the highest possible price.
INTRODUCTION
The objective of financial management of a corporation is the maximisation of shareholder value. A
firm will typically seek to achieve a wide range of other objectives as well, but each of these objectives
should ultimately add value to the corporation and therefore to its shareholders. Other objectives
may include minimising the average cost of funding, maximising profit margins, maintaining earnings
growth, ensuring a competitive position within the market, ensuring the firm meets its social obligations
and managing the operations of the firm to ensure business continuity.
Fundamentally, a corporation will create shareholder value by finding projects that return more
than what they cost on a present value basis. A project could be a marketing campaign, a takeover of
another company, a new product idea or positioning the company in a new geographical market. The
decision to allocate capital to any of these projects is called the capital budgeting decision. For example,
the decision by Apple Corporation to build and market the iPod was a capital budgeting decision. The
iPod was a very successful project. It certainly returned much more than what it cost and created value
for Apple’s shareholders.
The focus of Part 2 of the text is on equity funding, but it must be understood that a corporation
will finance its activities from a combination of equity funds and debt funds. Section 5.2.1 provides a
discussion of the importance of the ratio of debt-to-equity financing. Later chapters will look specifically
at the different types of short-term and longer-term debt financing available to a corporation.
The study of corporate finance traditionally distinguishes four aspects of financial management.
These are described as:
•
•
•
•
the investment decision or capital budgeting process
the financing decision or capital structure process
liquidity or working-capital management
the dividend policy decision.
The investment decision relates to the objectives of the corporation and is affected by the type of
business activity the firm intends to conduct. In other words, what assets does the corporation need to
obtain, or invest in, so that it can achieve its business objectives?
Once the corporation has determined what assets it needs to acquire, it then needs to decide how
it is going to raise the funds to finance the acquisition—the financing decision. This chapter considers
how a firm wishing to become a publicly listed corporation will raise equity funds through an initial
public offering (IPO), and then how an existing listed corporation is able to raise additional equity
funds to support its ongoing business growth.
Having acquired its assets, the firm needs to manage its day-to-day operations, and therefore
its working capital. The corporation needs access to short-term funding to finance the purchase of
inventory, to meet expenses and to pay creditors as they fall due.
Finally, once the corporation begins to conduct its business activities, it is assumed that it makes
a profit. Financial management therefore needs to consider issues related to the distribution of profits.
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What proportion of the profits should be returned to the owners of the business (the shareholders)?
What proportion should be retained to provide further equity funds to support the future growth of the
business? This is referred to as the dividend policy decision.
This chapter extends the discussion on the first two aspects of corporate finance: (1) the investment
decision and (2) the financing decision.
REFLECTION POINTS
•
•
A principal objective of the financial management of a corporation is the maximisation of
shareholder value, but within the context of the firm’s objectives and policies.
Financial management includes the investment decision (capital budgeting), the financing
decision (capital structure), liquidity or working-capital management and the dividend policy
decision.
5.1
The investment decision: capital budgeting
Capital budgeting refers to the choices that a company makes when allocating or budgeting its capital.
For example, capital may be allocated to an expansion of existing operations into new markets (such as
overseas), the opening of new stores, the engagement of an advertising firm to launch a new marketing
campaign for the firm’s products, the purchase of a new piece of machinery, the design and development
of a new factory assembly line or the development of a new product.
The range of possibilities for the decision maker is potentially unlimited. It may be desirable
to expand the existing business in the same core areas in which it is currently operating, or it may
be advantageous to diversify the scope of its business operations. Also, it may be appropriate for
the business to invest funds in financial assets, rather than in real assets such as property, plant or
equipment. This decision is referred to as the investment decision (or capital budgeting); that is, the
process whereby a corporation manages its long-term investments.
The investment decision is not simply a function of a corporation deciding what it wants to do.
The basic principle—to maximise shareholder value—must be remembered. Therefore, the firm must
be certain that its decisions will in fact add to shareholder value. At times, a corporation will have a
number of choices as to which projects it might decide to carry out. Again, it needs to measure the
relative financial and operational advantages of each choice and place each choice within the strategic
context of the overall operations of the organisation.
A corporation needs to be able to quantify its alternative investment opportunities in order to
determine which proposal should proceed, and which should be deferred or rejected. Two important
quantitative measures that assist management in making those decisions are:
•
•
LEARNING
OBJECTIVE
5.1
Understand issues
related to the capital
budgeting investment
decision.
Capital budgeting
the choices that a
company makes when
allocating its capital
Investment decision
the capital budgeting
process that determines
the strategic activities
of a firm
net present value
internal rate of return.
5.1.1
Net present value
The net present value (NPV) of an investment is the difference between its costs and its returns over
time. What is meant by the present value? Money has a time value. Money today is worth more than
the same amount received in the future. This is due to risk and uncertainty, the presence of inflation—
which erodes purchasing power over time—and the fact that people are generally impatient. If you are
promised a payment of $1 100 and the payment will be made one year from today, the present value of
that payment is determined by discounting it. The magnitude of the discount rate reflects the market’s
Net present value
(NPV)
the difference between
the cost of an asset and
the present value of
future cash flows
Present value
the current value
derived by discounting
a future cash flow by a
required rate of return
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assessment of uncertainty, risk, inflation and people’s desire to save or consume. If the discount rate is
10.00 per cent per annum, we find the present value of the $1 100 to be received one year from today by
dividing it by one plus the discount rate or 1.10. The present value is $1 000.
This can be written more formally as:
Present value = S​
(1 + k)​​ −n​
​ ​ ​​​
​
​ −1​
=​ ​  $1
100​( ​​
1.10)​​
​
= $1 000
5.1
where:
S = the future amount
k = the current discount rate expressed as a decimal
n = the number of interest periods
The present value is defined as the current value of future cash flows that have been discounted by
a required rate of return. The NPV of an investment opportunity is therefore the net difference between
the present value of cash flows associated with an investment and the cost of the investment.
These calculations can best be understood by applying them to an investment. For example, a business
is considering the purchase of a new processing machine that will coat macadamia nuts with chocolate. The
machine will cost $40 000 to purchase and install, and has an expected life of three years. The company
forecasts annual incremental costs of $15 000 per year and average annual cash sales of $35 000. The machine
will have a salvage value of $10 000 at the end of the three years. The required rate of return for the company
is 18.00 per cent per annum. The required rate of return is used interchangeably with the term ‘discount rate’.
In practice, the firm will usually use the weighted average cost of capital (WACC) as the discount rate.
The present value of the investment’s cash flows must be calculated. However, there are two sets
of cash flows, each with different characteristics. There are the single cash flows resulting from the
purchase of the machine (–$40 000) and the sale of the machine in three years’ time (+$10 000). There
is also a series of equal cash flows that occur annually over the three-year period. These cash flows
are the net of the cash sales ($35 000 less expenses of $15 000, equalling $20 000 per annum). Two
formulae are needed to calculate the present values of the future cash flows:
1 the present value of the net annual cash flows can be worked out using the present value of annuity
formula if all of the cash flows, C, are the same:
Present value = C​​
[​​ ​ _
​​]​​​
k
1
− ​
(
1.18
​ ​ ​​​
​  =
​  20
​)​​ −3​ ​​​​
000​​[_
​​ ​   ​​
​​
]
0.18
​
= $43 485.46
1 − ​(1 + k )​​ −n​
5.1a
2 the present value of the salvage value:
Present value = S​
(1 + k)​​ −n​
​ ​ ​​​
​
​​
​ −3​
=​ ​  $10
000​(1.18)​​
​
= $6 086.31
5.1b
Add the two present values (above) together and the present values of the cash flows is $49 571.77. To
determine the net present value of the project, the cost of the machine (–$40 000) must be deducted.
$40 000 ​​
+ $49 571.77​
​ Net
​​ present value
​  =​ −
​
= $9 571.77
NPV decision rule
accept an investment
opportunity that has a
positive NPV
5.1c
The above investment produces a positive NPV based on the projected cash flows and the corporation’s
required rate of return. The NPV decision rule that should be adopted is that a company should accept an
investment proposal that has a positive NPV and reject any proposal with a negative NPV. (The discussion
of the present value of a cash flow or a series of cash flows is extended in Chapter 8.)
Calculating the NPV to determine whether an investment will add to shareholder value seems
relatively simple. However, NPV is based only on the corporate finance team’s best forecasts or projections.
The projected cash flows over the term of the project are estimates. The environment in which a business
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operates is dynamic; things change, including cash flows. This obviously will have an impact on the original
NPV calculation.
Management must challenge the cash-flow estimates and determine the level of confidence it has
in them. Also, the discount rate used, or the required rate of return, will influence the NPV. Again,
management must be able to support the discount rate applied to NPV calculations.
5.1.2
I NTERNAL RATE OF RETURN
Another method regularly used by corporations to determine whether a business investment proposition
is acceptable is known as the internal rate of return (IRR). The IRR is often regarded as being easier to
understand in that it provides an actual percentage figure as the rate of return. NPV, on the other hand,
provides a positive or negative dollar amount.
The IRR on a business investment is defined as the discount rate that results in an NPV of zero when
it is used to discount an investment’s forecast cash flows. The basic rule is that an investment is acceptable
to a corporation if its IRR is greater than the firm’s required rate of return (discount rate or weighted
average cost of capital). If the IRR is less, it should be rejected. The IRR and the NPV are obviously
related. If the IRR is greater than the required rate of return, the NPV will be positive and vice versa.
Manually calculating the IRR on a business investment (without the use of an electronic calculator) is
difficult, and usually requires a series of trial-and-error calculations. However, a basic financial calculator will
calculate the IRR with a few keystrokes. The following example presumes access to a financial calculator.
While the keystrokes for different brands of calculators may vary, the data inputs will be the same.
The data required are the net cash flows per period and the number of periods per year.
Continuing with the hypothetical chocolate-coating machine in the previous NPV example, and
using a Hewlett-Packard Business calculator, input the following:
payments per year = 1
net cash flows: period 0 = − $40 000
period 1​ =​ $20
000​​ ​
​​
​ ​  ​ ​  ​
​
period 2 = $20 000
period 3 = $30 000 (i.e. $20 000 revenue + $10 000 salvage )
Internal rate of
return (IRR)
the discount rate that
results in an NPV of
zero
5.1d
Keystrokes:
P  ​
1 ​ [secondfunction] ​ ___
YR
− 40 000 ​ CFj
20 000 ​ CFj
​
​  ​
​
​​
​​ 20 000 ​ CFj
​​​
30 000 ​ CFj
IRR ​
​ ​ [second function] ​ ___
YR
​ Answer:​  IRR = $31.45%​
5.1e
Referring back to the calculation of NPV, the inclusion of the following two additional keystrokes
on the calculator will obtain the NPV:
​​
I  ​
18 ___
​ YR
​
​ ​ [second
​
​
​
​​
function] NPV ​​
Answer: NPV = $9 571.77
5.1f
​
If the corporation’s required rate of return is less than 31.45 per cent per annum, the business
investment opportunity is acceptable.
The above IRR calculation is reasonably easy to achieve and interpret, providing the corporation is
confident in its cash-flow forecasts. However, the simplified procedure suffers from two shortcomings,
the solutions for which are beyond the scope of this text.
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Non-conventional
cash flows
occur when the
ongoing cash flows
from an investment are
not always positive
Mutually exclusive
projects
from a choice of two or
more projects, only one
project will be chosen
The first problem occurs when the cash flows associated with an investment are non-conventional cash
flows. In the example above, there was an initial negative cash flow followed by a series of positive net cash
flows. To be precise, the ‘sign’ of the cash flows changed only once, from the negative initial cash flow to
the series of positive cash flows. If there are multiple changes in sign, there will not be a unique IRR for the
project. If there was a negative cash flow in the final period of the project because the company needed to
clean up the site of its operations, for example, there would be two changes in sign (negative to positive to
negative) and no unique IRR. In this situation the financial calculator will usually give an error message.
The second problem occurs when investment choices are mutually exclusive projects. This is a
situation where a business will choose one of two investment alternatives. The IRR may give a misleading
decision rule in that it does not account for the present value of the cash flows. The timing and size
of the cash flows associated with an investment are important when choosing between investment
alternatives. In this situation it is better to revert to the calculation of NPV.
REFLECTION POINTS
•
•
•
•
•
The investment decision derives from the firm’s objectives and relates to the acquisition of
assets necessary to conduct business operations.
A firm will acquire assets that make a positive contribution to shareholder value. Two methods
used to measure this contribution are the net present value and the internal rate of return.
The net present value (NPV) of an investment is the difference between the present value of an
investment’s costs and its returns over time. The present value discounts future cash flows by
the required rate of return. A firm should accept an investment opportunity that has a positive
NPV and reject those with a negative NPV.
The internal rate of return (IRR) on an investment is the required return that results in an NPV
of zero when it is used as the firm’s discount rate. An investment may be accepted if the IRR is
greater than the required rate of return.
Two problems may be evident with IRR calculations; the first is when non-conventional cash
flows occur, and the second is when investment choices are mutually exclusive.
5.2
LEARNING
OBJECTIVE
5.2
Identify issues relevant
to a corporation’s
funding choice between
debt and equity.
Financing decision
the capital structure that
finances a firm’s assets
and activities
Business risk
exposures to factors
that have an impact on
a firm’s activities and
operations
The financing decision: equity, debt and risk
The second financial management decision, referred to as the funding decision or financing decision,
relates to the question of how a business investment is to be funded. In traditional terms, the decision
makers have the choice of financing the investment through the use of debt or through the use of
equity. In reality, a combination of both forms of finance will be used.
The principal financial objective of the corporation is to maximise shareholder value over the
longer term, subject to an acceptable level of risk. Risk can be defined as the variability or uncertainty
of returns from the business’s investments. Since returns are generated from the net cash flows of the
business, risk is measured by the variance in net cash flows.
What are the sources of risk? Risk is often presented as deriving from two distinct sources: business
risk and financial risk.
Business risk is determined in part by the corporation’s choice of business activity, and the manner
in which it conducts its business operations. A speculative mining company, while offering the chance of
high returns, is generally exposed to high levels of operational risk, whereas a company with diversified
business operations is typically exposed to a lower degree of risk, but offers lower expected returns.
A company that is reliant upon technology-based product delivery systems is vulnerable to a failure
of those systems. A business that currently enjoys a large proportion of market share for its product is
exposed to the threat of new competitors entering the market and chipping away at that market share.
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Business risk is also affected by factors such as the rate of growth of that sector of the economy in
which the firm is operating, the firm’s share of the market, the aggressiveness of the competition it faces
and, most importantly, the competence of the firm’s management and workforce. The combination
of these factors will determine the magnitude of the profits generated by the firm’s assets and the
variability of the expected profit stream.
Financial risk is important as it has a direct impact on the value of assets and liabilities on the
balance sheet as well as affecting the level of cash flows passing through the business. There are many
broad categories of financial risk.
•
•
•
•
•
•
Interest rate risk is evident where interest rates may potentially move in a direction that adversely
affects the cost of funds or the return on investments. For example, a rise in interest rates will
adversely affect the cost of variable-rate debt issued by corporations.
Financial risk
exposure to factors
that affect the value of
assets, liabilities and
associated cash flows
Foreign exchange risk is evident when a firm has balance-sheet assets and liabilities, and associated
cash flows, denominated in a foreign currency. Movements in the exchange rate will affect the value
of these items. For example, a company that imports goods from overseas, where payment is to be
made in USD, will be adversely affected by a depreciation in the exchange rate; that is, it will be
more expensive to purchase the USD required to pay for the imported items.
Liquidity risk is about having sufficient cash, liquid assets or access to funding sources to meet
forecast day-to-day operating requirements. For example, a company needs to be able to pay creditors
when due, purchase inventory, pay staff and meet other operating expenses. A bank overdraft may
be used for this purpose (see Chapter 9).
Credit risk is a situation in which debtors do not repay their obligations on time or default in repayment.
For example, a company might have provided goods to a client with payment due in 30 days, but the
company is unable to collect the amount due because the client has gone into liquidation.
Capital risk occurs when shareholders’ funds are insufficient to meet capital growth needs or, in
an adverse situation, to write off abnormal losses. For example, a corporation might be aware of a
new business opportunity, but is unable to fund the purchase without breaching debt-to-equity loan
covenants on an existing loan from its bank.
Country risk is the risk of financial loss associated with a fixed exchange-rate currency devaluation,
currency inconvertibility, rescheduling of external debt, barriers to funds transfers, political
developments in a nation-state resulting in expropriation of a company’s assets, legal restrictions,
freezing of company assets or forced divestment of assets.
5.2.1
F INANCIAL RISK AND THE DEBT-TO-EQUITY RATIO
Financial risks attach to both debt and equity issued by a business; however, all else being equal, the
greater the proportion of debt relative to equity, the greater the risk to the business and its shareholders.
This conclusion flows from the obligation that attaches to debt. A fundamental characteristic of debt is
that interest payments and principal repayments on debt must be paid when they fall due. On the other
hand, shareholders only receive a dividend payment if the directors approve such a payment. Also, in
the event of the failure of the business, the providers of debt funding rank ahead of equity holders in
their claim on the assets of the corporation.
To dispel any idea that the raising of debt finance is necessarily against the interests of the
shareholders, however, it is important to recognise that increasing the degree of leverage, or debt, of
the business may significantly improve the shareholders’ earnings attributable to ordinary shares, or
expected earnings per share (EPS).
This can be understood by considering a situation in which the business can borrow funds at
9.00 per cent per annum and in which it expects to be able to earn a net return of 15.00 per cent on
its assets. Under those circumstances, shareholders benefit from the net 6.00 per cent positive return.
Earnings attributable
to ordinary shares
the net accounting
earnings on a
company’s shares
expressed in cents
per share
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However, if the debt-financed expansion resulted in a return of less than 9.00 per cent on assets,
shareholders would suffer.
In determining the appropriate mix of debt and equity, the corporate finance manager faces a
dilemma. The higher the proportion of debt, the higher will be the potential return on shareholders’
funds, or EPS. However, increased debt exposes the shareholders to a greater variance in their EPS,
and the firm is exposed to a greater risk of insolvency because income or revenue may fail to reach the
expected levels; nevertheless, debt interest and principal payments must be paid when due. One reason
for a sudden fall in expected revenue may be a downturn in economic activity, as was experienced
during the global financial crisis.
The higher the debt-to-equity ratio, the higher the degree of financial risk. One of the implications
of an increase in financial risk is that rational equity holders would demand a higher expected rate of
return to compensate them for incurring the higher financial risk.
5.2.2
Debt-to-equity ratio
the proportion of
a firm’s debt funds
relative to its equity
funds
Gearing ratio
the percentage of a
firm’s total funding
provided by debt
Loan covenants
W HAT IS THE APPROPRIATE DEBT-TO-EQUITY RATIO?
Although there is a wealth of literature on financial management, there is no agreed ideal debt-to-equity
ratio. The ratio appears to be decided, in practice, by reference to four main criteria.
•
•
•
conditions or
restrictions placed on a
borrower and specified
in a loan contract
•
First, a firm may consider the ratio that is the norm in the industry in which the firm operates, and
adopt something near that ratio. Significant deviations from the industry norm may cause concern
for the potential providers of both debt and equity funds.
The second criterion for determining future gearing ratio is the history of the ratio for the firm.
The ratio employed in the past may be regarded as the norm, and management may be reluctant to
change it greatly. If the business has been performing with a return on assets that is acceptable to
shareholders, it may be deemed appropriate to continue with a similar gearing ratio. Any significant
change in the ratio may result in the disaffection of the current shareholders.
The third criterion, and a more appropriate one than the first two, is the limit imposed by lenders.
It is quite common for lenders to impose various loan covenants on the borrowings of a company.
Loan covenants are conditions or restrictions incorporated into loan contracts that are designed to
protect the interests of the lender. (This is discussed further in Chapter 10.) A common covenant is
a limit on the ratio of debt liabilities to total assets. If a company exceeds a loan covenant limit, this
will constitute a violation of the loan agreement with the lender. The lender may then require the
loan to be repaid in full immediately.
The fourth criterion in determining the debt-to-equity ratio, and perhaps the most relevant, is
management’s decision concerning the firm’s capacity to service debt. The assessment is made by
determining the charges, the interest payments and the principal repayments associated with a given
level of debt, and assessing the capacity of the firm’s expected future income flows to cover the payments
while leaving sufficient profits to satisfy shareholders’ expectations for a return on their equity.
The critical issue in the fourth criterion is evaluation of the firm’s expected income flows. Since this
clearly cannot be known with certainty, management should consider various scenarios, including the
most likely and the most pessimistic income-flow expectations. If the pessimistic assessment shows that
a given level of debt can be serviced while allowing shareholders’ expectations to be met, management
may accept that level of debt as being satisfactory.
Where the cost of debt is exposed to a variable interest rate, a similar range of scenarios must be
used to test the capacity to service a given amount of debt under different interest rate scenarios.
The most prudent debt-to-equity ratio is the largest ratio at which a corporation still has the capacity
to service debt commitments under a pessimistic business scenario.
Notwithstanding the above discussion, debt-to-equity ratios tend to vary quite considerably
between industry sectors and between individual corporations. For example, in 2018, while the average
debt-to-equity ratio in Australia was less than 1.00, ANZ Ltd’s debt-to-equity ratio was 12.78 and NAB’s
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was 13.60. This is typical of commercial banks. The nature of their business—that is, the borrowing of
funds in order to provide loans to customers—inevitably means that they will have a great dependence
on debt liabilities as a source of funds. However, corporations in many other industry sectors, such
as the retail sector, maintain much lower debt-to-equity ratios. For example, in 2018, Woolworth’s
debt-to-equity ratio was 0.30. This provides management with the flexibility to make further strategic
investments in the future, and also to withstand the adverse impact of an economic downturn on future
cash flows.
Once a company decides on its appropriate debt-to-equity ratio, it faces the task of securing the
desired equity funding. Section 5.3 examines the situation of a newly listed company raising equity
through an IPO, Section 5.4 identifies the requirements that must be met by a business seeking to list
on a stock exchange and Section 5.5 considers the funding avenues available to a corporation that has
already listed on a stock exchange.
REFLECTION POINTS
•
•
•
•
•
•
The financing decision analyses and determines the combination of funding sources used to
finance the business.
Risk, being the variability or uncertainty of returns from business investments, affects the
financing decision.
Risk exposures include business risks, such as competition and the economic cycle, and
financial risks, such as interest rate risk and foreign exchange risk.
The basic characteristic of debt is that it must be repaid; equity does not have to be repaid.
A firm must monitor its debt-to-equity ratio to ensure that it is able to service its debt
commitments over time. Too much debt will increase the risk profile of the company and
therefore the cost of funds; too low a level of debt may not maximise shareholder value.
Gearing ratios will vary between companies, between industry sectors and over time,
depending on the economic cycle.
5.3
Initial public offering
Our focus is on the publicly listed corporation. However, it should be noted that businesses often evolve
from small beginnings: from a sole proprietorship to a private company and eventually to a size where
listing on a stock exchange is a possibility.
A sole proprietor is both the owner of the business and the manager of the business; the proprietor
is personally liable for the liabilities of the business, but is also entitled to all the profits generated. As
a business grows, a sole proprietor may seek additional equity funds and therefore form a small private
company with a limited number of shareholders. Should the company grow to a point where it wishes
to expand its equity and shareholder base further, then becoming a publicly listed corporation is an
attractive proposition.
Listing on a stock exchange provides access to a large equity capital market that is not available to
an unlisted business entity. Access to this market enables a listed corporation to extend the funding base
on which it can expand and grow its business activities into the future. Also, as discussed in Chapter 4,
shares issued by listed companies are very liquid; that is, they can easily be sold or purchased through
a stock exchange, and therefore are an attractive investment option for investors. Another advantage
of listing for a corporation is that it raises its profile in the financial markets and in the markets for its
products and services.
The choice concerning the type of equity available to a business that is listing for the first time
is relatively limited. Such a business does not have a history of share price performance, and is thus
LEARNING
OBJECTIVE
5.3
Examine the listing
and flotation or initial
public offering (IPO)
of a business on
a stock exchange,
including equity-funding
alternatives that are
available to a newly
listed corporation.
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Initial public offering
(IPO)
an offer to investors
of ordinary shares in a
newly listed company
on a stock exchange
Flotation of a business
the public listing
and quotation of a
corporation on a stock
exchange
Promoter
the party (company)
seeking to list as a
corporation on a stock
exchange
Underwriting
a contractual
undertaking to
purchase securities that
are not subscribed to
by investors
initially precluded from the alternatives that are available to a successful listed company. The only choice
facing most businesses is the form of incorporation; that is, should the business incorporate as a limited
liability company or as a no liability company? These structures are discussed in the next subsection.
Once the form of incorporation is determined, the sale of ordinary shares is the most usual option
available to the business. As discussed below, another option is the issuing of instalment receipts. The
initial offering of shares by a new publicly listed corporation is known as an initial public offering (IPO).
An IPO is described as the flotation of a business.
The method, terms, conditions and timing of an IPO are usually decided after consultation between
the business seeking the flotation, known as the promoter, and its financial advisers. The advisers may
include a stockbroker, an investment bank and other specialist advisers with the required financial,
technical and legal expertise and industry knowledge. The promoter will inform the advisers about the
company’s funding requirements, its expectations concerning future profitability and developments,
and its expectations relating to the pricing of the shares. Based on the advisers’ experience and
knowledge of similar types of companies in the market, and of investors’ current attitudes towards the
industry, the advisers will recommend the appropriate timing and structure of the IPO. It is essential
for advisers to be competent in legal aspects of an incorporation and listing of a company, and to have
sound knowledge of the relevant markets, competitors and investors.
The advisers also assist with the preparation of the prospectus (the public offer document) and its
lodgement with the corporate regulator. They also ensure that the listing requirements of the stock exchange
are met. The preparation of the prospectus is a critical component of the listing process. A prospectus
provides detailed information on the past and forecast performances of the organisation, and includes
reports from the board of directors and specialist experts and financial statements. All information
contained in the prospectus must be verified for accuracy through a process of due diligence, as there are
severe penalties for making false or misleading statements or for omitting relevant information.
An application form used to subscribe for ordinary shares in the IPO is attached to the prospectus.
