2016/3/10
IEB Wireframe
Page iii
http://textflow.mheducation.com/parser.php?secload=0.2&fake&print
1/1
2016/3/10
IEB Wireframe
Page i
FINANCIAL INSTITUTIONS, INSTRUMENTS AND MARKETS
Page ii
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
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.
http://textflow.mheducation.com/parser.php?secload=0.1&fake&print
1/1
2016/3/10
IEB Wireframe
Page iv
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd
Additional owners of copyright are acknowledged in on-page credits.
Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their
apologies should any infringement have occurred.
Reproduction and communication for educational purposes
The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work, whichever
is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes
provided that the institution (or the body that administers it) has sent a Statutory Educational notice to Copyright
Agency Limited (CAL) and been granted a licence. For details of statutory educational and other copyright licences
contact: Copyright Agency Limited, Level 15, 233 Castlereagh Street, Sydney NSW 2000. Telephone: (02) 9394 7600.
Website: www.copyright.com.au
Reproduction and communication for other purposes
Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Act, no
part of this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a
database or retrieval system, without the written permission of McGraw-Hill Education (Australia) Pty Ltd, including,
but not limited to, any network or other electronic storage.
Enquiries should be made to the publisher via www.mheducation.com.au or marked for the attention of the permissions
editor at the address below.
National Library of Australia Cataloguing-in-Publication Data
Author:
Title:
Edition:
ISBN:
Notes:
Subjects:
Other
Authors/Contributors:
Viney, Christopher, author.
Financial institutions, instruments and
markets / Christopher Viney, Peter Phillips.
8th edition
9781743079959 (paperback)
Includes index.
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.
Phillips, Peter John, author.
Published in Australia by
McGraw-Hill Education (Australia) Pty Ltd
Level 2, 82 Waterloo Road, North Ryde NSW 2113
Publisher: Jillian Gibbs
Senior product developer: Lisa Coady
Production editor: Natalie Crouch
Permissions editor: Haidi Bernhardt
Copyeditor: Julie Wicks
Proofreader: Anne Savage
Indexer: Graham Clayton
Cover design: Christa Moffit
Internal design: David Rosemeyer
Typeset in Chaparral Pro 10/12 by SR Nova
Printed in China on 70 gsm matt art by CTPS
http://textflow.mheducation.com/parser.php?secload=0.3&fake&print
1/2
2016/3/10
IEB Wireframe
Page xiv
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.
CH R I S T O P H E R VI N E Y
http://textflow.mheducation.com/parser.php?secload=0.4&fake&print
1/1
2016/3/10
IEB Wireframe
Page xv
C H R I S T O P H E R V I N E Y 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.
P E T E R P H I L L I P S 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.
http://textflow.mheducation.com/parser.php?secload=0.5&fake&print
1/1
2016/3/10
IEB Wireframe
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 McGraw-Hill
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.
CH R I S T O P H E R VI N E Y
AND
PE T E R PH I L L I P S
http://textflow.mheducation.com/parser.php?secload=0.6&fake&print
1/1
2016/3/10
IEB Wireframe
Page xvi
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 7 Forecasting share price movements
examines fundamental analysis and technical analysis approaches to share price forecasting
http://textflow.mheducation.com/parser.php?secload=0.7&fake&print
1/3
2016/3/10
IEB Wireframe
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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
Page xvii
C H A P T E R 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
C H A P T E R 12 Government debt, monetary policy and the payments system
examines why governments issue short-term and longer-term 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 15 Foreign exchange: the structure and operation of the FX market
examines the structure, participants, operation and conventions in the global FX markets
http://textflow.mheducation.com/parser.php?secload=0.7&fake&print
2/3
2016/3/10
IEB Wireframe
discusses and calculates spot and forward FX quotations
considers the impact of the Economic and Monetary Union of the European Union (EMU)
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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
C H A P T E R 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.
http://textflow.mheducation.com/parser.php?secload=0.7&fake&print
3/3
2016/3/10
IEB Wireframe
Page xviii
Page xxii
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.
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.
LEARNING OBJECTIVES These numbered points clearly outline what each reader should know and be able to do by the end of
the chapter. They will also assist in exam revision. Each learning objective notes the numbered section in which the
learning objective appears in the chapter. They are directly linked to the end-of-chapter summary, which systematically
works through each learning objective.
http://textflow.mheducation.com/parser.php?secload=0.8&fake&print
1/4
2016/3/10
IEB Wireframe
KEY TERMS, MARGIN DEFINITIONS AND THE KEY TERMS LIST Each key term or concept is highlighted in the text at its
first appearance, and the definition 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.
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!
Page xix
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.
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.
http://textflow.mheducation.com/parser.php?secload=0.8&fake&print
2/4
2016/3/10
IEB Wireframe
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.
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 in-depth extended learning sections and require students to demonstrate a
deeper understanding of the concepts and theories presented in the chapter.
Page xx
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.
http://textflow.mheducation.com/parser.php?secload=0.8&fake&print
3/4
2016/3/10
IEB Wireframe
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.
GLOSSARY This useful list of definitions contains all of the key terms and concepts as they appear in the margin notes.
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!
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.
http://textflow.mheducation.com/parser.php?secload=0.8&fake&print
4/4
2016/3/10
IEB Wireframe
Page xxi
McGraw-Hill Connect is a digital teaching and learning environment that improves performance over 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, anywhere. Connect can give you access to your assignments, eBook
(within Connect Plus), videos, animations and more. Millions of students have used Connect and the results are in:
research shows that studying with McGraw-Hill Connect will increase the likelihood that you'll pass your course and get
a better grade.
Connect support
Connect includes animated tutorials, videos and additional embedded hints within specific questions to help you succeed.
The Connect Success Academy for Students is where you'll find tutorials on getting started, your study resources and
completing assignments in Connect. Everything you need to know about Connect is here!
Visual progress
Connect provides you with reports to help you identify what you should study and when your next assignment is due, and
tracks your performance. Connect's Overall Performance report allows you to see all of your assignment attempts, your
score on each attempt, the date you started and submitted the assignment, and the date the assignment was scored.
To find out more about Connect and Connect Plus visit www.mheducation.com.au/digital/connect
http://textflow.mheducation.com/parser.php?secload=0.9&fake&print
1/1
2016/3/10
IEB Wireframe
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
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.
FINANCE
GLOSSARIES
This text includes a glossary of the main financial market words referred to in the book. As you extend your
understanding of the financial system further, www.investorwords.com provides online access to over 6000 words and 20 000
links. It is the biggest financial glossary on the web.
DATABASES
This is a list of some of the suggested databases your library may have access to that contain finance articles and
information. If your institution does not have access to all the databases you may be able to get access through another
institution, so check with your library about borrowing rights at other universities.
Proquest: Academic research library Covers finance, has full text articles.
Connect4: Annual report collections Business provides full text annual reports from various Australian companies
including some company financial statements.
APA Full Text (Australian Public Affairs full text) Lists a large range of Australian periodicals with some access to
full text.
Proquest: Banking Information Sources International database, full text article access. Covers banking and industry and
the financial services industry.
Expanded Academic ASAP Full text articles available, international.
Factiva Full text available, covers most Fairfax publications including Business Review Weekly, The Australian Financial
Review and The Age.
Science Direct Full text, international. Includes access to journals such as Journal of Financial Markets, Journal of
International Money and Finance and Journal of Banking and Finance.
You can find these databases by selecting your subject (finance, business, economics) and searching the library subject
pages for relevant journal listings. Alternatively, look them up in alphabetical order through the online library
catalogue to check for access. You may need a password when accessing them off campus.
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.
Page xxiii
FINANCE MEDIA
Although not all of these may be available from your library (either in hard copy or through online access with a
password) it is worth investigating the possibilities of interlibrary loans. Ask your subject librarian for information
about accessing the catalogues of other libraries.
Wall Street Journal
http://online.wsj.com/public/asia
The Wall Street Journal has great information available online without subscription.
MSN Money
www.money.msn.com
http://textflow.mheducation.com/parser.php?secload=0.10&fake&print
1/3
2016/3/10
IEB Wireframe
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 AUTHORITIES
The Reserve Bank of Australia website www.rba.gov.au/links provides direct link access to the websites of:
central banks
EMEAP members
other international organisations
Australian government departments and authorities
Australian legislation
Australian financial sector organisations
AUSTRALIAN
MAJOR BANKS
ANZ Banking Group – www.anz.com.au
Commonwealth Bank of Australia – www.commbank.com.au
National Australia Bank – www.nab.com.au
Westpac Banking Corporation – www.westpac.com.au
SELECT
INTERNATIONAL FINANCIAL INSTITUTIONS
Allianz – www.allianz.com
Citibank – www.citibank.com
Credit Suisse – www.credit-suisse.com
Goldman Sachs – www.goldmansachs.com
ING Bank – www.ing.com
JPMorgan Chase & Co – www.jpmorgan.com
UBS Investment Bank – www.ibb.ubs.com
CREDIT
RATING AGENCIES
Fitch Ratings – www.fitchibca.com
Moody's Investors Service – www.moodys.com
Standard & Poor's – www.standardandpoors.com
INFORMATION
PROVIDERS
Bloomberg – www.bloomberg.com
Dow Jones – www.dowjones.com
Thomson-Reuters – www.reuters.com
EXCHANGES
AND MARKETS
Australian Securities Exchange – www.asx.com.au
New Zealand Stock Exchange – www.nzx.com
http://textflow.mheducation.com/parser.php?secload=0.10&fake&print
2/3
2016/3/10
IEB Wireframe
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
http://textflow.mheducation.com/parser.php?secload=0.10&fake&print
3/3
2016/3/10
IEB Wireframe
Page xxiv
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
Page xxv
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
http://textflow.mheducation.com/parser.php?secload=0.11&fake&print
1/2
2016/3/10
IEB Wireframe
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!
Distinguish yourself from other applicants
Employers advise that the best way to make your application stand out are the simple things:
Fill out all the fields.
Proper business language should be used as you would for a paper-based application. Just because it is an online
form doesn't mean that you should use more informal or text language, or insert symbols, for example smiley faces.
Check your spelling, or get others to check it for you—spell checks don't pick up everything.
Answers to in-depth questions should be carefully thought out and tailored to each employer, not a generic cut-andpaste 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!
http://textflow.mheducation.com/parser.php?secload=0.11&fake&print
2/2
Front Matter
PART 1.FINANCIAL INSTITUTIONS
Chapter 1.A modern financial system: an overview
Chapter 2.Commercial banks
Chapter 3.Non-bank financial institutions
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
Chapter 7.Forecasting share price movements
PART 3.THE CORPORATE DEBT MARKET
Chapter 8.Mathematics of finance: an introduction to basic concepts and
calculations
Chapter 9.Short-term debt
Chapter 10.Medium- to long-term debt
Chapter 11.International debt markets
PART 4.GOVERNMENT DEBT, MONETARY POLICY, THE PAYMENTS SYSTEM AND
INTEREST RATES
Chapter 12.Government debt, monetary policy and the payments system
Chapter 13.An introduction to interest rate determination and forecasting
Chapter 14.Interest rate risk measurement
PART 5.THE FOREIGN EXCHANGE MARKET
Chapter 15.Foreign exchange: the structure and operation of the FX market
Chapter 16.Foreign exchange: factors that influence the exchange rate
Chapter 17.Foreign exchange: risk identification and management
PART 6.DERIVATIVE MARKETS AND RISK MANAGEMENT
Chapter 18.An introduction to risk management and derivatives
Chapter 19.Futures contracts and forward rate agreements
Chapter 20.Options
Chapter 21.Interest rate swaps, cross-currency swaps and credit default swaps
End Matter
2016/3/11
IEB Wireframe
Page 1
Financial institutions
Chapter 1 A modern financial system: an overview
Chapter 2 Commercial banks
Chapter 3 Non-bank financial institutions
Page 2
Part 1
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.
Page 3
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
http://textflow.mheducation.com/parser.php?secload=1&fake&print
1/2
2016/3/11
IEB Wireframe
the chapter an extended learning section is provided: ‘Project finance and structured finance’.
http://textflow.mheducation.com/parser.php?secload=1&fake&print
2/2
2016/3/10
IEB Wireframe
Page 4
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
Learning objectives
1. LO 1.1 Understand the effects and consequences of a financial crisis on a financial system and a real economy.
2. 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.
3. LO 1.3 Define the main classes of financial instruments that are issued into the financial system, that is, equity,
debt, hybrids and derivatives.
4. 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.
5. LO 1.5 Distinguish between various financial market structures, including wholesale markets and retail markets, and
money markets and capital markets.
6. 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
1. LO 1.7 Appreciate the importance of globalisation of the international financial markets.
2. LO 1.8 Appreciate the effects, consequences and relevance of the Asian financial crisis.
Page 5
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.
http://textflow.mheducation.com/parser.php?secload=2&fake&print
1/1
2016/3/10
IEB Wireframe
1.1Financial crises and the real economy
LEARNING OBJECTIVE 1.1
Understand the effects and consequences of a financial crisis on a financial system and a real economy
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.
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 mortgage-related securities
SUB-PRIME MORTGAGES loans to borrowers that under normal credit assessment standards would not have the capacity to
repay
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 under
tremendous pressure. Washington Mutual was placed in receivership. Wachovia was purchased by Wells Fargo. AIG was
effectively taken over by the Federal Reserve.
Page 6
FEDERAL RESERVE the central bank of the USA
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 writedowns in the estimated values of these securities when financial institutions realised that there were no buyers willing
to engage in transactions at prices even close to the previously recorded selling prices. With prices falling, writedowns 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.
http://textflow.mheducation.com/parser.php?secload=3.2&fake&print
1/4
2016/3/10
IEB Wireframe
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.
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
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. 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.
Page 7
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 credit-driven boom had to come to an end. The larger and
longer the boom, the more catastrophic must be the ensuing recession or depression. Despite the unique circumstances of
each individual case, all economic crises can be traced to this same root cause.
Following the onset of the crisis, governments and central banks around the world undertook unprecedented interventions
in the financial and economic systems. In 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
http://textflow.mheducation.com/parser.php?secload=3.2&fake&print
2/4
2016/3/10
IEB Wireframe
holding risk and the impact on the markets if the ultimate risk holder failed. For example, CDOs simply moved the risk
exposure from one party to another party. Everyone made money along the way, including the mortgage brokers, the banks,
the credit rating agencies and the fund managers, but the risk was still in the financial system. The process of risk
shifting was also often made easier by implicit or explicit guarantees given by governments, often with limited or no
regulatory oversight.
To ensure the soundness and stability of a financial system, governments establish legislation and regulatory
authorities responsible for the prudential supervision of the financial system. The soundness and stability of the
financial system and the role of financial regulation are issues that have acquired even more significance following the
GFC. The GFC produced a number of regulatory and policy responses. Some of these were directed to the problem of
managing the ensuing economic recession while others were directed at specific parts or activities of the financial
system. The response of governments and their regulators to the GFC will be a topic of ongoing discussion for many
years. Anyone who doubts that this will be the case need look no further than the recent intense focus on the role of
central bankers' responses to the collapse of the dot-com boom in 2000 in sowing the seeds for the GFC almost a decade
later. The reduction of interest rates and their maintenance at very low levels following the dot-com collapse has been
criticised for inflating values in the real estate market. The subsequent decline in real estate prices from these overinflated levels is widely viewed as the proximate cause of the GFC.
Page 8
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 1.1Financial markets and flow of funds relationship
Page 9
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=3.2&fake&print
3/4
2016/3/10
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=3.2&fake&print
4/4
2016/3/10
IEB Wireframe
1.2The financial system and financial institutions
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 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.
FINANCIAL SYSTEM comprises a range of financial institutions, instruments and markets; overseen by central bank;
supervised by prudential regulator
FINANCIAL INSTRUMENTS issued by a party raising funds, acknowledging a financial commitment and entitling the holder
to specified future cash flows
FLOW OF FUNDS movement of funds through a financial system
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.
SURPLUS UNITS savers or providers of funds; funds are available for lending or investment
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.
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 day-to-day expenses and commitments
TIME-PATTERN OF CASH FLOWS the frequency of periodic cash flows (interest and principal) associated with a financial
instrument
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.
Page 10
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
http://textflow.mheducation.com/parser.php?secload=2.3&fake&print
1/4
2016/3/10
IEB Wireframe
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.
ASSET PORTFOLIO a combination of assets, each comprising attributes of return, risk, liquidity and timing of cash
flows
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.
PORTFOLIO STRUCTURING the buying and selling of assets and liabilities to best meet current savings, investment and
funding 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.
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)
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.
Page 11
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.
http://textflow.mheducation.com/parser.php?secload=2.3&fake&print
2/4
2016/3/10
IEB Wireframe
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.
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
trusts attract funds by inviting the public to purchase units in a trust.
are pooled and then invested by funds managers in asset classes specified
specialise in certain categories of investments, including equity trusts,
and mortgage trusts.
by a trustee or responsible entity. Unit
The funds obtained from the sale of units
in the trust deed. Trusts generally
property trusts, fixed-interest trusts
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-net-worth 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)
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:
SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.
D
Page 12
http://textflow.mheducation.com/parser.php?secload=2.3&fake&print
3/4
2016/3/10
IEB Wireframe
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-balance-sheet 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.
Page 13
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.
http://textflow.mheducation.com/parser.php?secload=2.3&fake&print
4/4
2016/3/10
IEB Wireframe
1.3Financial instruments
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
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.
Page 14
1.3.1Equity
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.
EQUITY the sum of the financial interest an investor has in an asset; an ownership position
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.
ORDINARY SHARE or COMMON STOCK the principal form of equity issued by a corporation; bestows certain rights to the
shareholder
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.
DIVIDEND that part of a corporation's profit that is distributed to shareholders
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.
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
The issue of hybrid securities, or quasi-equity instruments, has become an increasingly important means by which
corporations raise additional equity funding. These instruments are discussed in detail in Chapter 5.
The equity markets are discussed in much more detail in Part 2.
1.3.2Debt
http://textflow.mheducation.com/parser.php?secload=2.4&fake&print
1/3
2016/3/10
IEB Wireframe
A debt is a loan that must be repaid. Debt instruments represent a contractual claim against an issuer, and require the
borrower to make specified payments, such as periodic interest payments and principal repayments, over a defined period.
The types of debt instruments issued by a corporation include debentures, unsecured notes, term loans, commercial bills,
promissory notes, overdrafts and mortgage loans. These types of debt instruments are discussed in detail in Part 3 of
the text. However, when we discuss the financial markets later in this chapter, we will introduce the money markets and
the capital markets. Debentures and unsecured notes are longer-term debt instruments issued into the capital markets,
while commercial bills and promissory notes are short-term instruments issued into the money markets. Term loans,
mortgage loans and overdrafts are generally provided by financial institutions.
Government debt instruments are Treasury bonds and Treasury notes (T-notes); these are examined in Part 4.
Debt instruments entitle the holder to a claim (ahead of equity holders) to the income stream produced by the borrower
and to the assets of the borrower if the borrower defaults on loan repayments. Debt can be divided into two subcategories on the basis of the nature of the loan contract: secured debt and unsecured debt. A secured debt contract
will specify the assets of the borrower, or a third party, pledged as security or collateral. If the borrower defaults
on the loan the lender is entitled to take possession of those assets to recover the amount owing. In other cases a loan
may be made on an unsecured basis.
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
Page 15
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 nonnegotiable.
NEGOTIABLE DEBT INSTRUMENT a debt instrument that can be sold by the original lender through a financial market
Corporate debt is discussed in Part 3 and government debt in Part 4.
1.3.3Derivatives
A third class of instrument has become significant in the financial markets: the derivative instrument.
DERIVATIVE INSTRUMENT a synthetic security that derives its price from a physical market commodity or security; mainly
used to manage risk exposures
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. An option contract gives the buyer of the option the right—but not an obligation—to buy (or sell) the
designated asset at a specified date or within a specified period during the life of the contract, at a
predetermined price. The fact that the buyer is not obliged to proceed with the contract is valuable, and therefore
the buyer must pay a premium to the writer of the option. Option contracts are discussed in Chapters 18 and 20.
4. A swap contract is an arrangement to exchange specified future cash flows. With an interest rate swap there is an
exchange (swap) of future interest payments based on a notional principal amount. A currency swap is denominated in
a foreign currency and fixes the exchange rate at which the initial and final principal amounts are swapped.
Ongoing interest payments are also swapped at the same exchange rate. Swap contracts are discussed in Chapters 18
and 21.
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
http://textflow.mheducation.com/parser.php?secload=2.4&fake&print
2/3
2016/3/10
IEB Wireframe
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.
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.
Page 16
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.
http://textflow.mheducation.com/parser.php?secload=2.4&fake&print
3/3
2016/3/10
IEB Wireframe
1.4Financial markets
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.
1.4.1Matching 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).
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
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).
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
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!
Page 17
1.4.2Primary 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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
1/12
2016/3/10
IEB Wireframe
PRIMARY MARKET TRANSACTION the issue of a new financial instrument; funds are obtained by the issuer
Figure 1.2Primary market transactions
MONEY a commodity that is universally accepted as a medium of exchange
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.
Figure 1.3Secondary market transactions
SECONDARY MARKET TRANSACTION the buying and selling of existing financial securities; transfer of ownership, no new
funds raised by issuer
Secondary market transactions have no direct impact on the amount of funding raised or available to the company that was
the initial issuer of a financial instrument; that is, the company receives no extra funds from the secondary market
transaction. A secondary market transaction is simply a transfer of ownership from one party to another party.
However, the existence of well-developed secondary markets has important impacts on the marketability of new primary
market financial instruments or securities.
Secondary market transactions help overcome two potential obstacles that may stand in the way of savers providing funds
for the financing of long-term capital investment. These are the savers' preferences for liquidity and their aversion to
risk. Without an active secondary market, purchasers of new-issue instruments would be required to hold those long-term
instruments until they mature. In the case of equity, the problem would be even greater as there is generally no
maturity date. A deep and liquid secondary market solves this problem by providing markets where these instruments can
be bought and sold. A deep and liquid secondary market is one where there are many buyers and sellers in the market.
Page 18
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.
SECURITIES financial assets that are traded in a formal secondary market (e.g. stock exchange)
1.4.3Direct finance and intermediated finance
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
2/12
2016/3/10
IEB Wireframe
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
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 1.4Direct financial flows
DIRECT FINANCE funding obtained direct from the money markets and capital markets
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.
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
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.
Page 19
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.
CREDIT RATING the assessment by a credit rating agency of the creditworthiness of an obligor to a financial obligation
The main advantages of direct finance are as follows:
It removes the cost of a financial intermediary. If a borrower obtains a loan from a financial institution, the
borrower will pay a profit margin to the intermediary. Should a corporation or government authority have an
investment-grade credit rating (e.g. Standard & Poor's BBB and above), it may well be able to raise funds directly
from the domestic or international markets at a lower total cost than borrowing through a bank.
It allows a borrower to diversify funding sources by accessing both the domestic and international money and
capital markets. This reduces the risk of exposure to a single funding source or market. 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 sub-prime 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
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
3/12
2016/3/10
IEB Wireframe
markets for the firm's goods and services.
There are some disadvantages that may, at times, be associated with direct financing. These include:
There can be a problem of matching the preferences of lenders and borrowers. For example, a lender may have a
certain amount of funds available for investment, but this amount may not be sufficient for the needs of the
borrower, who would then need to seek out and enter into funding arrangements with additional suppliers of funds.
There may also be a mismatch in the maturity structure of the funding as the borrower may need to borrow for a
longer period than the risk-averse investor is willing to lend.
The liquidity and marketability of a direct finance instrument may be of concern. How easy is it for the holder of
an instrument issued by direct finance to sell at a later date? Is there a deep and liquid secondary market in that
instrument? Not all financial instruments have an active secondary market through which they may be sold.
The search and transaction costs associated with a direct issue can be quite high. These might include advisory
fees, the cost of preparing a prospectus, legal fees, taxation advice, accounting advice and specific expert advice
(such as a geologist's report). On very large direct finance transactions the fees and costs may run into 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.
DEFAULT RISK the risk that a borrower may not meet financial commitments such as loan repayments when they are due
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 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.
Figure 1.5Intermediated financial flows
INTERMEDIATED FINANCE financial transaction conducted with a financial intermediary (e.g. bank deposits and bank
loans); separate contractual agreements
Page 20
In order to be able to provide loans to its customers, an intermediary obtains its funding from savers. Savers receive
financial instruments issued by the intermediary, such as a term deposit receipt issued by a bank. A contractual
agreement then exists between the saver and the intermediary in relation to the term deposit. The intermediary creates a
separate contractual agreement with the borrower (the ultimate user of funds). The saver has no claim on the income or
assets of the ultimate borrower. Those entitlements reside with the bank as the intermediary. The saver only has a claim
for the payment of interest and the return of principal at maturity from the bank. On the other hand, under a separate
loan contract, the intermediary relies on the borrower for repayment of the loan. Failure of the bank to recover the
funds from the borrower does not change the contractual relationship the bank has with its depositor.
The benefits of financial intermediation
Very often the portfolio preferences of savers and borrowers differ. For example, a risk-averse lender may be prepared
to receive a lower rate of return in exchange for maintaining funds at call. On the other hand, a borrower may be
prepared to pay a higher rate of return, but may want to have the funds available for a number of years. It is likely
that many savers and borrowers would find it difficult to meet their investment and funding needs if only direct finance
was possible.
An intermediary is able to resolve this problem and satisfy the preferences of both parties, and at the same time make a
profit. An intermediary is able to transform short-term deposit funds into longer-term 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
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
4/12
2016/3/10
IEB Wireframe
credit risk diversification and transformation
liquidity transformation
economies of scale.
Asset transformation
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.
ASSET TRANSFORMATION the ability of financial intermediaries to provide a range of products that meet customers'
portfolio preferences
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 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.
Page 21
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.
MATURITY TRANSFORMATION financial intermediaries offer products with a range of terms to maturity
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.
LIABILITY MANAGEMENT where banks actively manage their sources of funds (liabilities) in order to meet future loan
demand (assets)
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.
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
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.
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
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
5/12
2016/3/10
IEB Wireframe
transactions. The time involved in carrying out a transaction may also be an important component of the total
transaction cost.
LIQUIDITY TRANSFORMATION measured by the ability of a saver to convert a financial instrument into cash
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.
Page 22
Economies of scale
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.
ECONOMIES OF SCALE financial and operational benefits gained from organisational size, expertise and volume of
business
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.
1.4.4Wholesale and retail markets
LEARNING OBJECTIVE 1.5
Distinguish between various financial market structures, including wholesale markets and retail markets, and money
markets and capital 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.
WHOLESALE MARKET direct financial flow transactions between institutional investors and borrowers
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.
RETAIL MARKET financial transactions conducted with financial intermediaries mainly by individuals and small to mediumsized businesses
1.4.5Money 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,
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
6/12
2016/3/10
IEB Wireframe
such as the foreign exchange market and the derivatives market, also form part of the financial system.
Money market transactions involve wholesale short-term-to-maturity securities of less than 12 months. As discussed
below, medium- to long-term-to-maturity transactions are referred to as capital-market transactions. Figure 1.6 depicts
the structure of the money markets and the capital markets. You will note that each market incorporates primary and
secondary markets within both the domestic and the international markets.
Figure 1.6Structure of the money and capital markets
MONEY MARKETS wholesale markets in which short-term securities are issued and traded
Page 23
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 welldeveloped 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.
INSTITUTIONAL INVESTORS participants in the wholesale markets (e.g. funds managers, insurance offices, banks)
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 shortterm 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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
7/12
2016/3/10
IEB Wireframe
Figure 1.7Money-market participants and instruments
Page 24
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.
Central bank: system liquidity and monetary policy
Central banks use the money markets to carry out transactions that will maintain, or change, the amount of liquidity
that is available within the financial system. The amount of daily liquidity in the financial system is affected mainly
by government budget surpluses or deficits, official foreign exchange transactions and net sales of government
securities. The amount of liquidity in the financial system directly impacts on interest rates in the market. The
central bank implements its monetary policy by targeting the cash rate, hence the central bank carries out money market
transactions so that the cash rate remains at its target level.
For example, in Australia the central bank is the Reserve Bank of Australia. The Reserve Bank deals regularly, usually
daily, in the money markets for the purpose of managing the supply of liquid funds (cash) available to the financial
system. The Reserve Bank deals in (buys and sells) Commonwealth Government Securities (CGS) and certain other specified
securities of up to one year to maturity, and in repurchase agreements (repos). The Reserve Bank conducts these market
operations with members of the Reserve Bank Information and Transfer System (RITS), principally commercial banks and
other institutions that participate in the wholesale market for CGS. RITS is an electronic settlement system.
Furthermore, the Reserve Bank is responsible for the implementation of monetary policy. Briefly, the main monetary
policy objective is to maintain an economic environment whereby inflation remains within a desired range of 2 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.
INTER-BANK MARKET the lending and borrowing of very short term funds by banks operating in the payments system
Page 25
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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
8/12
2016/3/10
IEB Wireframe
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.
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
The commercial bills
non-bank bills. There
maturity preferences.
be sold several times
market is the largest component of the money markets, and involves the trading of bank bills and
is an active secondary market in commercial bills. This allows market participants to manage their
For example, an investor can buy a 90-day bill but sell it after seven days. The same bill might
during its short 90-day life.
Commercial bills are discussed in Chapter 9.
BILLS MARKET an active money market for the issue and trading of bills of exchange (discount securities)
Commercial paper market
Another important segment of the money markets is the issue and trading of promissory notes. It is a market convention
to refer to promissory notes as commercial paper.
COMMERCIAL PAPER promissory notes (discount securities) issued into the money market by corporations with a good
credit rating
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 subprime securities with a high risk of default. Promissory notes (commercial paper) are discussed in Chapter 9.
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).
NEGOTIABLE CERTIFICATE OF DEPOSIT a discount security issued by a bank
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.
1.4.6Capital 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.
CAPITAL MARKETS markets for longer-term funding; includes equity, corporate debt and government debt, and is supported
by the foreign exchange and derivatives markets
Page 26
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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
9/12
2016/3/10
IEB Wireframe
Equity market
The principal characteristic of the equity market is that the provider of equity finance obtains an ownership interest
in an asset.
EQUITY MARKETS facilitate the issue of financial securities that represent an ownership interest in an asset (e.g.
stock market)
Within the context of a corporation, the main form of security issued is the ordinary share, sometimes referred to as
common stock. The shareholder has an entitlement to participate in the profits of the business, by way of receiving
either dividend payments or capital gains (losses) in the value of the shareholding.
From the perspective of the business, equity provides a source of long-term funding that does not have to be repaid.
Equity is available to:
finance physical infrastructure such as buildings and equipment
provide creditor confidence in dealing with the firm
ensure the availability of funds to absorb abnormal losses
improve the liquidity of the business.
This text focuses mainly on equity issued by publicly listed corporations on a stock exchange. Chapter 4 considers the
share market and the corporation, Chapter 5 explores a range of issues that a corporation needs to consider when issuing
equity, Chapter 6 examines equity financing from the point of view of an investor and Chapter 7 provides a detailed
analysis of share prices. As you can see, there is a lot to learn about the equity markets. However, it is easy to
become addicted to the stock market, particularly if you become an investor.
Corporate debt market
Longer-term debt is an important source of funding for the growth of business corporations. Capital-market 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.
CORPORATE DEBT MARKETS facilitate the issue and trading of debt securities issued by corporations (e.g. discount
securities, bonds)
These capital market products are discussed in Chapter 10.
Page 27
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).
EUROMARKET INSTRUMENTS financial transactions conducted in a foreign country in a currency other than the currency of
that country
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.
GOVERNMENT DEBT government borrowing for short-term liquidity needs, or longer-term budget capital expenditures (Tnotes, Treasury bonds)
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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
10/12
2016/3/10
IEB Wireframe
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.
CROWDING OUT government borrowing that reduces the net amount of funds available for other lending in the financial
system
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.
FOREIGN EXCHANGE MARKETS markets that facilitate the buying and selling of foreign currencies
Corporations, financial institutions and governments all access funds in the international capital markets, which
provide a range of funding instruments and a diversity of funding sources that otherwise may not be available within
domestic capital markets.
Financial instruments issued in the international capital markets are usually denominated in a foreign currency.
Therefore interest payments and principal repayments related to international debt commitments require the borrower to
purchase the necessary foreign currency in order to make those periodic payments.
The foreign exchange market facilitates the buying and selling of foreign currencies necessary for the conduct of
international capital-market transactions. The exchange rate is the price of one currency against another. Foreign
exchange risk is the risk that the exchange rate between currencies will change. Other issues that have an impact on the
exchange rate—and therefore the cost of funding in the international capital markets—are relative inflation, relative
interest rates, relative national income growth, government intervention and exchange rate expectations. The foreign
exchange market is discussed in Part 5.
Derivatives market
Within the context of the capital markets, the derivatives market provides a range of risk management products that
are available to borrowers to manage risks associated with capital-market transactions. The principal risks to be
managed include interest rate risk, foreign exchange risk and price risk. For example, a borrower with an existing loan
that has a variable interest rate might be concerned that the rate will increase in the future. The borrower might use a
derivative product to manage that risk. The same principles apply for the risk that the exchange rate might change or
that share prices may rise or fall.
Page 28
DERIVATIVES MARKETS markets in synthetic risk management products; futures, forwards, options, swaps
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 capitalmarket 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 longerterm 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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
11/12
2016/3/10
IEB Wireframe
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.
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.
http://textflow.mheducation.com/parser.php?secload=2.5&fake&print
12/12
2016/3/10
IEB Wireframe
1.5Flow of funds, market relationships and stability
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
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 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.
Page 29
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.
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-of-the-world sectors
The domestic economy can be divided into four sectors:
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 rest-of-the-world sector to become more sensitive to sudden
shifts in the flow of funds, as investors are able to move funds from one market to another quite quickly and with
relative ease.
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
http://textflow.mheducation.com/parser.php?secload=2.6&fake&print
1/2
2016/3/10
IEB Wireframe
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.
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)
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 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.
Page 30
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 the financial
system and highlight the importance of stability within the financial system.
http://textflow.mheducation.com/parser.php?secload=2.6&fake&print
2/2
2016/3/10
IEB Wireframe
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 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:
Page 31
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.
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?
http://textflow.mheducation.com/parser.php?secload=2.7&fake&print
1/1
2016/3/10
IEB Wireframe
CHAPTER ONE REVIEW
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.
Page 32
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.
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.
Page 33
LEARNING OBJECTIVE 1.4
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
1/8
2016/3/10
IEB Wireframe
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.
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.
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.
Page 34
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 nation-state. (This was discussed earlier
in the chapter.) Similarly, as production and international trade between multinational corporations and governments
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
2/8
2016/3/10
IEB Wireframe
expanded, so too did the need for a global financial system to support that expansion.
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.
GLOBALISATION the integration of financial institutions, instruments and markets into an international financial system
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 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.
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
Page 35
technology
population dynamics.
MURRAY REPORT a committee report, Financial System Inquiry Interim Report, Commonwealth of Australia, Canberra, July
2014 (www.fsi.gov.au)
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.
Post-GFC regulatory responses
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
3/8
2016/3/10
IEB Wireframe
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.
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 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.
Page 36
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
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.
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
4/8
2016/3/10
IEB Wireframe
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 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).
Page 37
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 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.
* 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.
D
MORAL HAZARD the taking of excessive risk in the belief that losses will be diminished by regulation or insurance
Page 38
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
5/8
2016/3/10
IEB Wireframe
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.
* 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.
D
The global financial crisis that resulted from the Asian financial crisis caused regulators, government policy makers,
academics and market participants to exercise their collective minds to reconsider issues of signals, cause, effect,
regulation and financial system architecture.
While changes in the structure, regulation and operation of the global financial system have occurred, and will continue
to occur, history indicates that change is usually a very slow process. The lessons of the Asian financial crisis have
prompted the Reserve Bank (RBA Bulletin, April 1998, p. 2) to identify a list of questions to ask about a country's
financial system if there is the likelihood of a currency crisis or a wider economic crisis.
