CHAPTER 4
INTERMEDIATE AND FOREIGN DEBT SECURITIES
4.1 INTRODUCTION
The intermediary financial market consists of commercial banks, savings and loans, insurance
companies, mutual funds, and other financial institutions and intermediaries. These intermediaries
sell financial claims to investors, then use the proceeds to purchase debt and equity claims issued by
ultimate deficit units or to create debt claims (loans). Commercial banks, for example, obtain funds
from investors by providing demand deposits and money market accounts (individual time
deposits), selling certificates of deposit, and borrowing from other banks. They, in turn, use their
funds to satisfy legal reserve requirements, to make loans, and to purchase financial securities.
Savings and loans and savings banks function very similarly to commercial banks, except that their
use of funds is directed more towards the creation of mortgage loans. Finally, life insurance
companies, pensions, trust funds, retirement funds, and mutual funds offer financial instruments in
the form of insurance policies, retirement plans, and shares in stock or bond portfolios. The
proceeds from their premiums, savings plans, and fund shares are used by these institutions to buy
stocks, corporate bonds, Treasury securities and other debt instruments, as well as provide
corporate, residential, and commercial mortgage loans.
In general, financial institutions, by acting as intermediaries, control a large amount of funds
and thus have a significant impact on the security markets. For investors there are a number of
securities created through this intermediary process that they can consider for their short-terms and
long-term investment portfolios, including negotiable certificates of deposit, bankers acceptances,
mortgage-backed instruments, and mutual fund shares. In this market we examine the market for
intermediate securities
In addition to intermediate securities, the other type of major group of debt securities are
foreign bonds. As noted in Chapter 1, international investment has been growing throughout the
world. Over the last twenty years, many multinational corporations and governments have
increased the sales of their securities in external markets to raise funds to finance their global
operations. Many have also listed their securities on foreign security exchanges to provide their
investors with liquidity. Similarly, many investors have found diversification benefits by including
foreign stocks and bonds in their portfolios. In addition to intermediate securities, in this chapter
we also examine the characteristics and markets for foreign debt securities.
4.2 NEGOTIABLE CERTIFICATES OF DEPOSIT
4.2.1 Characteristics
Negotiable certificates of deposit (CDs) are one of the most popular money market instruments.
They are interest-bearing notes, usually sold at their face value, with the principal and interest paid
at maturity if the CD is less than one year. (Banks, savings and loans, and other deposit-type
institutions also offer a number of non-negotiable certificates of deposit.) The maturities on
negotiable CDs range from three to 18 months, although most have maturities of six months or less.
The minimum denomination on CDs is typically $100,000, with the average denomination being
1
$1 million. CDs, like other bank and savings and loan deposits, are insured up to $100,000 against
default by the Federal Deposit Insurance Corporation (FDIC). Most negotiable CDs, though, have
denominations exceeding $100,000 and are therefore subject to default risk. Large investors,
though, can avoid such risk by investing in brokered deposits which spread the investment across a
number of CDs, each with denomination of $100,000 or less. The yields on CDs with large
denominations tend to exceed the rates on Treasury and federal agency instruments. Also, the
yields for the CDs of larger (supposedly more secured) banks (called prime CDs) tend to be lower
than those of smaller banks (called nonprime CDs). Finally, the rates banks pay on CDs are often
quoted on a 360-day basis, instead of 365 days. Thus, an investor buying a $1 million CD,
maturing in 180 days and paying a 6% interest, would receive $1,030,000 from the bank at
maturity:
180 IO
L
F
G
M
KP
N H360J
Q $1,300,000.
Cash Flow at Maturity  $1,000,000 1  .06
Quotes of CDs trading in the secondary market, in turn, are made in terms of the bank's discount
rate:
Bank Discount Rate 
F
G
H
IJ
K
Face Value  Purchase Pr ice
360
.
Face Value
Days to Maturity
Thus, if the 6% CD were trading in the secondary market, its rate would be quoted at 5.8%:
Bank Discount Rate 
F
IJ .058.
G
HK
$1,030,000  $1,000,000 360
$1,030,000
180
4.2.2 Markets
Today the primary and secondary markets for CDs are handled by approximately 25 dealers and
brokers who sell new CDs and trade and maintain inventories in existing ones. The major investors
in negotiable CDs are corporations, state and local governments, financial institutions, foreign
governments, and foreign central banks. While many of these investors hold their CDs until
maturity, there does exist an active secondary market for these instruments. In fact, it was the
creation of the secondary market for CDs in 1961 which made CDs popular. (See Exhibit 4.2-1 for
a brief history of the secondary market for CDs.)
2
The growth of the CD market over the last two decades has been accompanied by innovations.
In the 1980s, a longer-term variable rate CD (VRCD) was introduced. The VRCD can carry a
maturity of up to five years, with the coupon rates adjusted every 30, 60, 90, or 180 days to equal
the rate on a comparable CD rate. Other CDs with unique features that have been introduced over
the years are ones with rates tied to the stock market (bear and bull CDs), longer-term CDs with
gradually increasing rates (Rising-Rates CDs), contracts to buy CDs now and in the future
(Forward CDs and Rollover or Roly-Poly CDs), large denomination, negotiable CDs sold by
savings and loans and other thrift institutions (Jumbo CDs), and dollar-denominated CDs sold in
the U.S. by foreign banks (Yankee CDs). Of all the different types of CDs, though, one of the most
popular is the Eurodollar CD sold in the Eurocurrency market.
4.2.3 Eurocurrency Market and CDs
The Eurocurrency market is a market in which funds are intermediated (deposited or loaned)
outside the country of the currency in which the funds are denominated. For example, a certificate
of deposit denominated in dollars offered by a U.S. bank located or incorporated in Japan,
Bahamas, Europe, or any place other than the U.S. would be a Eurodollar CD. Similarly, a loan
made in yens from a bank located in the U.S. would be an American-yen loan. In both cases, the
Eurodollar deposit and the American-yen loan represent intermediation occurring in the
Eurocurrency market. Even though the intermediation occurs in many cases outside Europe, the
Euro prefix usually remains. An exception is the Asian dollar CD. This is a CD offered by U.S.,
Japanese, and other banks operating in Singapore. (For a brief history of the Eurocurrency market
see Exhibit 4.2-2.)