The IPO advisers usually take an active role in promoting the issue to potential individual and
institutional investors. To assist in the selling task, and to guarantee the promoter that all shares offered
for sale will be taken up, the advisers may arrange an underwriting group. The advisers normally also
take a significant underwriting position. There is no specific requirement that an issue be supported
by an underwriter. If an underwriter is appointed, it may be a single underwriter or a syndicate of
underwriters. The underwriters (usually one or more investment banks), in consultation with the
advisers, will provide advice on:
•
•
•
•
•
•
Out-clause
specific conditions
that preclude an
underwriting agreement
from being fully
enforced
the structure of the issue
the debt-to-equity ratio
the pricing of the issue
the timing of the issue
the marketing of the issue
the allocation of securities.
It is possible that the time elapsed between the initial agreement between the promoter and advisers on
the price and timing of the issue and the actual float may be such that market conditions have significantly
changed, particularly in periods of instability in the share market. If market prices have fallen and the
new issue is unattractive under the current circumstances, the underwriters may be left to take a large
proportion of the shares on issue. Normally, the underwriters protect themselves against being caught in
a situation where there are changes in circumstances that could not have been foreseen at the time of the
initial agreement by including an out-clause in the underwriting agreement. The out-clause may relate to
the level of a specified share price index, such as the S&P/ASX 200. If the index falls below a nominated
level, or by a certain percentage, then the underwriters may be released from their underwriting obligation.
It is usual in such circumstances for either the float to be withdrawn or the issue to be re-priced.
The costs directly associated with an IPO include fees charged by the advisers for the structuring,
valuation and preparation of documentation for the flotation, including legal, financial, technical,
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taxation and specialist expert reports (e.g. geologists’ reports). Other fees will be incurred for accounting
advice, printing and distribution and the stock exchange listing. The costs on large issues may be up to
10.00 per cent of the amount raised, while for small issues the costs may be even higher. The underwriting
fee usually includes about 1.00 per cent payable as brokerage on allotted shares.
5.3.1
O RDINARY SHARES: LIMITED LIABILITY COMPANIES
Two common types of corporate structures are:
•
•
a limited liability company
a no liability company.
Ordinary shares in a limited liability company are the principal source of equity funding for most
listed corporations.
Ordinary shares or common stock represent a residual ownership claim on the assets of the firm;
that is, they provide a return to the shareholders only after the firm has met its obligations to all other
providers of funds, and after all operating expenses have been paid.
As contributors of risk capital, shareholders are owners of the business and are entitled to have
control over its management. This does not mean that shareholders have a say in the day-to-day
management of a firm; rather, control is derived from the voting right attached to each share. The
voting right entitles the shareholder to vote for the board of directors and any other motions that the
directors may put to the shareholders from time to time. Voting rights are exercised by shareholders at
the annual general meeting and any extraordinary general meetings that may be called. The shareholder
may vote in person or by proxy. A proxy is someone who is authorised to vote on a shareholder’s behalf
at a general meeting of shareholders. For example, shareholders may give their proxy to the chair of the
meeting, thus authorising the chair to vote on their behalf.
Limited liability shares are usually sold on a fully paid basis; that is, on the initial issue of the share,
the shareholder pays the total issue price to the corporation. However, the shares may also be issued on
a partly paid or contributing basis, with the remainder to be paid on a specified date.
Another form of issue is the instalment receipt. An instalment receipt is issued instead of a partly paid
share; upon payment of a specified amount at a future date, the fully paid share is issued as a replacement
for the instalment receipt. A holder of instalment receipts generally retains the same rights as a shareholder.
In the case of contributing shares, also known as partly paid shares, and instalment receipts in a
limited liability company, the shareholder has a contractual obligation to pay the remaining amount
when it is called or due.
Importantly, with ordinary shares issued by a limited liability company, the shareholder’s liability is
limited to the extent of the fully paid share. Therefore, if the share has been fully paid, the shareholder
cannot be required to make any further payment to the company, its creditors or a liquidator.
The share issue price will be determined by reference to a range of variable factors. Important
factors include the expected future earnings of the company, and the price to earnings (P/E) ratios of
similar existing firms. Other related factors include the trend in economic activity, both domestic and
international, the forecast levels of interest rates, the exchange rate, the performance of the particular
industry, the firm’s products and services, and management expertise and performance.
5.3.2
Proxy
a party authorised
to vote on behalf of
a shareholder at a
general meeting
Instalment receipt
issued upon payment
of the first instalment
on a new share issue;
ordinary share issued
when final instalment
paid
O RDINARY SHARES: NO LIABILITY COMPANIES
In a diverse economy, a proportion of new business ventures will always be regarded as being highly
speculative. This is particularly the case in the resources sector, where a great deal of uncertainty exists
with new exploration ventures, such as the search for oil, gas and minerals. With many of these projects,
considerable financial investment is required progressively over time before the venture begins to reach
a point when positive cash flows are generated.
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Such ventures need access to equity funding, but potential shareholders may be deterred by the
likelihood that there will be a high level of risk for an extended period. One solution to this problem
is the formation of a no liability corporation. A no liability company will issue ordinary shares to raise
equity funds, but the shares will be issued on a partly paid basis. In Australia, only mining companies
are able to list on the ASX as a no liability company.
For example, a gold-mining company has acquired the rights to explore in a certain location. To
do this, the company will need finance and may issue ordinary shares at $2.00 per share, but with an
initial call (or payment) of 15 cents per share. This will provide the company with enough equity funds
to carry out the initial exploration process. If gold is discovered, the company will inform shareholders
of the forecast quantities of gold reserves and the commercial viability of mining the gold. To move to
the production phase of the business, the company may make a further call on the partly paid shares of
50 cents. At this point, with a no liability company, each shareholder can pay the 50 cent call or decide
not to pay the call. The decision will be based on the shareholder’s view of the prospect of the venture
succeeding. Shareholders in a no liability company cannot be compelled to meet a call on the shares,
but those who do not meet the call forfeit their shareholding.
In order to attract risk capital, a no liability company may also offer shareholders an option to
purchase additional shares in the company at a predetermined price at a predetermined future date.
An option gives the holder the right, but not the obligation, to buy a share at the nominated exercise
price by a specified future date. If the company’s exploration proves to be successful, the option will
increase in value (price) because the price of the company’s ordinary shares on the stock exchange
should be trading above the option exercise price. The holder of the option can exercise the option and
buy additional shares at the price specified in the option contract. If at the option expiry date the shares
are trading below the option exercise price, the option would be allowed to lapse.
REFLECTION POINTS
•
•
•
•
•
•
The listing of shares of a new company on a stock exchange is called an initial public offering (IPO).
The promoters of an IPO, in conjunction with their financial advisers, need to consider matters
such as the structure, pricing, timing, marketing and allocation of the share issue.
A prospectus, the public offer document, is compiled and will include all information required to
allow investors to make an informed investment decision.
A syndicate of underwriters (investment banks) may be used to promote the issue and, subject
to the terms of the underwriting agreement, purchase any shares not taken up by investors.
The liability of shareholders in a limited liability company is limited to the value of their fully paid
ordinary shares.
Shareholders in a no liability company cannot be required to pay calls on any unpaid amount
on their partly paid shares, but they may forfeit those shares if a call is not paid.
5.4
LEARNING
OBJECTIVE
5.4
Consider important
issues associated with
listing a business on a
stock exchange.
Listing a business on a stock exchange
A company must apply to a stock exchange to have its shares quoted if it wishes to become a publicly
listed corporation and raise equity capital through an offer of shares to the public.
A company will normally apply to a stock exchange in its home country. The application must be
accompanied by documentation outlining the company’s activities and performance. This information
will be provided directly to the exchange and will be contained in a prospectus that supports the share
offer to the public.
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The stock exchange will ensure that the company complies with the stock exchange listing requirements.
A stock exchange’s listing rules are additional to a company’s statutory obligations under the
corporations legislation of the nation-state in which the stock exchange is located. The stock exchange’s
listing rules represent a very strong element in the regulation of listed companies. If a listed corporation
does not comply with the listing rules of the stock exchange, the offending company is liable to be
suspended from quotation or it may be delisted.
The listing rules of a stock exchange are the rules that must be met by an entity seeking to be quoted
on that stock exchange, and the rules with which a listed corporation must continue to comply if it is to
remain a listed corporation on the exchange.
A stock exchange will establish listing rule principles that embrace the interests of listed entities,
the maintenance of investor protection and the need to maintain the reputation and integrity of the
market. The main principles that form the basis of a stock exchange’s listing rules are:
•
•
•
•
•
•
•
•
•
•
Delisted
removal from quotation
of the securities of an
entity that breaches
stock exchange listing
rules
Minimum standards of quality, size, operations and disclosure must be satisfied.
Sufficient investor interest must be demonstrated to warrant an entity’s participation in the market.
Securities must be issued in circumstances that are fair to new and existing security holders.
Securities must have rights and obligations attached to them that are fair to new and existing security
holders.
Timely disclosure must be made of information which may affect security values or influence investment
decisions, and information in which security holders, investors and the ASX have a legitimate interest.
Information must be produced according to the highest standards and, where appropriate, enable
ready comparison with similar entities.
The highest standards of integrity, accountability and responsibility of entities and their officers
must be maintained.
Practices must be adopted and pursued that protect the interests of security holders, including
ownership interests and the right to vote.
Security holders must be consulted on matters of significance.
Market transactions must be commercially certain.
For those who wish to consider the listing rules of a stock exchange further, it is possible to view
the rules of an exchange on the exchange’s website. The extended learning section at the end of the
chapter provides an introduction to the listing rules of the ASX.
While the majority of corporations list their shares solely on their domestic stock exchange, some large
multinational corporations choose to list on more than one exchange. The shares of the corporation are
said to have a dual listing. A company may seek dual listing to gain access to a much wider capital market for
the issue of new primary market securities, and ensure greater liquidity in the secondary market trading of
its existing shares. Dual listing is normally achieved by the creation of two holding companies, each entitled
to 50.00 per cent of the group’s assets. Shareholders in both holding companies have equivalent economic
and voting rights. For example, BHP Billiton is listed on the ASX and the London Stock Exchange (LSE)
through two holding companies—BHP Billiton Limited (ASX) and BHP Billiton Plc (LSE).
Dual listing
the shares of
a multinational
corporation are listed
on more than one stock
exchange
REFLECTION POINTS
•
•
•
•
A company will usually apply to its home stock exchange for the listing and quotation of its shares.
Companies must comply with the listing rules of the stock exchange; failure to do so may result
in the quotation of shares being suspended or the company being delisted.
A multinational corporation may choose to become a dual-listed company by listing its shares
on more than one stock exchange in order to access the wider international capital markets
and increase liquidity in the trading of its securities.
Listing rules seek to embrace the interests of listed entities, maintain investor protection and
maintain the reputation and integrity of the market.
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5.5
LEARNING
OBJECTIVE
5.5
Explore equityfunding alternatives
that are available to
an established listed
corporation, including
rights issues, share
purchase plans,
placements, takeover
issues, dividend
reinvestment schemes,
preference shares,
convertible notes and
other quasi-equity
securities.
Equity-funding alternatives for listed
companies
Companies that are listed on a stock exchange—and that have a proven track record of sound management,
good profitability growth and strong share price performance—provide attractive investment opportunities
for shareholders. These companies have a much wider choice of equity funding alternatives available.
For example, the raising of additional equity can be achieved through the issue of additional ordinary
shares, preference shares, convertible notes and other forms of quasi-equity.
Our discussion of these different forms of equity finance begins with a consideration of the various
ways a listed corporation might raise equity funds through the issue of additional ordinary shares.
These include:
•
•
•
•
a rights issue or a share purchase plan
placements
takeover issues
dividend reinvestment schemes.
This is followed by a discussion on some of the main hybrid securities that may also be issued,
including:
•
•
preference shares
convertible notes and other quasi-equity securities.
5.5.1
Pro-rata offer
a proportional offer to
buy securities based
on an investor’s current
shareholding
R IGHTS ISSUE OR SHARE PURCHASE PLAN
A company may seek to raise further equity funds by issuing additional ordinary shares to its existing
shareholders. An offer made to existing shareholders to purchase additional ordinary shares in the
corporation is called a rights issue.
An application to take up shares offered under a rights issue must be attached to a prospectus.
In making a rights issue, it is necessary to ensure that all shareholders receive an equal opportunity
to participate. This is achieved by making the offer on the basis of a fixed ratio of new shares to the
number of shares already held, that is, a pro-rata offer. For example, a 1:5 (one for five) offer grants
shareholders the right to purchase one new share for every five shares held.
The terms of the new share issue are determined by the board of directors in consultation with
the board’s financial advisers and, if applicable, the underwriters of the issue. In determining the offer
price, the board of directors will consider the following:
•
•
•
The company’s cash-flow requirements. The greater the necessity of the company’s funding needs, the
lower the rights issue offer price may need to be to ensure a sufficient take-up rate of the issue by
shareholders.
The projected return on assets expected to derive from the new investments funded by the rights issue.
This is directly related to the ability of the company to maintain its return on equity to shareholders.
This variable may have an effect on the price of the rights issue. The greater the expected earnings
cash flows, the more attractive the issue would be to shareholders. The more attractive the additional
shares are deemed to be, the smaller the discount that is required from the current market price to
encourage sufficient shareholder participation.
The cost of alternative funding sources. The company will carry out a cost–benefit analysis of various
funding forms and sources. For instance, if the company has a low debt-to-equity ratio, it may decide
that further debt funding would be preferable to a rights issue of equity. If equity is required, the
company may decide that a placement (see below) is a more preferable funding alternative.
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A rights issue is a financial instrument that provides a future right to the holder. Therefore,
the right itself has value. A company may make a rights issue offer today which normally can only
be exercised at a specified future date. Not all shareholders may wish to participate by purchasing
the extra shares offered. The company may decide to list the rights issue on the stock exchange
so that the right can be sold to another investor before the exercise date. Where a right may be
sold, it is said to be a renounceable right. With a renounceable rights issue, the right of the existing
shareholder to take up new shares on a pro-rata basis may be sold to another party during the
period the right is on offer. The ultimate buyer may then exercise the right to take up the new
shares with the rights offer.
A rights issue that may only be exercised by the shareholder and not sold to another party is a ­
non-renounceable right.
The effect of a rights issue on the share price is illustrated in Chapter 6.
An alternative method of offering additional shares to existing shareholders is through a share
purchase plan. Instead of offering new shares on a pro-rata basis under a rights issue, the company
may offer shareholders the opportunity to purchase a fixed dollar amount of shares at a predetermined
price. For example, shareholders may have the choice of purchasing $2500, $5000, $7500 or $10 000
worth of shares. The shareholder may choose not to purchase any shares.
5.5.2
Renounceable right
a right attached to a
security that can be
sold to a third party
Non-renounceable
right
a right attached to a
security that cannot be
sold to a third party
Share purchase plan
an offer to existing
shareholders to
purchase a fixed dollar
amount of new ordinary
shares
P LACEMENTS
Rather than make a rights issue or share purchase plan offer to all existing shareholders, the board
of directors may decide to raise further equity funds by making a placement of ordinary shares with
selected investors. Investors that purchase additional shares through a placement issue are institutional
investors such as fund managers.
There are numerous advantages to placements as a means of raising additional equity. A placement
can be arranged and finalised much more quickly than a pro-rata rights issue. Whereas a pro-rata rights
issue is likely to take over two months from the announcement of the rights issue to the receipt of
funds, placements can be effected within a matter of days. This attribute is particularly important in
times of volatile market behaviour.
Another potential feature of the placement is that the discount to current market price may be
less than that for a pro-rata rights issue. This is because a placement involves dealing with institutional
investors who are expected to be better informed than individual investors on current market values and
therefore may need less of an incentive to purchase the shares on offer.
It is also possible with a selective placement of shares for the board of directors to sell the shares
to institutional investors who are deemed to be friendly to the company and are likely to support the
development of the business.
One of the main disadvantages of the placement is that it dilutes the proportion of the
ownership of the company by existing shareholders. However, existing shareholders’ interests may
be partly protected by regulation, or by a stock exchange’s listing rules. For example, the ASX
listing rules state that a corporation that proposes a placement that will bring its total placements
in any 12-month period to more than 15.00 per cent of the company’s issued shares may do so only
if shareholders ratify previous placements at the annual general meeting. An exception applies to
smaller companies with a market capitalisation of less than $300 million. These companies are
permitted to raise an additional 10.00 per cent of their equity capital, above the 15.00 per cent limit,
if shareholders approve.
Nevertheless, placement issues have been abused in the past, when boards of directors favoured
certain shareholders by placing shares with them at an attractive price, but disenfranchised other
shareholders by excluding them from the offer. In many countries, legislation has been put in place to
protect shareholders from this form of inequitable practice. In Australia, for example, ASIC requires that a
placement consist of subscriptions of not less than $500 000, and that there must be no more than 20
participants. The discount from the current market price must not be excessive (more than 10.00 per cent).
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Memorandum of
information
information required
to be provided to
institutional investors
with a placement offer
Equity-funded
takeover
a takeover company
issues its shares in
exchange for the shares
of the target company
Placements may be made directly with institutions and individual investors who are deemed to be the
clients of brokers without the need to lodge a prospectus, but a memorandum of information detailing the
company’s activities must be sent to all participants.
5.5.3
T AKEOVER ISSUES
Mergers and acquisitions—where one company seeks to purchase another company—were discussed
in Chapter 3, and it was noted that an investment bank may be consulted to advise a company on
the takeover. In particular, the investment bank will advise the takeover company on the alternative
financing strategies that are available to fund the takeover.
An equity-funded takeover (or part-equity-funded takeover), in which the takeover company issues
additional ordinary shares to fund the acquisition of the shares in the target company, is a popular
method used to fund a merger and acquisition.
For example, company A may decide to issue additional shares to finance a full-equity-funded
takeover. Company A will offer those shares on a pro-rata basis to the existing shareholders in company
B. As the value of shares in the two companies will not be the same, company B shareholders may be
offered three shares in company A for every five shares they hold in company B. The pro-rata basis of
the offer will depend on the value of the shares in each company and any incentive being offered to
encourage company B shareholders to accept the offer. If shareholders in the target company B accept
the offer, they will receive shares in the takeover company A in return for their shares in company B,
provided that the takeover goes ahead.
The offer may include both a pro-rata share issue and a cash component. For example, company A
may offer a 3 for 5 share exchange, plus 50 cents cash for each share held.
Interestingly, the number of all-share takeover deals has dropped considerably. According to the
Financial Times, in the USA, only 10.00 per cent of transactions undertaken in 2017 were all-share
deals. Since the GFC, around 20.00 per cent of transactions each year have been all-share deals. This
represents a significant decline from the heyday of all-share deals in the late 1990s when this type of
deal represented more than 80.00 per cent of transactions. For the time being, cash is king in the world
of mergers and acquisitions.
5.5.4
D IVIDEND REINVESTMENT SCHEMES
The payment of dividends varies from corporation to corporation, between industries and even between
nation-states. For example, in some industries in the USA companies retain profits within the company
to finance future growth, rather than paying a dividend. In other countries, such as Australia, where
the percentage of profits returned to shareholders in the form of dividends is higher, one method of
encouraging shareholders to put further equity funds back into the corporation is through the use of a
dividend reinvestment scheme.
A dividend reinvestment scheme allows shareholders to reinvest their periodic dividend receipts by
purchasing additional ordinary shares in the company. That is, instead of receiving the cash dividend, a
shareholder may decide to reinvest the dividend back into the company and receive some additional shares.
One of the advantages to shareholders of a dividend reinvestment scheme is that the corporation
typically meets the associated transaction costs, such as brokerage fees, that otherwise would be
incurred if shareholders independently sought to use their dividends to purchase additional shares.
Dividend reinvestment schemes are also attractive to investors as they provide a simple savings regimen.
For example, if an investor received a $100 dividend in cash, the investor may be likely to spend the
cash received, but by automatically reinvesting the dividend into additional shares the investor is able to
increase their investment portfolio and personal wealth over time.
Dividends are usually paid twice a year: an interim dividend and a final dividend. This means that
shareholders can progressively top up their shareholding in the company by reinvesting their dividends.
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The method by which the issue price of a share is determined differs from one company to another.
However, a reasonably common practice is to take the weighted average of the market price of the
company’s shares traded on the stock exchange for the five days following the ex-dividend date, and
then adjust that price by the company’s stated discount. The discount on a dividend reinvestment
scheme is typically between 0 and 5.00 per cent.
Dividend reinvestment schemes are an attractive method of raising additional equity funds. They
allow companies simultaneously to pay dividends to shareholders and, assuming a sufficient reinvestment
rate, to maintain the necessary equity finance to fund the company’s future investments and growth.
However, there may be times when reinvestment schemes are inappropriate, such as during periods
when the company sees few new prospects for future profitable investments and when its cash position
is quite healthy. By adding to the company’s equity base at a time of poor investment prospects, shares
issued under dividend reinvestment schemes would dilute both the potential earnings per share and the
company’s net tangible asset backing per share. Given these possibilities, a company with a dividend
reinvestment scheme may suspend the scheme when it becomes concerned about future growth in
the short term and the dilution effects on shareholder value. The scheme can be re-activated by the
directors when business prospects improve.
5.5.5
P REFERENCE SHARES
Preference shares are a form of equity funding, but they have a number of features in common with debt
that serve to differentiate them from ordinary shares. Preference shares may therefore be described as
a hybrid security.
Unlike ordinary shares, preference shares have their dividend rates fixed at the issue date. Preference
shares rank ahead of ordinary shares in the payment of dividends and in their claim on assets in the
event of a winding-up or liquidation of the company. On both accounts, however, preference shares
rank behind the company’s creditors.
A range of features may be attached to preference shares. A preference share issue will include a
combination of the following features.
•
•
•
•
•
Cumulative or non-cumulative. If a company is not able to make the fixed dividend payment on
cumulative preference shares in one period, the amount due is carried forward to the next period. The
company is required to pay any unpaid preference share dividends from past years before it can make
any distribution to ordinary shareholders. On the other hand, with non-cumulative preference shares,
if the company is unable to make the fixed dividend payment, the obligation is not carried forward.
Redeemable or non-redeemable. Redeemable preference shares entitle the holder to redeem the
preference share on a predetermined date and to receive the specified value of the preference share in
a cash payment. The holder of a redeemable preference share may have the option to redeem for cash
or to convert into ordinary shares. A non-redeemable preference share would only be convertible.
Convertible or non-convertible. Convertible preference shares may be converted into ordinary shares
in the company at a future date, generally at the lowest rate specified in the prospectus or at a
discounted market price at the conversion date. It is unlikely that a preference share would be nonconvertible.
Participating or non-participating. Holders of participating preference shares are entitled to a higher
fixed dividend payment if the company should decide to pay ordinary shareholders a dividend
in excess of a specified rate. In other words, a participating preference shareholder is given the
opportunity to share in excess profit generated by the company.
Issued at different rankings. First-ranking preference share issues have preference over secondranking issues of preference shares in their claim on dividends and in their claim on the assets of the
company. Preference shares issued at different times may be given equal ranking.
Preference shares
a hybrid security
that combines
characteristics of
both equity and debt;
preference shares
usually pay a fixed
dividend and offer
the right to convert
to ordinary shares
at a future date (also
known as a redeemable
convertible preference
share)
Cumulative
preference shares
fixed dividends not
paid in one period carry
forward until paid
Redeemable
preference shares
may be redeemed for
cash at the expiry date
Convertible
preference shares
may be converted to
ordinary shares at a
future date and at a
specified price
Participating
preference shares
holders will receive
a higher dividend if
ordinary shareholders
receive a dividend
above a specified
amount
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A preference share issue may be desirable for a company that requires funds but has reached its
optimal gearing level, that is, its debt-to-equity ratio. The company can issue additional preference
shares that are, in effect, fixed-interest borrowings but count as equity. In this case, the preference
share issue widens the equity base of the firm, and thus allows further debt to be raised in the future
while maintaining the firm’s gearing ratio. Providing the shares are non-cumulative, the firm is not
committed to an immediate dividend payment, as it would be if it were to issue straight debt.
Stock exchanges allow corporations to list and quote preference share issues. This adds to the
liquidity and attractiveness of the preference share to an investor. The security pays a specified rate of
return, generally offers the option to convert to ordinary shares and is a liquid asset that can be sold on
a stock exchange.
5.5.6
C ONVERTIBLE NOTES AND OTHER QUASI-EQUITY SECURITIES
This category includes those instruments that provide the holder with the right to convert the instrument
into ordinary shares at a future specified date. The most common of these instruments is the convertible
note. Company-issued options and warrants are also included in this category.
Convertible notes
A convertible note is a hybrid debt instrument issued for a fixed term by the company and paying a
stated rate of interest for the term of the note. The holder of the note has the right to convert the note
into ordinary shares in the issuer company at a specified future date.
The conversion price, when the notes are issued, is set close to the market price of the share and
the rate of interest offered on the notes is usually lower than that offered on straight debt instruments.
The lower rate of interest is due to the value of the explicit option embedded in the note, that is, the
right to convert the note into equity at the specified future date and at a predetermined price.
The expectation of the note holder is that the share price will increase over the term of the note.
Therefore, the note holder will make a financial gain by converting the note into ordinary shares in the
issuer company. Should the share price fall to a level lower than the conversion price, the holder can
choose not to convert the note, but redeem the note for its nominal cash value.
The attraction of the convertible note to the issuing company is that it enables the company to
obtain funds on terms more favourable than would be applicable to straight debt. Not only is the
rate of interest lower than that for straight debt, but the term to maturity of the notes is often for a
considerably longer period than would be available through other debt instruments. Furthermore, the
expense of the interest paid on convertible notes may, subject to certain conditions, be a tax-deductible
expense of the company.
A convertible note issue may be made by direct placement, rather than by a pro-rata issue to
shareholders. The value of the placement must fall within the constraints of the rules of the stock
exchange. For example, Australian regulation imposes the same requirements on the placement of
convertible notes as for the placement of ordinary shares.
Company-issued options
Company-issued
option
bestows a right, but
not an obligation, on
the holder to buy new
ordinary shares in the
company
A company-issued option is a security issued by a corporation that gives the holder the right, but not
the obligation, to buy ordinary shares in the company on a predetermined date and at a predetermined
price. If the holder of the option exercises the right to buy the shares offered, the company is able to
raise additional equity funds.
Typically, a corporation will offer company-issued options in conjunction with a rights issue or a
placement. The option may be issued free, or sold at a price, at the same time as the underlying ordinary
share issue. The option may add to the marketability of the underlying rights issue or placement, without
the company having to incur the burden of an immediate increase in dividend payments.
