to be one of the market leaders in financial institutions management. With a
well-respected 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. This new edition encourages students to
understand, anticipate and challenge the complex and global nature of finance,
while maintaining an accessible approach and style.
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.
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Examples: integrated worked examples and short in-chapter exercises assist student
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Pedagogical features: navigation is made easier by the improved internal design
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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 eighth 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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
McGraw-Hill Education is a proud corporate member of AACSB International. Understanding the importance and value of
AACSB accreditation, Financial Institutions, Instruments and Markets 8e 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 8e 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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National Library of Australia Cataloguing-in-Publication Data
Author:
Viney, Christopher, author.
Title:
Financial institutions, instruments and markets / Christopher Viney, Peter Phillips.
Edition:
8th edition
ISBN:
9781743079959 (paperback)
Notes:
Includes index.
Subjects:
Financial institutions—Australia. Financial institutions—Australia—Problems, exercises, etc.
Financial instruments—Australia. Financial instruments—Australia—Problems, exercises, etc.
Money market—Australia. Money market—Australia—Problems, exercises, etc.
Other Authors/Contributors:
Phillips, Peter John, author.
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Brief
Part 1
contents
Financial institutions............................................................................................................. 1
Chapter 1
A modern financial system: an overview................................................................................... 4
Chapter 2
Commercial banks............................................................................................................... 42
Chapter 3
Non-bank financial institutions............................................................................................... 90
Part 2
Equity markets...................................................................................................................... 129
Chapter 4
The share market and the corporation.................................................................................. 132
Chapter 5
Corporations issuing equity in the share market..................................................................... 160
Chapter 6
Investors in the share market............................................................................................... 190
Chapter 7
Forecasting share price movements...................................................................................... 224
Part 3The corporate debt market................................................................................................. 257
Chapter 8
Mathematics of finance: an introduction to basic concepts and calculations.............................. 260
Chapter 9
Short-term debt.................................................................................................................. 288
Chapter 10
Medium- to long-term debt.................................................................................................. 318
Chapter 11
International debt markets................................................................................................... 352
Part 4
Government debt, monetary policy, the payments system and interest rates............ 389
Chapter 12
Government debt, monetary policy and the payments system.................................................. 392
Chapter 13
An introduction to interest rate determination and forecasting.................................................. 422
Chapter 14
Interest rate risk measurement.............................................................................................. 458
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Part 5The foreign exchange market............................................................................................ 489
Chapter 15
Foreign exchange: the structure and operation of the FX market.............................................. 492
Chapter 16
Foreign exchange: factors that influence the exchange rate..................................................... 520
Chapter 17
Foreign exchange: risk identification and management.......................................................... 546
Part 6Derivative markets and risk management........................................................................ 571
Chapter 18
An introduction to risk management and derivatives............................................................... 574
Chapter 19
Futures contracts and forward rate agreements...................................................................... 602
Chapter 20
Options............................................................................................................................ 634
Chapter 21
Interest rate swaps, cross-currency swaps and credit default swaps.......................................... 670
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v
Contents
in full
Preface������������������������������������������������������������������� xiv
Text at a glance����������������������������������������������������� xviii
About the authors������������������������������������������������������xv
Connect����������������������������������������������������������������� xxi
Acknowledgments�����������������������������������������������������xv
Exploring finance on the web���������������������������������� xxii
Highlights of the eighth edition���������������������������������� xvi
Careers in finance�������������������������������������������������� xxiv
PART 1
FINANCIAL INSTITUTIONS
Chapter 1A modern financial system: an overview
1
4
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1
Financial crises and the real economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2
The financial system and financial institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.3
Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.4
Financial markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.5
Flow of funds, market relationships and stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Extended learning A Globalisation of the financial markets . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Extended learning B The impact of the Asian financial crisis on the financial system . . . . . . . . . 36
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Chapter 2Commercial banks
42
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Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.1
The main activities of commercial banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2.2
Sources of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2.3
Uses of funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.4
Off-balance-sheet business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.5
Regulation and prudential supervision of commercial banks . . . . . . . . . . . . . . . . . . . . . 56
2.6
A background to the capital adequacy standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
2.7
Basel II and Basel iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.8
Liquidity management and other supervisory controls . . . . . . . . . . . . . . . . . . . . . . . . . 70
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Extended learning A The standardised approach to credit risk . . . . . . . . . . . . . . . . . . . . . . . . 76
Extended learning B Business continuity risk management. . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Extended learning C Corporate governance and ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Chapter 3Non-bank financial institutions
90
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3.1
Investment banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
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Contents
in full
3.2
Managed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.3
Cash management trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
3.4
Public unit trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.5
​Superannuation funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.6
Life insurance offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.7
General insurance offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
3.8
Hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
3.9
​Finance companies and general financiers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
3.10
​Building societies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
3.11
Credit unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
3.12
​Export finance corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Extended learning Project finance and structured finance . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
PART 2
Equity markets
Chapter 4The share market and the corporation
129
132
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Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
4.1
The nature of a corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
4.2
The stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
4.3
The primary market role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
4.4
The secondary market role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
4.5
The managed product and derivative product roles of a stock exchange . . . . . . . . . . . 140
4.6
The interest rate market role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
4.7
The trading and settlement roles of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . 146
4.8
The information role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
4.9
The regulatory role of a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
4.10
The private equity market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Chapter 5Corporations issuing equity in the share market
160
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
5.1
The investment decision: capital budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
5.2
The financing decision: equity, debt and risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
5.3
Initial public offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
5.4
Listing a business on a stock exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
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vii
Contents
in full
5.5
Equity-funding alternatives for listed companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Extended learning Australian Securities Exchange (ASX) listing rule requirements . . . . . . . . . . 181
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Chapter 6Investors in the share market
190
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
6.1
Share-market investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
6.2
Buying and selling shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
6.3
Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
6.4
Financial performance indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
6.5
Pricing of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
6.6
Stock-market indices and published share information . . . . . . . . . . . . . . . . . . . . . . . . 209
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
Chapter 7
Forecasting share price movements
224
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Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
7.1
Fundamental analysis: the top-down approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.2
Fundamental analysis: the bottom-up approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
7.3
Technical analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
7.4
Electronic trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
7.5
The random walk, efficient market and behavioural finance hypotheses . . . . . . . . . . . . 243
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
PART 3
The corporate debt market
Chapter 8Mathematics of finance: an introduction to basic concepts
and calculations
257
260
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
8.1
Simple interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
8.2
Compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
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Chapter 9Short-term debt
in full
288
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
9.1
Trade credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
9.2
Bank overdrafts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
9.3
Commercial bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
9.4
Calculations: discount securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
9.5
Promissory notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
9.6
Negotiable certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
9.7
Inventory finance, accounts receivable financing and factoring . . . . . . . . . . . . . . . . . 307
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
Chapter 10Medium- to long-term debt
318
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
10.1
Term loans or fully drawn advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
10.2
Mortgage finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
10.3
The bond market: debentures, unsecured notes and subordinated debt . . . . . . . . . . . . 328
10.4
Calculations: fixed-interest securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
10.5
Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Extended learning Securitisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
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Chapter 11International debt markets
352
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
11.1
The euromarkets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
11.2
Eurocurrency market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
11.3
Euronote market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
11.4
Eurobond market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
11.5
Markets in the USA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
11.6
Credit rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
Extended learning A Novation, subparticipation and transferable loan certificates . . . . . . . . . 378
Extended learning B Convertible bonds and warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
Extended learning C US medium-term notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Extended learning D Standard & Poor’s credit rating definitions . . . . . . . . . . . . . . . . . . . . . . 381
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
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in full
PART 4
Chapter 12
Government debt, monetary policy, the payments system
and interest rates
Government debt, monetary policy and the payments system
389
392
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
12.1
The Commonwealth Government borrowing requirement . . . . . . . . . . . . . . . . . . . . . . 393
12.2
Commonwealth Government securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
12.3
State government securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
12.4
Monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
12.5
The payments system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Extended learning Fixed-coupon Treasury bonds: price calculation
using the AOFM formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
Chapter 13An introduction to interest rate determination and forecasting
422
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
13.1
The macroeconomic context of interest rate determination . . . . . . . . . . . . . . . . . . . . . 424
13.2
The loanable funds approach to interest rate determination . . . . . . . . . . . . . . . . . . . . 428
13.3
The term structure of interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
13.4
The risk structure of interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444
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Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Extended learning The yield curve and expectations theory calculations . . . . . . . . . . . . . . . . 449
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456
Chapter 14Interest rate risk measurement
458
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458
14.1
Interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460
14.2
Exposure management systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
14.3
Assets re-priced before liabilities principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
14.4
Pricing financial securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464
14.5
Re-pricing gap analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
14.6
Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
14.7
Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475
14.8
Interest rate risk management techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
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PART 5
Chapter 15
The foreign exchange market
Foreign exchange: the structure and operation of the FX market
in full
489
492
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
15.1
Exchange rate regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
15.2
Foreign exchange market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
15.3
The operation of the FX market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 498
15.4
Spot and forward transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.5
Spot market quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
15.6
Forward market quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506
15.7
Economic and Monetary Union of the EU and the FX markets . . . . . . . . . . . . . . . . . . . 511
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Chapter 16
Foreign exchange: factors that influence the exchange rate
520
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
16.1
The fx markets and an equilibrium exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . 522
16.2
Factors that influence exchange rate movements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
16.3
Measuring exchange rate sensitivity to changes in economic variables . . . . . . . . . . . . 535
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538
Extended learning Purchasing power parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 540
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Chapter 17
Foreign exchange: risk identification and management
546
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
17.1
Foreign exchange risk policy formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548
17.2
Measuring transaction exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552
17.3
Risk management: market-based hedging techniques . . . . . . . . . . . . . . . . . . . . . . . . 558
17.4
Risk management: internal hedging techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570
PART 6
Derivative markets and risk management
Chapter 18An introduction to risk management and derivatives
571
574
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574
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18.1
Understanding risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576
18.2
The risk management process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
18.3
Futures contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
18.4
Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584
18.5
Option contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587
18.6
Swap contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 590
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601
Chapter 19
Futures contracts and forward rate agreements
602
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
19.1
Hedging using futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603
19.2
Main features of a futures transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 605
19.3
Futures market instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609
19.4
Futures market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610
19.5
Hedging: risk management using futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612
19.6
Risks in using futures contracts for hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617
19.7
Forward rate agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 626
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
Chapter 20Options
634
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634
20.1
The nature of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635
20.2
Option profit and loss payoff profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637
20.3
The organisation of the market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
20.4
Factors affecting an option contract premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647
20.5
Option risk management strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 652
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 663
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 669
Chapter 21Interest rate swaps, cross-currency swaps and credit default swaps
670
Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670
21.1
Interest rate swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672
21.2
Rationale for the existence of interest rate swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 676
21.3
Cross-currency swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679
21.4
Rationale for the existence of currency swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683
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Contents
in full
21.5
Credit default swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684
21.6
Credit and settlements risk associated with swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Financial news case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692
Key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 696
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697
Answers to true/false questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723
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xiii
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 eighth edition, Dr Peter Phillips and myself continue to present a finance text for you that is authoritative and scholarly,
which at the same time highlights the dynamic, exciting and global nature of financial institutions, instruments and markets.
The recent global financial crisis gradually became apparent from mid-2007 and had a significant adverse effect on
the financial markets from 2008. As the crisis then rapidly evolved it led to an extended period of continuing financial
market uncertainty and extreme volatility. Major global financial institutions had to be bailed out by government or
failed, sovereign debt in a number of countries reached unprecedented levels, economic activity slowed significantly
and unemployment rose to very high levels, particularly in the USA and a number of European countries. The nature and
contagion effects of this evolving global financial crisis are discussed in detail in various chapters of the book. Within this
context, it is important that the eighth edition should encourage new generations of students and industry practitioners to
understand, anticipate and challenge the complex and rapidly evolving structure of the financial system.
As argued by Nobel Laureate and leading economist Professor Joseph Stiglitz, effective financial market regulation
within the context of the integrated global financial markets is required to mitigate future financial crises. Interestingly,
the government initiated a review of the Australian financial system in 1997 (the Wallis Report). In part, structural and
regulatory change that was implemented as a result of that report ensured the Australian financial system came through
the global financial crisis relatively unscathed. The government has currently commissioned a new review of the system
(the Murray Report). The final report is due at the end of 2014 and hopefully the government and regulators will act upon
its recommendations of the report to ensure the financial system is made even more efficient and robust.
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. When, as a young boy of sixteen I began working in the industry, it was the time of pounds,
shillings and pence. I was required to record all transactions using a nib pen dipped in ink. Daily, weekly, monthly and
annual statements were added in my head. It was an exciting day when we received a mechanical adding machine—its
dimensions were 300 × 400 × 200 mm and it could only add, subtract, multiply and divide. I had to pull a large handle
to input each entry into the machine. There has been unbelievable change to the insulated environment of those days. In
particular, there has been significant deregulation of the financial markets, the development of electronic information and
product delivery systems, new and sophisticated financial products, the integration of domestic financial systems into a
global financial system and, from time to time, major financial and economic crises.
To remain relevant in business and finance you must continue to educate yourself and those for whom you may be
responsible in the future. You must read the daily press and periodic financial journals to keep yourself up to date. I suggest
you add notations of current and proposed future changes to the financial system to your personal copy of this book. This
is not a text that you will sell at the end of a particular unit of study, but rather is an important reference that you should
continue to use for further studies and on into your professional career.
I have enjoyed my career working in and teaching about the financial system. I encourage you to accept every
opportunity that comes your way and I wish you the best of success.
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Christopher Viney
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 twenty-seven 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. As the text book continues to evolve, a co-author, Peter Phillips, has
joined Chris in writing the seventh and eighth editions.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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. Peter completed a PhD at USQ in financial economics in 2003. 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. He has recently completed work on a book that explores SMSFs in more detail.
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
and Jane Roy. We would also like to acknowledge and thank the team at McGraw-Hill including: Lisa Coady, Natalie
Crouch, Marisa Rey Bulen, Haidi Bernhardt and Maryann D’Sa.
Christopher Viney and Peter Phillips
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xv
Highlights
of the eighth edition
Chapter 1 A modern financial system: An overview
highlights various aspects of the global financial crisis
with a special focus on the importance of regulation for
ensuring financial markets stability
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
extended learning—globalisation of the financial markets
and the drivers of change in the financial system
extended learning—the impact of the Asian financial crisis
on the financial system
Chapter 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 the Basel
II and Basel III Accords
outlines aspects of the regulatory response to the global
financial crisis
extended learning—standardised approach to credit risk
extended learning—business continuity risk management
extended learning—corporate governance and ethics
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Chapter 3 Non-bank financial institutions
an 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
Chapter 4 The share market and the corporation
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
Chapter 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—Australian Securities Exchange (ASX)
listing requirements
Chapter 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
Chapter 7 Forecasting share price movements
examines fundamental analysis and technical analysis
approaches to share price forecasting
considers the nature and impact of electronic trading on
the markets
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
Chapter 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
Chapter 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
calculation of prices and yields on discount securities
Chapter 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
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Highlights
Chapter 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
Chapter 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
extended learning—fixed-coupon Treasury bonds: price
calculation using the Australian Office of Financial
Management (AOFM) formula
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Chapter 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
Chapter 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
Chapter 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)
of the eighth edition
Chapter 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
Chapter 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
examines internal and external market-based hedging
techniques using derivative products
Chapter 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
Chapter 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
Chapter 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
Chapter 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.
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xvii
Text
at a glance
PART INTRODUCTIONS Introducing
each of the six parts is a short overview
of the material covered in the following
chapters. These openers are a helpful
introduction to how the key concepts,
institutions or instruments work together
and how they fit within the larger
picture.
Part 4
ChaPter 12
Government debt, monetary policy
and the payments system
Government debt,
monetary policy, the
payments system and
interest rates
CHAPTER OUTLINE
12.1
The Commonwealth Government borrowing requirement
12.2
Commonwealth Government securities
12.3
State government securities
12.4
Monetary policy
12.5
The payments system
Learning objectives
CHAPTER OPENERS Each chapter
begins with a short overview of the
information contained in the chapter,
providing not only an introduction to
the chapter, but also a useful study
reference.
ChaPter 12
Government debt, monetary policy and the payments system
ChaPter 13
An introduction to interest rate determination and forecasting
Part 4 Government debt, monetary policy, the payments system and interest rates
ChaPter 14
Interest rate risk measurement
1 Commonwealth
Government budget surpluses or deficits
The main types of Commonwealth Government budget transactions that influence the daily cash position
are:
•
•
•
•
LO 12.1
Consider the reasons for the existence of government debt markets and the government
borrowing requirement.
LO 12.2
Outline features of the main debt instruments issued by the Commonwealth Government, that is,
the Treasury bond and the Treasury note, and describe the issuance process, participants and
complete relevant calculations.
LO 12.3
Describe the purpose and structure of state government central borrowing authorities.
LO 12.4
Outline the monetary policy techniques currently employed by the Reserve Bank through which
it influences the level of interest rates in Australia, including open market operations and the
impacts on system liquidity.
LO 12.5
Describe the purpose and operation of the payments system, including exchange settlement
accounts, real-time gross settlement and repurchase agreements.
Extended learning
LO 12.6
Calculate the price of a bond using the AOFM formula.
taxation receipts, including income tax, company tax, capital gains tax, goods and services tax, fringe
benefits tax
government securities:
— tender subscriptions for T-notes and Treasury bonds
— interest or coupon payments on Treasury bonds
— principal repayments on T-notes and Treasury bonds
budget recurrent expenditures, for example social security pensions and benefits, and public service
expenses
budget capital expenditures, for example payments to fund the building of roads, hospitals and schools.
Cash flows change depending on seasonal and cyclical factors. Seasonal factors include, for example,
the due date for company tax payments or increased expenditure at Christmas. Cyclical factors relate
to the state of the economy. If the economy is growing, private and business expenditure is likely to be
higher, which affects financial system liquidity and cash flows generated from taxation. Commonwealth
expenditures add liquidity to the system; the payment of taxes to the government withdraws liquidity
from the system.
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
rrent operations. As with any business, section in which the learning
financial markets to raise funds. The debt ChaPter 12
into the money markets and the capital
objective appears in the chapter.
nt securities and medium- to long-term
relating to the description and structure Government debt, monetary policy
security issued by the Federal Reserve in They are directly linked to the
e type of security is known as a Treasury and the payments system
erent terms to maturity.
end-of-chapter summary, which
, particularly fiscal policy and monetary
tures of a government. If government CHAPTER OUTLINE
systematically works through each
ures, the budget is said to be in surplus.
in deficit. Governments have choices as
t of that surplus or deficit. Accumulated learning objective.
KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term or
2 Official FX transactions
concept is highlighted in the text at its first appearance, and the definition 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
(thus linking to the margin definition) as well as providing the context for the
definition. A full list with definitions appears in the glossary.
Official FX transactions can take place at any time. It was noted previously that the Reserve Bank can enter
the FX market to conduct FX transactions on behalf of the Commonwealth Government, or occasionally
to support the value of the AUD against other currencies.
The central bank is banker to the government. Therefore, if the government purchases goods from
overseas the central bank will arrange payment for the government. This will require the purchase of the
Chapter 12 Government debt, monetary policy and the payments system
necessary foreign currency in the FX market. In purchasing the foreign currency, the Reserve Bank will
pay in AUD. This means that there will be an increase in liquidity in the financial system. To offset this
liquidity increase, the central bank will neutralise its FX transactions through its market operations; that
The above arrangements facilitate the management of liquidity within the payments system and
is, if it buys FX, it will at the same time sell CGS. The increased supply of AUD from the FX transaction
support RTGS. They also enable the Reserve Bank, on a day-to-day basis, to maintain the target cash rate
is neutralised by the reduced supply of cash resulting from the market transaction. The neutralisation
at the desired monetary policy setting.
strategy means that there will be no net impact on its monetary policy interest rate stance.
The central bank’s sales of foreign currency reduce financial system liquidity. On the other hand, the
purchase of foreign currency adds to system liquidity. For example, if the Reserve Bank was concerned
that the AUD was rapidly falling in value, and that in its view such a fall was not warranted by economic
fundamentals, it might decide to enter the FX market and begin buying AUD. This is achieved by selling
eflection points
foreign currencies from its FX reserves. The purchase of the AUD would provide support for the AUD and
allow time for the FX markets to stabilise at a rational exchange rate level. • The Reserve Bank is responsible for the soundness of the payments system.
R
pter 12 Government debt, monetary policy and the payments system
12.1
Copyright © 2015. McGraw-Hill Education. All rights reserved.
s. A central bank is able to influence the
dity in the financial system. Monetary
onomic growth, high employment and a
urrently apply very similar principles in
kets and capital markets to fund their
ing of taxation revenues and other
that is, its income and expenditure;
e funded.
at target the level of inflation by using
The Commonwealth Government borrowing requirement
12.2
Commonwealth Government securities
12.3
State government securities
12.4
Monetary policy
12.5
The payments system
LO 12.1
Consider the reasons for the existence of government debt markets and the government
borrowing requirement.
LO 12.2
Outline features of the main debt instruments issued by the Commonwealth Government, that is,
the Treasury bond and the Treasury note, and describe the issuance process, participants and
complete relevant calculations.
LO 12.3
Describe the purpose and structure of state government central borrowing authorities.
LO 12.4
Outline the monetary policy techniques currently employed by the Reserve Bank through which
it influences the level of interest rates in Australia, including open market operations and the
impacts on system liquidity.
LO 12.5
Describe the purpose and operation of the payments system, including exchange settlement
accounts, real-time gross settlement and repurchase agreements.
Extended learning
Calculate the price of a bond using the AOFM formula.
ernment borrowing
timing of its cash flows and the financing
pter 1) also applies to government; that
quirements with the issue of short-term
itures and commitments with the issue
en the timing of government intra-year
e shortfall occurs when a budget is in
nd other income receipts. If necessary,
y: the short-term Treasury note and the
ent’s long-term (or full-year) borrowing
y requirements (those that exist within
SYSTEM SURPLUS
occurs when payments
by the official sector
to the private sector
exceed payments to
the official sector
SYSTEM BEING DOWN
occurs when payments
by the official sector to
the private sector are
less than payments to
the official sector
• The payments system facilitates the transfer of value for financial transactions conducted within
an economy.
The third impact on system liquidity comes from the net sales of CGS and repurchase
agreements.
Duringsystem, banks are required to maintain an exchange settlement
of the payments
• As part
any week, the money-market cash position may be boosted if Treasury bondsaccount
or T-notes
or areBank. For example, if a bank’s customer writes a cheque payable to
withmature
the Reserve
redeemed. Repurchase agreements (discussed below) also affect system liquidity.
There
is acustomer,
drain on the funds will be transferred from the first bank’s exchange settlement
another
bank’s
system liquidity when the private sector pays for its purchases of CGS in the periodic
CGS
system.
account
to tender
the second
bank’s account.
It is the sum of the three sets of transactions that determines the daily money-market cash position.
Banks
are
required
to keep their exchange settlement accounts in credit at all times with soIf payments from the official sector to the private sector exceed the flow of• funds to the official sector,
called same-day funds, that is, funds that have already been cleared through the payments
there will be a system surplus, also known as the system being ‘oversquare’. If the reverse is true—that
system.
is, if payments to the official sector exceed official sector payments to the private sector—there will be a
system deficit, often referred to as the system being down. When the flows
opposite
directionsfunds
are are surplus balances in banks’ exchange settlement accounts,
Sources
of same-day
• in
equal, the system is said to be ‘square’.
Reserve Bank payments for market operations or repurchase arrangements with the Reserve
In order to understand fully how the Reserve Bank obtains almost complete
Bank. control of the level
of short-term interest rates, it is necessary to recognise the relationships that are evident between the
The
central
bank
requires
• settlement and repurchase high-value transactions in the payments system to be settled by realpayments system, exchange settlement account transactions, real-time gross
time gross settlement (RTGS); that is, funds must be available in a bank’s exchange settlement
agreements.
account immediately. The purpose is to reduce settlement risk and systemic risk.
408
• To support RTGS, the Reserve Bank provides an intra-day liquidity facility for same-day funds,
or an overnight liquidity facility, known as a repurchase agreement (repo).
• The Reserve Bank will provide a repo based on underlying eligible securities. An intra-day repo
must be unwound by the end of the day.
Learning objectives
LO 12.6
3 Net sales of CGS and repurchase agreements
LEARNING
OBJECTIVE
12.1
Consider the reasons
for the existence of
government debt
markets and the
government borrowing
requirement
COMMONWEALTH
GOVERNMENT
the central government
of Australia
FINANCIAL NEWS CASE
STUDY Found at the
end of every chapter,
each financial news
case study contains
excerpts from financial
articles that provide
real-world examples
of concepts discussed
within the chapter. They
are followed by related
discussion questions
providing the opportunity
for self-assessment and
putting into practice what
you’ve learned!
financial news case study
In Chapter 12, much of the discussion was concerned with the government’s budget. The government’s
budget surplus or deficit periodically attracts attention in the press and it is often the subject of political
debate and commentary. Although the Australian budget deficit has attracted significant local attention,
governments around the world periodically face similar (or more extreme) fiscal challenges. When the
country in question is the world’s largest economy, there are implications for all other nations. One of the
most significant budget crises in recent history afflicted the USA during 2013 when the government was
forced to ‘shut down’ as politicians debated the budget and the ‘debt limit’. The significance of this event
and the potential for future episodes both in the USA and around the world certainly makes it a worthwhile
subject for study. The following points from The Guardian provide some answers to key questions:
Why?
The Federal government had no choice. The US financial year ended on 30 September, and politicians
on Capitol Hill have failed to agree a new budget for the 2013–2014 financial year.
Why couldn’t they agree a deal?
The House of Representatives is controlled by the Republican Party, whose Tea Party movement remain
deeply opposed to Obamacare [A key initiative of the Presidant and one that he can not implement of
his own accord].
393
Viney, Christopher, and Peter Phillips. Financial Institutions, Instruments and Markets, McGraw-Hill Education, 2015. ProQuest Ebook Central,
xviii
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Created from unsw on 2018-02-19 21:09:44.
413
Text
REFLECTION POINTS Located after every major section
within each chapter, the reflection points highlight the
most significant material covered as well as providing
regular summaries and a useful tool for revision, which
will help students identify areas requiring further study.
at a glance
CHAPTER SUMMARIES The 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.
Chapter 12 Government debt, monetary policy and the payments system
Chapter 10 Medium- to long-term debt
• In Australia, the Reserve Bank implements monetary policy to maintain inflation within a range
LEARNING OBJECTIVE 10.1
of 2 to 3 per cent, on average, over the economic or business cycle.
Explain term loans and fully drawn advances, including their structure, loan covenants and the
calculation of a loan instalment
• The central bank targets the overnight cash rate by carrying out open market operations. In an
efficient market, if one interest rate changes (cash rate) then other rates will also progressively
change to return to equilibrium.
• The financial system provides corporations with a wide range of medium- to long-term loan and debt
• A change in interest rates will have a transmission effect on the cost and availability of funds,
facilities. These facilities allow a corporation to diversify its funding sources and match its cash-flow
requirements.
the value of assets and liabilities, and the exchange rate; that is, it will impact on the level of
economic activity. These transmission effects are referred to as the monetary policy channel,
the credit channel, the wealth channel and the foreign exchange channel.
• The sources of medium- to long-term debt may be intermediated finance provided by financial
institutions or direct finance obtained from either the domestic or the international capital markets.
• Central bank monetary policy open market operations involve the buying or selling of
• A common form of intermediated debt is the term loan or fully drawn advance. The main providers
government securities within the money markets. If the central bank buys securities from the
market, it will pay cash for them, thus increasing liquidity in the system and allowing interest
rates to fall. To raise the rates, the central bank would sell securities.
of term loans are the commercial banks. However, investment banks, finance companies, insurance
offices and credit unions also provide term loans to the business sector.