Today the Eurocurrency market is thought to be second only to the U.S. security market in
terms of size.1 The underlying reason for this is that Eurocurrency loan and deposit rates are often
better than the rates on similar domestic loans and deposits because of the differences that exist in
banking and security laws among countries. That is, foreign lending or borrowing, regardless of
what currency it is denominated in and what country the lender or borrower is from, is subject to the
rules, laws, and customs of the foreign government in the country where deposits or loans are made.
Thus, a U.S. bank offering time deposits through its foreign subsidiary located in the Bahamas
(maybe in the form of a P.O. box) would be subject to the Bahamian laws with respect to reserve
requirements, taxes on deposits, anonymity of the depositor, and the like. Accordingly, if a
country's banking laws are less restrictive, then it is possible for a foreign bank or a foreign
subsidiary of a U.S. bank to offer more favorable rates on its loans and deposits than it could in its
own country by simply intermediating the deposits and loans in that country. Thus, the absence of
reserve requirements or regulations on rates paid on deposits in the Bahamas, for example, makes it
possible for the rates on Bahamian Eurodollar loans to be lower than U.S. bank loans and the rates
on their deposits to be higher.2
1
The actual size of the market is difficult to determine because of the lack of regulation and
disclosure. By most accounts, it is one of the largest financial markets.
2
For example, if the U.S.'s reserve requirement was 10% on time deposits for a certain size
bank, while no requirements existed in the Bahamas, then a U.S. bank, by accepting a domestic
deposit, could only loan out 90% of the deposit, earning 90% of the loan rate, in contrast to a
3
Currently, the Eurocurrency market consists of hundreds of banks, corporations, and
governments. Commercial banks, of course, are the foundation of the market, offering various
types of loans and deposits. Governments and companies use the market to deposit currencies, as
well as obtain loans to finance assets, infrastructures, and even balance of payment deficits.
For large investors the market offers two types of instruments: primary deposits and
Eurocurrency CDs. Primary deposits are time deposits with negotiated rates and short-term
maturities. These deposits, in turn, represent part of the Eurocurrency's interbank deposit network.3
Eurocurrency CDs are denominated in currencies outside the currency's country. A Eurodollar CD,
for example, is a bank CD of a foreign bank or foreign subsidiary of a U.S. bank, denominated in
dollars. The maturities on Eurocurrency CDs range from one day to several years, with the most
common maturities being 1, 3, 6 and 12 months. The rates on the CDs are usually negotiated
between the investor/depositor and the bank and they can be either fixed or variable. The rates
frequently are quoted relative to the London Interbank Offer Rate (LIBOR). For example: LIBOR
+ 1%. The LIBOR is the average rate at which London banks lend dollars among themselves.4
Eurocurrency CDs can take the form of Tap CDs, which are CDs issued in single amounts ($1 to $5
Bahamian deposit in which 100% of the deposit could be loaned out to earn the full amount of the
loan rate. Moreover, in a competitive market for deposits and loans, the rates on the Bahamian
loans and deposits could be made even more favorable, and probably would have to be, since with
all other things equal a depositor or borrower would prefer his own country.
3
To see how these deposits are created, consider the case of the ABC Company of Cincinnati
which wants to invest $2 million excess balance for 30 days in the Nassau branch of First Bank of
Cincinnati. To initiate this, the treasurer of ABC would call First Bank's Eurocurrency trader in
Cincinnati to get a quote on its Nassau bank's 30-day deposit rate. (Note, the Nassau branch of First
bank is likely to be staffed in Cincinnati, with its physical presence in Nassau being nothing more
than the Nassau incorporation papers and other documents in a lawyer's office; in fact, even the
books can be maintained in the U.S). The treasurer would give ABC a quote based on similar
Eurocurrency rates. If acceptable, a 30-day Eurocurrency deposit would be created, with ABC
transferring its cash account to First Bank, who would set up the Nassau account by recording it in
its Nassau books in Cincinnati. Now unless the bank has an immediate need for the $2 million, its
treasurer would invest the funds through the interbank market. This might involve phoning First
Bank's London branch and selling the deposit at a discount (e.g., 1/32 of 1%) or it might involve
calling an international money broker in New York or London. The broker, in turn, would provide
information and make arrangements. The information could be in the form of bid and offer quotes
on other Eurodollar deposits (or maybe the rate on a Euromark deposit with a quote on the forward
rate on marks in order to hedge). In this case, suppose a London broker was arranging a 30-day,
$10 million loan to a Japanese company to finance its inventory of computer equipment purchased
in New York. Informed of this by First Bank's broker, this London broker in packaging the $10
million loan, in turn, might accept at a discount the $2 million Eurodollar deposit. If so, then the
deposit would be transferred with the confirmation mailed and delivered two days later; at this point
the transfer would be completed.
4
Asian dollar CDs are quoted in terms of the Singapore Interbank Offer Rate (SIBOR). As
noted, rates on Eurodollar CDs are typically higher than the rates on comparable domestic CDs.
4
million) in order to finance a specific Eurodollar loan. Also there exist the Tranche CDs, which
are of a smaller denomination ($10,000), often offered to the public through a broker or an
underwriter.
4.3 BANKERS ACCEPTANCES
Bankers Acceptances (BAs) are time drafts, similar to post-dated checks, that are drawn on a bank,
usually by an exporter, and are guaranteed by the bank. The guarantee of the bank improves the
credit quality of the draft, making the securities marketable.