The company can also set the exercise date to coincide with expected future funding requirements.
For example, if the company forecasts that it will need some additional equity in 12 months, the exercise
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date for the option can be set for that time. The company is able to match the timing of its cash-flow
needs. However, the future funds are not guaranteed. The exercising of the option will depend on the
option exercise price relative to the current market price of the share at the exercise date.
The holder of a company-issued option gains a highly geared investment strategy that provides
a potential future equity interest in the corporation. In the best case, where the option is issued free,
investors have acquired the right to increase their equity participation in the issuer company in the
future, apparently at zero cost. The right would be exercised if the predetermined exercise price is lower
than the current market price of the share on the exercise date. If this sounds too good to be true, in
part it is. It is most likely that market participants will attempt to estimate the likelihood of being able
to exercise the option profitably. That is, they will calculate the value of holding the option, and that
value would then be loaded into the price paid for the initial rights issue or placement with the attached
option. The valuation of options is discussed in Chapter 20.
Company-issued equity warrants
A company-issued equity warrant is simply a form of an option. There are many different types
of warrants that are traded on a stock exchange and over the counter. This section considers those
warrants issued by a corporation where the exercise of the warrant will result in the company raising
additional equity capital.
A company-issued equity warrant differs from a company-issued option in that the warrant generally
attaches to a corporate bond debt issue of the company. Initially, an investor purchases bonds issued
by the corporation, and in so doing receives the additional security of the warrant. The warrant gives
the holder the right to exercise the warrant and buy ordinary shares of the company at a specified price
over a given period.
The terms of the warrant may allow the warrant to be detachable from the bond issue and traded
separately from the bond. The investor in this situation has two securities that may be held or sold
separately. For example, the investor could decide to retain the bond as an investment and sell the
warrant. If the warrant is non-detachable, it can only be sold together with the associated bond.
As the equity warrant provides the holder with a right to buy ordinary shares in the issuer company,
it has a value. The warrant holder does not receive dividend payments, but may benefit from capital
gains on share price rises above the warrant conversion price. Warrants are generally attractive to
investors and, as such, may lower the cost of borrowing associated with the issue of the underlying
corporate bonds.
Company-issued
equity warrant
an option to buy
additional shares that is
originally attached to a
debt issue
Detachable warrant
a warrant that can be
sold separately from the
original debt security to
which it was attached
Non-detachable
warrant
a warrant that cannot
be separated from the
host debt security
REFLECTION POINTS
•
•
•
•
•
Companies that are listed on a stock exchange have a number of choices when seeking to
raise additional equity to fund further business growth.
A rights issue is the offer of additional ordinary shares on a pro-rata basis to all existing
shareholders at a specified future date, for example, one new share for every five shares held.
The right to buy may be renounceable, whereby the right is listed on the stock exchange and
can be sold before the exercise date. A non-renounceable right cannot be sold.
A share purchase plan provides the opportunity for existing shareholders to invest a specified
dollar amount to buy additional shares in a company.
A placement occurs where a company offers additional shares to select institutional investors.
The Corporations Act 2001 places limits on the issue of shares through a placement in order to
protect existing shareholders.
A rights issue and a share purchase plan require a prospectus, whereas a placement requires
only a memorandum of information.
continued
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continued
•
•
•
•
•
A takeover issue occurs when company A seeks to acquire company B and offers company B
shareholders a pro-rata number of shares in company A in exchange for company B shares.
The takeover offer may also include a cash component.
A profitable company may pay cash dividends to its shareholders but offer shareholders the
right to reinvest that dividend by purchasing additional shares in the company. The dividend
reinvestment scheme allows the company to pay dividends but also retain at least a portion of
those dividends as capital available for growth.
A preference share is a hybrid security that pays a fixed dividend and at a specified date allows
the holder to convert the preference share into ordinary shares. Preference shares may be
cumulative, redeemable, convertible, participating and issued with different priority rankings.
Convertible notes are a hybrid security that pays a fixed-interest stream and offers the
opportunity to convert the note into ordinary shares at a future date.
A company-issued option gives the holder the right, but not the obligation, to buy ordinary
shares of the company at a specified date and at a specified price. A company-issued warrant
is similar, but is usually attached to a debt instrument issued by the company, such as a bond.
The warrant may be detachable or non-detachable.
CASE STUDY
COVENANT-LITE LOANS—RISK IMPLICATIONS
Loan covenants are conditions or restrictions specified in a loan contract and represent an important
factor in credit analysis. Loan covenants represent promises by the borrower to do or refrain from
doing certain things. The usual practices necessitated by loan covenants include maintaining interest
coverage, leverage ratios and the lender’s position in the company’s capital structure (Osterland, 2018).
According to the data from Moody’s, in early 2018 the protection of lenders from defaulting companies
is now the weakest it has been since records began. Contributing to this, almost 80.00 per cent of
leveraged loans were ‘covenant lite’, which do not come with certain conditions normally imposed by
more comprehensive loan covenants.
The risks inherent in such loans mean that there can be a significant loss in the financial value before
lenders can undertake the necessary steps to recover some portion of what they are owed. It has
been found that recovery rates following a bankruptcy declaration can differ substantially depending on
whether strong loan covenants are in place (Scaggs, 2018). Even in the Australian economy, leveraged
loans are often less protected by loan covenants than they once were.
The issuance of covenant-lite corporate loans has expanded rapidly in the past few years, reaching
almost 77.00 per cent of the estimated $1 trillion leveraged corporate loan market. Most of these loans
are packaged and resold as bonds. KKR, the private equity firm, issued $1.3 billion of such bonds while
completing its $8 billion leveraged buyout of Unilever’s margarine and spreads business.
Investors who are desperate for better yields in a low interest rate environment have, according to
some commentators, already overpaid to a point where they are not being compensated for the risks
they have taken (Cohan, 2018). Loan covenants are critical in the sense that they help balance the
financing requirements for firms against the risks that investors should be willing to bear given the
yields that they have been promised (‘Understanding Covenants – BondAdviser’, 2018).
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Cohan, W 2018, ‘The big, dangerous bubble in corporate debt’, The New York Times, 9 August, viewed
15 October 2018, http://www.nytimes.com/2018/08/09/opinion/corporate-debt-bubble-next-recession
.html
Osterland, A 2018, ‘The booming loan market is getting riskier’, CNBC.com, 25 June, retrieved from
http://www.cnbc.com/2018/06/21/the-booming-leveraged-loan-market-is-getting-riskier.html
Scaggs, A 2018, ‘Loan covenant quality hits record low, says Moody’s’, Financial Times, 24 July, viewed
15 October 2018, http://www.ft.com/content/54a27838-8f4d-11e8-b639-7680cedcc421
Understanding Covenants (18 May 2018), Bond Adviser, retrieved from http://www.bondadviser.com
.au/blog/understanding-covenants/
Discussion points
•
•
Explain the role played by loan covenants to protect investors, and how covenant-lite loans
affect investors.
From the point of view of investors in corporate bonds, covenants are critical to assessing
yields and risks. Discuss this statement.
CHAPTER FIVE REVIEW
Reference list
Master before you move on
LEARNING OBJECTIVE 5.1
Understand issues related to the capital budgeting investment decision.
•
•
•
•
•
•
The main objective of a corporation is the maximisation of shareholder value. In seeking to
achieve this objective, a corporation will consider its investment decision (the capital budgeting
process), its financing decision (the capital structure process), the management of liquidity and
working capital and the distribution of profits to shareholders.
Investment decisions are based on the objectives of the corporation, which state, in part, those
activities that the business intends to conduct. This determines the assets required to carry out
those activities.
Two methods that are used to determine which business activities should be profitable—that is,
those adding to shareholder value—are net present value (NPV) and the internal rate of return
(IRR).
The NPV is the difference between the cost of an asset, or project, and the present value of its
future returns. The present value is the discounted value today of a future cash flow or series of
cash flows. The cash flows are discounted at the firm’s required rate of return on the investment.
The corporation will accept investment proposals that indicate a positive NPV.
The IRR is the discount rate on a project that results in an NPV of zero. If the firm’s required rate
of return on an investment is less than the forecast IRR of the project, it may be acceptable.
However, IRR suffers from two shortfalls: non-conventional cash flows and mutually exclusive
investment opportunities.
Both the NPV and the IRR methods are exposed to the limitations and uncertainties of forecast
projections.
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LEARNING OBJECTIVE 5.2
Identify issues relevant to a corporation’s funding choice between debt and equity.
•
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•
•
A corporation must determine how it plans to finance its investment decisions.
A business must consider its current debt-to-equity ratio and the associated degree of financial
risk. If the ratio is such that increased debt can be sustained without an undue increase in
financial risk, it is in the interests of the shareholders for the expansion to be funded through
debt rather than equity.
However, debt commitments (interest and principal) must be paid when due. Therefore, a
corporation must forecast the business environment in which it operates and the impact of
changes on future cash flows.
Once a business reaches an appropriate debt-to-equity ratio, further expansion requires
additional equity.
LEARNING OBJECTIVE 5.3
Examine the listing and flotation or initial public offering (IPO) of a business on a stock exchange,
including equity-funding alternatives that are available to a newly listed corporation.
•
•
•
•
•
One way to access a much wider equity market is through the public listing (IPO) of a company
on a stock exchange.
The majority of companies will incorporate as limited liability companies and issue ordinary
shares.
A company engaged solely in mining may incorporate as a no liability company.
In either case, the business will retain financial advisers with expertise in the procedures
for listing on a stock exchange, the appropriate form of incorporation, the preparation of a
prospectus and the timing, structure and pricing of the share flotation (IPO).
The advisers may also arrange the underwriting of the issue and ensure that its structure meets
stock exchange listing rule prerequisites for the admission of the company to its official list and
for the quotation of its shares.
LEARNING OBJECTIVE 5.4
Consider important issues associated with listing a business on a stock exchange.
•
•
•
•
A primary concern of a stock exchange is to maintain the efficiency and integrity of its markets.
This is achieved, in part, by requiring a company that is seeking admission to the stock exchange
to comply with the exchange’s listing rules, as well as meeting its obligations under the relevant
company law.
Once listed, corporations must continue to comply with the rules or risk suspension or delisting
of their securities from the official list.
A multinational corporation may choose to become a dual-listed company by listing its shares
on more than one stock exchange in order to access the wider international capital markets and
increase liquidity in the trading of its securities.
LEARNING OBJECTIVE 5.5
Explore equity-funding alternatives that are available to an established listed corporation,
including rights issues, share purchase plans, placements, takeover issues, dividend reinvestment
schemes, preference shares, convertible notes and other quasi-equity securities.
•
Companies that have listed on a stock exchange and have a track record of sound management,
good profitability and good share price performance are generally able to raise additional equity
funding in a number of different ways.
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•
•
•
•
•
•
•
Additional ordinary shares may be issued on a pro-rata rights basis to existing shareholders.
A rights issue is usually offered at a discount to the current market price. However, a pro-rata
rights issue requires a prospectus and can take time.
An alternative method (the share purchase plan) is to offer existing shareholders the opportunity
to invest a fixed dollar amount to purchase additional shares in a company.
Rather than offer additional shares to all existing shareholders, some companies prefer a direct
placement of shares with selected institutional investors, such as fund managers. This can be
finalised more quickly, does not require a prospectus (only a memorandum of information) and
is often at a smaller discount.
Additional ordinary shares may also be issued by a takeover company as full payment, or part
payment with a cash component, in a merger and acquisition bid.
Dividend reinvestment is another technique by which a listed corporation can raise additional
equity funds. It allows shareholders to elect to convert their periodic cash dividend receipts into
new shares in the company. Dividend reinvestment schemes also give existing shareholders the
opportunity to increase their equity holding, usually without the normal transaction costs such
as brokerage.
CHAPTER FIVE REVIEW
•
A company may also issue preference shares to raise additional equity capital. Preference shares
are hybrid securities, and differ from ordinary shares in that they offer a fixed dividend that is set
at the issue date and most frequently have a fixed term to maturity. In both of these attributes
they are more like debt than equity. However, they rank behind the company’s creditors in their
claim on the assets of the company if the business fails. A preference share issue may or may
not be cumulative, redeemable, participating, convertible or issued with different rankings.
Convertible notes are hybrid securities that have attributes of both debt and equity. Holders of
convertible notes receive a predetermined rate of interest on their investment. However, the
notes may be converted into shares at a future date at a predetermined price.
Other forms of quasi-equity securities are company-issued options and company-issued equity
warrants. A company-issued option provides the holder with the right to purchase ordinary shares
at a predetermined price on a specified date. A company-issued equity warrant may be attached
to a corporate bond debt issue and provides the holder with the right to exercise the warrant and
convert the warrant into ordinary shares in the issuer company, also at a determinable price and
on or by a specified date. The warrants may be detachable and sold separately to the host bond.
Extended learning
LEARNING OBJECTIVE 5.6
Explain the listing requirements of the Australian Securities Exchange.
Australian Securities Exchange (ASX) listing rule requirements
The objectives of the ASX include the provision of a fair and well-informed market for financial
securities and the provision of an internationally competitive market. The ASX listing rules are a
key element in achieving these objectives. The listing rules are set down formally in 20 chapters
available at: https://www.asx.com.au/regulation/rules/asx-listing-rules.htm.
An entity wishing to have its securities listed and quoted on an exchange must first seek admission
to the exchange. The requirements imposed by stock exchanges will vary between exchanges and
nation-states, but the principles (discussed in Section 5.4) will be essentially the same; any variation
will mainly be in the detail. To gain an understanding of the listing requirements of one modern and
efficient stock exchange, the Australian Securities Exchange (ASX) is considered.
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The ASX has absolute discretion concerning an entity’s admission to the official list, the quotation
of its securities and its suspension and removal from the list. Listing rules are enforceable under
the Corporations Act 2001 and are additional and complementary to common law and statutory
obligations.
An entity that applies to the ASX for admission to the official list must provide prescribed
documentation, demonstrate compliance with the listing rules and pay listing fees. Entities that are
admitted are categorised as general (within this category there are specific rules for mining exploration
entities, investment entities and scientific research-based entities), debt issuer or exempt foreign.
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Profit test
minimum financial
performance
requirements
to be met by an
entity seeking
listing on a stock
exchange
•
•
Some of the broad requirements for general admission to the official list include:
The entity’s structure and operation must be appropriate for a listed entity.
The entity’s constitution must be consistent with the listing rules.
A prospectus, product disclosure statement or information memorandum must be issued and
lodged with the corporate regulator, ASIC.
A foreign entity must establish, in Australia, an Australian securities register (or subregister),
appoint an agent for service of process and be registered as a foreign company under the
Corporations Act 2001.
If the entity is a trust, it must be a registered managed investments scheme and the responsible
entity must not be under an obligation to allow a security holder to withdraw from the trust.
The entity must apply for and be granted permission for quotation of all the securities in its main
class of securities.
There must be at least 300 holders each having a parcel of the main class of securities (excluding
restricted securities) with a value of at least $2 000.
The entity must satisfy either the profit test or the assets test (discussed below).
If the entity issues restricted securities before it is admitted, it must comply with the related
listing rules.
Special conditions apply if an entity issued classified assets in the two years prior to application.
The ASX identifies several different types of classified assets. These include: (1) an interest in a
mining, oil or gas exploration area; (2) an interest in intangible property; and (3) an interest in an
asset that, according to the ASX, cannot be readily valued. See the ASX listing rules definitions
(Chapter 19 of the listing rules).
If the entity has options on issue, the exercise price for each underlying security must be at least
20 cents in cash.
The entity must appoint a person to be responsible for communication with the ASX in relation
to matters associated with the listing rules.
An entity seeking listing must advise the extent to which it will, upon admittance, comply with
the recommendations of the ASX Corporate Governance Council. The entity must advise the
ASX of the reason for non-compliance with all the recommendations.
An entity that is to be included in the S&P/ASX All Ordinaries Index must have an audit committee.
If the entity is included in the top 300 of the index, it must comply with the recommendations of
the ASX Corporate Governance Council.
The entity must agree to authenticate and provide documents to the ASX electronically.
The entity must have a trading policy that complies with the ASX listing rules.
Profit test
To meet the profit test requirement of admission, an entity must satisfy each of the following
conditions.
•
The entity must be a going concern, or the successor of a going concern.
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•
•
•
CHAPTER FIVE REVIEW
•
•
The entity’s main business activity at the date it is admitted must be the same as it was for the
last three full financial years.
The entity must provide audited financial statements for the last three full financial years. The
financial statements must be accompanied by audit reports, which must not be qualified with
regard to the entity’s capacity to continue as a going concern, or satisfy the profit levels required.
The entity’s aggregated profit from continuing operations for the last three full financial years
must have been at least $1 million.
The entity’s consolidated profit from continuing operations for the 12 months to a date no more
than two months before the date the entity applied for admission must exceed $500 000.
The entity must give the ASX a statement from all directors (in the case of a trust, all directors of
the responsible entity) confirming that they have made inquiries and nothing has come to their
attention to suggest that the economic entity is not continuing to earn a profit from continuing
operations up to the date of application.
Assets test
The assets test requirements of admission are as follows:
•
•
•
•
At the time of admission an entity must have net tangible assets of at least $4 million after
deducting the costs of fundraising, or an expected market capitalisation of at least $15 million.
The entity must have either one of the following:
–
Less than half of the entity’s total tangible assets, after raising any funds, must be cash or
in a form readily convertible to cash.
–
Half or more of the entity’s total tangible assets, after raising any funds, must be cash or in
a form readily convertible to cash, and the entity must have commitments consistent with
its business objectives to spend at least half of its combined cash and readily convertible
assets. The business objectives must be clearly stated and include an expenditure
program. If the prospectus does not contain a statement of the business objectives, the
entity must give a statement of its business objectives to the ASX.
Assets test
minimum level
of assets to be
held by an entity
seeking listing on
a stock exchange
The entity must satisfy each of the following:
–
If its prospectus, product disclosure statement or information memorandum does not
contain a statement that the entity has enough working capital to carry out its stated
objectives, the entity must give the ASX a statement prepared by an independent expert.
–
The entity’s working capital must be at least $1.5 million, or, if it is not, it would be at least
$1.5 million if the entity’s budgeted revenue for the first full financial year that ends after
listing was included in the working capital. For mining exploration entities, the amount must
be available after allowing for the first full financial year’s budgeted administration costs and
the cost of acquiring plant, equipment and mining tenements. The cost of acquiring mining
tenements includes the cost of acquiring and exercising an option over them.
An entity must provide financial statements for the last three full financial years. The financial
statements must be audited, and must include audit reports.
Quotation of securities
A general admission entity that wishes to have its main class of securities quoted on the official list
of the ASX must satisfy the following conditions:
•
•
The terms of the entity’s securities must comply with the ASX listing rules, including the rules
relating to voting rights, dividends and equitable representation.
The issue price or sale price of all securities (except options) for which the entity seeks quotation
must be at least 20 cents in cash. Restricted securities, after the escrow period ends, and
employee incentive scheme securities may still be quoted even though they are issued or sold
at less than 20 cents.
Escrow
assets held by a
third party that
cannot be sold
until conditions
of a contract are
fulfilled
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•
•
•
•
Any CHESS requirements relating to the entity’s securities must be satisfied.
If the securities are initially partly paid, there must be a defined call program setting out the
date and amount of each proposed call. The security must be paid in full within two years. This
condition does not apply to a no liability company.
If the securities are debt securities, or convertible debt securities, a copy of the documents
setting out the terms of the securities must have been given to the ASX.
If the securities are debt securities, their aggregate face value must be at least $10 million.
Costs of listing
An entity proposing to seek listing on the ASX should be aware that there are significant costs
associated with the process. As discussed in the body of Chapter 5 and listed below, there are a
number of fees and expenses associated with the public listing of a company. In addition, there are
fees charged by the ASX. The extent of the costs of listing will depend ultimately on the complexity of
the issue, the amount of equity issued, the method of issuing the securities, the number of advisers
involved and the level of marketing undertaken. An indicative list of initial general expenses that
may be incurred include:
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underwriting and handling fees
float management fees
legal fees
accounting and taxation fees
other expert adviser fees
printing costs
advertising and marketing costs
share registry expenses.
Specific fees charged by the ASX include:
ASX initial listing fees
ongoing annual listing fees
other fees as determined by the ASX.
Fees charged by the ASX will vary from time to time, and will depend on the type of security issued
(equity or debt) and the amount of the securities listed. The cost of listing is a significant initial
demand on the liquidity of a corporation. Therefore, the listing corporation must ensure that it has
access to sufficient sources of cash to be able to meet these initial cash-flow needs as they arise.
Continuous disclosure
All corporations admitted to the official ASX list must comply with the continuing listing requirements.
The first of these are the continuous disclosure requirements that were discussed in Chapter 4.
These require a company immediately to notify the ASX of any information concerning the company
that is necessary to ensure that trading in the entity’s securities occurs in a fair and well-informed
market. That is, the company must inform the exchange of any information that a reasonable person
would expect would have a material effect on the price or value of securities of the company. This
is essential in order to maintain the integrity of the market.
Notice must be given to the exchange by a listed corporation immediately when any relevant
material information is available on issues such as:
•
•
•
a change in an entity’s financial forecasts or expectations
the appointment of a receiver, manager, liquidator, administrator or change in directors
a transaction for which the consideration payable or receivable is a significant proportion of the
written-down value of the entity’s consolidated assets, usually 5.00 per cent
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CHAPTER FIVE REVIEW
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•
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a recommendation or declaration of a dividend or distribution
a recommendation or declaration that a dividend or distribution will not be declared
under-subscriptions or over-subscriptions to an issue
a copy of a document containing market-sensitive information that the entity lodges with an
overseas stock exchange or other regulator which is available to the public. The document must
be in English
an agreement or option to acquire a mining tenement
giving or receiving a notice of intention to make a takeover
an agreement between the entity (or related party or subsidiary) and a director (or related party
of the director)
a copy of any financial document that the entity lodges with an overseas stock exchange or
other regulator which is available to the public. The document must be in English
a change in accounting policy adopted by the entity
any rating applied by a rating agency to an entity, or securities of an entity, and any change to
such a rating
a proposal to change the entity’s auditor.
In addition to the continuous disclosure requirements, there is a routine requirement that companies
must provide the exchange with quarterly, half-yearly and annual reports at the same time as they
are provided to the corporate regulator, but within a specified maximum time after the end of the
reporting period.
Corporate governance
Corporate governance represents the internal relationships between shareholders, the board
of directors and managers. It consists of a system of structuring, operating and controlling an
organisation in order to achieve:
•
•
•
•
a fundamental ethical culture throughout the entire business operation
the long-term strategic objectives of shareholders—that is, the profitability of the organisation
and the maximisation of shareholder value
compliance with legal and regulatory requirements across different jurisdictions
a regime of accountability, transparency and reporting disclosure.
The ASX has formed a Corporate Governance Council which defines corporate governance as the
framework of rules, relationships, systems and processes within and by which authority is exercised
and controlled in corporations. It encompasses the mechanisms by which companies, and those in
control, are held to account. Corporate governance influences how the objectives of the company are
set and achieved, how risk is monitored and assessed, and how performance is optimised. The ASX
Corporate Governance Council has published eight principles and recommendations. The principles
state that companies should:
1
establish and disclose the respective roles and responsibilities of the board and management
2
have a board of effective composition, size and commitment to adequately discharge its
responsibilities and duties
3
promote ethical and responsible decision making
4
have a structure to independently verify and safeguard the integrity of their financial reporting
5
promote timely and balanced disclosure of all material matters concerning the company
6
respect the rights of shareholders and facilitate the effective exercise of those rights
7
establish a sound system of risk oversight and management and internal control
Transparency
the level of
information
that is provided
to market
participants
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8
ensure that the level and composition of remuneration is sufficient and reasonable and that its
relationship to performance is clear.
The foregoing discussion on the ASX listing rule requirements, although quite detailed, is selective
and certainly not comprehensive. In fact, the ASX listing rules currently comprise some 20 chapters
of specific requirements. Further information on the ASX listing rule requirements may be obtained
at www.asx.com.au. For comparison, the listing rules of other stock exchanges may be found on
their websites.
Questions
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points you raise in relation to each question.
1
Marketing is often portrayed as a creative enterprise. Why would a marketing executive need
to have an understanding of the capital budgeting process and techniques such as net present
value and internal rate of return? (LO 5.1)
2
Disney Corporation is considering the re-release of its classic film library. The project will involve
an investment of $78 000 000 and will produce a positive cash flow of $25 000 000 in the first
year. The cash flows will increase by 10.00 per cent each year thereafter for another five years
(i.e. the project runs for six years in total). At that stage the project will cease. The company
expects a rate of return of 17.00 per cent on this type of project.
(a) Calculate the NPV and the IRR.
(b) Should the company proceed with this investment opportunity? Why or why not? (LO 5.1)
3
Explain the effect on the firm’s market value of an increase in the firm’s debt-to-equity ratio. (LO 5.2)
4
Compare and contrast the average debt-to-equity ratios of commercial banks and major
retailers, such as Woolworths. Why is there such a big difference? (LO 5.2)
5
The owners of a successful private stationery business have decided that the next step in
the company’s development is to expand into overseas markets. In order to raise the capital
necessary to support this expansion, the company’s owners have decided to investigate the
possibility of listing the company on the ASX. You work for a boutique investment bank and
receive the first phone call from the owners. Explain the role that your company will play if the
owners decide to retain your services as an IPO adviser. (LO 5.3)
6
Techno Pty Ltd is a private company that has developed a range of innovative software packages
over the past five years. The company is considering seeking admission and quotation on a stock
exchange. List and briefly explain the advantages to the company of a public listing. (LO 5.3)
7
Santos Limited has expanded its exploration program and has decided to fund the expansion
through the issue of additional ordinary shares to its existing shareholders on a pro-rata basis
of one new share for each five shares held. The issue price is $5.75 per share and the current
market price is $6.50. The financial advisers to the corporation have recommended the use of
an underwriting facility. The board of directors has noted that the underwriting facility has an outclause if the market price drops below $5.50. Using this information, answer these questions.
(a) What type of issue is Santos Limited making to its shareholders?
(b) What is an underwriting facility, and why might Santos use such a facility?
(c)
What is the out-clause entered into by Santos? Discuss how the out-clause operates. (LO 5.3)
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Chapter 5 Corporations issuing equity in the share market
Rio Tinto Limited has decided to sell its shale coal part of the business by establishing a new
limited liability company to be known as Shoal Limited. Shoal Limited will be a listed corporation
on the ASX. Rio Tinto and Shoal decide to issue the new shares at $2.65, but through the issue
of instalment receipts. An initial payment of $1.25 is payable on application and a final payment
of $1.40 is due 12 months later.