Does the country have a fixed exchange rate and free movement of international capital
Is the exchange rate overvalued?
Has a country with similar economic characteristics recently experienced a currency crisis?
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.
Page 39
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 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 government-funded stimulus program.
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
6/8
2016/3/10
IEB Wireframe
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.
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.
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.
Page 40
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.
1. What are the differences between primary market and secondary market financial transactions?
2. Why is the existence of well-developed secondary markets important to the functioning of the primary markets
within the financial system? (LO 1.4)
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
7/8
2016/3/10
IEB Wireframe
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 longterm 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)
Page 41
Extended learning questions
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
asset portfolio 10 asset transformation 20 bills market 25 bonds 16 broker 18 capital markets 25 commercial
paper 25 compulsory superannuation 29 contractual savings institutions 11 corporate debt markets 26 credit
rating 19 credit risk transformation 21 crowding out 27 dealer 18 debt instruments 14 default risk 19 deficit
units 29 depository financial institutions 11 derivative instrument 15 derivatives markets 27 direct finance 18
discount securities 25 dividend 14 economies of scale 22 equity 14 equity markets 26 euromarket instruments 27
eurozone crisis or sovereign debt crisis 6 Federal Reserve 6 finance companies and general financiers 11 financial
instruments 9 financial system 9 fiscal policy 29 flow of funds 10 foreign exchange markets 27 forward contract 15
futures contract 15 global financial crisis (GFC) 5 globalisation 34 government debt 27 hybrid security 14
inflation 11 institutional investors 23 inter-bank market 24 intermediated finance 19 investment banks 11 liability
management 21 liquidation 14 liquidity 10 liquidity transformation 21 matching principle 16 maturity
transformation 21 monetary policy 11 money 17 money markets 22 moral hazard 37 Murray Report 34 negotiable
certificate of deposit 25 negotiable debt instrument 15 option contract 15 ordinary share or common stock 14
overdraft facility 16 portfolio structuring 11 primary market transaction 17 rate of return 10 retail market 22
return or yield 10 risk 10 secondary market transaction 17 sectorial flow of funds 29 secured debt 14
securities 18 securitisation 13 sub-prime mortgages 5 surplus units 10 swap contract 15 time-pattern of cash
flows 10 unit trusts 11 wholesale market 22
http://textflow.mheducation.com/parser.php?secload=2.f&fake&print
8/8
2016/3/10
IEB Wireframe
Page 42
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
1.
2.
3.
4.
5.
6.
7.
Learning objectives
LO 2.1 Evaluate the functions and activities of commercial banks within the financial system.
LO 2.2 Identify the main sources of funds of commercial banks, including current deposits, demand deposits, term
deposits, negotiable certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency
liabilities and loan capital.
LO 2.3 Identify the main uses of funds by commercial banks, including personal and housing lending, commercial
lending, lending to government, and other bank assets.
LO 2.4 Outline the nature and importance of banks' off-balance-sheet business, including direct credit substitutes,
trade- and performance-related items, commitments and market-rate-related contracts.
LO 2.5 Consider the regulation and prudential supervision of banks.
LO 2.6 Understand the background and application of Basel II and Basel III.
LO 2.7 Examine liquidity management and other supervisory controls applied by APRA in the context of Basel III.
Extended learning
1. LO 2.8 Understand the standardised approach to credit risk and compute the capital requirements for particular
transactions.
2. LO 2.9 Analyse business continuity risk and construct an education and training framework for operational risk
management for commercial banks.
3. LO 2.10 Discuss the importance of corporate governance and ethics in the context of Australian financial
institutions.
Page 43
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
http://textflow.mheducation.com/parser.php?secload=3&fake&print
1/2
2016/3/10
IEB Wireframe
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 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.
http://textflow.mheducation.com/parser.php?secload=3&fake&print
2/2
2016/3/10
IEB Wireframe
2.1 The main activities of commercial banking
LEARNING OBJECTIVE 2.1
Evaluate the functions and activities of commercial banks within the financial system
Commercial banks take deposits from customers and then invest those deposits by making loans to their customers.
Although these two functions represent a large proportion of their activities, commercial banks' activities are much
more complex than this, in that they provide a full range of financial services.
Commercial bank products and services include balance-sheet transactions and off-balance-sheet transactions. Briefly,
balance-sheet transactions are assets (e.g. loans), liabilities (e.g. deposits) and shareholders' funds (equity). Offbalance-sheet items are contingent liabilities; that is, they are transactions that do not appear on the balance sheet.
In a highly competitive global market, banks must compete aggressively to obtain the funds necessary to provide loans
and other products and services. For example, bank customers request loans from banks. The banks try to forecast future
loan demand to ensure they have the funds available to meet the forecast loan demand. As the banks lend hundreds of
millions of dollars in a short-term planning period, ensuring the availability of funds is a critical issue. To do this,
the banks have moved from a practice known as asset management to the practice of liability management.
Page 44
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.
ASSET MANAGEMENT a bank restricts growth in its lending to the level of funds available from its depositor base
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.
LIABILITY MANAGEMENT a bank actively manages its sources of funds (liabilities) in order to meet future loan demand
(assets)
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.
OFF-BALANCE-SHEET BUSINESS transactions that represent a contingent liability and therefore are not recorded on the
balance sheet
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. This is known as
http://textflow.mheducation.com/parser.php?secload=2.2&fake&print
1/2
2016/3/10
IEB Wireframe
liability management, whereby a bank borrows sufficient funds (liabilities) direct from the capital markets to meet
forecast loan demand.
http://textflow.mheducation.com/parser.php?secload=2.2&fake&print
2/2
2016/3/10
IEB Wireframe
2.2 Sources of funds
LEARNING OBJECTIVE 2.2
Identify the main sources of funds of commercial banks, including current deposits, demand deposits, term deposits,
negotiable certificates of deposit, bill acceptance liabilities, debt liabilities, foreign currency liabilities and loan
capital
If the major part of a commercial bank's business is the provision of loans to customers, then the first question must
be: where does the bank obtain the funds that it lends?
Sources of funds appear on a bank balance sheet either as liabilities that the bank will eventually repay or as equity
funds provided by shareholders.
In order to attract the savings of surplus entities, commercial banks offer a range of instruments with different terms
to maturity, liquidity, rates of return and cash-flow attributes. The main sources of commercial bank funds considered
in this section are:
current account deposits
call or demand deposits
term deposits
negotiable certificates of deposit
bills acceptance liabilities
debt liabilities
Page 45
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.
CURRENT ACCOUNT DEPOSITS liquid funds held in a cheque account; cheques drawn to purchase goods and services
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.
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 DEPOSITS funds held in a savings account that can be withdrawn on demand
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
http://textflow.mheducation.com/parser.php?secload=3.3&fake&print
1/4
2016/3/10
IEB Wireframe
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 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 funds lodged in an account for a predetermined period and at a specified fixed interest rate
Term deposits offer savers a higher rate of return than is available on current accounts or call deposits. The higher
return compensates the saver for the loss of liquidity with this type of deposit; that is, the term deposit is fixed for
the nominated period. Savers often use term deposits as an investment alternative for surplus funds that are not
immediately required for consumption.
The term deposit is a safe and stable investment that is particularly attractive to a conservative investor. Term
deposits are popular in countries that have an ageing population. Often these investors seek secure investments that
produce known income streams. History shows us that in times of volatility in the financial markets, especially when the
stock markets are more volatile, investors tend to revert to the safe haven of the bank term deposit.
Page 46
2.2.4 Negotiable certificates of deposit
Another source of short-term funding used by banks is the negotiable certificate of deposit, referred to in the
market as the CD. The CD is a certificate issued by a bank undertaking to pay to the bearer the face value of the CD at
the specified maturity date.
CERTIFICATE OF DEPOSIT a short-term discount security issued by a bank; face value repayable at maturity
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.
NEGOTIABLE SECURITY a financial instrument that can easily be sold into a deep and liquid secondary market
Another attribute of the CD is that the yield offered on new CDs can be adjusted quickly as the banks' funding
requirements change. CDs have become important in the liability management approach of banks. Effectively, the rate of
return can be changed from one transaction to another. This flexibility is not as easily achieved on the more standard
bank deposits.
2.2.5 Bill 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.
BILL OF EXCHANGE a short-term money-market 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
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
http://textflow.mheducation.com/parser.php?secload=3.3&fake&print
2/4
2016/3/10
IEB Wireframe
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.
Page 47
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 longer-term loans; therefore banks must actively borrow in
the capital markets in order to fund part of their lending.
Medium- to long-term instruments issued by banks include debentures, unsecured notes and transferable certificates of
deposit.
Debentures and unsecured notes are bonds issued by corporations, including banks. Bonds pay a regular interest coupon
to the holder, usually semi-annually or annually. The principal is repaid at the maturity date. The periodic interest
payments may be a fixed interest rate, or based on a variable rate that may change from time to time.
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
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.
COLLATERALISED FLOATING CHARGE security attached to a loan; if borrower defaults, the lender will take possession of
the borrower's assets
Transferable certificates of deposit are long-term fixed-rate instruments typically issued with a minimum face value of
$100 000 and with terms to maturity of three to five years.
2.2.7 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.
FOREIGN CURRENCY LIABILITIES debt instruments issued into the international capital markets that are denominated in
another currency
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).
EUROMARKETS debt markets where instruments are issued into another country, but not denominated in the currency of that
country
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 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.
LOAN CAPITAL sources of funds that have the characteristics of both debt and equity
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 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.
Page 48
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=3.3&fake&print
3/4
2016/3/10
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=3.3&fake&print
4/4
2016/3/10
IEB Wireframe
2.3 Uses of funds
LEARNING OBJECTIVE 2.3
Identify the main uses of funds by commercial banks, including personal and housing lending, commercial lending, lending
to government, and other bank assets
Funds used by commercial banks appear as assets on their balance sheets. The majority of bank assets are financial
assets that create an entitlement to future cash flows; for example, if a bank gives a customer a loan then the amount
outstanding on the loan will appear as an asset on the bank's balance sheet. The bank is entitled to receive periodic
interest payments plus repayment of the principal in accordance with the terms and conditions of the loan contract. A
bank will also accumulate other assets such as branch premises and electronic systems.
In this section we categorise commercial bank assets into the following categories:
personal and housing finance
commercial lending
lending to government
other bank assets.
2.3.1 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 of both lenders and borrowers.
In Australia, for example, the largest form of bank lending is for owner-occupied housing. Other forms of personal
finance include investment property finance, fixed-term loans, personal overdrafts and credit card finance.
Page 49
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.
HOUSING FINANCE the provision of long-term 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
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.
MORTGAGE ORIGINATORS specialist mortgage lenders that typically refinance their lending through securitisation
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.
SECURITISATION non-liquid assets are sold into a trust; the trustee issues new securities; cash flows from the
original securities are used to repay the new securities
The 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.
http://textflow.mheducation.com/parser.php?secload=3.4&fake&print
1/4
2016/3/10
IEB Wireframe
AMORTISED LOAN INSTALMENTS regular and equal loan instalments that comprise the current interest payment due, plus
part repayment of the loan principal outstanding
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.
INVESTMENT PROPERTY FINANCE funding that enables a borrower to purchase property to rent or lease to a third party
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.
FIXED-TERM LOAN a loan provided for a predetermined period; used to purchase specified goods or services
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.
CREDIT CARD a card facility that provides access to funds through electronic distribution systems: ATMs, EFTPOS
Page 50
2.3.2 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 nation-state. 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.
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
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.
OVERDRAFT an arrangement with a bank that allows a business to place its operating account into debit up to an agreed
limit
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.
http://textflow.mheducation.com/parser.php?secload=3.4&fake&print
2/4
2016/3/10
IEB Wireframe
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
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.
ROLLOVER FACILITY an arrangement whereby a bank agrees to discount new bills over a specified period as existing bills
mature
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.
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
Page 51
2.3.3Lending 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.
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
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 lower-risk attributes
enable a bank to manage the maturity structure of its balance sheet by purchasing securities with a range of
maturities and cash flows
allow a bank to manage its interest rate risk by buying or selling securities with different interest rate
structures (fixed or variable interest rates).
Therefore, lending to government, particularly through the purchase of government securities, provides a bank with the
flexibility to actively manage its overall asset portfolio, while at the same time lowering the overall levels of risk
in its asset portfolio.
2.3.4 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
http://textflow.mheducation.com/parser.php?secload=3.4&fake&print
3/4
2016/3/10
IEB Wireframe
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
Page 52
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.
http://textflow.mheducation.com/parser.php?secload=3.4&fake&print
4/4
2016/3/10
IEB Wireframe
2.4 Off-balance-sheet business
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
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.
Page 53
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.
DIRECT CREDIT SUBSTITUTE an undertaking provided by a bank to support the financial obligations of a client
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.
TRADE- AND PERFORMANCE-RELATED ITEM an undertaking provided by a bank to a third party promising payment under the
terms of a specified commercial contract
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:
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.
http://textflow.mheducation.com/parser.php?secload=3.5&fake&print
1/3
2016/3/10
IEB Wireframe
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 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.
COMMITMENTS the contractual financial obligations of a bank that are yet to be completed or delivered
Examples of commitments include:
Outright forward purchase agreements. These are where a bank contracts to buy a specified asset, such as foreign
currency, from its client at an agreed exchange rate on a specified date.
Page 54
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 Foreign exchange contracts, interest rate contracts and other market-rate-related contracts
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.
MARKET-RATE-RELATED CONTRACTS derivative products; allow management of exposures to interest rate, foreign exchange,
equity and commodity price risks
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.
HEDGING implementing strategies to protect against an identified risk exposure
Examples of foreign exchange, interest rate and other market-rate-related contracts include:
Forward exchange contracts. A bank contracts to buy or sell at a future date a specified amount of a foreign
currency at an exchange rate that is set today.
Currency swap. A bank exchanges a principal amount and ongoing associated interest payments that are denominated in
a foreign currency.
Forward rate agreements. A compensation agreement between a bank and client based on a notional principal amount.
One party compensates the other party if interest rates move above or below an agreed interest rate.
Interest rate futures contracts. These are exchange-traded agreements to buy or sell a specific security at a
specific price at a predetermined future date.
Interest rate options contracts. These provide the right, but not the obligation, to buy or sell a specified
financial instrument at an agreed date and price.
Equity contracts. These include futures and options contracts based on specified stock prices or stock indices.
These contracts lock in the equity price today that will apply at a specified future date.
2.4.5 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 off-balance-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
http://textflow.mheducation.com/parser.php?secload=3.5&fake&print
2/3
2016/3/10
IEB Wireframe
notional values of the various types of off-balance-sheet business are shown in Table 2.1.
SOURCE: Reserve Bank of Australia, 2013.
D
Page 55
The nature and size of market-rate-related contracts, combined with the volatility and speed at which contracts are repriced in the market, has resulted in a number of extraordinary losses being incurred by both financial institutions and
their clients. The threat to the stability of domestic and global financial systems that may result from large losses in
the derivatives markets has been the subject of much discussion by regulators and prudential supervisors.
One high-profile example (which has since been depicted in the movie Rogue Trader) was the loss of $1.5 billion by the
UK bank Baring Brothers plc. Speculation on price movements of derivative contracts on the Singapore and Osaka exchanges
by one of its traders, Nick Leeson, brought about the loss, which resulted in the eventual failure of the bank. Of
course, during the GFC a number of institutions, including Lehman Brothers and Bear Stearns, collapsed as the direct or
indirect result of excessive trading in mortgage-related derivatives. In the end, it is the responsibility of each bank
to ensure that it establishes and documents objectives, policies and procedures in relation to its use of derivative
products.
REFLECTION POINTS
Direct credit substitutes are provided by a bank to support a customer's financial obligations to a third party
(e.g. a letter of comfort written by the bank confirming that a customer has sufficient funding in place to proceed
with a project).
Trade- and performance-related items are guarantees given by a bank to support a customer's 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.
http://textflow.mheducation.com/parser.php?secload=3.5&fake&print
3/3
2016/3/10
IEB Wireframe
Page 56
2.5 Regulation and prudential supervision of commercial banks
LEARNING OBJECTIVE 2.5
Consider the regulation and prudential supervision of 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.
BANK REGULATION constraints on banking activities through prescriptive legislation and prudential supervision
PRUDENTIAL SUPERVISION the imposition and monitoring of standards designed to ensure the soundness and stability of a
financial system
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.
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).
Page 57
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).
http://textflow.mheducation.com/parser.php?secload=3.6&fake&print
1/2
2016/3/10
IEB Wireframe
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.
AUTHORISED DEPOSIT-TAKING INSTITUTIONS financial institutions authorised by APRA to accept retail deposits 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
whether, and how, it might provide emergency
not regard its balance sheet as available to
experience financial difficulty. Ultimately,
the financial system, the Reserve Bank is responsible for determining
liquidity support to the financial system. The Reserve Bank, however, does
support the solvency of an individual financial institution that may
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.
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.
http://textflow.mheducation.com/parser.php?secload=3.6&fake&print
2/2
2016/3/10
IEB Wireframe
2.6 A background to the capital adequacy standards
LEARNING OBJECTIVE 2.6
Understand the background and application of Basel II and Basel III
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 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.
Page 58
Capital has a number of important functions, including:
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.
G-10 Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the UK and the USA
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 ACCORD the standard that defines the minimum capital adequacy requirement for a bank
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.
BASEL III CAPITAL ACCORD an enhanced set of capital, leverage and liquidity standards
http://textflow.mheducation.com/parser.php?secload=3.7&fake&print
1/2
2016/3/10
IEB Wireframe
REFLECTION POINTS
An international capital adequacy standard for banks was developed to strengthen the global financial system.
Banks need sufficient capital to expand their business and also periodically to write off abnormal losses.
The Bank for International Settlements established a permanent committee, the Basel Committee on Banking
Supervision, to develop capital standards. The Basel I accord was introduced in 1988; 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.
http://textflow.mheducation.com/parser.php?secload=3.7&fake&print
2/2
2016/3/10
IEB Wireframe
Page 59
2.7 Basel II and Basel III
LEARNING OBJECTIVE 2.6
Understand the background and application of 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.
CREDIT RISK the risk that an obligor will not make future interest payments or principal repayments when due
MARKET RISK the exposure of a bank's trading book to changes in interest rates and exchange rates
Basel 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.
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 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.
Page 60
2.7.2 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.
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
1/10
2016/3/10
IEB Wireframe
TIER 1 CAPITAL highest quality; core capital for capital adequacy purposes
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.
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
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.
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.
D
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:
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
2/10
2016/3/10
IEB Wireframe
Figure 2.1Overview of Basel II capital accord framework
MARK-TO-MARKET the revaluation of a contract based on its current quoted price on an exchange
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.
PILLAR 1 incorporates components of credit risk, operational risk and market risk within the Basel II capital accord
Credit risk relates to the underlying counterparty
II applies a range of risk weightings based on the
asset is secured by eligible collateral or certain
appropriate to the counterparty to that collateral
to a balance-sheet asset or an off-balance-sheet transaction. Basel
counterparty to an asset or off-balance-sheet transaction. If an
forms of guarantee, it is risk-weighted according to the risk weight
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.
STANDARDISED APPROACH TO CREDIT RISK provides risk weights to be applied to balance-sheet assets and off-balancesheet items to calculate minimum capital requirement
Page 61
With regard to market-related off-balance-sheet transactions a bank has the choice of two methods for determining the
credit conversion factor: the current exposure method or the original exposure method. The current exposure method
(mark-to-market) is the sum of the current credit exposure and the potential future credit exposure of a contract. The
current credit exposure is defined as the sum of the positive mark-to-market value (or replacement cost) of a contract.
The potential future credit exposure is determined by multiplying the notional principal amount by the relevant credit
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
3/10
2016/3/10
IEB Wireframe
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.
Page 62
CURRENT EXPOSURE METHOD off-balance-sheet capital calculation based on the current and potential credit exposures
mark-to-market
ORIGINAL EXPOSURE METHOD off-balance-sheet capital calculation based on the notional contract value multiplied by a
credit conversion factor
Larger commercial banks, in particular those that operate in the international
the supervisor to use the internal ratings-based approach to credit risk
information systems and expertise that enable a more sophisticated approach to
commercial bank that receives approval from the supervisor to use the internal
rely on its own internal estimates of some or all of the necessary credit risk
capital requirement for credit exposures.
capital markets, will generally apply to
(see Figure 2.1). These banks have the
the measurement and management of risk. A
ratings-based approach to credit risk may
components in determining the regulatory
INTERNAL RATINGS-BASED APPROACH TO CREDIT RISK for capital calculations a bank may use some or all of its own risk
measurement model factors; supervisor approval required
Page 63
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.
OPERATIONAL RISKS exposures that may impact on the normal day-to-day business functions of an organisation
The Bank for International Settlements categorises operational risk as:
internal and external fraud
employment practices and workplace safety
clients, products and business practices
damage to physical assets
business disruption and system failures
execution, delivery and process management.
The categorisation of operational risk is very wide ranging and indicates that all aspects of an organisation's day-today 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
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
4/10
2016/3/10
IEB Wireframe
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 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 non-existent
education and training programs.
Page 64
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.
BUSINESS CONTINUITY MANAGEMENT maintenance of strategies to ensure the continuance of critical business functions
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:
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
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
5/10
2016/3/10
IEB Wireframe
particular issuers.
Page 65
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 issuer-specific factors, such as a change in the
creditworthiness of the issuer. This is relevant only to interest rate and equity positions.
GENERAL MARKET RISK for capital adequacy purposes; changes in the overall market for interest rates, equities, foreign
exchange and commodities
SPECIFIC MARKET RISK the risk that the value of a security will change due to issuer-specific factors
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.
VALUE AT RISK (VaR) a statistical probability model that measures financial risk exposures based on historic
observations
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 off-balance-sheet items, the risk management
needs of the institution, the theoretical and technical skills of its risk managers and the availability of computer
hardware and software.
Simple VaR models:
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.
Page 66
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
6/10
2016/3/10
IEB Wireframe
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
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.
Page 67
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
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
7/10
2016/3/10
IEB Wireframe
identified as:
1. board and senior management oversight
2. sound capital assessment
3. comprehensive assessment of risks
4. monitoring and reporting
5. internal control and review.
Principle 2 states: ‘Supervisors should review and evaluate banks’ internal capital adequacy assessments and
strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors
should take appropriate supervisory action if they are not satisfied with the result of this process.' To achieve these
outcomes, supervisors would be expected to be involved with, or require:
on-site examinations and inspections
off-site reviews
discussions with bank management
reviews of work done by external auditors
periodic reporting.
Principle 3 states: ‘Supervisors should expect banks to operate above the minimum regulatory capital ratios and should
have the ability to require banks to hold capital in excess of the minimum.’ Reasons why commercial banks should be
required to maintain a capital buffer include:
Pillar 1 requirements represent only a minimum level of capital. Banks will require additional capital in order to
achieve business growth.
International banks will require a higher level of capital to enhance their credit ratings.
Fluctuations in capital requirements will occur as the dynamic business environment changes.
Obtaining additional capital on short notice is generally more costly.
Failure of a bank to maintain the minimum capital requirement may trigger legislative or supervisory corrective
action.
A bank may be exposed to specific risks that are not taken into account in Pillar 1, 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.
Page 68
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.
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
8/10
2016/3/10
IEB Wireframe
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.
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.
Page 69
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
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
9/10
2016/3/10
IEB Wireframe
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 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.
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).
http://textflow.mheducation.com/parser.php?secload=3.8&fake&print
10/10
2016/3/10
IEB Wireframe
Page 70
2.8 Liquidity management and other supervisory controls
LEARNING OBJECTIVE 2.7
Examine liquidity management and other supervisory controls applied by APRA in the context of Basel III
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.
LIQUIDITY access to cash and other sources of funds to meet day-to-day expenses and commitments
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.
SECURITIES PORTFOLIO financial securities held by an institution for investment and trading purposes
Liquid securities include cash, government securities, semi-government securities and money-market 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.
LIQUIDITY MANAGEMENT STRATEGY an organisation's objectives, policies and procedures as they relate to cash flows and
liquidity
Page 71
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.
CONTINGENCY PLAN a set of predetermined strategies to be implemented if a designated event occurs
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
http://textflow.mheducation.com/parser.php?secload=3.9&fake&print
1/3
2016/3/10
IEB Wireframe
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.
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 money-market 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:
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.
2.8.1Other 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 outsideAustralia 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.
Page 72
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
http://textflow.mheducation.com/parser.php?secload=3.9&fake&print
2/3
2016/3/10
IEB Wireframe
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.
NON-EXECUTIVE BOARD MEMBERS board members who are not part of the management of a corporation or its subsidiaries
REFLECTION POINTS
Liquidity risk is a major risk exposure of commercial banks.
Banks need to have access to funds to meet day-to-day commitments, 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.
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.
http://textflow.mheducation.com/parser.php?secload=3.9&fake&print
3/3
2016/3/10
IEB Wireframe
Page 73
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.
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
additional
and Europe
capital by
assets.
to the market's demands for strong capital ratios does not necessarily mean that banks need
capital by selling shares and diluting the ownership shares of existing shareholders. Banks
have begun raising capital by other means, including sales of convertible debt. Other banks
issuing dividends in the form of shares rather than cash. Others have simply raised cash by
to raise
in both the UK
have raised
selling off
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.
Page 74
SOURCE: Extract from Patrick Jenkins and Daniel Schafer, ‘Europe's Banks Turn to Capital Raising to Meet Basel III’,
Financial Times, 13 May 2013.
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.
http://textflow.mheducation.com/parser.php?secload=3.10&fake&print
1/1
2016/3/10
IEB Wireframe
CHAPTER TWO REVIEW
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.
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.
Page 75
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 government.
Personal finance is provided to individuals and includes housing loans, investment property loans, fixed-term
loans, personal overdrafts and credit card finance.
Banks invest in the business sector by granting commercial loans. Commercial loan assets include overdraft
facilities, commercial bills held, term loans and lease finance.
While banks may lend some funds directly to government, their main claim is through the purchase of government
securities such as Treasury notes and Treasury bonds.
LEARNING OBJECTIVE 2.4
Outline the nature and importance of banks' off-balance-sheet business, including direct credit substitutes, trade- and
performance-related items, commitments and market-rate-related contracts
Viewing banks only in terms of their assets and liabilities greatly underestimates their role in the financial
system. Banks also conduct significant off-balance-sheet business.
The national value of off-balance-sheet business is over four times the value of the accumulated assets of the
banking sector.
Off-balance-sheet business is categorised as direct credit substitutes, trade- and performance-related items,
commitments, and foreign exchange, interest rate and other market-rate-related contracts.
Over 94 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
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
1/11
2016/3/10
IEB Wireframe
One of the main influences of change in the banking sector has been the regulatory environment within which banks
operate.
Commercial banks are now said to operate in a deregulated market. Relative to previous regulatory periods this is a
reasonable description; however, there still remains quite a degree of regulation that affects participants in the
financial markets, including the banks.
Each nation-state is responsible for the regulation and supervision of its own financial system. In particular,
central banks and prudential supervisors are responsible for the maintenance of financial system stability and the
soundness of the payments system.
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.
Page 76
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
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-balance-sheet item a
risk weight. The risk weights reflect the view of regulators about credit risk on a portfolio basis. The regulator
emphasises that the risk weights should not be seen as a substitute for the credit risk assessment of individual credit
risk exposures. A bank has primary responsibility to ensure that adequate systems are applied to measure credit risk,
and that sufficient capital is allocated to cover that risk.
The risk-weighted amount of a balance-sheet asset is calculated by multiplying its current book value by the relevant
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
2/11
2016/3/10
IEB Wireframe
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).
D
Page 77
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:
D
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.
Page 78
Had the bank given a $1 million loan to a company that has a BB credit rating, the capital requirement would have been
$1 million × 1.0 × 0.08 = $80 000. Therefore, there is a significant difference in the amount of capital a bank must
use between the AA-rated company and the BB-rated company.
Risk weights specified by the regulator may range from zero to 400 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
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
3/11
2016/3/10
IEB Wireframe
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.
LOAN-TO-VALUATION RATIO the percentage ratio of a loan to the bank's valuation of the property being mortgaged
D
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.
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. Nonmarket-related off-balance-sheet transactions are those items included in the first three types of bank off-balancesheet 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-balancesheet 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-balance-sheet transaction is $1 million × 0.20 × 1.50 × 0.08 = $24 000.
Page 79
Extended learning B
LEARNING OBJECTIVE 2.9
Analyse business continuity risk and construct an education and training framework for operational risk management for
commercial banks
Business continuity risk management
Business continuity risk management has an impact on a bank's ability to maintain its day-to-day business operations. It
relates to the risk of direct, indirect or consequential operational and financial impacts as a result of inadequate or
failed internal or external processes, people, systems or events. These may result, for example, from a natural disaster
such as an earthquake or a physical disaster such as a loss of computer or communication systems.
Business continuity risk management may be described as a dichotomy of:
1. a disaster recovery planning process, plus
2. a disaster recovery response process.
The two processes consist of a wide range of core components. Each component has implications for, and must be
incorporated in, business continuity risk management.
1. Disaster recovery planning process
The core components of the disaster recovery planning process are as follows:
The establishment of an organisational business continuity risk management structure that is horizontally and
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
4/11
2016/3/10
IEB Wireframe
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.
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.
Page 80
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.
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.
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
5/11
2016/3/10
IEB Wireframe
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
Page 81
All bank personnel and associated non-bank personnel should complete the induction/awareness program. Participants in
the contingency planning program will be specialist business continuity risk management personnel, while the board of
directors and executive management, including global risk committee members and audit and compliance committee members,
will complete the executive program.
Each education and training program includes the rationale, participants, objectives, curriculum framework, learning
outcomes and performance indicators.
Program 1: Induction/awareness
The induction/awareness program should be completed by all bank personnel. A bank may also provide the program to nonbank personnel from other organisations that provide critical services to the bank.
This program recognises that the effectiveness of business continuity risk management is dependent on the attitude and
actions of personnel. All bank personnel must know and apply the principles of risk management and want to participate
in a corporate culture and practice of active and positive disaster recovery planning and response.
The induction/awareness program curriculum framework incorporates the following issues and learning outcomes.
1. What is business continuity? Why is business continuity risk management important? Participants will be able to
describe examples of physical and natural disasters and identify critical business functions that may be exposed to
such situations.
2. Organisation of business continuity risk management objectives, policies and procedures. Participants will be able
to explain why a bank needs to maintain the continuity of its critical business functions. Participants will know
how they can include business continuity risk management in their day-to-day operational practice.
3. The bank's business continuity risk management organisational structure. Participants will be able to describe the
bank's business continuity risk management organisational structure, emphasising the roles and responsibilities of
individuals within business units.
4. Risk and the disaster recovery planning process. Participants will be able to give a range of examples of risk and
demonstrate the practical application of the risk management process.
5. The disaster recovery response process. Participants will be able to explain through examples why a bank implements
a structured and prioritised disaster recovery process.
6. How to respond in a disaster situation. Participants will know their responsibilities in an emergency, including
disaster identification and reporting procedures, personnel safety, asset damage mitigation and building evacuation
procedures.
7. Applying learning to practice. Participants will return to their workplace knowing they have the fundamental
knowledge and skills to apply effective business continuity risk management practices in their day-to-day business
operations.
Program 2: Contingency planning
Although all bank personnel must incorporate business continuity risk management into their 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 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
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
6/11
2016/3/10
IEB Wireframe
able to document a recovery prioritisation schedule.
Page 82
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
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.
Page 83
6. Global best practice. Participants will be able to investigate and evaluate global best practice in business
continuity risk management, and analyse and compare the bank's current practice. Participants will be able to
develop and implement policies and strategies that will enable the implementation of best practice.
7. Disaster response: recovery control centre, communications, media liaison. Participants will be able to demonstrate
leadership in responding to a disaster situation. Participants will be able to activate recovery control centre
procedures, particularly the initiation of communications. They will be able to command, control and coordinate the
disaster recovery process. Participants will also know their roles and responsibilities in relation to the bank's
policies and procedures for media liaison.
Summary
The business continuity risk management education and training framework for banks comprises three specific programs
that are directed towards identifiable groups of bank personnel:
an induction/awareness program for all bank personnel
a specialist contingency planning program
an executive program for strategic policy decision makers
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
7/11
2016/3/10
IEB Wireframe
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.1An education and training framework for disaster risk management for banks
Page 84
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.
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.
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
8/11
2016/3/10
IEB Wireframe
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 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.
Page 85
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.
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 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.
Page 86
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.
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
9/11
2016/3/10
IEB Wireframe
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
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.
1. Define what is meant by the off-balance-sheet business of banks.
2. Identify the four main categories of off-balance-sheet business and use an example to explain each category.
(LO 2.4)
Page 87
8. Following the GFC, the off-balance-sheet activities of commercial banks attracted a great deal of attention among
commentators. With reference to the size and composition of commercial banks' off-balance-sheet activities, outline
some of the possible reasons for this concern. (LO 2.4)
9. Bank regulators impose minimum capital adequacy standards on commercial banks.
1. Briefly explain the main functions of capital.
2. What is the minimum capital requirement under the Basel III capital accord?
3. 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.
1. Define operational risk.
2. 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)
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
10/11
2016/3/10
IEB Wireframe
11. Provide an overview and rationale for the two new liquidity standards introduced by Basel III. (LO 2.6)
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.
1. Define credit risk.
2. What approaches may be used to measure the credit risk capital adequacy component of Pillar 1?
3. 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.
1. Define business continuity risk management.
2. Identify and briefly explain the core components of a disaster recovery planning process.
3. 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.
1. Why is education and training important in the context of business continuity risk management?
2. Identify three discrete education and training programs that a bank should provide.
3. Briefly discuss what issues should be incorporated in each of the three education and training programs. (LO
2.9)
17.
1. Discuss the nature of corporate governance and its relationship with ethics. (LO 2.10)
2. 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)
Page 88
KEY TERMS
acceptance 46 amortised loan instalments 49 asset management 44 authorised deposit-taking institutions 56 bank bills
held 50 bank regulation 56 Basel II capital accord 58 Basel III capital accord 58 basis points 65 BBSW 50 bill of
exchange 46 business continuity management 64 call deposits 45 certificate of deposit 46 collateralised floating
charge 47 commercial bills 50 commitments 53 contingency plan 71 credit card 49 credit risk 59 current account
deposits 45 current exposure method 60 debenture 47 direct credit substitute 53 euromarkets 47 fixed-term loan 49
foreign currency liabilities 47 G-10 58 general market risk 65 hedging 54 housing finance 49 internal ratings-based
approach to credit risk 62 investment property finance 49 lease 50 liability management 44 liquidity 70 liquidity
management strategy 70 loan capital 47 loan-to-valuation ratio 78 market risk 59 market-rate-related contracts 54
mark-to-market 62 mortgage 49 mortgage originators 49 negotiable security 46 non-executive board members 72 offbalance-sheet business 44 operational risks 63 original exposure method 60 overdraft 50 Pillar 1 60 prudential
supervision 56 reference interest rate 50 rollover facility 50 securities portfolio 70 securitisation 49 specific
market risk 65 standardised approach to credit risk 60 term deposits 45 Tier 1 capital 60 Tier 2 capital (lower) 60
Tier 2 capital (upper) 60 trade- and performance-related item 53 Treasury bonds 51 Treasury notes (T-notes) 51
unsecured note 47 value at risk (VaR) 65
http://textflow.mheducation.com/parser.php?secload=3.f&fake&print
11/11
2016/3/10
IEB Wireframe
Page 90
Chapter 3
Non-bank financial institutions
CHAPTER OUTLINE
3.1Investment banks
3.2Managed funds
3.3Cash management trusts
3.4Public unit trusts
3.5Superannuation funds
3.6Life insurance offices
3.7General insurance offices
3.8Hedge funds
3.9Finance companies and general financiers
3.10Building societies
3.11 Credit unions
3.12Export finance corporations
1.