To see how BAs originate, consider the case of a small oil refinery which wants to import
crude oil from a new source in the Middle East. Suppose, though, that the oil exporter is not
willing to extend credit or is unwilling in this case because of his inability to assess the credit
worthiness of the company. However, suppose the exporter (or his bank) is willing to extend credit
for 90 days if the oil importer can guarantee payment. The oil importer might obtain such a
guarantee from his local bank with a BA. To do this, the company would go to his bank to secure a
line of credit to buy the oil. Once the credit is approved the oil importer's bank would issue a time
draft to the exporter (or possibly the exporter's bank), ordering the bank to pay the oil exporter the
amount due in 90 days. At this point the importer's bank is only obligated to honor the check if the
oil company has deposited funds in its account. However, if the company qualifies, then, for a fee
(plus sometimes collateral, such as the exported goods, the bank will stamp accepted across the
check's face, which obligates the bank to pay the draft when it comes due, whether the company has
deposited sufficient funds or not. At this point the importer has a guaranteed post-dated check -- a
bankers acceptance. If this is done, the oil importer or his bank would then mail the check to the
exporter (or his bank) and receive the oil. Since the post-dated check is guaranteed, the exporter
could sell the instrument at a discount, usually to his bank who can sell it in a secondary market.
Thus, the guarantee adds marketability. If all goes well, on the due date the oil importer will
deposit the funds and whoever is holding the BA on the due date will present it to the importer's
bank to be paid.
BAs are traded as pure discount bonds, with the face value equal to the payment order and the
maturity between 30 and 270 days; they are considered prime-quality instruments. The secondary
market trading of BAs takes place principally among banks and dealers. There are approximately
20 dealers who facilitate the secondary market. BAs are purchased primarily by banks,
corporations, money market funds, insurance companies, and local governments. The Federal
Reserve also buys and sells BAs as part of their open market operations, and commercial banks use
BAs as collateral for federal reserve loans. The market for BAs has existed for over 70 years in the
U.S.. Like CDs, this market grew steadily in the 60s and 70s, from $76 billion to $80 billion
between 1970 to 1985. It has declined marginally since 1985. The size and growth of the market is
correlated with the size and growth of world trade.
4.4 MORTGAGE-BACKED AND ASSET-BACKED SECURITIES
Up until the mid seventies most mortgages originated when saving and loans, commercial banks,
and thrift institutions borrowed funds or used their deposits to provide loans to home purchasers,
5
possibly later selling the resulting instruments in the secondary market to the Federal National
Mortgage Association (FNMA) or the Government National Mortgage Association (GNMA). To a
larger degree, real estate until then was financed by individual deposits, with little financing coming
from corporations or institutions. In an effort to attract institutional funds away from corporate
bonds and other capital market securities, as well as to minimize the poor hedge (short-term deposit
liabilities and long-term mortgage assets), financial institutions began to sell mortgage-backed
securities in the 1970s. These securities provided them with an instrument which could compete
more closely with corporate bonds for inclusion in the portfolios of institutional investors, and it
provided the mortgage industry with more liquidity.
By definition, mortgage-backed securities (MBS) are instruments which are backed by a pool
of mortgage loans. Typically, a financial institution, agency, or mortgage banker buys a pool of
mortgages of a certain type from mortgage originators (e.g., FHA-insured mortgages or mortgages
with a certain minimum loan-to-value ratio or a specified payment-to-income ratios). This
mortgage portfolio is financed through the sale of the MBS, which has a claim on the portfolio.
The mortgage originators usually agree to continue to service the loans, passing the payments on to
the mortgage-backed security holders. A MBS investor has a claim on the cash flows from the
mortgage portfolio. This includes interest on the mortgages, scheduled payment of principal, and
any prepaid principal. Since many mortgages are prepaid early as homeowners sell their homes or
refinance their current mortgages, the cash flows from a portfolio of mortgages, and therefore the
return on MBS, can be quite uncertain. To address this type of risk, a number of derivative MBS
were created in the 1980s. For example, in the late 1980s Freddie Mac introduced the
collateralized mortgage obligations (CMOs). These securities had different maturity claims and
different levels of prepayment risk.
A MBS is an asset-backed security created through a method known as securitization.
Securitization is a process of transforming illiquid financial assets into marketable capital market
instruments. Today, it is applied to not only mortgages but also home equity loans, automobile
loans, lines of credit, credit care receivables, and leases. Securitization is one of the most
important financial innovations introduced in the last two decades; it is examined in detail in
Chapter 11.
4.5 INVESTMENT COMPANY INSTRUMENTS
For many investors, an attractive alternative to directly buying stocks and bonds is to buy a share in
a mutual fund constructed by an investment company with such securities or to have one's
investment funds managed by an investment company, pension, or trust. The investment
companies who construct and manage such funds represent financial intermediaries. These
companies receive money from investors which they use to purchase stocks and bonds; the
investors, in turn, receive claims on the earnings of the funds.
For investors, purchasing shares in a fund or investing through an investment company has
several advantages over directly purchasing securities. First, investment funds provide divisibility.
Recall, in Chapter 1 we defined divisibility as the smallest denomination of an asset. An
investment company, by offering shares in a portfolio of high-denomination CDs makes it possible
for small investors to obtain a higher rate than she could obtain by investing in a lower yields
6
smaller-denomination CD. Second, an investment in a portfolio fund often provides an investor
more liquidity than forming his own portfolio; that is, it is easier for an individual investor to buy
and sell a share in an investment fund than it is to try to buy and sell a number of stocks. Third,
investment companies provide professional management. They have a team of security analysts
and managers who know the markets and the securities available. They buy and sell securities for
the fund, reinvest dividends and interest, and maintain records. Finally, since investment
companies often buy large blocks of securities, they can obtain lower brokerage fees and
commission costs for their investors.
4.5.1. The Market for Investment Company Securities
From the end of World War II to the late 1960s, investments in funds grew substantially, boasting
as many as 40 million investors in the 1960s. Most of the investment funds consisted of stock, with
their popularity attributed primarily to the general rise in stock prices during that period. In the
1970s, investments in funds declined as stock prices fell due to rising energy prices, inflation, and
recession. In the mid-1980s and in the 1990s, though, the popularity of fund investments
rebounded. This recent growth can be attributed to not only the strong bull markets during this
period, but also to financial innovations. In addition to the traditional stock funds, investment
companies today offer shares in bond funds (municipal bonds, corporate, junk bonds, foreign
bonds, etc.), money market funds (consisting of CDs, CP, Treasury securities, etc.), index funds
(funds whose values are highly correlated with a stock or bond index), funds with options and
futures, global funds (funds with stocks and bonds from different countries), and vulture funds
(funds consisting of securities of companies which are in financial trouble).