(a) Shoal Limited will be a limited liability company. What are the rights and financial obligations
of shareholders that purchase shares in the company?
(b) The company has decided to structure the issue using instalment receipts. Explain
how instalment receipts operate and why the company may have decided on this
strategy. (LO 5.3)
9
A mining corporation has obtained the rights to explore for gold in a new tenement. The
corporation decides to establish a new subsidiary company that will carry out this high-risk
venture. The new company will be listed on the stock exchange. The gold exploration company
expects to complete its exploratory search over the next 12 months, at which time it will report
back to shareholders and make recommendations on the viability of the project.
(a) What form of legal structure would you recommend the gold exploration company
incorporate? Why would you recommend this structure?
CHAPTER FIVE REVIEW
8
(b) What are the advantages to the company and also to the shareholders of the structure you
recommended? (LO 5.3)
10 An efficient stock exchange will establish listing rules that support the interests of listed entities,
maintain investor protection and ensure the reputation and integrity of the stock market. To
achieve this, a stock exchange will adopt a number of listing rule principles.
(a) List and explain five fundamental listing rule principles.
(b) If a multinational corporation seeks dual listing on two stock exchanges, how will this
impact on the corporation’s adherence to the listing rules? (LO 5.4)
11 JB Hi-Fi is expanding its retail operations and seeks to raise capital to do so. The company
advisers recommend the board of directors choose between a pro-rata rights issue or a
private placement. Explain each of these funding alternatives and discuss the advantages and
disadvantages of each alternative. (LO 5.5)
12 In some countries, such as Australia, it is common for corporations to offer shareholders a
dividend reinvestment scheme.
(a) Explain how dividend reinvestment schemes operate and discuss their significance as a
source of equity funding.
(b) Discuss the advantages of a dividend reinvestment scheme from the point of view of the
corporation and shareholders.
(c)
Under what circumstances might such schemes prove to be unattractive to the dividendpaying company? (LO 5.5)
13 In recent years, the popularity of all-share takeover deals has declined. What is an ‘all-share
takeover deal’ and what are some reasons for the decline in popularity? (LO 5.5)
14 Convertible notes, company-issued options and company-issued warrants are often referred to
as quasi-equity securities.
(a) What are the characteristics of each of these instruments that serve to distinguish them
from straight equity or debt?
(b) Why might a company issue quasi-equity rather than straight debt or equity? (LO 5.5)
Extended learning question
15 Listing on a stock exchange might be highly desirable for a company, but there are a number of
requirements, conditions and costs associated with becoming a publicly listed corporation.
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(a) Identify and explain 10 specific requirements that must be met by an Australian company
seeking general admission to the ASX.
(b) Discuss the ASX profit test and asset test requirements, and explain why these rules are in
place.
(c)
Identify and explain the different costs that a company will have to meet in the process.
What impact will these have on the liquidity management of the firm? (LO 5.6)
KEY TERMS
assets test 185
escrow 185
NPV decision rule 164
business risk 166
financial risk 167
out-clause 170
capital budgeting 163
financing decision 166
company-issued equity
warrant 179
flotation of a business 170
participating preference
shares 177
gearing ratio 168
preference shares 177
company-issued option 178
initial public offering (IPO) 170
present value 163
convertible preference
shares 177
instalment receipt 171
profit test 184
internal rate of return (IRR) 165
promoter 170
cumulative preference
shares 177
investment decision 163
pro-rata offer 174
loan covenants 168
proxy 171
memorandum of information 176
redeemable preference
shares 177
debt-to-equity ratio 168
delisted 173
detachable warrant 179
dual listing 173
earnings attributable to ordinary
shares 167
equity-funded takeover 176
mutually exclusive projects 166
net present value (NPV) 163
non-conventional cash flows 166
non-detachable warrant 179
non-renounceable right 175
renounceable right 175
share purchase plan 175
transparency 187
underwriting 170
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CHAPTER 6
Investors in the share market
CHAPTER OUTLINE
6.1
Share-market investment
6.2
Buying and selling shares
6.3
Taxation
6.4
Financial performance indicators
6.5
Pricing of shares
6.6
Stock-market indices and published share information
Learning objectives
LO 6.1
Consider the role of an investor in the share market, appreciate the wide range of investment
choices that are available and understand risks associated with investments in shares of listed
corporations.
LO 6.2
Detail the process for buying and selling shares.
LO 6.3
Understand the importance of taxation in the investment decision process.
LO 6.4
Identify and describe various indicators of financial performance.
LO 6.5
Apply quantitative methods to the pricing of shares.
LO 6.6
Analyse the functions and importance of share-market indices and interpret published sharemarket information.
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CHAPTER SNAPSHOT
Once a company’s shares trade on the stock market, they are subject to the jostling of supply
and demand. These forces are in turn shaped by perceptions of risk, reward and expectations
about the future. Investors consider both the risks specific to the company and the risks to
which the company is exposed that derive from the economy as a whole. Finance theory
distinguishes between these two types of risk. The first, company specific, is called unsystematic
risk (not related to the economic system). The second, deriving from the economy as a whole,
is called systematic risk. One of the key insights of finance theory is that unsystematic risk can
be removed by diversification, leaving the investor exposed only to systematic risk. As such, it
is only for bearing systematic risk that the investor should be rewarded.
INTRODUCTION
In order to raise equity funds, a publicly listed corporation may issue various financial instruments that
are quoted on a stock exchange. A stock exchange provides primary and secondary markets that facilitate
the quotation and trading of equity, hybrids and some debt securities. This chapter specifically focuses on
the share market from the point of view of investors who invest in ordinary shares issued by corporations.
So why do investors purchase shares issued by corporations? Shareholders receive a return in two
forms:
1 periodic dividend receipts
2 capital gains (losses) from changes in share value.
However, there is no guarantee that a company will pay a dividend to its shareholders, nor is there
any guarantee that the share price will increase in value over time. Clearly, such an investment must be
regarded as having a higher level of risk than many other investment alternatives.
One of the fundamental principles of finance is that higher risk should be rewarded with a higher return.
It is therefore reasonable to assume that investments in shares should, on average, provide a higher return to
shareholders than lower-risk investment categories such as fixed-interest and money-market securities.
There are a number of other important factors that encourage investors to invest in securities
quoted on a stock exchange. These include:
•
•
the depth and liquidity of share markets
efficient price discovery.
The depth of the market is measured by market capitalisation, that is, the number of shares issued
multiplied by share prices. Liquidity is attractive to investors in a stock market because they know that
in normal circumstances they are able to buy and sell shares at the current market price. This means
that they can buy and sell long-term, higher-risk securities and at the same time maintain liquidity in
their investment portfolio. A stock exchange measures liquidity as the volume of trading relative to
the size of the market. For example, the depth and liquidity of the ASX is quite high, with a market
capitalisation of around $2 trillion and daily turnover of approximately $5 billion.
Combined with liquidity is efficient price discovery. How quickly does information get to the market,
and how efficiently is that information absorbed by market participants and reflected in the current
price of a share? Major global stock exchanges apply continuous disclosure rules that require any
material information that may be expected by a reasonable person to have an effect on a share price
to be provided immediately to the exchange. The stock exchanges publish this information on their
websites; for example, the ASX site is www.asx.com.au. The efficiency of the markets is discussed in
more detail in Chapter 7.
This chapter first examines important issues relevant to share-market investment, including the
process of buying and selling listed shares. Next, the impact of taxation on the net returns on a share
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Chapter 6 Investors in the share market
investment is considered, followed by a number of financial performance indicators that influence
share prices. This is followed by an introduction to some of the mechanical issues that affect the pricing
of shares in the market. Finally, published share price information is analysed, and the structure and
purpose of share-market indices are considered.
REFLECTION POINTS
•
Investors buy shares issued by listed corporations in order to receive dividends and/or capital
gains. However, these returns are not certain, in that company profits and share prices are
variable over time.
•
A stock exchange should be deep and liquid. Depth is measured by market capitalisation, and
liquidity as the volume of trading relative to the size of the market.
•
A share market should also facilitate efficient price discovery. For example, continuous reporting
requirements ensure that investors are informed of material changes that may affect a share price.
6.1
Share-market investment
One of the major advantages of investing in securities listed on a stock exchange is that the investor has
a wide range of investment choices. In Chapter 4 we noted that a stock exchange typically lists several
categories of security:
•
•
•
•
•
•
equity securities, in particular ordinary shares or common stock
quasi-equity or hybrid securities, such as preference shares and convertible notes
units in managed funds (e.g. property trusts and exchange-traded funds)
fixed-interest securities, such as certain corporate bonds
rights issues, being the right to purchase additional ordinary shares offered by a listed corporation
derivative securities, including options and warrants.
LEARNING
OBJECTIVE
6.1
Consider the role of an
investor in the share
market, appreciate
the wide range of
investment choices
that are available
and understand
risks associated with
investments in shares of
listed corporations.
The above list demonstrates the extent of choice available to an investor. However, within each
category there are many hundreds of choices. For example, the ASX has more than 2 000 listed companies,
each being an investment opportunity. To extend investment choice even further, corporations listed on
a stock exchange are categorised into industry groups. This means that investors can select investment
opportunities within a range of different industry sectors within an economy. These are:
•
•
•
•
•
•
•
•
•
•
energy
materials
industrials
consumer discretionary
consumer staples
health care
financials
information technology
communication services
utilities.
With such a range of choices, an investor is able to structure an investment portfolio to meet
particular investment preferences. A primary preference will be the return on the portfolio. On average
over time, there should be a direct correlation between the level of risk taken and the return gained.
With share-market investments, return may be in the form of dividends received and/or capital gains
(losses) made. Some investors will have a preference to receive more of their return in the form of
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Systematic risk
exposures that affect
the price of the majority
of shares listed on a
stock exchange
income; others will prefer to receive more in the form of capital growth. The board of directors of a
company may pay income to shareholders in the form of a dividend, usually paid twice yearly. Capital
growth relates to gains or losses in the current market price of a listed share. Investors need to consider
the taxation implications of income versus capital growth. They also need to consider their liquidity
requirements, that is, whether they need to generate a cash flow from the investment (dividends) or
accumulate capital.
Within the context of investing in shares listed on a stock exchange, risk is often categorised as
(1) systematic and (2) unsystematic. Systematic risks are those risk exposures that will have an impact
on share prices generally in the market; that is, the majority of shares listed on a particular stock
exchange will be affected to a lesser or greater degree. This risk cannot be reduced by diversification.
The impact may be positive or negative. Examples of systematic risk exposures include:
•
•
•
•
•
•
Unsystematic risk
exposures that
specifically impact on
the share price of a
particular corporation
Diversified
investment portfolio
an investment portfolio
that includes a wide
range of financial
securities and assets
Beta
a statistical measure
of the sensitivity of
the price of an asset
relative to the market
Active investment
a portfolio structure
based on share
analysis, new
information and risk/
return preferences
changes in interest rates
changes in exchange rates
contraction or expansion in economic activity
introduction of new legislation
political stability
changes in market confidence and perception.
On the other hand, unsystematic risk affects a single corporation or a small group of companies.
Examples of unsystematic risk exposures that will have an impact on a company’s share price include:
•
•
•
•
•
•
the resignation of an executive manager
a change in future performance forecasts
the possibility of a merger
the failure of technology or communication systems
dissent within the board of directors
rumour or evidence of financial difficulty.
Investment choices available through shares listed on a stock exchange enable an investor to
diversify away a large proportion of the unsystematic risk. Investment theory contends that by holding
a diversified investment portfolio an investor is able to minimise the risk exposures associated with
investing in a single share. A diversified investment portfolio would include a range of investment
categories, including shares, fixed-interest securities and property. The share component of an
investment portfolio would hold a range of shares across different industry sectors within an economy.
It is generally agreed that a well-diversified share portfolio will include somewhere between 10 and
25 stocks.
Being able to diversify away unsystematic risk sends a very important message to investors, namely,
that they will not be rewarded for accepting this risk exposure. The main risk exposure is therefore
systematic risk. Investors will be rewarded for the level of systematic risk that is evident in an investment
portfolio. Systematic risk is measured by the so-called beta coefficient. The beta coefficient, or beta, is
the amount of systematic risk that is present in a particular share relative to an average share listed on
a stock exchange. The market (as represented by an index such as the S&P/ASX 200) has a beta of 1.0.
Therefore, if the shares of a listed company have a beta of 0.5, it will have only half as much systematic
risk, while another share with a beta of, say, 2.0 has twice as much risk as the market as a whole. By
taking the weighted average of the beta of individual shares, it is possible to determine the beta, or level
of systematic risk, of an investment portfolio.
Investors in the share market must also decide whether to take an active or passive investment
approach. Active investment involves an investor making strategic stock selections to structure a share
portfolio. An active investor will buy and sell shares based on new information received in the market.
Two active investment approaches, fundamental analysis and technical analysis, are discussed in detail
in Chapter 7. Each of these approaches will influence the structure and composition of an investment
share portfolio.
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Chapter 6 Investors in the share market
Briefly, technical analysis considers trends that are evident over time in individual share prices or
in share-market indices. Technical analysts contend that market behaviour history will be repeated from
time to time. Therefore, if an emerging share price trend corresponds to a past price trend, there is an
expectation that current share prices will react as they did previously. Share price trends are plotted on
graphs using a range of quantitative techniques, such as calculating a weighted 30-day moving average
of price movements.
The fundamental analysis approach, on the other hand, considers the domestic and international
economic environments (top-down approach) and the financial performance of a corporation
(bottom-up approach). For example, the top-down fundamental analysis approach considers economic
fundamentals that will have an impact on the performance of a corporation or the share market
generally, including interest rates, exchange rates, productivity levels, employment levels, the business
cycle, government fiscal policy and central bank monetary policy. The bottom-up fundamental analysis
approach involves the analysis of financial and accounting ratios such as the return on equity, the debtto-equity ratio, the debt-servicing capacity and liquidity.
Passive investment involves building an investment portfolio based on shares incorporated in
a share-market index. A share-market index is a grouping of shares listed on a stock exchange that
shows changes in the overall prices of those shares day by day. (Share-market indices are discussed in
Section 6.6.) Each stock exchange has its own set of indices. Well-known international indices include
the Dow Jones Industrial Average (USA), the FTSE (UK), the Nikkei 225 (Japan) and the Hang Seng
(Hong Kong). A passive investor who wishes to obtain returns on a share portfolio equal to the return
achieved by the Dow Jones will purchase the 30 stocks included in that index. Another investor may
replicate a sector index, such as the telecommunications sector or the industrials sector.
A number of managed funds are index funds. Index funds use a range of sophisticated techniques
to replicate or track the share market, including full or partial replication of a specified sharemarket index. Full replication occurs when a fund manager purchases all the stocks included in
an index. However, with a large index such as the S&P 500, the fund manager may hold only a
percentage of the stocks, so long as sufficient stocks are held to ensure that the portfolio closely
tracks the index.
An investor needs to understand the risk and return characteristics of each share investment and
its relationship with the total investment portfolio. It is not possible within this text to address portfolio
theory in detail; there are many other excellent texts in this specialist area. However, an investor should
be aware of risk and return relationships, including the spread of actual returns to expected returns,
variance and standard deviation.
For most investors it is necessary to consider the risk and return relationships of a diversified
portfolio of shares. The expected return of a portfolio is the weighted average of the expected returns of
each share. The weights are the proportion of each share to the total portfolio.
Portfolio variance, or risk, is the variability of the portfolio’s returns over time. It is the result
of the variance of each individual investment contained within the portfolio and the co-variance, or
correlation, between pairs of securities within the portfolio. Co-variance or correlation measures the
way two shares’ returns move in relation to each other. A positive correlation means that the shares’
returns move in the same direction, while a negative correlation means that the shares’ returns move
in opposite directions. A diversified share portfolio reduces the impact of individual share return
variances by combining shares with low co-variances or low or negative correlations. Interestingly,
portfolio theory contends that the addition of a higher-risk share to a portfolio may in fact reduce the
riskiness of the overall portfolio because of the co-variance characteristic.
Finally, an investor must consider asset allocation within the share portfolio. Major considerations
include:
•
•
Passive investment
a portfolio structure
based on the replication
of a specific sharemarket index
Index funds
acquire shares so that
a portfolio replicates a
specific share-market
index
Expected return of a
portfolio
weighted average of
the expected returns
of each share held in a
portfolio
Portfolio variance
the variability of the
returns of an investment
portfolio
Co-variance or
Correlation
the directional
relationship between
share price movements;
either positive or
negative
Risk versus return. This includes issues such as systematic and unsystematic risk, beta and
diversification.
Investment time horizon. While speculative trading in shares is common, share portfolios, on average,
produce consistently higher returns over the longer investment time horizon of five years or more.
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•
Strategic asset
allocation
a portfolio structured
to meet an investor’s
personal preferences
Tactical asset
allocation
a portfolio structured
to take account of a
dynamic investment
environment
Income versus capital growth. Each investor will have different liquidity needs that will influence
investments in shares that pay regular dividends as opposed to those shares where price increases,
or capital gains, are preferred.
•
Domestic and international share investments. A diversified share portfolio will typically include
stocks from the investor’s home share market plus stocks from a selection of international share
markets.
An investor may apply a strategic asset allocation approach; that is, the mix of shares satisfies the
investor’s known and projected cash-flow requirements, tax position, risk tolerance and future lifecycle positions. At the same time, the investor may adopt a tactical asset allocation approach; that is,
the mix of shares in the portfolio is changed to reflect altered circumstances of the investor and the
share markets.
REFLECTION POINTS
•
•
•
•
•
•
•
•
•
•
A stock exchange provides investors with a large choice of listed securities.
Corporations listed on a stock exchange are categorised into industry sectors; each company
included in an industry sector provides an investment opportunity.
Share-market investment risk is often categorised as systematic risk and unsystematic risk.
Systematic risks are exposures that affect most companies listed on the exchange (e.g. a
change in interest rates); unsystematic risk affects only a single company or a small group of
companies (e.g. a product recall).
Systematic risk is measured by the beta coefficient. The share market index has a beta of 1.0;
therefore, the price of a share with a beta of 1.2 will move 20 per cent more than the market index.
A diversified share portfolio of between 10 and 25 stocks minimises unsystematic risk.
Active investment uses fundamental analysis (top-down approach and bottom-up approach), or
technical analysis to support investment decisions.
Passive investment simply replicates the shares in a specified share-market index such as the
S&P/ASX 200.
Co-variance or correlation measures how two shares’ returns move relative to each other.
A positive correlation means both shares’ returns move in the same direction, and a negative
correlation means they move in opposite directions.
Issues that an investor will consider include risk, return, investment time horizon, income,
capital growth and domestic and international investments.
An investor may apply a strategic asset allocation or a tactical asset allocation approach to the
structure of a share portfolio.
6.2
LEARNING
OBJECTIVE
6.2
Detail the process for
buying and selling
shares.
Buying and selling shares
For many people, being a shareholder is exciting, dynamic and fun. Probably more than with any other
type of investment, a shareholder can analyse and monitor the day-to-day changes that occur in the
price of a stock. By reading the financial press each day, and searching for information on the internet,
an investor is able to keep abreast of new information that is continually coming into the market; the
investor can interpret that information and make informed strategic and tactical decisions in relation
to the structure of a share portfolio. An investor is able to experience the joy of watching personal
stock selections increase in value, or suffer the low of realising that certain stocks are not performing
as expected.
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Chapter 6 Investors in the share market
Before making a direct investment, an investor should consider a whole range of issues in the
share investment decision process. Some of these issues have already been mentioned and a number
will be discussed in detail later in the chapter; however, it is useful to list briefly some of these
considerations now:
•
•
•
•
•
•
•
•
•
•
liquidity: how easily shares can be converted to cash (sold)
risk: including variance, standard deviation, beta, volatility
integrity: of the company, management, share market
charges: transaction costs such as fees on managed funds, or brokerage on direct transactions
through a stockbroker
return: the type of return expected—dividends, capital growth
capital growth: factors that will affect the level of growth—inflation, interest rates, economic and
business cycles
accessibility: the depth and liquidity of the primary market and secondary market
flexibility: portfolio restructuring, active investment, passive investment
taxation: income tax, capital gains tax, dividend imputation (if available)
social security: effect of investment on the income test and assets test associated with social security
benefits (if applicable).
There are two approaches to buying and selling shares through a stock exchange: direct investment
and indirect investment. With the direct investment strategy, an investor will choose to buy or sell shares
directly through a stockbroker. Chapter 4 discusses the buying and selling of shares within the context
of the ASX’s electronic trading and settlements systems, ASX Trade and CHESS. It may be useful to
look again at Figure 4.3, as it depicts the processes of buying and selling securities on the ASX. As we
noted, the ASX plans to replace CHESS in 2021.
Briefly, an investor selects the company in which to invest and places an order with a stockbroker
to buy or sell specific shares. The broker will place that order into the stock exchange’s electronic
trading system. The system will prioritise by price and time, match corresponding buy and sell orders
and execute the trade. The stockbroker will send a contract note to the buyer or seller confirming the
transaction and advising of the stock traded, the number of shares, the date of the trade, the price,
the transaction costs and the total amount. On the ASX, settlement will occur in T + 2 days; that
is, the trade day plus two business days. The stock exchange will electronically transfer ownership of
the shares to the buyer and forward financial settlement for the transaction to the seller. To enable
financial settlement to occur, an investor will maintain a cash management trust account with a broker,
or provide a broker with the authority to access an account with a financial institution such as a bank.
The development of electronic trading and settlement systems, plus greater investor access to
the internet, has radically changed the way stockbrokers function. Other important factors include
an increase in investor knowledge, more affluent investors and an ageing population preparing for
retirement. Further, globalisation of the investment markets, investor demand for higher performance
outcomes and significantly increased competition for the provision of broker services have also changed
the structure of the stockbroking sector.
Stockbrokers can be categorised as discount (non-advisory) brokers or full-service (advisory) brokers.
A discount broker accepts buy or sell orders from clients, but provides no advice or recommendations
to the client in relation to investment alternatives or opportunities. The majority of orders to buy or sell
shares are initiated by the client entering an instruction to the stockbroker via the internet.
A full-service advisory broker offers advice and recommendations to clients on investment choices
and strategies. The range of services provided includes:
•
•
•
buying and selling shares on the instruction of clients
providing investment advice on securities listed on a stock exchange, including shares, fixed-interest
securities, derivatives and listed trusts
giving advice on other investment opportunities such as cash management trusts, property trusts
and equity trusts
Direct investment
an investor buys and
sells shares directly
through a stockbroker
Stockbroker
acts as the agent for an
investor in the buying
and selling of stockmarket securities
Discount broker
executes buy and sell
orders for clients; does
not provide investment
advice or services
Full-service advisory
broker
executes buy and
sell orders, but also
provides other services
to clients, including
investment advice
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•
•
•
Indirect investment
investing through a
fund manager in a unit
trust or a managed fund
making recommendations and establishing and monitoring personal financial plans for clients
preparing retirement plans for clients, including superannuation
conducting investment research, forecasting and disseminating information to clients.
Brokerage fees of a discount broker are lower than the fees of a full-service broker because of the
level of service provided. Discount brokers’ fees in Australia range between $25 and $40 per transaction
for smaller-value transactions, but increase to a percentage of the transaction value for larger-value
transactions; for example, 1.00 per cent of transactions over $50 000.
Investing in shares can also be achieved through indirect investment. The most common form of
indirect investment in shares occurs when an investor purchases units in a unit trust or managed fund.
The trustee of the fund will allocate part of the accumulated pool of the funds to professional fund
managers. The fund managers will invest the funds in asset classes permitted under the terms of the trust
deed of the fund. For example, a particular trust may be authorised to invest in domestic industrial and
resource shares, while another fund may only be permitted to invest in selected international markets.
Indirect investment fees may include entry, exit, management and administration fees; these will usually
be higher than direct investment fees. (Managed funds and unit trusts are discussed in Chapter 3.)
REFLECTION POINTS
•
•
•
•
•
•
Direct share investment occurs when an investor selects stock to be held in a portfolio and
places buy or sell orders with a stockbroker; the stockbroker provides access to the exchange’s
electronic trading and settlement systems.
A stockbroker may be a full-service broker who provides investment advice, facilitates buy/sell
orders and provides a range of other related financial services.
A discount broker only accepts electronic buy and sell orders.
The buy/sell process and electronic trading and settlement systems are discussed in Chapter 4
(see ASX Trade and CHESS).
Some issues a direct investor will consider before buying a stock include liquidity, risk/return,
integrity, transaction costs, capital growth/loss, accessibility, flexibility, taxation and social security.
Indirect share investment is typically achieved by investing in a unit trust or managed fund. The
fund will use professional fund managers to invest in the share markets.
6.3
LEARNING
OBJECTIVE
6.3
Understand the
importance of taxation
in the investment
decision process.
Capital gains
where the value of an
asset increases over
time
Taxation
The return received by an investor on a share portfolio may comprise dividend income and capital gains
or losses. Dividends, if paid, are usually received twice yearly, being an interim dividend and a final
dividend. The payment of a dividend from the profits of a company is at the discretion of the board of
directors. Capital gains occur when the value of the share, or share price, increases. In either case, an
investor may be required to pay taxation on total annual dividends received and realised capital gains
(that is, any capital gain received when a share is sold). Therefore, an investor will need to be aware of
the impact of taxation on an investment strategy. Taxation of investment returns varies from country to
country, particularly in relation to:
•
•
•
•
the taxation of dividend income
the taxation of capital gains
the rate of tax
the treatment of capital losses.
This text briefly considers the taxation of income and capital gains within Australia. The taxation
regimes of other countries may be accessed through the website of the taxation office in those
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countries. The address for the Australian Taxation Office is www.ato.gov.au. The taxation of individuals
in Australia is based on a progressive tax system whereby the percentage of taxation increases relative
to increases in taxable income. The personal tax income thresholds for the 2018–19 tax year are shown
in Table 6.1.
Table 6.1 Personal income tax rates, Australia, from 1 July 2018
Annual taxable income
Personal income tax payable (a Medicare levy of 2.00 per cent of
total taxable income is also payable)
0–$18 200
Nil
$18 201–$37 000
19c for each $1 over $18 200
$37 001–$90 000
$3 572 plus 32.5c for each $1 over $37 000
$90 001–$180 000
$20 797 plus 37c for each $1 over $90 000
$180 001 and over
$54 097 plus 45c for each $1 over $180 000
SOURCE: Australian Taxation Office.