• Term loans are provided to fund a specific purpose or project for a fixed period of time.
• Open market operations are conducted primarily by (1) repurchase agreements (repos) based
CHAPTER TEN REVIEW
Summary
Reflection points
• The repayment structure of a term loan may be amortised (each periodic instalment incorporates
on a range of nominated debt securities, (2) outright or direct transactions in short-dated
Commonwealth Government Securities (CGS), or (3) foreign exchange swaps.
an interest component and also a principal repayment component), interest only (each periodic
instalment only comprises the interest due on the full loan amount) or deferred (repayment is deferred
for a period until the business project generates positive cash flows).
• Liquidity in the financial system is affected by transactions between the official sector and the
private sector. Official sector transactions are Commonwealth Government budget surpluses or
deficits, official FX transactions and net sales of CGS and repurchase agreements.
• The normal practice is to price a variable-rate loan at a margin above a reference interest rate. The
margin will reflect the level of credit risk of the borrower.
• During the term of a variable rate loan, the interest rate will be periodically reset in relation to
changes in the specified reference rate, such as LIBOR, BBSW or the bank’s own prime rate.
• The bank bill swap rate (BBSW) is the mid-point of prime banks’ bid and offer rates for eligible
securities in the NCD and BAB secondary markets and is published by the AFMA. Thomson-Reuters
publishes LIBOR daily.
12.5 The payments system
• A range of fees may also apply, including an establishment fee, a periodic service fee, a commitment
Within a modern economy millions of the transactions that occur daily for goods and services use a
financial instrument to represent value for the transaction. For example, an individual may issue a cheque
drawn on a bank and present the cheque to another party, such as a business, in payment for goods
and services received. The business will deposit the cheque in its current account, which may be held
with a different bank. The cheque must be cleared through the payments system in order to obtain
actual value. The funds are debited to the account of the individual at the first bank and credited to the
account of the business at the second bank. The value transfer between the banks is completed through
the payments system.
The clearing of value payments system transactions in Australia is coordinated by the Australian
Payments Clearing Association (APCA). APCA is a limited liability company formed by banks, building
societies, credit unions and the Reserve Bank. APCA manages clearing for cheques, direct entry
payments, ATM and debit card transactions and high-value payments. Other payments clearing systems
include MasterCard and Visa. Also, there are two securities settlement systems with separate payment
arrangements: the Austraclear system which settles trades in CGS and other debt securities, and the
Australian Securities Exchange’s Clearing House Electronic Sub-register System (CHESS) for settlement
of equity trades.
Payments system transactions may be cash or non-cash instruments, being either high-value or lowvalue transactions. There are five payments system clearing systems:
•
•
•
•
•
fee or a line fee.
• Issues that a lender will consider when determining an interest rate and the margin include the credit
LEARNING
OBJECTIVE
12.5
risk of the borrower, the term of the loan and the loan repayment schedule.
• A loan contract may include a range of loan covenants to protect the lender. They include positive
Describe the purpose
and operation
of the payments
system, including
exchange settlement
accounts, real-time
gross settlement
and repurchase
agreements
covenants, which state actions that must be taken by a borrower (e.g. provision of financial statements),
and negative covenants, which limit the actions of a borrower (e.g. minimum debt to equity ratio).
• The formula used to calculate the instalment on a term loan (when payments occur at the end of each
period) is:
R =
PAYMENTS SYSTEM
facilitates the transfer
of value from one
party to another for
financial transactions
LEARNING OBJECTIVE 10.2
Describe the nature, purpose and operation of mortgage finance and the mortgage market, and
calculate an instalment on a mortgage loan
the Australian Paper Clearing System for cheques, payment orders and other paper-based payment
instructions
the Bulk Electronic Clearing System for recurring electronic credit and debit payment instructions
the Consumer Electronic Clearing System for proprietary-card-based ATM and EFTPOS transactions
the High Value Clearing System for high-value payment instructions
the Australian Cash Distribution Exchange System for the movement of notes and coins.
• Mortgage finance is a term loan with a specific type of security attached, being a mortgage registered
EXTENDED LEARNING The extended learning sections
provide an additional resource for self-assessment and a
variety of activities designed to address the more complex
aspects of the chapter. These sections are accompanied
by extended learning questions which test students’
understanding
of the material.
•
409
Chapter 12 Government debt, monetary policy and the payments system
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Extended learning
LEARNING OBJECTIVE 12.6
Calculate the price of a bond using the AOFM formula
Fixed-coupon Treasury bonds: price calculation using the Australian Office of
Financial Management (AOFM) formula
The settlement price per $100 face value, extended to the third decimal place, will be calculated on the
basis of the following formula:
f
Price per $100 face value = v d (c + gan + 100v n )
where:
v = 1/(1 + i ) where i is the annual percentage yield divided by 2
f = the number of days from the date of settlement to the next interest payment date
d = the number of days in the half-year ending on the next interest payment date
c = the amount of the interest payment (if any) per $100 face value at the next interest payment date
g = the fixed half-yearly coupon interest rate payable (equal to the annual fixed rate divided by 2)
n = the number of full half-years between the next interest payment date and the date of maturity.
It should be noted that n does not include the very next coupon. For example, if the investor is
entitled to the next coupon and there are a further 7 coupons remaining after that, n = 7.
(1 − v n )
i
12.5
SOURCE: www.aofm.gov.au
CHAPTER TWELVE REVIEW
Under an intra-day repo arrangement the Reserve Bank will provide liquidity based on eligible debt
securities and credit an exchange settlement account, but the position must be unwound by the end
of the day.
an = v + v 2 +  + v n =
A
−n 

1 − (1 + i ) 


i


over land and the property thereon. The borrower (mortgagor) conveys an interest in the land to the
lender (mortgagee).
• If a borrower defaults on loan repayments, the lender has the right of foreclosure, whereby the lender
will take possession of the land and sell it to recover the amounts outstanding.
END OF CHAPTER QUESTIONS Each chapter
contains a number of different question types
useful to test student recall and understanding of
the material covered in the chapter. The True or
false questions test your recall and the answers
are helpfully contained at the end of the book,
an excellent tool for exam revision. These true or
false questions can also be used as short answer
questions to test students’ ability to provide more
information.
The Essay questions provide the opportunity to put
the concepts that have been learnt into practice,
highlighting students’ ability to analyse and
evaluate the material.
The Extended learning questions relate to the indepth extended learning sections and require
students to demonstrate a deeper understanding of
the concepts and theories presented in the chapter.
341
The settlement amount will be rounded to the nearest cent (0.5 cent being rounded up).
The bond shown in Example 12.1 earlier in this chapter has a face value of $1000, pays 7.00 per
cent per annum with half-yearly coupons and matures on 15 November 2017. Assume that the bond is
sold on 15 July 2014. Current yields for similar Treasury bonds are 8.00 per cent per annum. Calculate
the price of the bond in the secondary market:
6





1
123 

 


6




1
1
 
184 $3.50 + 3.50 1 − 1 + 0.04   + $100 
P = 


1 + 0.04  
1 + 0.04  
0.04






= 0.974123[3.50 + 18.347 479 + 79.031453]
= 0.974123 × 100.878932
= 98.268 per $100 face value
= 98.268 × 10 (representing $1000 face value)
= $982.68
12.6
The current price of the Treasury bond is $982.68. This is the same answer that was calculated using
Equation 12.1 in Example 12.1.
417 Education, 2015. ProQuest Ebook Central,
Viney, Christopher, and Peter Phillips. Financial Institutions, Instruments and Markets, McGraw-Hill
http://ebookcentral.proquest.com/lib/unsw/detail.action?docID=4770231.
Created from unsw on 2018-02-19 21:09:44.
xix
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.
exPloring
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 on-line application is also presented.
Careers
finance on the weB
One of my very good friends established his own engineering business after graduating many years ago. The business
has grown and is very successful. A few years ago he obtained a copy of this text book and after reading commented
that he wished he had been able to study the book as part of his engineering degree before he began in business, as it
would have saved him from many of the financial pitfalls he experienced over the years. Within the context of careers
in finance, this true story highlights that a career in finance can be established in any country, economic sector, industry
sector, business or government.
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. Funds management or personal financial planning are also other
career opportunities. 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. Stock-broking is yet another career opportunity.
Finance is a global market and therefore there are possibilities for working in a range of developing and advanced
financial markets. In particular, you may wish to work in London or New York. While visiting many of the global financial
markets, I have encountered many people from different countries who have made the transition from their local market
to the international 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.
in finanCe
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
World CurrenCies
Before you start
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.
•
xxiii
Copyright © 2015. McGraw-Hill Education. All rights reserved.
GLOSSARY This useful list of
definitions contains all of the key
terms and concepts as they appear in
the margin notes.
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
xxiv
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!
Viney, Christopher, and Peter Phillips. Financial Institutions, Instruments and Markets, McGraw-Hill Education, 2015. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/unsw/detail.action?docID=4770231.
Created from unsw on 2018-02-19 21:09:44.
WORLD CURRENCIES Located on
the inside back cover for ease of
reference, this handy, updated table
lists the currencies of all the world’s
major countries, as well as their
common abbreviations.
Get connected.
Get results.
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a variety of critical outcomes; it is easy to use and proven to be effective.
Proven effective
With Connect, you can complete your coursework anytime,
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Millions of students have used Connect and the results are in:
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Copyright © 2015. McGraw-Hill Education. All rights reserved.
Connect includes animated tutorials, videos
and additional embedded hints within specific
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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 find out more about Connect and Connect Plus visit
www.mheducation.com.au/digital/connect
Viney, Christopher, and Peter Phillips. Financial Institutions, Instruments and Markets, McGraw-Hill Education, 2015. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/unsw/detail.action?docID=4770231.
Created from unsw on 2018-02-19 21:09:44.
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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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.
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.
Viney, Christopher, and Peter Phillips. Financial Institutions, Instruments and Markets, McGraw-Hill Education, 2015. ProQuest Ebook Central,
xxii
http://ebookcentral.proquest.com/lib/unsw/detail.action?docID=4770231.
Created from unsw on 2018-02-19 21:09:44.
Exploring
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.
Information providers
authorities
Bloomberg – www.bloomberg.com
Dow Jones – www.dowjones.com
Thomson-Reuters – www.reuters.com
Australian major banks
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 institutions and
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
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.ibb.ubs.com
Credit rating agencies
Fitch Ratings – www.fitchibca.com
Moody’s Investors Service – www.moodys.com
Standard & Poor’s – www.standardandpoors.com
finance on the web
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 – www.sse.com.cn
Singapore Exchange – www.sgx.com
Sydney Futures Exchange (a part of the Australian Securities
Exchange) – www.asx.com.au
Tokyo Stock Exchange – www.tse.or.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/rits
SWIFT – www.swift.com
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xxiii
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Careers
in finance
One of my very good friends established his own engineering business after graduating many years ago. The business
has grown and is very successful. A few years ago he obtained a copy of this text book and after reading commented
that he wished he had been able to study the book as part of his engineering degree before he began in business, as it
would have saved him from many of the financial pitfalls he experienced over the years. Within the context of careers
in finance, this true story highlights that a career in finance can be established in any country, economic sector, industry
sector, business or government.
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. Funds management or personal financial planning are also other
career opportunities. 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. Stock-broking is yet another career opportunity.
Finance is a global market and therefore there are possibilities for working in a range of developing and advanced
financial markets. In particular, you may wish to work in London or New York. While visiting many of the global financial
markets, I have encountered many people from different countries who have made the transition from their local market
to the international 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
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Careers
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–
•
•
•
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.
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!
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 cutand-paste answer. Use proper paragraphs, not just a list of dot points.
These tips may seem obvious, but you’d be amazed at the number of applications which are not successful because
they haven’t followed this advice!
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xxv
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Part 1
Financial institutions
Chapter 1
A modern financial system: an overview
Chapter 2
Commercial banks
Chapter 3
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Non-bank financial institutions
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Part 1
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Financial institutions
Career opportunities in finance are enormous and they are available to you if you dedicate yourself to learning
and understanding how the financial institutions, instruments and markets work. You should be excited that one
day you may, for example, work in a commercial bank in Hong Kong or Sydney, or an investment bank in London
or New York, or a multilateral government organisation in Paris or Washington, or a multinational corporation
anywhere in the world. Further, it does not matter where you live or study; financial institutions, instruments and
markets are essentially the same in all developed countries. What you learn from this textbook will be relevant in
the world of finance no matter where your travels take you.
This textbook discusses the structure, functions and operations of a modern financial system; that is, you
are going to learn about financial institutions, financial instruments and financial markets. Each nation-state
is responsible for the structure and operation of its own financial system; however, they form an integrated
global financial system. Although institutions, instruments and markets are fundamentally alike, they may
be differentiated by size, terminology, the level of government regulation and prudential supervision. For
example, in the UK the main type of financial instrument issued on the stock exchange is called an ordinary
share, whereas the same instrument issued in the USA is known as common stock.
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.
Much of what you will learn from this text is international in nature, but it will be necessary at times to
focus on the financial system of a particular nation-state. It is not possible to look at the variations that occur
in the financial systems of all nation-states. Therefore, when necessary, reference will be made to the Australian
financial system as it has a modern, efficient and stable financial system that operates effectively within the
global financial system.
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Think of a financial system as being 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
Financial crises and the real economy
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Learning objectives
LO 1.1
Understand the effects and consequences of a financial crisis on a financial system and a real
economy.
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 importance of globalisation of the international financial markets.
LO 1.8
Appreciate the effects, consequences and relevance of the Asian financial crisis.
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Chapter 1 A modern financial system: an overview
Introduction
The real economy where goods and services are exchanged is connected to the financial markets where
financial securities are exchanged. Each affects the other. The development of financial markets has made
the exchange of value for goods and services much easier. The introduction of money into the exchange
process increases the speed and efficiency with which transactions take place. The use of monetary value
also makes it easier to save surplus funds. In order to attract these surplus funds for use in capital projects
or consumption spending, businesses and governments issue financial securities such as shares and
bonds that entitle investors to a share of business profits or periodic interest payments. These securities
change hands on the financial markets at prices that reflect the prevailing business conditions, risk and
uncertainty and expectations of future returns.
Ups and downs are to be expected in the normal course of the business cycle. However, financial
markets are sometimes characterised by high levels of volatility. These periodic bursts of volatility send
market participants running for cover as the capital values of investments suddenly appear to have
been overestimated. The ensuing liquidation and crisis is the market’s remedial action to correct the
miscalculations of the preceding economic boom. In the modern financial system, this liquidation can
take place at terrifying speed. Although the particular circumstances of each crisis are unique, we can be
sure that at the depths of a crisis there will be calls for a review of the ways in which the financial system
is regulated. We start our study of the financial system with a discussion of the ways in which financial
markets and the real economy interact during periods of financial crisis.
1.1
Financial crises and the real economy
Copyright © 2015. McGraw-Hill Education. All rights reserved.
The most recent crisis was the global financial crisis (GFC). The 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
which 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 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 per cent and 42 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 per cent in 2007 to
just over 10 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 per cent. The American 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 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. 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
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LEARNING
OBJECTIVE
1.1
Understand the effects
and consequences of
a financial crisis on a
financial system and a
real economy
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 United States
and the consequences
of that collapse for the
market for mortgagerelated securities
SUB-PRIME
MORTGAGES
loans to borrowers
that under normal
credit assessment
standards would not
have the capacity to
repay
5
Part 1 Financial institutions
Copyright © 2015. McGraw-Hill Education. All rights reserved.
FEDERAL RESERVE
the central bank of the
USA
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
under tremendous pressure. Washington Mutual was placed in receivership. Wachovia was purchased by
Wells Fargo. AIG was effectively taken over by the Federal Reserve.
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 per cent reserves and cannot possibly meet all of these demands. 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 short-term 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.
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 write-downs 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 write-downs 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 has come 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 per cent of the
country’s national income, was actually twice as large, or more than 220 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.
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 now troubled 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.
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Chapter 1 A modern financial system: an overview
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 has shown no real signs of abating. And so, the GFC continues
to ripple through the global economic and financial system.
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 incentives 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 creditdriven 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 America, 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.
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 is
another factor that attracted the attention of critics before, during and after the GFC. Regulations that limit
compensation packages within the financial sector or realign incentive structures such that 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. 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’
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7
Part 1 Financial institutions
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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.
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.
We have already introduced some very important issues. The GFC demonstrated the vast
interconnectedness of global 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 had to 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. The flow of funds and the relationship between savers and users of funds, and the
place of the financial markets in the flow, are shown in Figure 1.1. Once it is understood why financial
markets have evolved, it is possible to consider the major functions served by a modern financial system.
Figure 1.1 ​Financial markets and flow of funds relationship
Suppliers of funds:
surplus (savings) units
Users of funds:
deficit units
are
are
Lenders:
Borrowers:
householders
companies
governments
rest of world
who
receive
funds
who
supply
funds
and
householders
companies
governments
rest of world
Financial markets
receive financial
instruments
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and
issue financial
instruments
Chapter 1 A modern financial system: an overview
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.
• Historically, financial markets have exhibited periods of extraordinary volatility. The GFC is a
recent and prominent example of the volatility that can characterise the financial markets and
the consequences that volatility can have in the real economy.
• The GFC is now viewed as having two parts or phases. The first was concentrated in the
mortgage derivatives markets and brought down a number of US-based institutions. The second
was a sovereign debt crisis emanating from several troubled European countries that eventually
engulfed much of the eurozone.
• The GFC, in both its parts, initiated a severe economic contraction in many countries,
especially the USA and parts of Europe.
• 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.
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1.2
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 which 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,
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 be burnt 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.
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LEARNING
OBJECTIVE
1.2
Explain the functions
of a modern financial
system and categorise
the main types of
financial institutions,
including depository
financial institutions,
investment banks,
contractual savings
institutions, finance
companies and unit
trusts
FINANCIAL SYSTEM
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
9
Part 1 Financial institutions
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
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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
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 which 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 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, for example 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
• 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.
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Chapter 1 A modern financial system: an overview
• 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.
• A 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 service, typically institutions tend to specialise in areas where they
have greater expertise. We will discuss the different types of institutions in detail in Chapters 2 and 3. In
this chapter we simply classify financial institutions into five categories based on the differences between
the institutions’ sources of funds and uses of funds.
1
Depository financial institutions obtain a large proportion of their funds from deposits lodged
by savers. Examples include deposits placed in demand deposit accounts or term deposit accounts
with commercial banks, building societies and credit cooperatives. A principal business of these
institutions is the provision of loans to borrowers in the household and business sectors.
2
Investment banks generally focus on the provision of advisory services for their corporate and
government clients. This includes advising clients on mergers and acquisitions, portfolio restructuring
and financial risk management. These institutions may provide some loans to clients but are more
likely to advise and assist a client to raise funds directly from the capital markets.
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3
Contractual savings institutions are financial institutions such as life insurance offices, general
insurers and superannuation funds. Their liabilities are mainly contracts which specify that, in return
for periodic payments made to the institution, the institution will make specified payouts to the
holder of the contract if and when an event specified in the contract occurs. The periodic cash receipts
received by these institutions provide them with a large pool of funds that they invest. Payouts made
by these institutions include payments for claims made on an insurance policy, or payment to a
superannuation fund member on their retirement from the workforce.
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.
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.
Table 1.1 shows the total assets of the various Australian financial institutions in June 1990, June
2008 and September–December 2013. 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. Some generalisations that emerge from Table 1.1 include:
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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
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
CONTRACTUAL
SAVINGS
INSTITUTIONS
offer financial
contracts such as
insurance and
superannuation; large
investors
FINANCE COMPANIES
AND GENERAL
FINANCIERS
borrow funds direct
from markets to
provide loans and
lease finance to
customers
UNIT TRUSTS
investors buy units
issued by the trust;
pooled funds invested
(e.g. equity trusts and
property trusts)
11
Part 1 Financial institutions
Table 1.1 ​Assets of financial institutions, Australia ($ billions)
1990
% total
assets
24.9
3.4
93.7
2.2
128.0
2.28
Commercial banks
325.8
43.8
2 239.5
52.0
3 214.1
57.17
Building societies
22.9
3.1
21.7
0.5
23.2
0.41
8.7
1.2
41.6
1.0
41.0
0.73
Money-market corporations
53.6
7.2
113.5
2.6
31.8
0.57
Finance companies and
general financiers
55.5
7.5
130.7
3.0
109.7
1.95
Life insurance offices
85.3
11.5
184.8
4.3
225.6
4.01
Superannuation funds
80.8
10.8
752.2
17.5
1 259.7
22.41
Cash management trusts
4.7
0.6
46.2
1.1
24.1
0.43
Common funds
7.0
0.9
11.6
0.3
6.5
0.12
Friendly societies
8.1
1.1
4.1
0.1
4.7
0.08
Public unit trusts
27.7
3.7
272.1
6.3
247.2
4.40
General insurance offices
32.5
4.4
130.0
3.0
179.6
3.19
5.7
0.8
263.9
6.1
127.0
2.26
Financial institution
Reserve Bank
Credit unions
Securitisation vehicles
Total
743.2
2008
4 305.6
% total
assets
2013
% total
assets
5 622.2
SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.
•
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
•
•
•
Total assets of the financial institutions increased more than sevenfold over the period, to $5622.2
billion.
Commercial banks account for the largest share of the assets of financial institutions, at 57 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 percentage share of financial assets of investment banks declined. This reflects the change in
focus of their business activities. Much of their business is based on the provision of off-balancesheet advisory services to their corporate and government clients.
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 business, particularly superannuation
products.
The percentage share of superannuation assets increased to 22 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.
Another growth area was in managed funds, specifically in unit trusts. This sector of the market
increased tenfold over the period. Managed funds provide investors with the opportunity to use the
specialist skills of funds managers, particularly in investment categories which are more difficult for
the individual investor to access, for example the international equity markets.
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Chapter 1 A modern financial system: an overview
•
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
2.20 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, for example housing loans, thereby generating new cash flows.
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
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 and
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.
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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
13
Part 1 Financial institutions
1.3.1
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
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.
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.
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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
Equity
Debt
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 sub-categories 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.
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Chapter 1 A modern financial system: an overview
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
Derivatives
A third class of instrument has become significant in the financial markets: the derivative instrument.
Derivatives 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 derivatives contracts for the management of risk exposures 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 derivatives 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.
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
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4
NEGOTIABLE DEBT
INSTRUMENT
a debt instrument that
can be sold by the
original lender through
a financial market
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.
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.
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
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.
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continued
15
Part 1 Financial institutions
continued
• A hybrid security, such as a preference share, incorporates the characteristics of both debt and
equity.
• The basic characteristic of debt is that is 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
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
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 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.
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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
bond-holder periodic
interest coupons and
the principal is repaid
at maturity
Financial markets
Matching principle
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!
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Chapter 1 A modern financial system: an overview
1.4.2
Primary 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.
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
Figure 1.2 ​Primary market transactions
Suppliers of funds
supply funds
(surplus units)
(deficit units)
Issue 'new' financial instruments
(debt or equity) to the suppliers of funds
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Users 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 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
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
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17
Part 1 Financial institutions
SECURITIES
financial assets that
are traded in a formal
secondary market
(e.g. stock exchange)
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 government 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.
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
Direct 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
direct 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
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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
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.
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Chapter 1 A modern financial system: an overview
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 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:
•
•
•
•
CREDIT RATING
the assessment by a
credit rating agency
of the creditworthiness
of an obligor to a
financial obligation
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.
Economic and financial conditions change from time to time, and a user of funds may suddenly find
that a traditional source of funds is no longer willing to provide further funding. For example, this
situation was evident in Thailand and Indonesia as a result of the Asian financial crisis of 1997–98,
and was repeated in Argentina after the collapse of the country’s financial and economic systems in
2002. Following the onset of the GFC, large increases in default rates associated with so-called subprime market securities made raising funds in the global money markets and capital markets very
difficult.
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:
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•
•
•
•
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 the 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 is to 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
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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
19
Part 1 Financial institutions
Figure 1.5 ​Intermediated financial flows
Suppliers of funds
funds
(surplus units)
Intermediaries
Financial instrument
funds
Users of funds
(deficit units)
Financial instrument
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.
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.
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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 and
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Chapter 1 A modern financial system: an overview
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.
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.
MATURITY
TRANSFORMATION
financial
intermediaries offer
products with a range
of terms to maturity
LIABILITY
MANAGEMENT
where banks actively
manage their sources
of funds (liabilities) in
order to meet future
loan demand (assets)
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
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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 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.
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LIQUIDITY
TRANSFORMATION
measured by the
ability of a saver to
convert a financial
instrument into cash
21
Part 1 Financial institutions
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
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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
MONEY MARKETS
wholesale markets
in which short-term
securities are issued
and traded
Wholesale 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
Money 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
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
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Chapter 1 A modern financial system: an overview
Figure 1.6 ​Structure of the money and capital markets
Financial markets
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Money markets
Capital markets
Primary capital
markets
(residual maturities
to one year)
(new shares and longterm debt issues)
Secondary capital
markets
International
short-term
money markets
Domestic
capital markets
International
capital markets
Primary money
markets
Secondary money
markets
(maturities to one year)
Domestic
short-term
money markets
(trading in existing
securities)
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.
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. At the time of writing, the
money markets around the world are still experiencing some liquidity problems stemming from the GFC.
All of this is taking place amid ongoing concerns about the health of the US and world economy despite
continued efforts by governments and central banks to stimulate economic activity.
As mentioned, 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 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.
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INSTITUTIONAL
INVESTORS
participants in the
wholesale markets
(e.g. funds managers,
insurance offices,
banks)
23
Part 1 Financial institutions
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
Inter-bank 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
inter-bank market
bills market
commercial paper market
negotiable certificates of deposit market.
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Central bank: system liquidity and monetary policy
INTER-BANK MARKET
the lending and
borrowing of very
short term funds by
banks operating in the
payments system
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 per cent to 3 per cent over time. To achieve this, the Reserve Bank seeks to
influence the level of interest rates by targeting the cash rate in the money markets. As at September
2014 the target cash rate was 2.50 per cent. 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.
Inter-bank market
The inter-bank market facilitates the management of the short-term liquidity needs of the commercial
banks.
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Chapter 1 A modern financial system: an overview
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 inter-bank 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 inter-bank market. The operation
of the payments system is discussed in Chapter 12.
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; do not pay
interest; 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)
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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.
1.4.6
Capital 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.
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NEGOTIABLE
CERTIFICATE OF
DEPOSIT
a discount security
issued by a bank
CAPITAL MARKETS
markets for longerterm funding; includes
equity, corporate debt
and government debt,
and is supported by
the foreign exchange
and derivatives
markets
25
Part 1 Financial institutions
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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Corporate debt market
CORPORATE DEBT
MARKETS
facilitate the issue
and trading of debt
securities issued by
corporations (e.g.
discount securities,
bonds)
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.
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.
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Chapter 1 A modern financial system: an overview
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.
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
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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.
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.
FOREIGN EXCHANGE
MARKETS
markets that facilitate
the buying and selling
of foreign currencies
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
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27
Part 1 Financial institutions
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 derivatives 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.
• 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.
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• Money markets experienced significant liquidity problems during the GFC. The lingering effects
of the crisis and new concerns about the economic stability of many developed nation-states
continue to weigh on the financial markets.
• 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.
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
1.5
Flow of funds, market relationships and
stability
This chapter has introduced many issues in relation to the flow of funds through the financial system, so
it is worthwhile at this stage to summarise the main points.
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
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Chapter 1 A modern financial system: an overview
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 savings and borrowing patterns of the key
sectors of an economy.
The domestic economy can be divided into four sectors:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
business corporations
financial corporations
government
household sector.
To these four sectors, the rest-of-the-world sector is added. This sector may be a source of surplus
funds flowing into a nation-state plus an outward investment destination for surplus funds within an
economy.
Net borrowing and net lending of the major sectors of the economy vary between nation-states. 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. For example, governments that spend large amounts on capital works
programs may need to fund those programs by borrowing in the markets.