4.5.2 Types of Funds
There are three types of investment funds: open-end funds (also called mutual funds), closed-end
funds, and unit investment trusts. The first two can be defined as managed funds, while the third
is an unmanaged one.
Open-End Fund
Open-end funds (mutual funds) stand ready to buy back shares of the fund at any time the fund's
shareholders want to sell, and they stand ready to sell new shares any time an investor wants to buy
into the fund. With an open-end fund the number of shares can change frequently. The price
investors pay for shares of an open-end fund is equal to the fund's net asset values (NAV). At a
given point in time, the NAV of the fund is equal to the difference between the value of the fund's
assets (VAt) and its liabilities (VLt) divided by the number of shares outstanding (Nt):
(4.4  1)
NAVt 
7
Vt A  Vt L
.
Nt
Thus, a fund with a stock and bond portfolio currently worth $208 million and liabilities equal to $8
million, and with 4 million shares outstanding, would have a current NAV of $50 per share: NAV =
($208M-$8M)/4M = $50. This value is subject to change if the number of shares, the asset values,
or the liability values change.
Open-end funds can be classified as either load funds or no-load funds. Load funds are sold
through brokers or other intermediators (e.g., insurance brokers); as such, the shares in no- load
funds sell at their NAV plus a commission. The load charges range from 3.5%, for funds which are
referred to as low-load funds, to 8.5%. The fees are usually charged up-front when investors buy
new shares. Some funds charge a redemption fee (also called an exit fee or back-end load) when
investors sell their shares back to the fund at their NAV. No-load funds, on the other hand, are sold
directly by the fund and therefore sell at just their NAV. Many of these funds are advertised in the
financial sections of papers, often with a toll-free number investors can call for information.
Closed-End Fund
Closed-end funds do not stand ready to buy existing shares or sell new shares. Thus, the number of
shares of a closed-end fund is fixed.5 Investors who want to buy shares in an existing closed-end
fund can do so only by buying them in the secondary market from an existing holder. Like stock,
shares in existing funds are traded on both the organized exchanges and the OTC market.
Interestingly, the prices of many closed-end funds often sell at a discount from their NAVs.
Unit Investment Trust
Although the composition of open- and closed-end fund investments can change as managers buy
and sell securities, the funds themselves usually have unlimited lives. In contrast, a unit investment
trust has a specified number of fixed-income securities which are rarely changed, and the fund
usually has a fixed life. A unit investment trust is formed by a sponsor (investment company) who
buys a specified number of securities, deposits them with a trustee (e.g., bank) and then sells claims
on the security, known as redeemable trust certificates, at their NAV plus a commission fee.
These trust certificates entitle the holder to proportional shares in the income from the deposited
securities. For example, an investment company might purchase $20 million worth of Treasury
bonds, place them in a trust, and then issue 20,000 redeemable trust certificates at $1,025 per share:
NAV + Commission = ($20 million/2,000) + $25 = $1,025. If the investment company can sell all
of the shares, it will be able to finance the $20 million bond purchase and earn a 2.5% commission
of $500,000.
Most unit investment trusts are formed with fixed-income securities: government securities,
corporate bonds, municipal bonds, and preferred stock. The trustee pays all the interest and
principal generated from the bonds to the certificate holders. Unlike open- and closed-end funds,
5
While it is generally true that the number of shares of a closed fund are fixed, such funds
occasionally issue new shares either through a public offering or through a share dividend, which is
sometimes offered to shareholders who are given an option of receiving either cash or new shares
based on the NAV of the fund if the dividend or interest income is reinvested. Also, some funds
occasionally go into the market and purchase their own shares.
8
when the securities in the pool mature the investment trust ceases. Depending on the types of
bonds, the maturity on a unit investment trust can vary from six months to 20 years. The holders of
the securities, though, usually can sell their shares back to the trustee prior to maturity at their NAV
plus a load. To finance the purchase of the certificate, the trustee often sells a requisite amount of
securities making up the trust.
4.5.3 Investment Company Policies
The general investment policies of open- and closed-end investment companies are determined by
a board of directors elected by the fund's shareholders. The actual implementation and
management of the policies, though, are done by a management or investment advisory firm, often
those who originally set up the funds. Some funds are actively managed, with fund managers
aggressively buying stocks and bonds, while others follow a more passive buy and hold investment
strategy, sometimes forming an option fund comprising stocks with option and futures contracts in
order to hedge the value of the stock portfolio.
One way of grouping many stock and bond funds is according to the classifications defined by
Weisenberger's Annual Investment Companies Manual for growth funds, income funds, and
balanced funds. Growth funds are those whose primary goal is in long-term capital gains. Such
funds tend to consist primarily of those common stocks offering growth potential. Many of these
are diversified stock funds, although there are some who specialize in certain sectors. Income
funds are those whose primary goal is providing income. These funds are made up mainly of
stocks paying relatively high dividends or bonds with high coupon yields. They include bond
funds, money market funds, and option funds. Finally, balanced funds are those with goals
somewhere between those of growth and income funds. Balance funds are constructed with bonds,
common stocks, and preferred stocks that are expected to generate moderate income with the
potential for some capital gains.
A second way of classifying funds is in terms of their specialization. Money-market funds, for
example, provide investors with a liquid investment in which they can invest or remove funds at
almost any time. Many of these funds even allow the investor to write checks on their accounts by
making arrangements with banks for redeeming shares and clearing checks. A municipal bond
fund specializes in providing investors with tax-exempt municipal securities. Some of these funds
are formed with municipal securities from the same state, enabling the fund investor to avoid
paying not only federal tax but also state taxes. Finally, there are index funds. These are welldiversified stock funds which are highly correlated with a specific index. They are designed to
provide investors with performances similar to a stock index such as the Standard and Poor's 500
and or a bond index such as the Shearson-Lehman inde.x. Other funds include those specializing in
specific sectors, metals, or commodities, option funds, global funds, and vulture funds.