2.
3.
4.
5.
6.
7.
8.
9.
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.
Page 91
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
1. 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:
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-balance-sheet 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
http://textflow.mheducation.com/parser.php?secload=4&fake&print
1/2
2016/3/10
IEB Wireframe
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.
Page 92
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.
http://textflow.mheducation.com/parser.php?secload=4&fake&print
2/2
2016/3/10
IEB Wireframe
3.1Investment banks
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
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.
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
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.
INVESTMENT BANKS specialist providers of financial and advisory services to corporations, high-net-worth individuals
and government
3.1.1Sources 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-balancesheet advisory services.
Page 93
3.1.2Off-balance-sheet business
Investment banks have established a reputation as financial innovators. Much of that financial innovation has been in
the development of sophisticated off-balance-sheet products and advisory services. Therefore, the principal income of
these banks is fee income associated with their off-balance-sheet activities. Examples of their off-balance-sheet
business include:
1. Operating as foreign exchange dealers. Within a global market, importers, exporters, investors, borrowers, central
banks, speculators and arbitrageurs conduct a range of transactions that are written or denominated in a foreign
currency. Investment banks that operate as foreign exchange dealers quote both bid (buy) and offer (sell) prices on
all major currencies. As we will discuss in Chapter 15, the foreign exchange markets are enormous, and at times
quite volatile.
2. Advising clients on how, where and when to raise funds in the domestic and international capital markets.
Investment banks understand the global financial markets and how to access funds in those markets. They provide
advice and expertise on the types and structures of securities that can be issued, interest rate risk and exchange
http://textflow.mheducation.com/parser.php?secload=4.2&fake&print
1/5
2016/3/10
IEB Wireframe
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 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.
Page 94
UNDERWRITER an institution that supports the issue of securities by a client and agrees to buy any securities not
bought by investors
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
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.
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
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.
http://textflow.mheducation.com/parser.php?secload=4.2&fake&print
2/5
2016/3/10
IEB Wireframe
HORIZONTAL TAKEOVER when two companies involved in a merger and acquisition are in the same business
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).
VERTICAL TAKEOVER when the target company in a merger and acquisition operates in a business related to that of the
takeover company
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).
CONGLOMERATE TAKEOVER when the business of a merger and acquisition target company is unrelated to the existing
business of the takeover 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.
HOSTILE TAKEOVER when the target company rejects the merger and acquisition proposal of the takeover 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.
Page 95
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
acquisition. Another firm may diversify
the takeover company will diversify its
single economic market that might occur
may extend its business operations into the international markets through
its business functions through a conglomerate takeover. In either situation
sources of revenue and will try to protect itself from a downturn in a
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, antitrust 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 nationstates, particularly in relation to the treatment of tax issues arising from merger and acquisition activity.
A brief description of a range of issues that an investment bank would bring to the attention of a corporate client when
considering a merger and acquisition proposition is provided below.
Analysis of the target company. Is the company a strategic fit? Issues to consider include the company's size,
geographic position, business mix, operational capacity, financial strength and availability for takeover.
Valuation of the company. Quantitative models will be used that incorporate net asset values (liquidation value),
net present values of incremental cash flows and future earning power. The value of the combined entity should be
greater than its pre-merger parts.
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
http://textflow.mheducation.com/parser.php?secload=4.2&fake&print
3/5
2016/3/10
IEB Wireframe
management structures.
Negotiation. Negotiation skills are essential when a dominant company is making a takeover bid for a target
company. If negotiations are conducted properly, there will be no perceived winners or losers. Negotiators must
resist taking positions, and should separate people from the business issues; that is, the takeover should not be
about personalities and personal gain, but rather about benefiting the business.
Due diligence. This involves the detailed and careful analysis of the financial and operational condition of the
target company. Clearly, information gained in the due diligence process will determine whether a proposal should
proceed and at what offer price.
Nature of the takeover. If an offer is made, will it be resisted by the board of directors of the target company?
If so, what are the strategic, financial and operational implications of proceeding with a hostile takeover? If an
unsolicited friendly merger is possible, what concessions will need to be made?
Communication with the market. This includes regulatory communication requirements to keep the market informed,
plus strategic communication with the media and specific market participants such as investment analysts.
Project management and integration. Development of a merger and acquisition proposal will, at times, be influenced
by issues of speed versus accuracy of information, confidentiality versus transparency of information provided to
stakeholders, and the robustness versus the efficiency of the transaction structure.
The merger and acquisition advisory role of an investment bank provides enormous opportunities for the institution to
offer a range of further services to its corporate client. Once it has advised on a merger proposal, the investment bank
will seek to facilitate the transaction on behalf of the client. Other additional services may include providing advice
and facilitating funding requirements for debt and equity, underwriting arrangements, balance-sheet restructuring and
risk management. All these functions are discussed in detail in other parts of this textbook.
Page 96
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.
http://textflow.mheducation.com/parser.php?secload=4.2&fake&print
4/5
2016/3/10
IEB Wireframe
The merger will seek to achieve synergy benefits such as economies of scale, finance advantages, competitive growth
opportunities and business diversification.
An investment bank would assist a client with analysis and valuation of the target company, and will provide
expertise in relation to contracts, transaction structures, negotiation, due diligence, communication with the
market, project management and integration.
http://textflow.mheducation.com/parser.php?secload=4.2&fake&print
5/5
2016/3/10
IEB Wireframe
3.2Managed funds
LEARNING OBJECTIVE 3.2
Explain the structure, roles and operation of managed funds and identify factors that have influenced their rapid growth
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.
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
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.
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
Page 97
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.
RESPONSIBLE ENTITY the trustee and manager of a trust in Australia
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.
3.2.1Structure of the managed funds sector
Managed funds provide a range of investment structures and opportunities for an investor. Managed funds gather the
savings of individuals and then invest the accumulated amount of funds in various asset classes in the domestic and
international money markets and capital markets. The main categories of managed funds are:
Cash management trusts (see Section 3.3)
Public unit trusts (see Section 3.4)
Superannuation funds (see Section 3.5)
Statutory funds of life offices (see Section 3.6)
Hedge funds (see Section 3.8)
Common funds. These are operated by trustee companies. They combine the funds of beneficiaries into an investment
pool and invest those funds in specified asset classes. Common funds are different from unit trusts in that they do
not issue units to investors. Solicitor firms often offer mortgage trusts through a common fund.
Friendly societies. A mutual organisation that provides investment and other services, such as insurance, sickness
and unemployment benefits, to its members. Friendly societies' investment products include the issue of bonds that
invest in a range of asset classes, such as cash, fixed-interest trusts, equity and property.
http://textflow.mheducation.com/parser.php?secload=4.3&fake&print
1/4
2016/3/10
IEB Wireframe
3.2.2Sources 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 will have a competitive incentive to achieve higher returns;
otherwise the services of the fund manager may be dispensed with.
Page 98
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.
SOURCE: Reserve Bank of Australia, September 2013.
D
There are a number of different types of managed funds. These types of funds are defined by the nature of the assets
held in the fund:
capital guaranteed funds
capital stable funds
balanced growth funds
managed growth or capital growth funds.
Managed funds offer members a choice of investment strategies to meet their particular risk and liquidity preferences.
For example, it might be reasonable for a person nearing retirement to want to minimise risk exposure and adopt a
conservative investment strategy in order to protect their funds. On the other hand, a young person may wish to take a
more aggressive risk strategy to try and maximise the return over the longer term. Therefore, managed funds may be
categorised by the investment risk profile of the different types of funds on offer. In some cases, however, there may
be a marked difference between what the fund is called and the nature of the risks that are borne by investors.
3.2.3Capital guaranteed funds
http://textflow.mheducation.com/parser.php?secload=4.3&fake&print
2/4
2016/3/10
IEB Wireframe
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 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.
Page 99
CAPITAL GUARANTEED FUND a fund that offers the potential of positive returns while putting in place strategies to
protect investors' capital from downside losses
3.2.4Capital 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.
CAPITAL STABLE FUND the capital invested exhibits low variability because the fund invests mainly in low-risk
securities
3.2.5Balanced 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.
BALANCED GROWTH FUND investments target longer-term income streams supported by limited capital growth
3.2.6Managed 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.
MANAGED GROWTH FUND invests to obtain greater return through capital growth; lower income streams
Now that we understand the purpose and function of managed funds, we will look at the following:
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.
http://textflow.mheducation.com/parser.php?secload=4.3&fake&print
3/4
2016/3/10
IEB Wireframe
Types of managed funds are categorised by their investment risk profile, being capital stable funds, balanced
growth funds, managed or capital growth funds.
http://textflow.mheducation.com/parser.php?secload=4.3&fake&print
4/4
2016/3/10
IEB Wireframe
Page 100
3.3Cash management trusts
LEARNING OBJECTIVE 3.3
Discuss the purpose and operation of cash management trusts and public unit 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.
CASH MANAGEMENT TRUST (CMT) invests the accumulated savings of individuals mainly in wholesale money-market
securities
The CMT deed defines the types of assets in which the trust may invest. The assets are generally restricted to shortterm 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.
SOURCE: Reserve Bank of Australia, September 2013.
D
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.
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=4.4&fake&print
1/2
2016/3/10
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=4.4&fake&print
2/2
2016/3/10
IEB Wireframe
Page 101
3.4Public unit trusts
LEARNING OBJECTIVE 3.3
Discuss the purpose and operation of cash management trusts and 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.
PUBLIC UNIT TRUST investors purchase units in a trust; the pooled funds are invested in asset classes specified in the
trust deed
The four main types of public unit trusts are defined by the assets accumulated in the fund:
property trusts
equity trusts
mortgage trusts
fixed-interest trusts.
Property trusts invest in industrial, commercial, retail and residential property. A particular trust may invest only
in residential rental properties, while another may invest in shopping centres, another in hotels and another in central
business district properties. The potential investment choices are quite wide, and the nature of the unit trust, whereby
investors purchase a limited number of units in the trust, means that the investors gain access to investment
opportunities that they may not be able to afford to purchase direct from the market. For example, an individual person
generally cannot afford to buy a shopping centre complex; however, individuals are able to buy units in a trust which
invests in shopping centres.
PROPERTY TRUSTS invest in different types of property specified in the trust deed; includes industrial, commercial and
retail property
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.
EQUITY TRUST invests in different types of shares listed on stock exchanges (e.g. industrial, resources, emerging
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.
MORTGAGE TRUST invests in mortgages registered as loan securities over land
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.
FIXED-INTEREST TRUST invests in a range of debt securities such as government and corporate bonds
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.
http://textflow.mheducation.com/parser.php?secload=4.5&fake&print
1/3
2016/3/10
IEB Wireframe
SOURCE: Reserve Bank of Australia, September 2013.
D
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.
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
The distinction between listed and unlisted trusts is important. For example, this was highlighted in Australia during
the late 1980s when, in an environment of falling property prices, the valuations of most property trusts were marked
down. This caused a significant demand for withdrawals by unit holders who wanted to exit the trusts before they
experienced further write-downs. The unlisted trusts were generally unable to meet the demand for a large number of
simultaneous withdrawal requests as, quite reasonably, the trusts did not hold cash reserves to the extent of the
withdrawal demand. Many trusts began to impose a withdrawal notice period, which had the effect of stopping immediate
withdrawals. It also served to signal to investors what should have been obvious all the time: that unlisted property
trusts should not be seen as highly liquid investments but as medium- to long-term investments.
Page 102
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.
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=4.5&fake&print
2/3
2016/3/10
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=4.5&fake&print
3/3
2016/3/10
IEB Wireframe
Page 103
3.5Superannuation funds
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
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.
SUPERANNUATION savings accumulated by an individual to fund their retirement from the workforce
In some countries individuals must fund their own retirement, while in other countries, such as
entitlements are available from the government. However, these entitlements are restrictive and
sufficient to allow an individual to live in the manner to which they may have been accustomed.
experiencing an ageing population, it is probable that governments may provide less support for
future. Therefore, superannuation savings will be essential for younger people currently in the
Australia, age pension
generally are not
With many countries
retirees into the
workforce.
AGE PENSION a limited regular income stream paid by a government to older retired persons
For most individuals the secret to accumulating sufficient retirement funds is progressive long-term 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.
SOURCE: APRA, Statistics Quarterly Superannuation Performance, September 2013.
D
In Table 3.4, APRA classifies superannuation funds as:
Entities with more than four members: regulated superannuation entities with more than four members.
Pooled superannuation trusts (PSTs): trusts in which regulated superannuation funds, approved deposit funds and
other PSTs invest.
http://textflow.mheducation.com/parser.php?secload=4.6&fake&print
1/5
2016/3/10
IEB Wireframe
Small APRA funds: superannuation entities regulated by APRA with less than five members.
Page 104
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.
3.5.1Sources 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
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.
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 government-sponsored fund established for the benefit of 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.
COMPULSORY SUPERANNUATION employers must contribute minimum specified amounts into retirement savings for employees
(Australia)
Page 105
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
http://textflow.mheducation.com/parser.php?secload=4.6&fake&print
2/5
2016/3/10
IEB Wireframe
Australian Taxation Office. The SGC is therefore a penalty taxation charge made on employers who do not contribute to
their employees' superannuation.
SUPERANNUATION GUARANTEE CHARGE (SGC) the compulsory superannuation scheme operating in Australia
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.
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.
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.
Page 106
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 onequarter 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 funds
http://textflow.mheducation.com/parser.php?secload=4.6&fake&print
3/5
2016/3/10
IEB Wireframe
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.
ROLLOVER FUND holds existing eligible termination payments within the regulated superannuation environment
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.
ELIGIBLE TERMINATION PAYMENT (ETP) superannuation funds due on termination of employment plus related redundancy
payments
3.5.2Defined 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.
DEFINED BENEFIT FUND the amount of superannuation paid to an employee on retirement is based on a defined formula
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 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.
Page 107
ACCUMULATION FUND the amount of superannuation funds available at retirement consists of past contributions plus
earnings, less taxes and expenses
3.5.3Regulation
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
http://textflow.mheducation.com/parser.php?secload=4.6&fake&print
4/5
2016/3/10
IEB Wireframe
Superannuation funds, provident funds or pension funds accumulate retirement savings of individuals.
Superannuation funds may be classified as corporate funds, industry funds, public sector funds, retail funds, small
regulated funds and self-managed funds.
Superannuation savings come from a number of sources, including employer contributions, employee contributions,
compulsory superannuation contributions, personal contributions and eligible rollover funds.
Many countries are experiencing a demographic shift to an ageing population. Some have introduced compulsory
superannuation schemes to ensure people fund at least part of their own retirement.
In Australia, employers are required to pay the equivalent of 9.50 per cent of an employee's wage or salary into a
superannuation fund in the employee's name.
A fund may be a defined benefit fund or 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.
http://textflow.mheducation.com/parser.php?secload=4.6&fake&print
5/5
2016/3/10
IEB Wireframe
Page 108
3.6Life insurance offices
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. 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.
PREMIUM the amount paid by the buyer of a contract, such as an option or an insurance policy
POLICYHOLDER the person who takes out an insurance policy that covers a defined risk event
BENEFICIARY the party who is entitled to receive payment under the terms of an insurance policy
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.
SOURCE: Reserve Bank of Australia, September 2013.
D
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.
Page 109
3.6.1Life 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.
http://textflow.mheducation.com/parser.php?secload=4.7&fake&print
1/3
2016/3/10
IEB Wireframe
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.
WHOLE-OF-LIFE POLICY a life insurance policy that incorporates a risk component and an investment component, thus
accumulating bonuses and a surrender value
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.
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
Therefore, the policy will pay both the sum insured and the total bonuses attached to the policy. Should the
policyholder get into financial difficulty and not be able to pay the premiums on the policy, the accumulated bonuses
may be used to offset the outstanding premium payments due.
A whole-of-life policy, over time, acquires a surrender value—that is, an amount that will be paid if the policy is
cancelled by the policyholder.
Term-life policy
The term-life policy pays a specified benefit to a nominated beneficiary on the death of the insured, if that death
occurs during the term of the policy. The term-life policy is for a predetermined period and does not include an
investment component.
TERM-LIFE POLICY life insurance cover for a fixed amount and a predetermined period
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.
Page 110
Total and permanent disablement insurance
Total and permanent disablement insurance is often taken as an extension to a life insurance policy. It would seem
prudent and logical to cover the situation in which death does not occur but serious injury results. This is quite often
the case, for example, in a car accident. The injury suffered may be such that the policyholder is no longer able to
work.
TOTAL AND PERMANENT DISABLEMENT INSURANCE insurance policy covering loss of limbs or total inability to resume an
occupation
A total and permanent disablement policy will pay a specified amount, either as a lump sum or as an annuity, if an
http://textflow.mheducation.com/parser.php?secload=4.7&fake&print
2/3
2016/3/10
IEB Wireframe
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.
ANNUITY a series of cash flows of equal amount, equally spaced over time
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
Another type of insurance policy that can be attached to a
life office will make a lump-sum payment to the insured in
events include cancer, heart attack, HIV, major body parts
insurance, the extent of coverage of a policy, definitions
great care. For example, at what point is a heart attack a
life policy is trauma insurance. With trauma insurance, the
the event of a specified trauma occurring. Examples of trauma
failure and terminal disease or illness. Again, as with all
of events and terms and conditions need to be examined with
trauma event under a policy?
TRAUMA INSURANCE a lump-sum payment made if a specified trauma event, such as a stroke, occurs
Income protection insurance
Serious injury 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.
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
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.
BUSINESS OVERHEADS INSURANCE coverage of specified day-to-day operating expenses in the event of business disruption
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.
Page 111
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.
http://textflow.mheducation.com/parser.php?secload=4.7&fake&print
3/3
2016/3/10
IEB Wireframe
3.7General insurance offices
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 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.
3.7.1General insurance policies
General insurance offices provide a wide range of risk insurance products. Policies offer protection to individuals in
the retail market and to businesses in the commercial market. This section considers two of the principal insurance
policy types:
house and contents insurance
motor vehicle insurance
House and contents insurance
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.
CO-INSURANCE CLAUSE if an asset is under-insured the policy will cover only the proportional value insured
For example, if a house is insured for $400 000 but the replacement cost is determined to be $500 000, then under a coinsurance 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:
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.
Page 112
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.
PUBLIC LIABILITY INSURANCE covers injury or death of a third party due to negligence of a property owner or occupier
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
http://textflow.mheducation.com/parser.php?secload=4.8&fake&print
1/2
2016/3/10
IEB Wireframe
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.
COMPREHENSIVE INSURANCE policy covers damage to the insured vehicle, plus third-party vehicle or property damage
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.
THIRD-PARTY, FIRE AND THEFT POLICY policy covers only fire or theft of the insured vehicle, plus third-party vehicle
or property damage
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.
THIRD-PARTY POLICY policy covers only third-party vehicle or property damage
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.
COMPULSORY THIRD-PARTY INSURANCE covers legal liability for bodily injury resulting from a motor vehicle accident
REFLECTION POINTS
General insurance provides financial protection against an insured event (e.g. travel or medical insurance).
House and contents insurance protects against loss or damage to a residential property, up to a specified amount,
caused by a range of perils specified in the policy, such as fire, flood or theft. The policy will include a coinsurance clause. The policy should also include public liability insurance which covers negligent injury to third
parties.
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.
http://textflow.mheducation.com/parser.php?secload=4.8&fake&print
2/2
2016/3/10
IEB Wireframe
3.8Hedge funds
LEARNING OBJECTIVE 3.6
Discuss hedge funds, including their structure, investors, investment strategies and risk
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 invest in exotic financial products mainly for high-net-worth individuals and institutional investors
Hedge funds may be offered and managed by individual managers or financial institutions, particularly investment banks.
Individual managers usually have a very high profile and an established reputation in the financial markets. Similarly,
investment banks employ individuals with specialist skills, but offer the extra protection of operational transparency.
That is, they keep investors informed. Hedge funds use their reputation to attract funds 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.
Page 113
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.
REFLECTION POINTS
A hedge fund seeks to achieve above-average returns using sophisticated investment strategies and exotic investment
products.
Funds are often highly leveraged by using borrowed funds or derivative products, and invest in equities, foreign
http://textflow.mheducation.com/parser.php?secload=4.9&fake&print
1/2
2016/3/10
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=4.9&fake&print
2/2
2016/3/10
IEB Wireframe
3.9Finance companies and general financiers
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 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 AND GENERAL FINANCIERS borrow funds direct from markets to provide loans and lease finance to
customers
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.
Page 114
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.
3.9.1Sources 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.
3.9.2Sector 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.
http://textflow.mheducation.com/parser.php?secload=4.10&fake&print
1/2
2016/3/10
IEB Wireframe
RACV Finance Limited: a vehicle roadside service organisation that has diversified into the provision of financial
products.
Page 115
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.
http://textflow.mheducation.com/parser.php?secload=4.10&fake&print
2/2
2016/3/10
IEB Wireframe
3.10Building societies
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 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.
BUILDING SOCIETIES authorised deposit-taking institutions that primarily give loans to customers to buy 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-marketrelated 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.
AUTHORISED DEPOSIT-TAKING INSTITUTION (ADI) financial institution authorised by APRA to accept retail deposits in
Australia
Page 116
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
http://textflow.mheducation.com/parser.php?secload=4.11&fake&print
1/2
2016/3/10
IEB Wireframe
building societies merged and eventually converted into commercial banks.
Building societies are authorised deposit-taking institutions that are regulated by APRA.
http://textflow.mheducation.com/parser.php?secload=4.11&fake&print
2/2
2016/3/10
IEB Wireframe
3.11Credit 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 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 authorised deposit-taking institutions that accept retail deposits and provide loans to members
COMMON BOND OF ASSOCIATION members are drawn together from a common background of work, industry or community
Credit unions 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.
http://textflow.mheducation.com/parser.php?secload=4.12&fake&print
1/1
2016/3/10
IEB Wireframe
3.12Export 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.
EXPORT FINANCE CORPORATIONS government authorities that provide finance and insurance support and services to
exporters
Page 117
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.
There is a continual demand for export credit. This is particularly true for the export of capital and semi-capital
goods, where the terms of payment and financing facilities can be just as important as price. To be successful in
international markets, exporters need access to payments insurance, guarantees and bonding and loan facilities that
compete with those available to overseas competitors.
Exporters wishing to compete successfully in overseas markets sometimes need to offer deferred payment terms; however,
this increases the risk exposure to non-payment. EFIC provides protection against this risk. Where applicable, EFIC
makes loans for export sales of capital equipment and services at concessional rates of interest. An EFIC loan is
usually made to the buyer or to its financier in the buyer's country. For government and public sector buyers in
countries that are recipients of Australian aid, mixed credits may be made available—that is, EFIC finance combined
with aid funds.
REFLECTION POINTS
Export finance corporations typically encourage export trade through the provision of trade insurance and financial
services and products to corporations.
Export finance corporations are often able to provide exporters with innovative trade finance solutions that may
not be available through other financial institutions.
In Australia the official export credit agency is the Export Finance and Insurance Corporation (EFIC).
http://textflow.mheducation.com/parser.php?secload=4.13&fake&print
1/1
2016/3/10
IEB Wireframe
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.
Page 118
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.
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?
http://textflow.mheducation.com/parser.php?secload=4.14&fake&print
1/1
2016/3/10
IEB Wireframe
Page 119
CHAPTER THREE REVIEW
Summary
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, 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 balancesheet 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.
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.
Page 120
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.
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
1/8
2016/3/10
IEB Wireframe
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, 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 thirdparty 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.
Page 121
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
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
2/8
2016/3/10
IEB Wireframe
finance are available to their members.
A defining characteristic of a credit union is the common bond of association of its members, usually based on
employment, industry or community.
LEARNING OBJECTIVE 3.9
Describe the unique role of export finance corporations
Government agencies play an important role in providing financial services to the corporate sector to support the
export of goods and services.
The official Australian agency is the Export Finance and Insurance Corporation (EFIC), which provides trade
insurance and trade-related financial services and products.
Extended learning
LEARNING OBJECTIVE 3.10
Understand project finance and structured finance and the related roles of investment banks
Project finance and structured finance
Project finance
Project finance is an interesting and complex area of finance. Project finance supports economic growth within a
country in that it enables important 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.
PROJECT FINANCE financing large projects where loan repayments are based on the future cash flows of the completed
project
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.
Page 122
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.
Figure 3A.1Conceptual 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.
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.
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
3/8
2016/3/10
IEB Wireframe
PROJECT SPONSORS the originators and equity providers of a project
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.
Page 123
Project finance loans are generally for a considerably longer term than is usually available through finance
provided by banks and other intermediaries.
Debt is on a ‘limited recourse’ or ‘non-recourse’ basis.
The recourse provisions are important, because they specify the rights of the lenders from project commencement up to
the time when the project is built and begins to generate positive cash flows. Under non-recourse lending, lenders are
totally dependent on the project's future cash flows for interest payments and the eventual repayment of the debt.
During the total life of the loan the lenders have no recourse to other repayment sources, including the project's
sponsors. 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.
NON-RECOURSE LENDING the lender is totally reliant on future project cash flows for loan repayments
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.
LIMITED RECOURSE LENDING lenders have certain claims on the assets of the project sponsors if project cash flows fail
to achieve specified levels
PROJECT COMPLETION point at which a project is built and is generating a prescribed level of cash flows
Completion is said to occur when construction is finished, the project is operational and specified cash-flow levels are
achieved. For example, with a toll road, completion is said to occur when the road has been built, is open for public
use and is generating a required level of revenue from vehicle tolls.
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.
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.
SYNDICATED LOAN the provision of loan funds by a group of financiers for a single project
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
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
4/8
2016/3/10
IEB Wireframe
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.
LEASING the borrowing of an asset in return for lease payments, rather than borrowing the funds to purchase the asset
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.
Page 124
Structured finance
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).
STRUCTURED FINANCE funding provided for major infrastructure projects
In the past, governments have primarily been responsible for infrastructure development and finance. However, in recent
years a change in political ideology has seen an enormous increase in private sector infrastructure developments.
Factors that have influenced private sector infrastructure finance include:
the current preference of governments to maintain budget surpluses, resulting in fiscal constraints being imposed
on the ability of governments to fund large infrastructure projects
the granting of tax concessions to qualified infrastructure projects in order to encourage private sector
investment
policy initiatives to create market competition within economic sectors that were previously monopolised by
government
the privatisation of existing government authorities and enterprises.
The above initiatives have encouraged new infrastructure projects, often referred to as greenfield projects.
Infrastructure projects often retain a monopoly position within the market, and also retain very stable and predictable
cash flows. For example, retail electricity users will continue to buy similar quantities of electricity regardless of
the supplier.
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.
EMBEDDED OPTIONS specific performance guarantees included in a project contract
CONSUMER PRICE INDEX a measure of changes in the price of a basket of goods and services
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.
SUBORDINATED JUNIOR DEBT claims of these security holders are subordinated after all other creditors
Risks associated with project finance
For providers of debt finance, particular importance is attached to the project reaching the completion stage. It is at
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
5/8
2016/3/10
IEB Wireframe
that point that the limited recourse provisions expire, and both limited recourse and non-recourse lenders become
dependent on the project's future income stream for repayment of their loans. As a result, lenders must carefully assess
the risks associated with achieving project completion, and the subsequent risk that may adversely impact upon the
project's income streams, such that they may not be sufficient to provide for the repayment of debt.
There are a host of risks that can be identified. Most of them are also relevant to the assessment of the risk of a
borrower seeking any loan. However, the risks are more critical in the case of project finance because the project (the
borrower) often has no other assets that can be secured by the lenders. As a result, it is likely that, when quantifying
the risks, the lenders will be more conservative in their calculations than they would be if they were assessing the
risk for the purposes of making a secured loan.
Page 125
For example, in the case of a resource development project, one of the risks that must be taken into account is the
amount of recoverable resources. Will they be sufficient to cover commitments to the debt providers, particularly if
resource prices fall? To cover themselves against this risk, debt providers typically seek an assurance that the proven
reserves that are accessible under current technologies are well in excess of those necessary to meet the debt-servicing
requirements. A 2:1 ratio of accessible reserves to necessary sales is not uncommon. In projects where the object is the
development of infrastructure, such as the development of electricity-generating facilities, usage and revenue
guarantees may be sought from the relevant government authorities.
Given the significance of completion, lenders will typically seek non-completion covenants from the project sponsors.
The forms of the covenants are varied and may include some of the following.
Guarantees from the sponsors that they will repurchase the debt, or convert it on specified terms into obligations
of the sponsoring corporations, if the completion conditions are not achieved.
Guarantees from the sponsors that they will provide the appropriate management expertise and additional funding
(including equity funding) to ensure that the completion conditions will be met.
Guarantees from the sponsors that they will meet any working capital shortfall during the development phase.
NON-COMPLETION COVENANTS specific loan conditions enforceable against project sponsors if a project is not completed
WORKING CAPITAL finance required by a firm to fund its day-to-day operations
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.
In addition to these risks, the debt providers must also calculate the risks associated with the management of the
project beyond completion, the impact of future changes in the regulatory environment and financial risks such as the
impact of changes in interest rates and exchange rates.
The complexity and sophistication of project financing should now be evident. Managers of corporations typically are not
experienced in these aspects of finance and therefore seek the expertise and advice of investment banks. Fees earned on
a project by an investment bank may run into millions of dollars.
Questions
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.
Page 126
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.
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
6/8
2016/3/10
IEB Wireframe
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.
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-balancesheet 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)
Page 127
5. Managed funds are often categorised by the type of investments purchased by the fund. These include capital stable
funds, balanced growth funds and managed capital growth funds. For each of these funds, discuss the types of
investments the fund might accumulate and explain the purpose of the investment strategies. (LO 3.2)
6. 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.
1. Why has there been such growth in superannuation savings?
2. 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.
1. How does the life office derive income from this function?
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
7/8
2016/3/10
IEB Wireframe
2. Describe the basic characteristics of the two main types of life insurance policies.
3. 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.
1. Explain the three different levels of motor vehicle cover that you can choose from.
2. 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.
1. Describe how a hedge fund is structured, including the manager, investors and types of investment
2. 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.
1. Define the nature and role of a credit union.
2. Explain the concept of a common bond of association and provide two examples of this form of association. (LO
3.8)
Page 128
Extended learning questions
15. Project finance is largely based on forecast future cash flows.
1. 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.
2. 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 age pension 103 annuity 110 authorised deposit-taking institution (ADI) 115 back office 92
balanced growth fund 99 beneficiary 108 building societies 115 business overheads insurance 110 capital guaranteed
fund 98 capital stable fund 99 cash management trust (CMT) 100 co-insurance clause 111 common bond of
association 116 comprehensive insurance 112 compulsory superannuation 104 compulsory third-party insurance 112
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 equity trust 101 export finance
corporations 117 finance companies and general financiers 114 fixed-interest trust 101 front office 92 hedge
funds 113 horizontal takeover 94 hostile takeover 94 income protection insurance 110 industry superannuation
fund 104 investment banks 92 investment component 109 leasing 123 limited recourse lending 123 listed trust 101
managed funds 97 managed growth fund 99 merger and acquisition 94 middle office 92 mortgage trust 101 mutual
funds 97 non-completion covenants 125 non-recourse lending 123 policyholder 108 premium 108 project completion 123
project finance 121 project sponsors 122 property trusts 101 public liability insurance 112 public sector
superannuation fund 104 public unit trust 101 responsible entity 97 risk component 109 rollover fund 106 spinoff 94 structured finance 124 subordinated junior debt 124 superannuation 103 superannuation guarantee charge
(SGC) 105 syndicated loan 123 term-life policy 109 third-party policy 112 third-party, fire and theft policy 112
total and permanent disablement insurance 110 trauma insurance 110 trust deed 96 trust fund 96 underwriter 93
unlisted trust 101 vertical takeover 94 whole-of-life policy 109 working capital 125
http://textflow.mheducation.com/parser.php?secload=4.f&fake&print
8/8
2016/3/11
IEB Wireframe
Page 129
Equity markets
Chapter
Chapter
Chapter
Chapter
4
5
6
7
The share market and the corporation
Corporations issuing equity in the share market
Investors in the share market
Forecasting share price movements
Page 130
Part 2
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 flow-on effects
of the Asian financial crisis from mid-1997, the collapse of the technology stock market, another period of recovery and
growth, the effect of the 11 September 2001 terrorist attacks in the USA, 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 role in the
financial system were introduced in Part 1. The purpose of Part 2 is to examine the share market in more detail.
Page 131
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
http://textflow.mheducation.com/parser.php?secload=5&fake&print
1/2
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=5&fake&print
2/2
2016/3/11
IEB Wireframe
Page 132
Chapter 4
The share market and
the corporation
CHAPTER OUTLINE
4.1 The nature of a corporation
4.2 The stock exchange
4.3 The primary market role of a stock exchange
4.4 The secondary market role of a stock exchange
4.5 The managed product and derivative product roles of a stock exchange
4.6 The interest rate market role of a stock exchange
4.7 The trading and settlement roles of a stock exchange
4.8 The information role of a stock exchange
4.9 The regulatory role of a stock exchange
4.10 The private equity market
Learning objectives
1. LO 4.1 Understand the structure of a corporation and identify advantages and disadvantages of being a publicly
listed corporation.
2. LO 4.2 Consider the origins and purpose of a stock exchange.
3. LO 4.3 Understand the primary market role of a stock exchange through which corporations raise new funding.
4. LO 4.4 Discuss the secondary market role of a stock exchange through which existing securities are bought and sold.
5. LO 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.
6. LO 4.6 Examine the interest rate market role of a stock exchange.
7. LO 4.7 Explain the electronic trading (ASX Trade) and settlement (CHESS) platforms used for share-market
transactions by the Australian Securities Exchange (ASX).
8. LO 4.8 Recognise the importance of information flows to the efficiency and integrity of stock exchanges.
9. LO 4.9 Identify the principal regulators that affect the behaviour of participants in the Australian share market.
10. LO 4.10 Explain the structure and purpose of the private equity market.
Page 133
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.
ORDINARY SHARE OR COMMON STOCK the principal form of equity issued by a corporation; bestows certain rights to the
shareholder
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.
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=6&fake&print
1/2
2016/3/11
IEB Wireframe
A stock exchange is a formal market within a nation-state that lists a range of securities issued by publicly
listed corporations; the largest component of a stock exchange is its share market.
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.
http://textflow.mheducation.com/parser.php?secload=6&fake&print
2/2
2016/3/11
IEB Wireframe
4.1The nature of a corporation
LEARNING OBJECTIVE 4.1
Understand the structure of a corporation and identify advantages and disadvantages of being a publicly listed
corporation
A corporation is a company that is a legal entity established under the Corporations Law of a nation-state. The shares
of a publicly listed corporation are listed on a stock exchange and the main source of equity funding, the ordinary
share, is quoted in the share market. There are a number of features that distinguish a corporation.
Page 134
Ownership is generally widely dispersed among a large number of shareholders and shares issued by a company can be
readily bought and sold in the share market without directly affecting the continuing existence of the business.
Shareholders, as owners of a company, do not have a right to participate directly in the day-to-day operation and
management of the business. The objectives and policies of a corporation are determined by a board of directors,
the members of which are elected at a general meeting of shareholders. Directors have a legal responsibility to
ensure that the corporation operates in the best interests of the shareholders. The board of directors appoints
an executive management group that is responsible for achieving the specified objectives and policies of the
organisation through the management of the day-to-day financial and operational affairs of the company. Executive
management is responsible to the board of directors. The board of directors reports to shareholders.
The liability of shareholders for the debts of the business is limited. If a sole proprietorship, a partnership or
an unlimited company fails to meet its obligations to creditors, the creditors have a legal right to take
possession of the personal assets of the owners in order to recover any amount owing. The rights of creditors
against shareholders in a publicly listed company (i.e. a limited liability company or a no liability company)
are significantly less. These are defined more fully in Chapter 5, but, by way of summary, in the event that a
publicly listed company is liquidated the following applies:
The liability of shareholders in a limited liability company is limited to the issue price of the share.