The household sector is typically a surplus sector—that is, a net saver of funds. In particular, the
accumulated savings of an ageing population should ensure that this sector remains in surplus.
The rest-of-the-world sector may be likened to a balancing item. A nation-state that has a stable
political environment and an 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 restof-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.
While each sector has been identified as being either in surplus or in deficit, it should also be
recognised that not every participant within a particular sector will behave in the same way. For example,
even though the household sector may be a surplus sector, not every individual is a net saver of funds.
Whether an individual is a net saver depends on the stage of the individual’s life cycle; that is, individuals
who have been in the workforce for longer typically have a greater capacity to save.
Finally, it is important to study the sectorial flow of funds to gain some insight into the effects of
government policy on savings and investment decisions. At one level it is necessary to understand the
effects of fiscal policy and monetary policy decisions. At another level, policy decisions on issues such
as compulsory superannuation have obvious impacts on increased levels of savings within that sector
of the market and therefore on the investment decisions that will flow from an increase in retirement
savings. Government guarantees provided to bank deposits and bank borrowings vary from country to
country and are designed to increase confidence and stability in the nation-state’s financial system.
The GFC reinforced the importance of stability within the financial system. According to the Reserve
Bank of Australia, a stable financial system is characterised by the smooth flow of funds between surplus
and deficit units so that the advantages of a well-functioning financial system that have been outlined in
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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
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)
29
Part 1 Financial institutions
this chapter, including economic growth, have the best chance of being realised. The GFC had a significant
impact on the flow of funds in the global financial system. Government policy responses varied, but
included the provision of deposit and borrowing guarantees, the injection of an enormous amount of
liquidity into the financial system and the provision of additional capital for some struggling financial
institutions.
In some notable cases, especially Greece, Spain, Portugal, Ireland and Italy, the GFC, combined
with specific circumstances in each case, impacted severely on the financial health of the government
sector of these nation-states. The management of these ‘sovereign debt crises’ required the combined
actions of the European Union (EU) through the European Central Bank (ECB) and the International
Monetary Fund (IMF). The support packages provided to some countries, especially Greece and Spain,
helped to support their financial sectors. Significant uncertainties still cloud the global financial markets,
particularly as some central banks face the delicate task of winding down the stimulus packages that had
been implemented in order to foster economic recovery. The task confronting governments, central banks
and other regulators who wish to maintain the stability of the financial system is very challenging.
For those who wish to extend their understanding of the financial system further, there are two
extended learning sections at the end of the chapter. Extended learning A considers the globalisation of
the financial markets and Extended learning B examines the impact of the Asian financial crisis on the
financial system.
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 sectorial 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.
• Financial crises, such as the GFC, have a significant disruptive impact on the flow of funds in
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the financial system and highlight the importance of stability within the financial system.
Financial news case study
In Chapter 1, the GFC was discussed in considerable detail along with the response of governments both
in terms of regulation and economic stimulus. Although markets have recovered since the dark days of
the crisis, central banks face the unenviable task of winding back the stimulus programs, the low interest
rates and large purchases of government securities, which have propped up the markets since 2008. In
2013, US President Barack Obama announced Ben Bernanke’s successor at the Federal Reserve, Janet
Yellen. Managing this stimulus wind-back is viewed by many to be her greatest short-term challenge.
Over several years, financial markets have become used to low interest rates and continued monetary
stimulus. This has been one of the driving forces behind the recovery of the US stock markets, which
returned to record highs. On the one hand, strong financial markets are a good thing but central banks
are wary about creating another ‘bubble’ by keeping interest rates artificially low. The problem is that the
underlying economic conditions, although improved, are not showing clear signs of robust growth. Without
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Chapter 1 A modern financial system: an overview
continued monetary stimulus it is feared that the economy might soon begin to show signs of weakness
and precipitate a correction on the financial markets. As a result, central banks have found themselves in
a position that requires extremely delicate management of monetary policy. According to The Atlantic:
Ever since Lehmangeddon, the Fed has been stuck in a brave, old monetary world where even zero interest
rates aren’t enough to jumpstart the economy. It’s a world that, outside of Japan, we haven’t seen since the
1930s. And one that the Fed has tried to find a way out of in fits and starts. By late 2012, it had settled
on a two-pronged strategy to do so: purchases and promises. The Fed purchased $85 billion of long-term
bonds a month with newly-printed money, and promised to keep rates at zero at least until unemployment
fell below 6.5 per cent or inflation rose above 2.5 per cent. But now these programs are winding down,
and we still haven’t gotten the catch-up growth that’s always a day (or 6–12 months) away.
In this sensitive and confusing climate, every announcement released by the Federal Reserve is heavily
scrutinised and sometimes the rhetoric can be more powerful than the Fed’s actions. During 2013,
talk of a wind-down in the stimulus led to falls in both the bond market and the stock market even
though the Federal Reserve continued to purchase bonds in substantial volumes and even though its
underlying inflation and unemployment targets remained unchanged. What makes the situation more
challenging is that the underlying economic situation remains under a cloud. According to The Atlantic,
the unemployment rate has fallen but new jobs have not been created. That is, the unemployment rate has
declined in part because people have given up looking for work and dropped out of the labour market.
In such an environment, the Federal Reserve’s promise to keep interest rates low until unemployment falls
below 6.5 per cent is ‘useless’.
With the Fed’s promises blunted, at least so far as they relate to the unemployment rate, a key plank of
the Fed’s rhetoric looks rather shaky. So shaky in fact that it might have to be supported by continued
purchases of government securities. But this is just the thing that the Fed wants to wind back.
SOURCE: Extract from Matthew O’Brien, ‘This is Janet Yellen’s Biggest Challenge’, The Atlantic, 14 February 2014.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Discussion points
•
Give a brief overview of challenges that face central banks seeking to wind down the economic
stimulus programs initiated during the GFC.
•
Discuss the consequences in terms of economic growth and the stability of financial markets of
(1) untimely removal of the stimulus, and (2) prolonged stimulus past the point at which it was
desirable or required.
•
To what extent do you think Australia’s central bank, the Reserve Bank of Australia, faces a
similar challenge?
Summary
LEARNING OBJECTIVE 1.1
Understand the effects and consequences of a financial crisis on a financial system and a real
economy
• The global financial crisis (GFC) had a significant effect on financial systems and the real economies
of many countries and highlighted the interconnectedness of the world’s financial markets.
• The interconnected global financial system traces its origins to the introduction of money and the
development of local markets to trade goods.
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31
Part 1 Financial institutions
• 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 in the provision of 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 policy holder, 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.
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• 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.
• 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.
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Chapter 1 A modern financial system: an overview
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 long-term assets should be
funded by long-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.
• 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.
Chapter one Review
LEARNING OBJECTIVE 1.4
• 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 inter-bank 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.
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• Within the money and capital markets there are also the wholesale markets (institutional investors)
and the retail markets.
• Money markets experienced significant liquidity problems during the GFC. The lingering effects of
the crisis and new concerns about the economic stability of many developed nation-states continue to
weigh on the financial 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.
• 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. The GFC highlighted the importance of maintaining stability in the financial system.
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33
Part 1 Financial institutions
Extended learning A
LEARNING OBJECTIVE 1.7
Appreciate the importance of globalisation of the international financial markets
Globalisation of the financial markets
A nation-state’s financial system is an integral part of the global financial system. An important
relationship exists between an efficient financial system and growth in the real economy within a nationstate. (This was discussed earlier in the chapter.) Similarly, as production and international trade between
multinational corporations and governments expanded, so too did the need for a global financial system
to support that expansion.
GLOBALISATION
the integration
of financial
institutions,
instruments and
markets into an
international
financial system
Essentially, globalisation refers to the process whereby financial markets are interconnected,
interdependent and integrated. The rapid development and adoption of technology-based information
systems, communication systems and product delivery systems has facilitated globalisation of the financial
markets and the standardisation of the financial instruments used in the global markets. At the same time,
technology has enabled the development of a whole new range of sophisticated financial instruments
that facilitate the movement of funds between surplus units and deficit units in different nation-states. New
markets in risk management products, in particular those using derivative products, have also evolved.
While the role of technology in the development of global financial markets is critical, it should be noted
that there are a number of other important factors and relationships that impact upon globalisation. These
include:
• Unrestricted movement of capital around the world. Theoretically, the global market will encourage
savings and allocate those savings efficiently to the most productive purposes without regard to
national boundaries.
• Deregulation of nation-state financial systems, including the removal of significant regulatory
constraints that restrict financial markets, products, participants and pricing.
• Financial innovation, to develop new systems, products and services.
• The need of corporations and governments to diversify their funding sources on a global scale.
• Increased competition between financial markets and institutions for the provision of financial products
and services.
• Exchange rate, interest rate and price volatility within the international markets and the associated
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increase in demand for risk management products.
• Changing demographic and savings patterns. For example, the ageing of populations of many
economies has resulted in the accumulation and mobilisation of greater levels of savings.
• The development of emerging markets, in particular, parts of Asia, South America and Eastern Europe.
MURRAY
REPORT
a committee
report,
Financial
System Inquiry
Interim Report,
Commonwealth
of Australia,
Canberra, July
2014 (www.fsi.
gov.au)
Rapid technological innovation and a more sophisticated business environment, together with longer-term
changes in the financial needs of market participants, are reshaping the financial system. A progressively
greater array of participants, products and distribution channels has developed (and will continue to
develop) the financial system. Competition is emerging from new providers of financial services and
through the increasing globalisation of financial markets. Nation-states are striving to achieve improved
market efficiency and performance.
To help understand the drivers for change in a modern financial system, it is beneficial to refer to the
interim report of an inquiry into the Australian financial system. The (interim) Murray Report, released
in 2014, considered the growing interconnectedness of the Australian financial system with the rest of
the world and identified a number of areas from which changes have stemmed in the years since the
previous financial system inquiry (Wallis’s 1997 Report). These are:
• growth and consolidation
• post-GFC regulatory responses
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Chapter 1 A modern financial system: an overview
• population dynamics.
Growth and consolidation
A primary driver of change over time is the growth in size of the financial system. In Australia, the
financial system has grown considerably over the past two decades. This has been especially evident in
the superannuation sector. Interestingly, there has also been considerable consolidation and an increase
in concentration in Australia’s banking sector over the same period of time. The key issues to emerge
from these changes include:
• competition
• distortions in funding flows
• efficiency of the superannuation system.
Although the interim Murray Report finds that competition is relatively strong, larger banks appear to
derive a number of competitive advantages over their smaller counterparts, including more sophisticated
risk-management systems and funding advantages. The large and growing superannuation system also
demonstrates little evidence of strong competition. Both fees and costs remain high. Over time, the
Australian superannuation system has come to be ‘feature rich’ but costly, with regulatory changes often
imposing costs that are passed onto investors.
Chapter one Review
• technology
Post-GFC regulatory responses
Regulation is often shaped by external events and innovation but regulation also plays a role in facilitating
and initiating change. The relationship between regulation and change in the financial sector is not a
straightforward or unidirectional one. In recent years, the GFC and the response of regulators has been
key in shaping the current and future financial system. Key issues to emerge from the regulatory response
to the GFC were identified in the interim Murray Report:
• stability
• consumer outcomes
• regulatory architecture.
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Overseas, government responses to the GFC included ‘bailing out’ troubled institutions. This has
contributed to the perception that some institutions are indeed ‘too big to fail’. Such a perception may
govern the way in which people behave. Reducing the perception that government support will always
be forthcoming in times of trouble is seen as an important challenge but one which promises to increase
the stability of the financial system by encouraging prudent behaviour.
Although higher-level or macro-level stability is an important objective, meeting the needs of
consumers remains a core purpose of the financial system. The Murray Report notes the increasing
involvement of consumers in the financial system over the past two decades, primarily as the result of
compulsory superannuation. Competition, innovation and regulation combine to enhance consumer
outcomes. The consumer protection framework requires periodic updating to ensure that consumers’
best interests are promoted. Strengthening this framework in certain key areas such as disclosure, the
affordability of financial advice, and effective and affordable insurance are areas that may require
attention. Any introduced changes take place in the context of Australia’s regulatory architecture,
which includes the Australian Prudential Regulation Authority (APRA), the Australian Securities and
Investments Commission (ASIC) and the Australian Competition and Consumer Commission (ACCC).
The coordination between these different regulators and their ability to attract talented staff represent
ongoing challenges.
Technology
Technology was identified as an important driver of change in previous financial system inquiries. It
remains the case in the 21st century. Technology brings both risks and benefits for consumers. The interim
Murray Report identifies a number of potential benefits, including increases in efficiency, increases in
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35
Part 1 Financial institutions
competition, better information and better products. The potential risks must be monitored. These include
the increasing involvement of technology and retail firms in the provision of financial services.
Although new participants and products can foster competition, regulators face the challenges associated
with assessing the applicability of existing regulatory frameworks to new firms and products. Similarly,
the amount of personal and financial information collected by firms participating in the retail, technology
and financial services space may have benefits for consumers if it is used to improve internal processes,
generate efficiencies and provide more accurate risk assessments. However, the misuse of this information
represents a risk to consumers. This might be heightened by the increasingly online nature of these
activities where the threat and potential impact of lapses in cyber-security has grown significantly over
the past 20 years.
Population dynamics
Like technology, demographic changes have been identified in previous financial system inquiries as
being important drivers of change. The interim Murray Report once again identifies retirement incomes
and ageing as core emerging trends in the financial sector. Although the accumulation phase of Australia’s
retirement income stream has been well served by compulsory superannuation, the retirement phase
represents substantial risks both to individual retirees and to the effectiveness of the superannuation
sector. Of particular concern is the management of risk during the retirement phase.
The GFC demonstrated the financial devastation that can be caused when a crisis coincides with retirement.
The development of products, strategies, advice and education that reduce the risks faced during the
retirement phase may have significant implications for the financial system and the broader economy,
especially if the reliance on the age pension can be mitigated. In an increasingly integrated financial
system characterised by more volatile financial markets, risk management at both the institutional and
individual level may have profound effects on the robustness with which a future crisis can be withstood.
The linkages between economic growth and a modern and efficient financial system have been well
established. As a nation-state’s economic performance becomes more tied to the international economy,
so too will the international financial system need to respond to those dynamic forces.
Extended learning B
LEARNING OBJECTIVE 1.8
Appreciate the effects, consequences and relevance of the Asian financial crisis
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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 has
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 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
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Chapter 1 A modern financial system: an overview
Chapter one Review
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:
• Excessive bank credit was available, which encouraged over-investment in industrial capacity (in
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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.
• 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.
MORAL
HAZARD
the taking of
excessive risk in
the belief that
losses will be
diminished by
regulation or
insurance
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.
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37
Part 1 Financial institutions
Table 1B.2 ​Interest rates and exchange rates during the crisis
Interest
rates—
overnight
rate peak
Interest rates—
three-month
rate peak
Stock market indices—
falls between 1 January
1997 and 4 February
1998
Exchange rate
depreciation*—low
between July 1997
and March 1998
Hong Kong
100.0
25.0
–22.5%
0
Taiwan
–11.5
–9.8
n.a.
–19.3
Indonesia
300.0
27.7
–76.9%
–84.3
South Korea
–27.2
25.0
–54.6%
–54.6
Malaysia
–50.0
–8.8
–65.3%
–46.3
Philippines
102.6
85.0
n.a.
–41.8
Singapore
–50.0
10.3
–46.9%
–21.0
Thailand
–27.4
26.0
–62.8%
–55.0
* Percentage change in the US dollar/local currency exchange rate since June 1997.
SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p. 136.
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.
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?
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• Has a country with similar economic characteristics recently experienced a currency crisis?
• 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.
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Chapter 1 A modern financial system: an overview
True/False questions
Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief
notes explaining your response.
1
The GFC was a ‘contained crisis’ and only affected a small number of financial institutions in the
United States.
2
The Eurozone crisis emerged first in countries such as Spain, Greece and Ireland, but quickly
spread northwards due to the interconnectedness of Europe’s financial institutions.
3
In Australia, the effects on the real economy of the GFC were offset by a large governmentfunded stimulus program.
4
Providing advice on mergers and acquisitions represents a significant part of the business
operations of depository financial institutions.
5
In Australia, the assets of financial institutions have gradually declined over time.
6
Monetary policy is the actions of a central bank that influence the level of interest rates in order
to achieve certain economic objectives.
7
A principal role of investment banks is to gather deposit savings from customers and provide
loans to their retail clients.
8
Finance companies are examples of contractual savings institutions.
9
The matching principle contends that short-term assets should be funded with equity.
Chapter one Review
Questions
10 Equity in a corporation represents an ownership position that is represented by the issue of
ordinary shares.
11 Debt differs from equity in that debt normally has a specified life and pays some form of return
to the debt holder.
12 A derivative contract is a hybrid security that incorporates the characteristics of both debt and
equity.
13 The issue of new shares by a corporation provides the firm with additional equity funding and is
an example of a primary market transaction.
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14 The issue of new money-market debt securities by a borrower is said to be a secondary market
transaction.
15 In a direct financial flow the surplus entity provides funds to the deficit entity and acquires a
primary claim from the user of the funds.
16 Three advantages of intermediated finance are asset transformation, liquidity transformation and
maturity transformation.
17 Money-market securities are exclusively debt instruments, and capital-market instruments are
exclusively equity securities.
18 Bills of exchange and promissory notes are discount securities that may be traded in the money
markets.
19 Borrowers in the international markets obtain long-term loans from the foreign exchange market.
20 The corporate sector borrows to fund business activities and therefore is typically a deficit sector
within the economy.
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39
Part 1 Financial institutions
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 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 1.1)
2
The GFC is now thought of as having had 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 1.1)
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 2013). 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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9
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)
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Chapter 1 A modern financial system: an overview
14 The evolution of domestic financial systems into an integrated global financial system has
occurred, and continues to occur, due to a number of specific factors. Identify and discuss the
factors that have influenced the development of the global financial system. (LO 1.7)
15 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
money markets 22
asset transformation ​20
eurozone crisis or sovereign
debt crisis 6
bills market ​25
Federal Reserve ​6
Murray Report 34
bonds ​16
finance companies and general
financiers ​11
negotiable certificate of
deposit ​25
financial instruments ​9
negotiable debt instrument ​15
financial system ​9
option contract ​15
fiscal policy ​29
flow of funds ​10
ordinary share or common
stock ​14
foreign exchange markets ​27
overdraft facility ​16
corporate debt markets ​26
forward contract ​15
portfolio structuring ​11
credit rating ​19
futures contract ​15
primary market transaction ​17
credit risk transformation ​21
global financial crisis (GFC) ​5
rate of return ​10
crowding out ​27
globalisation ​34
retail market ​22
dealer ​18
government debt ​27
return or yield ​10
debt instruments ​14
hybrid security ​14
risk 10
default risk ​19
inflation ​11
deficit units ​29
institutional investors ​23
secondary market
transaction ​17
depository financial
institutions ​11
inter-bank market 24
sectorial flow of funds 29
intermediated finance 19
secured debt ​14
derivative instrument ​15
investment banks 11
securities ​18
derivatives markets ​27
liability management 21
securitisation ​13
direct finance ​18
liquidation 14
sub-prime mortgages ​5
discount securities ​25
liquidity 10
surplus units ​10
dividend ​14
liquidity transformation 21
swap contract ​15
economies of scale ​22
matching principle 16
time-pattern of cash flows ​10
equity ​14
maturity transformation 21
unit trusts 11
equity markets ​26
monetary policy 11
wholesale market ​22
euromarket instruments ​27
money 17
asset portfolio ​10
broker ​18
capital markets ​25
commercial paper ​25
compulsory superannuation ​29
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contractual savings
institutions ​11
moral hazard ​37
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Chapter one Review
Extended learning questions
41
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
Basel II and Basel III
2.8
Liquidity management and other supervisory controls
Learning objectives
LO 2.1
LO 2.2
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LO 2.3
LO 2.4
LO 2.5
LO 2.6
LO 2.7
Evaluate the functions and activities of commercial banks within the financial system.
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.
Identify the main uses of funds by commercial banks, including personal and housing lending,
commercial lending, lending to government, and other bank assets.
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.
Consider the regulation and prudential supervision of banks.
Understand the background and application of Basel II and Basel III.
Examine liquidity management and other supervisory controls applied by APRA in the context of
Basel III.
Extended learning
LO 2.8
LO 2.9
LO 2.10
Understand the standardised approach to credit risk and compute the capital requirements for
particular transactions.
Analyse business continuity risk and construct an education and training framework for
operational risk management for commercial banks.
Discuss the importance of corporate governance and ethics in the context of Australian financial
institutions.
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Chapter 2 Commercial banks
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 per cent of the total assets of
financial institutions in Australia. Therefore, 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.
There is a direct correlation between the dominance of the commercial banks and the level of
regulation within a financial system. For example, prior to the mid-1980s there was a high degree of bank
regulation in most countries. At that time, a major purpose of bank regulation was to ensure that economic
objectives could be achieved by controlling the flow of funds within an economy. It was argued that as the
commercial banks controlled the largest amount of funds in the financial system, if the commercial banks
were controlled through regulation then economic objectives could effectively be targeted. However, the
extent of the regulation constrained the development of the commercial banks and led to a wide range of
new financial institutions evolving in competition with the commercial banks. Regulation resulted in a
reduction in the dominance of the commercial banks, and therefore, a reduction in the control of the flow
of funds in the financial system to achieve economic objectives. Governments at that time had two basic
options: either regulate all financial institutions or deregulate the commercial banks. The governments
of most major economies eventually decided to deregulate the commercial banks and this has resulted in
significant growth of the banking sector. Following the GFC, this deregulatory phase was criticised for
having contributed to the crisis. The financial system is dynamic and, over the years, the environment in
which the banks operate has experienced considerable change. We start our study of commercial banks
by looking at their main activities.
Reflection points
• Commercial banks are the main type of financial institution that operates within a financial
system.
• There is a direct correlation between the nature of commercial bank business, the relative size
Copyright © 2015. McGraw-Hill Education. All rights reserved.
of the banks and the level of bank regulation.
• The majority of developed economies have significantly reduced the level of bank regulation
and there has therefore been considerable growth in the commercial bank sector.
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-balancesheet 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
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LEARNING
OBJECTIVE
2.1
Evaluate the functions
and activities of
commercial banks
within the financial
system
43
Part 1 Financial institutions
ASSET MANAGEMENT
a bank restricts
growth in its lending
to the level of funds
available from its
depositor base
LIABILITY
MANAGEMENT
a bank actively
manages its sources
of funds (liabilities) in
order to meet future
loan demand (assets)
OFF-BALANCE-SHEET
BUSINESS
transactions that
represent a contingent
liability and therefore
are not recorded on
the balance sheet
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 practised. Because of regulation, the
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 and 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.
As mentioned above, 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. These types of business are
discussed later in the chapter.
We begin with an analysis of the commercial banks’ main sources of funds, and then examine how
the banks use those funds. This is followed by a detailed look at the off-balance-sheet business of the
commercial banks.
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.
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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
Sources of funds
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
bills acceptance liabilities
debt liabilities
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Chapter 2 Commercial banks
•
•
foreign currency liabilities
loan capital and shareholders’ equity.
2.2.1
Current 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 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.
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2.2.2
Call 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. They may take the form of the
traditional passbook account, whereby the depositor holds a physical passbook that provides a record
of all transactions and funds held. More probably, the savings account will be an electronic statement
account, whereby the bank will record transactions and periodically forward a statement to the depositor.
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
CURRENT ACCOUNT
DEPOSITS
liquid funds held in
a cheque account;
cheques drawn to
purchase goods and
services
CALL DEPOSITS
funds held in a savings
account that can be
withdrawn on demand
Term 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
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TERM DEPOSITS
funds lodged in
an account for a
predetermined period
and at a specified
fixed interest rate
45
Part 1 Financial institutions
in the financial markets, especially when the stock markets are more volatile, investors tend to revert to
the safe haven of the bank term deposit.
2.2.4
CERTIFICATE OF
DEPOSIT
a short-term discount
security issued by
a bank; face value
repayable at maturity
NEGOTIABLE
SECURITY
a financial instrument
that can easily be sold
into a deep and liquid
secondary market
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 range 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.
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.
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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
Negotiable certificates of deposit
Bill 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.
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Chapter 2 Commercial banks
2.2.6
Debt 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 longerterm 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.
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.
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2.2.7
​Foreign 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
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 borrower
defaults, the lender
will take possession of
the borrower’s assets
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
Loan 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 retained as
additional shareholders’ funds. Equity is an important source of long-term funds for the commercial
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LOAN CAPITAL
sources of funds
that have the
characteristics of both
debt and equity
47
Part 1 Financial institutions
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.
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.
• 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
long-term funding.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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
Uses of funds
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
Personal 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
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Chapter 2 Commercial banks
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 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. 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, for example 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, for example 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.
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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
MORTGAGE
ORIGINATORS
specialist mortgage
lenders that typically
refinance their lending
through securitisation
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
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
49
Part 1 Financial institutions
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 bills over a
specified period as
existing bills 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
Commercial 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. 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 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.
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Chapter 2 Commercial banks
2.3.3
Lending 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
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 lowerrisk 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).
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
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.
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2.3.4
Other 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, 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
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51
Part 1 Financial institutions
•
•
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.
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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-raterelated contracts
Off-balance-sheet business
The focus of the discussion above 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.
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.
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Chapter 2 Commercial banks
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
Direct 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
Trade- 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:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
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.
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
TRADE- AND
PERFORMANCERELATED ITEM
an undertaking
provided by a bank
to a third party
promising payment
under the terms of a
specified commercial
contract
​Commitments
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.
Examples of commitments include:
•
DIRECT CREDIT
SUBSTITUTE
an undertaking
provided by a bank to
support the financial
obligations of a client
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.
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COMMITMENTS
the contractual
financial obligations
of a bank that are yet
to be completed or
delivered
53
Part 1 Financial institutions
•
•
•
•
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
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:
•
•
•
•
•
•
Copyright © 2015. McGraw-Hill Education. All rights reserved.
F​ oreign exchange contracts, interest rate contracts and
other market-rate-related contracts
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
Volume 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 September 2013 stood at
$23 048 211 (million). This compares with a December 2010 figure of $14 855 593 (million). In September
2013, the total value of banks’ assets stood at $3 129 935 (million). That is, the notional value of offbalance-sheet business is over seven times the value of total assets held by the banks. As described in
Part 6, the notional value of many derivative products is significantly greater than the actual associated
cash flows. Comparing the notional value of derivatives with the value of balance-sheet assets does
overstate the relationship.
The second characteristic of the off-balance-sheet business is that it is mainly market-rate-related
contracts. The notional values of the various types of off-balance-sheet business are shown in Table 2.1.
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Chapter 2 Commercial banks
Table 2.1 Bank off-balance-sheet business, Australia, as at September 2013
Off-balance-sheet business type
Notional amount ($ millions)
Direct credit substitutes
41 021
Trade- and performance-related items
62 302
Commitments
Interest rate contracts
870 502
16 392 105
Foreign exchange contracts
289 900
Credit derivatives
141 155
Other
297 220
Total
23 048 211
SOURCE: Reserve Bank of Australia, 2013.
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.
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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
non-financial obligations; for example, a bank will execute a documentary letter of credit to
finance the importation of goods from overseas.
• 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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55
Part 1 Financial institutions
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
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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 has 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. Financial institutions that had argued so strenuously for
a relaxation in banking regulations in the two decades before the crisis failed to demonstrate an ability
to regulate their own activities in the absence of government regulatory intervention. Because financial
institutions do not keep reserves that exactly match their liabilities, the danger of some type of a ‘bank
run’ is ever-present in the financial system.
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 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 higher-risk
lending strategies to support their activities with higher amounts of capital or shareholders’ funds. The
main features of the current system, designed to encourage prudent lending behaviour by the banks, are
outlined below.
Financial systems have evolved principally in response to regulatory change. 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 Law supervision.
By way of example, Australia has implemented a regulatory structure with the following features.