It should be noted that there are a number of investment companies, such as Fidelity and
Vanguard, which manage a family of mutual funds. From this family these companies are able to
offer investors different funds based on the investor's risk-return preferences. Most of these are
open-end funds with different investment policies or specialization.
4.5.4 Accumulation Plans
Typically most fund investors buy shares and receive cash from the fund when it is distributed. For
9
investors looking for different cash flow patterns, mutual funds also provide voluntary and
contractual accumulation plans with different types of contributions and withdrawal plans.
Included here are automatic reinvestment plans in which the net income and capital gains of the
funds are reinvested, with the shareholders accumulating additional shares, and fixed contribution
plans in which investors contribute (either contractually or voluntarily) a fixed amount on a regular
basis for a set period (e.g., monthly for 5 years).
4.5.5. Taxes
Most mutual funds make two types of payments to their shareholders: a net income payment from
dividends and interest and a realized capital gain payment. If an investment fund complies with
certain rules, it does not have to pay corporate income taxes. To qualify for this favorable tax
treatment, the company must have a diversified portfolio and it must pay out at least 90% of the
fund's net income to shareholders. As a result, most investment companies distribute all of the net
income from the fund to their shareholders. Investment companies can either distribute or retain
their realized capital gains. Most investment companies distribute capital gains. If they retain the
gain, they are required to pay a tax equal to the maximum personal income tax rate; the
shareholders, in turn, receive a credit for the taxes paid.
4.5.6 Information on Investment Funds
Information on many open- and closed-end funds is provided daily in the WSJ. Exhibit 4.5.1
shows a partial listing of the NAVs, offer prices, and net changes of several mutual funds. The
quotations are grouped by management companies (shown in bold) with the company's family of
funds listed below. Each fund's NAV is based on the closing prices of the fund's securities on that
day. The offer price is equal to the NAV plus the load change. If the fund is a no-load, the letters
NL appear instead. The net change is the percentage difference in the fund's NAV from the
previous day's close.
Exhibit 4.5.2 shows a partial listing of the NAV and prices of closed-end funds from the WSJ.
The Journal publishes the prices of funds daily; the fund's NAV is published only on Monday. The
Monday listing shown in this exhibit indicates the exchange where the fund is listed, the fund's
NAV, the Friday closing price (or the dealer's last quoted price if there is no trade on Friday), and
the percentage difference between the fund's stock price and its NAV. As shown in the exhibit,
many of the fund's percentage differences are negative, indicating that their prices are less than their
NAVs; a feature which we noted earlier was common to many closed-end funds.
In addition to daily information from the WSJ, other information on investment companies can
be found in Weisenberger's Survey of Investment Companies, the Mutual Fund Fact Book, and
Vickers Guide to Investment Company Portfolios (see Exhibit 4.5-3).
4.6 OTHER INTERMEDIARY INSTRUMENTS
In addition to investment company shares, there are a number of other intermediate instruments
available to investors. These include Real Estate Investment Trusts, pension funds, annuities, and
commingled funds.
10
4.6.1 Real Estate Investment Trust
A Real Estate Investment Trust (REIT) is a fund which specializes in investing in real estate or
real estate mortgages. The trust acts as an intermediary, selling stocks and warrants and issuing
debt instruments (bonds, commercial paper, or loans from banks), then using the funds to invest in
commercial and residential mortgage loans and other real estate securities. REITs can take the form
of an equity trust which invests directly in real estate, a mortgage trust which invests in mortgage
loans, or a hybrid trust which invests in both. REITs are tax-exempt corporations, often formed by
banks, insurance companies, and investment companies. To qualify for tax exemptions, the
company must receive approximately 75% of its income from real estate, rents, mortgage interest,
and property sales, and distribute 95% of its income to its shareholders. The stocks of many
existing shares in REITs are listed on the major exchanges and the OTC market.
Most REITs are highly leveraged, with 70% of their total assets financed through debt. This
makes them subject to default risks, especially during periods of economic recession. This was
particularly evident during the 1970s when economic slowdowns and higher interest rates led to the
bankruptcy of a number of REITS.
4.6.2 Pension Funds
Pension funds are financial intermediaries which invest the savings of employees in stocks, bonds,
and other assets, providing them with a large pool of funds at their retirements. Pension funds are
one of the fastest growing intermediaries in the United States. As shown in Exhibit 4.5-4, the total
assets of pension funds (private and government) have grown from $700 billion in 1980 to
approximately $3 trillion in 1990. Part of this growth reflects a work force of baby boomers
making contributions to their pensions. As this generation enters retirement during the next century
and begins to draw from its investments, there is expected to be a marked decline in such growth.
To pension contributors/members, pension funds represent long-term investments through
intermediaries. The investments of a pension fund depends on whether it is government controlled
or private. Private funds tend to invest more in stock than state and local funds, state and local
funds tend to invest more in corporate bonds, federal agency securities, and Treasury securities,
than do private funds.
Both interest and dividend income and capital gains of pension funds are exempt from federal
taxes. Pension members are not taxed on their contributions, but they do pay taxes on benefits
when they are paid out. Private funds are governed by the 1974 Employee Retirement Income
Security ACT (ERISA). ERISA requires prudent management of the fund's investments and
requires that all private plans be fully funded: assets and income cover all promised benefits. In
1974, Congress also created the Pension Benefit Guaranty Corporation (PBGC or Penny Benny) to
provide insurance for employee benefits. Today, Penny Benny insures the pension benefits of over
40 million workers.6
6
As of 1992, though, Penny Benny had deficit of over $2 billion and over $40 billion in
unfunded liabilities, strongly suggesting the need for Congress to reform these quasi-government
agencies.