Providing the shareholder has paid the full 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.
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
4.1.1Advantages of the corporate form of business organisation
A publicly listed corporation has important advantages over other forms of business organisation. They include the
following:
Large amounts of equity funding can normally be obtained more easily, through access to a wide pool of investors in
the market. These investors are willing to purchase shares because the stock exchange provides an active secondary
market for the sale of those shares. It is said that the share market is normally deep and liquid; that is, there
are usually buyers willing to purchase shares at the current market price.
Shareholders can reduce the risks of share ownership by holding a diversified portfolio of share investments. The
ability of shareholders to spread risk through diversification, and also readily to transfer ownership by buying
and selling share holdings in a deep and liquid market, reduces risk and therefore enables listed corporations to
raise capital on more favourable terms.
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.
http://textflow.mheducation.com/parser.php?secload=6.2&fake&print
1/3
2016/3/11
IEB Wireframe
Page 135
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.
SHARE MARKET a formal exchange that facilitates the issue, buying and selling of equity securities
RIGHT OF PERPETUAL SUCCESSION a corporation continues to operate regardless of changes in ownership
4.1.2Disadvantages 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.
AGENCY PROBLEM the conflict of interest that may exist between shareholders and management of a corporation
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.
SHARE OPTIONS the remuneration of a manager may include an option to purchase shares in the company at a specified
price
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.
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.
Page 136
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,
http://textflow.mheducation.com/parser.php?secload=6.2&fake&print
2/3
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=6.2&fake&print
3/3
2016/3/11
IEB Wireframe
4.2The stock exchange
LEARNING OBJECTIVE 4.2
Consider the origins and purpose of a 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 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.
Page 137
While the principal security quoted on a stock exchange is an equity instrument, other securities are also quoted. These
are typically government bonds, corporate bonds and hybrid securities. A further role of a stock exchange is the
provision of derivative products that enable investors to (1) purchase equity-based securities rather than purchasing
ordinary shares directly, (2) manage risk exposures associated with their investment portfolios, or (3) synthetically
restructure or leverage their portfolios.
A principal determinant of an efficient market is the speed at which new information flows to the market, and the speed
at which that information is absorbed and then reflected in share prices. A stock 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
http://textflow.mheducation.com/parser.php?secload=6.3&fake&print
1/2
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=6.3&fake&print
2/2
2016/3/11
IEB Wireframe
4.3The primary market role of a stock exchange
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 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).
PRIMARY MARKET the issue of new financial securities such as ordinary shares
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).
MSCI GLOBAL INDEX RANKING a ranking of the stock markets of developed economies by MSCI Inc.
SOURCE: ASX Limited, Market Notices, 3 April 2014.
D
Page 138
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.
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 pro-rata 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
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.
http://textflow.mheducation.com/parser.php?secload=6.4&fake&print
1/3
2016/3/11
IEB Wireframe
Figure 4.1Participants in a primary market issue of shares
PROSPECTUS document prepared by a company stating the terms and conditions of an issue of securities to the public
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.
Page 139
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).
http://textflow.mheducation.com/parser.php?secload=6.4&fake&print
2/3
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=6.4&fake&print
3/3
2016/3/11
IEB Wireframe
4.4The secondary market role of a stock exchange
LEARNING OBJECTIVE 4.4
Discuss the secondary market role of a stock exchange through which existing securities are bought and sold
Secondary market transactions in a stock exchange involve the buying and selling of existing financial securities,
principally ordinary shares. The participants associated with secondary market transactions in existing shares are shown
in Figure 4.2. We noted in Figure 4.1 that ownership of shares flows to individuals, institutions and the rest of the
world. If any of these shareholders decide to sell their shares, they will carry out a secondary market transaction.
Figure 4.2Participants in a secondary market share 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.
Page 140
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.
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
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
http://textflow.mheducation.com/parser.php?secload=6.5&fake&print
1/2
2016/3/11
IEB Wireframe
The secondary market role provides a market structure for the buying and selling of existing listed securities.
Buy and sell orders are lodged through a stockbroker that has access to the exchange's trading and settlement
platforms.
Secondary market transactions do not raise additional equity for the original issuing corporation—they are a
transfer of ownership for value.
Market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market encourages investors.
Market capitalisation is the number of issued shares multiplied by the share price.
http://textflow.mheducation.com/parser.php?secload=6.5&fake&print
2/2
2016/3/11
IEB Wireframe
4.5The managed product and derivative product roles of a stock exchange
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
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.
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
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 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.
Page 141
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 exchangetraded 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.
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
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.
HEDGE implement a strategy that manages or protects against an identified risk exposure
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:
exchange traded funds
contracts for difference
real estate investment trusts
infrastructure funds
http://textflow.mheducation.com/parser.php?secload=6.6&fake&print
1/5
2016/3/11
IEB Wireframe
options
warrants
futures.
Derivative contracts are discussed in much more detail in Part 6.
4.5.1Exchange 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.
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
Typically, the ETF will be a registered managed investment scheme. Investors purchase units in
of an equity-based ETF seeks to track the performance of a benchmark stock exchange index, for
by using the funds raised from the sale of units in the ETF to purchase a securities portfolio
specified index. For example, the ETF would hold all or the majority of shares included in the
an ETF. The fund manager
example, the S&P/ASX200,
that replicates 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 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.
Page 142
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.
4.5.2Contracts for difference
A contract for difference (CFD) is a contract listed on a stock exchange that is an agreement between a buyer and
seller to exchange the difference in the value of a CFD. The difference in value is calculated by subtracting the value
of the CFD contract at the start date from the value of the contract at the close date.
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
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.
4.5.3Real 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.
http://textflow.mheducation.com/parser.php?secload=6.6&fake&print
2/5
2016/3/11
IEB Wireframe
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
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.
Page 143
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.
4.5.4Infrastructure 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 FUND managed fund that provides investors with the opportunity to invest in infrastructure assets such
as toll roads and utilities
Infrastructure projects are normally
average investor. The infrastructure
funds. This enables the fund manager
the form of capital gains and income
toll charged for vehicles travelling
multi-million dollar projects and therefore beyond the investment capacity of the
fund accepts funds from a large number of investors to create a significant pool of
to then invest in these types of projects or assets. Returns to investors may take
generated from the project. For example, a toll road will generate income from the
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.
4.5.5Options
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.
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
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.
EXERCISE PRICE the price specified in an options contract at which the option buyer can buy or sell
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.
http://textflow.mheducation.com/parser.php?secload=6.6&fake&print
3/5
2016/3/11
IEB Wireframe
4.5.6Warrants
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.
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
Page 144
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.
4.5.7Futures 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.
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
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.
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.
http://textflow.mheducation.com/parser.php?secload=6.6&fake&print
4/5
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=6.6&fake&print
5/5
2016/3/11
IEB Wireframe
Page 145
4.6The interest rate market role of a stock exchange
LEARNING OBJECTIVE 4.6
Examine 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).
INTEREST RATE MARKET listing, quotation and trading in debt securities
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.
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).
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
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.
Page 146
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=6.7&fake&print
1/2
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=6.7&fake&print
2/2
2016/3/11
IEB Wireframe
4.7The trading and settlement roles of a stock exchange
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)
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 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
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.
http://textflow.mheducation.com/parser.php?secload=6.8&fake&print
1/3
2016/3/11
IEB Wireframe
Figure 4.3Buying and selling shares on the ASX
Page 147
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.
UNCERTIFICATED SECURITIES electronic record of share ownership; original share certificate is not issued
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.
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
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.
BID AND OFFER bid is an order to buy; offer is an order to sell
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.
Page 148
http://textflow.mheducation.com/parser.php?secload=6.8&fake&print
2/3
2016/3/11
IEB Wireframe
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.
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
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 subregister or, alternatively, on the sub-register of individual companies.
T + 3 settlement of a share transaction will occur in three business days
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.
CHESS SPONSOR market participant such as a stockbroker that has access to CHESS
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.
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.
http://textflow.mheducation.com/parser.php?secload=6.8&fake&print
3/3
2016/3/11
IEB Wireframe
4.8The information role of a stock exchange
LEARNING OBJECTIVE 4.8
Recognise the importance of information flows to the efficiency and integrity of stock exchanges
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 rules that are designed to ensure a wellinformed 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.
Page 149
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
Any information concerning a listed entity that a reasonable person would
or value of the entity's securities must immediately be given to the ASX.
states that a reasonable person would consider information to be material
commonly invest in securities in deciding whether or not to subscribe to,
expect to have a material effect on the price
In Australia, the Corporations Act (Cwlth)
if it would be likely to influence persons who
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.
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
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.
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=6.9&fake&print
1/2
2016/3/11
IEB Wireframe
Share prices move as demand and supply for shares change. Demand and supply changes as a result of new information
coming to the market.
Stock exchange listing rules require continuous disclosure of information that may impact upon investment decisions
and share prices. This is in addition to prescribed reporting requirements, such as the lodging of periodic
financial statements.
A stock exchange will monitor information flows to ensure the market is fully informed in order to maintain the
integrity and confidence in the market.
http://textflow.mheducation.com/parser.php?secload=6.9&fake&print
2/2
2016/3/11
IEB Wireframe
4.9The regulatory role of a stock exchange
LEARNING OBJECTIVE 4.9
Identify the principal regulators that affect the behaviour of participants in the Australian share market
Given the importance of the share market in encouraging and facilitating the raising of risk capital or equity finance,
it is important that the participants in the market have confidence in the integrity of its operation. Each nation-state
is responsible for the regulation and supervision of its own stock exchanges. The methods vary from country to country;
however, all developed countries maintain a government-appointed regulator to supervise the country's Corporations 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 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.
Page 150
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 the regulatory body responsible for the supervision of the Corporations Law in Australia
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.
DELISTING removal from quotation on a stock exchange of the securities of an entity
Another important participant in the regulatory structure in Australia is the Reserve Bank of Australia (RBA). The RBA
is responsible for the monitoring and assessment of licensed clearing and settlement platforms and systems; for example,
CHESS which is operated by the ASX. In particular, the RBA ensures participants comply with its Financial Stability
Standards in order to reduce systemic risk within the financial system.
REFLECTION POINTS
Each nation-state is responsible for the regulation and supervision of its own stock exchanges. Usually this role
is shared between government-appointed regulatory authorities and the actual exchange itself.
In Australia, the Australian Securities and Investments Commission (ASIC) has responsibility for the supervision of
real-time trading in the domestic licensed markets.
ASIC is responsible for enforcement of laws against misconduct, and the supervision of financial services licence
http://textflow.mheducation.com/parser.php?secload=6.10&fake&print
1/2
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=6.10&fake&print
2/2
2016/3/11
IEB Wireframe
4.10The private equity market
LEARNING OBJECTIVE 4.10
Explain the structure and purpose of 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.
Page 151
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 higherrisk 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.
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
http://textflow.mheducation.com/parser.php?secload=6.11&fake&print
1/2
2016/3/11
IEB Wireframe
the break-up of a company so that the component parts may be sold separately.
http://textflow.mheducation.com/parser.php?secload=6.11&fake&print
2/2
2016/3/11
IEB Wireframe
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.
Page 152
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 moneymanagement units from struggling financial institutions in the aftermath of the crisis.
Other people's money
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 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.
Page 153
The last crisis had many causes. One of them, which perhaps lay behind all the others, was that investors stopped
http://textflow.mheducation.com/parser.php?secload=6.12&fake&print
1/2
2016/3/11
IEB Wireframe
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 markets perform?
http://textflow.mheducation.com/parser.php?secload=6.12&fake&print
2/2
2016/3/11
IEB Wireframe
CHAPTER FOUR REVIEW
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.
Page 154
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 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
http://textflow.mheducation.com/parser.php?secload=6.f&fake&print
1/5
2016/3/11
IEB Wireframe
platforms.
Secondary market transactions do not raise additional equity for the original issuing corporation—they are a
transfer of ownership for value.
Page 155
Market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market encourages investors.
Market capitalisation is the number of issued shares multiplied by the share price.
LEARNING OBJECTIVE 4.5
Examine the managed 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).
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
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)
Page 156
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.
http://textflow.mheducation.com/parser.php?secload=6.f&fake&print
2/5
2016/3/11
IEB Wireframe
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 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.
Page 157
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 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
http://textflow.mheducation.com/parser.php?secload=6.f&fake&print
3/5
2016/3/11
IEB Wireframe
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.
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.
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)
Page 158
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.
1. Briefly explain the concept of corporate governance within the context of a corporation.
2. 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.
1. Identify and discuss the five principal functions of a modern and efficient stock exchange.
2. 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.
1. Discuss the secondary market role of a stock exchange and its importance to the corporation. Illustrate your
answer by using examples.
2. 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.
1. 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.
2. 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
http://textflow.mheducation.com/parser.php?secload=6.f&fake&print
4/5
2016/3/11
IEB Wireframe
exposure to the individual shares, a specified share market index, foreign currencies and commodities.
1. Explain how a CFD is structured.
2. 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)
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.
1. 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.
2. Briefly describe the main characteristics of a debenture. (LO 4.6)
12.
1. 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)
2. 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)
Page 159
13.
1. It may be argued that information is the life-blood of an efficient stock market. Explain this proposition.
2. Within the context of the ASX, explain the requirements and purpose of continuous reporting.
3. 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 ASIC 150 ASX Trade 146 ASX Trade24 146 bid and offer 148 board of directors 134 call
option 143 CHESS 147 CHESS sponsor 148 continuous disclosure 149 contract for difference (CFD) 142 contract
note 147 convertible note 145 corporate governance 135 corporation 134 coupon 145 debenture 145 delisting 150
derivative 141 directors' interests 149 dividend 149 dividend reinvestment scheme 138 electronic sub-register 148
exchange-traded contracts 141 exchange traded funds (ETFs) 141 exercise price 143 floating rate note (FRN) 145
futures contract 144 hedge 141 infrastructure fund 143 interest rate market 145 limited liability company 134
liquidator 149 listing rules 149 market capitalisation 140 market liquidity 140 MSCI global index ranking 137 new
float or initial public offering (IPO) 138 no liability company 134 objectives and policies 134 option contract 143
ordinary share or common stock 133 over-the-counter contracts 141 physical market 141 placement 138 preference
share 145 premium 143 primary market 137 prospectus 138 publicly listed corporation 134 put option 143 real estate
investment trust (REIT) 142 right of perpetual succession 134 rights issue 138 settlement risk 148 share market 134
share options 135 straight corporate bond 145 T + 3 148 uncertificated securities 147 warrant 143 warrant
issuer 143
http://textflow.mheducation.com/parser.php?secload=6.f&fake&print
5/5
2016/3/11
IEB Wireframe
Page 160
Chapter 5
Corporations issuing equity
in the share market
CHAPTER OUTLINE
5.1The investment decision: capital budgeting
5.2The financing decision: equity, debt and risk
5.3Initial public offering
5.4Listing a business on a stock exchange
5.5Equity-funding alternatives for listed companies
Learning objectives
1. LO 5.1 Understand issues related to the capital budgeting investment decision.
2. LO 5.2 Identify issues relevant to a corporation's funding choice between debt and equity.
3. 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.
4. LO 5.4 Consider important issues associated with listing a business on a stock exchange.
5. 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
1. LO 5.6 Explain the listing requirements of the Australian Securities Exchange.
Page 161
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 longterm 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:
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.
http://textflow.mheducation.com/parser.php?secload=7&fake&print
1/2
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=7&fake&print
2/2
2016/3/11
IEB Wireframe
Page 162
5.1The investment decision: capital budgeting
LEARNING OBJECTIVE 5.1
Understand issues related to the capital budgeting investment decision
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.
CAPITAL BUDGETING the choices that a company makes when allocating its capital
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.
INVESTMENT DECISION the capital budgeting process that determines the strategic activities of a firm
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.
5.1.1Net 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.
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
This can be written more formally as:
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
purchase of a new processing machine that
purchase and install, and has an expected
per year and average annual cash sales of
http://textflow.mheducation.com/parser.php?secload=7.2&fake&print
by applying them to an investment. For example, a business is considering the
will coat macadamia nuts with chocolate. The machine will cost $40 000 to
life of three years. The company forecasts annual incremental costs of $15 000
$35 000. The required rate of return for the company is 18.00 per cent per
1/4
2016/3/11
IEB Wireframe
annum. The machine will have a salvage value of $10 000 at the end of the three years.
Page 163
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:
5.1a
2. the present value of the salvage value:
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.
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.)
NPV DECISION RULE accept an investment opportunity that has a positive NPV
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.
5.1.2Internal 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.
INTERNAL RATE OF RETURN (IRR) the discount rate that results in an NPV of zero
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 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.
Page 164
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:
http://textflow.mheducation.com/parser.php?secload=7.2&fake&print
2/4
2016/3/11
IEB Wireframe
5.1d
Keystrokes:
5.1e
Referring back to the calculation of NPV, the inclusion of the following two additional keystrokes on the calculator
will obtain the NPV:
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.
NON-CONVENTIONAL CASH FLOWS occur when the ongoing cash flows from an investment are not always positive
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.
MUTUALLY EXCLUSIVE PROJECTS from a choice of two or more projects, only one project will be chosen
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.
Page 165
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.
http://textflow.mheducation.com/parser.php?secload=7.2&fake&print
3/4
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=7.2&fake&print
4/4
2016/3/11
IEB Wireframe
5.2The financing decision: equity, debt and risk
LEARNING OBJECTIVE 5.2
Identify issues relevant to a corporation's funding choice between debt and equity
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.
FINANCING DECISION the capital structure that finances a firm's assets and activities
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.
RISK the possibility or probability that an actual outcome will vary from the expected outcome; uncertainty
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 exposures to factors that have an impact on a firm's activities and operations
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-today 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).
Page 166
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 nationstate resulting in expropriation, legal restrictions, freezing of company assets, or forced divestment of assets.
FINANCIAL RISK exposures to factors that affect the value of assets, liabilities and associated cash flows
5.2.1Financial 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
http://textflow.mheducation.com/parser.php?secload=7.3&fake&print
1/3
2016/3/11
IEB Wireframe
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).
EARNINGS ATTRIBUTABLE TO ORDINARY SHARES the net accounting earnings on a company's shares expressed in cents per
share
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 debt-financed expansion resulted in a
return of less than 9.00 per cent on assets, shareholders would suffer.
In determining the appropriate mix of debt and equity, the corporate finance manager faces a dilemma. The higher the
proportion of debt, the higher will be the potential return on shareholders' funds, or EPS. However, increased debt
exposes the shareholders to a greater variance in their EPS, and the firm is exposed to a greater risk of insolvency
because income or revenue may fail to reach the expected levels; nevertheless, debt interest and principal payments must
be paid when due. One reason for a sudden fall in expected revenue may be a downturn in economic activity, as was
experienced during the global financial crisis.
The higher the debt-to-equity ratio, the higher 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.
5.2.2What is the appropriate debt-to-equity ratio?
Although there is a wealth of literature on financial management, there is no agreed ideal debt-to-equity ratio. The
ratio appears to be decided, in practice, by reference to four main criteria.
DEBT-TO-EQUITY RATIO the proportion of a firm's debt funds relative to its equity funds
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.
Page 167
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.
GEARING RATIO the percentage of a firm's total funding provided by debt
LOAN COVENANTS conditions or restrictions placed on a borrower and specified in a loan contract
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,
http://textflow.mheducation.com/parser.php?secload=7.3&fake&print
2/3
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=7.3&fake&print
3/3
2016/3/11
IEB Wireframe
Page 168
5.3Initial public offering
LEARNING OBJECTIVE 5.3
Examine the listing and flotation or initial public offering (IPO) of a business on a stock exchange, including equityfunding alternatives that are available to a newly listed corporation
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.
PUBLICLY LISTED CORPORATION a company whose shares are listed and quoted on a stock exchange
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.
INITIAL PUBLIC OFFERING (IPO) an offer to investors of ordinary shares in a newly listed company on a stock exchange
FLOTATION OF A BUSINESS the public listing and quotation of a corporation on a stock exchange
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.
PROMOTER the party (company) seeking to list as a corporation on a stock exchange
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.
PROSPECTUS document prepared by a company stating the terms and conditions of an issue of securities to the public
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
http://textflow.mheducation.com/parser.php?secload=7.4&fake&print
1/3
2016/3/11
IEB Wireframe
the pricing of the issue
Page 169
the timing of the issue
the marketing of the issue
the allocation of securities.
UNDERWRITING a contractual undertaking to purchase securities that are not subscribed to by investors
It is possible that the time elapsed between the initial agreement between the promoter and advisers on the price and
timing of the issue and the actual float may be such that market conditions have significantly changed, particularly in
periods of instability in the share market. If market prices have fallen and the new issue is unattractive under the
current circumstances, the underwriters may be left to take a large proportion of the shares on issue. Normally, the
underwriters protect themselves against being caught in a situation where there are changes in circumstances that could
not have been foreseen at the time of the initial agreement by including an out-clause in the underwriting agreement.
The out-clause may relate to the level of a specified share price index, such as the S&P/ASX 200. If the index falls
below a nominated level, or by a certain percentage, then the underwriters may be released from their underwriting
obligation.
OUT-CLAUSE specific conditions that preclude an underwriting agreement from being fully enforced
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.
5.3.1Ordinary shares: limited liability companies
Ordinary shares in a limited liability company are the principal source of equity funding for most listed
corporations.
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 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.
ORDINARY SHARES or COMMON STOCK the principal form of equity issued by a corporation; bestows certain rights to the
shareholder
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.
PROXY a party authorised to vote on behalf of a shareholder at a general meeting
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.
INSTALMENT RECEIPT issued upon payment of the first instalment on a new share issue; ordinary share issued when final
instalment paid
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.
http://textflow.mheducation.com/parser.php?secload=7.4&fake&print
2/3
2016/3/11
IEB Wireframe
The share issue price will be determined by reference to a range of variable factors. Important factors include the
expected future earnings of the company, and the price to earnings (P/E) ratios of similar existing firms. Other related
factors include the trend in economic activity, both domestic and international, the forecast levels of interest rates,
the exchange rate, the performance of the particular industry, the firm's products and services, and management
expertise and performance.
Page 170
5.3.2Ordinary 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.
NO LIABILITY COMPANY shareholders may decide not to pay calls on partly paid shares, but will forfeit such shares
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.
http://textflow.mheducation.com/parser.php?secload=7.4&fake&print
3/3
2016/3/11
IEB Wireframe
Page 171
5.4Listing a business on a stock exchange
LEARNING OBJECTIVE 5.4
Consider important issues associated with 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.
DELISTED removal from quotation of the securities of an entity that breaches stock exchange listing rules
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.
LISTING RULES specific criteria that must be met by an entity seeking listing on a stock 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:
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).
DUAL LISTING the shares of a multinational corporation are listed on more than one stock exchange
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=7.5&fake&print
1/2
2016/3/11
IEB Wireframe
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.
Page 172
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.
http://textflow.mheducation.com/parser.php?secload=7.5&fake&print
2/2
2016/3/11
IEB Wireframe
5.5Equity-funding alternatives for listed companies
LEARNING OBJECTIVE 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
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.
5.5.1Rights 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.
RIGHTS ISSUE the issue of additional shares to existing shareholders on a pro-rata basis
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.
PRO-RATA OFFER a proportional offer to buy securities based on an investor's current shareholding
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.
Page 173
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.
RENOUNCEABLE RIGHT a right attached to a security that can be sold to a third party
http://textflow.mheducation.com/parser.php?secload=7.6&fake&print
1/5
2016/3/11
IEB Wireframe
A rights issue that may only be exercised by the shareholder and not sold to another party is a non-renounceable
right.
NON-RENOUNCEABLE RIGHT a right attached to a security that cannot be sold to a third party
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.
SHARE PURCHASE PLAN an offer to existing shareholders to purchase a fixed dollar amount of new ordinary shares
5.5.2Placements
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.
PLACEMENT additional ordinary shares are sold by a corporation to selected institutional investors
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 prorata 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
existing shareholders. However, existing shareholders'
exchange's listing rules. For example, the ASX listing
will bring its total placements in any 12-month period
only if shareholders ratify previous placements at the
it dilutes the proportion of the ownership of the company by
interests may be partly protected by regulation, or by a stock
rules state that a corporation that proposes a placement that
to more than 15 per cent of the company's issued shares may do so
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.
MEMORANDUM OF INFORMATION information required to be provided to institutional investors with a placement offer
Page 174
5.5.3Takeover issues
Mergers and acquisitions—where one company seeks to purchase another company—were discussed in Chapter 3, and it was
noted that an investment bank may be consulted to advise a company on the takeover. In particular, the investment bank
will advise the takeover company on the alternative financing strategies that are available to fund the takeover.
An equity-funded takeover (or part-equity-funded takeover), in which the takeover company issues additional ordinary
shares to fund the acquisition of the shares in the target company, is a popular method used to fund a merger and
acquisition.
EQUITY-FUNDED TAKEOVER a takeover company issues its shares in exchange for the shares of the target company
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.
5.5.4Dividend reinvestment schemes
The payment of dividends varies from corporation to corporation, between industries and even between nation-states. For
http://textflow.mheducation.com/parser.php?secload=7.6&fake&print
2/5
2016/3/11
IEB Wireframe
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.
DIVIDEND REINVESTMENT SCHEME allows shareholders to reinvest dividends by buying additional shares in the company
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.
Page 175
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.
5.5.5Preference 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.
PREFERENCE SHARE a hybrid security that pays a fixed dividend and offers the right to convert to ordinary shares at a
future date
Unlike ordinary shares, preference shares have their dividend rates fixed at the issue date. Preference shares rank
ahead of ordinary shares in the payment of dividends and in their claim on assets in the event of a winding-up or
liquidation of the company. On both accounts, however, preference shares rank behind the company's creditors.
A range of features may be attached to preference shares. A preference share issue will include a combination of the
following features.
Cumulative or non-cumulative. If a company is not able to make the fixed dividend payment on cumulative
preference shares in one period, the amount due is carried forward to the next period. The company is required to
pay any unpaid preference share dividends from past years before it can make any distribution to ordinary
shareholders. On the other hand, with non-cumulative preference shares, if the company is unable to make the fixed
dividend payment, the obligation is not carried forward.
Redeemable or non-redeemable. Redeemable preference shares entitle the holder to redeem the preference share on
a predetermined date and to receive the specified value of the preference share in a cash payment. The holder of a
redeemable preference share may have the option to redeem for cash or to convert into ordinary shares. A nonredeemable 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.
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
http://textflow.mheducation.com/parser.php?secload=7.6&fake&print
3/5
2016/3/11
IEB Wireframe
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
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, fixedinterest 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.
Page 176
5.5.6Convertible 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
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.
CONVERTIBLE NOTE a hybrid fixed-interest debt security that includes an option to convert to ordinary shares at a
specified 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
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.
COMPANY-ISSUED OPTION bestows a right, but not an obligation, on the holder to buy ordinary shares in the company
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.
Page 177
http://textflow.mheducation.com/parser.php?secload=7.6&fake&print
4/5
2016/3/11
IEB Wireframe
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.
COMPANY-ISSUED EQUITY WARRANT an option to buy additional shares that is originally attached to a debt issue
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.
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
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.
REFLECTION POINTS
Companies that are listed on a stock exchange have a number of choices when seeking to raise additional equity to
fund further business growth.
A rights issue is the offer of additional ordinary shares on a pro-rata basis to all existing shareholders at a
specified future date, for example, one new share for every five shares held. The right to buy may be renounceable,
whereby the right is listed on the stock exchange and can be sold before the exercise date. A non-renounceable
right cannot be sold.
A share purchase plan provides the opportunity for existing shareholders to invest a specified dollar amount to buy
additional shares in a company.
A placement occurs where a company offers additional shares to select institutional investors. The Corporations 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.
Page 178
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.
http://textflow.mheducation.com/parser.php?secload=7.6&fake&print
5/5
2016/3/11
IEB Wireframe
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 wellknown 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.
Soon after listing, Facebook's shares were trading at a considerable discount to
is something that owners of privately held companies do not have to worry about.
course, but it is not flashed before everyone's eyes on a daily basis. A private
generally perceived to be the ‘short termism’ of the stock market. Rather than
quarterly earnings estimate, management can focus on the longer term development
the issue price. A falling share price
The company's value is important, of
company is also insulated from what is
concentrate on continually beating a
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.
Page 179
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?
http://textflow.mheducation.com/parser.php?secload=7.7&fake&print
1/1
2016/3/11
IEB Wireframe
CHAPTER FIVE REVIEW
Summary
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).
The NPV is the difference between the cost of an asset, or project, and the present value of its future returns.
The present value is the discounted value today of a future cash flow or series of cash flows. The cash flows are
discounted at the firm's required rate of return on the investment. The corporation will accept investment
proposals that indicate a positive NPV.
The IRR is the discount rate on a project that results in an NPV of zero. If the firm's required rate of return on
an investment is less than the forecast IRR of the project, it may be acceptable. However, IRR suffers from two
shortfalls: non-conventional cash flows and mutually exclusive investment opportunities.
Both the NPV and the IRR methods are exposed to the limitations and uncertainties of forecast projections.
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.
Page 180
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 equityfunding 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
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
1/8
2016/3/11
IEB Wireframe
exchange in order to access the wider international capital markets and increase liquidity in the trading of its
securities.
LEARNING OBJECTIVE 5.5
Explore equity-funding alternatives that are available to an established listed corporation, including rights issues,
share purchase plans, placements, takeover issues, dividend reinvestment schemes, preference shares, convertible notes
and other quasi-equity securities
Companies that have listed on a stock exchange and have a track record of sound management, good profitability and
good share price performance are generally able to raise additional equity funding in a number of different ways.
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.
Page 181
Additional ordinary shares may also be issued by a takeover company as full payment, or part payment with a cash
component, in a merger and acquisition bid.
Dividend reinvestment is another technique by which a listed corporation can raise additional equity funds. It
allows shareholders to elect to convert their periodic cash dividend receipts into new shares in the company.
Dividend reinvestment schemes also give existing shareholders the opportunity to increase their equity holding,
usually without the normal transaction costs such as brokerage.
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.
Extended learning
LEARNING OBJECTIVE 5.6
Explain the listing requirements of the Australian Securities Exchange
Australian Securities Exchange (ASX) listing rule requirements
The objectives of the ASX include the provision of a fair and well-informed market for financial securities and the
provision of an internationally competitive market. The ASX listing rules are a key element in achieving these
objectives.
An entity wishing to
requirements imposed
Section 5.4) will be
listing requirements
have its securities listed and quoted on an exchange must first seek admission to the exchange. The
by stock exchanges will vary between exchanges and nation-states, but the principles (discussed in
essentially the same; any variation will mainly be in the detail. To gain an understanding of the
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 researchbased entities), debt issuer or exempt foreign.
Some of the broad requirements for general admission to the official list include:
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
2/8
2016/3/11
IEB Wireframe
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.
Page 182
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.
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.
RESPONSIBLE ENTITY the trustee and manager of a trust in Australia
Profit test
To meet the profit test requirement of admission, an entity must satisfy each of the following conditions.
The entity must be a going concern, or the successor of a going concern.
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
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.
PROFIT TEST minimum financial performance requirements to be met by an entity seeking listing on a stock exchange
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.
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
3/8
2016/3/11
IEB Wireframe
Page 183
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
million if the entity's budgeted revenue for the first full financial
included in the working capital. For mining exploration entities, the
for the first full financial year's budgeted administration costs and
and mining tenements. The cost of acquiring mining tenements includes
option over them.
is not, it would be at least $1.5
year that ends after listing was
amount must be available after allowing
the cost of acquiring plant, equipment
the cost of acquiring and exercising an
An entity must provide financial statements for the last three full financial years. The financial statements must
be audited, and must include audit reports.
ASSETS TEST minimum level of assets to be held by an entity seeking listing on a stock exchange
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 amount
of each proposed call. The security must be paid in full within two years. This condition does not apply to a no
liability company.
If the securities are debt securities, or convertible debt securities, a copy of the documents setting out the
terms of the securities must have been given to the ASX.
If the securities are debt securities, their aggregate face value must be at least $10 million.
ESCROW assets held by a third party that cannot be sold until conditions of a contract are fulfilled
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
Page 184
other expert adviser fees
printing costs
advertising and marketing costs
share registry expenses.
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
4/8
2016/3/11
IEB Wireframe
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
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.
Page 185
Corporate governance
Corporate governance represents the internal relationships between shareholders, the board of directors and managers.
It consists of a system of structuring, operating and controlling an organisation in order to achieve:
a fundamental ethical culture throughout the entire business operation
the long-term strategic objectives of shareholders—that is, the 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.
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
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
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
5/8
2016/3/11
IEB Wireframe
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.
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.
Page 186
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 outclause 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.
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
6/8
2016/3/11
IEB Wireframe
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.
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.
Page 187
1. Calculate the NPV and the IRR.
2. 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.
1. Discuss the four main criteria that a corporation should analyse when determining the firm's appropriate debtto-equity ratio.
2. 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
is to expand into overseas markets. In order to raise the capital necessary to support
company's owners have decided to investigate the possibility of listing the company on
boutique investment bank and receive the first phone call from the owners. Explain the
play if the owners decide to retain your services as an IPO adviser. (LO 5.3)
in the company's development
this expansion, the
the ASX. You work for a
role that your company will
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.
1. What type of issue is Santos Limited making to its shareholders?
2. What is an underwriting facility, and why might Santos use such a facility?
3. What is the out-clause entered into by Santos? Discuss how the out-clause operates. (LO 5.3)
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.
1. Shoal Limited will be a limited liability company. What are the rights and financial obligations of
shareholders that purchase shares in the company?
2. 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.
1. What form of legal structure would you recommend the gold exploration company incorporate? Why would you
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
7/8
2016/3/11
IEB Wireframe
recommend this structure?
2. 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.
Page 188
1. List and explain five fundamental listing rule principles.
2. 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.
1. Explain how dividend reinvestment schemes operate and discuss their significance as a source of equity
funding.
2. Discuss the advantages of a dividend reinvestment scheme from the point of view of the corporation and
shareholders.
3. Under what circumstances might such schemes prove to be unattractive to the dividend-paying 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.
1. Explain the structure and cash flows associated with a preference share.
2. 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.
1. What are the characteristics of each of these instruments that serve to distinguish them from straight equity
or debt?
2. Why might a company issue quasi-equity rather than straight debt or equity? (LO 5.5)
Extended learning question
15. Listing on a stock exchange might be highly desirable for a company, but there are a number of requirements,
conditions and costs associated with becoming a publicly listed corporation.
1. Identify and explain 10 specific requirements that must be met by an Australian company seeking general
admission to the ASX.
2. Discuss the ASX profit test and asset test requirements and explain why these rules are in place.
3. Identify and explain the different costs that a company will have to meet in the process. What impact will
these have on the liquidity management of the firm? (LO 5.6)
KEY TERMS
assets test 182 business risk 165 capital budgeting 162 company-issued equity warrant 177 company-issued option 176
convertible note 176 convertible preference shares 175 corporate governance 185 cumulative preference shares 175
debt-to-equity ratio 166 delisted 171 detachable warrant 177 dividend reinvestment scheme 174
Page 189
dual listing 171 earnings attributable to ordinary shares 166 equity-funded takeover 174 escrow 183 financial
risk 165 financing decision 165 flotation of a business 168 gearing ratio 166 initial public offering (IPO) 168
instalment receipt 169 internal rate of return (IRR) 163 investment decision 162 limited liability company 169
listing rules 171 loan covenants 167 memorandum of information 173 mutually exclusive projects 164 net present value
(NPV) 162 no liability company 170 non-conventional cash flows 164 non-detachable warrant 177 non-renounceable
right 173 NPV decision rule 163 ordinary shares or common stock 169 out-clause 169 participating preference
shares 175 placement 173 preference share 175 present value 162 profit test 182 promoter 168 pro-rata offer 172
prospectus 168 proxy 169 publicly listed corporation 168 redeemable preference shares 175 renounceable right 173
responsible entity 182 rights issue 172 risk 165 share purchase plan 173 transparency 185 underwriting 168
http://textflow.mheducation.com/parser.php?secload=7.f&fake&print
8/8
2016/3/11
IEB Wireframe
Page 190
Chapter 6
Investors in the share market
CHAPTER OUTLINE
6.1 Share-market investment
6.2 Buying and selling shares
6.3 Taxation
6.4 Financial performance indicators
6.5 Pricing of shares
6.6 Stock-market indices and published share information
Learning objectives
1. 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.