The taxation of dividends in the hands of the recipient was introduced as a temporary measure
during World War II. This tax effectively resulted in dividends being taxed twice. First, companies paid
tax on their net profits before a proportion of those after-tax profits was then distributed to shareholders
in the form of dividend payments. Second, tax was also payable by shareholders on the dividends
received. The tax was levied at the shareholder’s marginal rate of tax. This essentially represented a
system of double taxation. This double taxation continues in many countries today.
However, in July 1987 Australia introduced a system known as dividend imputation which removed
the double taxation of dividends. Table 6.2 illustrates a simplified example of the beneficial effects for
shareholders of the dividend imputation system. Apart from the obvious taxation benefit, dividend
imputation encourages investment and growth in the share market.
Marginal rate of tax
the percentage of
income tax paid
progressively increases
relative to the amount
of income earned
Table 6.2 Dividend imputation (Australia)
Company X:
Taxable income
$100.00
Tax liability (at 30%)(a)
−$30.00
After-tax profits distributed as dividends(b)
Franked dividend received
Income included in tax return (grossed-up amount, being
the dividend of $70 plus the franking credit of $30)
Shareholder:
Marginal tax liability (at, say, 39%)(c)
Less the franking credit (paid by Company X)
Tax payable
(a)
$70.00
$70.00
$100.00
$39.00
–$30.00
$9.00
Company tax rate for 2017–2018 = 30%; $30 tax paid by the company is available for allocation to shareholders as a franking credit. It
should be noted that companies with turnover of less than $25 million pay 27.5% company tax.
(b)
Assume 100% of profits are distributed as dividends to shareholders.
(c)
Assume personal marginal income tax rate = 37% plus 2.00% Medicare levy.
Franked dividends
dividends paid to
shareholders that have
a tax franking credit
attached that is derived
from company tax paid
Grossed-up amount
the total of the franked
dividend plus the
franking credit included
in a shareholder’s
taxable income
Franking credit
Under the current dividend imputation system, dividends on which the company has already paid
company tax are referred to as franked dividends. For personal taxation purposes, the franked dividend
received by the shareholder is grossed-up by the franking credit and the total amount is included in
the amount of company
tax paid and transferred
to a shareholder with a
franked dividend
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taxable income. The individual shareholder is entitled to receive a tax rebate up to the amount of the
franking credit. The franking credit is calculated as follows:
company tax rate
​Franking credit = franked dividend × ​ __________________
​​
1 − company tax rate
Inflation component
that part of a capital
gain that is accounted
for by the percentage
increase in prices over
the period
6.1
Therefore, as shown in Table 6.2, the franking credit is calculated as $30.00, being the fully franked
dividend of $70.00 multiplied by ​0.30 / (1 − 0.30 ) .​ The franking credit of $30.00 is added to the franked
dividend of $70.00 to give a grossed-up receipt of $100.00, which is included in the shareholder’s
assessable income.
The franking credit reduces the tax payable. In Table 6.2, the marginal personal income tax rate of
37 per cent, plus 2.00 per cent Medicare levy, is used. Tax payable on the grossed-up amount is $39.00,
but the shareholder receives the benefit of the franking credit of $30.00, being the amount of tax
already paid by the company. This reduces the tax payable by the shareholder to $9.00.
Without the benefit of the dividend imputation system, the shareholder would have been required
to pay $27.30 in tax on the $70.00 dividend received. A shareholder whose marginal tax rate is lower
than the company tax rate will pay no tax on the dividend received, and the excess franking credit can
be applied against other taxable income. If the shareholder is entitled to a franking credit greater than
the income tax payable, the shareholder will receive a cash tax refund. Clearly, an investor needs to
consider the tax implications of a share investment.
The Australian dividend imputation system applies only to Australian company tax paid; therefore
companies that generate part of their income overseas, and do not pay Australian tax on that income,
cannot allocate a franking credit for the non-Australian tax paid overseas. In that situation the company
may allocate a partly franked dividend based on Australian tax paid.
Another relevant aspect of taxation is the tax payable on capital gains realised from the buying
and selling of shares. This area of taxation has changed a number of times in Australia and both the
previous and the current capital gains tax regimes are discussed here. Where shares were acquired
(or deemed to have been acquired) after 19 September 1985, a capital gain that is realised from the
sale of those shares within 12 months of purchase is taxed in full at the taxpayer’s marginal tax rate.
Where a capital gain is realised on shares sold more than 12 months from purchase, different rules
may be applied. From September 1985 until 21 September 1999, a capital gain was indexed; that is, it
was adjusted to reflect the inflation component of the asset’s price change. The net capital gain after
indexation was taxed at the taxpayer’s marginal tax rate.
Since 21 September 1999 the rule has changed. Currently, 50 per cent of any non-indexed capital gain
on shares acquired since that date is now taxed, where the shares have been held for at least 12 months.
The tax rate is the shareholder’s marginal tax rate. For shares acquired between 19 September 1985 and
21 September 1999, the shareholder can choose between paying capital gains tax on the indexed capital
gain, or the 50 per cent discounted gain. Capital losses can be offset against future capital gains.
REFLECTION POINTS
•
•
•
•
Dividends and realised capital gains are taxable. Taxation structures and rates vary
considerably between countries.
In Australia there is a system of dividend imputation.
Dividend imputation allows companies to pass tax credits for Australian company tax already
paid to shareholders when dividends are paid. This is a franked dividend and the tax transfer is
called a franking credit. The grossed-up amount is added to the shareholder’s taxable income,
but the shareholder is able to reduce the tax payable with the amount of the franking credit.
In Australia the taxation of capital gains has varied over time. Without considering retrospective
arrangements, the current system requires at least 50 per cent of a capital gain to be included
as taxable income. Capital losses may be used to offset capital gains.
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6.4
Financial performance indicators
In deciding whether or not to purchase shares in a company, a potential shareholder who applies
the fundamental approach to share investment analysis will be particularly interested in forecasting
the future level of profitability of the company and the degree of risk associated with those forecast
future cash flows. Though the emphasis of any share analysis should be based on future earnings, this
generally is not possible and therefore an investor will, to a large extent, depend on historic data to form
a view on the company’s projected performance.
Significant indicators of a company’s past and present financial performance include its capital
budgeting, capital structure, liquidity and cash management, dividend policies, record of profitability,
overall performance relative to that of other firms in the industry and the impact of economic
fluctuations on performance.
The indicators of a company’s performance that we will consider are capital structure, liquidity,
debt servicing, profitability, share price and risk.
6.4.1
Identify and describe
various indicators of
financial performance.
Capital structure
Capital represents the funds available to a company for its business purposes. This may seem a bit
confusing because in Chapter 2 we referred to capital within the context of the Basel III capital accord
as primarily equity-type funds. However, in this instance, capital structure refers to the proportions of
funding derived from debt and equity.
Capital structure is usually measured by the debt-to-equity ratio. The importance of the debt-to-equity
ratio is discussed in detail in Chapter 5. Another relevant capital structure ratio is the proprietorship
ratio, or shareholders’ interest ratio, which is the ratio of shareholders’ funds to total assets.
The shareholders’ interest ratio is an indicator of the long-term financial viability and stability of a
firm. Companies with a higher ratio of equity to other forms of finance are less dependent on external
funding and thus have a lower level of financial risk. Such companies are also in a stronger position to
grow the business, as they hold the necessary equity to support any expansion. It was pointed out in
Chapter 5 that there is no single ideal ratio of debt to equity and that there is a wide spread between the
ratios in different industries, and also between companies in the same industry. In analysing the debtto-equity ratio or the shareholders’ interest ratio, it is important to compare various industry groups.
An examination of the ratio for a single company through time must also be carried out, typically over
a three- to five-year period.
The higher the level of debt financing relative to the proportion of equity provided by the
shareholders of a firm, the greater the level of risk associated with future profitability. The higher level
of risk derives from the nature of debt; that is, interest payments on debt and principal repayments
must be made when they fall due. Should revenues from business operations fall as a result of adverse
business conditions, the company might struggle to make these debt payments.
6.4.2
LEARNING
OBJECTIVE
6.4
Capital structure
proportion of company
assets financed by debt
and equity
Liquidity
A company must ensure that it has access to sufficient cash to be able to meet its current commitments
and take advantage of future business opportunities. This is indicated by the company’s level of liquidity,
that is, its ability to continue to meet its short-term financial obligations and thus to continue trading.
One ratio used to measure the level of liquidity available to a company is the current ratio, that is,
the ratio of current assets, being assets maturing within one year, to current liabilities, being liabilities
due within one year. Current assets include cash, accounts receivable, stock (inventories) and short-term
financial investments. Current liabilities include accounts payable and short-term debt commitments
such as a bank overdraft facility, bills drawn and commercial paper issued.
Current ratio
ratio of current assets
to current liabilities
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current assets (maturing within one year)
_________________________________
​Current ratio = ​
​​
current liabilities (due within one year)
Liquidity ratio
ratio of current assets,
less inventory, to
current liabilities, less
bank overdraft
6.2
A second, more specific, ratio is the liquidity ratio, that is, the ratio of current assets less stock, to
current liabilities less the company’s bank overdraft.
current assets − inventory (stock on hand)
​Liquid ratio = ​ __________________________________
​​
current liabilities − bank overdraft
6.3
Of the two ratios, the liquidity ratio provides a more realistic view of a company’s liquidity position.
The reason for excluding inventory from current assets is that the liquidation of inventory may be
quite difficult to achieve if the company is experiencing a liquidity crisis. Overdrafts are deducted from
current liabilities because an overdraft facility with a bank is typically an ongoing financial arrangement
and is less likely to be required to be repaid.
On the liquidity criterion alone, it would seem that a company with a higher liquidity ratio or
current ratio is in a healthier position than one with lower ratios. However, this is relative; the real
question is whether a company has access to sufficient liquidity to meet its forecast needs under a
pessimistic business scenario. Too much liquidity is not a good performance indicator, as there is a cost
in maintaining a high level of liquidity; that is, the return received on liquid assets is generally lower.
It is important to recognise that the ratios will vary considerably between firms in different sectors,
and that there is no theoretical basis for the determination of the appropriate ratio even for firms
within the same sector. One of the major reasons for the differences between the various sectors is
different operating practices. For example, some firms and industries operate with a large volume of
accounts receivable and inventories, and thus have a relatively high current ratio. Other companies
will carry virtually no inventories, and will have little by way of accounts receivable; in this case, their
liquidity ratios will be relatively low but will not necessarily indicate that there is a liquidity problem.
It is important, therefore, that comparisons on the basis of liquidity be made only within the same
industry group or sector. It may also be informative to compare, for the specific firm, the most recent
performance of the ratios against a long-term average.
That having been said, a rule of thumb generally accepted in the accounting literature is a current
ratio of 1.5. This implies that a company with a 1.5 ratio will have liquid assets sufficient to cover its
current liabilities one and a half times, thus providing a buffer to meet unexpected situations. A similar
rule of thumb for the liquidity ratio may well be in the order of 0.7 to 0.8.
This discussion of liquidity measurement has focused on the use of standard accounting ratios
to measure the level of liquidity within a firm. These ratios are convenient for analysts and investors
because the data needed for the calculations are available within published financial accounts. However,
firms should adopt more sophisticated techniques for the internal measurement of liquidity. One
method is to identify the liquidity characteristics of both assets and liabilities in order to understand
the cash-flow implications of each asset and liability over different planning periods. This method
recognises that the management of liquidity, as with other financial risks, is a dynamic rather than
a static process. Liquidity within any corporation will change on a daily basis and therefore must be
continually measured, managed and monitored.
6.4.3
Interest cover ratio
the number of times
a firm’s financial
commitments are
covered by earnings
Debt servicing
The amount and timing of cash flows available to a company are of critical importance to its ability to
meet its short-term financing requirements and to ensure its solvency.
Generally, companies always retain a level of debt because, as one debt issue matures, it is usually
refinanced. However, refinancing may become very expensive when credit conditions in the capital markets
are tight, so a strong cash flow is a good indicator of a company’s ability to maintain its ongoing operation.
One measure of a firm’s capacity to service debt is the interest cover ratio. This ratio represents
the number of times the business’s finance lease and interest charges are covered by its earnings before
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lease charges, interest and tax. The higher the ratio, the greater is the ability of the business to cover
its interest commitments. Again, a rule of thumb in the accounting literature often gives a minimum
interest cover ratio of two times. This means that a rise in interest rates will not result in an undue
negative situation for the company. It also provides scope for the company to obtain further borrowings
if necessary. An interest cover ratio of less than 1 means that the company will experience an operating
loss before income tax, and a negative cover ratio indicates a loss situation even before interest expenses
are deducted.
earnings before finance lease charges, interest and tax
​Interest cover = ​ ___________________________________________
​​
finance lease charges and interest
6.4.4
6.4
Profitability
A company’s profitability may be represented by a range of different accounting ratios. A ratio that
allows for comparisons to be made between companies with different capital structures is the ratio of
earnings before interest and tax (EBIT) to total funds employed:
EBIT
​EBIT to total funds ratio = ​_______________________________________________
​​
total funds employed (shareholders’ funds and borrowings)
6.5
A variation of this ratio is to exclude short-term funding. This eliminates the effects of seasonal
fluctuations in the amount of short-term debt employed by some companies. This ratio is referred to as
the EBIT to long-term funds ratio:
EBIT
​EBIT to long-term funds ratio = ​______________________________________________
​​
long-term total funds (i.e. total funds less short-term debt)
Return on equity
6.7
Another ratio considered by shareholders is earnings per share (EPS). Company data for this
ratio are normally published daily in major newspapers and therefore are easy to obtain. The EPS
ratio measures the earnings that are attributable to each ordinary share after abnormal items. One
shortcoming of the EPS ratio is that it is impacted by the number of shares outstanding. Investors will
usually complement their analysis of earnings with the firm’s price to earnings (P/E) ratio. We discuss
this shortly.
Table 6.3 shows the EPS ratios of selected companies in the retail, banking and resources sectors.
There are quite wide differences between companies and sectors. However, prior to concluding that
those with the highest ratios are the ones that should be invested in, it is important to consider a range
of other indicators of an industry’s and a company’s performance, such as the price to earnings ratio. It
is also important to consider the history of the ratio in order to allow for the effects of fluctuations in
the overall economic environment on particular companies and industry sectors.
6.4.5
the profits of a firm
before allowing for
interest expenses and
tax payments
6.6
A further measure of profitability is the return on equity. It is given by:
operating profit after tax
​ eturn on equity = ​ _______________________
R
​​
equity (shareholders’ funds)
Earnings before
interest and tax
(EBIT)
operating profit after
tax as a percentage of
shareholders’ funds
Earnings per share
(EPS)
earnings attributed to
an ordinary share
Share price
The price of ordinary shares in a company listed on a stock exchange represents the opinion of investors
as to the present value of the future net cash flows to be generated by the company. The more optimistic
the evaluation of the company’s future earnings prospects, the greater will be the demand for its shares,
and thus the higher the share price of the company. There are two commonly used measures of the
investors’ evaluation of a firm. They are the price to earnings ratio and the share price to net tangible
assets ratio.
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Table 6.3 Selected earnings per share ratios, July 2017 (cents)
Retail sector
Harvey Norman
40.85
JB Hi-Fi
186.83
Woolworths
110.45
Banking sector
Australia and New Zealand Banking Group
195.33
Commonwealth Bank
556.45
National Australia Bank
239.30
Westpac Banking Corporation
233.32
Resources sector
BHP Billiton
172.74
Rio Tinto
628.01
Santos
–22.08
Woodside Petroleum
154.38
SOURCE: Morningstar DatAnalysis, 2018.
Price to earnings
ratio (P/E)
the current share price
divided by the earnings
per share
Share price to net
tangible assets ratio
current share price
relative to the firm’s net
tangible assets
The price to earnings ratio (P/E) is the market price of a company’s shares divided by its earnings
per share. This ratio is an indicator of investors’ evaluation of the future earnings prospects of a firm,
rather than an indicator of the firm’s current or past performance. Where good earnings growth is
expected, the P/E ratio will rise and be relatively high. Where there is less optimism about the future
prospects, the P/E ratio will generally fall. Table 6.4 provides P/E ratios for selected companies within
the retail, banking and resource industry classifications. The published data used in Table 6.4 are
based on historic earnings rather than on a forecast of future earnings. Variations are evident between
companies within the same industry sectors. This implies that the prices of company shares do, to some
extent, already reflect anticipated changes in future earnings.
While the P/E ratio is generally used and is conceptually quite simple, it is often difficult to
calculate and interpret. The P/E ratio for a particular company can vary from one published source
to another, depending on the earnings figure used in the calculation and on the estimation of the
projected earnings growth rate. As noted above, the ratio should be based on expected future earnings.
However, there are likely to be as many numbers put on the future earnings figure as there are analysts
who are constructing P/E ratios for specific firms. Again, when interpreting P/E ratios published in
the financial press, keep in mind that they will have been calculated using the immediate past earnings
figures.
Another measure of the value of a company is the share price to net tangible assets ratio. This is a
measure of the discount or premium that a company’s share price is trading at relative to its net tangible
assets. When the ratio is less than 1, the share price is at a discount and this may form the basis for
another company to take over the assets of the company that theoretically may be undervalued.
A ratio of less than 1 will not automatically result in a takeover. One of the inadequacies of this
measure is that the value for net tangible assets (NTA) may not truly reflect the real, or replacement,
value of the assets. For example, the valuation of some company assets may not take account of the
fact that the assets cannot be converted into cash because they are purpose-built or they cannot be
relocated.
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Table 6.4 Selected price to earnings (P/E) ratios (times), May 2018
Retail sector
Harvey Norman
10.45
JB Hi-Fi
11.78
Woolworths
22.84
Banking sector
Australia and New Zealand Banking Group
12.95
Commonwealth Bank
12.87
National Australia Bank
12.19
Westpac Banking Corporation
12.58
Resources sector
BHP Billiton
15.16
Rio Tinto
12.93
Santos
—
Woodside Petroleum
19.71
SOURCE: Morningstar DatAnalysis, 2018.
6.4.6
Risk
Of fundamental importance in the decision to invest in a particular company or industry is the assessment
of the risk that the investor would face from the investment. The notion of risk here is the variability,
or fluctuation, in the share price. Modern portfolio theory provides a rigorous approach to analysing
investment risk, in which risk is divided into two components: systematic risk and unsystematic risk. The
nature of systematic and unsystematic risk was introduced in Section 6.1. That discussion is continued here.
Systematic, or market, risk arises from factors that affect the whole market; that is, it relates to the
variability of the general share market, not the variability of the shares of an individual firm. Variations
in overall market performance could be brought about by:
•
•
the state of the economy, including the levels of interest rates and the availability of credit, the rate
of inflation, the rate of growth of the economy, changes in the taxation system and in government
spending and movements in the exchange rate
the state of international economies and the performances of major foreign share markets.
The second component, unsystematic risk, is caused by factors specific to an individual company.
The relevant influences include:
•
•
•
•
•
the effectiveness and experience of the managers of the company
productivity and the cost of labour
the particular impact of financial risk exposures (e.g. interest rate changes will have a greater impact
on highly geared companies, and unfavourable foreign exchange movements will affect companies
that have not hedged their foreign currency exposures)
exposures to particular operational risks (e.g. loss of computer systems, denial of access to company
premises due to a flood or fire or industrial action by employees)
the competitiveness of the company relative to other firms, both domestic and foreign, in the same industry.
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As discussed previously, one of the contentions of modern portfolio theory is that an investor
can significantly reduce the effects of unsystematic risk through investment in a well-constructed and
diversified portfolio. On the other hand, systematic, or market, risk cannot be diversified away. Therefore,
in constructing a share portfolio it is important to identify the systematic risk of the firms to be included
in the portfolio. The higher the systematic risk, the higher should be the expected rate of return.
As discussed in Section 6.1, estimating systematic risk involves comparing the price history of a
particular stock relative to movements in the market index. This measure of risk is referred to as the
beta coefficient. The higher a stock’s beta, the greater the risk of that particular stock, and therefore the
higher should be the expected rate of return. One of the problems in using beta calculations is that they
are based on historic data. Nevertheless, beta is a very useful comparative measure of risk.
Beta factors should be used as a starting point for the analysis of risk that may be inherent within
various companies, and for the construction of an appropriate share portfolio. A company listed on a
stock exchange with a beta of 1.15 indicates that, based on historic data, the share price can be expected
to perform 15.00 per cent better than the overall market when share prices are rising, but 15.00 per cent
worse if the market is falling. A company with a beta of 0.5 implies that the share price will rise, or fall,
at only half the rate at which the overall market moves.
However, what is relevant when choosing between investment alternatives is the expected future
performance of a company. Chapter 7 considers some of the approaches that are used to assess the
future performance of various sectors of the market and of individual companies.
REFLECTION POINTS
•
•
•
•
•
•
•
An investor will consider a range of financial performance indicators when analysing the future
earnings and profitability of a company.
Capital structure looks at the risks associated with the funding of a firm, including the debt-toequity ratio and the type of debt held.
Liquidity considers the access a company has to liquid funds to meet its day-to-day
commitments.
Debt servicing analyses the ability of a company to meet payments on its liabilities over
different business scenarios.
Profitability analyses the earnings per share of a company and its return on equity.
The share price is the present value of forecast future net cash flows. Within this context, an
investor will consider the price to earnings (P/E) ratio.
An investor will analyse systematic risks (e.g. the impact of an increase in interest rates on debt
facilities) and unsystematic risks (e.g. the impact of a computer system failure). Investors should,
in part, manage systematic risk using beta factors, and diversify away unsystematic risk.
6.5
LEARNING
OBJECTIVE
6.5
Apply quantitative
methods to the pricing
of shares.
Pricing of shares
Share investors are particularly interested in share prices and will scan the newspaper, or the website
of the stock exchange, each day to see if the prices of shares held in a share portfolio have risen or
fallen. In general, people are excited when the price of a share has risen, but surprised and disappointed
when a share price falls. Fundamentals that impact on the price of a share include company-specific
performance indicators and macroeconomic effects such as changing interest rates, exchange rates,
prices, employment levels and business cycles.
This section looks at the ways an investor can estimate the price of an ordinary share issued by a
listed corporation, and the impact on a current share price of dividend announcements and payments,
the issue of bonus shares, share splits and pro-rata rights issues.
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6.5.1
Estimating the price of a share
The price of a share listed on a stock exchange is principally a function of the supply and demand
for that stock. However, there are factors at work in the market that influence the level of supply and
demand. One of the biggest influences is information. It may be argued that a share price moves in
response to new information coming to the market.
Why does new information have such an impact on share prices? The answer lies in the method
that is used to estimate the price of a share. The price of a share is the present value of its future cash
flows. New information will change investors’ expectations of forecast earnings and future dividends,
and this will be reflected in a movement in the share price. That is, there will be a change in the supply
and demand of a share as a result of the new information that changes expectations of future cash flows.
Where the price of a dividend-paying ordinary share is equal to the present value of all future
dividends, this may be expressed as:
​Dt​ ​​
∞
​​P​ 0​​ = ​∑ ​​ ​
​  _______
​​
t
t=1 ​(1 + ​rs​ ​​)​​ ​
6.8
where:
P0 = current share price
Dt = expected dividend per share in period
rs = required rate of return
In fact, an accurate estimation of future dividends over an extended period is very difficult. The
calculations are therefore often simplified by using two alternative assumptions. In the first case it
is assumed that a company will continue to pay a constant dividend over time; in the second, that a
company will pay a dividend that grows at a constant rate over time.
Valuing a share with a constant dividend
When a company’s dividend payments are expected to remain constant, such that ​​D0​ ​​ = ​D1​ ​​ = ​D2​ ​​ = ... ​Dn​ ​​,​ the share price can be calculated based on a perpetuity. The present value of a perpetuity is the cash
flow divided by the relevant discount rate. The discount rate is the required rate of return that an
investor requires on this particular investment. The equation may be expressed as:
​D0​ ​​
​​P​ 0​​ = ​ __
​r​  ​​​​
6.9
s
For example, if Techno Limited’s last dividend payment of $0.50 per share is expected to remain
constant, and the required rate of return on this investment is 15 per cent per annum, the price of the
stock should be:
​P​ ​​ = ____
​ 0.50 ​
​ ​​ 0​  ​ ​  0.15​ ​​
​ = $3.33
6.9a
The price of Techno Limited should change if the required rate of return changes as a result of new
information coming to the market, or if new information implies a shift in the constant dividend to a
new level.
Valuing a share with a constant dividend growth rate
A more common situation is one in which the dividend paid to shareholders over time increases. (It is
assumed that the growth rate is constant.) Therefore, the next dividend paid will be the last dividend
multiplied by the growth rate (g). This is expressed as:
​​D​ 1​​ = ​D0​ ​​ (1 + g)​
6.10
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therefore:
​​D​ t​​ = ​D0​ ​​ ​(1 + g)​​ t​​
The original pricing formula can now be reconfigured so that:
​D0​ ​​(1 + g)
​​P​ 0​​ = ​ ________
​​
(​rs​ ​​ − g)
6.11
This formula represents the constant dividend growth model. For example, Ocka Limited has a
constant dividend growth policy of 7.00 per cent. In the last financial year the company paid a dividend
of $0.75 per share. If an investor’s required rate of return on this investment is 12.00 per cent, the
current price of the stock should be:
​D0​ ​​(1 + g)
​P0​ ​​ = ________
​
​
(​rs​ ​​ − g)
6.12
​ ​​ ​  ​  ___________
​​
​ ​
(0.75
×
1.07)
​ =
​
​
(0.12 − 0.07)
= $16.05
The constant dividend growth model recognises that a share price will be influenced by:
•
•
•
•
a company’s earnings per share
the company’s dividend payout ratio
the expected growth rate in dividend payments
an investor’s required rate of return.
While the formula seems to imply that it is simple to accurately calculate the price of a share, in
fact each of the component parts of the formula is not known with any certainty.
6.5.2
Cum-dividend
a share price includes
an entitlement to
receive a declared
dividend
Ex-dividend
date at which a share
price is theoretically
expected to fall by the
amount of the declared
dividend
Cum-dividend and ex-dividend share prices
In addition to fundamental factors that affect the price of a share, there are some other reasons—
unrelated to the performance of the company—which lead to changes in a share price. These reasons
are associated with the announcement by a company of a shareholder entitlement to receive a dividend,
and the actual payment of the dividend to shareholders.