11
In addition to employee and institutional pension plans, retirement plans for individuals can be
set up through Keough plans and individual retirement accounts (IRAs). By tax laws established
in 1962, self-employed people can contribute up to 20% of their net earnings, to a maximum of
$30,000, to a Keough plan (retirement account) with the contribution being tax deductible from
gross income. Since the passage of the Economic Recovery Tax Act, any individual can also
contribute up to $2,000 of their earned income to an IRA with no taxes paid on the account until
they are withdrawn.7 Keough account plans and IRAs are set up through banks, brokerage firms,
other financial institutions, and employers with pensions plans.
4.6.3 Annuities
Life insurance companies offer annuities in which they promise to pay fixed dollar payments for
either a pre-specified period or until the investor's death. There are three general types of annuities:
A life annuity, which pays a fixed amount regularly (e.g., monthly) until the investor's death; a last
survivor's annuity which pays regular fixed amounts until both the investor and spouse die; a
fixed-period annuity which makes regular fixed payments for a specified period (5, 10, 20 years),
with payments made to a beneficiary if the investor dies. These annuities are referred to as fixed
annuities. They are constructed based on the rates of return insurance companies can obtain from
investing an individual's payment for a period equal to the individual's life expectancy (fixed-life
annuity), or for a pre-specified period (fixed-period annuity). In addition to fixed annuities,
insurance companies also offer a variable annuity in which regular payments are not fixed, but
rather depend on the returns from the investments made by the insurance company (the insurance
company sometimes invests in a mutual fund that they also manage). Finally, insurance companies
offer deferred annuities (variable or fixed) which allow an investor to make a series of payments
instead of a single payment.
4.6.4 Commingled Funds
Bank trust departments and insurance companies offer and manage individual retirement accounts,
Keough plans, trusts, and pensions. For small accounts, these institutions often combine the
accounts in a commingled fund, instead of managing each account separately. A commingled fund
is similar to a mutual fund. For accounting purposes, individuals setting up accounts are essentially
buying shares in the fund at their NAV and when they withdraw funds they are selling essential
shares at their NAV. Like mutual funds, insurance companies and banks offer a number of
commingled funds: money market funds, stock funds, and bond funds.
4.7 FOREIGN DEBT SECURITIES
A U.S. bond investor looking to speculate or to internationally diversify his portfolio has several
7
If one's spouse does not work, $2,250 can be contributed to two IRAs.
12
options. First, he might buy a bond of a foreign government or foreign corporation that is issued in
the foreign country or traded on that country's exchange. These bonds are referred to as domestic
bonds. Secondly, the investor might be able to buy bonds issued in a number of countries through
an international syndicate. Such bonds are known as Eurobonds. Finally, an investor might to able
to buy a bond of a foreign government or corporation being issued or traded in his own country.
These bonds are called foreign bonds.
The markets where domestic, foreign, and Eurobonds are traded can be grouped into two
categories -- the internal bond market and the external bond market. The internal market, also
called the national market, consists of the trading of both domestic bonds and foreign bonds; the
external market, also called the international bond market and the offshore market, is where
Eurobonds are bought and sold. Finally, there are some bonds that are sold in both the external and
internal markets; these bonds are referred to as global bonds. In this section, we examine the
markets and characteristics of Eurobonds, foreign bonds, non-U.S. domestic bonds, and global
bonds.
4.7.1 The Eurobond Market
A Eurobond is a debt security, issued from a country outside the issuer’s or underwriter’s primary
country and usually sold in a number of countries. For example, to raise funds to finance its French
operations, a U.S. company might sell a bond denominated in British pounds throughout Europe
through its foreign subsidiary in Netherlands Antilles underwritten through a foreign investment
bank.
The Eurobond market is handled through an international syndicate consisting of multinational
banks, brokers, and dealers. A corporation or government wanting to issue a Eurobond will
usually contact a multinational bank who will form a syndicate of other banks, dealers, and brokers
from different countries. The members of the syndicate usually agree to underwrite a portion of the
issue, which they usually sell to other banks, brokers, and dealers.8 The secondary market for
Eurobonds is handled primarily through an international OTC market consisting of Eurobond
dealers. Many of these dealers belong to the Association of International Bond Dealers (AIBD).
This association is similar to NASD, except that there is little government involvement. While
most secondary trading of Eurobonds occurs in the OTC market, many Eurobonds are listed on
organized exchanges in Luxembourg, London, and Zurich. These listings are done primarily to
accommodate investors from countries which prohibit institutional investors from acquiring
securities which are not listed. An investor who wants to buy a Eurobond would contact several
market-makers on the international OTC market to get several bid-ask quotes, before selecting the
best one. A Eurobond transaction occurring in the secondary market usually takes several days to
clear.9
8
Eurobonds are typically sold by corporations, governments, or supranationals (e.g., World
Bank). GMAC, Citicorp, and the World Bank are examples of entities active in financing through
the Eurobond market. Also, it should be noted that while Eurobonds are issued through syndicates,
in recent years there have been several issues sold through just one underwriter.
9
The major clearing firms for Eurobonds are Euroclear and Cedela. Euroclear consists of a
13
Characteristics
General Features
The generic, plain vanilla Eurobond pays an annual fixed interest and has a long-term maturity.
There are a number of different currencies in which Eurobonds are sold. The major currency
denominations are the U.S. dollar, yen, Swiss franc, and mark. Some Eurobonds are also valued in
terms of a portfolio of currencies, such as the European currency unit (ECU). The central bank of
a country can protect its currency from being used. Japan, for example, prohibited the yen from
being used for Eurobond issues of its corporations until 1984.
There are two features of Eurobonds that have served to differentiate them from other bonds
-- their lack of regulation and their tax status. Eurobonds are usually issued from countries in which
there is little regulation. As a result, many Eurobonds are unregistered, issued as bearer bonds.
While this feature provides confidentiality, it has created some problems in countries such as the
U.S., where regulations require that security owners be registered on the books of issuer. However,
to accommodate U.S. investors, the SEC allows them to purchase these bonds after they are
"seasoned": sold for a period of time (e.g., 2 months).10
Most Eurobonds are also not subject to foreign withholding taxes. In the early development of
this market (before many countries rescinded their withholding taxes) a multinational corporation
would often create a financial subsidiary in the Netherlands Antilles or some other country where
there was no withholding taxes and where there were few regulations. The company would then
issue Eurobonds through its subsidiary.