2. LO 6.2 Detail the process for buying and selling of shares.
3. LO 6.3 Understand the importance of taxation in the investment decision process.
4. LO 6.4 Identify and describe various indicators of financial performance.
5. LO 6.5 Apply quantitative methods to the pricing of shares.
6. LO 6.6 Analyse the functions and importance of share-market indices and interpret published share-market
information.
Page 191
Introduction
In order to raise equity funds a publicly listed corporation may issue various financial instruments that are quoted on
a stock exchange. A stock exchange provides primary and secondary markets that facilitate the quotation and trading of
equity, hybrids and some debt securities. This chapter specifically focuses on the share market from the point of view
of investors who invest in ordinary shares issued by corporations.
So why do investors purchase shares issued by corporations? Shareholders receive a return in two forms:
1. periodic dividend receipts
2. capital gains (losses) from changes in share value.
However, there is no guarantee that a company will pay a dividend to its shareholders, nor is there any guarantee that
the share price will increase in value over time. Clearly, such an investment must be regarded as having a higher level
of risk than many other investment alternatives.
One of the fundamental principles of finance is that higher risk should be rewarded with a higher return. It is
therefore reasonable to assume that investments in shares should, on average, provide a higher return to shareholders
than lower-risk investment categories such as fixed-interest and money-market securities.
There are a number of other important factors that encourage investors to invest in securities quoted on a stock
exchange. These include:
the depth and liquidity of share markets
efficient price discovery.
The depth of the market is measured by market capitalisation, that is, the number of shares issued multiplied by share
prices. Liquidity is attractive to investors in a stock market because they know that in normal circumstances they are
able to buy and sell shares at the current market price. This means that they can buy and sell long-term, higher-risk
securities and at the same time maintain liquidity in their investment portfolio. A stock exchange measures liquidity as
the volume of trading relative to the size of the market. For example, the depth and liquidity of the ASX is quite high,
with a market capitalisation 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
http://textflow.mheducation.com/parser.php?secload=8&fake&print
1/2
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=8&fake&print
2/2
2016/3/11
IEB Wireframe
Page 192
6.1 Share-market investment
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:
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:
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.
SYSTEMATIC RISK exposures that affect the price of the majority of shares listed on a stock exchange
http://textflow.mheducation.com/parser.php?secload=8.2&fake&print
1/4
2016/3/11
IEB Wireframe
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
Page 193
the possibility of a merger
the failure of technology or communication systems
dissent within the board of directors
rumour or evidence of financial difficulty.
UNSYSTEMATIC RISK exposures that specifically impact on the share price of a particular corporation
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.
DIVERSIFIED INVESTMENT PORTFOLIO an investment portfolio that includes a wide range of financial securities and
assets
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.
BETA a statistical measure of the sensitivity of the price of an asset relative to the market
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.
ACTIVE INVESTMENT a portfolio structure based on share analysis, new information and risk/return preferences
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-toequity 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.
PASSIVE INVESTMENT a portfolio structure based on the replication of a specific share-market index
A number of managed funds are index funds. Index funds
the share market, including full or partial replication
a funds manager purchases all the stocks included in an
funds manager may hold only a percentage of the stocks,
portfolio closely tracks the index.
use a range of sophisticated techniques to replicate or track
of a specified share-market index. Full replication occurs when
index. However, with a large index such as the S&P 500, the
so long as sufficient stocks are held to ensure that the
INDEX FUNDS acquire shares so that a portfolio replicates a specific share-market index
http://textflow.mheducation.com/parser.php?secload=8.2&fake&print
2/4
2016/3/11
IEB Wireframe
An investor needs to understand the risk and return characteristics of each share investment and its relationship with
the total investment portfolio. It is not possible within this text to address portfolio theory in detail; there are
many other excellent texts in this specialist area. However, an investor should be aware of risk and return
relationships, including the spread of actual returns to expected returns, variance and standard deviation.
Page 194
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.
EXPECTED RETURN OF A PORTFOLIO weighted average of the expected returns of each share held in a 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.
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
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.
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
REFLECTION POINTS
A stock exchange provides investors with a large choice of listed securities.
Corporations listed on a stock exchange are categorised into industry sectors; each company included in an industry
sector provides an investment opportunity.
Share-market investment risk is often categorised as systematic risk and unsystematic risk. Systematic risks are
exposures that affect most companies listed on the exchange (e.g. a change in interest rates); unsystematic risk
affects only a single company or a small group of companies (e.g. a product recall).
Systematic risk is measured by the beta coefficient. 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.
http://textflow.mheducation.com/parser.php?secload=8.2&fake&print
3/4
2016/3/11
IEB Wireframe
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.
http://textflow.mheducation.com/parser.php?secload=8.2&fake&print
4/4
2016/3/11
IEB Wireframe
Page 195
6.2 Buying and selling shares
LEARNING OBJECTIVE 6.2
Detail the process for buying and selling of 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:
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.
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
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.
DISCOUNT BROKER executes buy and sell orders for clients; does not provide investment advice or services
Page 196
A full-service advisory broker offers advice and recommendations to clients on investment choices and strategies. The
http://textflow.mheducation.com/parser.php?secload=8.3&fake&print
1/2
2016/3/11
IEB Wireframe
range of services provided includes:
buying and selling shares on the instruction of clients
providing investment advice on securities listed on a stock exchange, including shares, fixed-interest securities,
derivatives and listed trusts
giving advice on other investment opportunities such as cash management trusts, property trusts and equity trusts
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.
FULL-SERVICE ADVISORY BROKER executes buy and sell orders, but also provides other services to clients, including
investment advice
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.)
INDIRECT INVESTMENT investing through a funds manager in a unit trust or a managed fund
REFLECTION POINTS
Direct share investment occurs when an investor selects stock to be held in a portfolio and places buy or sell
orders with a stockbroker; the stockbroker provides access to the exchange's electronic trading and settlement
systems.
A stockbroker may be a full-service broker who provides investment advice, facilitates buy/sell orders and provides
a range of other related financial services.
A discount broker only accepts electronic buy and sell orders.
The buy/sell process and electronic trading and settlement systems are discussed in Chapter 4 (see ASX Trade and
CHESS).
Some issues a direct investor will consider before buying a stock 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.
http://textflow.mheducation.com/parser.php?secload=8.3&fake&print
2/2
2016/3/11
IEB Wireframe
6.3 Taxation
LEARNING OBJECTIVE 6.3
Understand the importance of taxation in the investment decision process
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:
Page 197
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.
D
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.
MARGINAL RATE OF TAX the percentage of income tax paid progressively increases relative to the amount of income earned
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.
http://textflow.mheducation.com/parser.php?secload=8.4&fake&print
1/3
2016/3/11
IEB Wireframe
(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.
D
Page 198
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:
6.1
FRANKED DIVIDENDS dividends paid to shareholders that have a tax franking credit attached that is derived from company
tax paid
GROSSED-UP AMOUNT the total of the franked dividend plus the franking credit included in a shareholder's taxable
income
FRANKING CREDIT the amount of company tax paid and transferred to a shareholder with a franked dividend
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.
INFLATION COMPONENT that part of a capital gain that is accounted for by the percentage increase in prices over the
period
Since 21 September 1999 the rule has changed. Currently, 50 per cent
since that date is now taxed, where the shares have been held for at
marginal tax rate. For shares acquired between 19 September 1985 and
between paying capital gains tax on the indexed capital gain, or the
offset against future capital gains.
of any non-indexed capital gain on shares acquired
least 12 months. The tax rate is the shareholder's
21 September 1999, the shareholder can choose
50 per cent discounted gain. Capital losses can be
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=8.4&fake&print
2/3
2016/3/11
IEB Wireframe
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 grossedup 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.
http://textflow.mheducation.com/parser.php?secload=8.4&fake&print
3/3
2016/3/11
IEB Wireframe
Page 199
6.4Financial performance indicators
LEARNING OBJECTIVE 6.4
Identify and describe various indicators of financial performance
In deciding whether or not to purchase shares in a company, a potential shareholder who applies the fundamental approach
to share investment analysis will be particularly interested in forecasting the future level of profitability of the
company, and the degree of risk associated with those forecast future cash flows. Though the emphasis of any share
analysis should be based on future earnings, this generally is not possible and therefore an investor will, to a large
extent, depend on historic data to form a view on the company's projected performance.
Significant indicators of a company's past and present financial performance include its capital budgeting, capital
structure, liquidity and cash management, dividend policies, record of profitability, overall performance relative to
that of other firms in the industry, and the impact of economic fluctuations on performance.
The indicators of a company's performance that we will consider are capital structure, liquidity, debt servicing,
profitability, share price and risk.
6.4.1 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 proportion of company assets financed by 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 debt-to-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 threeto-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 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.
6.2
CURRENT RATIO ratio of current assets to current liabilities
Page 200
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.
6.3
LIQUID RATIO ratio of current assets, less inventory, to current liabilities, less bank overdraft
Of the two ratios, the liquid ratio provides a more realistic view of a company's liquidity position. The reason for
http://textflow.mheducation.com/parser.php?secload=8.5&fake&print
1/5
2016/3/11
IEB Wireframe
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 Debt servicing
The amount and timing of cash flows available to a company are of critical importance to its ability to meet its shortterm 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.
DEPRECIATION the amount by which the value of an asset is written down in an accounting period
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 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.
6.4
Page 201
INTEREST COVER RATIO the number of times a firm's financial commitments are covered by earnings
6.4.4 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:
6.5
EARNINGS BEFORE INTEREST AND TAX (EBIT) the profits of a firm before allowing for interest expenses and tax
payments
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:
http://textflow.mheducation.com/parser.php?secload=8.5&fake&print
2/5
2016/3/11
IEB Wireframe
6.6
A further measure of profitability is the return on equity. It is given by:
6.7
RETURN ON EQUITY operating profit after tax as a percentage of shareholders' funds
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.
EARNINGS PER SHARE (EPS) earnings attributed to an ordinary share
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.
SOURCE: Morningstar DatAnalysis, 2013.
D
6.4.5 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 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.
Page 202
PRICE TO EARNINGS RATIO (P/E) the current share price divided by the earnings per share
http://textflow.mheducation.com/parser.php?secload=8.5&fake&print
3/5
2016/3/11
IEB Wireframe
SOURCE: Morningstar DatAnalysis, 2014.
D
Page 203
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.
SHARE PRICE TO NET TANGIBLE ASSETS RATIO current share price relative to the firm's net tangible assets
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 Risk
Of fundamental importance in the decision to invest in a particular company or industry is the assessment of the risk
that the investor would face from the investment. The notion of risk here is the variability, or fluctuation, in the
share price. Modern portfolio theory provides a rigorous approach to analysing investment risk, in which risk is divided
into two components: systematic risk and unsystematic risk. The nature of systematic and unsystematic risk was
introduced in Section 6.1. That discussion is continued here.
Systematic, or market, risk arises from factors that affect the whole market; that is, it relates to the variability of
the general share market, not the variability of the shares of an individual firm. Variations in overall market
performance could be brought about by:
the state of the economy, including the levels of interest rates and the availability of credit, the rate of
inflation, the rate of growth of the economy, changes in the taxation system and in government spending and
movements in the exchange rate
the state of international economies, and the performances of major foreign share markets.
The second component, unsystematic risk, is caused by factors specific to an individual company. The relevant influences
include:
the effectiveness and experience of the managers of the company
productivity and the cost of labour
the particular impact of financial risk exposures (e.g. interest rate changes will have a greater impact on highly
geared companies, and unfavourable foreign exchange movements will affect companies that have not hedged their
foreign currency exposures)
exposures to particular operational risks (e.g. loss of computer systems, denial of access to company premises due
to a flood or fire, or industrial action by employees)
http://textflow.mheducation.com/parser.php?secload=8.5&fake&print
4/5
2016/3/11
IEB Wireframe
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.
Page 204
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-to-equity 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.
http://textflow.mheducation.com/parser.php?secload=8.5&fake&print
5/5
2016/3/11
IEB Wireframe
6.5 Pricing of shares
LEARNING OBJECTIVE 6.5
Apply quantitative methods to the 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 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.
Page 205
Where the price of a dividend-paying ordinary share is equal to the present value of all future dividends, this may be
expressed as:
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:
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:
6.9a
The price of Techno Limited should change if the required rate of return changes as a result of new information coming
to the market, or if new information implies a shift in the constant dividend to a new level. 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
http://textflow.mheducation.com/parser.php?secload=8.6&fake&print
1/5
2016/3/11
IEB Wireframe
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:
6.10
therefore:
The original pricing formula can now be reconfigured so that:
6.11
This formula represents the constant dividend growth model. For example, Ocka Limited has a constant dividend growth
policy of 7.00 per cent. In the last financial year the company paid a dividend of $0.75 per share. If an investor's
required rate of return on this investment is 12.00 per cent, the current price of the stock should be:
6.12
Page 206
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 and ex-dividend share prices
In addition to fundamental factors that affect the price of a share, there are some other reasons—unrelated to the
performance of the company—which lead to changes in a share price. These reasons are associated with the announcement
by a company of a shareholder entitlement to receive a dividend, and the actual payment of the dividend to shareholders.
Dividends are payments to shareholders, made out of the company's after-tax earnings. Dividends are normally expressed
as cents per share. Companies typically pay dividends twice a year: an interim (half-year) dividend and a final
dividend. After a dividend is declared, shares are normally traded for a period of time with the dividend entitlement
attached. That is, the share is said to trade cum-dividend (cum is the Latin for ‘with’). This occurs because there
is a period of time between the announcement by the board of directors of a dividend payment during which the
entitlement to receive that dividend changes if the shares are sold.
CUM-DIVIDEND a share price includes an entitlement to receive a declared dividend
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.
EX-DIVIDEND date at which a share price is theoretically expected to fall by the amount of the declared dividend
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:
D
6.5.3 Bonus share issues
Occasionally, the board of directors of a company will issue additional ordinary shares to existing shareholders at no
cost to the shareholder. The shares will usually be issued based on a predetermined ratio, 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.
http://textflow.mheducation.com/parser.php?secload=8.6&fake&print
2/5
2016/3/11
IEB Wireframe
BONUS ISSUE where a company capitalises reserves through the issue of additional shares to shareholders
As with dividends, bonus share entitlements are traded cum-bonus and ex-bonus. When shares go ex-bonus there should be a
downward adjustment in the share price. This is to be expected since a bonus issue does not result in a change in the
total assets, or earnings expectations, of the company. Rather, it simply represents a change in the structure of the
company's financial capital. The price adjustment for ex-bonus shares should reflect the new number of shares in, or
claims on, the asset value of the company. For example, if a company offers a one-for-four bonus issue, and its shares
are currently priced at $10.00 cum-bonus, the theoretical price ex-bonus would be calculated as:
D
Page 207
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
The board of directors may decide to split the number of issued ordinary shares of a company. A motivation for a share
split might be to increase the liquidity of the shares on the stock market. For example, if the share price of a company
has, over time, increased significantly, to a point where the dollar amount is large relative to the majority of other
company shares traded on the exchange, the share may be seen as too expensive for some investors. If this is the case,
those investors will be reluctant to buy the high-priced share and as such there will be less liquidity in the market
for that share. A share split enables the board of directors to lower the price of the stock without changing the
capital structure of the company or diluting the return to shareholders.
SHARE SPLIT a proportional division of the number of shares issued by a company
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 presplit price of $40.00 is split two for one, then:
D
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:
D
6.5.5 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 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.
Page 208
RIGHTS ISSUE the issue of additional shares to existing shareholders on a pro-rata basis
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:
http://textflow.mheducation.com/parser.php?secload=8.6&fake&print
3/5
2016/3/11
IEB Wireframe
D
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:
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:
6.13a
RENOUNCEABLE a right that can be sold before it is executed
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.
Page 209
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
http://textflow.mheducation.com/parser.php?secload=8.6&fake&print
4/5
2016/3/11
IEB Wireframe
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 prorata 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.
http://textflow.mheducation.com/parser.php?secload=8.6&fake&print
5/5
2016/3/11
IEB Wireframe
6.6 Stock-market indices and published share information
LEARNING OBJECTIVE 6.6
Analyse the functions and importance of share-market indices and interpret published share-market 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.
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
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 stock-market indices are comparable between countries. In
this chapter, the focus is on S &P Indices as an index manager.
By arrangement, and in consultation with a local stock exchange, S&P manages three main types of share-market indices:
1. performance benchmark indices
2. tradable benchmark indices
3. market indicator indices.
Page 210
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.
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
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.
TRADABLE BENCHMARK INDEX a narrow index generally used as the basis for pricing certain derivative products
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).
MARKET INDICATOR INDEX seeks to measure the overall performance of the share market
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 priceweighted index, while the S&P 500 index is a market value-weighted index; that is, the weighting of each company
included in the index is proportional to each company's share price and shares outstanding. The main market indicator
index in Australia is the S&P/ASX All Ordinaries Index which incorporates 500 stocks.
An index may be a share price index that measures the capital gains or losses evident from investing in an indexrelated share portfolio, or an accumulation index that recognises both changes in share prices and the benefit of
http://textflow.mheducation.com/parser.php?secload=8.7&fake&print
1/4
2016/3/11
IEB Wireframe
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.
SHARE PRICE INDEX measures changes over time in the price of shares included in the index
ACCUMULATION INDEX measures changes in share prices, plus the reinvestment of dividends received
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 subindustries. 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.
GLOBAL INDUSTRY CLASSIFICATION STANDARD (GICS®) an international standard that groups listed companies into 10
standard industry sector indices
The 10 standard international GICS indices are:
1. Energy. This includes companies primarily involved in the exploration, construction, production, marketing,
refining or distribution of oil, gas, coal and consumable fuels.
2. Materials. This includes corporations involved in commodity-related manufacturing, such as construction materials,
chemicals, metals, glass, non-energy resources, aluminium, steel producers, gold and precious metals, forest
products and paper.
3. Industrials. This sector incorporates manufacturers and distributors of capital goods, consumer and professional
services, plus transportation industries. This includes aerospace and defence, construction, engineering and
building products, electrical equipment, industrial machinery and industrial conglomerates. It also includes
commercial services and suppliers such as printing, data processing, office supplies and employment services.
Transportation industries include airlines, railroads, marine and trucking corporations and transport
infrastructure.
4. Consumer discretionary. This index includes industries that tend to be more sensitive to economic cycles. This
includes manufacturers such as automotive, household durable goods, textiles and apparel, and leisure equipment.
The services segment of the index includes hotels, restaurants, leisure and education services. The media segment
includes advertising, broadcasting, movies and publishing. The retailing segment includes merchandise distributors
and department and speciality stores.
Page 211
5. Consumer staples. Consumer industries in this index are less sensitive to economic cycles. The index includes
manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and
personal products. Examples include food retailers, brewers, soft drink manufacturers, agriculture products and
beauty care products.
6. Health care. This includes health-care equipment and instrument manufacturers and suppliers, diagnostic services,
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.
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 stockmarket 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.
Page 212
http://textflow.mheducation.com/parser.php?secload=8.7&fake&print
2/4
2016/3/11
IEB Wireframe
SOURCE: Australian Financial Review, www.afr.com/share_tables, S&P/ASX300 extract, December 2013.
Figure 6.1ASX share-market listing (extract)
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.
http://textflow.mheducation.com/parser.php?secload=8.7&fake&print
3/4
2016/3/11
IEB Wireframe
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.
Page 214
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, economic and sharemarket information relevant to share investments.
http://textflow.mheducation.com/parser.php?secload=8.7&fake&print
4/4
2016/3/11
IEB Wireframe
FINANCIAL NEWS CASE STUDY
In Chapter 6 we discussed some widely used indicators of market value, especially the P/E or price-to-earnings 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
Page 215
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 twothirds 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.
‘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.
http://textflow.mheducation.com/parser.php?secload=8.8&fake&print
1/2
2016/3/11
IEB Wireframe
SOURCE: Pett, D. 2013, ‘The Trouble With P/E Values’, The Financial Post, 12 November 2013, www.financialpost.com
Page 216
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 longterm 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.
http://textflow.mheducation.com/parser.php?secload=8.8&fake&print
2/2
2016/3/11
IEB Wireframe
CHAPTER SIX REVIEW
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 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.
Page 217
With a passive approach, an investor will seek to replicate the structure, and therefore the return, of a specific
share-market index.
Within a diversified share portfolio the investor will consider the correlation of risk and return between shares.
Finally, the allocation of shares within the portfolio will be both strategic, in that it meets the investor's
personal 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 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?
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.
http://textflow.mheducation.com/parser.php?secload=8.f&fake&print
1/5
2016/3/11
IEB Wireframe
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.
Page 218
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.
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.
http://textflow.mheducation.com/parser.php?secload=8.f&fake&print
2/5
2016/3/11
IEB Wireframe
Page 219
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. 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.
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.
13. A company announces the payment of an interim dividend of 65 cents per share. The cum-dividend 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 cum-rights, 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 stock-market indices
around the world.
20. A share price accumulation index measures changes over time in the price of shares included in the index.
Page 220
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.
1. 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.
http://textflow.mheducation.com/parser.php?secload=8.f&fake&print
3/5
2016/3/11
IEB Wireframe
2. 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:
D
1. What does each beta coefficient imply about the volatility of each company's shares relative to the overall
market?
2. What is the portfolio's beta?
3. 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.
1. Explain the role of a stockbroker in the direct investment approach to share investments.
2. 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.
1. Explain the dividend imputation process.
2. Why might a dividend be only partly franked?
3. Calculate the income tax payable by the investor. (LO 6.3)
7.
1. Explain what is meant by the liquidity of a company. Define two common accounting measures of liquidity.
2. Why is liquidity an important indicator that an investor should consider when analysing share investment
opportunities? (LO 6.4)
Page 221
8. Define the commonly used measures of the profitability of a firm. Which measure do you consider to be most
informative in comparing the profitability of firms across different industry sectors? (LO 6.4)
9.
1. Define two measures of a company's debt-servicing capacity.
2. 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:
D
1. Define the calculation and discuss the meaning and purpose of a P/E ratio.
2. 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
http://textflow.mheducation.com/parser.php?secload=8.f&fake&print
4/5
2016/3/11
IEB Wireframe
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.
1. Explain the strategy adopted by the company. In your answer define the terms ‘cum-dividend’ and ‘exdividend’.
2. 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.
1. Explain the effect of the offer being renounceable.
2. What is the price of the right?
3. Calculate the theoretical ex-rights share price.
4. 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.
1. What is the purpose of share-market indices?
2. How does the existence of standard international industry sector indices facilitate global investment?
3. Identify and briefly explain the structure of the GICS indices. (LO 6.6)
Page 222
KEY TERMS
accumulation index 210 active investment 193 bear market 209 beta 193 bonus issue 206 bull market 209 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 earnings per share (EPS) 201 ex-dividend 206 expected return of a portfolio 194 franked dividends 198
franking credit 198 full-service advisory broker 196 global industry classification standard (GICS®) 210 grossed-up
amount 198 index funds 193 indirect investment 196 inflation component 198 interest cover ratio 200 liquid
ratio 200 marginal rate of tax 197 market capitalisation 210 market indicator index 210 passive investment 193
performance benchmark index 210 portfolio variance 194 price to earnings ratio (P/E) 201 renounceable 208 return on
equity 201 rights issue 207 share price index 210 share price to net tangible assets ratio 203 share split 207
stock-market index 209 stockbroker 195 stock liquidity 210 strategic asset allocation 194 systematic risk 192
tactical asset allocation 194 tradable benchmark index 210 unsystematic risk 192
http://textflow.mheducation.com/parser.php?secload=8.f&fake&print
5/5
2016/3/11
IEB Wireframe
Page 224
Chapter 7
Forecasting share
price movements
CHAPTER OUTLINE
7.1 Fundamental analysis: the top-down approach
7.2 Fundamental analysis: the bottom-up approach
7.3 Technical analysis
7.4 Electronic trading
7.5 The random walk, efficient market and behavioural finance hypotheses
Learning objectives
1. LO 7.1 Identify and interpret economic variables that impact on share price movements within the context of the
top-down approach to fundamental analysis.
2. LO 7.2 Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the
analysis of the financial and operational performance of a corporation.
3. LO 7.3 Describe and apply technical analysis to forecasting movements in share prices.
4. LO 7.4 Examine the role of electronic trading in influencing share price movements.
5. LO 7.5 Explain the theoretical concepts that form the basis of the random walk hypothesis, and consider the
implications of the efficient market hypothesis and the behavioural finance hypothesis when analysing and
forecasting share price movements.
Page 225
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 (roadshows), 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.
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
http://textflow.mheducation.com/parser.php?secload=9&fake&print
1/2
2016/3/11
IEB Wireframe
The price of shares of listed corporations is a function of supply and demand; that is, if there are more sellers
than buyers of a particular stock, the share price will fall; similarly, if the demand from investors increases for
a stock, the price will be pushed upwards.
New information coming to the market is the primary determinant of factors that affect the supply and demand for a
stock.
Investors may apply a number of approaches to the analysis of share investments and the forecasting of share price
movements: fundamental analysis top-down approach, fundamental analysis bottom-up approach, and technical analysis.
Page 226
Three theoretical concepts that consider the relationship of information and share price movements are the random
walk hypothesis, the efficient markets hypothesis and the behavioural finance hypothesis.
http://textflow.mheducation.com/parser.php?secload=9&fake&print
2/2
2016/3/11
IEB Wireframe
7.1Fundamental analysis: the top-down approach
LEARNING OBJECTIVE 7.1
Identify and interpret economic variables that impact on share price movements within the context of the top-down
approach to fundamental analysis
Within the context of stock-market investments, a wide range of parties have an interest in the future performance of
share prices and the overall stock market, including funds managers, stock analysts, individual investors, regulators,
government and financial journalists. These parties may be expected to seek rational approaches to the analysis and
forecasting of share price movements. Fundamental analysis is one such approach.
Fundamental analysis seeks to identify factors that are likely to influence directional changes in the value of a
company and hence its share price. These factors may be macro or micro in context. Macro factors are those that
influence the overall market, typically economic fundamentals such as interest rates, economic growth, business
investment and consumer confidence. Micro factors are firm-specific and relate to the financial and operational
performance and strength of a company, and also to the influence of management on the company's performance. For
example, indicators will include the return on equity, the return on assets, sales growth and market share.
FUNDAMENTAL ANALYSIS considers macro and micro fundamentals that may impact future share price changes
Therefore, fundamental analysis is divided into two components: the top-down approach and the bottom-up approach. While
each component is considered separately, in reality investors will use both approaches as each component supports the
full analysis necessary to make informed investment decisions.
The position taken by analysts in the top-down approach is that it is necessary to forecast and analyse the overall
economic environment and consider how forecast changes in economic fundamentals will impact on the performances of
various firms and industry sectors.
TOP-DOWN APPROACH forecasts the overall global and domestic economic environment in which corporations operate
INDUSTRY SECTORS components of an overall economy defined by the nature of the participants' business operations
Ideally, both the top-down and the bottom-up approaches should be used to determine the specific shares to include in an
investment portfolio. For example, the top-down approach should be used to determine those industry sectors most likely
to perform well given forecast changes in the overall economy and those sectors that are more likely to be adversely
affected. An investment portfolio should then be restructured so that it is overweight in those sectors forecast to do
well, and underweight in those sectors forecast to face a contracting economic and business environment. The top-down
approach will be applied to the local economy and also other international economies.
Having used the top-down approach to determine the better-performing industry sectors within an economy, the bottom-up
approach should then be used to select the most robust firms within those industry sectors. Similarly, when deciding to
sell shares of companies that operate in industry sectors that are not forecast to perform as well, the first to go
should be those stocks identified by the bottom-up approach as having less financial and management strength.
As indicated above, the top-down approach seeks to identify factors within an economy which may impact on the future
performance and profitability of corporations. These factors include:
the rate of growth of major international economies
the exchange rate between a domestic currency and the currencies of major trading partners and competitors
interest rate movements resulting from monetary policy changes or credit supply factors in the financial markets
the rate of growth of the economy—what is the shape and sustainability of the business cycle?
developments in the balance of payments current account (i.e. the trade in goods and services with the rest of the
world)
price rises, as measured by the rate of inflation (consumer price index)
the rate of growth in wages and productivity
government policy responses to developments in the above variables—both domestic and international.
Page 227
This section considers these economic fundamentals. In commenting on each of them, it should be noted that the various
parts of the list are interdependent. A change in one economic fundamental is likely to have a flow-on effect on many of
the other variables. It is important to recognise and understand the effects of these interrelationships.
7.1.1International economies
The rate of growth in major international economies can have quite a strong effect on the expected profitability of
many companies within a domestic economy. The performance of regional economies (e.g. Asia and the European Union) and
specific country economies (e.g. the USA, China, India and Japan) clearly has an impact on overall growth in the global
http://textflow.mheducation.com/parser.php?secload=9.2&fake&print
1/5
2016/3/11
IEB Wireframe
economy.
INTERNATIONAL ECONOMIES the economies of overseas nation-states
DOMESTIC ECONOMY the local or home economy of a nation-state
It is reasonable to assume that the higher the rate of growth in the rest of the world, the greater will be the demand
for exports generally. For firms that have a large proportion of their output devoted to export markets, and for those
that have branches or subsidiaries in overseas countries, an increase in the growth rate in those countries should be
bullish, or positive. The potential size of exporting firms' markets, and thus their expected earnings cash flows,
should increase.
EXPORTS the sale of goods and services into international economies
The business and performance effects of economic changes may vary from company to company, and from industry sector to
industry sector, depending on the nature of the growth in the different international economies. For example, if the
growth was being driven by increased consumer demand, then the suppliers of the more consumer-related raw materials,
products and services might obtain a relatively greater benefit. If, on the other hand, the growth was being driven by a
surge in business investment in capital equipment, it is reasonable to assume that the suppliers and users of basic
minerals and other resources could do quite well, as would the manufacturers of the component parts of such equipment.
The extent to which the incomes of suppliers and manufacturers will be boosted depends on, among other things, the
extent to which the expanding countries can rely on their stockpiles of commodities and inventories that may have
accumulated during prior periods of low demand and lower prices. If their stockpiles, and those of the competing
supplier countries, are relatively low, then exporters can be expected to do well. Their sales should expand, and as the
demand for exports increases so too should the price obtained per unit of export. The extent to which the profits of
exporters are boosted depends, in part, on what is likely to happen to the exchange rates of the currencies of the
trading partners and competitors (see below).
7.1.2The rate of growth of an economy
While it is appealing to conclude that a faster rate of growth in an economy is more positive for the stock market and
share prices than is a slower rate of growth, the story is not quite that clear. Certainly, stronger growth should be
expected to improve companies' expected future cash flows; however, unsustainable economic growth may also bring with it
some less desirable outcomes. Some of the problems associated with rapid, unsustainable rates of growth in an economy
include:
a deterioration in the balance of payments current account, for example increased demand for imported goods
an increase in inflationary pressures; supply constraints will push up domestic prices for goods and services
upward pressure on wages; labour shortages will result in higher wages costs
an eventual depreciation of the exchange rate; as economic activity becomes unsustainable, demand for the currency
will fall
a rise in interest rates; monetary policy will need to be tightened to slow the economy to a sustainable level
an inevitable downturn in economic activity and the business cycle.
These issues are discussed further in the following sections.
What is a sustainable rate of economic growth? There is, unfortunately, no single definitive answer. It depends on a
range of variables. Typically, it would seem that less developed economies are able to sustain relatively higher growth
rates for some time, but if that growth is not eventually tempered the economy will inevitably overheat to a point where
growth is no longer sustainable. Developed economies have the advantage of being able to look at long-term historic
growth trends, which tend to suggest that sustainable long-term growth is best achieved within a certain growth range:
between 3 and 4 per cent per annum. Another issue relates to where the drivers of growth are coming from. Economic
growth across an economy is often not uniform; therefore it is necessary to ascertain in which industry sectors the
growth is occurring in order to analyse whether that growth is likely to be sustained in the long term.
Page 228
7.1.3Exchange rates
In an environment of global growth, resource and commodity exporters are expected to experience increased demand for
their products and they could expect increased profitability. However, if export contracts are priced in US dollars
(USD), as many of them are, the level of profitability could be affected by foreign exchange risk. If there were a
strengthening, or appreciation, of the exchange rate of a local currency against the USD, then profits from increased
export sales would be less than if the exchange rate had remained constant. This occurs because the exporter will need
to convert its USD income back into the local currency at the higher exchange rate. It is possible that an adverse
change in the exchange rate could wipe out the exporter's profit margin.
FOREIGN EXCHANGE RISK the risk that the value of one currency relative to another currency will change
As well as forecasting the future exchange rate, it is also necessary to forecast the rate of exchange between the USD
and the currencies of other countries supplying the world markets in competition with a local supplier. If, for example,
the currency of the country of a major business competitor were to weaken against the USD, that competitor company would
receive the same amount of USD for each unit of exports, but when the USD income is converted into the competitor's home
currency its profits would increase. The increased profit margin may allow the company to renegotiate a lower USD price
for the export commodity and still maintain a reasonable profit. The lower USD price would undermine the competitiveness
and profitability of the local supplier. The above principles also apply to contracts written in other foreign
http://textflow.mheducation.com/parser.php?secload=9.2&fake&print
2/5
2016/3/11
IEB Wireframe
currencies such as the euro, yen or pound sterling.
Changes in the foreign exchange value of a currency can also have some unexpected results. Firms that appear to have no
contact with international trade may be affected by changes in the value of the domestic currency. For example, a fall
or depreciation in a local currency will, over time, push up the price of imports, and therefore add to the cost of
living. That is, the depreciation in the exchange rate will put upward pressure on the rate of inflation in the
economy. The flow-on effects of a currency exchange rate change are important. For example, if the workforce seeks to
maintain its standard of living, wages will need to rise in line with the increased cost of living. Any increase in
wages means that firms that were quite remote from the export-competing and import-competing sectors of the economy
would find that their costs of doing business have been affected by the change in the value of the currency.
INFLATION an increase in prices of goods and services over time; measured by the consumer price index (CPI)
It is quite probable that the central bank or government would intervene in an attempt to dampen the inflationary impact
of a weakening currency. One form of intervention might be a tightening of monetary policy by the central bank through
an increase in short-term interest rates. Another might be a cut in government spending. Both of these policies would be
designed to slow the growth in the economy, with a view to reducing inflationary pressures. The former policy would
increase the cost of funds to businesses; the latter would reduce the rate of business growth and would thus adversely
affect future income flows. Profits would be squeezed from both sides.
7.1.4Interest rates
The majority of firms are exposed to interest rate risk. Interest rates represent a significant cost of doing
business. The cost of debt finance is the interest paid to the provider of the finance. Therefore, any future change in
interest rates will have a direct impact on cash flows and the profitability of a firm. If interest rates are forecast
to rise, the market expectation would be for a reduction in business profitability and a fall in current share values.
At the same time, a rise in interest rates would signal a possible slowing of economic activity and also a further
reduction in profitability. Conversely, a forecast fall in interest rates would lead to an expectation of an increase in
profitability, business activity and share prices.