AUTHORISED DEPOSITTAKING INSTITUTIONS
financial institutions
authorised by APRA to
accept retail deposits
in Australia
•
•
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).
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).
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Chapter 2 Commercial banks
•
•
Regulation and supervision of market integrity and consumer protection, within the context of the
Corporations Law, is the responsibility of the Australian Securities and Investments Commission
(ASIC).
Matters of competition policy (Trade Practices Act) 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, for example 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 government supported deposit
insurance. For example, limited deposit insurance has been provided in the USA for many years. This
played a major role in preventing bank runs for a very long period of time. Deposit insurance, in the
form of a Financial Claims Scheme (FCS), was introduced in Australia in October 2008 during the GFC.
Deposits of up to $1 million in eligible ADIs were guaranteed by the Australian government. Following a
review in late 2011, a new permanent cap of $250 000 per person per institution to be covered under the
FCS came into effect in early 2012. More details are available at www.apra.gov.au.
In order to ensure that banks have sufficient strength in their balance sheets, bank regulators require
commercial banks to source a minimum percentage of their funds from certain forms of capital. This
prudential standard is known as the ‘capital adequacy requirement’.
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.
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• The GFC highlighted the importance of effective regulatory frameworks.
• 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 Corporations Law.
• Government guarantees may be provided for certain bank deposits.
• A principal international standard applied to commercial banks is the capital adequacy
requirement. This standard is designed to ensure that banks have sufficient capital to meet their
obligations.
2.6
A background to the capital adequacy
standards
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 relevant accounting period. However, if loan losses increase
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LEARNING
OBJECTIVE
2.6
Understand the
background and
application of Basel II
and Basel III
57
Part 1 Financial institutions
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:
•
•
•
•
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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 2008, 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 proposed enhancements to the quantity and quality of banks’ capital reserves, liquidity ratios and
leverage ratios. Basel III will be fully implemented by 2018.
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.
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Chapter 2 Commercial banks
• 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; the Basel II capital accord had been implemented in most countries.
• The Basel III capital accord introduces enhanced capital requirements. Following APRA’s
finalisation of the nature of Basel III adoption within Australia, the new regime will be
implemented by the end of 2018.
2.7
Basel II and 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 standard. The main components of
Basel II were adopted by those countries that have financial institutions operating in the global financial
markets; however, there are often minor variations in the detail of each country’s application of the
accord. In this text we will look at the application of Basel II and Basel III in Australia by APRA. While our
study of capital adequacy is quite comprehensive, the relevant prudential standards run into hundreds
of pages. You can view updates on Basel III as well as the full Basel II prudential standards at www.apra.
gov.au.
2.7.1
LEARNING
OBJECTIVE
2.6
Understand the
background and
application of Basel II
and 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
Minimum capital adequacy requirement
Minimum capital adequacy requirements apply to commercial banks and any other institutions specified
by a country’s prudential regulator. Australian Prudential Standard APS 111 states that for capital
adequacy purposes authorised deposit-taking institutions (commercial banks) must hold a minimum
amount of Tier 1 capital and capital base on both an individual institution (Level 1) basis and consolidated
banking group (Level 2) basis. In addition, they may include an amount of Tier 2 capital as part of their
required capital holdings, up to the limits specified in the prudential standard.
The prudential standard requires an institution, at a minimum, to maintain a risk-based capital
ratio of 8.00 per cent of total-risk-weighted assets at all times. Basel II required that at least half of
the risk-based capital ratio must take the form of Tier 1 capital; that is, at least 4.00 per cent. The
remainder of the capital requirement could be held as Upper Tier 2 and Lower Tier 2 capital. After the
GFC, Australian banks acted to strengthen their capital ratios. As a result, their holdings of Tier 1 capital
rose to approximately 10.00 per cent and their total capital ratios (including Tier 1 and Tier 2 capital) to
approximately 12.00 per cent. This position is relatively strong but still serves to highlight the leverage
inherent in the banking system.
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59
Part 1 Financial institutions
2.7.2
TIER 1 CAPITAL
highest quality; core
capital for capital
adequacy purposes
TIER 2 CAPITAL
(UPPER)
specified acceptable
capital adequacy
instruments, including
hybrids, of a
permanent nature
TIER 2 CAPITAL
(LOWER)
specified acceptable
capital adequacy
instruments that are
not permanent
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PILLAR 1
incorporates
components of credit
risk, operational risk
and market risk within
the Basel II capital
accord
STANDARDISED
APPROACH TO CREDIT
RISK
provides risk weights
to be applied to
balance-sheet assets
and off-balance-sheet
items to calculate
minimum capital
requirement
CURRENT EXPOSURE
METHOD
off-balance-sheet
capital calculation
based on the current
and potential credit
exposures mark-tomarket
ORIGINAL EXPOSURE
METHOD
off-balance-sheet
capital calculation
based on the notional
contract value
multiplied by a credit
conversion factor
The definition of capital
Capital, within the context of both Basel II and Basel III, is measured in two tiers, Tier 1 and Tier 2 capital.
Tier 1 capital, or core capital, consists of the highest quality capital elements that fully satisfy all
the essential capital characteristics:
•
•
•
•
They provide a permanent and unrestricted commitment of funds.
They are freely available to absorb losses.
They do not impose any unavoidable servicing charge against earnings.
They rank behind the claims of depositors and other creditors in the event of winding-up.
Tier 1 capital must comprise at least half of a bank’s minimum required capital base.
Tier 2, or supplementary, capital includes other elements which, to varying degrees, fall short of the
quality of Tier 1 capital, but nonetheless contribute to the overall strength of an institution as a going
concern. Tier 2 capital is divided into two parts:
•
•
Upper Tier 2 capital, which consists of elements that are essentially permanent in nature, including
some hybrid capital instruments.
Lower Tier 2 capital, which consists of instruments that are not permanent—that is, dated or
limited-life instruments.
The different types of Tier 1 and Tier 2 capital are shown in Table 2.2. More detailed information is
available at the internet sites of bank supervisors (e.g. www.apra.gov.au). A number of bank supervisor
internet addresses are provided at the front of the book.
2.7.3
Basel II structural framework
The Basel II capital accord framework is shown in Figure 2.1 and is based on three integrated pillars:
•
•
•
Pillar 1: the capital adequacy minimum requirements
Pillar 2: the supervisory review of capital adequacy
Pillar 3: the market discipline, incorporating disclosure and transparency requirements.
Pillar 1: Credit risk component
As shown in Figure 2.1, 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. Basel II applies a range of risk weightings based on the counterparty to an asset or offbalance-sheet transaction. If an asset is secured by eligible collateral or certain forms of guarantee, it is
risk-weighted according to the risk weight appropriate to the counterparty to that collateral or guarantee.
Basel II provides three alternative ways for a bank to measure credit risk:
1
the standardised approach
2
the foundation internal ratings-based approach (FIRB)
3
the advanced internal ratings-based approach (AIRB)
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. Extended Learning A provides
an example of the calculations involved. 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
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Chapter 2 Commercial banks
Table 2.2 Basel II—regulatory capital(a)
Tier 1 (core capital)(b)
Paid-up ordinary shares
General reserves (excluding any general reserve for credit losses which is included in Upper Tier 2 capital)
Retained earnings
Current year’s earnings
Foreign currency translation reserve
Capital profits reserve (representing realised gains on the disposal of revalued assets that have not been
transferred from asset revaluation reserves to retained earnings)
Minority interests arising from consolidation of Tier 1 capital of subsidiaries (only for Level 2
calculations)
Non-innovative residual Tier 1 capital—comprising perpetual non-cumulative preference shares that
satisfy relevant criteria listed in APS 111
Innovative Tier 1 capital—comprising all other residual Tier 1 capital instruments that satisfy relevant
criteria listed in APS 111
Tier 2 (supplementary capital)(c)
Upper Tier 2 capital
Perpetual cumulative preference shares
Perpetual cumulative mandatory convertible notes
Perpetual cumulative subordinated debt
Any capital amounts otherwise meeting APRA’s requirements for Tier 1 capital instruments that are
ineligible for inclusion as Tier 1 capital as a result of the limits in this Prudential Standard
Any other hybrid capital instruments of a permanent nature approved, in writing, by APRA
Shares issued from 1 January 1992 by way of a fully paid bonus issue arising from capitalisation of
property revaluation reserves
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A general reserve for credit losses (refer to Prudential Standard APS 220 Credit Quality)
45 per cent of pre-tax revaluation reserves for property (readily available for sale), readily marketable
securities and investments in securities
45 per cent of the post-acquisition reserves of associates, for example the share of undistributed profits,
plus any share of asset revaluations in associates
Lower Tier 2 capital
Term subordinated debt
Limited-life redeemable preference shares
Any other similar limited-life capital instruments approved, in writing, by APRA
SOURCE: APRA, Prudential Standard APS 111 Capital Adequacy: Measurement of Capital, January 2008 (www.apra.
gov.au).
(a)
The capital allocations in this table are those issued by the Australian regulator (APRA). Other nation-state regulators may
vary the allocation of Tier 1 and Tier 2 capital.
(b)
Refer to Australian Prudential Standard APS 111 issued by APRA for a detailed explanation of each component.
(c)
Refer to Australian Prudential Standard APS 111 issued by APRA for a detailed explanation of each component.
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61
Part 1 Financial institutions
Figure 2.1 Overview of Basel II capital accord framework
Basel II capital accord
Pillar 1:
Capital
adequacy
Pillar 2:
Supervisory
review
Pillar 3:
Market
discipline
Standardised
approach
Credit risk
Foundation internal ratings-based approach
Internal ratingsbased approach
Advanced internal ratings-based approach
Standardised
approach
Operational risk
Advanced
measurement
approach
Standardised
approach
Market risk
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Internal model
approach (VaR)
MARK-TO-MARKET
the revaluation of a
contract based on its
current quoted price
on an exchange
INTERNAL RATINGSBASED APPROACH
TO CREDIT RISK
for capital calculations
a bank may use some
or all of its own risk
measurement model
factors; supervisor
approval required
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, in particular those that operate in the international capital markets, will
generally apply to the supervisor to use the internal ratings-based approach to credit risk (see
Figure 2.1). These banks have the information systems and expertise that enable a more sophisticated
approach to the measurement and management of risk. A commercial bank that receives approval from
the supervisor to use the internal ratings-based approach to credit risk may rely on its own internal
estimates of some or all of the necessary credit risk components in determining the regulatory capital
requirement for credit exposures.
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Chapter 2 Commercial banks
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, being 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.
The internal ratings-based approach requires institutions to categorise their banking book exposures
into six broad asset classes: corporate, sovereign, bank, retail, equity and a residual class.
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 on 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 operations. The
direct and consequential operational and financial losses associated with that disaster were significant.
The Bank for International Settlements categorises operational risk as:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
•
•
OPERATIONAL RISKS
exposures that may
impact on the normal
day-to-day business
functions of an
organisation
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.
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
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63
Part 1 Financial institutions
BUSINESS
CONTINUITY
MANAGEMENT
maintenance of
strategies to ensure the
continuance of critical
business functions
by operational and financial imperatives that limited the development of risk management objectives,
policies and practice. 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 nonexistent 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 Basel II capital accord (Figure 2.1).
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
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 II requires banks to hold additional capital to support their exposure to operational risk. In
order to calculate the amount of capital needed, banks may use the standardised approach or may apply
to the regulator to use an advanced measurement approach. This section considers the standardised
approach.
In the standardised approach to operational risk an institution is required to map its activities and
divide them into two areas of business: retail/commercial banking, and all other activity.
An institution must document its mapping process, detailing the policy and procedures used to map
the full range of business activities. This process must be subject to independent review.
The operational risk capital requirement for the retail/commercial banking area of business is
determined using a proportion of an institution’s total gross outstanding loans and advances as an
indicator of that area’s operational risk exposure. This also includes the book value of securities held in
the banking book.
The operational risk capital requirement for the ‘all other activity’ area of business is determined
using a proportion of an institution’s net income as an indicator of that area’s operational risk exposure.
Net income is defined as profit from ordinary activities before goodwill, amortisation and income tax.
The operational risk capital requirement for the retail/commercial banking area of business is
calculated by:
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•
•
•
taking the last six half-yearly observations of total gross outstanding loans and advances,
multiplying a proportion (being 3.5 per cent of total gross outstanding loans and advances at each
observation point) by a factor of 15 per cent, to produce a result in respect of each observation, and
determining an average result for the six observations.
The operational risk capital requirement for the ‘all other activity’ area of business is calculated by:
•
•
•
taking the last six half-yearly observations of net income earned over a six-month period
multiplying net income at each observation point by a factor of 18 per cent to produce a result in
respect of each observation
determining an average result for the six observations.
The total operational risk capital requirement under the standardised approach to operational risk is
the sum of the two average results determined above.
Pillar 1: Market risk component
Market risk is the third component of Pillar 1 shown in Figure 2.1 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.
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Chapter 2 Commercial banks
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. Market risk capital must be held 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 a choice of two approaches to calculate their market risk capital requirements: the
internal model approach and the standardised approach. The internal model approach is considered here.
In order to adopt the internal model approach to measure the market risk capital requirement, a
commercial bank must obtain approval from the prudential supervisor. The bank must demonstrate the
quality, integrity and robustness of its internal model.
An internal model is required to 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 regulator. 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.
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 issuerspecific factors
VALUE AT RISK (VaR)
a statistical probability
model that measures
financial risk
exposures based on
historic observations
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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 quarterly.
The regulator requires a model to apply a 99 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 offbalance-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:
•
•
•
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 per cent probability of a certain dollar amount loss.
BASIS POINTs
interest rates; 100
basis points equal
1 per cent
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.
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65
Part 1 Financial institutions
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.
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).
Pillar 2: Supervisory review of capital adequacy
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As shown in Figure 2.1, the supervisory review process forms the second pillar of the Basel II capital accord.
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.
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:
•
•
•
•
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, for example 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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Chapter 2 Commercial banks
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:
•
•
•
•
•
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•
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, for example 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 in the Basel II capital accord (Figure 2.1). 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.
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.
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67
Part 1 Financial institutions
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.
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, plus 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 II 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.
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2.7.4
​Basel iii
Basel II forms the foundation for Basel III, which strengthens the three pillars of Basel II. The most
important changes to the ‘three pillars’ are concerned with enhancing the capital requirements (the first
pillar of Basel II). Basel III introduces a new minimum Tier 1 capital requirement of 6.00 per cent, up from
4.00 per cent. Within Tier 1, Basel III introduces a new common equity Tier 1 requirement (CET1) that sets
a minimum of 4.50 per cent as the proportion of Tier 1 that must be common equity, the highest quality
form of capital. In effect, CET1 will be set at a minimum of 7.00 per cent because Basel III also introduces
an additional ‘capital conservation buffer’ of 2.50 per cent, which must consist of common equity.
Basel III further strengthens the first pillar of Basel II by introducing two new 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 NSFR will take longer to implement and is not
expected to take effect until 2018 after a lengthy monitoring period has been completed.
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 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 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 II’s standardised approach to credit risk.
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Chapter 2 Commercial banks
HQLA2 assets, which cannot exceed 40 per cent of a bank’s total HQLA holdings, may comprise
marketable securities representing claims on or by sovereigns, quasi-sovereigns, central banks
and multilateral development banks, which are assigned a 20 per cent risk weight under the Basel II
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. For more, see APRA’s Implementing Basel III Liquidity
Reforms in Australia (2013).
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 it. 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 of 8.00 per cent, of which, under Basel
III, at least 6.00 per cent must be Tier 1 capital; the remainder may be Upper or Lower Tier 2
capital.
• The Basel II capital accord comprises three integrated pillars:
— Pillar 1: the capital adequacy minimum requirements
— 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
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and systems or external events (e.g. the failure of the computer system, employee fraud or
a major fire). Basel II requires banks to hold additional capital to support their exposure to
operational risk.
• The standardised approach to operational risk requires a bank to map its activities and divide
them into two areas: retail/commercial banking and all other activity. Calculations are applied
to these two areas to determine the operational risk capital requirement.
• 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 typically will use an internal value-at-risk (VaR) model to measure their
market risk requirement.
• VaR models estimate potential gains or losses that may be incurred on a portfolio over a
10-day holding period, based on a 99 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.
continued
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69
Part 1 Financial institutions
continued
• 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 is an enhancement of Basel II that introduces stricter capital requirements and
enhanced liquidity requirements, including the Liquidity Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR).
2.8
LEARNING
OBJECTIVE
2.7
Examine liquidity
management and
other supervisory
controls applied by
APRA in the context of
Basel III
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LIQUIDITY
access to cash and
other sources of
funds to meet dayto-day expenses and
commitments
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
​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. As we have seen, Basel III introduces two
new liquidity standards that aim 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.
The Australian supervisor, 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.
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Chapter 2 Commercial banks
APRA states that a liquidity management strategy must include the following elements:
•
•
•
•
•
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.
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.
APRA stipulates two scenarios that must be addressed:
1
The going concern. This refers to the normal behaviour of cash flows in the ordinary course of business.
A bank must be able to specify how its liquidity obligations and commitments are to be met on a
­day-to-day basis over at least the next 30 days.
2
The name crisis. This refers to the behaviour of cash flows in adverse operating circumstances. A bank
must be able to demonstrate that it is able to obtain access to sufficient liquidity to keep operating
during the crisis situation for at least five business days.
CONTINGENCY PLAN
a set of predetermined
strategies to be
implemented if a
designated event
occurs
A commercial bank that is exempted, or inadequately carries out scenario analysis, is required to
maintain a minimum holding of 9 per cent of its liabilities in highly liquid assets such as cash and moneymarket securities approved by APRA.
The current liquidity standard places great emphasis on a bank’s own internal management
practices for managing liquidity. Banks are now able to adopt a range of strategies to manage liquidity,
including:
•
•
•
•
•
•
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•
•
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.
APRA will, if it has concerns about a particular bank’s liquidity management strategy, require the bank
to hold a specified minimum level of liquid assets as deemed necessary. As we have seen, Basel III introduces
additional liquidity requirements and governance and oversight responsibilities for bank boards. The
qualitative or governance related aspects of these reforms are incorporated into APRA’s APS 210.
2.8.1
​Other 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
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71
Part 1 Financial institutions
•
•
•
•
•
•
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•
NON-EXECUTIVE
BOARD MEMBERS
board members who
are not part of the
management of a
corporation or its
subsidiaries
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 II and Basel III, bank
supervisors now 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 per cent of the group’s capital base to an individual client or client group. Further capital
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 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.
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, for example 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.
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Chapter 2 Commercial banks
• 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.
Financial news case study
In Chapter 2, the latest addition to the Basel accords, Basel III, was discussed. Although the new Basel
III capital adequacy requirements will be implemented very gradually, changes to capital adequacy
can have a significant impact on financial institutions. Australian banks weathered the global financial
crisis and have tended to maintain capital ratios in excess of those required by Basel II. They should be
well placed to make a smooth transition to Basel III. Elsewhere around the world, financial institutions
confront more difficult challenges, particularly as they recover from the lingering effects of the GFC
and the sovereign debt crisis. Interestingly, the approach that banks have taken has been different
in different countries. In Europe, banks have taken steps to raise cash in the form of equity capital to
strengthen their balance sheets. In America, leverage ratios remain relatively high. According to the
Financial Times:
Deutsche Bank recently completed a €2.96bn accelerated issue of new shares, fellow German lender
Commerzbank in March said it would raise €2.5bn and Greek banks are on the road to raise as much
as they can from commercial investors to plug a €21.7bn equity shortfall.
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This appears to be due to pressure to comply with Basel III sooner rather than later. Even though regulators
will not require full compliance, capital markets and investors have signalled strongly that healthy capital
ratios are desirable. For example, Deutsche Bank’s share price increased by 6 per cent on the day that
its latest equity capital raising was announced. Ordinarily, equity capital raisings dilute the ownership
share of the existing shareholders and may be expected to depress rather than inflate the share price –
particularly in the current environment where banks’ share prices are depressed. Raising capital at such
low equity prices is a very expensive exercise. Nevertheless, the push for strong capital ratios dominates
the other considerations. Importantly, though, the contrast between Europe and America on this point is
stark. According to the Financial Times:
It is a very different story in the US, where bank investors have been pressuring the likes of JPMorgan,
Goldman Sachs and Citigroup to return capital to shareholders through higher dividends and share
buybacks. Four of the best capitalised large global banks are now European – UBS, BNP Paribas, HSBC
and, post-capital raising, Deutsche Bank – while only one, Morgan Stanley, is a US group. [However]
Analysts at Citi note that there is a persistent north-south divide across the region. While Nordic lenders
boast Basel III core tier one ratios of up to 17 per cent, even the strongest Spanish banks are on 8 per
cent or less.
Succumbing to the market’s demands for strong capital ratios does not necessarily mean that banks need
to raise additional capital by selling shares and diluting the ownership shares of existing shareholders.
Banks in both the UK and Europe have begun raising capital by other means, including sales of convertible
debt. Other banks have raised capital by issuing dividends in the form of shares rather than cash. Others
have simply raised cash by selling off assets.
Basel III is a common thread that explains many of the capital raisings being undertaken by banks
around the world. It is clear, however, that whatever the regulatory pressure may be, pressure stemming
from the markets exerts a strong influence over bankers’ decisions. In America, where investors appear
to have different preferences, leverage ratios remain high.
SOURCE: Extract from Patrick Jenkins and Daniel Schafer, ‘Europe’s Banks Turn to Capital Raising to Meet Basel III’,
Financial Times, 13 May 2013.
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73
Part 1 Financial institutions
Discussion points
•
Outline the steps that European banks have taken in order to comply with Basel III.
•
Explore some of the reasons for the north-south divide mentioned in the article.
•
Describe the challenges that confront banks trying to balance capital requirements against
investor demands for increased dividends and share buybacks.
•
Compare and contrast the preparedness and preparations for Basel III in Europe, North America
and Australia.
Summary
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.
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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
• 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, bills 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.
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Chapter 2 Commercial banks
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.
Chapter two Review
• The use of funds is represented as assets on a bank’s balance sheet.
• Bank lending is categorised as personal and housing lending, commercial lending and lending to
• 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 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
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particular, central banks and prudential supervisors are responsible for the maintenance of financial
system stability and the soundness of the payments system.
LEARNING OBJECTIVE 2.6
Understand the background and application of Basel II and 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.
• Under Basel II banks were required to maintain a minimum risk-based capital ratio of 8.00 per cent.
Basel III increased the amount of Tier 1 capital that must be included in a bank’s capital ratio.
• Basel III enhances the capital requirements of Basel II and introduces additional liquidity
requirements. In particular, banks will be required to maintain a ratio of High Quality Liquid
Assets (HQLA) to net cash outflows per month of at least 100 per cent. This is called the Liquidity
Coverage Ratio (LCR).
• Capital is categorised as either Tier 1 capital, Upper Tier 2 capital or Lower Tier 2 capital. Under
Basel III, at least 6.00 per cent of a bank’s 8.00 per cent risk-based capital requirement must be held
in Tier 1 capital. This has been increased from 4.00 per cent under Basel II.
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Part 1 Financial institutions
• As part of the calculation process, risk weights are applied to balance-sheet assets using specified
risk weights. These weights may be based on the counterparty to an asset, or on an external rating
provided by an approved credit rating agency.
• Off-balance-sheet items are converted to a balance-sheet equivalent using credit conversion factors
before applying the specified risk weights.
• The Basel II capital accord comprises three pillars, which are enhanced under Basel III.
• Pillar 1 relates to the calculation of the minimum capital requirement. Pillar 1 considers three areas
of risk: credit risk, operational risk and market risk. Within each of these risk categories banks have
a choice of applying a standardised approach or an internal approach to measuring their capital
requirement. Subject to approval from the bank supervisor, an internal approach method allows a
bank to use its own risk management models.
• Pillar 2 provides for a supervisory review process and includes four basic principles: (1) the assessment
of total capital requirements by a bank, (2) the review of capital levels and the monitoring of banks’
compliance by supervisors, (3) the ability of a supervisor to increase the capital requirement of a
bank, and (4) the intervention of a supervisor at an early stage to maintain capital levels.
• Pillar 3 seeks to achieve market discipline through a process of transparency and disclosure. Banks
are required to provide information and data on a periodic basis to the supervisor. Some of these
reports may be made public.
LEARNING OBJECTIVE 2.7
Examine liquidity management and other supervisory controls applied by APRA in the context of
Basel III
• The 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
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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 off-balancesheet 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 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).
Basel II applies six external rating grades to these published credit ratings (see Table 2.3).
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Chapter 2 Commercial banks
External rating
grade
Standard & Poor’s
Corporation
Moody’s
Investors Service
Fitch Ratings
1
AAA
AA+
AA
AA−
Aaa
Aa1
Aa2
Aa3
AAA
AA+
AA
AA−
2
A+
A
A−
A1
A2
A3
A+
A
A−
3
BBB+
BBB
BBB−
Baa1
Baa2
Baa3
BBB+
BBB
BBB−
4
BB+
BB
BB−
Ba1
Ba2
Ba3
BB+
BB
BB−
5
B+
B
B−
B1
B2
B3
B+
B
B−
6
CCC+
CCC
CCC−
CC
C
D
Caa1
Caa2
Caa3
Ca
C
CCC+
CCC
CCC−
CC
C
D
Chapter two Review
Table 2.3 ​Basel II standardised approach: external long-term rating grades
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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 2.3) will need to use the relevant risk weight:
External rating grade
Risk weight
1
20%
2
50%
3, 4
100%
5, 6
150%
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.
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77
Part 1 Financial institutions
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.
Loan-tovaluation
ratio
the percentage
ratio of a loan
to the bank’s
valuation of the
property being
mortgaged
Risk weights specified by the regulator may range from zero to 400 per cent.
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 2.4, the risk weight is 50 per cent with no
mortgage insurance or 35 per cent with at least 40 per cent of the mortgage insured.
Table 2.4 Risk weights for standard residential mortgages
Loan-to-valuation
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%
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 Basel II risk 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.
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The Basel II capital accord also requires banks to hold capital to support their off-balance-sheet
transactions. 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:
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 market-related
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 Basel II risk weights applied by the Australian bank
supervisor, 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 per cent and that the external rating grade 5
represents a risk weight of 150 per cent. The capital required by the bank to support this off-balancesheet transaction is $1 million × 0.20 × 1.50 × 0.08 = $24 000.
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Chapter 2 Commercial banks
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
Chapter two Review
Extended learning B
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 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.
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• 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 backup
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.
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Part 1 Financial institutions
• 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. Media liaison personnel will
establish communications with bank supervisors, government authorities, the press, customers and
other market participants.
• Implementation of prioritised business recovery. Backup 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.
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• 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.
Three business continuity risk management education and training programs have been developed:
1
Induction/awareness program
2
Contingency planning program
3
Executive program
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Chapter 2 Commercial banks
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.
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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.
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.
Chapter two Review
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.
Program 2: Contingency planning
Although all bank personnel must incorporate business continuity risk management into their day-to-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 in 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
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81
Part 1 Financial institutions
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,
backup 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.
Program 3: Executive program
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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.
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Chapter 2 Commercial banks
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.
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
Chapter two Review
6
• 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.
Figure 2A.1 An education and training framework for disaster risk
management for banks
Program 1
Business continuity
risk management:
Induction/awareness
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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
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83
Part 1 Financial institutions
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 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 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.
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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.
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
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Chapter 2 Commercial banks
Most Australian companies now have something to say on their websites about ethics and corporate
governance. For ADIs, it is usually possible to find an outline of the company’s corporate governance
framework. For example, consider the Commonwealth Bank of Australia (CBA). CBA has developed a
corporate governance framework that is designed to ‘properly balance performance and conformance
and thereby allow CBA to undertake, in an effective manner, the prudent risk-taking activities which are
the basis of its business’. CBA complies with the ASX principles and recommendations on corporate
governance in setting down a corporate governance framework designed to ensure the Board can
effectively undertake its roles and responsibilities. The framework encompasses board composition,
education, independence, remuneration and auditing.