Even though the U.S., Germany, and other countries with withholding taxes in the 1970s had
treaties which granted tax credits to their residents when they paid foreign taxes on the incomes
from foreign bonds and stocks holdings, a number of countries did not have such treaties, and many
tax-free investors, such as pension funds could not take advantage of the credit (or could, but only
after complying with costly filing regulations). As a result, during the 1970s and early 1980s,
Eurobonds were often more attractive to foreign investors than foreign bonds.
In 1984 both the U.S. and Germany rescinded their withholding tax laws on foreign
investments. A number of other countries followed this lead by eliminating or relaxing their tax
codes. Even with this trend, though, the Eurobond market still remains a very active market.
Special Features
Like many securities issued today, Eurobonds often are sold with many innovative features. Dualcurrency Eurobonds, for example, pay coupon interest in one currency and principal in another,
and the option currency Eurobond offers investors a choice of currency. For example, the
number of multinational banks headed by Morgan Guaranty Trust Corporation.
10
U.S. banks are also allowed to be part of a Eurobond syndicate provided they can guarantee that
U.S. citizens do not buy the initial issue, a provision which is difficult to guarantee when the bonds
are sold in bearer form.
14
sterling/deutsche mark bond gives the holder the right to receive interest and principal in either
currency. A number of Eurobonds have special conversion features or warrants attached to them.
One type of convertible is a dual-currency bond which allows the holder to convert the bond into
stock or another bond that is denominated in another currency. For example, the Toshiba
Corporation sold a bond denominated in Swiss francs that could be converted into shares of
Toshiba stock at a set yen/SF exchange rate. Some of the warrants sold with Eurobonds include
those giving the holder the right to buy stock, additional bonds, currency, or gold. There are also
Eurobonds with variable rates (often tied to the LIBOR), zero discount bonds, and Eurobonds with
no maturities.
4.7.2 The Foreign Bond Market
A foreign bond market refers to that market in which the bonds of issuers not domiciled in that
country are sold and traded. For example, the bonds of a German company issued in the U.S. or
traded in the U.S. secondary markets would be part of the U.S. foreign bond market. Foreign bonds
are sold in the currency of the local economy. Unlike Eurobonds, they are subject to the regulations
governing all securities traded in the national market and sometimes special regulations governing
foreign borrowers (e.g., additional registration).
Foreign bonds have been issued and traded on a national market for many years. They
provide foreign companies access to funds they often use to finance their operations in the country
where they sell the bonds. In the U.S., foreign bonds are referred to as Yankee bonds; in Japan,
yen-denominated foreign bonds are called Samurai bonds; in Spain they are called Matador bonds,
and in the United Kingdom, they are nicknamed Bulldog bonds.
4.7.3 Global Bonds
A global bond is both a foreign bond and a Eurobond. Specifically, it is issued and traded as a
foreign bond (being registered in a country) and also it is sold through a Eurobond syndicate as a
Eurobond. The first global bond issued was a 10-year, $1.5 billion bond sold by the World Bank in
1989. This bond was registered and sold in the U.S. (Yankee bond) and also in the Eurobond
market.
4.7.4 Non-U.S. Domestic Bonds
Bonds sold in a national market by companies, agencies, or intermediaries domiciled in that country
are referred to as domestic bonds. In the preceding chapters many of the domestic bonds traded in
the U.S. were examined. There are, of course, many countries whose corporations, governments,
and financial institutions offer bonds that are attractive to U.S. and other foreign investors.
Foreign investors who buy domestic bonds will find many differences from country to
country in how the bonds are issued and regulated. In a number of countries, new bonds are
underwritten by banks instead of investment bankers. In Germany, for example, there is a history
of no separation between commercial and investment banking. Many banks in Germany act as
security underwriters and as brokers and dealers in the secondary market, trading existing bonds
and stocks through an interbank market. In contrast, Japan, like the U.S. until 2000, separates its
15
commercial and investment banking activities. In Japan, brokerage houses such as Nikko,
Normura, and Yamaichi broker and underwrite bonds and other securities. In the secondary
market, some countries trade bonds exclusively on exchanges, while others, such as the U.S.,
Switzerland, Japan, and the United Kingdom, trade bonds on both the exchanges and through
market makers on an OTC market.
Bonds sold in different countries also differ in terms of whether they are sold as either
registered bonds or bearer bonds. A foreign investor buying a domestic bond may also be subject to
special restrictions. These can include special registrations, exchange controls, and foreign
withholding taxes. Finally, domestic bonds in other countries differ in their innovations. For
example, the British government issues a bond, also referred to as a gilt, which has a short-term
maturity which can be converted to a bond with a longer maturity. They also issue an irredeemable
gilt (perpetuals) which does not have a maturity, although it can be redeemed after a specified date.
4.8 CONCLUSION
The intermediary financial and foreign debt security markets offers investors a wide array of
instruments from short-term securities, such as CDs, BAs, Eurocurrency CDs, and shares in money
market funds, to long-term instruments, such as mortgage-backed securities, mutual fund shares,
closed-end fund shares, annuities, and Eurodollar and foreign bonds. Investments in intermediate
and foreign securities often provide one with better divisibility, liquidity, and management than do
direct investments in securities. Such advantages, explain, in part, the growth in the market for
these securities.