INTEREST RATE RISK the sensitivity of the value of assets, liabilities and future cash flows to a change in interest
rates
Page 229
The profitability effects of interest rate changes need to be analysed separately for each company, as each company will
have a different level of debt. Furthermore, each company may have managed its exposure to potential interest rate
movements differently. One company may have a policy to reduce interest rate exposures by hedging the risk through the
use of derivative product strategies. For example, it may enter into a forward rate agreement with its bank that
effectively locks in today an interest rate that will apply at a future date. Another company may manage a forecast
exposure to a rise in interest rates by borrowing most of its funds at fixed interest rates.
There is a strong relationship between the level of exchange rates and the level of interest rates. This relationship
varies over time. For example, if an economy is perceived to be growing at an unsustainable rate, overseas investors
will withdraw investment funds, thus placing downward pressure on the local currency. At a point in time the central
bank will typically decide to tighten monetary policy (increase short-term interest rates) in an endeavour to slow
down economic growth. The rise in interest rates should adjust economic activity to more sustainable levels, increase
investor confidence and, as overseas investors return, put upward pressure on the exchange rate. The timing and speed of
these changes is an unknown and usually will vary from business cycle to business cycle.
MONETARY POLICY actions of a central bank that influence the level of interest rates in order to achieve economic
outcomes; primary target is inflation
Understanding the relationship between interest rates, monetary policy and economic activity is therefore essential in
analysing changes in share prices. Monetary policy is applied by a central bank to achieve economic and social
objectives, principally by controlling the level of inflation in order to maintain levels of employment and economic
growth. Central banks implement monetary policy by influencing the level of interest rates. Monetary policy is discussed
in detail in Chapter 12.
7.1.5The balance of payments current account
The balance of payments current account is a financial record of earnings from the export of goods and services to
the rest of the world less imports, plus income earned on investments made overseas less the cost of overseas
borrowings. Therefore, it records cash receipts of a country resulting from the sale of goods and services, but deducts
payments made for goods and services bought from overseas suppliers. The current account also recognises the receipt of
income from local funds invested in the international markets. From this is deducted interest and dividends paid on
foreign borrowings and on foreign investments.
BALANCE OF PAYMENTS CURRENT ACCOUNT record of net trade in goods and services, and international investment and
borrowings, with the rest of the world
If the total payments exceed total receipts, there is said to be a current account deficit. To finance the current
account deficit it is necessary for a country to obtain funding from overseas. This results in the country building up
its level of foreign debt, and thus increases the interest payment burden of future years. Progressively, more and more
export income needs to be devoted to servicing the current interest commitments.
CURRENT ACCOUNT DEFICIT international export and investment receipts are less than imports and overseas debt payment
What is the relevance of this to the share market? There is very clear evidence that the current account is affected by
the rate of growth in an economy. The faster the rate of growth, the more a country as a whole imports and the worse the
current account deficit becomes. Consequently, the level of foreign debt becomes greater. To contain the current account
http://textflow.mheducation.com/parser.php?secload=9.2&fake&print
3/5
2016/3/11
IEB Wireframe
deterioration, the government or the central bank is likely to take measures designed to slow the economy. These
measures may include a tightening of monetary policy, that is, a rise in interest rates, and significant reductions in
government expenditure. These initiatives will be aimed largely at slowing the economy in order to slow import demand.
Some of the impacts of tightened monetary and budgetary policy on the profitability of businesses were outlined above.
7.1.6Inflationary pressures
Inflation is a reflection of increases in prices. Inflation is typically measured using a consumer price index (CPI).
The CPI measures changes in the cost of a basket of selected goods and services that typify those bought by individual
households in a particular nation-state. Changes in the CPI over time are used as a measure of the rate of inflation.
Care needs to be taken when comparing the CPI (or its equivalent) between countries, as the basket of goods and services
will vary.
CONSUMER PRICE INDEX (CPI) a measure of changes in the price of a basket of goods and services
Stronger economic growth is often—though not always—a precursor to increased rates of inflation. Many countries
through their central banks now target a level of inflation that is deemed to be conducive to maintaining long-term
sustainable economic growth. The target rate of inflation will generally fall within a defined band. For example,
Australia, through the monetary policy actions of the Reserve Bank, targets a level of inflation between 2 and 3 per
cent per annum (on average) over the business cycle. The policy tool used to maintain inflation within the target range
is monetary policy. If the central bank is concerned that inflation is threatening to exceed the target range, there is
a clear expectation that the central bank will begin to tighten monetary policy, that is, increase short-term interest
rates. Therefore, in forecasting the effects of strong economic growth on a company's performance, it is necessary to
consider the possibility and effects of inflation and monetary policy.
Page 230
Another aspect of inflation that should be appreciated is its impact on the nominal rate of interest. The nominal
rate of interest is the unadjusted annual rate of interest. That is, no adjustment has been made to the rate to reflect
the effects of compounding interest or the rate of inflation. The determination of interest rates is discussed in
Chapter 13. Briefly, the nominal rate of interest has two major components: the real rate of interest and the rate of
anticipated inflation. If the nominal rate or carded rate of a bank term loan is 6.50 per cent per annum and inflation
is expected to run at 2.50 per cent, the approximation of the real rate of interest is 4.00 per cent per annum. If
inflation is expected to increase to say 3.00 per cent, there is an expectation that the nominal rate of interest will
also increase, to 7.00 per cent. Investors will require the higher rate of return in order to maintain the real rate of
return and to compensate for the anticipated increase in prices. The increase in interest rates will make debt funding
more expensive for business.
NOMINAL RATE OF INTEREST the annual market interest rate; includes the real rate of return plus an anticipated
inflation component
COMPOUNDING INTEREST an arrangement where periodic interest payments accumulate on a financial instrument
CARDED RATE a financial institution's advertised nominal interest rate on loans and deposits
A further implication to be taken into account is the varying impact of inflation on different companies within the
context of the tax treatment of depreciation of capital assets. Capital-asset-intensive companies may be particularly
adversely affected by inflation. Depreciation allowances are based on the historic (or purchase) cost of an asset rather
than its replacement cost, which rises during periods of inflation. The accounting and taxation system then overstates
the true after-tax earnings of the firm. Investors need to be aware that a growth in reported earnings brought about by
inflation may need to be discounted. The same argument applies for inventories. Inventories carried on the books at
purchase price are later sold at higher prices during inflationary periods. However, they have to be replaced at higher
prices. Thus the inventory profit may be illusory. Again, potential share buyers should discount the reported profits
for this effect.
DEPRECIATION the amount by which the value of an asset is written down in an accounting period
7.1.7Wages growth
During periods of relatively rapid economic growth, business activity increases and therefore the demand for labour also
increases. Firms wanting to expand will tend to seek workers who are skilled and already working in a similar type of
employment. Expanding firms will attract labour by offering better salary packages than those offered by workers'
current employers. This competitive bidding can set up a wage spiral that ultimately affects the cost of labour for all
employers.
Wage increases that are in excess of an increase in the productivity of that labour will reduce the proportion of the
company's income revenue that goes to profit, and will render the company less attractive to shareholders and to
potential share investors. This consequence is even more important to those firms that normally have a large proportion
of their total costs as labour expenses.
An increase in economic growth will not, however, automatically increase wages growth and reduce the share of income
going to profits. Wages are also affected by the wage-setting mechanisms of a nation-state. For example, throughout
Australia's recent strong economic expansion, the share of national income going to wages actually fell and company
profits increased. Many economists and market commentators attributed this outcome to government policies that set the
parameters for possible wage increases.
7.1.8Understanding the interrelationships of economic fundamentals
It is timely to restate the previous statement that the fundamentals considered above are often highly interrelated.
This creates an analysis environment that is very dynamic. In attempting to forecast share price movements, an investor
must not take a piece of information in isolation, but should consider the impact that information will also have on the
wide range of other variables.
http://textflow.mheducation.com/parser.php?secload=9.2&fake&print
4/5
2016/3/11
IEB Wireframe
Page 231
The foregoing discussion on the top-down approach to fundamental analysis has been highly selective. While the main
economic fundamentals were introduced, there are many more to be considered, and analysts will incorporate what they
perceive to be other important economic fundamentals in their own models.
Essentially, the top-down approach involves the forecasting of developments in the fundamentals of the domestic economy
in which a business operates and in the economies of major trading partners. Once the forecasts are available, the task
then is to identify those industry sectors of the economy and of the share market that are likely to be advantaged or
disadvantaged by the forecast changes. The bottom-up approach should then be used to select specific firms within
industry sectors that should benefit from the forecast changes for inclusion in a share investment portfolio.
REFLECTION POINTS
The top-down approach considers macroeconomic factors that impact on the overall investment environment; it assists
investors to determine which economies and industry sectors offer the best investment opportunities.
The rate of growth in international economies impacts on overseas investment opportunities and also affects the
performance of investment opportunities in the local economy; investors need to consider international business
cycles and government policy responses (fiscal and monetary).
Firms that conduct business in the international markets are exposed to foreign exchange risk; that is, movements
in exchange rates may adversely impact on future cash flows and the value of assets and liabilities.
The cost of debt funds is the interest rate. Any change in interest rates will affect the cash flows and
profitability of a business. Interest rate changes (monetary policy) will impact on economic growth and the
business cycle.
Changes in the balance of payments current account (exports of goods and services minus imports, and foreign
interest earned minus interest paid) will affect economic performance and a current account deficit will need to be
funded with increased foreign debt.
Central bank monetary policy specifically targets the level of inflation; that is, changes in inflation may result
in interest rate changes which will affect economic activity.
Wages growth that is above the growth in productivity will reduce the profit margins of corporations.
http://textflow.mheducation.com/parser.php?secload=9.2&fake&print
5/5
2016/3/11
IEB Wireframe
7.2Fundamental analysis: the bottom-up approach
LEARNING OBJECTIVE 7.2
Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the analysis of the
financial and operational performance of a corporation
Once an investor has completed a top-down analysis of the fundamentals that impact on the overall investment
environment, the investor is able to determine which economies and industry sectors provide the best investment
opportunities.
For example, an investor may have decided that economic fundamentals indicate strong economic growth within the Swiss
and Australian economies and that the growth will be particularly strong in the pharmaceuticals sector in Switzerland
and the resources sector in Australia.
The investor has a number of choices of company shares to buy within each of those sectors. In which companies should
the investor purchase shares? How can the investor make an informed investment decision? Fundamental analysis using the
bottom-up approach assists with that analysis.
The fundamental analysis bottom-up approach considers micro factors that indicate a firm's financial, operational and
management performance. The approach focuses on accounting ratios and other measures of a firm's performance. A number
of the main ratios were outlined in Chapter 6. These included ratios for:
Page 232
capital structure
liquidity
debt servicing
profitability
share price and equity
risk.
BOTTOM-UP APPROACH performance analysis that focuses on accounting ratios and other measures of a firm's performance
ACCOUNTING RATIOS measures of a company's financial and management performance, strength and efficiency
It may be useful to review Section 6.4 before proceeding.
An appropriate starting point is to calculate the important ratios for the various companies, in particular industries
in which the investor is interested. Those companies with the most favourable combination of indicators would then be
selected. It is important to make direct comparisons only between companies that are substantially in the same industry,
since the norm, or the benchmark, for the various ratios often differs quite significantly between industry sectors. The
fundamental analysis bottom-up approach to the selection of companies for inclusion in an investment portfolio is
illustrated in Table 7.1.
(a) Chapter 6 provides a discussion on the ratios
D
Based on the bottom-up approach alone, of the two hypothetical companies presented in the table, company A would be the
preferred choice for inclusion in an investor's share portfolio. The table has been constructed so that the selection is
obvious. On each criterion, company A outperforms company B. In reality, the choice will rarely be so apparent. It is
more likely that the results of the calculations will be mixed and an investor will need to exercise both analysis and
judgment in the investment decision process. Additional inputs that may help in making a decision include:
http://textflow.mheducation.com/parser.php?secload=9.3&fake&print
1/2
2016/3/11
IEB Wireframe
intelligence on changes in key management positions
information on the corporate mission, corporate governance and planned strategic directions of the company into
the future
an examination of the recent history of the indicators included in Table 7.1, typically over the past three to five
years
a comparison of the performance indicators with other similar firms in the same industry.
CORPORATE MISSION the ultimate objectives and purpose of a corporation as determined by the board of directors
With this additional information, the investor should then keep in mind the position argued by modern portfolio
theory: the greater the degree of systematic risk, the greater should be the expected rate of return. If a higher rate
of return is not expected, then the higher risk is not worth accepting in the investment portfolio. A further issue is
that a well-diversified portfolio, being one that is constructed to minimise unsystematic risk, will incorporate
shares of firms from various industry sectors across geographic regions and in a range of countries. The selection
processes outlined above would be applied to select the specific firms from within each of the desired industry sectors.
MODERN PORTFOLIO THEORY concepts that enable a portfolio to be constructed with optimal risk and return relationships
SYSTEMATIC RISK exposures that affect the price of the majority of shares listed on a stock exchange
UNSYSTEMATIC RISK exposures that specifically impact on the share price of a particular corporation
While the detail and the discipline of the bottom-up approach are appealing to many investors, the approach may suffer
from a major drawback. The drawback relates to the need to calculate the performance ratios using historic data. The
historic data provides useful information on past performance, which may be an indicator of future performance, but it
is also possible that future performance may be different. This raises the question of how to forecast the future
direction of the performance of a firm, the industry sector and the stock market generally. The fundamental analysis
solution is to combine a top-down approach with the bottom-up approach.
Page 233
REFLECTION POINTS
Once an investor has determined which economies and which industry sectors offer the most attractive investment
opportunities, the investor must conduct an analysis of firms in those sectors to decide which shares to buy or
sell.
The bottom-up approach analyses a firm's financial, operational and management performance over time using
accounting ratios and other measures of a firm's performance.
Accounting ratios include capital structure, liquidity, debt servicing, profitability, share price and equity
ratios.
Ratios will be measured over time and compared with those of similar corporations in the same industry. (Note:
Ratios use historic data that may not accurately reflect future performance.)
Other indicators include information on key management positions, corporate governance and the strategic direction
of the firm.
http://textflow.mheducation.com/parser.php?secload=9.3&fake&print
2/2
2016/3/11
IEB Wireframe
7.3Technical analysis
LEARNING OBJECTIVE 7.3
Describe and apply technical analysis to forecasting movements in share prices
An alternative approach to forecasting the movement of share prices for individual companies, and forecasting the
performance of particular industry sectors and the overall stock market, is technical analysis. This approach seeks to
explain and forecast share price movements on the basis of the past behaviour of prices.
TECHNICAL ANALYSIS explains and forecasts price movements based on past price behaviour
One underlying assumption of technical analysis is that markets are dominated at certain times by a mass psychology, and
that over time regular patterns in share price movements are evident. As a share price pattern begins to emerge, it is
assumed that the historic pattern will re-emerge in full; that is, the full pattern will unfold this time as it did in
the past. An emerging share price pattern formation is taken as being a pointer to the path of the future share price
series.
SHARE PRICE PATTERN a graph over time of movements in a share price or a market index
Most typically, analysts adopt either a technical approach or a fundamental approach. Rarely will an individual analyst
adopt a combination of the two. However, some funds managers and individual investors take inputs from both approaches.
Some research indicates that it is a combination of both approaches that provides the better forecasts. Fundamental
analysis has a reasonable forecasting track record until the share market moves well above, or below, what the
fundamentals would normally support. At that stage it is argued that the chartists, or technical analysts, provide the
best forecasting record. For example, if the values of shares in a particular industry sector (e.g. technology sector)
rise at rates well above forecast future cash earnings potential, then share prices may not be explained by economic
fundamentals and technical analysis may provide indicators of future share price corrections.
The reason for the change in forecasting strategy has to do with timing. A limitation of fundamental analysis is that
forecasting on the basis of the fundamentals can suggest that the market is overvalued and is due for a correction, but
cannot predict the timing of the downturn. Once the market gets out of line with the fundamentals and it is widely
recognised that an adjustment is due, an alternative method of analysis—the forecasting models of the technical
analysts—may be used to signal the timing of the adjustment. Indeed, one of the major claims made by some technical
analysts is that they can pick the timing of market turning points.
Of the various types of technical analysis forecasting models, two will be considered here:
moving-averages models
charting.
Page 234
7.3.1Moving-averages models
An analyst is able to plot historic share price movements of individual corporations, or, alternatively, price movements
in a particular share price index, on a graph. In either event, the analyst creates a price series. The graph will show
price changes over the period, and from that graph certain price trends may be evident.
PRICE SERIES a graph of historic share price or market index movements over time
A technical analyst will usually apply more sophisticated price models; one type of model is based on moving averages.
Constructing a moving-averages model (MA) from a series of numbers tends to smooth out more erratic price movements.
It is designed to reveal more clearly the trends in a price series.
MOVING-AVERAGES MODEL (MA) a graph of a series of average prices constructed over time
For example, Table 7.2 illustrates the procedures for calculating a simple five-day MA. An average of five numbers in a
series is obtained by adding the numbers together and then dividing that value by five. For series such as share prices,
where the value changes daily, an MA is constructed in order to keep the average up to date.
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
1/8
2016/3/11
IEB Wireframe
D
The construction of the value of the MA is quite simple. On the fifth day, the average daily price for the past five
days is the sum of the prices divided by five. On day 6, the day 1 price is dropped and the day 6 price is brought in.
The sum of the current set of five daily prices is divided by five, and the resulting figure gives the five-day MA on
day 6. This process is repeated daily in order to update the MA series continually. Computer spreadsheet programs make
this task very simple; however, even calculating it manually is simple.
Once the actual price series and the MA series are plotted on the same graph, buy and sell signals are generated. Those
who subscribe to the benefits of the MA technique would adopt the following rules:
Buy when the actual price series cuts the MA from below—especially if the MA has been flat or is in a gentle
decline. This is illustrated in Figure 7.1(a).
Figure 7.1Buy signals: when the price series intersects, or tests, a rising MA line
Buy when the MA series is rising strongly and the price series cuts or touches the MA from above, but then moves
back above the MA after only a few observations, as shown in Figures 7.1(b) and (c).
Sell when the MA flattens, or declines after a steady rise, and the price series cuts the MA from above, as shown
in Figure 7.2(a).
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
2/8
2016/3/11
IEB Wireframe
Figure 7.2Sell signals: when the price series intersects, or tests, a falling MA line
Sell when the MA series is in decline and the price series cuts or touches the MA from below, but then moves back
beneath the MA after only a few observations, as shown in Figures 7.2(b) and (c).
Where an MA is constructed using daily price movements, the most commonly adopted periods are 10 days and 30 days. The
10-day MA will pick up short-term changes in trend, while the 30-day MA is more likely to pick up medium-term trend
changes. Some analysts who use the MA approach prefer to use a combination of MA series in order to generate their
buy/sell signals, rather than use a single MA with the actual price series. For example, a 10-day MA and a 30-day MA may
be applied together. The buy/sell rules are the same as those presented above, except that the 10-day average
substitutes for the actual price series in the buy/sell rules.
Page 235
Another variation is the use of a weighted MA rather than a simple MA. Analysts who prefer the weighted MA argue that
the most recent price contains the most valuable information on what the market perceives the value of the share to be.
It should thus carry the greatest weight in the calculation of the MA. In constructing a weighted MA, each piece of the
raw price data is given a weighting; the latest price data is given a higher weight than the earlier price data. For
example, in a five-day MA, today's price may be given a weighting of five; that is, it is multiplied by five.
Yesterday's price, day 4, is multiplied by four and so on. The calculations are illustrated in Table 7.3. The sum of the
five values is divided by the sum of the weights; in Table 7.3 this is day 1 + 2 + 3 + 4 + 5 = 15.
(a) Weighted total divided by the sum of the weights (that is, 1 + 2 + 3 + 4 + 5 = 15)
D
Page 236
The calculation for day 6 would be as follows:
Delete the day 1 price.
Recalculate the weighted values of the prices for days 2 to 6 and add them together:
(7 × 1) + (8 × 2) + (7 × 3) + (8 × 4) + (9 × 5) = 121
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
3/8
2016/3/11
IEB Wireframe
Divide the weighted total by the sum of the weights, being 121/15 = 8.07.
The new figure of 8.07 is added to the moving average in Table 7.3.
An advantage of the MA technique is that, insofar as it works at all, it provides rule-based buy/sell signals; there is
no need for discretion.
On the other hand, the use of charting techniques for generating and interpreting buy/sell signals allows considerable
scope for individual interpretation of the patterns that emerge in the charts. It is not surprising then that analysts
who use charting techniques will differ from those using MA analysis in their interpretations of the same objective
price series data.
7.3.2Charting
The second type of technical analysis forecasting model considered in this chapter is charting. The following is an
overview of the major patterns that are claimed by chartists to contain valuable information for forecasting share price
movements. The patterns will be discussed under the headings:
trend lines
support and resistance lines
continuation patterns
reversal patterns.
Page 237
Trend lines
Many prices appear to move in trends. The chartist seeks to observe the trend and any changes that might occur in the
trend. Two trend lines are considered:
the uptrend line
the downtrend line.
By connecting the lower points of a rising price series, an analyst is able to create an uptrend line. On the other
hand, an analyst will draw a downtrend line by connecting the higher points of a falling price series. A return line
is drawn parallel to the trend line in order to establish the trend channel.
UPTREND LINE achieved by connecting the lower points of a rising price series
DOWNTREND LINE achieved by connecting the higher points of a falling price series
RETURN LINE a line drawn parallel to a trend line to create a trend channel
An important focus of attention for the chartist is the determination of when the trend is about to change. When does a
penetration of the trend line constitute a signal that the trend has changed? Some of the patterns discussed below are
used by chartists to shed some light on this question. In the meantime, the following are regarded as reasonably
reliable generalisations:
The longer a trend line has been in force, and the more times it has been tested, the greater is its validity.
If a trend line is of long standing and has withstood three or four tests, and then an indecisive break is
experienced, this penetration can be ignored and the original trend retained.
Intra-day trades that break through established trend lines are considered to be unimportant; however, if the
breakout is on high trading volumes it may signal a weakening trend.
Failure to reach the return line in a well-established trend indicates deterioration in the trend.
Once a trend is broken on the downside, prices fall from it and then often make a return move towards the line. The
pullback frequently retraces approximately 50 per cent of the move away from the trend. This pullback provides a
good sell point, if the trader has not already sold at the break of the trend.
Figure 7.3 shows an uptrend, a downtrend and a sideways trend.
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
4/8
2016/3/11
IEB Wireframe
Figure 7.3Trend lines
Support and resistance lines
Chartists consider support and resistance levels to be next in importance to trends, and dotted lines are drawn across
the chart at historic support and resistance levels. In addition to these strong support and resistance levels, some
chartists include levels based on more recent activity in order to provide so-called weak support and resistance levels.
Support lines occur at a price level where there is increasing demand, and sufficient volumes, to halt any further
downward price movement. Resistance lines occur at that high price level at which supply, relative to demand, is
sufficient to halt a further advance in prices. Figure 7.4 shows the support and resistance lines.
Page 238
SUPPORT LINES lower price levels where an increase in demand halts a price fall
Figure 7.4Support and resistance lines
RESISTANCE LINES higher price levels where an increase in supply halts a price rise
A support/resistance pattern that is quite common in equity markets is the rectangle, which consists of sideways price
fluctuations contained within horizontal support and resistance levels. This pattern represents a period of conflict
between buyers and sellers, with the price being bounced between the two lines. Ultimately, it will be knocked through
the top line or the bottom line to form a new pattern. Sometimes a prediction can be made as to the direction of the
breakout. The following are said to be fairly reliable indicators:
Rectangles tend to be characterised by reducing volumes, except for a few days before the breakout when there are
strong increases in volumes of trade in the shares.
If the last bottom does not touch the support level, beginning the formation of an ascending triangle, and if
prices then rise rapidly, on increasing volumes, it is likely that there will be a topside breakout.
Conversely, if the tops fail to reach resistance levels, beginning the formation of a descending triangle, then a
downside breakout is likely.
Analysts often observe that when a break occurs from a rectangle, the extent of the breakout is likely to equal the
height of the price rectangle.
Continuation patterns
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
5/8
2016/3/11
IEB Wireframe
The price patterns mentioned above are called continuation patterns, since they are believed to occur most frequently
during a pause in the trend channel. They are essentially sideways trading and do not normally signal a change in an
established trend. Two main continuations are:
triangles
pennants and flags.
CONTINUATION PATTERNS sideways share trading that does not normally signal a change in a trend
Triangles
Symmetrical triangles are composed of a series of price fluctuations, with each top and bottom smaller than its
predecessor; that is, each minor top and bottom stops short of its previous levels. Transaction volumes usually continue
to diminish throughout this formation. No safe prediction of the direction of a breakout is offered by chartists, though
most often the breakout is presumed to continue the previous trend. Ascending triangles usually form in an uptrend and
are characterised by ascending bottoms and horizontal tops. Again, volumes decrease during the formation but increase,
often sharply, just prior to the usual upside breakout. Conversely, descending triangles usually form in a downward
trend and are characterised by descending tops and horizontal bottoms. Again, volumes decrease during the formation but
increase just prior to the usual downside breakout. Figure 7.5 illustrates the three types of triangles.
SYMMETRICAL TRIANGLES a series of price fluctuations with each top and bottom smaller than the previous triangle
ASCENDING TRIANGLES form an uptrend characterised by increasing bottoms and horizontal tops
Figure 7.5Continuation patterns: triangles
DESCENDING TRIANGLES form a downward trend characterised by decreasing tops and horizontal bottoms
Page 239
Pennants and flags
Pennants and flags normally form in very fast moving markets. Both formations tend to form rapidly. In a rising market
this usually occurs after a very sharp increase in prices on high volumes. This part of the formation is referred to as
the pole supporting the pennant or flag. During the formation of a pennant or flag, trading volumes fall and then
increase suddenly to take prices sharply lower then higher respectively. The presumption of many chartists is that the
breakout of prices will most often be to a height equal to the height of the pole that preceded the pennant or flag
formation. These patterns can also develop in falling markets. Chartists consider these patterns to be very reliable.
Figure 7.6 illustrates pennants and flags.
Figure 7.6Continuation patterns: pennants and flags
POLE rapid rise in share prices and volumes before a pennant or flag forms
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
6/8
2016/3/11
IEB Wireframe
Reversal patterns
Typically, after a major share-market shift, trend lines begin to break up and various reversal patterns form. The socalled head and shoulders pattern is seen by chartists to be one of the most reliable of patterns. The structure of a
head and shoulders pattern is depicted in Figure 7.7.
Figure 7.7Reversal patterns: head and shoulders
Page 240
A simple head and shoulders pattern consists of three successive rallies and reactions, the second rally reaching a
higher point than the rallies on either side. The left shoulder forms on an expanding volume-strong rally towards the
end of an uptrend. This is followed by a reaction on quite reduced volumes. The head forms on a strong second rally,
which carries the price higher than that for the left shoulder, and is followed by a reaction that sees prices moving
back to the vicinity of the previous low. Volumes, though high on the peak, are not as high as those on the left
shoulder. The formation of the right shoulder represents the conclusion of the pattern. The third rally is marked by
reduced volumes and indicates price weakness. Completion of the pattern occurs when prices break through the so-called
neckline, which is formed by a line drawn across the lows of the left and right shoulders. This line may be horizontal
but is often slightly sloping, as illustrated in Figure 7.7. Following the breakout of the neckline, prices often move
by at least the height of the head. Frequently also there is pullback; this represents the last selling position. Head
and shoulders bottoms are similar in form to their tops.
HEAD AND SHOULDERS PATTERN three successive rallies and reactions, the second rally being stronger than the first and
third rallies
LEFT SHOULDER first rally and reaction in head and shoulders pattern
HEAD second, and strongest, rally and reaction in head and shoulders pattern
RIGHT SHOULDER third rally and reaction in head and shoulders pattern
NECKLINE a line drawn across the bottoms of the left and right shoulders
BREAKOUT occurs when prices break through the neckline
There is a variety of other formations identified by chartists, including triple tops and bottoms, double tops and
bottoms, V and saucer bottoms and so on, but these are beyond the scope of this study.
An aspect of technical analysis worthy of note concerns the Elliott wave theory. Based on the statistical studies of
an American analyst, the Elliott wave theory maintains that there are distinctive wave patterns that characterise sharemarket cycles. The key proposition is that a bull market consists of three major waves upwards, followed by two major
down-legs, which result in a reversion of share prices to about 60 per cent of the peak.
ELLIOTT WAVE THEORY the existence of distinctive wave patterns that characterise share-market cycles
The objective with all charting techniques is to try and obtain early warning signals relating to likely movements in
share prices. Often it is difficult for investors with a background in finance and economics to place significant
credence in the techniques of technical analysts. However, insofar as they influence the trading behaviour of funds
managers and other investors, the techniques should be examined along with fundamental factors when making an assessment
of the likely course of share prices.
Even if it is argued by some that the techniques of technical analysis have little validity, if a sufficient number of
market participants employ technical analysis to guide their actions, they will have an impact on the behaviour of share
prices at various times. We started this chapter by saying that new information moves the market. The determinations of
technical analysts are in fact part of the comprehensive amount of new information coming into the market and therefore
will affect share prices to some extent.
REFLECTION POINTS
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
7/8
2016/3/11
IEB Wireframe
Technical analysis does not consider fundamentals; rather it seeks to explain and forecast share price movements on
the basis of past price patterns.
Page 241
Plotting price movements over time creates a share price series. Technical analysts often smooth out a series by
constructing moving averages, for example a 30-day moving average.
With a straight moving average the earliest data drop off and the newest data are added to calculate the next
average data plot. Some models may apply weights whereby the latest data have a greater weight than the older data.
Technical analysts also construct charts over time which allow the observation of trend lines (upward trend,
downward trend, return line), support and resistance lines (share prices at which supply and demand halt a trend),
continuation patterns (triangles, pennants, flags) and reversal patterns (left shoulder, head, right shoulder,
breakout).
Elliot wave theory contends that there are distinctive wave patterns that characterise share-market cycles.
http://textflow.mheducation.com/parser.php?secload=9.4&fake&print
8/8
2016/3/11
IEB Wireframe
7.4Electronic trading
LEARNING OBJECTIVE 7.4
Examine the role of electronic trading in influencing share price movements
In the fast-moving, high-volume and often volatile world of share trading, technology has been an integral part of the
stock market infrastructure for many years. Program trading refers to buy and sell orders, typically in large amounts,
that are automatically triggered by computer-based programs in response to movements in share prices. The potential for
program trading to increase the speed and magnitude of price declines was first recognised following the 1987 stock
market crash, where indexes around the world suffered unprecedented percentage declines on a single day.
PROGRAM TRADING buy and sell orders automatically triggered by rules entered into a computer program
Committees of inquiry into the 1987 share-market crash largely absolved program trading from causing the crash. There
was general agreement that all it did was to cause prices to fall faster and thus further in any specific period (per
hour or per day). However, while program trading might not be a significant cause, it certainly has an impact on sharemarket behaviour in that it may, in extreme circumstances, exaggerate an overreaction by market participants.
In recognition of this potential underlying problem, a number of stock exchanges, including the NYSE and the ASX,
have rules in place that will suspend trading on the exchange if, on any day of trading, the overall market index
by more than a specified percentage. The rationale for this rule is that large rises or falls in a single day may
a panic contagion effect among other market participants who, though not program trading, may enter a stampede to
or to buy. Time allows rationality to return to the market.
now
moves
cause
sell
Trading technology used in stock exchanges has advanced significantly since the October 1987 share-market crash. Market
participants, in particular market regulators, have for some time been concerned at the rapid development of highly
sophisticated computer-controlled trading programs that conduct transactions in microseconds. On 6 May 2010 this was
brought to a head when the NYSE experienced a ‘flash crash’ where the Dow Jones Industrial Average fell 1000 points or
about 10 per cent and then rebounded by 1000 points in a matter of minutes. The source of this event was traced to the
use of a particular type of computer algorithm used by a large market participant when selling securities as part of a
hedging strategy and a sequence of high frequency trades that followed in its wake. The sophisticated trading programs
and practices of most concern were high-frequency trading, flash trading and dark pools. News analytics trading is
another practice that is heavily used.
High-frequency trading (HFT) is the application of high-speed supercomputers that are controlled by algorithms that
analyse data, identify investment opportunities, and influence stock order flows and therefore share prices in the
market. For example, an HFT firm is able to electronically place thousands of orders in seconds and then immediately
cancel them and place new orders. Up to 90 per cent of HFT orders are cancelled in this manner. The HFT algorithms allow
a supercomputer to instantaneously identify spreads between bid (buy) and offer (sell) prices and place orders at a
price that will either influence a change in the existing spread, or ensure the HFT order is processed above other
orders. In this case the HFT firm can sell at one price and immediately buy at a better price using the spread. As the
spread changes, or if demand for a stock disappears, the HFT firm cancels its outstanding orders. HFT firms make between
$0.001 and $0.002 cents per share traded, but as their volumes are enormous, so too are the profits.
Page 242
HIGH-FREQUENCY TRADING (HFT) supercomputer algorithms analyse data, identify investment opportunities and place
thousands of buy/sell orders in seconds to take advantage of bid/offer spreads
Flash trading is a situation where certain privileged institutional investors, typically HFT firms, receive (are
flashed) information from a stock exchange of incoming stock orders a fraction of a second before this information is
sent to the exchanges trading system. By gaining access to this flash information before other market participants, the
HFT firm is able to match the best bid or offer in the system and pick up the incoming order. This is known as a flash
trade. Flash trades would appear to violate the principle of market fairness. The NYSE has banned flash trading but the
practice is still encouraged in many other exchanges as a competitive measure to increase trading volume growth on an
exchange.
FLASH TRADING privileged HFT firms receive information on incoming orders a fraction of a second before the information
reaches the exchange's trading system
Dark pools is a dedicated trading system that operates within an exchange that allows certain institutional investors
to place large buy or sell orders without having to disclose the trade to the entire market. Dark pools participants
place an indication of interest to buy or sell a quantity of securities at a set price to be determined at a nominated
time during the trading day. As the market is not aware of the dark pool trade, the price at which the trade is settled
will not reflect the impact of the large trade. For example, if the dark pool trade was a large sell order and had been
conducted on the open trading system, it would be expected that the share price would fall as the order was
progressively fulfilled. However, the lack of transparency in the dark pool means the transaction will not push down the
price during the trade.
DARK POOLS a trading system within an exchange that allows certain institutional investors to conduct large
transactions without immediate disclosure to the market
News analytics is another popular algorithmic-based trading strategy. Using computer technology, including natural
language processing, financial institutions and traders scan large volumes of textual information, such as newspaper
http://textflow.mheducation.com/parser.php?secload=9.5&fake&print
1/2
2016/3/11
IEB Wireframe
reports, internet sites, investor updates, forums, blogs and social media. For example, the algorithms may gather and
assess the ‘sentiment’ across a large volume of textual information by determining whether the commentary is
accompanied by a greater number of positive statements than negative statements (or vice versa). A trading strategy is
attached to the result. If the computer detects a relatively large amount of positive commentary about a company, buy
orders may be executed. The technology allows huge volumes of textual information to be scanned and assessed in
nanoseconds.
NEWS ANALYTICS the collection and analysis of text-based non-quantitative news and media stories
High frequency trading, flash trading, dark pools and computer-executed news analytics-based trading all provide
challenges for stock exchanges, markets participants and market regulators. At the time of writing, regulators in the
USA, UK and Europe are investigating whether more stringent regulation is required to cope with the potential negative
impacts of these systems and practices. As mentioned above, some stock exchanges have already moved to ban or limit some
of these practices. However, there is very strong pressure being exerted on the regulators by the HFT firms to allow HFT
to continue. The HFT firms have invested heavily in this infrastructure and their competitive advantage results in
enormous profits.
Within the context of this chapter, program trading, HFT, flash trading dark pools and news analytics trading all have
short-term impacts on share prices and therefore may need to be recognised in models that forecast share price
movements.
REFLECTION POINTS
Program trading refers to buy/sell orders that are automatically triggered by computer-based share trading systems.
Such automated programs may result in rapid share price changes which in turn may trigger further buy/sell orders.