As we can see, corporate governance involves frameworks for the management of the company that, we
hope, will be undertaken in an ethical manner. Companies place a good deal of emphasis on ethics and
ethical behaviour within their organisations and statements on ethics can be found on many companies’
websites. CBA has approached this issue by developing a Statement of Professional Practice for its
employees. Employees are expected to comply with certain expectations regarding professionalism,
honesty, common sense and fairness. These encompass matters such as confidentiality, equal opportunity
and conflicts of interest. Together with good corporate governance frameworks, the ethical behaviour of
all employees is of the utmost importance to a financial institution. When there is crisis or scandal the
reputations of the individuals and the organisation can suffer markedly. Reputation is a very valuable
asset for a financial institution. Corporate governance and ethics frameworks are important components
in maintaining the value of this asset.
Chapter two Review
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.
Questions
True/False questions
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Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief
notes explaining your response.
1
The Basel III capital adequacy requirements strengthen and extend the Basel II capital accord.
2
Term deposits are unlikely to be viewed as attractive investments during times of volatility in the
financial markets.
3
Banks’ off-balance-sheet activities have continued to show strong growth in recent years.
4
Bank runs are always a possibility in a financial system that does not require banks to hold an
amount of reserves that is equal to the amount of deposits.
5
There are no government guarantees on bank deposits in Australia.
6
The LCR and the HQLA are two key components of the new liquidity standards introduced as
part of changes associated with the introduction of Basel III.
7
A negotiable certificate of deposit is a discount security that may be issued into the money
markets.
8
One of the attractions for a bank of funding a client through a bank bill facility is that the security
can be sold into the money markets.
9
A bank may seek to obtain funds by issuing unsecured notes with a collateralised charge over
the assets of the institution.
10 Bank regulators restrict the type and amount of securities that commercial banks can issue into
the international capital markets.
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Part 1 Financial institutions
11 Mortgage originators often use the process of securitisation to finance their housing lending
activities.
12 A housing loan with an amortised loan requires the borrower to make periodic interest-only
instalments and repay the principal at the maturity date.
13 Small- to medium-sized businesses mainly borrow direct from the capital markets, while large
corporations with good credit ratings prefer to borrow from the banks.
14 A reference interest rate such as the BBSW may be used periodically to set the interest rate on a
variable-rate loan.
15 The deregulation of the banking sector means that it is no longer necessary for the central bank
to concern itself with the overall stability of the financial system.
16 Off-balance-sheet business is a transaction where a contingent liability exists and therefore it
cannot be recorded on the balance sheet.
17 Derivative products are primarily designed to facilitate hedging risks such as changes in interest
rates or exchange rates.
18 Under the Basel II capital accord, banks are required to maintain a maximum risk-based capital
ratio of 8.00 per cent at all times.
19 Pillar 3 of the Basel II capital accord requires commercial banks to report directly changes in
their capital structure to the Bank for International Settlements.
20 The standardised approach to the measurement of Pillar 1 credit risk allows a bank to use
external credit ratings.
Essay questions
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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 risk following the GFC and the market
volatility that continues to characterise world financial markets. 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 seven 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)
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Chapter 2 Commercial banks
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.
(a) Briefly explain the main functions of capital.
(b) What is the minimum capital requirement under the Basel III capital accord?
(c) Identify and define the different types of acceptable capital under the Basel II and Basel
III capital accords. Remember that Basel II continues to function, with Basel III acting to
strengthen its main pillars. (LO 2.5)
10 Pillar 1 of the Basel II capital accord includes an operational risk component.
(a) Define operational risk.
(b) Using the standardised approach, explain how a commercial bank is required to measure
the operational risk component of its minimum capital adequacy requirement. (LO 2.6)
11 Provide an overview and rationale for the two new liquidity standards introduced by Basel III. (LO 2.6)
Chapter two Review
8
12 With reference to liquidity management, outline the implications of Basel III and the associated
changes to APRA’s APS 210 for the boards of directors of Australia’s financial institutions. (LO 2.7)
13 As part of the prudential supervision of banks the regulator requires banks to use an internal
model such as VaR to estimate potential gains and losses. Outline some of the strengths and
weaknesses of VaR models and briefly explain why regulators have moved to implement a
‘stressed VaR’ requirement for Australian banks. (LO 2.7)
Extended learning questions
14 The Basel II 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?
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(c) Using the standardised approach to credit risk, explain how a commercial bank will use this
method to calculate its minimum capital requirement. (LO 2.8)
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)
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87
Part 1 Financial institutions
KEY TERMS
acceptance ​46
debenture 47
amortised loan instalments ​49
direct credit substitute 53
non-executive board
members 72
asset management ​44
euromarkets ​47
off-balance-sheet business ​44
authorised deposit-taking
institutions ​56
fixed-term loan ​49
operational risks ​63
foreign currency liabilities ​47
original exposure method ​60
bank bills held ​50
G-10 ​58
overdraft ​50
bank regulation ​56
general market risk ​65
Pillar 1 ​60
Basel II capital accord ​58
hedging ​54
prudential supervision ​56
Basel III capital accord 58
housing finance ​49
reference interest rate ​50
basis points 65
rollover facility ​50
BBSW ​50
internal ratings-based approach
to credit risk ​62
bill of exchange ​46
investment property finance ​49
securitisation ​49
business continuity
management 64
lease ​50
specific market risk ​65
liability management ​44
call deposits ​45
liquidity ​70
standardised approach to
credit risk 60
certificate of deposit ​46
liquidity management
strategy 70
term deposits ​45
loan capital ​47
Tier 2 capital (lower) 60
commercial bills ​50
loan-to-valuation ratio ​78
Tier 2 capital (upper) 60
commitments ​53
market risk ​59
contingency plan ​71
market-rate-related contracts ​54
trade- and performance-related
item ​53
credit card ​49
mark-to-market ​62
Treasury bonds 51​
credit risk ​59
mortgage ​49
Treasury notes (T-notes) ​51
current account deposits 45
mortgage originators ​49
unsecured note ​47
current exposure method ​60
negotiable security ​46
value at risk (VaR) ​65
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collateralised floating
charge 47
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securities portfolio ​70
Tier 1 capital ​60
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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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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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Chapter 3 Non-bank financial institutions
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.
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:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
•
•
•
•
•
•
•
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.
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, such as advising corporate clients on 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.
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Part 1 Financial institutions
Reflection points
• A wide range of non-bank financial institutions is able to 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
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
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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
INVESTMENT BANKS
specialist providers of
financial and advisory
services to corporations,
high-net-worth individuals
and government
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.
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 direct 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. 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.
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Chapter 3 Non-bank financial institutions
3.1.2
Off-balance-sheet business
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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.
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.
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
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UNDERWRITER
an institution that
supports the issue of
securities by a client
and agrees to buy any
securities not bought
by investors
93
Part 1 Financial institutions
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 off-balance-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
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
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.
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 and 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.
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Chapter 3 Non-bank financial institutions
•
•
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.
•
•
•
•
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•
•
•
•
•
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.
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
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Part 1 Financial institutions
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:
—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.
• The merger will seek to achieve synergy benefits such as economies of scale, finance advantages,
competitive growth opportunities and business diversification.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• An investment bank would assist a client with analysis and valuation of the target company,
and will provide expertise in relation to contracts, transaction structures, negotiation, due
diligence, communication with the market, project management and integration.
3.2
LEARNING
OBJECTIVE
3.2
Explain the structure,
roles and operation of
managed funds and
identify factors that
have influenced their
rapid growth
Managed funds
Over the past decade 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 funds 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.
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Chapter 3 Non-bank financial institutions
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.
Managed funds use the services and skills of professional investment managers or funds managers.
The funds 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
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
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:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
•
•
•
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 fund manager
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Part 1 Financial institutions
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 $2042 billion at the end of 2013.
Table 3.1 ​Managed funds, Australia ($ million, September 2013)
1995
2010
2013
Statutory funds of life offices
124 183
232 710
265 445
Superannuation funds
155 992
1 109 866
1 458 772
44 217
286 356
279 610
7 455
27 116
24 541
Public unit trusts
Cash management trusts
Common funds
4 884
7 243
7 508
Friendly societies
8 300
3 600
6 131
Total of all funds
345 031
1 666 891
2 042 007
SOURCE: Reserve Bank of Australia, September 2013.
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:
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•
•
•
•
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.
3.2.3
CAPITAL GUARANTEED
FUND
a fund that offers the
potential of positive
returns while putting
in place strategies
to protect investors’
capital from downside
losses
Capital guaranteed funds
A capital guaranteed fund aims to provide investors with positive returns while protecting their
investment from downside loss. Despite being ‘capital guaranteed’, the investor’s capital is at risk and the
Australian Investment and Securities 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
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Chapter 3 Non-bank financial institutions
outcome they expected, particularly if they fail to understand the nature of the product in which they
have invested. Sometimes, products such as insurance or savings annuities are advertised as capital
guaranteed or capital protected. These are not to be confused with a capital guarantee fund offering the
type of product described above.
3.2.4
Capital stable 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
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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
the capital invested
exhibits low variability
because the fund
invests mainly in lowrisk securities
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.
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 funds managers.
• Funds 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.
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99
Part 1 Financial institutions
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 moneymarket 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.
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 funds 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 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.
Table 3.2 ​Cash management trusts (Australia): Assets as at September 2013
Copyright © 2015. McGraw-Hill Education. All rights reserved.
$ million
Cash and deposits
19 727
Bills of exchange
1 080
Other assets
3 270
Total assets
24 541
SOURCE: Reserve Bank of Australia, September 2013.
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.
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Chapter 3 Non-bank financial institutions
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 funds 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:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
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 which 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 funds managers who have an intimate knowledge of particular
international markets.
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 2013. The amount invested in public unit trusts has increased from about $40
billion to approximately $280 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.
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.
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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)
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
101
Part 1 Financial institutions
Table 3.3 ​Public unit trusts (Australia): Assets as at September 2013 ($ million)
Type of trust
1995
2013
17 000
129 178
2 129
4 445
1 079
38 227
• ​unlisted
16 571
88 024
Mortgage trusts
1 904
1 667
Other trusts (including fixed-interest trusts)
5 534
18 069
44 217
279 610
Property trusts
• ​listed
• ​unlisted
Equity trusts
• ​listed
Total
SOURCE: Reserve Bank of Australia, September 2013.
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 but as medium- to long-term 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
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, plus the growing
number of more educated, affluent and sophisticated investors.
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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, for example residential property,
hotels, shopping centres.
• An equity trust will invest in specified shares listed on local or international stock exchanges, for
example industrial stocks or emerging market stocks.
• 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.
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Chapter 3 Non-bank financial institutions
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.
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 in excess of $1700 billion represent a significant and growing level of savings within the context of
a small, open economy such as Australia.
In Table 3.4, APRA classifies superannuation funds as:
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
LEARNING
OBJECTIVE
3.4
Describe the
nature and roles
of superannuation
funds, including the
primary sources of
superannuation funds
and the different types
of fund
SUPERANNUATION
savings accumulated
by an individual to
fund their retirement
from the workforce
AGE PENSION
a limited regular
income stream paid by
a government to older
retired persons
Entities with more than four members: regulated superannuation entities with more than four members.
Pooled superannuation trusts (PSTs): trusts in which regulated superannuation funds, approved
deposit funds and other PSTs invest.
Small APRA funds: superannuation entities regulated by APRA with less than five members.
Table 3.4 ​Superannuation assets and entities (Australia) as at September 2013
Superannuation fund classification
Entities with more than four members
Assets ($ billion)
Number of entities
1 166.8
317
107.5
60
1.6
2 962
Self-managed superannuation funds
531.5
516 925
Balance of life office statutory funds
47.1
Pooled superannuation trusts
Small APRA funds
Total
1 747.1
520 327
SOURCE: APRA, Statistics Quarterly Superannuation Performance, September 2013.
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103
Part 1 Financial institutions
•
•
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
Corporate funds, industry funds and public sector superannuation funds
Copyright © 2015. McGraw-Hill Education. All rights reserved.
CORPORATE
SUPERANNUATION
FUND
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
a governmentsponsored fund
established for the
benefit of government
employees
COMPULSORY
SUPERANNUATION
employers must
contribute minimum
specified amounts into
retirement savings for
employees (Australia)
A corporate superannuation fund provides benefits to employees of a particular corporation, an
industry superannuation fund provides benefits to employees working within a particular industry
and a public sector superannuation fund provides 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 servants’ 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 per cent of an academic’s salary, and the academic
contributes a further 7 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.
Compulsory superannuation funds
In many countries around the world the average age of the population is increasing. An ageing population
presents a twofold problem:
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 per cent of an employee’s earnings and employees a further 16 per cent.
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Chapter 3 Non-bank financial institutions
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
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 $1 trillion. However, for a number of years there
has been debate about the adequacy of the 9 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 per cent to 12 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 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 earnings of
a superannuation fund are taxed at a concessional 15 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.
SUPERANNUATION
GUARANTEE CHARGE
(SGC)
the compulsory
superannuation
scheme operating in
Australia
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. Their superannuation
contributions and those of their employer will now be directed to the retail fund sector.
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Self-managed superannuation funds
Approximately 30 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 $500 billion and a substantial proportion, more than
$150 billion, is invested in cash. This has proven to be a useful buffer against financial crises 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 $170 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 $90 billion in
listed and unlisted trusts and other managed investments. About $80 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.
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105
Part 1 Financial institutions
Most SMSF trustees are middle-aged or older. Only about one-fifth of the more than 500 000 SMSFs
are managed by people aged 44 or less. About one-quarter of trustees are aged above 45, one-third are
aged above 55 and one-quarter are aged above 64. 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. Interestingly, the taxable income of more than 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 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 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
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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
3.5.2
DEFINED BENEFIT
FUND
the amount of
superannuation paid
to an employee on
retirement is based on
a defined formula
ACCUMULATION
FUND
the amount of
superannuation
funds available at
retirement consists of
past contributions plus
earnings, less taxes
and expenses
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
superannuation 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 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.
An accumulation 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
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Chapter 3 Non-bank financial institutions
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 remains with the fund
member. Accumulation schemes are the predominant type of superannuation fund today.
3.5.3
Regulation
The regulation and supervision of superannuation funds and pension funds varies between nation-states.
This text briefly considers the regulatory environment in Australia.
By the early 1990s the Commonwealth Government had developed a retirement incomes 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 per
cent tax rate applied to fund contributions and earnings. 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
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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 an accumulation fund. At retirement, a defined benefit
fund pays a lump sum or pension based on a predetermined formula, whereas an accumulation
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
per cent applies to contributions and earnings of a fund. Funds may be withdrawn tax-free after
age 60.
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107
Part 1 Financial institutions
3.6
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
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BENEFICIARY
the party who is
entitled to receive
payment under the
terms of an insurance
policy
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 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, long-term securities
and property, in both the domestic and international markets, with over $260 billion in total funds
invested.
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 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.
Table 3.5 ​Life insurance offices (Australia): Statutory funds
as at September 2013
Statutory funds
$ millions
Cash and short-term investments
19 259
Long-term securities
21 625
Equities and unit trusts
Land and buildings
Overseas assets
199 430
1 531
14 483
Other assets
9 116
Total assets
265 445
SOURCE: Reserve Bank of Australia, September 2013.
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Chapter 3 Non-bank financial institutions
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
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 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 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.
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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.
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 term-life
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. 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.
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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
109
Part 1 Financial institutions
Total and permanent disablement insurance
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
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:
•
•
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
TRAUMA INSURANCE
a lump-sum payment
made if a specified
trauma event, such as
a stroke, occurs
Another type of insurance policy that can be attached to a life policy is trauma insurance. With trauma
insurance, the life 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?
Income protection insurance
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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
Serious injury or illness 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 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.
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.
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Chapter 3 Non-bank financial institutions
• 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
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 the uncertain nature of the risks that are underwritten in general insurance
policies, claims are less predictable than those of life 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
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 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
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House and contents insurance
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 on 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 per cent of any loss. 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 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:
•
•
•
•
•
•
CO-INSURANCE
clause
if an asset is underinsured the policy
will cover only the
proportional value
insured
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.
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111
Part 1 Financial institutions
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
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, plus 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.
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.
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• 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
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 invest in a number of single-manager funds; that is, the fund of
funds attempts to diversify their hedge 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
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Chapter 3 Non-bank financial institutions
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 in that 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 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.
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 they forecast will fall in price. Alternatively, the fund may buy
shares they forecast will rise in price by using either borrowed funds or 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.
HEDGE FUNDS
invest in exotic
financial products
mainly for high-networth individuals and
institutional investors
Reflection points
• A hedge fund seeks to achieve above-average returns using sophisticated investment strategies
Copyright © 2015. McGraw-Hill Education. All rights reserved.
and exotic investment products.
• Funds are often highly leveraged by using borrowed funds or derivative products, and 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.
• 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.
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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
113
Part 1 Financial institutions
FINANCE COMPANIES
AND GENERAL
FINANCIERS
borrow funds direct
from markets to
provide loans and
lease finance to
customers
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
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 per cent of the total assets of financial institutions, but
by 1980 their market share had risen to 13 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 2013 stood at less than 2 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
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 a commercial bank. 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.
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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 manufacturer’s 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.
Ford Credit Australia Limited: 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.
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Chapter 3 Non-bank financial institutions
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 June 2014, the building society sector held $23.5 billion in balance-sheet assets,
which represented 0.50 per cent of the total assets of the financial system. Over 80 per cent of liabilities
required to fund the balance sheet came from deposits from customers. Residential lending represented
73 per cent of total assets.
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 savings 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:
•
•
•
•
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, for example an increase in lending to
small business, 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.
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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
AUTHORISED DEPOSITTAKING INSTITUTION
(ADI)
financial institution
authorised by APRA to
accept retail deposits
in Australia
115
Part 1 Financial institutions
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.
3.11 Credit unions
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
COMMON BOND OF
ASSOCIATION
members are drawn
together from a
common background
of work, industry or
community
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 business.
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 $41 billion in assets (June 2014), which represents
1.2 per cent of the total assets in the financial system. Although the asset base is relatively small, in June
2014 there were 84 credit unions.
Credit cooperatives are authorised deposit-taking institutions and as such are regulated and
supervised by APRA. The regulator applies the same prudential and reporting standards to credit unions
as to banks and building societies. These requirements were discussed in Chapter 2—in particular, the
capital adequacy and liquidity management requirements.
Reflection points
• Credit unions accept deposits from their members and provide loans to those members,
including housing loans, term loans and credit card finance.
• Members of a credit union tend to have a common bond of association. This may be based 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
LEARNING
OBJECTIVE
3.9
Describe the unique
role of 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.
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Chapter 3 Non-bank financial institutions
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 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.
EXPORT FINANCE
CORPORATIONS
government authorities
that provide finance
and insurance support
and services to
exporters
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
(EFIC).
Financial news case study
In Chapter 3, we discussed a number of different types of managed funds. One type of fund that
always intrigues students, investors and the media is the hedge fund. The ways in which these funds
work, the strategies that they follow and the mystery that sometimes characterises their operations is not
only conducive to developing curiosity, but also to attracting the scrutiny of regulators. This scrutiny is
heightened during and after periods of extreme financial markets’ volatility. Research seems to suggest,
however, that hedge funds may be much more straightforward than one might suspect given all of the
commentary that they attract and the mystique that has been accorded to star hedge fund managers. The
following two articles shed a little bit more light on hedge funds.
continued
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117
Part 1 Financial institutions
continued
The best hedge fund managers tend to find profits in short-term, contrarian bets.
That’s the finding of a study published by Russell Jame of the University of Kentucky and set to be
presented at the American Economic Association’s annual meeting in Philadelphia.
Investigating an industry that has grown to over $2 trillion from $38 billion in 1990, Jame found the top
30 per cent of hedge funds outperform rivals by a statistically significant 0.25 per cent per month over
the subsequent year, indicating their superior performance persists.
Star hedge funds secure profits over short periods, with more than 25 per cent of an annual outperformance
occurring within a month after a trade. The profits are also often made when managers have bet against
the prevailing market view.
The winning funds are net buyers of so-called growth stocks, which are those of companies whose
earnings are forecast to grow faster than the market average. They also don’t trade more frequently or
more profitably prior to corporate earnings’ announcements, undermining any idea that insider trading
explains how they make profits.
Jame’s sample featured 74 hedge fund management companies managing money for 253 different
clients from 1999 to 2010.
SOURCE: Simon Kennedy, ‘Hedge Fund Secrets Lie in Short Term Over Luck: Cutting Research’, Bloomberg News,
20 December 2013.
The hedge fund industry grew to a record size last year after investors added billions of dollars more to
managers’ coffers and rising stock prices swelled assets, new data show.
Total assets under management rose to $2.63 trillion, up from $2.25 trillion a year ago, according to
Chicago-based data provider Hedge Fund Research.
The bulk of the gains came from a rise in the value of investments held by hedge funds, but $63.7
billion—about 15 per cent of the increase and almost double 2012’s $34.4 billion—came from net new
money invested, HFR said.
Event-driven strategies—which try to make money betting on the outcome of corporate transactions—and
funds trading shares accounted for the biggest chunks of the new cash, HFR said.
Assets under management in the hedge fund industry have recovered since the 2008 financial crisis as
institutional investors look to diversify away from their traditional stock and bond holdings. This increased
demand has continued despite the industry underperforming equity markets since 2009.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
SOURCE: Tommy Wilkes, ‘Hedge Fund Assets Reach Record High’, Reuters, 22 January 2014.
Discussion points
•
In 2013, hedge fund assets grew to a new record level. Outline the reasons behind this growth
and discuss some of the implications this may have from a regulatory perspective. In your
answer, refer to the ways in which hedge funds derive their profits.
•
Hedge funds profit from contrarian investment strategies. Is it possible that these contrarian
strategies may actually help to bring market prices in line with underlying values by preventing
prices from drifting too high or too low?
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Chapter 3 Non-bank financial institutions
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 their 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 direct from
the domestic and international money markets and capital markets.
• Investment banks specialise in the provision of off-balance-sheet products and advisory services,
Chapter Three Review
Summary
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.
• 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• 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 funds 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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119
Part 1 Financial institutions
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 9.5 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 an accumulation fund pays the total of contributions plus fund earnings after tax and expenses.
• 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, an amount is paid to the named beneficiary.
• Related insurance policies include total and permanent disablement insurance, trauma insurance,
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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 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.
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Chapter 3 Non-bank financial institutions
Chapter Three Review
• 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.
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 derive the largest proportion of their funding from the sale of debentures.
• They 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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 development 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.
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PROJECT
FINANCE
financing
large projects
where loan
repayments
are based
on the future
cash flows of
the completed
project
121
Part 1 Financial institutions
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 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 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
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. Non-recourse 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.
Completion is said to occur when construction is finished, the project is operational and specified cashflow 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.
Participants
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:
• 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.
• 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.
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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 direct
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.
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NONRECOURSE
LENDING
the lender is
totally reliant
on future
project cash
flows for loan
repayments
LIMITED
RECOURSE
LENDING
lenders have
certain claims
on the assets
of the project
sponsors if
project cash
flows fail
to achieve
specified levels
Chapter Three Review
• Project finance loans are generally for a considerably longer term than is usually available through
PROJECT
COMPLETION
point at which
a project is
built and is
generating a
prescribed level
of cash flows
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
123
Part 1 Financial institutions
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
EMBEDDED
OPTIONS
specific
performance
guarantees
included in a
project contract
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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
• 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.
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 nonrecourse 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.
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
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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 meet any working capital shortfall during the
NONCOMPLETION
COVENANTS
specific loan
conditions
enforceable
against project
sponsors if a
project is not
completed
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.
WORKING
CAPITAL
finance
required by
a firm to fund
its day-to-day
operations
• 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.
development phase.
Chapter Three Review
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.
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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Questions
True/False questions
Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief
notes explaining your response.
1
Investment banks are conservative organisations that only adopt financial innovations once they
have been tried and tested.
2
Identifying and facilitating spin-offs, where a company breaks into pieces and the pieces become
separate publicly listed companies, is an important part of the investment banking business.
3
In Australia, self-managed superannuation funds or SMSFs are not a popular choice among
investors.
4
Investors may sometimes misunderstand the nature of the financial products offered as ‘capital
guaranteed’.
5
Self-managed superannuation funds are managed and operated by large financial institutions.
6
A managed fund that offers a balanced growth fund invests mainly in securities that have the
potential for large capital growth over time.
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125
Part 1 Financial institutions
7
Cash management trusts provide retail savers with an investment opportunity that returns a yield
that is derived mainly from yields in the wholesale money markets.
8
From the point of view of the unit holder, units in a listed property trust tend to be more liquid
than units in an unlisted property trust.
9
Because superannuation savings do not provide savers with a very liquid asset, it is probable
that they will become less important in the flow of funds into the capital markets in the future.
10 With a defined benefit scheme, the amount of superannuation funds paid to a member on
retirement consists of all contributions paid plus income earned by the fund.
11 A whole-of-life insurance policy includes a risk component and an investment component, thus
accumulating bonuses and a surrender value.
12 Term-life insurance policies only cover a policyholder for a limited period and therefore are not
attractive as a form of life insurance.
13 The prudential supervisor of life insurance offices in Australia is the Australian Prudential
Regulation Authority (APRA).
14 General insurance offices are contractual savings institutions that provide a promise to pay
the insured up to a predetermined amount in the event that the peril that is insured against
occurs.
15 A motor vehicle third-party policy only covers damage to the vehicle or property of the
policyholder.
16 Hedge fund investments are lower risk because they use leverage rather than equity to achieve
above-market returns.
17 In Australia, building societies and credit unions are authorised deposit-taking institutions and
generally provide personal finance to their members.
18 Export finance corporations assist corporations to import foreign goods from the international
markets at a favourable exchange rate.
Extended learning questions
19 Project sponsors are the originators of a project; they establish a project company into which
they inject large amounts of debt, supported by collateral security.
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20 Limited recourse lending provides lenders with claims against project sponsors if project cash
flows do not achieve a specified level.
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
Describe the activities that take place within investment banks. List some of the ways in which the
GFC may have impacted upon these activities. (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)
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)
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Chapter 3 Non-bank financial institutions
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
Since 1995, there has been significant growth in public unit trusts. With reference to the structure
and operation of public unit trusts, explain some of the reasons why investors may have been
willing to invest a growing amount in these vehicles. (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.
Chapter Three Review
5
(a)​How does the life 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.
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(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 Along with investment banks, hedge funds have figured prominently in the commentary that has
been written on the GFC. With reference to the types of strategies that hedge funds may use,
outline some of the reasons why hedge funds may have attracted criticism during and after the
crisis. (LO 3.7)
14 Credit unions typically have a common bond of association.
(a)​Define the nature and role of a credit union.
(b)​Explain the concept of a common bond of association and provide two examples of this
form of association. (LO 3.8)
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127
Part 1 Financial institutions
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
structure is established, the major participants and the guarantees that the lenders will
request from the project sponsors to support their loans.
(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
accumulation fund ​106
equity trust ​101
project sponsors ​122
age pension ​103
export finance corporations ​117
property trusts ​101
annuity ​110
finance companies and general
financiers ​114
public liability insurance ​112
fixed-interest trust 101
public sector superannuation
fund ​104
back office ​92
front office ​92
public unit trust ​101
balanced growth fund ​99
hedge funds 113
responsible entity ​97
beneficiary ​108
horizontal takeover ​94
risk component ​109
building societies ​115
hostile takeover ​94
rollover fund ​106
business overheads
insurance ​110
income protection
insurance ​110
spin-off 94
capital guaranteed fund ​98
industry superannuation
fund ​104
subordinated junior debt ​124
authorised deposit-taking
institution (ADI) ​115
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capital stable fund 99
structured finance ​124
superannuation ​103
cash management trust
(CMT) ​100
investment banks 92
investment component ​109
superannuation guarantee
charge (SGC) ​105
co-insurance clause 111
leasing ​123
syndicated loan 123
common bond of
association ​116
limited recourse lending ​123
term-life policy ​109
listed trust 101
comprehensive insurance ​112
third-party policy ​112
managed funds ​97
compulsory superannuation ​104
managed growth fund ​99
third-party, fire and theft
policy ​112
compulsory third-party
insurance ​112
merger and acquisition 94
conglomerate takeover ​94
consumer price index ​124
corporate superannuation
fund 104
credit unions ​116
defined benefit fund ​106
eligible termination payment
(ETP) 106
embedded options ​124
middle office ​92
total and permanent
disablement insurance ​110
mortgage trust 101
trauma insurance ​110
mutual funds ​97
trust deed ​96
non-completion covenants ​125
trust fund ​96
non-recourse lending ​123
underwriter ​93
policyholder ​108
unlisted trust ​101
premium ​108
vertical takeover ​94
project completion ​123
whole-of-life policy ​109
project finance ​121
working capital ​125
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Part 2
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
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Chapter 7
Forecasting share price movements
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Part 2
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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 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 flowon 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, 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, have all raised public awareness of share-market price volatility.