Dividends are payments to shareholders, made out of the company’s after-tax earnings. Dividends
are normally expressed as cents per share. Companies typically pay dividends twice a year: an interim
(half-year) dividend and a final dividend. After a dividend is declared, shares are normally traded for a
period of time with the dividend entitlement attached. That is, the share is said to trade cum-dividend
(cum is the Latin for ‘with’). This occurs because there is a period of time between the announcement
by the board of directors of a dividend payment during which the entitlement to receive that dividend
moves to the new owner of the shares if the shares are sold.
When a share is trading cum-dividend, the buyer of a share will also receive the next dividend payment.
At a specified date, the share begins to trade ex-dividend (ex is the Latin for ‘without’) and the seller of
a share, not the buyer, will receive the next dividend when the payment is finally made by the company.
The ex-dividend share price should, theoretically, adjust downwards by the amount of the dividend.
For example, if a company has declared a dividend of 5 cents per share, and its price cum-dividend is
$1.00, the theoretical ex-dividend price would be calculated as:
Share price cum-dividend
$1.00
Dividend paid
$0.05
Theoretical ex-dividend price
$0.95
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6.5.3
Bonus share issues
Occasionally, the board of directors of a company will issue additional ordinary shares to existing
shareholders at no cost to the shareholder. The shares will usually be issued based on a predetermined
ratio, such as one bonus share for every four ordinary shares held. The reason the board of directors
makes a bonus issue is in order to convert accumulated reserves into equity; this is referred to as
capitalising reserves.
As with dividends, bonus share entitlements are traded cum-bonus and ex-bonus. When shares
go ex-bonus there should be a downward adjustment in the share price. This is to be expected since a
bonus issue does not result in a change in the total assets, or earnings expectations, of the company.
Rather, it simply represents a change in the structure of the company’s financial capital. The price
adjustment for ex-bonus shares should reflect the new number of shares in, or claims on, the asset value
of the company. For example, if a company offers a one-for-four bonus issue, and its shares are currently
priced at $10.00 cum-bonus, the theoretical price ex-bonus would be calculated as:
Cum-bonus share price
$10.00
Market value of four cum-bonus shares
$40.00
Theoretical value of five ex-bonus shares
$40.00
Theoretical value of one ex-bonus share = $40.00/5
Bonus issue
where a company
capitalises reserves
through the issue of
additional shares to
shareholders
$8.00
The ex-bonus price may not fall to its theoretical value. The act of issuing bonus shares may be
taken by the market as a signal from the management of the company that it anticipates an increase in
profitability. This is because, with the bonus issue, there are a greater number of shares in existence,
and thus there are a greater number of shares to be serviced with dividends in the future. Assuming
that management will not want to pay lower dividends in the future, it must have reason to believe that
higher profitability is expected. If that is the interpretation that is placed on the bonus issue, demand
for the shares should increase and there would be a consequent increase in the price of the shares. In
this case, the ex-bonus price may not be adjusted down by as much as the calculations above suggest.
6.5.4
Share splits
The board of directors may decide to split the number of issued ordinary shares of a company. A
motivation for a share split might be to increase the liquidity of the shares on the stock market. For
example, if the share price of a company has, over time, increased significantly, to a point where the
dollar amount is large relative to the majority of other company shares traded on the exchange, the share
may be seen as too expensive for some investors. If this is the case, those investors will be reluctant to
buy the high-priced share and as such there will be less liquidity in the market for that share. A share
split enables the board of directors to lower the price of the stock without changing the capital structure
of the company or diluting the return to shareholders.
A share split involves the division of the number of shares on issue. While the split often involves
the doubling of the number of shares on issue (2 for 1), there can be other ratios as well. In assessing the
impact of a share split on the market price of an ex-split share, it must be remembered that there is no
fundamental change in the asset value of the company. The price adjustment should simply reflect the
ratio of the split. For example, if a share with a current pre-split price of $40.00 is split two for one, then:
Pre-split share price
$40.00
Theoretical ex-split share price
$20.00
Share split
a proportional division
of the number of shares
issued by a company
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Should the split be a 5 for 1 split, that is, the split results in five new shares for one existing share,
then, given a pre-split share price of $40.00:
Pre-split share price
Theoretical ex-split share price
6.5.5
$40.00
$8.00
Pro-rata rights issues
A pro-rata rights issue was discussed in Chapter 5. Briefly, a rights issue comprises an offer to existing
shareholders of additional ordinary shares in the company on a pro-rata basis, such as one new share
for every five shares held. A rights issue allows a company to increase its issued capital. The offer or
subscription price of a rights issue is typically made at a discount to the market price. Thus, one should
expect, theoretically, a downward adjustment in the share price when it is traded ex-rights compared
with the cum-rights price. The extent of the adjustment should reflect the number of new shares issued
and the amount of funds raised from the issue of the additional shares. The greater the number of shares
issued, and the deeper the discount at which they are issued, the greater is the expected downward
adjustment in the ex-rights share price.
For example, a company with a cum-rights share price of $2.00 has made a one-for-four rights
issue priced at $1.80; that is, the new share will cost $1.80. The theoretical ex-rights price would be
calculated as:
Cum-rights share price
$2.00
Market value of four cum-rights shares
$8.00
Plus:
New funds raised through take-up of one-for-four issue
$1.80
Gives:
Market value of five ex-rights shares
$9.80
Therefore:
Theoretical ex-rights share price ($9.80/5) =
Renounceable
a right that can be sold
before it is executed
$1.96
Typically, the board of directors will announce a rights issue today, but the right will be exercisable
by shareholders at a future date, such as in six weeks’ time. From the investor’s point of view, if the
board of directors makes the rights issue renounceable—that is, the entitlement, or rights to purchase
the new share, can be sold—the rights offer has a value before it is exercised. If the shareholder from the
above example holds four cum-rights shares priced at $2.00, and a rights issue of one for four is offered
at $1.80, the value of the right is 16 cents. The value of the right is expressed as:
N(cum-rights price − subscription price)
​Value of right = ​ _________________________________
​​
N+1
6.13
where N is the number of shares required to obtain one rights issue share, and the subscription
price is the discounted price of the additional share. Therefore:
4($2.00 − $1.80)
______________
Value of right =
​
​
5
​ ​​
​
​  _____
​​
​
​
$0.80
​
= ​   ​
5
​
= $0.16
6.13a
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Chapter 6 Investors in the share market
Since each of the original shares has one-quarter of the right attached to it, being a one-for-four
rights issue, each ex-rights share can be expected to fall in value by 4 cents, that is, from $2.00 to $1.96.
This is exactly the theoretical ex-rights share price that was calculated previously.
Quite often the ex-rights price will not fall to its theoretical value. This is explained by the
informational content of the rights issue. The fact that the company has increased its equity base may
be taken by the market to mean that it anticipates improved profitability. Investors may well presume
that the additional capital raised with the rights issue will be used by the company for profitable growth.
As with bonus shares, that presumption of profitable growth is necessary if the company is to maintain
its current dividends and earnings per share on the increased number of shares.
REFLECTION POINTS
•
•
•
•
•
•
•
•
•
•
The price of a company’s shares is the present value of forecast future cash flows. New
information will change investors’ expectations and cash-flow forecasts and therefore the share
price.
Where a company is expected to pay a constant dividend over time, the price of the share is
the constant dividend divided by the required rate of return.
Where a company pays a dividend that has a constant growth rate, the price of a share is the
current dividend multiplied by one plus the growth rate, divided by the required rate of return
minus the growth rate.
A share is said to be cum-dividend when a company has announced that it will pay a dividend;
holders of those shares are entitled to receive the dividend.
A company will announce the date when a share goes ex-dividend; new shareholders after that
date are not entitled to receipt of that dividend.
All other things being unchanged, the price of the share will theoretically fall by the amount of
the dividend on the ex-dividend date.
If a company issues bonus shares to existing shareholders, no additional capital is raised;
therefore the share price should adjust downwards by the pro-rata number of shares issued.
Occasionally, a company will decide to split the number of shares on issue, often to lower
the share price and generate more liquidity in the stock. The share price should adjust by the
percentage of the split.
A rights issue provides shareholders with the opportunity to buy additional shares at a specified
price on a pro-rata basis. The price of the share will adjust downwards relative to the current
market price and the rights issue price. For example, if the current share price is $3.00 and
a 1:1 rights issue has a subscription price of $2.80, the theoretical ex-rights price is $5.80
divided by 2, which equals $2.90.
If a rights offer is renounceable, it has a value and can be sold on the stock exchange.
6.6
Stock-market indices and published
share information
A stock-market index provides a measure of the performance of a share market or industry sectors
within the overall market. An index incorporates a group of selected company stocks designed to
represent changes in the value of the market over time. Each day, news reports on television and
radio comment on movements in the share market. For example, the evening news normally reports
movements in the S&P/ASX 200 index and compare it with other indices in the USA, Europe and
Asia. Stock-market indices have become an important barometer of the mood of the markets. When the
Stock-market index
a measure of the
price performance of
the share market or a
sector of the market
LEARNING
OBJECTIVE
6.6
Analyse the functions
and importance
of share-market
indices and interpret
published share-market
information.
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Bull market
a period when share
prices are steadily rising
over time
Bear market
a period when share
prices are steadily
falling over time
indices are continually rising, it is said to be a bull market, but when the indices are steadily falling it is
said to be a bear market.
A stock exchange will publish a set of share-market indices that reflect the composition and strength
of that market. Major stock exchanges around the world also publish a standard set of indices known
as global industry classification standard (GICS®) indices. These are discussed below. Many stock
exchanges use the services of specialist index providers. Two specialist index providers are S&P Dow
Jones Indices (http://au.spindices.com) and MSCI Inc. (www.msci.com/products/indices/).
The use of specialist managers for market indices is an acknowledgment of the increasing importance
and global nature of investment. Fund managers typically now have an increasing pool of funds that are
strategically invested in a wide range of international markets. Therefore, it is important that stock-market
indices are comparable between countries. In this chapter, the focus is on S&P Indices as an index manager.
By arrangement, and in consultation with a local stock exchange, S&P manages three main types
of share-market indices:
1 performance benchmark indices
2 tradable benchmark indices
3 market indicator indices.
Performance
benchmark index
broad measures
of share-market
performance; based
on capitalisation and
liquidity
Stock liquidity
the percentage of a
corporation’s shares
available for trading on
a stock exchange
Tradable benchmark
index
a narrow index
generally used as the
basis for pricing certain
derivative products
Market indicator
index
seeks to measure the
overall performance of
the share market
Share price index
measures changes
over time in the price of
shares included in the
index
Accumulation index
measures changes
in share prices, plus
the reinvestment of
dividends received
Global industry
classification
standard (GICS®)
an international
standard that groups
listed companies into
10 standard industry
sector indices
A performance benchmark index measures the performance and risk of a broad market, and includes
a combination of company shares that represent 75–90 per cent of a share market’s capitalisation.
Listed companies included in a performance benchmark index are required to demonstrate an adequate
amount of market capitalisation combined with a high level of stock liquidity. Within the Australian equity
market, the S&P/ASX 200 is the main benchmark index adopted by index (passive) fund managers. The
index incorporates the shares of 200 eligible companies listed on the ASX. Eligibility is determined
based on market capitalisation (size) and share liquidity (the percentage of shares actively traded). The
S&P/ASX 200 covers around 80 per cent of the Australian market and is updated every quarter.
A tradable benchmark index may also be a performance benchmark index, but it is a narrower
index and is the basis upon which certain derivative contracts are priced, such as equity index futures
contracts. Derivative contracts are discussed in detail in Part 6. The stocks included in this type of index
are relatively stable in that they do not change regularly, thus enabling pricing consistency over time.
Finally, a market indicator index measures the performance of an overall market, or the
performance of a select group of stocks that indicate the performance of the overall market. Widely
known international stock market indicator indices include the Dow Jones Industrial Average (USA),
the S&P 500 (USA), the FTSE (UK), the DAX (Germany), the Nikkei 225 (Japan), the Hang Seng
(Hong Kong) and the Straits Times (Singapore).
It is interesting to note that the Dow Jones (a widely quoted US stock-market index) comprises
only 30 stocks. Therefore, the S&P 500 has become the most widely used index in the USA. The S&P
500 incorporates 500 US stocks chosen primarily for their market size, liquidity and industry grouping.
The Dow Jones Industrial Average index is a price-weighted index, while the S&P 500 index is a market
value-weighted index; that is, the weighting of each company included in the index is proportional to
each company’s share price and shares outstanding. The main market indicator index in Australia is the
S&P/ASX All Ordinaries Index which incorporates 500 stocks.
An index may be a share price index that measures the capital gains or losses evident from investing
in an index-related share portfolio, or an accumulation index that recognises both changes in share
prices and the benefit of reinvesting company dividend payments. The accumulation index facilitates
comparisons between returns on a range of different investment products. If dividend imputation is
available within a country (e.g. Australia), no allowance is made to an accumulation index for dividend
franking credits, or for any discounts on dividend reinvestment schemes.
S&P Indices manages its industry sector indices with a global industry classification standard
(GICS®). The GICS comprises 10 standard international industry sector indices incorporating
24 industry groups, 67 industries and 147 sub-industries. Globally, around 27 000 companies are
encompassed by this framework. Additional sector indices that recognise special market conditions
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Chapter 6 Investors in the share market
that apply to a particular country may be added to the list; for example, in Australia additional industry
sector indices include financials excluding property trusts, real estate investment trusts (property trusts),
metals and mining industry and gold sub-industry indices. The additional GICS indices used in the
Australian market are essentially components of standard GICS indices, and reflect certain strengths
within the Australian economy; that is, metals and mining, financials, property trusts and gold.
The 10 standard international GICS indices are:
1 Energy. This includes companies primarily involved in the exploration, construction, production,
marketing, refining or distribution of oil, gas, coal and consumable fuels.
2 Materials. This includes corporations involved in commodity-related manufacturing, such as
construction materials, chemicals, metals, glass, non-energy resources, aluminium, steel producers,
gold and precious metals, forest products and paper.
3 Industrials. This sector incorporates manufacturers and distributors of capital goods, consumer
and professional services, plus transportation industries. This includes aerospace and defence,
construction, engineering and building products, electrical equipment, industrial machinery and
industrial conglomerates. It also includes commercial services and suppliers such as printing, data
processing, office supplies and employment services. Transportation industries include airlines,
railroads, marine and trucking corporations and transport infrastructure.
4 Consumer discretionary. This index includes industries that tend to be more sensitive to economic
cycles. This includes manufacturers such as automotive, household durable goods, textiles and apparel,
and leisure equipment. The services segment of the index includes hotels, restaurants, leisure and
education services. The media segment includes advertising, broadcasting, movies and publishing.
The retailing segment includes merchandise distributors and department and speciality stores.
5 Consumer staples. Consumer industries in this index are less sensitive to economic cycles. The
index includes manufacturers and distributors of food, beverages and tobacco, and producers of
non-durable household goods and personal products. Examples include food retailers, brewers,
soft drink manufacturers, agriculture products and beauty care products.
6 Health care. This includes health-care equipment and instrument manufacturers and suppliers,
diagnostic services and operators of health-care facilities, including hospitals and medical clinics.
It also includes companies involved in research, development, production and marketing of
pharmaceuticals and biotechnology products.
7 Financials. This includes companies involved in banking, mortgage finance, consumer finance,
corporate lending, specialised finance, investment banking, broking, asset management, custody
services, insurance, financial investment and real estate, including property trusts.
8 Information technology. This includes software development for the internet, application-based
software, systems software and IT consulting and other services. It also includes manufacturers
and distributors of technology hardware and equipment, including communications equipment,
computers and peripherals, electronic equipment and semiconductors.
9 Communication services. This includes diversified telecommunication services, such as fixed-line,
cellular, wireless, high band width and fibre optic networks, as well as companies that offer related
content and information through various media.
10 Utilities. This includes companies involved in the production and distribution of electricity, gas and
water.
Passive fund managers use stock-market indices to target certain investment performance outcomes.
For example, a fund manager within the Australian market may adopt the S&P/ASX 200 index as the
benchmark for a particular investment fund. In this case, the fund manager will purchase shares of
those companies that are included in the index, in the same weighted proportions. The performance of
the fund will then track the performance of the stock market generally, as the S&P/ASX 200 represents
approximately 80 per cent of market capitalisation. In the USA, a funds manager might choose to
replicate the S&P 500, while in Japan the Nikkei 225 might be appropriate.
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Major financial newspapers and other financial journals publish share-market information. The
depth of information provided within the financial press does vary, and it is revealing to choose a local
newspaper and analyse the stock-market information that is provided. To assist with your understanding
of the information typically provided in the financial press, the following is a brief description of each
of the column headings used by the Australian Financial Review (AFR). The daily share tables can be
downloaded from www.afr.com/share-tables.
•
•
•
52 week high/low: the highest and also the lowest sale prices recorded over the past year.
Day’s high/low: the highest and lowest sale prices recorded during the trading day.
ASX code: an alpha code given by the stock exchange for each listed security; for example, Woodside
Petroleum Limited is WPL.
•
•
•
•
•
Company name: the abbreviated name of the company.
Last sale: the final sale price recorded at the close of trading on the previous business day.
+ or – : the rise or fall in the share price, in cents, from the previous day’s closing price.
Vol 100’s: the total volume, in hundreds, of a company’s shares traded on the exchange for that day.
Quote buy: the highest price at which a buyer is offering to buy a share as recorded on the ASX
Trade electronic trading system.
•
Quote sell: the lowest price at which a seller is offering to sell a share as recorded on the ASX Trade
electronic trading system.
•
Dividend cents per share: the latest annual dividend, in cents per share, declared by the company.
(The letter f following a dividend figure denotes that the dividend is fully franked, the letter p that a
dividend is partly franked.)
•
Dividend times coverage: the number of times the dividend per share is covered by the earnings
per share.
•
•
NTA: total assets less total liabilities expressed in dollars per share.
Dividend yield per cent: the dividend return to the shareholder based on the current share price;
calculated by dividing the current dividends by the last sale price.
•
EPS (cents): earnings per share recorded in cents; represents the net profit divided by the total
number of ordinary shares issued by the company.
•
P/E ratio: the current share price divided by earnings per share. The P/E ratio is expressed as a
multiple (times), and shows the number of times the share price covers historic earnings.
Other listed securities issued by corporations are also included in the daily published information;
for example, pref indicates preference shares and opt indicates options issued.
Students who feel they have an appreciation of the dynamics of investing in a stock market should
consider two challenges: first, go to the website of the local stock exchange (e.g. www.asx.com.au) and
explore the enormous amount of information that is readily available; second, look in the daily newspaper
and interpret the stock exchange trading information that is published. Chapter 7 further extends the
discussion of the share markets, with an analysis of factors that influence share price movements.
REFLECTION POINTS
•
•
A stock-market index provides a measure of the performance of a share market or sectors
within the share market.
S&P Indices manages three main types of share-market indices: (1) performance benchmark
indices based on 75–90 per cent of a share market and including market capitalisation and
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Chapter 6 Investors in the share market
liquidity requirements; (2) tradable benchmark indices which are narrower indices used to price
certain derivative products; and (3) market indicator indices which are representative of an
overall share market.
•
•
•
A share price index monitors movements in share prices, while an accumulation index also
incorporates the reinvestment of dividends.
S&P also manages global industry classification standard (GICS®) indices for industry sectors of
energy, materials, industrials, consumer discretionary, consumer staples, health care, financials,
information technology, communications services and utilities. Additional GICS indices used
in the Australian market are financials excluding property trusts, real estate investment trusts
(property trusts), metals and mining industry and gold sub-industry indices.
Electronic and printed media services provide investors with an enormous range of financial,
economic and share-market information relevant to share investments.
CASE STUDY
PRIVATE EQUITY FIRMS, ANGEL INVESTORS AND EXIT STRATEGIES
Apart from venture capitalists, angel investors and private equity firms are dominant forces in the
private equity market. In the largest acquisition of an e-commerce company in history, the US retail
giant Walmart is set to acquire India’s largest online retailer Flipkart for $16 billion in 2018, overcoming
Amazon in the race for expansion.
The transaction will also record the largest exit for private equity and venture capital investors in India,
who collectively will make $14 billion by selling shares to Walmart (ET Bureau, 2018). The global private
equity firms Tiger Global and Softbank have emerged as the major winners from the Walmart deal.
Tiger Global is set to gain $424 million from its 2.20 per cent stake in Flipkart (Giriprakash, 2018).
Walmart has agreed to pay between $4 to $4.5 billion for Softbank’s stake, which represents a 60.00
per cent return on Softbank’s (a Japanese conglomerate) $2.5 billion investment in Flipkart (Sen, 2018).
In the world of private equity, the focus is drawn towards giants such as Blackstone, KKR and Carlyle, all
set to explore the high potential of Asian markets. However, this opportunity has been long recognised
by smaller firms such as Navis Capital Group. Navis Capital, which was founded in 1998, manages
private and public equity funds worth $5 billion. Its success story started with the acquisition of King’s
Safetywear, a Singapore based manufacturer of safety footwear. After taking the company private,
Navis Capital initiated an expansion of King’s markets into Australia, India and South Korea, followed
by negotiations for the acquisition of Oliver Footwear, the largest manufacturer of safety footwear in
Australia. In 2011, Navis Capital exited from King’s footwear by selling the company for $430 million,
earning a 350 per cent return on its initial investment.
Beyond these large private equity firms lie the smaller angel investors who provide funds to a private
business and who are not directly related to the owner or operator of the firm (DeGennaro, 2014).
Investments by angel investors act as informal venture capital for fledgling companies. Scholars
suggest that angel investors often look for entrepreneurial passion as an important investment
criterion (Mitteness, 2012). Information about the investing records of angel investors is scarce. The
Walmart–Flipkart deal, however, also features an angel investor, Ashish Gupta, who will reportedly earn
$20 million by selling his stake in Flipkart, which he purchased in 2009. This will represent a return to
this angel investor of 126 per cent (Dalal & Sen, 2018).
References
Cumming, D & Johan, S 2009, Venture Capital and Private Equity Contracting: An International
Perspective, Academic Press, Oxford.
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Dalal, M & Sen, A 2018, ‘Ashish Gupta, the angel investor likely to make $20 million from FlipkartWalmart deal’, Hindustan Times, 11 May, viewed 16 October 2018, https://www.hindustantimes.
com/business-news/ashish-gupta-the-angel-investor-likely-to-make-20-million-from-flipkartwalmart-deal/story-queRXfEdhTKBPv0lnbN86M.html
DeGennaro, RP & Dwyer, GP 2014, ‘Expected returns to stock investments by angel investors in
groups’, European Financial Management, 20(4), pp. 739–755.
ET Bureau 2018, ‘Walmart acquires Flipkart for $16 billion in world’s largest ecommerce deal’,
Economic Times, 10 May, viewed 16 October 2018, http://economictimes.indiatimes.com/smallbiz/startups/newsbuzz/walmart-acquires-flipkart-for-16bn-world’s-largest-ecommerce-deal/
articleshow/64095145.cms
Giriprakash, K 2018, ‘Tiger Global’s 2.2% stake sale for $424 m boosts Flipkart’s valuation
to $17-19 b’, The Hindu BusinessLine, 30 January, viewed 16 October 2018, https://www
.thehindubusinessline.com/info-tech/tiger-globals-22-stake-sale-for-424-m-boosts-flipkartvaluation-to-19-b/article22597158.ece
Mitteness, C, Sudek, R & Cardon, MS 2012, ‘Angel investor characteristics that determine whether
perceived passion leads to higher evaluations of funding potential’, Journal of Business Venturing,
27(5), pp. 592–606, doi:10.1016/j.jbusvent.2011.11.003
Sen, S 2018, ‘Walmart top dollar to SoftBank for Flipkart: 60% returns on $2.5bn in eight months’,
Factor Daily, 27 April, viewed 16 October 2018, https://factordaily.com/walmart-flipkart-softbanktop-returns
Discussion points
•
•
What are the characteristics of angel investors?
Describe the common exit strategies adopted by private equity firms.
Master before you move on
LEARNING OBJECTIVE 6.1
Consider the role of an investor in the share market, appreciate the wide range of investment
choices that are available and understand risks associated with investments in shares of listed
corporations.
•
•
•
•
•
Securities quoted on a stock exchange provide investors with an enormous range of investment
opportunities.
A corporation makes no promise of a return to ordinary shareholders, so the higher level of risk
attached to these securities creates an expectation in the investor of a higher level of return, on
average, over the longer term.
A stock exchange brings buyers and sellers together to form an efficient, deep and liquid market
in securities.
A share in a listed company entitles an investor to receive a return on the investment in the form
of any dividends paid and any capital gain or loss accumulated on the current market value of
the share.
Risks associated with share investments are described as systematic and unsystematic.
Systematic risk exposures affect the price of most shares listed on a stock exchange, to a
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Chapter 6 Investors in the share market
•
•
•
•
•
Portfolio theory demonstrates that, by holding a diversified share portfolio, unsystematic risk
can be substantially reduced through diversification. The remaining systematic risk is measured
using a beta coefficient. This is a statistical measure of the sensitivity of a share price relative to
the overall market (as represented by a market index).
Investors will consider the cash-flow and investment characteristics of a particular share. An
investor may adopt an active or a passive share investment approach.
The active approach might use fundamental analysis or technical analysis to structure a portfolio
to meet the investor’s personal risk and return profile.
With a passive approach, an investor will seek to replicate the structure, and therefore the
return, of a specific share-market index.
Within a diversified share portfolio the investor will consider the correlation of risk and return
between shares.
Finally, the allocation of shares within the portfolio will be both strategic, in that it meets the
investor’s personal profile, and tactical, in that it will be monitored and managed to take account
of new information that comes to the market.
CHAPTER SIX REVIEW
•
greater or lesser extent. Unsystematic risk specifically impacts on the share price of individual
stocks.
LEARNING OBJECTIVE 6.2
Detail the process for buying and selling shares.
•
•
•
•
•
•
An investor buying or selling shares can take a direct investment approach or an indirect
approach.
With the direct approach, an investor will select the shares to be included in a portfolio. The
transaction will usually be carried out through a stockbroker.
A stockbroker accepts buy or sell orders from investors and acts as the agent in placing the
orders into the stock exchange’s trading system.