A number of stock exchanges, including the NYSE and the ASX, have rules in place whereby trading is suspended if
the markets move by more than a specified percentage during a trading day.
High-frequency trading (HFT) is the application of high-speed supercomputers that are controlled by algorithms that
analyse data, identify investment opportunities, and influence stock order flows and therefore share prices in the
market.
Page 243
Flash trading is a situation where certain privileged institutional investors, typically HFT firms, receive (are
flashed) information from a stock exchange of incoming stock orders a fraction of a second before this information
is sent to the exchanges trading system.
Dark pools is a dedicated trading system that operates within an exchange that allows certain institutional
investors to place large buy or sell orders without having to disclose the trade to the entire market.
News analytics involves the analysis of large volumes of textual or qualitative information from newspapers, blogs,
websites and social media in order to derive insights relating to factors such as sentiment that may be used as the
basis for trading strategies. When executed algorithmically, large volumes of information can be analysed and buy
or sell orders placed within seconds.
Program trading, high frequency trading, flash trading, dark pools and news analytics all have an impact on share
prices and therefore need to be considered when conducting analysis to forecast movements in share prices.
http://textflow.mheducation.com/parser.php?secload=9.5&fake&print
2/2
2016/3/11
IEB Wireframe
7.5The random walk, efficient market and behavioural finance hypotheses
LEARNING OBJECTIVE 7.5
Explain the theoretical concepts that form the basis of the random walk hypothesis and consider the implications of the
efficient market hypothesis and the behavioural finance hypothesis when analysing and forecasting share price movements
This chapter has described factors that influence share prices, and the methodologies used to forecast future share
price changes. In trying to understand more completely how share pricing mechanisms work, investors attempt to theorise
the interactions of the share markets.
Within the context of forecasting share price movements, we now consider three of the most popular of modern theories on
the determination of, and changes in the value of, shares and other securities:
the random walk hypothesis
the efficient market hypothesis
the behavioural finance hypothesis.
7.5.1The random walk hypothesis
The random walk hypothesis contends that each observation in a time or price
independent of the previous observation. That is, the path of a series of share
the price of a share rises in period one, there is an equal probability that in
remain unchanged. Once the result for period two is observed, again there is an
the price may rise, fall or remain unchanged.
series such as share prices is
prices is random and unpredictable. If
period two the price may rise, fall or
equal probability that in period three
RANDOM WALK HYPOTHESIS each new share price change is independent of the previous share price
The important consideration for an investor is that if the random walk process does describe the movement of a share
price, the history of the previous movements of the share price contains no valuable information as to likely future
price movements. This would discount the methodologies used by technical analysts, other than that the analysis itself
becomes a source of new information.
Each share is assumed to have an intrinsic value that is based on investors' expectations about the present value of the
firm's future net cash flows. The price of the share reflects investors' estimation of the share's intrinsic value, and
is based on the latest information available and relevant to the company's current state and its future prospects.
Variations in the price of the share through time should only be in response to changes in the relevant information that
comes to the attention of the market concerning the company.
Though it is possible that the nature of the new information relevant to the particular company may be predominantly
good or predominantly bad, it is most likely that, over time, the news will not have a particular trend. It is likely to
be randomly distributed. Given this assumption, it follows that the movements in the share price will be random.
Page 244
Share prices react to new information coming into the market, and therefore it is necessary to consider how quickly
information is provided to a stock exchange and how quickly that information is absorbed and reflected in share prices.
One explanation can be found in the efficient market hypothesis.
7.5.2The efficient market hypothesis
One aspect of the efficient market hypothesis is derived from the random walk hypothesis. Share markets are said to
be information-efficient if share prices adjust virtually instantaneously to new information. If markets are efficient,
it should not be possible for an investor to make abnormal profits through having superior information to that of the
rest of the market.
EFFICIENT MARKET HYPOTHESIS share prices reflect all available information; superior profits are not available
The efficient market hypothesis also denies that there is a chance of making superior profits from employing the
techniques of technical analysis, since these techniques rely almost totally on the assumption that past price patterns
will repeat themselves.
The hypothesis also argues that employing fundamental analysis (either the top-down or the bottom-up approach) to share
valuation will not yield superior results for one investor over another. This is because all of the information required
in either approach should be available to all market participants. However, there would seem to be an obvious disparity
between the ability of analysts to understand, evaluate and interpret information that comes into the market. Further,
there are a large number of listed companies all generating, or impacted by, new information and therefore it is not
possible for all market analysts and investors to absorb and act upon that information immediately. This raises issues
in relation to the degree of efficiency within a market.
The efficient market hypothesis has been tested on three different levels, with each level making different assumptions
about the degree of information efficiency. In the least stringent test of the hypothesis, the so-called weak form
efficiency, the hypothesis suggests that successive changes in the price of shares are independent of one another.
http://textflow.mheducation.com/parser.php?secload=9.6&fake&print
1/6
2016/3/11
IEB Wireframe
Investors cannot make superior profits through determining the share's trading behaviour on the basis of historic price
data.
WEAK FORM EFFICIENCY share price changes are independent and not based on historic price data
The semi-strong form efficiency version of the hypothesis contends that all publicly available information regarding
a company is fully reflected in the price of a share. Therefore, the semi-strong form efficiency states that an investor
cannot make superior profits using publicly available information because it is already reflected in the share price. If
this is the case, an analyst who seeks to identify mispriced shares using the fundamental analysis approaches will not
be successful, again because the information will already be reflected in the share price.
SEMI-STRONG FORM EFFICIENCY all publicly available information is fully reflected in a share price
There would seem to be an issue of timing here. An important factor is how quickly market participants are able to
absorb information. Clearly, electronic information systems facilitate the rapid dissemination of an enormous volume of
news and information to the international markets. It cannot and will not be read by everyone at the same time.
Therefore, who has access to that information; and when will it be read? Those analysts who read the information first
and react to that information would seem to have an advantage.
Another factor is the interpretation of information. A group of analysts will often produce a range of different
outcomes while having access to the same information. Even when analysts might agree that a piece of information is
positive or negative, they will often disagree on the extent of the impact of that news.
The strictest form of the hypothesis, strong form efficiency, states that all information, including that which is
publicly available and that which is available only through private inquiries and research, will be reflected fully in
the market price of a share. The implication of the strong form hypothesis is that specialist analysts and insiders in
the company, who may have access to information that is not yet public, cannot earn greater profits than can those who
do not have access to the not-yet-public news.
STRONG FORM EFFICIENCY all publicly available information and private research is fully reflected in a share price
It would seem a reasonable assumption to state that private information does exist. Having access to that information
will have a value. For example, a team of investment bankers working on a takeover proposal for a client will be privy
to information that could affect the share price of both the takeover company and the target company. It comes down to a
question of whether the use of that information is ethical or legal.
What do the empirical research studies reveal about the level of efficiency of the share market? The studies generally
show that prices tend to fluctuate around an intrinsic or base value in an unbiased fashion, and that market prices
respond promptly to publicly available new information. Other studies have compared the profit performance of actively
managed portfolios, managed by professional portfolio managers, with the profits derived from randomly selected
portfolios bearing similar risk. On balance, such studies indicate that the former do not consistently outperform the
latter. These results offer support for the weak and the semi-strong forms of the efficient market hypothesis.
Page 245
There is less agreement from the studies designed to test the strong form of the hypothesis. Some US studies indicate
that share traders who possess inside information, including corporate executives, brokers and specialist analysts, have
been able to secure profits beyond those available to average investors. There has also been evidence that, at least in
the past, the returns on shares of smaller firms, for which there is likely to be less information publicly available,
tend to be persistently higher than the returns earned on the shares of larger firms. Also, as discussed in the previous
section, high frequency traders often appear to have an advantage because of the sophisticated trading platforms they
operate.
If a conclusion can be drawn from the studies, it appears at this stage that there is support for the view that share
markets are generally information-efficient. Share prices do appear generally to follow the random walk process, and to
reflect the current information available. Above-normal profits are unlikely to be made by using currently available
information, since that information is likely already to be reflected in the price of the share. Nevertheless, for some
skilled analysts, and for those able to uncover not-yet-public information, above-average rates of return may be
available. Also, it may be argued that a share market is not homogeneous and that different levels of efficiency may
exist in different sectors of a share market; for example, share prices of the top 100 stocks may be more informationefficient than share prices of the smallest 100 stocks.
7.5.3The behavioural finance hypothesis
Behavioural finance attempts to extend our understanding of investor behaviour, based on psychological principles of
decision making. The focus of behavioural finance is to identify and recognise the importance of cognitive factors that
may shape investor behaviour and lead to a divergence between actual share prices and those that would be expected to
prevail in an efficient market.
BEHAVIOURAL FINANCE explains investment decisions within the context of the impact of psychological factors
The efficient markets hypothesis is essentially an equilibrium hypothesis. In fact, the efficient market hypothesis
cannot be tested independently of a market equilibrium model such as the Capital Asset Pricing Model (CAPM). The central
prediction of such a model, which mirrors the ideas that constitute the core of neoclassical economics, is that market
prices and returns will settle at their equilibrium levels and return quickly to those equilibrium levels following a
disturbance. The arrival of new information that alters the structure of market equilibrium will be followed by a smooth
and rapid adjustment to a new point of equilibrium.
Periods of disequilibrium will be short and we would not expect to see violent upheavals in the absence of new
information relevant to the underlying equilibrium structure. Since all of the ups and downs in market prices and
http://textflow.mheducation.com/parser.php?secload=9.6&fake&print
2/6
2016/3/11
IEB Wireframe
returns are due to the trading activity of people and the computer programs they have designed, a better understanding
of the financial markets may be obtained by studying the psychology of investors. Dissatisfaction with the traditional
models of decision making and the apparent incongruity of equilibrium theory with the volatility observed to
characterise the markets has led to the development of an entire field of behavioural economics (or ‘economics and
psychology’). Behavioural finance is perhaps the most well-developed part of this literature.
Barberis and Thaler's (2003) A Survey of Behavioural Finance identifies two main tenets of behavioural finance theory.
The first is that rational investors may not necessarily correct the mistakes of irrational investors. The equilibriumtype arguments of neoclassical economics may be defended by arguing that, although investors may make mistakes and
although some investors might be irrational, those mistakes and the market inefficiencies created by them will be
quickly corrected by rational investors or arbitrageurs. Proponents of behavioural finance argue that market
inefficiencies may remain uncorrected, even if rational investors recognise that an investment opportunity has been
created, because there are ‘limits to arbitrage’. Such limits exist because the strategies that would need to be put
in place to correct some market inefficiencies may be too risky or too costly. A perfect arbitrage that yields a riskfree return is rare and it may not be possible to perfectly hedge the type of position necessary to correct the market
inefficiency. The position might also be very costly to implement and maintain. As a result, there is no incentive for
rational traders to step in. There are limits to the arbitrage process that is supposed to return market prices to their
equilibrium values.
Page 246
The ‘limits to arbitrage’ concept is both a challenge to the orthodox neoclassical equilibrium model and a defence of
the rationale of behavioural finance theory. Behavioural finance theorists could not possibly take the position that
there are no rational investors taking advantage of market inefficiencies because it is clearly the case that obvious
profit opportunities do not usually exist for very long. Rather than rule out arbitrage in all shapes and forms,
behavioural finance simply argues that the process is limited and may not operate even when rational investors are fully
aware that a profit opportunity exists. As such, there should be market inefficiencies that will require an explanation
that orthodox analysis cannot provide.
The question remains, however, as to how and why market inefficiencies emerge in the first place. This leads us to the
second tenet of behavioural finance theory, which argues that investors' decisions diverge from those that would be
consistent with the efficient markets hypothesis in ways that can be explained and predicted on the basis of cognitive
psychology. The investigation of the underlying structure of individuals' decision-making processes, particularly in the
presence of risk and uncertainty, has led to the identification of numerous decision-making biases to which market
inefficiencies might be traced.
Before outlining the growing list of biases that seem to pervade decision making under conditions of risk and
uncertainty, we should briefly outline the orthodox model of rational choice that is challenged by the discovery of
these decision-making biases. In economic theory, an individual makes a choice from his or her available opportunities
in a manner that maximises his or her utility or satisfaction. Human action is purposeful in the sense that people act
in order to achieve some objective. Because resources are scarce and we cannot have everything that we desire all at
once, we have to make choices. If I observe you heading off to the coffee shop rather than the pizza shop, I presume
that you are using your scarce resources, including time, to satisfy your most pressing desire: coffee.
All human action can be explained according to this model of choice. People act purposefully to achieve their ends or
objectives. The achievement of objectives confers some satisfaction, like the quenching of thirst associated with a
great coffee. We call this utility. For some other types of activity there is an added dimension: risk and uncertainty.
Outcomes are risky when there is a chance that the actual outcome may be different from that which was expected. Risk
and uncertainty characterise games of chance and strategy, and financial decisions. In choosing how to act the
individual cannot simply pick the opportunity with the outcome that will bring him or her the greatest utility or
satisfaction. Each opportunity may yield many different outcomes each with different levels of utility. The expected
utility of a particular opportunity is the sum of the utility of each possible outcome weighted (multiplied) by its
probability of occurrence.
EXPECTED UTILITY the sum of the utility of each possible outcome weighted (multiplied) by its probability of
occurrence
A formal representation of expected utility was developed by John von Neumann and Oskar Morgenstern in their Theory of
Games and Economic Behaviour, published in 1944. If certain axioms or rules apply, choice under risk and uncertainty can
be depicted in terms of the maximisation of an expected utility function. This implies that when confronted with risky
opportunities, people assess their opportunities and make a choice by assessing the outcomes that are likely to be
associated with each opportunity and the probability that that outcome will occur. The weight that each possible outcome
has on the person's decision-making process is its probability of occurrence.
In the example above, where I observed you heading off to the coffee shop, there was no risk. You would certainly get a
coffee. Likewise, if you chose to go to the pizza shop, you would get your choice of pizza. Let's say that there is a
chance that either the coffee shop or the pizza shop is closed. Now you have to assess whether the chance of a coffee
gives you more expected utility than the chance of a slice of pizza. As before, you would assess the utility of both
opportunities.
If you assign higher utility to coffee than to pizza, then you would go to the coffee shop if there was no risk (as
before). However, even if you assign more utility to coffee than to pizza, the expected utility that you assign to each
option may be different if the odds that the coffee shop will be closed are different from the odds that the pizza shop
will be closed. If you assigned a utility value of 2.00 to coffee and 1.00 to pizza, you would go to the pizza shop if
you thought there was only a 20 per cent chance that the coffee shop would be open versus a 50–50 chance that the pizza
shop would be open (2.00 multiplied by 0.20 is 0.40 while 1.00 multiplied by 0.50 is 0.50). You cannot be in both places
at the same time. Your time is scarce and must be allocated one way or the other.
Page 247
http://textflow.mheducation.com/parser.php?secload=9.6&fake&print
3/6
2016/3/11
IEB Wireframe
Although it is elegant and logical, dissatisfaction with the von Neumann and Morgenstern expected utility theory began
to grow. Criticism of an existing model is, however, little use without a plausible replacement. This would take until
the late 1970s to be developed. Throughout the 1970s, two cognitive psychologists, Daniel Kahneman and Amos Tversky,
worked diligently to construct an alternative model to expected utility theory that would reflect the types of biases
that they and others had identified in laboratory experiments. Applying experimental economics, Kahneman and Tversky
had found that people do not seem to make their choices in the way prescribed by expected utility theory.
EXPERIMENTAL ECONOMICS a branch of economics that attempts to explore the operation of economic theory under
controlled conditions
Kahneman and Tversky identified several ways in which the decision-making process appears to diverge from expected
utility theory: (1) people tend to assess their options against a reference point rather than absolutely; (2) people do
not tend to weight possible outcomes by the probability that those outcomes will occur; (3) people tend to be averse to
losses and would obtain more utility from avoiding a loss than acquiring a gain of the same magnitude; and (4) people
will tend to be risk-seeking in the ‘loss domain’, preferring to gamble if there is some small chance to avoid a
certain loss by doing so, and risk-averse in the ‘domain of gains’, preferring to play it safe when positive payoffs
are there for the taking. Kahneman and Tversky's attempt at incorporating these factors into an alternative model of
choice under risk is called prospect theory.
PROSPECT THEORY an alternative model of choice under risk
Prospect theory depicts the decision maker as assessing different risky opportunities or prospects on the basis of
prospect value. The decision maker assesses the value of each prospect and chooses the one with the highest value. In
this regard, expected utility theory and prospect theory involve conceptually equivalent depictions of the choice
process. That is, the opportunities are assessed and the best one is chosen. However, where expected utility is
determined quite simply by weighting utilities by probabilities and adding them up, prospect value is determined in a
way that reflects the different types of behaviour that people were observed to exhibit while making choices in Kahneman
and Tversky's laboratory experiments.
The process that prospect theory sets down is more complicated and the mathematical expression involves a number of
additional equations. Unlike expected utility theory, where utility is assessed on the basis of ‘absolute outcomes’,
the value for each prospect is determined by an assessment of gains and losses from a reference point. Even a positive
outcome may be viewed as a loss if it falls short of the reference point. The values are then weighted, just like in
expected utility theory. But in Kahneman and Tversky's model the weights are not the probabilities. Prospect theory uses
a more complex weighting scheme to allow for the observation that people tend to weight losses more heavily than gains.
The result of all this weighing up is a prospect value for each prospect that forms the basis for the person's choice.
An expected utility maximiser would choose the opportunity with the highest expected utility. The prospect-value
decision maker would choose the prospect with the highest prospect value. Predictions regarding actual choices may be
quite different depending on which model the economist decides to use.
The development of prospect theory was a major milestone in the development of behavioural economics and behavioural
finance, but much work remained to be done. The first version of prospect theory contained some theoretical and
conceptual problems that required additional work. An updated version of prospect theory, cumulative prospect theory,
was eventually published more than a decade later. In addition, more work needed to be done to investigate the structure
of decision making under risk and uncertainty and determine the robustness of the behavioural biases that had been
observed. This was in response to criticisms regarding the applicability of the results of economics experiments to
real-world contexts where substantial sums of money are at stake rather than the small or hypothetical amounts that were
usually used in experimental contexts. The identification and classification of decision-making biases that might be
responsible for market inefficiencies continues.
CUMULATIVE PROSPECT THEORY an updated version of prospect theory that resolves a number of theoretical and practical
problems identified by critics of the original version
Some of the most important and interesting decision-making biases that have been identified are listed below.
Investigation continues in order to determine whether these biases represent an explanation for some of the
characteristics that we observe in market prices. Potentially, decision-making biases may lead to the overreaction of
share market prices to new information, excess volatility, higher returns on equities than predicted by the orthodox
equilibrium model and momentum in share prices. It is important to keep in mind that debate is ongoing and nothing has
been completely settled. By and large, it is plausible to conclude that the market is usually but not always efficient.
Explaining and predicting departures from efficiency remains an open challenge to financial economists.
Page 248
People are overconfident. They overestimate the accuracy of their investment decisions and underestimate their
potential for error. When they happen to be correct, they attribute the positive outcome to their own ability, and
when they happen to be wrong they blame external factors. Overconfidence may cause more pronounced divergences of
share prices from fundamental values as investors initially overreact to either positive or negative news and then
gradually correct their mistakes.
People are averse to losses. This aspect of behaviour is a cornerstone of Kahneman and Tversky's prospect theory.
Losses loom larger than gains of the same magnitude. Because share prices are volatile and losses are likely, a
large premium may be required to entice investors into the share market. This may explain why the return on shares
has been much higher than the orthodox equilibrium models predict (the so-called equity premium puzzle). People
also tend to take more risk when trying to avoid losses. Rather than accept a certain loss of $100, they will
engage in a risky gamble that may see them avoid the loss but will more than likely end up in an even greater loss.
People exhibit framing bias. People make different decisions when the same problem is presented to them in
different ways. For example, people may purchase more apples when the choice is framed as ‘10 apples for $8′
rather than ‘apples 80 cents each’. The way in which an investment opportunity is presented can affect the
http://textflow.mheducation.com/parser.php?secload=9.6&fake&print
4/6
2016/3/11
IEB Wireframe
investor's decision. Investment decisions are subjected to various frames, such as the language used by financial
planners in describing alternative investment options. If enough investors exhibit framing bias, share prices may
diverge from fundamental values because investors are making decisions on the basis of the framing of the
investment opportunities rather than on the basis of an assessment of the underlying risks and rewards.
People exhibit representativeness bias. People sometimes make decisions on the basis of stereotypes. This may lead
investors and analysts to be more optimistic about recent winners (shares that have been going up in value) and
more pessimistic about recent losers (shares that have been declining in value). The recent performance of an
investment may be given too much weight in the decision-making process. As a result, there will be periods when
winners are overpriced and losers are underpriced. If this departure from efficiency is corrected, we would expect
losers to perform better than winners over time. This type of market behaviour has been observed, but it would be
hasty to conclude that it is a manifestation of a decision-making bias such as representativeness. There is an
orthodox explanation. Losers are very risky and should reward those investors brave enough to add them to their
portfolios with a higher average return.
People display cognitive dissonance. New information will sometimes conflict with a person's existing attitudes,
values or beliefs and cause discomfort. Two cognitions, the new and pre-existing, are in dissonance or
disagreement. To alleviate this discomfort people may try to convince themselves that their pre-existing ideas are
correct. This may affect investment decisions in a number of different ways. In particular, people may tend to hold
losing investments longer than they should as they try to convince themselves that their initial evaluation of the
investment was correct, even though new information or the subsequent performance of the investment suggests
otherwise. If enough people, having bought into an initial story (that the housing market will experience strong
capital growth, for example), display cognitive dissonance in the face of new information, trends in market prices
may be exacerbated.
People make decisions with a reference point in mind. ‘Reference point dependence’ is another cornerstone of
Kahneman and Tversky's prospect theory. It is not necessarily a bias but it is inconsistent with expected utility
theory. The orthodox model depicts the decision maker as assessing the utility of outcomes. In general, positive
outcomes will be accorded positive utility and vice versa. The assessment is made absolutely. Prospect theory
depicts decision makers as assessing the value or utility of outcomes relatively against a reference point. A
positive outcome may be accorded a negative value if it is below the reference point. If you observe all your
friends making $1000 on their investments, you might feel as though you have lost even if you make $500. Reference
point dependence may interact with other behavioural phenomena such as loss aversion. Faced with a positive
financial payoff, but one that lies below your reference point, you may take additional risks in order to avoid the
loss and record a gain or an outcome above your reference point.
Hopefully, this brief introduction to the concepts of behavioural economics and behavioural finance will begin to
demonstrate that the financial markets are dynamic and extremely complex. The neat argument that market participants
will act in a rational manner in order to maximise returns does not always hold. Further, investor actions will vary
depending on the particular investment horizon or time-frame. Day-traders and many fund managers operate on a shortterm, often intra-day, time-frame. Other investors maintain a buy and hold strategy for the majority of their investment
portfolio.
Page 249
Behavioural finance does not necessarily invalidate the efficient market hypothesis; rather, it recognises that there
are many factors, other than simple rationality, that impact investment decisions and therefore influence market trends
and prices.
REFLECTION POINTS
The random walk hypothesis contends that each observation in a share price time series is independent of the
previous observation; that is, the share price may rise, fall or remain unchanged.
Each share has an intrinsic value, the present value of its forecast future cash flows. Only new information that
changes those forecasts should impact on the share price in the future. As the next piece of information is not
known, then the next share price movement is also unknown.
Share markets are said to be information-efficient if prices rapidly adjust to new information; however, the level
of efficiency in a share market is indicated by how quickly information reaches the market, and how quickly that
information is absorbed into share prices.
There are said to be three levels of efficiency:
1. weak form efficiency—where successive changes in the price of shares are independent of one another,
therefore investors cannot make superior profits on the basis of historic price data
http://textflow.mheducation.com/parser.php?secload=9.6&fake&print
5/6
2016/3/11
IEB Wireframe
2. semi-strong form efficiency—where all publicly available information regarding a company is fully reflected
in the price of a share
3. strong form efficiency—where all information, including that which is publicly available and that which is
available only through private inquiries and research, will be reflected fully in the market price of a share.
Information efficiency may not be constant across all stocks listed on a stock exchange.
Behavioural finance recognises that investor psychological and cognitive factors impact upon, and sometimes impede,
the expected rational investment decision process.
http://textflow.mheducation.com/parser.php?secload=9.6&fake&print
6/6
2016/3/11
IEB Wireframe
FINANCIAL NEWS CASE STUDY
In our discussion in Chapter 7 we identified two quite different ways of looking at the financial markets. On the one
hand we explored the efficient market hypothesis that implies an inherent tendency towards equilibrium and by
implication some sort of utility maximising behaviour on the part of investors. Although this does not imply that
investors will never make mistakes, it certainly downplays the emotional and behavioural factors that might shape
investors' decisions and pushes aside the possibility that share prices may not only be moved up and down by new
information but by investor sentiment without any real foundation in the economic ‘fundamentals’. On the other hand,
we identified a significant scholarly effort that aims to develop an explanation for market prices based on the
behavioural ‘biases’ that might shape investor decision-making and the waves of sentiment that might be even more
powerful than information when it comes to swaying share prices in one direction or the other. These are two quite
contrasting views on how market prices are determined.
Page 250
Intriguingly, the 2013 Nobel Prize for economics was awarded to three gentlemen who were responsible, in part, for the
development of these contrasting views. That they should share the prize for such differences of opinion is very
interesting and highlights the fact that the debate is far from settled. Even in the absence of a decisive victory for
the proponents of the efficient market hypothesis, led by Eugene Fama, or the behavioural hypothesis, which has
benefited from important contributions by Robert Shiller, the study that has been undertaken as part of the research
programs that these men helped to initiate has greatly improved our understanding of the financial markets. Lars Peter
Hansen developed important economic measurement tools that helped to revolutionise research into stock market
volatility.
Their work is reflected in this overview of the main contributions of the prize winners noted by the Financial Times:
Mr Fama, from the University of Chicago, is one of the fathers of the so-called ‘efficient market hypothesis’. This
theory – which underlies his seminal 1965 paper ‘Random Walks in Stock Market Prices’ – formulates that markets are
‘informationally efficient’, as investors immediately incorporate any new available information in the price of an
asset.
In contrast, Mr Shiller, from Yale University, believes that any explanation of investors' behaviour cannot be fully
based on rationality and must acknowledge the role played by psychology. In the 1980s, he showed that stock prices tend
to fluctuate more than corporate dividends. This should not happen if investors were fully rational, since stock prices
forecast future dividends.
Mr Hansen, also at the University of Chicago, designed methods to explore the drivers of stock market volatility which
confirmed Mr Shiller's finding that swings in asset prices could not be explained via standard models based on
rationality.
Research into the efficient markets hypothesis and its alternatives never really abated at any time during the period
since 1970. Fama's original articles sparked interest and controversy and appeared at almost exactly the right time. The
rational expectations revolution was transforming both macroeconomics and microeconomics and financial economics was
about to enjoy its classical period. Shiller's challenge appeared during the early 1980s. It was also well timed.
Prospect theory had just been developed and many other people were beginning to question the behavioural foundations of
the newly created economic theories. Hansen's development of the tools required to test some of the newly crafted
hypotheses have been critical in creating a vigorous empirical and theoretical debate. The GFC reignited interest in
efficient markets as people questioned just how an efficient market could be the seen for such a catastrophe. Not
surprisingly, opinion on the matter is divided.
SOURCE: Extract from F. Giugliano and J. Aglionby, ‘Fama, Hansen and Shiller Win Nobel Prize for Economics, Financial
Times, 14 October 2013, www.ft.com.
Discussion points
Discuss the contrasting views of Shiller and Fama and give reasons why their contributions have been jointly
recognised even though the debate is far from resolved.
Outline some of the ways in which the debate between efficient market proponents and behavioural finance theorists
may enhance our understanding of the operation of the financial markets.
One of Shiller's contributions was the finding that share prices are more volatile than the underlying dividend
series. Briefly discuss the implications of this finding for the efficient markets hypothesis.
http://textflow.mheducation.com/parser.php?secload=9.7&fake&print
1/1
2016/3/11
IEB Wireframe
Page 251
Summary
LEARNING OBJECTIVE 7.1
Identify and interpret economic variables that impact on share price movements within the context of the top-down
approach to fundamental analysis
The price of a share is essentially determined by the demand for and supply of the share. At any moment, the
balance between buyers and sellers of a company's shares is determined by their assessments of the future
profitability of a company and forecast movement in the share's price.
Investors and share analysts may conduct their evaluations and issue their buy/sell recommendations using
fundamental analysis.
Fundamental analysis, incorporating the top-down approach and the bottom-up approach, examines variables that
finance and economic theories identify as being relevant to a company's future performance.
The top-down approach looks at prospective developments in the broader economic environment within which the
various industry sectors and specific companies are situated.
Important variables that are identified as being of relevance to the future performance of various industry
sectors, and therefore companies operating within those sectors, include:
developments in major international economies
the rate of growth within a domestic economy
the variability and volatility of exchange rates, particularly those of major trading partners
changes in monetary policy settings and movements in interest rates
the balance of payments current account, and whether the current account is in surplus or deficit
upward pressures on wages growth relative to increases in productivity.
LEARNING OBJECTIVE 7.2
Evaluate and apply the principles of the bottom-up approach to fundamental analysis, in particular the analysis of the
financial and operational performance of a corporation
Once an investor has determined which economies and which industry sectors offer the most attractive investment
opportunities (using the top-down approach), the investor must conduct an analysis of firms in those sectors to
decide which shares to buy or sell.
The fundamental analysis bottom-up approach uses accounting ratios and other performance measures to analyse the
financial, operational and management performance of a particular company.
Ratios that are analysed include capital structure, liquidity, debt servicing, profitability, share price and
equity and risk.
Ratios will be measured over time and compared with those of similar corporations in the same industry. (Note:
Ratios use historic data which may not accurately reflect future performance.)
Other indicators include key management, corporate governance and strategic direction.
LEARNING OBJECTIVE 7.3
Describe and apply technical analysis to forecasting movements in share prices
Technical analysis adopts an alternative approach to share price forecasting. The approach is based on the
assumption that, over time, apparent trends and patterns in share price movements are formed.
It is further assumed that as a new pattern emerges the past behaviour pattern observed in an historic pattern will
also re-emerge.
Two principal models used by technical analysts are (1) moving-averages models and (2) charting.
Page 252
A moving-averages model is a graph of a series of average prices constructed over time. The moving average is
designed to smooth out the effects of intra-period volatility. An example might be the construction of a 10-day
moving-averages model or a 30-day model.
Alternatively, a weighted model may be structured in order to give greater value to the most recent data
observations. Therefore the most recent information will have a higher weight than earlier or past data.
Technical analysts use strict decision rules; that is, if a model develops in a certain pattern, decisions to buy
http://textflow.mheducation.com/parser.php?secload=9.f&fake&print
1/5
2016/3/11
IEB Wireframe
or sell are automatically triggered.
Another form of technical analysis is the use of charting. A chartist will use price movements to plot uptrend and
downtrend lines. A return line is drawn to create a trend channel. A chartist is looking for support and resistance
lines incorporating continuation patterns such as triangles, pennants and flags.
Each of these patterns denotes price behaviour patterns and enables the chartist to make forecasts on future price
movements. After a major shift in a trend line, a chartist will expect reversal patterns to emerge. One such
pattern is known as the head and shoulders pattern.
Elliot wave theory contends that there are distinctive wave patterns that characterise share-market cycles.
LEARNING OBJECTIVE 7.4
Examine the role of electronic trading in influencing share price movements
Program trading refers to buy/sell orders that are automatically triggered by computer-based share trading systems.
Such automated programs may result in rapid share price changes which in turn may trigger further buy/sell orders.
A number of stock exchanges, including the NYSE and the ASX, have rules in place whereby trading is suspended if
the markets move by more than a specified percentage during a trading day.
High-frequency trading (HFT) is the application of high-speed supercomputers that are controlled by algorithms that
analyse data, identify investment opportunities, and influence stock order flows and therefore share prices in the
market.
Flash trading is a situation where certain privileged institutional investors, typically HFT firms, receive (are
flashed) information from a stock exchange of incoming stock orders a fraction of a second before this information
is sent to the exchanges trading system.
Dark pools is a dedicated trading system that operates within an exchange that allows certain institutional
investors to place large buy or sell orders without having to disclose the trade to the entire market.
News analytics involves the analysis of large volumes of textual or qualitative information from newspapers, blogs,
websites and social media in order to derive insights relating to factors, such as sentiment, that may be used as
the basis for trading strategies. When executed algorithmically, large volumes of information can be analysed and
buy or sell orders placed within seconds.
Program trading, high frequency trading, flash trading, dark pools and news analytics all have an impact on share
prices and therefore need to be considered when conducting analysis to forecast movements in share prices.
LEARNING OBJECTIVE 7.5
Explain the theoretical concepts that form the basis of the random walk hypothesis and consider the implications of the
efficient market hypothesis and the behavioural finance hypothesis when analysing and forecasting share price movements
The random walk hypothesis contends that share price observations are independent of each other and that the next
price movement cannot be directionally predicted.
That is, the next price of a share may be an increase or a decrease or it may remain the same. A change in a share
price will occur in response to new information coming to the market.
The efficient market hypothesis is a formalisation of the information process of the random walk hypothesis.
Page 253
It challenges the view that analysts are able to select a portfolio of shares that will outperform the overall
market. The challenge rests on the view that markets are information-efficient and therefore all relevant
information is already reflected in the current price of a share.
Three forms of market efficiency are identified:
1. weak form efficiency—where successive changes in the price of shares are independent of one another,
therefore investors cannot make superior profits on the basis of historic price data
2. semi-strong form efficiency—where all publicly available information regarding a company is fully reflected
in the price of a share
3. strong form efficiency—where all information, including that which is publicly available and that which is
available only through private inquiries and research, will be reflected fully in the market price of a share.
The majority of empirical studies find in favour of the first two forms of efficiency; however, there is less
agreement on the strong form efficiency.
Information efficiency may not be constant across all stocks listed on a stock exchange.
The behavioural finance hypothesis challenges aspects of the efficient market hypothesis and contends that
psychological and cognitive factors actually influence the investment decision process.
http://textflow.mheducation.com/parser.php?secload=9.f&fake&print
2/5
2016/3/11
IEB Wireframe
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. Prospect theory and expected utility theory are two interchangeable models of choice under risk and uncertainty.
2. For people who are loss averse, losses loom larger than gains. They attach greater disappointment to a $100 loss
than the happiness they attach to a $100 gain.
3. It is possible to change the decisions that people make under risk and uncertainty by changing the way in which the
characteristics of a potential investment decision are framed.
4. The economic performance of international economies has very little relevance to the expected performance of the
majority of local companies listed in the share market.
5. High levels of economic growth in developing economies may not be sustainable in the long term and may well lead to
upward wages and inflationary pressures.
6. Changes in foreign currency exchange rates principally affect the financial markets and therefore will have little
impact upon the share price of listed corporations.
7. With the top-down approach to fundamental analysis, monetary policy actions of the central bank are not considered
as they are beyond the control of corporations.
8. Wage increases that are in excess of productivity increases may have a negative impact on the share market.
9. The bottom-up approach to fundamental analysis focuses on the use of financial ratio data to forecast future
company growth and profitability.
10. With the bottom-up approach to fundamental analysis, company ratio analysis should be compared with companies in
the same industry and over a three- to five-year period.
11. One of the inadequacies of the bottom-up approach to fundamental analysis is that financial ratios generally
reflect the past performance of a company.
Page 254
12. Economic fundamentals measure a corporation's financial, operational and management performance, strength and
efficiency.
13. One of the features of the technical analysis approach to share price forecasting is the reliance on very
sophisticated technical models of the macroeconomic environment.
14. Moving-averages models are highly flexible in that they allow considerable scope for an analyst's interpretation of
the data and in the generation of buy and sell orders.