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, for example 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
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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.
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 share-market indices.
Chapter 7 discusses techniques employed by market analysts and funds 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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Learning objectives
LO 4.1
LO 4.2
LO 4.3
LO 4.4
LO 4.5
LO 4.6
LO 4.7
LO 4.8
LO 4.9
LO 4.10
Understand the structure of a corporation and identify advantages and disadvantages of being a
publicly listed corporation.
Consider the origins and purpose of a stock exchange.
Understand the primary market role of a stock exchange through which corporations raise new
funding.
Discuss the secondary market role of a stock exchange through which existing securities are
bought and sold.
Examine the managed products (exchange traded funds, contracts for difference, real estate
investment trusts and infrastructure funds) and derivative products (options, warrants and futures
contracts) roles of a stock exchange.
Examine the interest rate market role of a stock exchange.
Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for share-market
transactions by the Australian Securities Exchange (ASX).
Recognise the importance of information flows to the efficiency and integrity of stock exchanges.
Identify the principal regulators that affect the behaviour of participants in the Australian share market.
Explain the structure and purpose of the private equity market.
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Chapter 4 The share market and the corporation
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 Law 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.
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 residual cash flows of the corporation. That
is, a shareholder may benefit from the net profits of the organisation after all other claims have been
paid. 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.
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.
ORDINARY SHARE or
COMMON STOCK
the principal form of
equity issued by a
corporation; bestows
certain rights to the
shareholder
Reflection points
• A stock exchange is a formal market within a nation-state that lists a range of securities issued
Copyright © 2015. McGraw-Hill Education. All rights reserved.
by publicly listed corporations; the largest component of a stock exchange is its share market.
• 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
The nature of a corporation
A corporation is a company that is a legal entity established under the Corporations Law of a nationstate. 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.
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LEARNING
OBJECTIVE
4.1
Understand the
structure of a
corporation and
identify advantages
and disadvantages of
being a publicly listed
corporation
133
Part 2 Equity markets
CORPORATION
a legal entity formed
under Corporations
Law; main source of
equity is ordinary
shares
•
•
PUBLICLY LISTED
CORPORATION
a company whose
shares are listed and
quoted on a stock
exchange
OBJECTIVES AND
POLICIES
what a company
intends to achieve
and how that will be
achieved
•
BOARD OF DIRECTORS
elected by
shareholders;
determine the
objectives and policies
of the corporation
LIMITED LIABILITY
COMPANY
the claims of creditors
against shareholders
are limited to the issue
price of their fully paid
shares
NO LIABILITY
COMPANY
shareholders may
decide not to pay calls
on partly paid shares,
but will forfeit such
shares
4.1.1
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•
•
•
RIGHT OF PERPETUAL
SUCCESSION
a corporation
continues to operate
regardless of changes
in ownership
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:
•
SHARE MARKET
a formal exchange
that facilitates the
issue, buying and
selling of equity
securities
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-today 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 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.
•
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.
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.
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Chapter 4 The share market and the corporation
•
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.
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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 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 signaling 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.
AGENCY PROBLEM
the conflict of interest
that may exist between
shareholders and
management of a
corporation
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
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 reporting back to
the board.
continued
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135
Part 2 Equity markets
continued
• 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.
4.2
LEARNING
OBJECTIVE
4.2
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Consider the origins
and purpose of a
stock exchange
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 northeast 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:
•
•
•
•
•
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 has,
until recently, held a monopoly position in the market, but the Australian government has legislated to
allow competition in the Australian market. To date, two new exchanges have applied to the regulator to
run in competition with the ASX.
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
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Chapter 4 The share market and the corporation
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 equitybased 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
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
• 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, and 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.
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4.3
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 fixed-interest
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 MSCI global index ranking for the principal
stock exchange in Australia, the Australian Securities Exchange (ASX).
Table 4.1 ​The ASX market statistics as at 3 April 2014
Number of listed companies
2183
Domestic market capitalisation
$1.5 trillion
S&P/ASX200 index
5409
MSCI global index ranking
8th
LEARNING
OBJECTIVE
4.3
Understand the
primary market role
of a stock exchange
through which
corporations raise
new funding
PRIMARY MARKET
the issue of new
financial securities
such as ordinary
shares
MSCI GLOBAL INDEX
RANKING
a ranking of the stock
markets of developed
economies by
MSCI Inc.
SOURCE: ASX Limited, Market Notices, 3 April 2014.
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137
Part 2 Equity markets
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
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
PROSPECTUS
document prepared by
a company stating the
terms and conditions
of an issue of
securities to the public
As at April 2014, there were 2183 companies listed on the ASX. The market capitalisation of the share
market, that is, the current value of shares issued, was $1.5 trillion, with over 75 new listings accepted
onto the exchange during the first two months of 2014. New companies listed on a stock exchange are
referred to as a new float or an initial public offering (IPO); between 2009 and 2013 more than
$240 billion of capital was raised, placing the ASX in the top five of global exchanges; $36 billion was
raised in the first two months of 2014. 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 funds managers.
Dividend reinvestment schemes 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.
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
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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.
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Chapter 4 The share market and the corporation
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).
• 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.
• The ASX, as at April 2014, had 2183 listed corporations and was ranked eighth in the MSCI
global index ranking.
4.4
The secondary market role of a
stock exchange
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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.
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 facilitate payment for
the purchase.
LEARNING
OBJECTIVE
4.4
Discuss the secondary
market role of a stock
exchange through
which existing
securities are bought
and sold
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
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139
Part 2 Equity markets
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
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.
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 well-developed
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.
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.
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• Market capitalisation is the number of issued shares multiplied by the share price.
4.5
LEARNING
OBJECTIVE
4.5
Examine the managed
products (exchange
traded funds, contracts
for difference, real
estate investment trusts
and infrastructure
funds) and derivative
products (options,
warrants and futures
contracts) roles of a
stock exchange
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 so-called 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. The value of the ETF
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Chapter 4 The share market and the corporation
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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
Woodside Petroleum 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 Woodside 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 funds 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 synthetically to restructure an investment portfolio, for example
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:
•
•
•
•
•
•
•
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
EXCHANGE-TRADED
CONTRACTS
standardised financial
contracts traded on a
formal exchange
OVER-THE-COUNTER
CONTRACTS
non-standardised
contracts negotiated
between a writer and
a buyer
HEDGE
implement a strategy
that manages or
protects against
an identified risk
exposure
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
Exchange 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.
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
exchange index, for example, 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.
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
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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
141
Part 2 Equity markets
that replicates the S&P/ASX200, such as the iShares MSCI Australia 200 fund, provides exposure to the
top 200 shares listed on the ASX, while an ETF such as the iShares S&P/ASX 20 fund provides exposure
to the top 20 companies across the main sectors of the Australian market.
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.
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.
4.5.2
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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
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.
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 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 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.
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
Contracts for difference
Real 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 $5000 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.
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Chapter 4 The share market and the corporation
Investors may benefit from both capital gains on the property assets plus 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 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.
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4.5.5
Options
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. 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
$19.50 per share within the next three months. The premium paid to the option writer is quoted at $0.70
per share. Assume that the share price actually falls to $18.00; the option buyer will then exercise the
option and sell the shares at $19.50, 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, 1000 ($19.50 − $18.00 − $0.70) = $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
Warrants
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. 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.
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INFRASTRUCTURE
FUND
managed fund that
provides investors
with the opportunity to
invest in infrastructure
assets such as toll
roads and utilities
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
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
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
PREMIUM
the amount paid
by the buyer of a
contract, such as an
option or an insurance
policy
EXERCISE PRICE
the price specified in
an options contract at
which the option buyer
can buy or sell
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
143
Part 2 Equity markets
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.
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
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
Futures 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
instrument, 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.
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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• 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 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.
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Chapter 4 The share market and the corporation
4.6
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, so an issuer of debt direct into the capital markets 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 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 a debt issue
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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
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 as interest rates for new issues of similar types of
securities change in the bond 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).
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 generally 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.
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LEARNING
OBJECTIVE
4.6
Examine the interest
rate market role of a
stock exchange
INTEREST RATE
MARKET
listing, quotation
and trading in debt
securities
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
DEBENTURE
a corporate bond
issued with security
attached, being a
charge over the assets
of the issuer
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 SHARE
a hybrid security that
pays a fixed dividend
and offers the right to
convert to ordinary
shares at a future date
145
Part 2 Equity markets
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.
• 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 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
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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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Chapter 4 The share market and the corporation
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
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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 trust held with the broker or other financial
institution. Settlement, that is, the transfer of ownership and value payment, occurs through CHESS.
ASX Trade provides a fast and efficient trading system, delivering 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
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.
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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
147
Part 2 Equity markets
BID AND OFFER
bid is an order to buy;
offer is an order to sell
SETTLEMENT RISK
the possibility that one
party to a financial
transaction will not
deliver value
ELECTRONIC
SUB-REGISTER
a computer-based
system that records
securities ownership
T+3
settlement of a share
transaction will occur
in three business days
CHESS SPONSOR
market participant
such as a stockbroker
that has access to
CHESS
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.
2
It provides an electronic sub-register that records the ownership of listed securities.
Currently, the ASX requires settlement of trades to occur three business days after the transaction
(T + 3). 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. The
clearing house will issue holding statements 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
• 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• The broker will issue a contract note which provides full details of the transaction.
• Settlement will normally occur in T + 3 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
LEARNING
OBJECTIVE
4.8
Recognise the
importance of
information flows to
the efficiency and
integrity of stock
exchanges
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 price of a share
will reflect 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
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Chapter 4 The share market and the corporation
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 the
market regulator. 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
DIVIDEND
that part of a
corporation’s profit
that is distributed to
shareholders
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
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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.
4.9
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 governmentappointed regulator to supervise the country’s Corporations Law, 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
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LEARNING
OBJECTIVE
4.9
Identify the principal
regulators that affect
the behaviour of
participants in the
Australian share
market
149
Part 2 Equity markets
ASIC
the regulatory body
responsible for the
supervision of the
Corporations Law in
Australia
DELISTING
removal from
quotation on a stock
exchange of the
securities of an entity
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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
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.
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Chapter 4 The share market and the corporation
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.
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:
•
•
•
•
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). 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.
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.
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• Specialist private equity funds obtain the majority of their funds from institutional investors.
• Private equity funding is regarded as a higher-risk investment.
• Principal objectives of private equity funds may be to improve company performance in
preparation for an IPO, or the break-up of a company so that the component parts may be sold
separately.
Financial news case study
In Chapter 4 we discussed private equity and the role of private equity firms in the financial markets. It
may come as a surprise to some to learn that a private equity firm, BlackRock, is the largest investor in the
world, with approximately $15 trillion of assets under its direct or indirect control. The ‘rise of BlackRock’
generated some interesting media commentary. The following article from The Economist provides a
number of insights into BlackRock and the surprisingly multifaceted nature of the biggest company in the
private equity business.
continued
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Part 2 Equity markets
continued
Ask conspiracy theorists who they think really runs the world, and they will probably point to global
banks, such as Citigroup, Bank of America and JPMorgan Chase. Oil giants such as Exxon Mobil and
Shell may also earn a mention. Or perhaps they would focus on the consumer-goods firms that hold
billions in their thrall: Apple, McDonald’s or Nestlé.
One firm unlikely to feature on their list is BlackRock, an investment manager whose name rings few
bells outside financial circles. Yet it is the single biggest shareholder in all the companies listed above.
It owns a stake in almost every listed company not just in America but globally. (Indeed, it is the biggest
shareholder in Pearson, in turn the biggest shareholder in The Economist.) Its reach extends further: to
corporate bonds, sovereign debt, commodities, hedge funds and beyond. It is easily the biggest investor
in the world, with $4.1 trillion of directly controlled assets (almost as much as all private-equity and
hedge funds put together) and another $11 trillion it oversees through its trading platform, Aladdin.
Established in 1988 by a group of Wall Streeters led by Larry Fink, BlackRock succeeded in part by
offering ‘passive’ investment products, such as exchange-traded funds, which aim to track indices such
as the S&P 500. These are cheap alternatives to traditional mutual funds, which often do more to enrich
money managers than clients (though BlackRock offers plenty of those, too). The sector continues to grow
fast, and BlackRock, partly through its iShares brand, is the largest competitor in an industry where scale
brings benefits. Its clients, ranging from Arab sovereign-wealth funds to mom-and-pop investors, save
billions in fees as a result.
The other reason for its success is its management of risk in its actively managed portfolio. Early on, for
instance, it was a leader in mortgage-backed securities. But because it analysed their riskiness zipcode
by zipcode, it not only avoided a bail-out in the chaos that followed the collapse of Lehman, but also
advised the American Government and others on how to keep the financial system ticking in the darkest
days of 2008, and picked up profitable money-management units from struggling financial institutions
in the aftermath of the crisis.
Other people’s money
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Compared with the many banks which are flourishing only thanks to state largesse, BlackRock’s
success—based on providing value to customers and paying attention to detail—is well-deserved. Yet
when taxpayers have spent billions rescuing financial institutions deemed too big to fail, a 25-year-old
company that has grown so vast so quickly sets nerves jangling. American regulators are therefore
thinking about designating BlackRock and some of its rivals as ‘systemically important’. The tag might
land them with hefty regulatory requirements.
If the regulators’ concern is to avoid a repeat of the last crisis, they are barking up the wrong tree. Unlike
banks, whose loans and deposits go on their balance-sheets as assets and liabilities, BlackRock is a mere
manager of other people’s money. It has control over investments it holds on behalf of others—which
gives it great influence—but it neither keeps the profits nor suffers the losses on them. Whereas banks
tumble if their assets lose even a fraction of their value, BlackRock can pass on any shortfalls to its clients,
and withstand far greater shocks. In fact, by being on hand to pick up assets cheaply from distressed
sellers, an unleveraged asset manager arguably stabilises markets rather than disrupting them.
But for regulators that want not merely to prevent a repeat of the last blow-up but also to identify the
sources of future systemic perils, BlackRock raises another, subtler issue, concerning not the ownership
of assets but the way buying and selling decisions are made. The $15 trillion of assets managed on its
Aladdin platform amount to around 7 per cent of all the shares, bonds and loans in the world. As a result,
those who oversee many of the world’s biggest pools of money are looking at the financial world, at
least in part, through a lens crafted by BlackRock. Some 17 000 traders in banks, insurance companies,
sovereign-wealth funds and others rely in part on BlackRock’s analytical models to guide their investing.
Aladdin’s genius
That is a tribute to BlackRock’s elaborate risk-management models, but it is also discomfiting. A principle
of healthy markets is that a cacophony of diverse actors come to different conclusions on the price of
things, based on their own idiosyncratic analyses. The value of any asset is discovered by melding all
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Chapter 4 The share market and the corporation
these different opinions into a single price. An ecosystem which is dominated by a single line of thinking
is not healthy, in politics, in nature or in markets. Such groupthink in finance is a recipe for booms (when
everyone wants to buy the same thing) and busts (when they all rush to sell). Though Aladdin advises
clients on investment decisions rather than making them, it inevitably frames how they think of market risk.
The last crisis had many causes. One of them, which perhaps lay behind all the others, was that investors
stopped thinking critically about what they were buying. Too many decided to trust credit-rating agencies,
which assured them, for example, that packages of American subprime mortgages were extremely
unlikely to default. BlackRock’s models are no doubt better than the clunkers put out by Moody’s or
Standard & Poor’s up to 2008: the firm’s relative recent success has proved that. But too many investors
relying on a single model spreads an unhealthy orthodoxy and is likely to make the markets more volatile
than they otherwise would be.
That is probably not a serious systemic risk, for it will be self-limiting: the more money follows BlackRock,
the more money there is to be made betting against it. The real danger is for investors. The more they
rely on BlackRock’s analysis, the smaller the upside when it gets things right and the greater the downside
when it gets things wrong—as, one day, it eventually will. Until then BlackRock’s single-minded focus on
mastering risk is to be commended. If its peers in the financial world had taken the same approach in the
run-up to 2008, much of the chaos of the past five years would have been averted.
SOURCE: ‘The Rise of BlackRock’, The Economist, 7 December 2013.
Discussion points
• ‘BlackRock is not just a private equity firm.’ Discuss this statement with reference to BlackRock’s
Aladdin trading platform.
• BlackRock controls more assets that almost all other private equity firms and hedge funds
combined. Discuss the implications of the market dominance of BlackRock.
• The size of the Aladdin trading platform means that many investors frame their view of
the markets through a lens provided by BlackRock. Should regulators be concerned about
BlackRock’s dominance and the systematic risk it may create?
• Does the size of the Aladdin trading platform have any implications for the information role that
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markets perform?
Summary
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.
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Part 2 Equity markets
• 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.
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 and 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.
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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.
• The ASX, as at 3 April, had 2183 listed corporations and was ranked 8th in the MSCI global index
ranking.
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.
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Chapter 4 The share market and the corporation
investors.
• Market capitalisation is the number of issued shares multiplied by the share price.
LEARNING OBJECTIVE 4.5
Examine the managed products (exchange traded funds, contracts for difference, real estate investment
trusts and infrastructure funds) and derivative products (options, warrants and futures contracts) roles of
a stock exchange
• 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.
• 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).
Chapter four Review
• Market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market encourages
• 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
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
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• 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.
• 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 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 share-market
transactions by the Australian Securities Exchange (ASX)
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Part 2 Equity markets
• 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 + 3 business days when transfer of ownership and financial
settlement will be processed through CHESS.
• CHESS will issue a holding statement on the uncertificated shareholding.
LEARNING OBJECTIVE 4.8
Recognise the importance of information flows to the efficiency and integrity of stock exchanges
• 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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 the break-up of a company so that the component parts may be sold
separately.
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Chapter 4 The share market and the corporation
True/False questions
Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief
notes explaining your response.
1
The agency problem refers to a conflict of interest arising between the CEO and the board of
directors.
2
The Australian share market is relatively small and ranks well outside of the top 10 global share
markets.
3
Shareholder dissatisfaction can be reflected or signalled by price movements in the company’s
shares.
4
Share options have been a popular component of management compensation packages
designed to minimise potential agency problems.
5
It is not possible to raise significant amounts of capital by undertaking an initial public offering
of shares on the ASX.
6
The market capitalisation of a corporation is calculated by multiplying the number of shares on
issue by the current share price and dividing the result by an appropriate discount rate.
7
A physical market is defined as a formal exchange in which derivative products are traded.
8
An exchange traded fund (ETF) provides an investor with the opportunity to gain exposure to a
diversified share portfolio.
9
The main type of asset held in a REIT managed fund is property.
Chapter four Review
Questions
10 Infrastructure funds are normally established by the government to ensure basic services are
provided to the community.
11 The writer of an option has the right, but not the obligation, to buy or sell a security at a
predetermined price and date, on payment of a premium to the option buyer.
12 A straight corporate bond is a long-term debt security that pays a periodic fixed rate coupon and
repays the face value at maturity.
13 A preference share gives the shareholder a right to purchase additional shares in a corporation
at a predetermined price and date.
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14 An uncertificated security is issued by the ASX to a shareholder when the original share certificate
has been misplaced.
15 The paper-based CHESS system for value settlement and transfer of ownership of shares mean
that final settlement takes, on average, seven days to complete.
16 An essential role of a stock exchange is to ensure that market participants are immediately
informed of material changes to a listed company’s operations.
17 The ASX currently has a government protected monopoly as a stock exchange in Australia.
18 ASIC has responsibility for the supervision of real-time trading on the ASX.
19 The private equity market has grown rapidly and is now almost as large as the stock exchange.
20 The GFC had very little impact on global equity markets, but rather it mainly impacted global
economic growth.
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)
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Part 2 Equity markets
2
Freelancer Ltd is one of the newest public companies to list on the Australian Securities Exchange.
Identify and discuss the rights, roles and responsibilities of Freelancer’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.
(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 the corporation. (LO 4.4)
7
(a) As a stockbroker, you have been approached by a client seeking to establish a diversified
portfolio of domestic shares. After identifying the client’s investment needs, you recommend
the client use an exchange traded fund (ETF) to achieve her investment objectives. Explain to
the client how an ETF will achieve the objective of a diversified share portfolio.
(b) The client also wishes to gain an investment exposure to the international share markets. Is
it possible to use ETFs to achieve this objective? Explain. (LO 4.5)
8
As an experienced investor, you are aware that a contract for difference (CFD) can be used
to gain a leveraged exposure to the individual shares, a specified share market index, foreign
currencies and commodities.
(a) Explain how a CFD is structured.
(b) Describe the impact of leverage on this type of investment. (LO 4.5)
9
Two managed investment products offered through the ASX are real estate investment trusts
(REITs) and infrastructure funds. Identify and briefly describe the main features of each of these
products. (LO 4.5)
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10 Three equity-based derivative products that may be offered through a stock exchange are an
options contract, an equity warrant and a futures contract. Briefly explain the main features of
each of these products. Why might an investor use these products? (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 1000 Rio Tinto Limited shares and another investor
places a sell order for 1000 Rio Tinto Limited shares; both orders at market price. (LO 4.7)
(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 + 3 business days. (LO 4.7)
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Chapter 4 The share market and the corporation
(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 participant’s 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
agency problem ​135
electronic sub-register ​148
over-the-counter contracts ​141
ASIC ​150
exchange-traded contracts ​141
physical market ​141
ASX Trade ​146
exchange traded funds
(ETFs) ​141
placement 138
ASX Trade24 ​146
bid and offer ​148
exercise price ​143
premium ​143
board of directors ​134
floating rate note (FRN) ​145
primary market ​137
call option ​143
futures contract ​144
prospectus ​138
CHESS ​147
hedge ​141
CHESS sponsor ​148
infrastructure fund 143
publicly listed
corporation ​134
continuous disclosure 149
interest rate market ​145
put option ​143
contract for difference
(CFD) 142
limited liability company ​134
real estate investment trust
(REIT) 142
contract note ​147
listing rules ​149
convertible note ​145
market capitalisation ​140
corporate governance ​135
market liquidity ​140
corporation ​134
MSCI global index
ranking ​137
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coupon ​145
debenture ​145
delisting ​150
derivative ​141
directors’ interests ​149
dividend ​149
dividend reinvestment
scheme ​138
liquidator ​149
Chapter four Review
13 (a) It may be argued that information is the life-blood of an efficient stock market. Explain this
proposition.
preference share 145
right of perpetual
succession ​134
rights issue ​138
settlement risk ​148
share market ​134
new float or initial public
offering (IPO) 138
share options ​135
straight corporate bond ​145
no liability company ​134
T + 3 ​148
objectives and policies ​134
uncertificated securities ​147
option contract ​143
warrant ​143
ordinary share or common
stock 133
warrant issuer ​143
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159
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
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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 right 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 5 Corporations issuing equity in the share market
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.
Each of these objectives should contribute to maximising shareholder value. However, if managed
incorrectly they may reduce shareholder value. A corporation needs to know precisely how it is to measure
each objective, how the achieving of that objective will add to shareholder value and over what time-frame
the objective is to be measured.
Consider the following situation: a firm has set itself an objective to maximise sales and increase
its market share. How will management achieve that objective? If it is achieved by reducing profit
margins, this may not be to the long-term benefit of the corporation, as the firm may not be able to
maintain a pricing discount indefinitely. However, if the increased market share is achieved through the
development of a higher-quality product that meets consumer demand, and sales are supported by an
effective marketing strategy, then positive shareholder value may well be the outcome.
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:
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•
•
•
•
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 as they fall due and to pay creditors.
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.
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.
The 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.
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Part 2 Equity markets
5.1
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
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 to 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—the need to maximise shareholder value—must be remembered. Therefore, the firm
must be certain that its decisions will in fact make a profit sufficient to 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:
•
•
net present value
internal rate of return.
5.1.1
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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
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 somewhat impatient. If you
are promised a payment of $1100 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 interest rate reflects the market’s
assessment of uncertainty, risk, inflation and people’s desire to save or consume. If the interest rate is
10.00 per cent per annum, we find the present value of the $1100 to be received one year from today by
dividing it by one plus the interest rate or 1.10. The present value is $1000.
This can be written more formally as:
Present value = S(1 + i)−n
= $1100(1.10)−1
= $1000
5.1
where:
S = the future amount
i = the current interest 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
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Chapter 5 Corporations issuing equity in the share market
$35 000. The required rate of return for the company is 18.00 per cent per annum. The machine will have
a salvage value of $10 000 at the end of the three years.
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:
 1 - (1 + i )- n 

Present value = C 


i
 1 - (1.18)- 3 

= 20000 


0.18
= $43485.46
2
5.1a
the present value of the salvage value:
Present value = S(1 + i )- n
= $10000(1.18)- 3
= $6086.31
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.
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Net present value = -$40 000 + $49 571.77
= $9571.77
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
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
NPV DECISION RULE
accept an investment
opportunity that has a
positive NPV
Internal rate of return
Another method regularly used by corporations to determine whether a business investment proposition
is acceptable in 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. 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
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INTERNAL RATE OF
RETURN (IRR)
the discount rate that
results in an NPV of
zero
163
Part 2 Equity markets
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)
5.1d
Keystrokes:
1
-40 000
20 000
20 000
30 000
[second function]
P
YR
CFj
CFj
CFj
CFj
[second function]
IRR
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:
18
I
YR
[second function ] NPV
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Answer: NPV = $9571.77
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
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.
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.
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Chapter 5 Corporations issuing equity in the share market
• 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.
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5.2
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.
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 most important, in that 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.
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).
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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
RISK
the possibility or
probability that
an actual outcome
will vary from the
expected outcome;
uncertainty
BUSINESS RISK
exposures to factors
that have an impact
on a firm’s activities
and operations
FINANCIAL RISK
exposures to factors
that affect the value of
assets, liabilities and
associated cash flows
165
Part 2 Equity markets
•
•
•
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, legal restrictions, freezing of company
assets, or forced divestment of assets.
5.2.1
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EARNINGS
ATTRIBUTABLE TO
ORDINARY SHARES
the net accounting
earnings on a
company’s shares
expressed in cents per
share
Financial 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 is 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. However, if the debtfinanced 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 is the degree of financial risk. One of the implications
of the 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
What is the appropriate debt-to-equity ratio?
DEBT-TO-EQUITY
RATIO
the proportion of
a firm’s debt funds
relative to its equity
funds
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.
GEARING RATIO
the percentage of a
firm’s total funding
provided by debt
•
•
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 ratios 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.
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Chapter 5 Corporations issuing equity in the share market
•
•
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 in 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.
LOAN COVENANTS
conditions or
restrictions placed
on a borrower and
specified in a loan
contract
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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, commercial banks
generally have very high debt-to-equity ratios, often in excess of 1000 per cent. 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, for example the retail sector, maintain a prudent debt-to-equity ratio,
usually less than 40 per cent. 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.