The share trading system used by the ASX is known as ASX Trade and the transfer and
settlement system is known as CHESS. Settlement occurs in T + 2 business days.
A broker may be a discount broker that executes transactions but does not provide investment
advice. A full-service broker will execute buy and sell orders, but will also provide investment
advice and some other financial services.
With the indirect investment approach, an investor does not select the stocks to be held in a
portfolio; rather, the investor purchases units in a managed fund such as a public unit trust.
LEARNING OBJECTIVE 6.3
Understand the importance of taxation in the investment decision process.
•
•
•
•
Taxation will impact on the net return received by an investor. Taxation regimes vary
considerably between countries. However, two major taxes that may be imposed on the return
of a shareholder are income tax and capital gains tax.
An investor needs to consider the level of income tax payable. For example, is income taxed at
a flat rate or a marginal rate? Are realised capital gains taxed or not, and at what rate?
For example, in Australia the marginal tax rate ranges up to 45 per cent, plus a 2.00 per cent
Medicare levy. Generally, at least 50 per cent of a realised capital gain is also taxed at the
taxpayer’s marginal income tax rate.
However, there is a tax benefit available to Australian shareholders known as dividend
imputation. The dividend imputation system enables corporations to pay franked dividends to
shareholders, whereby the company tax paid on profits can be passed as a franking credit to
the shareholder. This reduces the amount of tax payable by the shareholder.
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LEARNING OBJECTIVE 6.4
Identify and describe various indicators of financial performance.
•
•
•
•
•
•
When analysing a share investment opportunity, an investor should consider a range of financial
performance indicators.
Measures of a company’s liquidity, such as the current and liquid ratios, provide an indication of
the company’s ability to meet its short-term financial obligations.
The long-term financial viability of a company is indicated by the company’s capital structure, as
measured by the debt-to-equity ratio or the proprietorship ratio.
Past profitability may be measured by different earnings ratios. These include the earnings
before interest and tax (EBIT) to total funds ratio, the EBIT to long-term funds ratio and the aftertax earnings on shareholders’ funds ratio.
Another important indicator is the company’s ability to ensure its solvency by being able to meet
its short-term financing commitments. This is frequently measured by the company’s interest
coverage ratio.
An investor may also rank companies on the basis of the market’s current valuation of the
business and its prospective earnings stream. Indicators of market valuation are obtained
through the price to earnings (P/E) ratio and the ratio of share price to net tangible assets.
LEARNING OBJECTIVE 6.5
Apply quantitative methods to the pricing of shares.
•
•
•
•
•
•
•
•
•
Investors are interested in estimating the theoretical price of a share. The price may be said
to be a function of the supply and demand for a stock. This is influenced by future earnings
expectations.
The price of a share is theoretically the present value of its future dividend streams. New
information that changes future earnings forecasts will also change the share price.
The future dividend payments of a corporation may be constant over time; in this case, the dividend
payment is simply divided by the required rate of return to estimate the theoretical share price.
Alternatively, a dividend payment may increase over time. It is assumed that increase will be at a
constant growth rate. To calculate the share price, the last dividend is multiplied by one plus the
constant growth rate; this is then divided by the required rate of return less the growth rate.
There are other more mechanical issues that affect a company’s share price. These include the
price adjustments that occur when a share trades ex-dividend. All other things being equal, a
cum-dividend share price should fall by the amount of a dividend that is paid.
If a company makes a bonus issue to shareholders, where no new capital is raised, the share
price will theoretically fall by the relative proportion of new shares issued.
A similar price adjustment expectation will occur with a share split. A share split changes the
number of shares issued by a corporation, again without raising additional capital.
Another reason for an adjustment in a share’s price is that, if it has been trading with an entitlement
to participate in a rights issue, the theoretical ex-rights price will be lower than the cum-rights price.
A renounceable right has a value in that it can be sold before the rights issue exercise date.
LEARNING OBJECTIVE 6.6
Analyse the functions and importance of share-market indices and interpret published sharemarket information.
•
•
A stock-market index is a measure of the price performance of a specific sector of a share market.
S&P Indices provides specialist index management services to international stock markets and
compiles a range of different market and industry sector indices.
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Chapter 6 Investors in the share market
•
•
The global industry classification standard (GICS) comprises 10 industry sectors (energy,
materials, industrials, consumer discretionary, consumer staples, health care, financials,
informational technology, communication services and utilities). Indices representing specific
market strengths may be constructed by S&P.
An index may be a share price index or an accumulation index.
There is a wealth of share-market information that is published daily. Investors need to
understand and interpret this information.
Questions
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain
in your own words the points you raise in relation to each question.
1
Outline two general strategies or approaches that can be taken to investing in the share
market. (LO 6.1)
2
(a)Ms Brown has an investment portfolio comprising Australian shares. At a meeting with
her investment adviser, she requests explanations of the definition of systematic risk and
unsystematic risk, and an explanation of factors that are responsible for the two types of
risk. Explain these issues to Ms Brown.
CHAPTER SIX REVIEW
•
(b) Why should an investor not expect to be rewarded for the unsystematic risk element in a
share portfolio? (LO 6.1)
3
An investor holds the following shares in an investment portfolio:
JB Hi-Fi
$6 500
beta 1.20
Telstra
$8 600
beta 0.95
ANZ Bank
$7 900
beta 1.05
(a) What does each beta coefficient imply about the volatility of each company’s shares
relative to the overall market?
(b) What is the portfolio’s beta?
(c)
If the investor added to the portfolio with the purchase of $5 000 worth of shares in AGL
Energy (beta 1.60), what impact would that purchase have on the risk structure of the
portfolio? (LO 6.1)
4
Combining domestic shares with some international shares can help reduce portfolio risk.
Explain how this risk reduction is achieved. (LO 6.1)
5
Jack and Jill have recently married and have decided to start buying shares for an investment
portfolio.
(a) Explain the role of a stockbroker in the direct investment approach to share investments.
(b) Within the context of services provided by a stockbroker, discuss the two main types
of stockbrokers that an investor may choose to use. Differentiate between the services
provided by these brokers. (LO 6.2)
6
Condor Limited is listed on the ASX, and earns part of its income in Australia and part overseas,
where it is required to pay tax. The Australian company tax rate is 30 per cent. Condor Limited
can provide dividend imputation to Australian shareholders from Australian tax paid. Assume
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the shareholder’s marginal tax rate is 37 per cent, plus Medicare levy of 2 per cent. The investor
receives a 70 per cent partly franked dividend of $12 700.00.
(a) Explain the dividend imputation process.
(b) Why might a dividend be only partly franked?
(c)
7
Calculate the income tax payable by the investor. (LO 6.3)
(a)Explain what is meant by the liquidity of a company. Define two common accounting
measures of liquidity.
(b) Why is liquidity an important indicator that an investor should consider when analysing
share investment opportunities? (LO 6.4)
8
Define the commonly used measures of the profitability of a firm. Which measure do you consider to
be most informative in comparing the profitability of firms across different industry sectors? (LO 6.4)
9
(a) Define two measures of a company’s debt-servicing capacity.
(b) Explain why it is not appropriate to compare, on the basis of the identified measures,
companies in different industry classifications. (LO 6.4)
10 A company with a lower P/E ratio is a better investment than a company with a higher P/E ratio.
Discuss this statement. (LO 6.4)
11 Caltex Australia Limited pays a constant dividend of $0.60 cents per share. A fund manager
is considering purchasing the shares as part of an investment portfolio. The fund manager
requires a return of 15 per cent on the investment. Calculate the price that the funds
manager would be willing to pay for the shares. (LO 6.5)
12 The last dividend paid to shareholders by Vicinity Centres was $0.10 per share. Assume that
the board of directors of the company plans to maintain a constant dividend growth policy of
7.00 per cent. An investor, in evaluating an investment in the company, has determined that
she would require a 12.00 per cent rate of return from this type of investment. If the current
price of Vicinity shares in the stock market is $4.00, should the investor purchase the shares?
(Show your calculations.) (LO 6.5)
13 AGL Energy Limited has declared a $0.33 cents per share dividend, payable in one month. At
the same time the company has decided to capitalise reserves through a one-for-three bonus
issue. The current share price at the close of business on the final cum-dividend date is $16.15.
(a) Explain the strategy adopted by the company. In your answer, define the terms ‘cumdividend’ and ‘ex-dividend’.
(b) Calculate the theoretical price of the share after the bonus issue and the dividend payment
have occurred. (LO 6.5)
14 Alumina Limited has a share price of $2.82. The company has made a renounceable rights issue
offer to shareholders. The offer is a three-for-10 pro-rata issue of ordinary shares at $2.60 per share.
(a) Explain the effect of the offer being renounceable.
(b) What is the price of the right?
(c)
Calculate the theoretical ex-rights share price.
(d) Explain why an actual ex-rights price of a share may at times differ from the calculated
theoretical price. (LO 6.5)
15 S&P Indices manages a global industry classification standard (GICS) for share-market industry
sector indices. The standard comprises 10 international industry sector indices.
(a) What is the purpose of share-market indices?
(b) How does the existence of standard international industry sector indices facilitate global
investment?
(c)
Identify and briefly explain the structure of the GICS indices. (LO 6.6)
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Chapter 6 Investors in the share market
accumulation index 212
ex-dividend 208
active investment 194
bear market 212
expected return of a
portfolio 195
beta 194
franked dividends 199
price to earnings ratio (P/E) 204
bonus issue 209
franking credit 199
renounceable 210
bull market 212
full-service advisory
broker 197
return on equity 203
global industry classification
standard (GICS®) 212
share price to net tangible
assets ratio 204
grossed-up amount 199
share split 209
index funds 195
stockbroker 197
indirect investment 198
stock-market index 211
inflation component 200
stock liquidity 212
interest cover ratio 202
strategic asset allocation 196
liquidity ratio 202
systematic risk 194
earnings before interest and tax
(EBIT) 203
marginal rate of tax 199
tactical asset allocation 196
market indicator index 212
tradable benchmark index 212
earnings per share (EPS) 203
passive investment 195
unsystematic risk 194
capital gains 198
capital structure 201
co-variance or correlation 195
cum-dividend 208
current ratio 201
direct investment 197
discount broker 197
diversified investment
portfolio 194
performance benchmark
index 212
portfolio variance 195
share price index 212
CHAPTER SIX REVIEW
KEY TERMS
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CHAPTER 7
Forecasting share price
movements
CHAPTER OUTLINE
7.1
Fundamental analysis: the top-down approach
7.2
Fundamental analysis: the bottom-up approach
7.3
Technical analysis
7.4
Electronic trading
7.5
The random walk, efficient market and behavioural finance hypotheses
Learning objectives
LO 7.1
Identify and interpret economic variables that impact on share price movements within the
context of the top-down approach to fundamental analysis.
LO 7.2
Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in
particular the analysis of the financial and operational performance of a corporation.
LO 7.3
Describe and apply technical analysis to forecasting movements in share prices.
LO 7.4
Examine the role of electronic trading in influencing share price movements.
LO 7.5
Explain the theoretical concepts that form the basis of the random walk hypothesis, and consider
the implications of the efficient market hypothesis and the behavioural finance hypothesis when
analysing and forecasting share price movements.
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Chapter 7 Forecasting share price movements
CHAPTER SNAPSHOT
How accurate are the share prices that we observe on the world’s stock markets? This is one of
the great debates of twentieth and twenty-first century financial economics. It started in 1970
when Eugene Fama, a finance professor at Chicago, published his famous account of the
efficient markets literature. This sparked a long series of investigations aiming to determine
whether share prices accurately reflected information relevant to company fundamentals,
whether those prices quickly adjusted to new information and whether those prices were
subject to influence from other factors, especially mass psychology and other decision-making
biases. The counterarguments, raised by behavioural economists such as Robert Shiller, have
resulted in a flourishing research program that continues today. Fama and Shiller shared the
Nobel Memorial Prize for Economic Sciences in 2013.
INTRODUCTION
Information is the lifeblood of the stock market. New information may derive from many sources,
including company notices to the stock exchange, advice to shareholders at general meetings,
management meetings with institutional investors (roadshows) or articles in the media. Sometimes the
new information is rumour or speculation or noise.
If shareholders become disenchanted with the performance of a company, they may decide to sell
their shares. This increases the supply of the company’s shares on the market. The increased supply
of shares is likely to bring about a fall in the share price. Conversely, if a company is expected to
perform better than other companies, there will be an increased demand for the company’s shares and
an increase in the share price.
Given the importance of information as a determinant of supply and demand on the stock market,
it is necessary to understand the main sources of information. Investment analysts tend to take one (or
a combination) of three approaches when sourcing information:
•
•
•
Noise
the opposite of
information but can be
mistaken for it
fundamental analysis top-down approach, which considers economic variables that may affect the
future performance of an investment opportunity
fundamental analysis bottom-up approach, which considers the historic and forecast performance
of a specific investment opportunity
technical analysis, which evaluates and interprets historical share price movements over time.
This chapter analyses each approach in turn. We also consider the impact electronic trading might
have on influencing share price movements. Then, having gained an awareness of factors that influence
demand and supply on the stock market, we introduce three theoretical concepts that seek to explain
movements in share prices:
1 the random walk hypothesis, which recognises that share price movements respond to new
information coming to the market
2 the efficient market hypothesis, which considers how quickly share prices respond to new
information
3 the behavioural finance hypothesis, which attempts to explain share price movements based on
psychological principles of investor decision making.
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REFLECTION POINTS
•
•
•
•
The price of shares of listed corporations is a function of supply and demand; that is, if there are
more sellers than buyers of a particular stock, the share price will fall; similarly, if the demand
from investors increases for a stock, the price will be pushed upwards.
New information coming to the market is the primary determinant of factors that affect the
supply and demand for a stock.
Investors may apply a number of approaches to the analysis of share investments and the
forecasting of share price movements: fundamental analysis top-down approach, fundamental
analysis bottom-up approach and technical analysis.
Three theoretical concepts that consider the relationship of information and share price
movements are the random walk hypothesis, the efficient market hypothesis and the
behavioural finance hypothesis.
7.1
LEARNING
OBJECTIVE
7.1
Identify and interpret
economic variables
that impact on share
price movements within
the context of the
top-down approach to
fundamental analysis.
Fundamental analysis
considers macro and
micro fundamentals that
may impact future share
price changes
Top-down approach
forecasts the overall
global and domestic
economic environment
in which corporations
operate
Industry sectors
components of an
overall economy
defined by the nature
of the participants’
business operations
Fundamental analysis: the top-down
approach
Many people have an interest in the future performance of share prices and the overall stock market,
including fund managers, stock analysts, individual investors, regulators, government and financial
journalists. They may be expected to explore rational approaches to the analysis and forecasting of
share price movements. Fundamental analysis is one such approach.
Fundamental analysis seeks to identify factors that are likely to influence directional changes in the
value of a company and hence its share price. These factors may be macro or micro in context. Macro
factors are those that influence the overall market, typically economic fundamentals such as interest
rates, economic growth, business investment and consumer confidence. Micro factors are firm-specific
and relate to the financial and operational performance and strength of a company, and also to the
influence of management on the company’s performance. For example, indicators will include the
return on equity, the return on assets, sales growth and market share.
Therefore, fundamental analysis is divided into two components: the top-down approach and the
bottom-up approach. While each component is considered separately, in reality investors will use both
approaches as each component supports the full analysis necessary to make informed investment
decisions.
The position taken by analysts in the top-down approach is that it is necessary to forecast and analyse
the overall economic environment and consider how forecast changes in economic fundamentals will
impact on the performances of various firms and industry sectors.
Ideally, both the top-down and the bottom-up approaches should be used to determine
the specific shares to include in an investment portfolio. For example, the top-down approach
should be used to determine those industry sectors most likely to perform well given forecast
changes in the overall economy and those sectors that are more likely to be adversely affected.
An investment portfolio should then be restructured so that it is overweight in those sectors
forecast to do well, and underweight in those sectors forecast to face a contracting economic and
business environment. The top-down approach will be applied to the local economy and also other
international economies.
Having used the top-down approach to determine the better-performing industry sectors within
an economy, the bottom-up approach should then be used to select the most robust firms within those
industry sectors. Similarly, when deciding to sell shares of companies that operate in industry sectors
that are not forecast to perform as well, the first to go should be those stocks identified by the bottomup approach as having less financial and management strength.
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Chapter 7 Forecasting share price movements
As indicated above, the top-down approach seeks to identify factors within an economy which may
impact on the future performance and profitability of corporations. These factors include:
•
•
•
•
•
•
•
•
the rate of growth of major international economies
the exchange rate between a domestic currency and the currencies of major trading partners and
competitors
interest rate movements resulting from monetary policy changes or credit supply factors in the
financial markets
the rate of growth of the economy—what is the shape and sustainability of the business cycle?
developments in the balance of payments current account (i.e. the trade in goods and services with
the rest of the world)
price rises, as measured by the rate of inflation (consumer price index)
the rate of growth in wages and productivity
government policy responses to developments in the above variables—both domestic and
international.
This section considers these economic fundamentals. In commenting on each of them, it should be
noted that the various parts of the list are interdependent. A change in one economic fundamental is
likely to have a flow-on effect on many of the other variables. It is important to recognise and understand
the effects of these interrelationships.
7.1.1
International economies
The rate of growth in major international economies can have quite a strong effect on the expected
profitability of many companies within a domestic economy. The performance of regional economies
(e.g. Asia and the European Union) and specific country economies (e.g. the USA, China, India and
Japan) clearly has an impact on overall growth in the global economy.
It is reasonable to assume that the higher the rate of growth in the rest of the world, the greater will
be the demand for exports generally. For firms that have a large proportion of their output devoted to
export markets, and for those that have branches or subsidiaries in overseas countries, an increase in
the growth rate in those countries should be bullish, or positive. The potential size of exporting firms’
markets, and thus their expected earnings cash flows, should increase.
The business and performance effects of economic changes may vary from company to company, and
from industry sector to industry sector, depending on the nature of the growth in the different international
economies. For example, if the growth was being driven by increased consumer demand, then the suppliers
of the more consumer-related raw materials, products and services might obtain a relatively greater benefit.
If, on the other hand, the growth was being driven by a surge in business investment in capital equipment,
it is reasonable to assume that the suppliers and users of basic minerals and other resources could do quite
well, as would the manufacturers of the component parts of such equipment.
The extent to which the incomes of suppliers and manufacturers will be boosted depends on, among
other things, the extent to which the expanding countries can rely on their stockpiles of commodities
and inventories that may have accumulated during prior periods of low demand and lower prices. If their
stockpiles, and those of the competing supplier countries, are relatively low, then exporters can be expected to
do well. Their sales should expand, and as the demand for exports increases, so too should the price obtained
per unit of export. The extent to which the profits of exporters are boosted depends, in part, on what is likely
to happen to the exchange rates of the currencies of the trading partners and competitors (see below).
7.1.2
International
economies
the economies of
overseas nation-states
Domestic economy
the local or home
economy of a nationstate
Exports
the sale of goods
and services into
international economies
The rate of growth of an economy
While it is appealing to conclude that a faster rate of growth in an economy is more positive for the
stock market and share prices than is a slower rate of growth, the story is not quite that clear. Certainly,
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stronger growth should be expected to improve companies’ expected future cash flows; however,
unsustainable economic growth may also bring with it some less desirable outcomes. Some of the
problems associated with rapid, unsustainable rates of growth in an economy include:
•
•
•
•
•
•
a deterioration in the balance of payments current account; for example, increased demand for
imported goods
an increase in inflationary pressures; supply constraints will push up domestic prices for goods
and services
upward pressure on wages; labour shortages will result in higher wages costs
an eventual depreciation of the exchange rate; as economic activity becomes unsustainable, demand
for the currency will fall
a rise in interest rates; monetary policy will need to be tightened to slow the economy to a
sustainable level
an inevitable downturn in economic activity and the business cycle.
These issues are discussed further in the following sections.
What is a sustainable rate of economic growth? There is, unfortunately, no single definitive answer.
It depends on a range of variables. Typically, it would seem that less developed economies are able
to sustain relatively higher growth rates for some time, but if that growth is not eventually tempered,
the economy will inevitably overheat to a point where growth is no longer sustainable. Developed
economies have the advantage of being able to look at long-term historic growth trends, which tend to
suggest that sustainable long-term growth is best achieved within a certain growth range: between 3.00
and 4.00 per cent per annum. Another issue relates to where the drivers of growth are coming from.
Economic growth across an economy is often not uniform; therefore, it is necessary to ascertain in
which industry sectors the growth is occurring in order to analyse whether that growth is likely to be
sustained in the long term.
7.1.3
Foreign exchange
risk
the risk that the value
of one currency relative
to another currency will
change
Exchange rates
In an environment of global growth, resource and commodity exporters are expected to experience
increased demand for their products and they could expect increased profitability. However, if export
contracts are priced in US dollars (USD), as many of them are, the level of profitability could be
affected by foreign exchange risk. If there were a strengthening, or appreciation, of the exchange rate
of a local currency against the USD, then profits from increased export sales would be less than if the
exchange rate had remained constant. This occurs because the exporter will need to convert its USD
income back into the local currency at the higher exchange rate. It is possible that an adverse change in
the exchange rate could wipe out the exporter’s profit margin.
As well as forecasting the future exchange rate, it is also necessary to forecast the rate of exchange
between the USD and the currencies of other countries supplying the world markets in competition
with a local supplier. If, for example, the currency of the country of a major business competitor were
to weaken against the USD, that competitor company would receive the same amount of USD for
each unit of exports, but when the USD income is converted into the competitor’s home currency, its
profits would increase. The increased profit margin may allow the company to renegotiate a lower USD
price for the export commodity and still maintain a reasonable profit. The lower USD price would
undermine the competitiveness and profitability of the local supplier. The above principles also apply
to contracts written in other foreign currencies such as the euro, yen or pound sterling.
Changes in the foreign exchange value of a currency can also have some unexpected results. Firms
that appear to have no contact with international trade may be affected by changes in the value of the
domestic currency. For example, a fall or depreciation in a local currency will, over time, push up the
price of imports and therefore add to the cost of living. That is, the depreciation in the exchange rate will
put upward pressure on the rate of inflation in the economy. The flow-on effects of a currency exchange
rate change are important. For example, if the workforce seeks to maintain its standard of living, wages
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will need to rise in line with the increased cost of living. Any increase in wages means that firms that
were quite remote from the export-competing and import-competing sectors of the economy would find
that their costs of doing business have been affected by the change in the value of the currency.
It is quite probable that the central bank or government would intervene in an attempt to dampen
the inflationary impact of a weakening currency. One form of intervention might be a tightening of
monetary policy by the central bank through an increase in short-term interest rates. Another might
be a cut in government spending. Both of these policies would be designed to slow the growth in the
economy, with a view to reducing inflationary pressures. The former policy would increase the cost of
funds to businesses; the latter would reduce the rate of business growth and would thus adversely affect
future income flows. Profits would be squeezed from both sides.
7.1.4
Interest rates
The majority of firms are exposed to interest rate risk. Interest rates represent a significant cost of doing
business. The cost of debt finance is the interest paid to the provider of the finance. Therefore, any future
change in interest rates will have a direct impact on cash flows and the profitability of a firm. If interest
rates are forecast to rise, the market expectation would be for a reduction in business profitability and a
fall in current share values. At the same time, a rise in interest rates would signal a possible slowing of
economic activity and also a further reduction in profitability. Conversely, a forecast fall in interest rates
would lead to an expectation of an increase in profitability, business activity and share prices.
The profitability effects of interest rate changes need to be analysed separately for each company,
as each company will have a different level of debt. Furthermore, each company may have managed its
exposure to potential interest rate movements differently. One company may have a policy to reduce
interest rate exposures by hedging the risk through the use of derivative product strategies. For example,
it may enter into a forward rate agreement with its bank that effectively locks in today an interest rate
that will apply at a future date. Another company may manage a forecast exposure to a rise in interest
rates by borrowing most of its funds at fixed interest rates.
There is a strong relationship between the level of exchange rates and the level of interest rates. This
relationship varies over time. For example, if an economy is perceived to be growing at an unsustainable
rate, overseas investors will withdraw investment funds, thus placing downward pressure on the local
currency. At a point in time, the central bank will typically decide to tighten monetary policy (increase
short-term interest rates) in an endeavour to slow down economic growth. The rise in interest rates
should adjust economic activity to more sustainable levels, increase investor confidence and, as overseas
investors return, put upward pressure on the exchange rate. The timing and speed of these changes is an
unknown and usually will vary from business cycle to business cycle.
Understanding the relationship between interest rates, monetary policy and economic activity is
therefore essential in analysing changes in share prices. Monetary policy is applied by a central bank
to achieve economic and social objectives, principally by controlling the level of inflation in order to
maintain levels of employment and economic growth. Central banks implement monetary policy by
influencing the level of interest rates. Monetary policy is discussed in detail in Chapter 12.
7.1.5
Interest rate risk
the sensitivity of
the value of assets,
liabilities and future
cash flows to a change
in interest rates
The balance of payments current account
The balance of payments current account is a financial record of earnings from the export of goods
and services to the rest of the world, less imports, plus income earned on investments made overseas,
less the cost of overseas borrowings. Therefore, it records cash receipts of a country resulting from the
sale of goods and services, but deducts payments made for goods and services bought from overseas
suppliers. The current account also recognises the receipt of income from local funds invested in the
international markets. From this is deducted interest and dividends paid on foreign borrowings and on
foreign investments.
Balance of payments
current account
record of net trade in
goods and services,
and international
investment and
borrowings, with the
rest of the world
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Current account
deficit
international export and
investment receipts are
less than imports and
overseas debt payment
If the total payments exceed total receipts, there is said to be a current account deficit. To finance
the current account deficit it is necessary for a country to obtain funding from overseas. This results
in the country building up its level of foreign debt, and thus increases the interest payment burden of
future years. Progressively, more and more export income needs to be devoted to servicing the current
interest commitments.
What is the relevance of this to the share market? There is very clear evidence that the current
account is affected by the rate of growth in an economy. The faster the rate of growth, the more a
country as a whole imports and the worse the current account deficit becomes. Consequently, the
level of foreign debt becomes greater. To contain the current account deterioration, the government
or the central bank is likely to take measures designed to slow the economy. These measures may
include a tightening of monetary policy—that is, a rise in interest rates—and significant reductions in
government expenditure. These initiatives will be aimed largely at slowing the economy in order to slow
import demand. Some of the impacts of tightened monetary and budgetary policy on the profitability
of businesses were outlined above.