15. The five-day moving average for the following data collected over a seven-day period is $7.10: day 1, $9.25; day 2,
$8.75; day 3, $8.25; day 4, $7.50; day 5, $7.00; day 6, $6.25; day 7, $6.50.
16. According to the ‘limits to arbitrage’ idea, all anomalies in share market prices should be eliminated quickly
and completely.
17. Blogs and websites may be analysed by news analysts in order to gather information about investor sentiment.
18. The random walk hypothesis implies that the examination of past price movements provides no useful information on
the direction of future price movements.
19. Within the context of the efficient market hypothesis, share markets are said to be information-efficient if share
prices adjust immediately to new information.
20. Under the strong form efficiency test of the efficient market hypothesis, a corporate insider trading illegally on
private information should be able to make superior profits.
Essay questions
Write short essay-type responses to the following questions. Make sure that you are able to explain in your own words
the points you raise in relation to each question.
1. The top-down approach to fundamental analysis includes an analysis of the local economy in which a company is
situated, plus the economies of major trading partner countries and the global economy more generally. Why would an
investor be interested in forecasting changes in these economies? (LO 7.1)
2. A funds manager is considering investment opportunities in China, Hong Kong and Japan. Data indicate the rate of
economic growth over the past year as:
• China
• Hong Kong
9.50 per cent
5.75 per cent
http://textflow.mheducation.com/parser.php?secload=9.f&fake&print
3/5
2016/3/11
IEB Wireframe
• Japan
2.25 per cent
Based on these data, the funds manager concludes that the significantly stronger economic growth in China
represents much higher potential investment returns in the form of capital growth on share investments. Critically
analyse this conclusion. (LO 7.1)
3. The board of directors of BHP Billiton Limited is concerned about changes in the exchange rate between the
Australian dollar and the US dollar. Analyse this situation and discuss the main impacts a change in exchange rates
might have on the performance of BHP Billiton Limited and its share price. (LO 7.1)
4. HESTA Super Fund controls over $15 billion in investment assets for its 690 000 members. HESTA is currently
reviewing the structure of its balanced fund and analysing forecasts prepared by independent experts on interest
rates, the rate of inflation, economic growth, the business cycle and the performance of corporations. Within the
context of the top-down approach to fundamental analysis, HESTA is particularly concerned about the effects of the
relationships between these variables on the value of the balanced fund. Analyse and write a report for HESTA. (LO
7.1)
5. Evans and Partners is an investment advisory firm that provides specialist investment advice to its private
clients. As part of the investment decision process, the senior investment analysts at the firm apply the bottom-up
approach to the fundamental analysis of share prices. This approach focuses on the analysis of accounting ratios
and other performance measures.
Page 255
1. Explain why Evans and Partners will use this type of analysis.
2. Identify and discuss six different accounting ratios that should be included in a bottom-up approach model.
3. Identify and discuss three other performance measures that may be used. (LO 7.2)
6. Perpetual Limited is a large funds manager within Australia. Perpetual is preparing a presentation to a new client
on the investment approaches taken by the company. One approach used by Perpetual is the bottom-up approach to
fundamental analysis. From past experience, Perpetual knows that the new client will ask a number of questions
about the bottom-up approach. Assume you work for Perpetual and are required to answer these questions. Prepare an
answer relating to the main advantages and disadvantages of the bottom-up approach to fundamental analysis. (LO
7.2)
7. An investor is evaluating the use of the bottom-up approach and the top-down approach to fundamental analysis. The
investor wants to use the approach that will best enable them to structure a diversified share portfolio that will
achieve specified income returns and capital gains. Which approach do you recommend the investor adopt? (LO 7.1 and
7.2)
8. After graduating from university, you obtain a position as a junior journalist with a local newspaper. A number of
readers have made requests for information about technical analysis. You know that technical analysis seeks to
forecast and explain share price and share-market movements. In conceptual terms, write a short article for the
newspaper that explains how the technical analysis approach to share price forecasting operates. (LO 7.3)
9. Listed below are the close-of-business share prices for Fortescue Metals over the last 10 trading days:
1. $5.28
2. $5.29
3. $5.41
4. $5.54
5. $5.59
6. $5.46
7. $5.45
8. $5.39
9. $5.46
10. $5.31
1. Calculate a five-day moving average and plot on a graph.
2. Why might a technical analyst seek to plot moving averages?
3. Recalculate the moving average using a simple weighted five-day moving average (show your calculations). What
is the purpose and advantage of using this method? (LO 7.3)
10. A technical analyst has been charting movements in a share price and notices that the trend line has been rising
for some time.
1. As the analyst, draw and label an uptrend line and a return line on the chart. Explain how this is achieved.
http://textflow.mheducation.com/parser.php?secload=9.f&fake&print
4/5
2016/3/11
IEB Wireframe
2. After a major shift in a trend line a technical analyst might expect a reversal to become apparent. One
reversal pattern is called the head and shoulders pattern. Describe the main characteristics of a head and
shoulders pattern that you would expect to become evident.
3. You know that there are at least five reasonably reliable generalisations that can be made when analysing
trend lines. Briefly identify and explain these generalisations. (LO 7.3)
Page 256
11.
1. Explain why a funds manager might employ the services of both a technical analyst and a fundamental analyst
even though each may argue that the other's approach to share price forecasting is not reliable.
2. Having regard to your understanding of the fundamentals of price movements in the share market, including
fundamental and technical analysis, identify any intangible issues that an investor might need to consider.
(LO 7.1, 7.2 and 7.3)
12. Stock-market regulators endeavour to maintain confidence in the markets by establishing regulation that ensures
efficiency, transparency and fairness for all market participants. Within this context, briefly discuss the impacts
of high frequency trading, flash trading, news analytics and dark pools. (LO 7.4)
13. The random walk hypothesis is analogous to the Brownian motion model from physics, which describes how microscopic
particles bombarded by water molecules, for example, trace a random haphazard pattern over time. Outline the main
features of the random walk model and discuss the appropriateness of the analogy between share price movements and
the random movements of physical particles. (LO 7.5)
14.
1. Briefly outline the main contentions of the efficient market hypothesis. In your answer, discuss the
contentions of the efficient market hypothesis within the context of technical analysis and fundamental
analysis.
2. How can the hypothesis be tested? In your response, distinguish between the weak, semi-strong and strong forms
of efficiency. (LO 7.5)
15. Behavioural finance has gained in popularity as an alternative to the efficient market hypothesis. With reference
to the types of decision-making behaviour that behavioural finance attempts to incorporate into its models of
investor behaviour, explore the reasons for the growing popularity of behavioural finance and prospect theory
relative to the orthodox expected utility model.
KEY TERMS
accounting ratios 231 ascending triangles 238 balance of payments current account 229 behavioural finance 245
bottom-up approach 231 breakout 240 carded rate 230 compounding interest 230 consumer price index (CPI) 229
continuation patterns 238 corporate mission 232 cumulative prospect theory 247 current account deficit 229 dark
pools 242 depreciation 230 descending triangles 238 domestic economy 227 downtrend line 237 efficient market
hypothesis 244 Elliott wave theory 240 expected utility 246 experimental economics 247 exports 227 flash
trading 242 foreign exchange risk 228 fundamental analysis 226 head 240 head and shoulders pattern 240 highfrequency trading (HFT) 241 industry sectors 226 inflation 228 interest rate risk 228 international economies 227
left shoulder 240 modern portfolio theory 232 monetary policy 229 moving-averages model (MA) 234 neckline 240 news
analytics 242 nominal rate of interest 230 pole 239 price series 234 program trading 241 prospect theory 247
random walk hypothesis 243 resistance lines 237 return line 237 right shoulder 240 semi-strong form efficiency 244
share price pattern 233 strong form efficiency 244 support lines 237 symmetrical triangles 238 systematic risk 232
technical analysis 233 top-down approach 226 unsystematic risk 232 uptrend line 237 weak form efficiency 244
http://textflow.mheducation.com/parser.php?secload=9.f&fake&print
5/5
2016/3/11
IEB Wireframe
Page 257
The corporate debt market
Chapter
Chapter
Chapter
Chapter
8 Mathematics of finance: an introduction to basic concepts and calculations
9 Short-term debt
10 Medium- to long-term debt
11 International debt markets
Page 258
Part 3
THE CORPORATE DEBT MARKET
Both business and government require a combination of short-term and medium- to long-term funds to finance their day-today operations and their capital expenditures. Most businesses finance their activities through a combination of debt
and equity sources of funds. Part 2 presented a discussion of the range of equity-funding instruments that are available
to medium-sized and larger businesses. Part 3 considers the main types of debt instruments that are issued by businesses
to raise funds. Part 4 examines government debt alternatives.
The law draws a distinction between debt and equity, in particular between the responsibilities of a corporation to its
shareholders and the responsibilities of a corporation to the holders of its debt instruments. The responsibilities of a
corporation to its debt holders are primarily contractual in nature. The duties are specific rather than general and are
typically spelled out in detail in the loan agreement or contract. For example, the debt agreement will require the
borrower to repay the debt. This may include the periodic payment of interest and repayment of the principal throughout,
or at the end of the agreed period. On the other hand, equity in the form of ordinary shares is not redeemable, nor is
there any contractual requirement for a corporation to pay a dividend to the holders of equity. The distinctions,
however, are sometimes blurred with hybrid (or quasi-equity) instruments such as preference shares and convertible notes
(discussed in Part 2).
There is clearly a cost to a corporation that issues paper (debt instruments and securities) in order to obtain debt
funding: lenders of debt will require a return on their funds. That cost is typically measured as an interest rate or
yield. The structure of the debt issue (how it is to be repaid), and the yield paid, will affect the amount of funds
lent or borrowed. Therefore, consideration of the different forms of debt available requires an understanding of the
mathematics of finance. Chapter 8 provides an introduction to these basic concepts and calculations. Factors and
theories that influence the determination and level of interest rates are discussed in Part 4 (Chapters 12 and 13).
The matching principle states that a business should fund its short-term assets with short-term liabilities, and its
longer-term assets with longer-term liabilities and equity. Market participants within the financial system provide a
range of short-term and longer-term debt instruments. Chapter 9 examines the purpose, structure and pricing of a range
of short-term debt instruments and facilities. These include trade credit, bank overdrafts, commercial bills, promissory
notes, negotiable certificates of deposit, inventory loans, accounts receivable financing and factoring.
Page 259
Longer-term funding techniques and instruments are presented in Chapter 10. As with the short-term debt instruments,
longer-term techniques include both intermediated debt finance and direct debt issues. These include term loans, fully
drawn advances, mortgage finance, debentures, unsecured notes and subordinated debt. Another financing technique
discussed is leasing. More complex forms of financing include project finance and securitisation. These are discussed in
the Extended learning sections of Chapter 3 and Chapter 10 respectively.
Part 3 concludes with an introduction to the major international debt markets. With globalisation and the integration of
nation-state financial systems with those of the rest of the world, many businesses, financial institutions and
governments now have access to significant offshore sources of funding. Two of the main international debt markets
considered in Chapter 11 are the euromarkets and the US debt markets. When a borrower seeks to raise funds, particularly
in the international markets, the borrower will need to obtain a credit rating for the proposed debt issue. The
important functions and roles of credit rating agencies are also discussed. Finally, borrowing funds within the
international debt markets will usually involve debt contracts being denominated in foreign currencies. The foreign
exchange markets are discussed in Part 5.
http://textflow.mheducation.com/parser.php?secload=10&fake&print
1/1
2016/3/11
IEB Wireframe
Page 260
Chapter 8
Mathematics of finance: an introduction to basic concepts and calculations
CHAPTER OUTLINE
8.1Simple interest
8.2Compound interest
Learning objectives
1. LO 8.1 Understand and carry out a range of simple interest calculations, including:
— simple interest accumulation
— present value with simple interest
— initial yields
— holding period yields.
2. LO 8.2 Understand and carry out important compound interest calculations, including:
— compound interest accumulation (future value)
— present value with compound interest
— present value of an annuity
— accumulated value of an annuity (future value)
— effective rates of interest.
Page 261
Introduction
When it comes to mathematics there seem to be two groups of people: those who love it and those who hate it. Either way,
in the world of finance it is not possible to avoid financial mathematics. This chapter introduces the basic concepts
that are used, and relevant calculations such as price and yields. To make the topic more interesting and perhaps easier
to understand, each form of calculation is explained through the use of examples.
The formulae to be used are represented by a set of symbols. Each symbol denotes an input to a formula. It is assumed
that at this stage of your learning you will understand how to transpose a formula—that is, how to rearrange the
symbols, or inputs, to enable the calculation of the answer to a particular question.
One problem is that different textbooks often use different symbols to represent the same input. For example, in this
text the current interest rate is represented by the symbol i, but in another text the symbols r or k may be used. Table
8.1 provides a list of the main symbols used in this chapter and generally throughout the book.
D
At times the formulae may seem a little intimidating, but Table 8.1 shows that there are relatively few symbols involved
at this point. The list of symbols will increase in later chapters as the calculations are extended further. The
formulae in this chapter form the basis of most of the calculations used in Chapters 9 and 10, when short-term and
longer-term debt instruments are considered.
Throughout this book, reference is frequently made to the cost of borrowing, return on investment, yield and the
interest rate. This chapter examines some of the mathematics associated with calculating the cost of borrowing or the
return earned on an investment. In doing so it is necessary to distinguish between the following techniques for
calculating interest charges or earnings:
http://textflow.mheducation.com/parser.php?secload=11&fake&print
1/2
2016/3/11
IEB Wireframe
simple interest calculations
compound interest calculations
nominal interest rate calculations
effective interest rate calculations.
The value of future cash flows in today's terms—that is, the present value of future cash flows—is also discussed.
Simple interest is used to calculate the prices of discount instruments in Chapters 9 and 12, such as bills of exchange,
promissory notes, Treasury notes and negotiable certificates of deposit. Compound interest is used to calculate the
instalment on a term loan or mortgage loan, plus the price of a coupon instrument such as a corporate bond, eurobond or
Treasury bond, in Chapters 10, 11 and 12 respectively.
Page 262
REFLECTION POINTS
Businesses and governments require access to both short-term debt funding and longer-term debt funding.
Debt must be repaid, but the structure of the debt instrument will affect the amount of funds raised, and the cash
flows associated with interest payments and principal repayment.
Formulae are used to calculate the interest and principal repayment cash-flow requirements; the formulae are
represented by a set of symbols; each symbol denotes an input into a formula.
Basic financial mathematical concepts of simple interest, compound interest, present values, future values,
annuities, nominal interest rates and effective interest rates form the basis of calculations associated with the
different debt instruments issued as intermediated finance by financial institutions or direct finance issued into
the money markets and capital markets.
http://textflow.mheducation.com/parser.php?secload=11&fake&print
2/2
2016/3/11
IEB Wireframe
8.1Simple interest
LEARNING OBJECTIVE 8.1
Understand and carry out a range of simple interest calculations, including simple interest accumulation, present value
with simple interest, initial yields and holding period yields
The phrase simple interest is not used to describe the calculation as being easy; rather, it is used to signify that
the calculation of interest is based only on the initial amount of funds invested or borrowed, that is, the original
principal amount. For example, if you invest some funds in a term deposit with a bank, the amount invested is the
principal. The bank will pay you a rate of return, or interest, on that investment. Let us assume that the amount is
invested for two years with simple interest payable annually. At the end of the first year the bank will calculate and
pay the interest amount direct to the depositor. The principal amount remains unchanged. At the end of the second year
the bank will make another interest payment, plus also repay the original principal amount on the maturity date. A
similar situation occurs if a company obtains an interest-only business loan from a bank and is required to make annual
interest payments on the principal amount borrowed and repay the full principal amount at the maturity date.
SIMPLE INTEREST interest paid on the original principal amount borrowed or invested
PRINCIPAL the face value amount of a loan or deposit
8.1.1Simple interest accumulation
The amount of interest to be paid on a debt, or earned on a deposit, depends on three things:
the amount involved, that is, the principal or present value (A)
the time or duration of the loan; the number of interest payments payable during the term of the loan is
represented by n (the number of interest periods)
the current nominal interest rate per period (i), where i is expressed as a decimal. For example, if the interest
rate is 5.25 per cent then i = 0.0525 (calculated 5.25/100).
The total dollar amount of interest paid or earned (I) is:
8.1
The following examples illustrate the use of Equation 8.1 in the calculation of simple interest.
EXAMPLE 8.1
If $10000 is borrowed for one year, and simple interest of 8.00 per cent per annum is charged, the total amount of
interest paid on the loan will be:
Page 263
EXAMPLE 8.2
Had the same loan been for two years, the total amount of simple interest paid would be:
EXAMPLE 8.3
If the same amount is borrowed at the same rate of interest, but for a 90-day term, the total amount of interest paid
would be:
In Example 8.3 the amount was borrowed for 90 days, which must be converted into a fraction of a year in order to apply
Equation 8.1. It is important to note that the market convention relating to the number of days in the year varies
between countries. In the UK, Australia and a number of other countries the convention is that a per-annum rate relates
to a 365-day year. However, in the USA and in the euromarkets the convention is to use a 360-day year. In this chapter
the 365-day convention is used.
http://textflow.mheducation.com/parser.php?secload=11.2&fake&print
1/5
2016/3/11
IEB Wireframe
MARKET CONVENTION a common practice that occurs within a particular financial market
In the Examples 8.1 and 8.2 we used d/365. In fact it would have been easier to use n. In Example 8.1 n would be 1
instead of 365/365, and in Example 8.2 n would be 2 instead of 730/365.
Once the amount of interest is calculated it is easy to determine the final amount payable. The amount would simply be
the sum of the principal and the interest amount. Alternatively, the final amount payable can be calculated in a single
equation. Let S stand for the accumulated amount payable, then:
8.2
For the three examples above, the accumulated amounts payable, calculated using Equation 8.2, are as follows.
EXAMPLE 8.1a
EXAMPLE 8.2a
Page 264
EXAMPLE 8.3a
The illustration in Figure 8.1 reinforces the process of accumulation under conditions of simple interest. It shows the
essential aspect of simple interest accumulation, namely, that for each interest period interest is calculated on the
original principal amount only.
Figure 8.1Simple interest accumulation
8.1.2Present value with simple interest
Section 8.1.1 considered the future or accumulated values of principal amounts of money invested or borrowed. However,
in many situations it is the reverse situation that is relevant; that is, how much is a cash flow to be received in,
say, two years' time worth today? In other words, what is the present value today of a future cash flow?
The present value may be defined as the current value of a future cash flow, or series of cash flows, discounted by the
required rate of return. The notion of present value is clear from the following two statements:
the future value of $100 in one year, with simple interest of 10.00 per cent per annum, is $110, so
the present value of $110 received in one year, with simple interest of 10.00 per cent per annum, is $100.
PRESENT VALUE the current value derived by discounting a future cash flow by a required rate of return
The present value can be thought of as the amount needed to be invested today to yield a particular value in the future.
YIELD the total rate of return on an investment; comprises investment income and capital gains (or losses)
To calculate the present value of a future amount, simply rearrange Equation 8.2 (the future value equation). That is,
rearrange:
where A (the principal or present value) is solved, given the future value S, the number of interest periods n and the
simple rate of interest i:
8.3
This states that the present value of a future amount is the future amount discounted (or mathematically divided) by the
simple interest factor. Examples 8.4 to 8.6 illustrate the use of Equation 8.3.
Page 265
EXAMPLE 8.4
http://textflow.mheducation.com/parser.php?secload=11.2&fake&print
2/5
2016/3/11
IEB Wireframe
An investor has an asset that will be worth $100000 in 120 days' time. However, the investor would like to sell the
asset today. The investor decides that, based on current market returns, the investment should be discounted at a rate
of 11.00 per cent per annum. To find out the price that the investor will sell the asset for today, we need to calculate
the present value of $100000 payable in 120 days' time at 11.00 per cent per annum simple interest.
EXAMPLE 8.5
A company discounts (sells) a commercial bill with a face value of $500000, a term to maturity of 180 days and a yield
of 8.75 per cent per annum. How much will the company receive when it sells the bill? (Commercial bills are discussed in
Chapter 9. Briefly, a bill is a debt security issued by a company to raise funds. A bill is a discount security; that
is, it is issued with a face value payable at a date in the future, but in order to raise the funds today the company
sells the bill for less than the face value. The investor who buys the bill will receive the face value at the maturity
date.)
The price of the bill will be:
Often there is more than one way to write a formula. For example, in Chapter 9 the money-market convention for the
calculation of the price of a discount security is adopted and Equation 8.3 is rewritten as:
8.4
Compare the result using this formula with that of the formula above. The next step is to apply the discount security
formula in Example 8.6, using another discount security that may be issued by government, the Treasury note (T-note).
(T-notes are issued by the government to raise short-term funds and are discussed in Chapter 12.)
Page 266
EXAMPLE 8.6
What price per $1 million of face value would a funds manager be prepared to pay to purchase 180-day T-notes if the
current yield on these instruments is 5.82 per cent per annum?
Figure 8.2 provides a pictorial presentation of the concept of present value under simple interest and the relationship
between present value and future value.
Figure 8.2Present value with simple interest
8.1.3Calculation of yields
In the examples given above the interest rate or yield on an instrument was given. However, at times the yield may not
be given and it will be necessary to calculate the yield on an investment, or the cost of borrowing. Equation 8.1 can be
rearranged to obtain the solution for the yield. Given that:
and since the yield is the relationship between the principal and the interest earned over a certain period, then:
8.5
Page 267
The following examples illustrate the use of Equation 8.5.
EXAMPLE 8.7
What is the yield (rate of return) earned on a deposit of $50000 with a maturity value of $50975 in 93 days? That is,
this investment has a principal (A) of $50000, interest (I) of $975 and an interest period (d) of 93 days.
http://textflow.mheducation.com/parser.php?secload=11.2&fake&print
3/5
2016/3/11
IEB Wireframe
EXAMPLE 8.8
Which of the following commercial bills provides the better per cent per annum return? The first bill matures in 96
days' time and is currently selling at $97.44 for each $100 of face value; the second matures in 132 days and is
currently selling at $96.85.
The yield on the first bill is:
The yield on the second bill is:
The yield on the first bill is higher.
Note: The interest earned (I) is the difference between the face value at maturity ($100) and the current price.
8.1.4Holding period yield
The odd days to maturity of the two commercial bills in Example 8.8 indicate that the bills probably had an original
maturity of 180 days and they are now being sold by investors on the secondary market prior to their maturity. This
occurs frequently with money-market securities, for a range of reasons, including:
The current investors may have bought them with the intention of investing surplus funds for a few days or weeks
only.
The intention may have been to hold the securities to maturity, but the holder's cash-flow position may have
changed such that the holder needs to sell in order to raise cash.
The securities may be sold because a better rate of return can now be obtained on an alternative investment; that
is, there is a restructuring of an asset portfolio.
SECONDARY MARKET a market that facilitates the buying and selling of existing securities
MONEY MARKET wholesale markets in which short-term securities are issued and traded
When a financial instrument such as a discount security is sold prior to the maturity date, the yield for the period
over which the instrument has been held is likely to be different from the yield that would have been obtained had it
been held to maturity. The two yields are referred to as the holding period yield (HPY) and the yield to maturity
respectively. The holding period yield is the actual return received on an investment, having regard to the cost of the
instrument, the sale price and any interest, or return, received in the interim. In the event of the holding period
being less than the period to maturity, the investor would need to calculate the holding period yield.
Page 268
HOLDING PERIOD YIELD the actual percentage per annum return received for the period an investment is held
YIELD TO MATURITY the return received on an investment held until its maturity date; expressed as a percentage of the
sum invested
The calculation of the holding period yield on a discount security is a relatively simple procedure. A discount
security, such as a commercial bill, is sold today for less than its face value, which is payable at maturity. A
discount security makes no interest payments. All that is required is the calculation of the difference between the
purchase price of the instrument and the sale price. The difference between the two values is the dollar amount earned.
This amount is then expressed in terms of a per cent per annum yield on the original purchase price. These steps are
illustrated in Example 8.9.
DISCOUNT SECURITIES short-term securities issued with a face value payable at maturity; does not pay interest; sold
today at a discount to the face value
EXAMPLE 8.9
A commercial bill with a face value of $100000 and 180 days to maturity is purchased with a yield to maturity of 7.85
per cent per annum. After the bill has been held for 50 days it is sold at a yield of 7.35 per cent per annum. What rate
of return was earned by the original holder of the bill; that is, what is the holding period yield?
First, calculate the purchase price using Equation 8.3, or alternatively Equation 8.4:
Next, calculate the sale price of the bill that is now yielding 7.35 per cent per annum and has 130 days remaining to
maturity:
The investor bought low at $96273.05 and sold high at $97448.97 after 50 days. The return earned is the difference
between the two prices; that is, $1175.92. Using the yield equation (Equation 8.5), the holding period yield is:
http://textflow.mheducation.com/parser.php?secload=11.2&fake&print
4/5
2016/3/11
IEB Wireframe
In Example 8.9 the holding period yield is higher than the yield to maturity. This is because at the sale date the
market yield had declined from the yield that prevailed at the original purchase date. As the yield declines, the price
of the instrument is affected: the lower the yield, the higher the price of the instrument. In this example the owner of
the bill has made a capital gain on the sale of the bill that increased the total yield. Had the bill been sold into a
market in which the yield was higher than the yield that prevailed at the original purchase date, a capital loss would
have been made and the holding period yield would have been less than the yield to maturity.
Page 269
REFLECTION POINTS
Simple interest calculations are based on the original principal amount; interest receipts or payments do not
affect the principal amount of a simple interest loan or investment.
The amount of interest received on an investment or paid on a loan, based on the original principal amount, is:
8.1
Therefore, the amount of simple interest plus the principal amount is:
8.2
What is an amount due at a future date worth today? The present value of a single cash flow with simple interest
is:
8.3
What is the present value of a money-market discount security? The discount security formula is:
8.4
The yield is the return on an investment or the cost of borrowing. The calculation of the yield, or the holding
period yield, on an investment is the interest earned divided by the amount invested, adjusted for the number of
days the investment is held:
8.5
http://textflow.mheducation.com/parser.php?secload=11.2&fake&print
5/5
2016/3/11
IEB Wireframe
8.2Compound interest
LEARNING OBJECTIVE 8.2
Understand and carry out important compound interest calculations, including compound interest accumulation (future
value), present value with compound interest, present value of an annuity, accumulated value of an annuity (future
value) and effective rates of interest
In the discussion in Section 8.1, the interest applied to a loan or an investment was calculated on the principal only
(simple interest). However, more commonly, interest will accumulate on the principal amount over time. For example, you
may invest an amount in a term deposit with a bank. The bank agrees to pay you monthly interest on the term deposit.
Rather than receive the monthly interest payment in cash, you may decide to reinvest the interest by allowing it to add
to the original principal. In each successive period the bank will pay interest on the increasing amount invested. This
is known as compound interest.
COMPOUND INTEREST interest is calculated on the accumulated principal amount; interest is added to the principal
8.2.1Compound interest accumulation (future value)
When an amount is borrowed or invested for only a small number of periods, it is possible to calculate the compound
interest payable by:
calculating the first interest due, using the simple interest equation (Equation 8.1)
adding that interest to the original principal
calculating the next interest due on the adjusted principal
adding that interest to the previously adjusted principal, and so on.
This process is illustrated in Example 8.10.
Page 270
EXAMPLE 8.10
A loan of $5000 is obtained for three years, at an annually compounding rate of 15 per cent per annum. The total amount
will be repayable at the maturity date. In the first year the accumulating interest is:
In the second year the interest due is calculated on the adjusted principal; that is, the first year's interest is
compounded into the principal. The second year's principal is now $5750, and so:
The compounding of interest into the principal is continued. For the third year the principal is $6612.50, and so the
interest for the third year is:
The total interest on the loan for the three years is $2604.38. The final amount payable, or the future value of the
loan (S), is equal to $7604.38.
This procedure is cumbersome, even in calculating I and S for such a small number of periods. When interest is
compounded through a larger number of periods, for example the above loan may well have had monthly rather than annual
compounding, the procedure is unacceptably time consuming. It is preferable to use equations appropriate to the
compounding process.
The general form of the compounding interest formula is:
8.6
where:
S = the accumulated amount or future value
A = the present value
i = the current nominal interest rate expressed as a
http://textflow.mheducation.com/parser.php?secload=11.3&fake&print
1/8
2016/3/11
IEB Wireframe
decimal
n = the number of compounding interest periods
This equation is now used to calculate S for the loan described in Example 8.10, where A = $5000, i = 0.15 and n = 3:
This demonstration using a very simple example shows the advantage of using Example 8.6 rather than the repeated
application of the simple interest calculations.
On many investments and loans it is often the case that interest will accumulate more frequently than once a year. For
example, interest could accumulate daily, monthly, quarterly or half-yearly. It is necessary to recognise the effect of
the compounding frequency on the inputs i and n in Equation 8.6. For example, if interest had accumulated monthly on the
above loan, then it is necessary to divide the annual interest rate by 12 to obtain the monthly rate, and to multiply
the monthly interest period by 3 years to obtain the total number of interest periods:
then
Page 271
The investment that has interest accumulating quarterly achieves a higher return than the investment where interest
accumulates only half-yearly. In Example 8.11a the total amount was $12837.65, whereas in Example 8.11b the total amount
was $12750.78. This can be explained by understanding the effect of compounding; that is, the investment is earning
interest on its accumulated interest. The more frequently the interest accumulates, the greater the amount earned.
EXAMPLE 8.11a
A term deposit of $8000 is made for four years and will earn 12.00 per cent per annum, with the interest compounding
quarterly.
The interest paid at each interest date is 12.00 per cent per annum, but since it is paid four times per year the
interest paid per quarter (i) is 12/4 = 3%, or 0.03.
Similarly, n represents the number of interest periods, or principal conversion periods. In this example, n = 4 periods
× 4 years = 16. Thus:
Then:
EXAMPLE 8.11b
The effect of compounding can be further understood by considering a similar deposit of $8000 paying 12.00 per cent per
annum, but where interest accumulates half-yearly for four years:
so:
Page 272
http://textflow.mheducation.com/parser.php?secload=11.3&fake&print
2/8
2016/3/11
IEB Wireframe
Figure 8.3 illustrates the nature of the compounding process. In both parts of the figure, the interest due from each
interest period is compounded into the principal at period end. It then becomes part of the principal upon which the
next period's interest is calculated. In part (b), the more frequent compounding results in a larger accumulated value.
Figure 8.3Compound interest accumulation
8.2.2Present value with compound interest
In the discussion of present values with simple interest, we noted that the calculation of the present value of a future
amount involves the division of the future value by the discount interest factor. Exactly the same procedure applies in
the case of compound interest. Equation 8.6 shows that the future value is the present value (A) multiplied by the
interest factor (1+i)n. The present value of a future amount then becomes the future value divided by the same interest
factor, which, in the case of calculating present values, might be better referred to as the discount factor. This is
expressed as:
8.7a
Another way of expressing this relationship is:
8.7b
8.2.3Present value of an annuity
The calculations in the previous examples relate to the present value of a single future amount; however, it is common
for many financial arrangements to comprise a series of future cash flows over time. Where a series of periodic cash
flows occurs, this is known as an annuity. If the annuity periodic cash flows occur at the end of each period, this is
known as an ordinary annuity. If the cash flows occur at the beginning of each period, this is known as an annuity
due.
Page 273
ANNUITY a series of cash flows of equal amount, equally spaced over time
ORDINARY ANNUITY periodic cash flows that occur at the end of each period
ANNUITY DUE periodic cash flows that occur at the beginning of each period
EXAMPLE 8.12
What is the present value of $18500 due to be paid at the end of three years, if current interest rates are 7.25 per
cent per annum, compounded annually? Using Equation 8.7a:
where:
therefore:
That is, the holder of the entitlement to receive $18500 in three years' time could sell that entitlement to someone
else today for $14996.15, assuming a discount factor of 7.25 per cent per annum.
EXAMPLE 8.13
You have been offered a job that will pay a lump-sum bonus of $25 000 at the end of the seven-year contract. In
assessing the offer, you wish to know the value of the bonus in today's dollar terms. You decide that 10.00 per cent per
annum compounded monthly is an appropriate discount factor. Calculate the present value:
where:
therefore:
http://textflow.mheducation.com/parser.php?secload=11.3&fake&print
3/8
2016/3/11
IEB Wireframe
Page 274
For example, a business may obtain a loan where loan repayments are payable at the end of each month; this is an
ordinary annuity. In another situation, this is an individual may be required to pay an insurance policy premium at the
start of each year; this is an annuity due.
Therefore, an annuity is any financial contract where a series of equal cash flows occur. Figure 8.4 shows a situation
where an annuity of $100 is paid annually for three years using a discount factor of 12.00 per cent per annum.
Figure 8.4Present value of an annuity
As shown in Figure 8.4, the present value of an annuity stream may be calculated by applying Equation 8.7a or Equation
8.7b to each of the individual cash flows and then adding the present values to obtain the present value of the total
annuity flow. This procedure would be slow even for the three-payment annuity illustrated in Figure 8.4, which requires
only three separate present value calculations. Using this method to price a longer-term annuity with, say, half-yearly
payments and perhaps 10 years to maturity would be extremely cumbersome: 20 payments would have to be converted into
present value terms. Fortunately, there is a single equation that can be applied to calculate the present value of an
annuity of any number of payments. Equation 8.8 is:
8.8
where:
A = the present value
C = the annuity payments (regular cash flows)
current nominal interest rate, per period, expressed as a
i =
decimal
n = number of periods
Therefore, using Equation 8.8, the present value of the annuity in Figure 8.4 is:
The following examples illustrate the use of Equation 8.8.
Page 275
EXAMPLE 8.14
The present value of an annuity of $200, received at the end of each quarter for 10 years, where the required rate of
return is 6.00 per cent per annum, compounded quarterly, would be:
therefore:
The calculations above have been for an ordinary annuity, that is, one in which the cash flows occur at the end of a
period. If the cash flows occur at the beginning of the period, this is known as an annuity due. To calculate the value
of an annuity due, it is necessary only to recognise that the interest effect occurs earlier; that is, the start of the
interest period is brought forward to the beginning of the period. Therefore all that is needed is to multiply the
http://textflow.mheducation.com/parser.php?secload=11.3&fake&print
4/8
2016/3/11
IEB Wireframe
ordinary annuity formula by (1+i). This is shown in Equation 8.9.
8.9
The effect of the annuity due can be observed by changing the cash flows from Example 8.14 so that they occur at the
beginning of each period.
The higher present value of $6072.92 in Example 8.15 recognises the benefit of the earlier receipt of the periodic cash
flows at the beginning of each quarter.
EXAMPLE 8.15
The present value of an annuity of $200, received at the beginning of each quarter for 10 years, where the required rate
of return is 6.00 per cent per annum compounded quarterly, would be:
therefore:
Page 276
A number of long-term financial instruments issued into the capital markets incorporate a series of interest payments
over time (an annuity) plus the repayment of the principal at the maturity date. An example of this type of financial
instrument is a bond. Bonds are often issued by corporations and governments to borrow long-term funds direct from the
capital markets. Typically, a straight bond will pay a fixed-interest coupon for the term of the bond, with the
principal only repayable at the maturity date. Securities of these types can be sold in the secondary markets, and
therefore the value of the bond must be determined by calculating the present value of the future cash-flow
entitlements.
With a bond, there are two sets of cash flows, and therefore it is necessary to calculate the present value of each. The
first is the present value of the annuity (being the periodic interest coupon payments) and the second is the present
value of the principal (a single cash flow repaid at the maturity date). Bonds and their calculations are discussed in
detail in Chapters 10 and 11, but an example is given here.
In Example 8.16 below, we need to calculate the price today of an existing corporate bond that pays a fixed coupon rate
of 12.00 per cent per annum compounding half-yearly and maturing in five years. Current yields in the market are 9.00
per cent per annum. (Note: i in the formula is based on the current yield, being 9.00 per cent per annum adjusted to
half-yearly = 0.045.