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Part 2 Equity markets
5.3
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
PUBLICLY LISTED
CORPORATION
a company whose
shares are listed and
quoted on a stock
exchange
INITIAL PUBLIC
OFFERING (IPO)
an offer to investors of
ordinary shares in a
newly listed company
on a stock exchange
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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
PROSPECTUS
document prepared by
a company stating the
terms and conditions
of an issue of
securities to the public
UNDERWRITING
a contractual
undertaking to
purchase securities
that are not subscribed
to by investors
Initial public offering
In this text the 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 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 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, a merchant bank or 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, in consultation with the advisers, will provide advice on:
•
•
the structure of the issue
the pricing of the issue
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Chapter 5 Corporations issuing equity in the share market
•
•
•
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 outclause 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.
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,
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.
Two common types of corporate structures are:
•
•
a limited liability company
a no liability company.
5.3.1
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OUT-CLAUSE
specific conditions
that preclude
an underwriting
agreement from being
fully enforced
Ordinary shares: limited liability companies
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 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
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LIMITED LIABILITY
COMPANY
the claims of creditors
against shareholders
are limited to the issue
price of their fully paid
shares
ORDINARY SHAREs or
COMMON STOCK
the principal form of
equity issued by a
corporation; bestows
certain rights to the
shareholder
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
169
Part 2 Equity markets
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
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NO LIABILITY
COMPANY
shareholders may
decide not to pay calls
on partly paid shares,
but will forfeit such
shares
Ordinary 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, for example 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.
Such ventures need access to equity funding, but potential shareholders are 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, the pricing, the timing, the marketing and the allocation of the share issue.
• A prospectus, the public offer document, is compiled and will include all information needed to
allow investors to make an informed investment decision.
• A syndicate of underwriters 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 will forfeit those shares if a call is not paid.
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Chapter 5 Corporations issuing equity in the share market
5.4
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.
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:
•
•
•
•
•
•
•
•
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
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 attaching 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 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 Australian Securities Exchange (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 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 plus the London Stock Exchange (LSE) through
two holding companies—BHP Billiton Limited (ASX) and BHP Billiton Plc (LSE).
LEARNING
OBJECTIVE
5.4
Consider important
issues associated with
listing a business on a
stock exchange
DELISTED
removal from
quotation of the
securities of an entity
that breaches stock
exchange listing rules
LISTING RULES
specific criteria that
must be met by an
entity seeking listing
on a stock exchange
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.
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continued
171
Part 2 Equity markets
continued
• 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.
5.5
LEARNING
OBJECTIVE
5.5
Explore equityfunding alternatives
that are available
to an established
listed corporation,
including right issues,
share purchase plans,
placements, takeover
issues, dividend
reinvestment schemes,
preference shares,
convertible notes and
other quasi-equity
securities
Companies that are listed on a stock exchange, and that have a proven track record of sound management,
good profitability growth and a 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
5.5.1
RIGHTS ISSUE
the issue of additional
shares to existing
shareholders on a prorata basis
PRO-RATA OFFER
a proportional offer
to buy securities
based on an investor’s
current shareholding
Equity-funding alternatives for listed
companies
Rights 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 is the discount that is required from the current market price to
encourage sufficient shareholder participation.
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Chapter 5 Corporations issuing equity in the share market
•
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.
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 nonrenounceable 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.
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5.5.2
Placements
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 funds 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 per cent of the company’s issued shares may do so only if shareholders ratify previous
placements at the annual general meeting.
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. 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.
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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
PLACEMENT
additional ordinary
shares are sold by a
corporation to selected
institutional investors
MEMORANDUM OF
INFORMATION
information required
to be provided to
institutional investors
with a placement offer
173
Part 2 Equity markets
5.5.3
EQUITY-FUNDED
TAKEOVER
a takeover company
issues its shares in
exchange for the
shares of the target
company
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.
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.
An example of this method of equity financing was the takeover of the Melbourne casino, Crown
Limited, by Publishing and Broadcasting Limited (PBL). The offer, approved by Crown shareholders,
involved the exchange of 11 ordinary shares in Crown for one ordinary share in PBL.
5.5.4
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DIVIDEND
REINVESTMENT
SCHEME
allows shareholders
to reinvest dividends
by buying additional
shares in the company
Takeover issues
Dividend 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.
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.
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Chapter 5 Corporations issuing equity in the share market
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 when business
prospects improve.
5.5.5
Preference 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.
•
•
•
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•
•
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 issuer company at a future date, generally at the lesser of a maximum amount nominated
in the prospectus or a discounted market price at the conversion date. It is unlikely that a preference
share would be non-convertible.
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 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 second-ranking
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.
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 addition, 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.
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PREFERENCE SHARE
a hybrid security that
pays a fixed dividend
and offers the right to
convert to ordinary
shares at a future date
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
175
Part 2 Equity markets
5.5.6
Convertible notes and other quasi-equity
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
CONVERTIBLE NOTE
a hybrid fixed-interest
debt security that
includes an option to
convert to ordinary
shares at a specified
date
A convertible note is a hybrid debt instrument, issued for a fixed term 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 notes are usually issued at a price close to the market price of the share at the time of issue, 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 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
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COMPANY-ISSUED
OPTION
bestows a right, but
not an obligation,
on the holder to buy
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
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.
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Chapter 5 Corporations issuing equity in the share market
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 convert the warrant into 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 convert to 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.
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The Corporations Law 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.
• A takeover issue occurs when company A seeks to merge with 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.
continued
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177
Part 2 Equity markets
continued
• 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 convert the option
into ordinary shares 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.
Financial news case study
In Chapter 5 we introduced the main types of equity funding available to corporations. We learned
that a significant step in the lifetime of any corporation is its initial listing on a stock exchange. The IPO
process is a multifaceted and sometimes dramatic event. This is especially the case when the company
that is listing on the exchange is a well-known one. Media interest is high and speculation about the fate
of the IPO can be very intense. In recent years, the IPO of Facebook and the subsequent performance
of its shares has attracted a lot of attention. The story behind the IPO provides a fascinating insight into
the process in a context made all the more interesting by the strong likelihood that the average finance
student will have more than a passing familiarity with the company’s product: a social network.
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Soon after listing, Facebook’s shares were trading at a considerable discount to the issue price. A falling
share price is something that owners of privately held companies do not have to worry about. The
company’s value is important, of course, but it is not flashed before everyone’s eyes on a daily basis. A
private company is also insulated from what is generally perceived to be the ‘short termism’ of the stock
market. Rather than concentrate on continually beating a quarterly earnings estimate, management can
focus on the longer term development of the company.
The financial news media has argued that Facebook’s founder, Mark Zuckerberg, perhaps wary of
the financial markets and Wall Street’s professional money managers, wanted to put off becoming a
public company as long as possible and kept Facebook private for a much longer period of time than
other internet companies such as Amazon. Although this postponed the constant scrutiny of market
commentators, fund managers and analysts, it created another problem. To raise capital, Facebook
needed private investors. This placed a limit on how much capital could be raised and started the clock
ticking towards the day when these investors would desire to sell their investment. Arguably, it also
reduced the pressure on the company to innovate. Facebook eventually listed on the stock exchange in
2012. According to Forbes:
Waiting eight years to conduct an IPO, however, has turned out to be an impossible problem to manage.
The hype associated with the hottest company in Silicon Valley had created massive expectations and
lots of shareholders with tons of stock looking for an exit. But the numbers that Facebook announced in
its first quarterly earnings report were underwhelming.
With a falling stock price, high expectations, investors seeking to cash in their investments and other
investors waiting to see what Facebook’s next big move or next big idea will be, the business is being
run under an intense spotlight. Although there are a number of reasons why owners and managers
might wish to keep a company in private hands, this approach also entails risk. Sometimes, the constant
scrutiny of Wall Street can force a company to keep moving forward. According to Forbes:
The lesson of the Facebook fiasco for Silicon Valley is clear. Start-up entrepreneurs cannot evade the
discipline of the capital markets any more than can the prime ministers of Spain and Italy. The markets
have a way of focusing the mind. Zuckerberg & Co. might have not been so late to embrace mobile or
might have had more urgency to develop a monetizing strategy had Facebook faced the trading hordes
earlier.
SOURCE: Extract from Vardi, N., ‘Mark Zuckerberg’s Big Facebook Mistake’, Forbes, 27 July 2012.
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Chapter 5 Corporations issuing equity in the share market
Discussion points
•
Timing is everything in the IPO business. Did Facebook’s management wait too long before
taking the company public? What are some of the funding problems that beset the company as
a result of delaying the IPO?
•
Discuss the rationale for delaying an IPO and keeping a company private?
•
Is being at the ‘mercy of the markets’ something to be avoided or can the pressures of being a
publicly held company foster innovation?
LEARNING OBJECTIVE 5.1
Understand issues related to the capital budgeting investment decision
• The main objective of a business 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.
• Quantitative methods are used to determine business activities that should be profitable, that is, those
adding to shareholder value. Two methods are net present value (NPV) and internal rate of return (IRR).
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• 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.
Chapter five Review
Summary
• 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.
LEARNING OBJECTIVE 5.2
Identify issues relevant to a corporation’s funding choice between debt and equity
• A corporation must determine how it plans to finance its investment decisions.
• 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.
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179
Part 2 Equity markets
• 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, in the appropriate form of incorporation, in the preparation of a prospectus and
in 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.
• Once listed, corporations must continue to comply with the rules or risk suspension or de-listing 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.
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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.
• 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 funds managers. This can be finalised
more quickly, does not require a prospectus (only a memorandum of information) and is often at a
smaller discount.
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Chapter 5 Corporations issuing equity in the share market
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.
• 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 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 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.
Chapter five Review
• Additional ordinary shares may also be issued by a takeover company as full payment, or part
Extended learning
LEARNING OBJECTIVE 5.6
Explain the listing requirements of the Australian Securities Exchange
Australian Securities Exchange (ASX) listing rule requirements
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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.
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 nationstates, 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.
The ASX has absolute discretion concerning an entity’s admission to the official list, the quotation of its
securities and its suspension and removal from the list. Listing rules are enforceable under the Corporations
Act 2001 and are additional and complementary to common law and statutory obligations.
An entity that applies to the ASX for admission to the official list must provide prescribed documentation,
demonstrate compliance with the listing rules and pay listing fees. Entities that are admitted are categorised
as general (within this category there are specific rules for mining exploration entities, investment entities
and scientific research-based entities), debt issuer or exempt foreign.
Some of the broad requirements for general admission to the official list include:
• The entity’s structure and operation must be appropriate for a listed entity.
• The entity’s constitution must be consistent with the listing rules.
• A prospectus, product disclosure statement or information memorandum must be issued and lodged
with the corporate regulator, ASIC.
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Part 2 Equity markets
• A foreign entity must establish, in Australia, an Australian securities register (or sub-register), appoint
an agent for service of process and be registered as a foreign company under the Corporations Act.
RESPONSIBLE
ENTITY
the trustee
and manager
of a trust in
Australia
• 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 500 holders each having a parcel of the main class of securities (excluding
restricted securities) with a value of at least $2000. Alternatively, there must be at least 400 holders
each having a parcel of the main class of securities (excluding restricted securities) with a value of at
least $2000, who are not related parties of the entity that must hold at least 25 per cent of the total
number of securities (excluding restricted securities) in the main class. (A related party is one that has
an ownership interest in the entity seeking admission.)
•
•
•
•
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.
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 recommendation 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.
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Profit test
PROFIT TEST
minimum
financial
performance
requirements
to be met
by an entity
seeking listing
on a stock
exchange
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.
• 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 $400 000.
• The entity must give the ASX a statement from all directors (in the case of a trust, all directors of the
ASSETS TEST
minimum level
of assets to
be held by an
entity seeking
listing on a
stock exchange
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 requirement of admission is as follows:
• At the time of admission an entity must have net tangible assets of at least $2 million after deducting
the costs of fundraising, or a market capitalisation of at least $10 million.
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Chapter 5 Corporations issuing equity in the share market
Chapter five Review
• 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.
• 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.
• 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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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.
ESCROW
assets held by
a third party
that cannot
be sold until
conditions of
a contract are
fulfilled
• 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:
•
•
•
•
underwriting and handling fees
float management fees
legal fees
accounting and taxation fees
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Part 2 Equity markets
•
•
•
•
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 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 or administrator
• 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 per cent
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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.
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Chapter 5 Corporations issuing equity in the share market
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 survival 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
8
ensure that the level and composition of remuneration is sufficient and reasonable and that its
relationship to performance is clear.
CORPORATE
GOVERNANCE
policy and
practice that
define the
relationship
between
shareholders,
the board and
management
TRANSPARENCY
the level of
information
that is provided
to market
participants
Chapter five Review
Corporate governance
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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
True/False questions
Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief
notes explaining your response.
1
The time value of money concept says that money received today is worth no more and no less
than money received at some point in the future.
2
An important step in maximising shareholder value is the selection of projects that have positive
net present value.
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Part 2 Equity markets
3
A project should be accepted and undertaken whenever the investment cost today minus the
present value of the project’s future cash flows is positive.
4
Whenever the NPV is positive, the IRR will be less than the required rate of return and vice versa.
5
The IRR will return a clear-cut result whenever there are more than two changes of sign in the
cash flows series.
6
Regardless of a period of economic growth or an economic downturn, a higher debt-to-equity
ratio should generate a higher return on equity for shareholders.
7
The corporate regulator has stipulated a standard optimal debt-to-equity ratio that must be
maintained by all corporations.
8
A prospectus includes detailed information on the past and forecast activities of an organisation.
9
The flotation of a business refers to the actions of the liquidators when a company goes into
liquidation.
10 A company issuing new shares is assured they will all be taken up if the issue is underwritten,
unless an out-clause in the underwriting agreement is triggered.
11 The listing rules of the stock exchange provide corporations with a useful guideline on how to
structure their business activities.
12 Dual listing provides multinational corporations with greater access to the international capital
markets.
13 A pro-rata rights issue of new shares to existing shareholders is said to be non-renounceable if
the right can be sold to another investor.
14 An issue of ordinary shares to retail investors must be accompanied by a memorandum of
information that details the activities and financial position of the issuing corporation.
15 One advantage of a placement of new shares is that a company can issue the shares quickly
and at a lower discount to the current market price than it could with a rights issue.
16 A cumulative preference share normally reinvests the periodic fixed dividend payments and the
accumulated total is repaid at maturity.
17 A preference share issue is generally not listed on a stock exchange as the shares have only
limited liquidity.
18 Convertible notes are debt instruments that provide the holder with the right to convert the notes
into ordinary shares at a determinable price and at a specified date.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
19 Company-issued share options guarantee the issuing company future equity funding at the option
exercise date which can be set to coincide with future funding requirements.
20 Company-issued equity warrants are often attached to a corporate bond debt issue and give the
holder the right to convert the warrant into ordinary shares in the issuing company.
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 decision to produce and market a new product is an important capital budgeting problem
for many companies. This is especially the case for those companies operating at the cutting
edge of consumer technology. One such company is Apple Corporation. Discuss the capital
budgeting process from the perspective of a company like Apple and how it may apply the
process to its product decisions. (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 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 per cent on this type of project.
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Chapter 5 Corporations issuing equity in the share market
(b) Should the company proceed with this investment opportunity? Why? (LO 5.1)
3
‘The higher the ratio of debt to equity, the higher the return to the shareholders. Therefore,
companies should fund all of their projects with debt.’ (LO 5.2)
4
Debt-to-equity ratios may vary quite considerably between business corporations.
(a) Discuss the four main criteria that a corporation should analyse when determining the firm’s
appropriate debt-to-equity ratio.
(b) Is the firm’s debt-to-equity ratio likely to change over time? Support your answer with
examples. (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 5 shares held. The issue price is $11.75 per share and the current
market price is $11.95. 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
out-clause if the market price drops below $11.45. Having regard to this information, answer
these questions.
Chapter five Review
(a) Calculate the NPV and the IRR.
(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)
Copyright © 2015. McGraw-Hill Education. All rights reserved.
8
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 decides 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?
(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.
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Part 2 Equity markets
(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 Woolworths Limited is a publicly listed corporation. Its core business is in supermarkets.
Woolworths has decided to set up a major hardware goods chain in competition with the
Wesfarmers Limited-owned Bunnings stores. Woolworths needs to raise additional equity capital
to fund the expansion. The company advisors 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 From time to time, corporations such as the National Australia Bank Limited make an issue of
preference shares as part of the overall capital structure of the organisation.
(a) Explain the structure and cash flows associated with a preference share.
(b) What specific features might the National Bank include in the structure of the preference
share to ensure it is attractive to investors, but at the same time meets the funding needs of
the bank? (LO 5.5)
14 Convertible notes, company-issued options and company issued warrants are often referred to
as quasi-equity.
(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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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.
(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
cumulative preference
shares ​175
assets test ​182
company-issued option ​176
business risk ​165
convertible note ​176
capital budgeting 162
convertible preference
shares 175
debt-to-equity ratio ​166
corporate governance ​185
detachable warrant 177
company-issued equity
warrant 177
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delisted ​171
Chapter 5 Corporations issuing equity in the share market
listing rules ​171
preference share 175
loan covenants ​167
present value ​162
dual listing ​171
memorandum of
information 173
profit test ​182
mutually exclusive projects ​164
equity-funded takeover ​174
pro-rata offer ​172
net present value (NPV) ​162
escrow ​183
prospectus ​168
no liability company ​170
financial risk ​165
proxy ​169
non-conventional cash flows ​164
financing decision ​165
publicly listed corporation ​168
non-detachable warrant 177
flotation of a business ​168
non-renounceable right ​173
redeemable preference
shares 175
gearing ratio 166
NPV decision rule ​163
renounceable right ​173
initial public offering
(IPO) ​168
ordinary shares or common
stock ​169
responsible entity ​182
instalment receipt ​169
out-clause ​169
internal rate of return (IRR) ​163
risk ​165
investment decision ​162
participating preference
shares 175
share purchase plan ​173
limited liability company ​169
placement ​173
promoter ​168
rights issue ​172
transparency ​185
underwriting ​168
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earnings attributable to ordinary
shares ​166
Chapter five Review
dividend reinvestment
scheme ​174
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189
Chapter 6
Chapter 12
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 of 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 6 Investors in the share market
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 moneymarket securities.
There are a number of other important factors that encourage investors to invest in securities quoted
on a stock exchange. These include:
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•
•
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 as
at 31 March 2014 of approximately $1.4 trillion and market liquidity in excess of 90 per cent.
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 websits; 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 of listed shares. Next the impact of taxation on the net returns on a share
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.
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191
Part 2 Equity markets
6.1
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
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:
•
•
•
•
•
•
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UNSYSTEMATIC RISK
exposures that
specifically impact on
the share price of a
particular corporation
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.
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 2000 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:
•
•
•
•
•
•
•
•
•
•
SYSTEMATIC RISK
exposures that affect
the price of the
majority of shares
listed on a stock
exchange
Share-market investment
energy
materials
industrials
consumer discretionary
consumer staples
health care
financials
information technology
telecommunication 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 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. The impact may be positive or negative. Examples of systematic
risk exposures include:
•
•
•
•
•
•
changes in interest rates
changes in exchange rates
contraction or expansion in economic activity
introduction of new legislation
political stability
changes in market confidence and perception.
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
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Chapter 6 Investors in the share market
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•
•
•
•
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. An average share 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. 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.
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 debt-to-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 share-market index.
Full replication occurs when a funds manager purchases all the stocks included in an index. However, with
a large index such as the S&P 500, the funds 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
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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
PASSIVE INVESTMENT
a portfolio structure
based on the
replication of a
specific share-market
index
INDEX FUNDS
acquire shares so that
a portfolio replicates a
specific share-market
index
193
Part 2 Equity markets
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
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
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 share prices move in relation to each other. A positive correlation means that the share prices move in
the same direction, while a negative correlation means that the share prices move in opposite directions.
A diversified share portfolio reduces the impact of individual share price variances by combining shares
with low co-variances or low or negative correlations. Interestingly, portfolio theory contends that the
addition of a higher-risk share to a portfolio may in fact reduce the riskiness of the overall portfolio
because of the co-variance characteristic.
Finally, an investor must consider asset allocation within the share portfolio. Major considerations
include:
•
•
•
•
Risk versus return. This includes issues such as systematic and unsystematic risk, beta and 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.
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 life-cycle
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.
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• 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. An average share 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 average.
• 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 share prices move relative to each other. A
positive correlation means both share prices 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.
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Chapter 6 Investors in the share market
6.2
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.
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:
•
•
•
•
•
•
Copyright © 2015. McGraw-Hill Education. All rights reserved.
•
•
•
•
LEARNING
OBJECTIVE
6.2
Detail the process for
buying and selling of
shares
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.
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, transaction costs and
the total amount due. On the ASX, settlement will occur in T + 3 days; that is, the trade day plus three
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.
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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
stock-market securities
DISCOUNT BROKER
executes buy and sell
orders for clients; does
not provide investment
advice or services
195
Part 2 Equity markets
FULL-SERVICE
ADVISORY BROKER
executes buy and
sell orders, but also
provides other services
to clients, including
investment advice
A full-service advisory broker offers advice and recommendations to clients on investment
choices and strategies. The range of services provided includes:
•
•
•
•
•
•
INDIRECT INVESTMENT
investing through
a funds manager
in a unit trust or a
managed fund
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
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 funds
managers. The funds 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).
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• Some issues a direct investor will consider before buying a stock are 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 funds managers to invest in the share markets.
6.3
LEARNING
OBJECTIVE
6.3
Understand the
importance of taxation
in the investment
decision process
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:
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Chapter 6 Investors in the share market
•
•
•
•
the taxation of dividend income
the taxation of capital gains
the rate of tax
the treatment of capital losses.
CAPITAL GAINS
where the value of an
asset increases over
time
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 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 2014–15 tax year are shown in Table 6.1.
Table 6.1 ​Personal income tax rates, Australia, from 1 July 2014
Personal income tax payable (a Medicare levy of
2.00 per cent of taxable income is also payable)
Annual taxable income
0–$18 200
Nil
$18 201–$37 000
19c for each $1 over $18 200
$37 001–$80 000
$3572 plus 32.5c for each $1 over $37 000
$80 001–$180 000
$17 547 plus 37c for each $1 over $80 000
$180 001 and over
$54 547 plus 45c for each $1 over $180 000
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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 taxation regime occurs 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)
Taxable income
Company X:
$100.00
Tax liability (at 30%)(a)
–$30.00
After-tax profits distributed as dividends
$70.00
Franked dividend received
$70.00
(b)
Income included in tax return
Shareholder:
(grossed-up amount, being the dividend
of $70 plus the franking credit of $30)
Marginal tax liability (at, say, 39%)
(c)
Less the franking credit (paid by Company X)
Tax payable
$100.00
$39.00
–$30.00
$9.00
(a) ​Company tax rate for 2013–2014 = 30%; $30 tax paid by the company is available for allocation to
shareholders as a franking credit.
(b) ​Assume 100 per cent of profits are distributed as dividends to shareholders.
(c) ​Assume personal marginal income tax rate = 37% plus 2.00% Medicare levy.
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Part 2 Equity markets
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
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FRANKING CREDIT
the amount of
company tax paid
and transferred to a
shareholder with a
franked dividend
INFLATION
COMPONENT
that part of a capital
gain that is accounted
for by the percentage
increase in prices over
the period
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
assessable 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:
Franking credit = franked dividend ×
company tax rate
1 - company tax rate
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 assessable 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 50 per cent of a capital gain to be
included as assessable income. Capital losses may be used to off set capital gains.
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Chapter 6 Investors in the share market
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.
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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, 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 is 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, financial investments, accounts receivable and stock
(inventories). Current liabilities include accounts payable and short-term debt commitments such as a
bank overdraft facility, bills drawn and commercial paper issued.
Current ratio =
current assets (maturing within one year)
current liabilities (due within one year)
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CURRENT RATIO
ratio of current assets
to current liabilities
6.2
199
Part 2 Equity markets
LIQUID RATIO
ratio of current assets,
less inventory, to
current liabilities, less
bank overdraft
A second, more specific, ratio is the liquid ratio, that is, the ratio of current assets less stock, to
current liabilities less the company’s bank overdraft.
Liquid ratio =
current assets - inventory (stock on hand)
current liabilities - bank overdraft
6.3
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Of the two ratios, the liquid 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 liquid 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. 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 liquid 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
DEPRECIATION
the amount by which
the value of an asset
is written down in an
accounting period
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.
One ratio used to measure a firm’s solvency is the debt to gross cash-flow ratio, which compares the
amount of debt outstanding with the firm’s gross cash flow. Gross cash flow is defined as net profit after
tax, plus non-cash charges, the most important of which is the provision for depreciation. Depreciation
is the amount by which the value of an asset is written down during an accounting period. This ratio
provides an indication of the number of years required for the cash flow to repay the total debt of the
company.
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.
A further 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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Chapter 6 Investors in the share market
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.
Interest cover =
6.4.4
earnings before finance lease charges, interest and tax
finance lease charges and interest
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 to total funds ratio =
EBIT
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 to long ¯ term funds ratio =
EBIT
long ¯ term total funds (i.e. total funds
less short ¯ term debt)
6.6
A further measure of profitability is the return on equity. It is given by:
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Return on equity =
operating profit after tax
equity (shareholders’ funds)
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.
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, for example 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
EARNINGS BEFORE
INTEREST AND TAX
(EBIT)
the profits of a firm
before allowing for
interest expenses and
tax payments
RETURN ON EQUITY
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.
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
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PRICE TO EARNINGS
RATIO (P/E)
the current share
price divided by the
earnings per share
201
Part 2 Equity markets
Table 6.3 ​Selected earnings per share ratios, July 2013 (cents)
Retail sector
Harvey Norman
19.1
JB Hi-Fi
117.02
Woolworths
188.7
Banking sector
Australia and New Zealand Banking Group
216.3
Commonwealth Bank
473.09
National Australia Bank
248.5
Westpac Banking Corporation
224.3
Resources sector
BHP Billiton
238.2
Rio Tinto
484.5
Santos
Woodside Petroleum
45.03
243.6
SOURCE: Morningstar DatAnalysis, 2013.
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.
Table 6.4 ​Selected price to earnings (P/E) ratios (times),
­January 2014
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Retail sector
Harvey Norman
15.42
JB Hi-Fi
16.07
Woolworths
17.00
Banking sector
Australia and New Zealand Banking Group
13.52
Commonwealth Bank
15.05
National Australia Bank
13.14
Westpac Banking Corporation
13.57
Resources sector
BHP Billiton
14.88
Rio Tinto
13.59
Santos
23.20
Woodside Petroleum
17.13
SOURCE: Morningstar DatAnalysis, 2014.
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Chapter 6 Investors in the share market
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.
6.4.6
SHARE PRICE TO NET
TANGIBLE ASSETS
RATIO
current share price
relative to the firm’s
net tangible assets
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.
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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.
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 an average stock listed on an exchange. This measure of risk is
referred to as the beta coefficient. The further a beta moves above or below a beta of 1, the greater is the
risk of the 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.
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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 per cent better than the overall market when share prices are rising, but 15 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 average market share price 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.
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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.
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
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Chapter 6 Investors in the share market
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:
∞
P0 =
Dt
∑ (1 + r )
t =1
s
t
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:
P0 =
D0
rs
6.9
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:
0.50
0.15
= $3.33
P0 =
6.9a
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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. The price will also change if an investor’s required rate of return changes in the future.
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:
D1 = D0(1 + g)
6.10
therefore:
Dt = D0(1 + g)t
The original pricing formula can now be reconfigured so that:
P0 =
D0 (1 + g )
(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
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Part 2 Equity markets
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 )
(rs - g )
(0.75 × 1.07)
=
(0.12 × 0.07)
= $16.05
P0 =
6.12
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
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EX-DIVIDEND
date at which a share
price is theoretically
expected to fall by
the amount of the
declared dividend
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
changes 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:
6.5.3
BONUS ISSUE
where a company
capitalises reserves
through the issue of
additional shares to
shareholders
Cum-dividend and ex-dividend share prices
Share price cum-dividend
$1.00
Dividend paid
$0.05
Theoretical ex-dividend price
$0.95
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, for example 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
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Chapter 6 Investors in the share market
simply represents a change in the structure of the company’s financial capital. The price adjustment for
ex-bonus shares should reflect the new number of shares in, or claims on, the asset value of the company.