7.1.6
Nominal rate of
interest
the annual market
interest rate; includes
the real rate of return
plus an anticipated
inflation component
Compounding
interest
an arrangement where
periodic interest
payments accumulate
on a financial
instrument
Carded rate
a financial institution’s
advertised nominal
interest rate on loans
and deposits
Depreciation
the amount by which
the value of an asset
is written down in an
accounting period
Inflationary pressures
Inflation is a reflection of increases in prices. Inflation is typically measured using a consumer price
index (CPI). The CPI measures changes in the cost of a basket of selected goods and services that
typify those bought by individual households in a particular nation-state. Changes in the CPI over time
are used as a measure of the rate of inflation. Care needs to be taken when comparing the CPI (or its
equivalent) between countries, as the basket of goods and services will vary.
Stronger economic growth is often—though not always—a precursor to increased rates of inflation.
Many countries through their central banks now target a level of inflation that is deemed to be
conducive to maintaining long-term sustainable economic growth. The target rate of inflation will
generally fall within a defined band. For example, Australia, through the monetary policy actions of
the Reserve Bank, targets a level of inflation between 2.00 and 3.00 per cent per annum (on average)
over the business cycle. The policy tool used to maintain inflation within the target range is monetary
policy. If the central bank is concerned that inflation is threatening to exceed the target range, there is
a clear expectation that the central bank will begin to tighten monetary policy, that is, increase shortterm interest rates. Therefore, in forecasting the effects of strong economic growth on a company’s
performance, it is necessary to consider the possibility and effects of inflation and monetary policy.
Another aspect of inflation that should be appreciated is its impact on the nominal rate of
interest. The nominal rate of interest is the unadjusted annual rate of interest; that is, no adjustment
has been made to the rate to reflect the effects of compounding interest or the rate of inflation. The
determination of interest rates is discussed in Chapter 13. Briefly, the nominal rate of interest has two
major components: the real rate of interest and the rate of anticipated inflation. If the nominal rate or
carded rate of a bank term loan is 6.50 per cent per annum and inflation is expected to run at 2.50 per
cent, the approximation of the real rate of interest is 4.00 per cent per annum. If inflation is expected to
increase to say 3.00 per cent, there is an expectation that the nominal rate of interest will also increase,
to 7.00 per cent. Investors will require the higher rate of return in order to maintain the real rate of
return and to compensate for the anticipated increase in prices. The increase in interest rates will make
debt funding more expensive for business.
A further implication to be taken into account is the varying impact of inflation on different
companies within the context of the tax treatment of depreciation of capital assets. Capital-assetintensive companies may be particularly adversely affected by inflation. Depreciation allowances are
based on the historic (or purchase) cost of an asset rather than its replacement cost, which rises during
periods of inflation. The accounting and taxation system then overstates the true after-tax earnings of
the firm. Investors need to be aware that a growth in reported earnings brought about by inflation may
need to be discounted. The same argument applies for inventories. Inventories carried on the books
at purchase price are later sold at higher prices during inflationary periods. However, they have to
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be replaced at higher prices. Thus the inventory profit may be illusory. Again, potential share buyers
should discount the reported profits for this effect.
7.1.7
Wages growth
During periods of relatively rapid economic growth, business activity increases and therefore the
demand for labour also increases. Firms wanting to expand will tend to seek workers who are skilled
and already working in a similar type of employment. Expanding firms will attract labour by offering
better salary packages than those offered by workers’ current employers. This competitive bidding can
set up a wage spiral that ultimately affects the cost of labour for all employers.
Wage increases that are in excess of an increase in the productivity of that labour will reduce the
proportion of the company’s income revenue that goes to profit, and will render the company less
attractive to shareholders and to potential share investors. This consequence is even more important to
those firms that normally have a large proportion of their total costs as labour expenses.
An increase in economic growth will not, however, automatically increase wages growth and
reduce the share of income going to profits. Wages are also affected by the wage-setting mechanisms
of a nation-state. For example, throughout Australia’s recent strong economic expansion, the share
of national income going to wages actually fell and company profits increased. Many economists
and market commentators attributed this outcome to government policies that set the parameters for
possible wage increases.
7.1.8
Understanding the interrelationships
of economic fundamentals
It is timely to restate the previous statement that the fundamentals considered above are often highly
interrelated. This creates an analysis environment that is very dynamic. In attempting to forecast share
price movements, an investor must not take a piece of information in isolation, but should consider the
impact that information will also have on the wide range of other variables.
The foregoing discussion on the top-down approach to fundamental analysis has been highly
selective. While the main economic fundamentals were introduced, there are many more to be
considered, and analysts will incorporate what they perceive to be other important economic
fundamentals in their own models.
Essentially, the top-down approach involves the forecasting of developments in the fundamentals
of the domestic economy in which a business operates and in the economies of major trading partners.
Once the forecasts are available, the task then is to identify those industry sectors of the economy and
of the share market that are likely to be advantaged or disadvantaged by the forecast changes. The
bottom-up approach should then be used to select specific firms within industry sectors that should
benefit from the forecast changes for inclusion in a share investment portfolio.
REFLECTION POINTS
•
•
The top-down approach considers macroeconomic factors that impact on the overall
investment environment; it assists investors to determine which economies and industry sectors
offer the best investment opportunities.
The rate of growth in international economies impacts on overseas investment opportunities
and also affects the performance of investment opportunities in the local economy; investors
need to consider international business cycles and government policy responses (fiscal and
monetary).
continued
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continued
•
•
•
•
•
Firms that conduct business in the international markets are exposed to foreign exchange risk;
that is, movements in exchange rates may adversely impact on future cash flows and the value
of assets and liabilities.
The cost of debt funds is the interest rate. Any change in interest rates will affect the cash flows
and profitability of a business. Interest rate changes (monetary policy) will impact on economic
growth and the business cycle.
Changes in the balance of payments current account (exports of goods and services minus
imports, and foreign interest earned minus interest paid) will affect economic performance and
a current account deficit will need to be funded with increased foreign debt.
Central bank monetary policy specifically targets the level of inflation; that is, changes in
inflation may result in interest rate changes which will affect economic activity.
Wages growth that is above the growth in productivity will reduce the profit margins of
corporations.
7.2
LEARNING
OBJECTIVE
7.2
Evaluate and apply
the principles of the
bottom-up approach to
fundamental analysis,
in particular the
analysis of the financial
and operational
performance of a
corporation.
Bottom-up approach
performance analysis
that focuses on
accounting ratios and
other measures of a
firm’s performance
Accounting ratios
measures of a
company’s financial
and management
performance, strength
and efficiency
Fundamental analysis: the bottom-up
approach
Once an investor has completed a top-down analysis of the fundamentals that impact on the overall
investment environment, the investor is able to determine which economies and industry sectors
provide the best investment opportunities.
For example, an investor may have decided that economic fundamentals indicate strong economic
growth within the Swiss and Australian economies and that the growth will be particularly strong in the
pharmaceuticals sector in Switzerland and the resources sector in Australia.
The investor has a number of choices of company shares to buy within each of those sectors.
In which companies should the investor purchase shares? How can the investor make an informed
investment decision? Fundamental analysis using the bottom-up approach assists with that analysis.
The fundamental analysis bottom-up approach considers micro factors that indicate a firm’s
financial, operational and management performance. The approach focuses on accounting ratios and
other measures of a firm’s performance. A number of the main ratios were outlined in Chapter 6. These
included ratios for:
•
•
•
•
•
•
capital structure
liquidity
debt servicing
profitability
share price and equity
risk.
It may be useful to review Section 6.4 before proceeding.
An appropriate starting point is to calculate the important ratios for the various companies, in
particular, industries in which the investor is interested. Those companies with the most favourable
combination of indicators would then be selected. It is important to make direct comparisons only
between companies that are substantially in the same industry, since the norm, or the benchmark, for
the various ratios often differs quite significantly between industry sectors. The fundamental analysis
bottom-up approach to the selection of companies for inclusion in an investment portfolio is illustrated
in Table 7.1.
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Chapter 7 Forecasting share price movements
Table 7.1 Financial characteristics of two retail companies
(a)
Ratio(a)
Company A
Company B
Current
1.85
1.10
Proprietorship (shareholders’ interest) (%)
71.00
31.50
EBIT/long-term funds (%)
17.00
12.50
Return on shareholders’ funds (%)
14.50
9.75
Debt/gross cash flow (years)
2.91
3.85
Interest cover (times)
3.10
2.30
P/E (times)
5.21
12.10
Price/NTA (times)
1.00
0.99
Chapter 6 provides a discussion on the ratios
Based on the bottom-up approach alone, of the two hypothetical companies presented in the table,
company A would be the preferred choice for inclusion in an investor’s share portfolio. The table has
been constructed so that the selection is obvious. On each criterion, company A outperforms company
B. In reality, the choice will rarely be so apparent. It is more likely that the results of the calculations will
be mixed and an investor will need to exercise both analysis and judgment in the investment decision
process. Additional inputs that may help in making a decision include:
•
•
•
•
intelligence on changes in key management positions
information on the corporate mission, corporate governance and planned strategic directions of the
company into the future
an examination of the recent history of the indicators included in Table 7.1, typically over the past
three to five years
a comparison of the performance indicators with other similar firms in the same industry.
With this additional information, the investor should then keep in mind the position argued by
modern portfolio theory: the greater the degree of systematic risk, the greater should be the expected
rate of return. If a higher rate of return is not expected, then the higher risk is not worth accepting in
the investment portfolio. A further issue is that a well-diversified portfolio, being one that is constructed
to minimise unsystematic risk, will incorporate shares of firms from various industry sectors across
geographic regions and in a range of countries. The selection processes outlined above would be applied
to select the specific firms from within each of the desired industry sectors.
While the detail and the discipline of the bottom-up approach are appealing to many investors,
the approach may suffer from a major drawback. The drawback relates to the need to calculate
the performance ratios using historic data. The historic data provides useful information on past
performance, which may be an indicator of future performance, but it is also possible that future
performance may be different. This raises the question of how to forecast the future direction of
the performance of a firm, the industry sector and the stock market generally. The fundamental analysis
solution is to combine a top-down approach with the bottom-up approach.
Corporate mission
the ultimate objectives
and purpose of
a corporation as
determined by the
board of directors
Modern portfolio
theory
concepts that enable
a portfolio to be
constructed with
optimal risk and return
relationships
REFLECTION POINTS
•
Once an investor has determined which economies and which industry sectors offer the most
attractive investment opportunities, the investor must conduct an analysis of firms in those
sectors to decide which shares to buy or sell.
continued
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continued
•
•
•
•
The bottom-up approach analyses a firm’s financial, operational and management performance
over time using accounting ratios and other measures of a firm’s performance.
Accounting ratios include capital structure, liquidity, debt servicing, profitability, share price and
equity ratios.
Ratios will be measured over time and compared with those of similar corporations in the same
industry. (Note: Ratios use historic data that may not accurately reflect future performance.)
Other indicators include information on key management positions, corporate governance and
the strategic direction of the firm.
7.3
LEARNING
OBJECTIVE
7.3
Describe and apply
technical analysis to
forecasting movements
in share prices.
Technical analysis
explains and forecasts
price movements based
on past price behaviour
Share price pattern
a graph over time of
movements in a share
price or a market index
An alternative approach to forecasting the movement of share prices for individual companies, and
forecasting the performance of particular industry sectors and the overall stock market, is technical
analysis. This approach seeks to explain and forecast share price movements on the basis of the past
behaviour of prices.
One underlying assumption of technical analysis is that markets are dominated at certain times by
a mass psychology, and that over time regular patterns in share price movements are evident. As a share
price pattern begins to emerge, it is assumed that the historic pattern will re-emerge in full; that is, the
full pattern will unfold this time as it did in the past. An emerging share price pattern formation is taken
as being a pointer to the path of the future share price series.
Most typically, analysts adopt either a technical approach or a fundamental approach. Rarely will
an individual analyst adopt a combination of the two. However, some fund managers and individual
investors take inputs from both approaches. Some research indicates that it is a combination of both
approaches that provides the better forecasts. Fundamental analysis has a reasonable forecasting track
record until the share market moves well above, or below, what the fundamentals would normally
support. At that stage it is argued that the chartists, or technical analysts, provide the best forecasting
record. For example, if the values of shares in a particular industry sector (e.g. technology sector) rise
at rates well above forecast future cash earnings potential, then share prices may not be explained by
economic fundamentals, and technical analysis may provide indicators of future share price corrections.
The reason for the change in forecasting strategy has to do with timing. A limitation of fundamental
analysis is that forecasting on the basis of the fundamentals can suggest that the market is overvalued
and is due for a correction, but cannot predict the timing of the downturn. Once the market gets out of
line with the fundamentals and it is widely recognised that an adjustment is due, an alternative method
of analysis—the forecasting models of the technical analysts—may be used to signal the timing of the
adjustment. Indeed, one of the major claims made by some technical analysts is that they can pick the
timing of market turning points.
Of the various types of technical analysis forecasting models, two will be considered here:
•
•
moving-averages models
charting.
7.3.1
Price series
a graph of historic share
price or market index
movements over time
Technical analysis
Moving-averages models
An analyst is able to plot historic share price movements of individual corporations or, alternatively,
price movements in a particular share price index on a graph. In either event, the analyst creates a price
series. The graph will show price changes over the period, and from that graph certain price trends may
be evident.
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Chapter 7 Forecasting share price movements
A technical analyst will usually apply more sophisticated price models; one type of model is based on
moving averages. Constructing a moving-averages model (MA) from a series of numbers tends to smooth
out more erratic price movements. It is designed to reveal more clearly the trends in a price series.
For example, Table 7.2 illustrates the procedures for calculating a simple five-day MA. An average
of five numbers in a series is obtained by adding the numbers together and then dividing that value by
five. For series such as share prices, where the value changes daily, an MA is constructed in order to
keep the average up to date.
Moving-averages
model (MA)
a graph of a series
of average prices
constructed over time
Table 7.2 Construction of a simple five-day moving average
Day
Price
Delete
Add
Net change
Sum
Moving average
36
7.2
1
6
2
7
3
8
4
7
5
8
6
9
6
+9
+3
39
7.8
7
10
7
+ 10
+3
42
8.4
8
8
8
+8
+0
42
8.4
9
10
7
+ 10
+3
45
9.0
10
12
8
+ 12
+4
49
9.8
The construction of the value of the MA is quite simple. On the fifth day, the average daily price
for the past five days is the sum of the prices divided by five. On day 6, the day 1 price is dropped and
the day 6 price is brought in. The sum of the current set of five daily prices is divided by five, and the
resulting figure gives the five-day MA on day 6. This process is repeated daily in order to update the
MA series continually. Computer spreadsheet programs make this task very simple; however, even
calculating it manually is simple.
Once the actual price series and the MA series are plotted on the same graph, buy and sell signals
are generated. Those who subscribe to the benefits of the MA technique would adopt the following rules:
•
•
•
•
Buy when the actual price series cuts the MA from below—especially if the MA has been flat or is in
a gentle decline. This is illustrated in Figure 7.1(a).
Buy when the MA series is rising strongly and the price series cuts or touches the MA from above,
but then moves back above the MA after only a few observations, as shown in Figures 7.1(b) and (c).
Sell when the MA flattens, or declines after a steady rise, and the price series cuts the MA from
above, as shown in Figure 7.2(a).
Sell when the MA series is in decline and the price series cuts or touches the MA from below, but
then moves back beneath the MA after only a few observations, as shown in Figures 7.2(b) and (c).
Where an MA is constructed using daily price movements, the most commonly adopted periods
are 10 days and 30 days. The 10-day MA will pick up short-term changes in trend, while the 30-day MA
is more likely to pick up medium-term trend changes. Some analysts who use the MA approach prefer
to use a combination of MA series in order to generate their buy/sell signals, rather than use a single
MA with the actual price series. For example, a 10-day MA and a 30-day MA may be applied together.
The buy/sell rules are the same as those presented above, except that the 10-day average substitutes for
the actual price series in the buy/sell rules.
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Figure 7.1 Buy signals: when the price series intersects, or tests, a rising MA line
(a)
Buy
(b)
Buy
(c)
Buy
Figure 7.2 Sell signals: when the price series intersects, or tests, a falling MA line
(a)
Sell
(b)
Sell
(c)
Sell
Another variation is the use of a weighted MA rather than a simple MA. Analysts who prefer the
weighted MA argue that the most recent price contains the most valuable information on what the
market perceives the value of the share to be. It should thus carry the greatest weight in the calculation
of the MA. In constructing a weighted MA, each piece of the raw price data is given a weighting; the
latest price data is given a higher weight than the earlier price data. For example, in a five-day MA,
today’s price may be given a weighting of five; that is, it is multiplied by five. Yesterday’s price, day 4, is
multiplied by four and so on. The calculations are illustrated in Table 7.3. The sum of the five values is
divided by the sum of the weights; in Table 7.3 this is day 1 + 2 + 3 + 4 + 5 = 15.
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Chapter 7 Forecasting share price movements
The calculation for day 6 would be as follows:
•
•
•
•
Delete the day 1 price.
Recalculate the weighted values of the prices for days 2 to 6 and add them together:
​(7 × 1) + (8 × 2) + (7 × 3) + (8 × 4) + (9 × 5) = 121​
Divide the weighted total by the sum of the weights, being 121/15 = 8.07.
The new figure of 8.07 is added to the moving average in Table 7.3.
Table 7.3 Construction of a weighted five-day moving average
(a)
Day
Price
Price × weight
1
6
6×1=6
2
7
7 × 2 = 14
3
8
8 × 3 = 24
4
7
7 × 4 = 28
5
8
8 × 5 = 40
6
Weighted total
Weighted MA(a)
112
7.47
9
121
8.07
7
10
132
8.80
8
8
130
8.67
9
10
138
9.20
10
12
153
10.20
Weighted total divided by the sum of the weights (i.e. 1 + 2 + 3 + 4 + 5 = 15)
An advantage of the MA technique is that, insofar as it works at all, it provides rule-based buy/sell
signals; there is no need for discretion.
On the other hand, the use of charting techniques for generating and interpreting buy/sell signals
allows considerable scope for individual interpretation of the patterns that emerge in the charts. It is
not surprising then that analysts who use charting techniques will differ from those using MA analysis
in their interpretations of the same objective price series data.
7.3.2
Charting
The second type of technical analysis forecasting model considered in this chapter is charting. The
following is an overview of the major patterns that are claimed by chartists to contain valuable
information for forecasting share price movements. The patterns will be discussed under the headings:
•
•
•
•
trend lines
support and resistance lines
continuation patterns
reversal patterns.
Trend lines
Many prices appear to move in trends. The chartist seeks to observe the trend and any changes that
might occur in the trend. Two trend lines are considered:
•
•
the uptrend line
the downtrend line.
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Uptrend line
achieved by connecting
the lower points of a
rising price series
Downtrend line
achieved by connecting
the higher points of a
falling price series
Return line
a line drawn parallel to
a trend line to create a
trend channel
By connecting the lower points of a rising price series, an analyst is able to create an uptrend line.
On the other hand, an analyst will draw a downtrend line by connecting the higher points of a falling
price series. A return line is drawn parallel to the trend line in order to establish the trend channel.
An important focus of attention for the chartist is the determination of when the trend is about
to change. When does a penetration of the trend line constitute a signal that the trend has changed?
Some of the patterns discussed below are used by chartists to shed some light on this question. In the
meantime, the following are regarded as reasonably reliable generalisations:
•
•
•
•
•
The longer a trend line has been in force, and the more times it has been tested, the greater is its validity.
If a trend line is of long standing and has withstood three or four tests, and then an indecisive break
is experienced, this penetration can be ignored and the original trend retained.
Intra-day trades that break through established trend lines are considered to be unimportant;
however, if the breakout is on high trading volumes it may signal a weakening trend.
Failure to reach the return line in a well-established trend indicates deterioration in the trend.
Once a trend is broken on the downside, prices fall from it and then often make a return move towards
the line. The pullback frequently retraces approximately 50.00 per cent of the move away from the trend.
This pullback provides a good sell point, if the trader has not already sold at the break of the trend.
Figure 7.3 shows an uptrend, a downtrend and a sideways trend.
Figure 7.3 Trend lines
rn
Retu
line
end
Uptr
Dow
line
ntren
Retu
rn
d line
line
Sideways trend
Return line
Support and resistance lines
Support lines
lower price levels
where an increase
in demand halts a
price fall
Resistance lines
higher price levels
where an increase in
supply halts a price rise
Chartists consider support and resistance levels to be next in importance to trends, and dotted lines
are drawn across the chart at historic support and resistance levels. In addition to these strong support
and resistance levels, some chartists include levels based on more recent activity in order to provide socalled weak support and resistance levels. Support lines occur at a price level where there is increasing
demand, and sufficient volumes, to halt any further downward price movement. Resistance lines occur
at that high price level at which supply, relative to demand, is sufficient to halt a further advance in
prices. Figure 7.4 shows the support and resistance lines.
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Chapter 7 Forecasting share price movements
Figure 7.4 Support and resistance lines
Resistance level
Resistance level
Support level
Support level
A support/resistance pattern that is quite common in equity markets is the rectangle, which consists
of sideways price fluctuations contained within horizontal support and resistance levels. This pattern
represents a period of conflict between buyers and sellers, with the price being bounced between the
two lines. Ultimately, it will be knocked through the top line or the bottom line to form a new pattern.
Sometimes a prediction can be made as to the direction of the breakout. The following are said to be
fairly reliable indicators:
•
•
•
Rectangles tend to be characterised by reducing volumes, except for a few days before the breakout
when there are strong increases in volumes of trade in the shares.
If the last bottom does not touch the support level, beginning the formation of an ascending
triangle, and if prices then rise rapidly, on increasing volumes, it is likely that there will be a topside
breakout.
Conversely, if the tops fail to reach resistance levels, beginning the formation of a descending
triangle, then a downside breakout is likely.
Analysts often observe that when a break occurs from a rectangle, the extent of the breakout is
likely to equal the height of the price rectangle.
Continuation patterns
The price patterns mentioned above are called continuation patterns, since they are believed to occur
most frequently during a pause in the trend channel. They are essentially sideways trading and do not
normally signal a change in an established trend. Two main continuations are:
•
•
triangles
pennants and flags.
Triangles
Symmetrical triangles are composed of a series of price fluctuations, with each top and bottom smaller
than its predecessor; that is, each minor top and bottom stops short of its previous levels. Transaction
volumes usually continue to diminish throughout this formation. No safe prediction of the direction of
a breakout is offered by chartists, though most often the breakout is presumed to continue the previous
trend. Ascending triangles usually form in an uptrend and are characterised by ascending bottoms and
horizontal tops. Again, volumes decrease during the formation but increase, often sharply, just prior
to the usual upside breakout. Conversely, descending triangles usually form in a downward trend and
are characterised by descending tops and horizontal bottoms. Again, volumes decrease during the
formation but increase just prior to the usual downside breakout. Figure 7.5 illustrates the three types
of triangles.
Continuation patterns
sideways share trading
that does not normally
signal a change in a
trend
Symmetrical triangles
a series of price
fluctuations with each
top and bottom smaller
than the previous
triangle
Ascending triangles
form an uptrend
characterised by
increasing bottoms and
horizontal tops
Descending triangles
form a downward
trend characterised by
decreasing tops and
horizontal bottoms
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Figure 7.5 Continuation patterns: triangles
Symmetrical triangle
Ascending triangle
Descending triangle
Pennants and flags
Pole
rapid rise in share
prices and volumes
before a pennant or
flag forms
Pennants and flags normally form in very fast moving markets. Both formations tend to form rapidly.
In a rising market, this usually occurs after a very sharp increase in prices on high volumes. This part
of the formation is referred to as the pole supporting the pennant or flag. During the formation of a
pennant or flag, trading volumes fall and then increase suddenly to take prices sharply lower, then
higher, respectively. The presumption of many chartists is that the breakout of prices will most often be
to a height equal to the height of the pole that preceded the pennant or flag formation. These patterns
can also develop in falling markets. Chartists consider these patterns to be very reliable. Figure 7.6
illustrates pennants and flags.
Figure 7.6 Continuation patterns: pennants and flags
Pennants
Flags
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Reversal patterns
Typically, after a major share-market shift, trend lines begin to break up and various reversal patterns
form. The so-called head and shoulders pattern is seen by chartists to be one of the most reliable of
patterns. The structure of a head and shoulders pattern is depicted in Figure 7.7.
Figure 7.7 Reversal patterns: head and shoulders
Head
Right shoulder
Left shoulder
Neckline
Breakout
Pullback
Volume
A simple head and shoulders pattern consists of three successive rallies and reactions, the second
rally reaching a higher point than the rallies on either side. The left shoulder forms on an expanding
volume-strong rally towards the end of an uptrend. This is followed by a reaction on quite reduced
volumes. The head forms on a strong second rally, which carries the price higher than that for the left
shoulder, and is followed by a reaction that sees prices moving back to the vicinity of the previous low.
Volumes, though high on the peak, are not as high as those on the left shoulder. The formation of the
right shoulder represents the conclusion of the pattern. The third rally is marked by reduced volumes
and indicates price weakness. Completion of the pattern occurs when prices break through the so-called
neckline, which is formed by a line drawn across the lows of the left and right shoulders. This line may
be horizontal but is often slightly sloping, as illustrated in Figure 7.7. Following the breakout of the
neckline, prices often move by at least the height of the head. Frequently also there is pullback; this
represents the last selling position. Head and shoulder patterns bottoms are similar in form to their tops.
There is a variety of other formations identified by chartists, including triple tops and bottoms,
double tops and bottoms, V and saucer bottoms and so on, but these are beyond the scope of this study.
An aspect of technical analysis worthy of note concerns the Elliott wave theory. Based on the
statistical studies of an American analyst, the Elliott wave theory maintains that there are distinctive
wave patterns that characterise share-market cycles. The key proposition is that a bull market consists
of three major waves upwards, followed by two major down-legs, which result in a reversion of share
prices to about 60.00 per cent of the peak.
The objective with all charting techniques is to try and obtain early warning signals relating to likely
movements in share prices. Often it is difficult for investors with a background in finance and economics
to place significant credence in the techniques of technical analysts. However, insofar as they influence
the trading behaviour of fund managers and other investors, the techniques should be examined along
with fundamental factors when making an assessment of the likely course of share prices.
Ev