For example, if a company offers a one-for-four bonus issue, and its shares are currently priced at $10.00
cum-bonus, the theoretical price ex-bonus would be calculated as:
Cum-bonus share price
$10.00
Market value of four cum-bonus shares
$40.00
Theoretical value of five ex-bonus shares
$40.00
Theoretical value of one ex-bonus share = $40.00/5
$8.00
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. The ex-bonus
price may not be adjusted down by as much as the calculations above suggest.
6.5.4
Share splits
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 highpriced 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
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, for example 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
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RIGHTS ISSUE
the issue of additional
shares to existing
shareholders on a prorata basis
207
Part 2 Equity markets
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, for example 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 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:
Value of right =
N (cum¯rights price - subscription price)
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)
5
$0.80
=
5
= $0.16
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Value of right =
6.13a
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 share 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.
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Chapter 6 Investors in the share market
• Where a company pays a dividend that has a constant growth rate, the price of a share is the
current dividend multiplied by 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; 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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 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. Funds 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 stockmarket 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.
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LEARNING
OBJECTIVE
6.6
Analyse the functions
and importance
of share-market
indices and interpret
published sharemarket information
STOCK-MARKET
INDEX
a measure of the price
performance of the
share market or a
sector of the market
BULL MARKET
a period when share
prices are steadily
rising over time
BEAR MARKET
a period when share
prices are steadily
falling over time
209
Part 2 Equity markets
PERFORMANCE
BENCHMARK INDEX
broad measures
of share-market
performance; based
on capitalisation and
liquidity
MARKET
CAPITALISATION
the number of shares
issued by listed
corporations multiplied
by current share prices
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
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) funds 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 78 per cent of the Australian market.
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, for example equity index futures
contracts. Derivative contracts are discussed in detail in Part 6. The stocks included in this type of index
are relatively stable, 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 valueweighted 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, 68 industries and 154 sub-industries. Additional sector indices that recognise special
market conditions 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,
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Chapter 6 Investors in the share market
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 nondurable 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, operators of health-care facilities, including hospital 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 Telecommunication services. This includes diversified telecommunication services, such as fixed-line,
cellular, wireless, high band width and fibre optic networks.
10 Utilities. This includes companies involved in the production and distribution of electricity, gas and
water.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Passive funds managers use stock-market indices to target certain investment performance
outcomes. For example, a funds manager within the Australian market may adopt the S&P/ASX200 index
as the benchmark for a particular investment fund. In this case, the funds 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 78 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.
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). An extract from the AFR report on
the S&P/ASX 300 is shown in Figure 6.1.
•
•
•
•
•
•
•
•
•
•
•
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.
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211
Part 2 Equity markets
Figure 6.1 ​ASX share-market listing (extract)
52
Week
High
52
Week
Low
Day’s
High
2.51
2.095
2.22
2.19
ABP
4.12
2.18
2.28
2.23
ACR Acrux
3.88
3.01
3.59
3.51
ABC
16.60
13.85
14.69
14.42
4.79
2.56
4.31
4.19
AGI
4.73
1.94
2.49
2.39
0.87
0.245
0.36
12.272
7.86
1.405
Copyright © 2015. McGraw-Hill Education. All rights reserved.
Earn
share
¢
P/E
ratio
7.43
13.68
16.2
0.14
3.54
4.16
54.3
1.41
1.30
4.66
23.20
15.3
63.00
1.12
7.56
4.33
70.70
20.6
8.00
2.00
0.54
1.89
16.00
26.5
–
–
–318.93
–
–
–
19.00
1.9
-0.07
5.44
53.73
15.7
–
1.01
–
–1.92
–
5.50
1.55
0.34
2.67
8.50
24.2
11.48
40.00
1.24
0.94
3.49
49.80
23.0
4.22
4.24
24.00
1.03
1.18
5.69
24.80
17.0
2 802
19.67
19.73
38.00
2.75
1.79
1.93 104.60
18.9
4.0
42 567
30.28
30.32 164.00
1.41
13.48
5.41 231.30
13.1
+ or
– (¢)
Abacus Prop
stp
2.22
1.0
3 661
2.20
2.22
16.50
0.83
2.32
2.26
2.0
5 620
2.25
2.26
8.00
0.52
3.54
3.0
11 068
3.53
3.55
16.50
14.55
–8.0
13 334
14.53
14.57
Ainsworth
Game Tech
4.24
–2.0
788
4.21
4.24
AQG
Alacer Gold
cdi
2.42
6.0
5 504
2.42
2.44
–
–
0.35
ALK
Alkane Res
0.355
1.5
2 736
0.355
0.36
–
–
8.58
8.10
ALQ ALS
8.46
36.0
37 531
8.45
8.49
46.00
1.17
0.89
1.02
0.982
AWC Alumina
1.02
1.5
78 017
1.01
1.02
–
2.20
1.39
2.10
2.05
AMM Amcom Telco
2.06
1.0
1 495
2.05
2.08
11.53
7.84
11.53
11.41
11.47
17.0
47 690
11.42
4.28
4.22
4.22
–7.0
68 716
19.73 –12.0
4.155
AGK AGL Energy
AMC Amcor
AMP AMP
Quote Quote
Buy
Sell
Div
Net
Div
Times Tangible yield
cov’d Assets
%
Last
Sale
Adelaide
Brighton
Vol
100’s
Div ¢
per
share
Company
Name
5.79
Day’s ASX
Low Code
22.24
14.62
19.85
19.55
ANN Ansell
34.06
24.47
30.59
29.98
ANZ
ANZ Banking
30.29
Grp
6.97
5.35
6.37
6.17
APA
APA Grp stp
6.36
20.0
52 817
6.33
6.36
35.50
1.09
1.42
5.58
38.70
16.4
0.52
0.235
0.455
0.44
APN
APN News &
0.455
Media
1.5
8 419
0.44
0.46
–
–
–0.18
–
–18.60
–
3.27
1.63
2.195
2.13
AQA Aquila Res
2.18
2.0
468
2.16
2.18
–
–
–
77.10
2.8
13.88
10.79
11.39
11.02
11.24
–3.0
1 069
11.20
11.24
28.00
2.09
2.27
2.49
58.44
19.2
2.06
1.27
1.94
1.91
1.94
1.0
4 183
1.925
1.94
12.00
0.78
0.73
6.19
9.32
20.8
5.12
3.04
4.39
4.30
ALL
Aristocrat
Leisure
4.38
2.0
6 886
4.37
4.38
14.50
1.34
0.41
3.31
19.50
22.5
1.68
0.675
1.635
1.56
ARI
Arrium
1.61
3.0
49 426
1.61
1.615
5.00
–
1.25
3.11 –51.52
6.23
4.47
5.545
5.42
AIO
Asciano
5.48
–6.0
15 189
5.48
5.51
11.50
3.03
0.86
2.10
2.35
1.43
1.54
1.50
APZ
Aspen Grp
stp
1.535
3.5
996
1.53
1.54
15.00
–
2.21
9.77 –28.40
3.98
2.79
3.49
3.33
AJA
Astro Japan
Prop Grp
forus
–
372
3.45
3.46
17.50
1.19
3.75
5.07
20.76
16.6
30.076
35.63
35.26
ASX
ASX
5 643
35.36
35.41 170.20
1.15
5.04
4.81 195.50
18.1
0.685
1.17
1.135
AGO Atlas Iron
31 468
1.15
–
1.62
2.60 –27.00
–
39.38
1.945
ARP
ARB Corp
Ardent
AAD Leisure Grp
stp
3.45
35.40 –30.0
1.155
0.5
1.16
3.00
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–
34.90
–
15.7
–
Chapter 6 Investors in the share market
Figure 6.1 (continued) ASX share-market listing (extract)
52
Week
High
Day’s
High
Day’s
Low
ASX
Code
Company
Name
Last
Sale
+ or –
(¢)
Vol
100’s
Div ¢
per
share
Div
Times
cov’d
Net
Tangible
Assets
Div
yield
%
Earn
share
¢
P/E
ratio
3.32
10.09
1.12
1.59
3.04
11.34
29.3
–
2.63
19.80
23.6
–
21.95
13.0
Quote
Buy
Quote
Sell
434
3.30
3.33
2.11
3.33
3.25
AIA
Auckland
Airport
3.32
4.825
3.62
4.73
4.65
AZJ
Aurizon
Hldgs
4.68
–2.0 124 947
4.68
4.71
12.30
1.61
3.92
2.63
2.95
2.85
AUT
Aurora Oil &
Gas
2.86
–1.0
17 006
2.86
2.87
–
–
3.27
0.76
0.87
0.815
ASL
Ausdrill
0.865
–1.5
20 695
0.855
0.87
12.00
2.47
2.39 13.87
29.63
2.9
3.627
0.57
0.70
0.665
AAX Ausenco
0.685
3.5
20 379
0.68
0.69
12.10
1.64
0.52 17.66
19.80
3.5
1.33
0.997
1.21
1.195
AAC
1.20
–1.0
3 971
1.20
1.21
–
–
1.58
–
–9.02
–
0.67
0.36
0.55
0.537
API
Aust Pharma­
0.545
ceutical
–0.5
2 095
0.535
0.545
3.25
1.54
0.77
5.96
5.00
10.9
5.96
2.95
3.24
3.05
ANG
Austin
Engineer
3.21
14.0
394
3.14
3.21
15.00
2.61
0.89
4.67
39.18
8.2
4.02
3.14
3.72
3.66
ALZ
Australand
Prop stp
3.72
3.0
12 558
3.70
3.72
21.50
1.44
3.57
5.78
31.00
12.0
4.37
3.05
3.43
3.35
AHE
Automotive
Hldgs
3.42
–1.0
1 629
3.40
3.42
20.00
1.28
0.91
5.85
25.62
13.3
2.20
0.915
2.02
1.98
AOG Aveo Grp stp
2.00
2.0
8 843
1.995
2.00
1.00
–
3.53
0.50 –57.56
1.47
1.105 1.305
1.247
AWE AWE
1.27
8.5
37 715
1.265
1.275
–
–
1.44
12.76
7.16 11.51
11.38
BOQ Bank of Qld
11.43
1.0
8 781
11.42
11.43
58.00
1.01
0.11 0.185
0.175
BRL
Bathurst Res
NZ
0.175
–1.5
8 101
0.175
0.18
–
–
8.30 10.95
10.80
BEN
Bendigo &
Adelaide Bk
10.95
15.0
12 767
10.93
10.95
61.00
1.39
1.705
IMF
Bentham IMF 1.705
–1.5
1 418
1.705
1.72
5.00
30.43 35.735
35.38
BHP
BHP Billiton
35.66 –19.0
64 758
35.65
35.67 119.94
0.122 0.435
0.417
BBG Billabong Int’l
0.277
11.43
2.12
39.34
Copyright © 2015. McGraw-Hill Education. All rights reserved.
52
Week
Low
1.02
5.81
2.38
1.505
1.73
Aust
Agriculture
4.0
1.23
3.84
33.1
5.07
58.40
19.6
–
–
–
6.62
5.57
84.90
12.9
2.24
0.32
2.93
11.21
15.2
1.84
13.47
3.36 220.38
16.2
–
–
–
–
0.43
–0.5
24 401
0.425
0.43
–
–
0.11
–
–173.80
–
–
–
0.06
–
–15.10
–
5.23
5.13
BSL
BlueScope
Steel
5.20
3.0
15 985
5.19
5.20
0.255 0.335
0.31
BLY
Boart
Longyear
0.33
2.5
54 101
0.325
0.33
0.96
–
1.19
2.91 –84.82
–
Boral
4.63
1.0
36 753
4.63
4.65
11.00
–
3.17
2.38 –27.70
–
3.22
5.28
3.97
4.64
4.58
BLD
7.63
4.03
5.72
5.36
BKN Bradken
5.63
32.0
31 015
5.63
5.68
38.00
1.04
2.23
6.75
39.60
14.2
9.85
7.30
8.62
8.43
BXB
8.61
–2.0
33 816
8.58
8.61
27.00
1.65
0.66
3.14
44.42
19.4
Brambles
SOURCE: Australian Financial Review, www.afr.com/share_tables, S&P/ASX300 extract, December 2013.
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Part 2 Equity markets
•
•
•
•
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
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, telecommunications 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,
Copyright © 2015. McGraw-Hill Education. All rights reserved.
economic and share-market information relevant to share investments.
Financial news case study
In Chapter 6 we discussed some widely used indicators of market value, especially the P/E or price-toearnings ratio. The P/E ratio has been used for decades as an indicator that promises to allow investors
to gain some insights into whether shares are cheap or expensive. When the average P/E ratios for
particular sectors or the share market as a whole are tracking lower than their historical averages there
is an indication that the market is not overvalued and might even be undervalued (and vice versa).
In recent years, the ‘classical’ P/E ratio has been surpassed in popularity by Shiller’s cyclically adjusted
P/E ratio (CAPE), or simply ‘the Shiller P/E’, named after Robert Shiller from Yale University (more will be
said about him in Chapter 7). This ratio is now widely reported. Several years after the global financial
crisis, with American market indexes posting record highs, debate ensued regarding the validity of the
Shiller P/E as it indicated that markets were significantly overvalued. The following article discusses the
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Chapter 6 Investors in the share market
Shiller P/E and outlines some criticisms of it. It is important for finance students to be familiar with the
Shiller P/E and its use, particularly in the North American financial markets.
The Shiller price/earnings ratio has become the go-to method for valuing stock markets, but its flaws are
drawing more attention as markets hit new highs. David Bianco, chief investment strategist at Deutsche
Bank, has been one of the more vocal critics, detailing the ratio’s pitfalls in two recent notes.
His main beef centres on its approach to estimating normalized earnings and the corresponding cyclically
adjusted price/earnings ratio. The Shiller P/E ratio, which is named after well-known Yale professor
Robert Shiller, uses the annual earnings of S&P 500 companies over the past 10 years and then adjusts
past earnings for inflation using the consumer price index.
This makes it a more stable market valuation indicator than a simple P/E ratio, because it eliminates
the variation of profit margins during business cycles. But Mr. Bianco believes the ratio is not sufficient,
largely because it does not adjust for EPS growth that should come from retained earnings.
‘This is a major pitfall because dividend payout ratios have declined tremendously since 1900–1950,
from over two-thirds to less than a third the last decade,’ he said. ‘Not adjusting past EPS for growth that
should come from retained earnings is a major distortion that compounds with time.’
It also means, he added, that the EPS underlying the Shiller ratio significantly underestimates today’s
normal EPS. ‘This makes the observed Shiller PE unreliable in both absolute terms and relative to history,’
Mr. Bianco said.
His solution—aka the Bianco ratio—is to raise past earnings per share by the nominal cost of equity less
the dividend yield. It’s heady stuff, for sure, but what’s important for investors is the striking difference in
results between the two valuation methods.
The Shiller ratio is currently near 25, well above its historical average back to 1910 of 16.3, while the
Bianco ratio has the S&P 500 trading at 16.5, just slightly above its average of 13.9 over the same
period. That suggests the key U.S. equity benchmark may not be as expensive as many investors think,
but the debate doesn’t end there.
The current Shiller ratio is usually compared to its 113-year average, but Mr. Bianco believes a better
comparison is the average from 1960 onwards as the S&P 500 didn’t exist until 1957. In this case,
the historical average for the Shiller is 19.6 while it’s 15.6 for the Bianco. ‘[The historical average from
1910] includes the WWI EPS cycle, when companies benefited tremendously from supplying Europe,’
the Deutsche Bank strategist noted.
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‘Profits tripled from 1914 to 1916, and then fell to less than a fifth during the 1921 post war recession.
This exceptional profit swing distorts the long-term average 10yr PE a full point.’
James Paulsen, chief investment strategist at Wells Capital Management, also recently questioned the
historic valuation range used for the Shiller and most other popular valuation metrics. He said there are
actually two distinct valuation ranges—one prior to 1990 and a noticeably higher range since 1990—
with the Shiller experiencing the most profound change over the past 23 years.
‘The mean Shiller PE has been almost double its old historical average (about 26 times since 1990 versus
about 14 times prior to 1990) and since 1990 has ranged almost persistently beyond one standard
deviation above the old mean PE prior to 1990,’ he told clients in a note recently.
There could be a number of reasons for the shift, Mr. Paulsen said, including broader stock market
participation, aging demographics and the technology boom and bust of the late 1990s and early
2000s.
Whatever the case, he believes the new valuation range, which suggests a reasonably priced S&P 500
at the moment, has persisted too long to ignore. At the same time, he’s not willing to dismiss the old and
presently more pessimistic valuation range altogether.
‘Perhaps investors are best served by heeding both,’ he said.
SOURCE: Pett, D. 2013, ‘The Trouble With P/E Values’, The Financial Post, 12 November 2013, www.financialpost.com
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Part 2 Equity markets
Discussion points
•
Outline the difference between the Shiller P/E and the ‘ordinary’ P/E ratio.
•
Explain how biases in underlying data, such as those introduced by earnings volatility or
changes in accounting standards over time, may undermine a conclusion based on a comparison
between the current Shiller P/E and its long-term historical average.
•
The Shiller P/E is computed on the basis of the past 10 years of earnings adjusted by inflation.
Explain why this approach is supposed to make the Shiller P/E a more ‘stable’ indicator of value
than the traditional approach of computing the P/E ratio for a company or market on the basis
of one year of earnings.
•
In an interview with the New York Times in 2013, James Stack of InvesTech Research commented:
‘Normalised earnings are fine to use if the periods you’re looking at are going to be more
normal. But anyone looking at 10-year P/E’s today has to realise that the past decade has been
anything but normal.’ Discuss the implications of this statement with reference to the applicability
of the Shiller P/E ratio as an indicator of market value after the global financial crisis.
Summary
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
Copyright © 2015. McGraw-Hill Education. All rights reserved.
attached to these securities creates an expectation in the investor of a higher level of return, on
average, over time.
• A stock exchange brings buyers and sellers together to form an efficient, deep and liquid market in
securities.
• A share in a listed company, in part, 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 greater or lesser extent.
Unsystematic risk specifically impacts on the share price of individual stocks.
• Portfolio theory demonstrates that, by holding a diversified share portfolio, unsystematic risk can be
substantially reduced. The remaining systematic risk is measured using a beta coefficient. This is a
statistical measure of the sensitivity of a share price relative to an average share listed on a stock
exchange.
• 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 preferences.
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Chapter 6 Investors in the share market
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 preferences, and tactical, in that it will be monitored and managed to take account of new
information that comes to the market.
LEARNING OBJECTIVE 6.2
Detail the process for buying and selling of 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
Chapter six Review
• With a passive approach, an investor will seek to replicate the structure, and therefore the return, of
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 + 3 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?
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• For example, in Australia the marginal tax rate ranges up to 45 per cent, plus a 2.00 per cent
Medicare levy. Generally, 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.
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.
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Part 2 Equity markets
• 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 after-tax 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 through the ratio of debt to gross cash
flows, or through the ratio of EBIT to total interest.
• 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 current market 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 share price.
• Alternatively, a dividend payment may increase over time. It is assumed that that increase will be at
a constant growth rate. To calculate the share price, the last dividend is multiplied by 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.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
• 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 share-market
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.
• The global industry classification standard (GICS) comprises 10 industry sectors (energy, materials,
industrials, consumer discretionary, consumer staples, health care, financials, informational technology,
telecommunication 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.
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Chapter 6 Investors in the share market
True/False questions
Answer TRUE or FALSE to the following statements. To assist in your review, you might also write brief
notes explaining your response.
1
Fixed interest securities are more volatile and, as such, will generate higher average returns than
shares in publicly listed corporations.
2
Systematic risk refers to the risk that derives from factors unique to a particular company.
3
Portfolio theory contends that the imperfect correlation characterising the returns of different
securities is the basis for an investment strategy that can reduce the total risk of a portfolio.
4
A share that has a beta of 0.50 is half as risky as an average share listed on a stock market.
5
If new economic information comes to the market, shares that demonstrate a zero price correlation
will tend to move in opposite directions.
6
With dividend imputation, a shareholder with a marginal tax rate that is lower than the company
tax rate will pay no tax on a fully franked dividend received, and the excess credit can be
applied against other assessable income.
7
A company’s liquidity, that is, its ability to meet its short-term financial obligations, may be measured
using the current ratio and the liquid ratio. Of the two ratios, the latter is the more stringent measure.
8
It can be safely inferred that a company with a low current ratio is a riskier investment than a
company with a high current ratio.
9
In comparing the profitability of different companies that have quite different financial structures,
the use of the EBIT to total funds employed ratio would be more suitable than the EBIT to
shareholders’ funds ratio.
Chapter six Review
Questions
10 Given that the banking sector consistently displays a higher debt-to-equity ratio than do other
sectors of the market, it can be reasonably concluded that there is a greater level of risk associated
with investments in this sector.
11 A price to net tangible assets ratio of less than 1 indicates that the book value of the company’s
assets exceeds the market’s valuation of the company.
12 A share with a constant dividend of $1.00, discounted at a rate of 20 per cent, should trade at
a price of $5.00.
Copyright © 2015. McGraw-Hill Education. All rights reserved.
13 A company announces the payment of an interim dividend of 65 cents per share. The cumdividend shares are trading at $12.60. The theoretical ex-dividend price will be $13.25.
14 The issue of bonus shares merely changes the composition of the firm’s equity as bonus issues do
not add to the firm’s capital.
15 In a one-for-nine bonus issue, if the cum-bonus price of the share was $10, then the theoretical
ex-bonus price would be $9.
16 A pro-rata rights issue that has a 100 per cent take-up rate simply increases the number of shares
issued and has no effect on the company’s capital.
17 If a rights issue is renounceable, the right may be sold by a shareholder to another party before
the exercise date.
18 In a one-for-five rights issue, priced at $2 a share, and with the shares valued at $2.40 cumrights, the theoretical ex-rights price of the share would be $2.33, and the value of the right
would be $0.33.
19 The global industry classification standard (GICS) is a measure of the liquidity in major stockmarket indices around the world.
20 A share price accumulation index measures changes over time in the price of shares included in
the index.
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Part 2 Equity markets
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
Portfolio management draws on some well-known statistical concepts, including averages,
variance, co-variance and correlation. In assuming control of an existing portfolio, explain how
each of these statistical concepts may give you an insight into the portfolio’s expected returns
and risk. (LO 6.1)
2
(a) Ms Brown has an investment portfolio comprising Australian shares. At a meeting with
her investment advisor 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.
(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
$6500
beta 1.20
Telstra
$8600
beta 0.95
ANZ Bank
$7900
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 $5000 worth of shares in Myer
(beta 1.60), what impact would that purchase have on the risk structure of the portfolio?
(LO 6.1)
4
As an investment adviser for a managed fund that invests in Australian resources shares, you
must advise clients on the fund’s strategy of passive investment. Analyse and explain the concept
of passive investment to your client, and describe how the fund manager uses an index fund to
achieve a specific performance outcome. (LO 6.1)
5
Jack and Jill have recently married and have decided to start buying shares for an investment
portfolio.
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(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
the shareholder’s marginal tax rate is 37 per cent, plus Medicare levy of 2 per cent. The investor
receives a 70 per cent partly franked dividend of $12 700.00.
(a)Explain the dividend imputation process.
(b) Why might a dividend be only partly franked?
(c) Calculate the income tax payable by the investor. (LO 6.3)
7
(a) Explain what is meant by the liquidity of a company. Define two common accounting
measures of liquidity.
(b) Why is liquidity an important indicator that an investor should consider when analysing
share investment opportunities? (LO 6.4)
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Chapter 6 Investors in the share market
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 corporation’s price to earnings ratio (P/E) is a commonly used measure in the analysis of share
investments. An investor who is analysing two retail sector corporations notes their P/E ratios for
the past three years:
JB Hi-Fi
Woolworths
2012
2013
2014
8.37
14.37
16.95
12.00
17.38
18.56
Chapter six Review
8
(a) Define the calculation and discuss the meaning and purpose of a P/E ratio.
(b) Analyse and interpret the data in the table. (LO 6.4)
11 Gazal Limited pays a constant dividend of $0.18 cents per share. A fund manager is considering
purchasing the shares as part of an investment portfolio. The fund manager requires a return of
14 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 AMP Limited was $0.23 per share. Assume that the board
of directors of the company plans to maintain a constant dividend growth policy of 4.00 per cent.
An investor, in evaluating an investment in the company, has determined that she would require a
17 per cent rate of return from this type of investment. If the current price of AMP shares in the stock
market is $5.22, 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 ‘cum-dividend’
and ‘ex-dividend’.
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(b) Calculate the theoretical price of the share after the bonus issue and the dividend payment
have occurred. (LO 6.5)
14 Myer Holdings 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-ten 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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221
Part 2 Equity markets
Key terms
accumulation index 210
ex-dividend 206
active investment 193
bear market 209
expected return of a
portfolio 194
beta 193
franked dividends 198
price to earnings ratio (P/E) 201
bonus issue 206
franking credit 198
renounceable 208
bull market 209
full-service advisory
broker 196
return on equity 201
global industry classification
standard (GICS®) 210
share price index 210
capital gains 197
capital structure 199
co-variance or correlation 194
cum-dividend 206
current ratio 199
depreciation 200
direct investment 195
discount broker 195
diversified investment
portfolio 193
earnings before interest and tax
(EBIT) 201
portfolio variance 194
rights issue 207
grossed-up amount 198
share price to net tangible
assets ratio 203
index funds 193
share split 207
indirect investment 196
stock-market index 209
inflation component 198
stockbroker 195
interest cover ratio 200
stock liquidity 210
liquid ratio 200
strategic asset allocation 194
marginal rate of tax 197
systematic risk 192
market capitalisation 210
tactical asset allocation 194
market indicator index 210
tradable benchmark index 210
passive investment 193
unsystematic risk 192
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earnings per share (EPS) 201
performance benchmark
index 210
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Chapter 7
Chapter 12
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
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LO 7.2
LO 7.3
LO 7.4
LO 7.5
Identify and interpret economic variables that impact on share price movements within the context
of the top-down approach to fundamental analysis.
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.
Describe and apply technical analysis to forecasting movements in share prices.
Examine the role of electronic trading in influencing share price movements.
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
Introduction
The market price for a company’s shares is determined by the demand for, and supply of, the shares.
At any point in time, the level of demand and supply represents the liquidity of a specific stock and the
stock market generally. Most importantly, demand, supply and liquidity are primarily influenced by new
information coming to the market. Therefore, information is the life-blood of the stock market.
New information may derive from many sources, including company notices to the stock exchange
(continuous reporting requirements), advice to shareholders at general meetings, management meetings
with institutional investors (road-shows), or articles in the media. Information may take the form of
reports published using recent company performance data or analysis of forecasts for economic, industry
and company growth into the future. Sometimes the new information is rumour or speculation.
In the secondary market, if shareholders become disenchanted with the performance of a company in
which they hold shares, they may decide to sell their shares and thus increase the supply of that company’s
shares on the market. The increased supply of shares is likely to bring about a fall in the share price. The
price fall occurs because the demand for the shares from potential new investors will also decline as they
become aware that existing shareholders are not happy with the performance of the company. The fall in
price will be necessary to encourage investors to buy the shares, that is, to achieve equilibrium between
demand and supply of that share.
Conversely, if a company is expected to perform better than other companies, there will be an
increased demand for the company’s shares. It will generally be necessary to bid a price above the current
price in order to induce current shareholders to sell their shares.
Given the importance of information as a driver of change in the demand for, and the supply of, shares
listed on a stock exchange, 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:
•
•
•
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 historic share price movements over time.
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This chapter analyses each approach. Further, we consider the impact electronic trading might have
in influencing share price movements.
Finally, having gained an awareness of factors that influence the demand for and supply of shares
in the market, three theoretical concepts are introduced that seek to explain movements in share prices
further:
1 the random walk hypothesis, which recognises that share price movements respond to new
information coming to the market
2
the efficient markets 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.
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 pri