16
KEY TERMS
Load funds
No-load funds
Closed-end funds
Unit investment trust
Redeemable trust certificates Dual-purpose
funds
Growth funds
Income funds
Balanced funds
Real Estate Investment Trust (REIT)
Employee Retirement Income Security Act
(ERISA)
Keough plans
Individual retirement accounts (IRAs)
Life annuity
Last survivor's annuity
Fixed-period annuity
Variable annuity
Deferred annuities
Commingled fund
Domestic bonds
Eurobonds
Foreign bonds
Internal bond market
External bond market
National market
International bond market
Offshore market
Global bonds
Association of International Bond Dealers
(AIBD)
European currency unit (ECU)
Dual-currency Eurobonds
Option currency Eurobond
Yankee bonds
Samurai bonds
Matador bonds
Bulldog bonds
Gilt
Prime CDs
Nonprime CDs
Longer-term variable rate CD (VRCD)
Bear and bull CDs
Rising-Rates CDs
Forward CDs
Rollover, Roly-Poly CDs
Jumbo CDs
Yankee CDs
Eurodollar CD
Eurocurrency market
London Interbank Offer Rate (LIBOR)
Tap CDs
Tranche CDs
Bankers acceptances (BAs)
Mortgage bankers
Graduated payment mortgages (GPM)
Reset mortgages
Mortgage-backed securities
Mortgage pass-throughs
Agency pass-throughs
Conventional pass-throughs
GNMA mortgage-backed securities (MBS)
Guaranteed mortgage certificates (GMCs)
Collateralized mortgage obligations (CMOs)
Fully modified pass-through
Modified pass-through
FNMA mortgage-backed securities (MBS)
Boutique securities
Mortgage-Backed Security Dealers
Association
Money market funds
Index funds
Global funds
Vulture funds
Open-end funds (mutual funds)
Net asset values (NAV)
17
SELECTED REFERENCES
Intermediate Securities
Abken, P.A., "Corporate Pensions and Government Insurance: Dejà Vu All Over Again?"
Economic Review, Federal Reserve Bank of Atlanta (March/April 1992): 1-16.
Balbach, A.B. and Resler, D.H., "Eurodollars and the U.S. Money Supply," Review, Federal
Reserve Bank of Saint Louis (June-July 1980): 1-12.
Fabozzi, F.J. Bond Markets, Analysis, and Strategies (Englewood Cliffs, NJ: Prentice Hall, 1993):
218-278.
Fabozzi, F.J. and Modigliani, F., Mortgage and Mortgage-Backed Securities Markets (Boston,
MA: Harvard Business School Publications, 1992), Chapter 11.
Goldberg, C.J. and Rogers, K., "An Introduction to Asset Backed Securities," Journal of Applied
Corporate Finance, 1, No. 3: 20-31.
Goodfriend, M., "Eurodollars," Economic Review, Federal Reserve Bank of Richmond (May-June
1981): 12-18.
Investment Companies, New York: CDA/Weisenberger, published annually.
Jacob, D., McGranery, C., Gallop, S., and Tong, L., "The Seasoning of Prepayment Speeds and its
Effect on the Average Lives and Values of MBS," Chapter 31 in Frank J. Fabozzi, ed., The
Handbook of Mortgage-Backed Securities, 3rd edition (Chicago: Probus Publishing, 1992).
Jensen, F.H. and Parkinson, P.M., "Recent Developments in the Bankers' Acceptance Market,"
Federal Reserve Bulletin, (January 1986): 4-12.
Morningstar Mutual Funds, Chicago, IL: Morningstar, Inc.
Napoli, J. and Baer, H.L., "Disintermediation Marches On," Chicago Fed Letter, Federal Reserve
Bank of Chicago (January 1991): 1-3.
Neihaus, J. and Hewson, J., "The Eurodollar Market and Monetary Theory," Journal of Money,
Credit, and Banking (1976): 1-27.
Ocampo, J.M. and Rosenthal, J.A., "The Future of Securitization and the Financial Services
Industry," Journal of Applied Corporate Finance, 1, No. 3: 90-101.
Richard, S.F. and Edens, L.M., "Prepayment and Valuation Modeling for Adjustable Rate
18
Mortgage-Backed Securities," Chapter 11 in The Handbook of Mortgage-Backed Securities,
3rd edition (Chicago: Probus Publishing, 1992).
Rose, P.S., Money and Capital Markets (Burr Ridge, IL: Richard D. Irwin, Inc., 1982): 422-430.
Tucker, A.L., Madura, J., and Chiang, T.C. International Financial Markets (St. Paul, MN: West
Publishing, 1991): 123-126.
Foreign Investments
Adler, M., and Dumas, B. "The Exposure of Long-Term Foreign Currency Bonds," Journal of
Finance and Quantitative Analysis, (November 1980): 973-94.
Bowe, M. Eurobonds (Kent, U.K.: Square Mile Books, 1988): 16-17.
Cholerton, K., Pieraerts, P., and Solnik, B. "Why Invest in Foreign Currency Bonds?" Journal of
Portfolio Management, (Summer 1986): 4-8.
Chrystal, K.A. "A Guide to Foreign Exchange Markets," Federal Reserve Bank of Saint Louis
Review, (March 1986).
Eiteman, D.K. "International Capital Markets," In: N. Roussekis (ed.) International Banking:
Principals and Practices, Praeger, (1983).
Essayyad, M., and Wu, H. "The Performance of U.S. International Mutual Funds," Quarterly
Journal of Business and Economics, (Autumn 1988): 32-46.
Fabozzi, F.J. Bond Markets, Analysis, and Strategies (Englewood Cliffs, NJ: Prentice Hall, 1993):
162-182.
Garbade, K.D., and Silber, W.L. "Dominant and Satellite Markets: A study of Dually Traded
Securities," The Review of Economics and Statistics, (August 1979).
Hilliard, J. "The Relationship between Equity Indices on World Exchanges," Journal of Finance
(March 1979): 103-114.
Jones, F.J. and Fabozzi, F.J., International Government Bond Markets (Chicago: Probus
Publishing, 1992).
Ibbotson, R., Carr, R., and Robinson, A. "International Equity and Bond Returns," Financial
Analysts Journal (July/August 1982): 61-76.
Kidwell, D., Mann, W., and Thompson, R. "Eurodollar Bonds: Alternative Financing for U.S.
Companies," Financial Management (Winter 1985): 18-27.
19
Levy, H. and Lerman, Z. "The Benefits of International Diversification in Bonds," Financial
Analysts Journal (September/October 1988): 18-27.
McCauley, R., and Hargraves, L. "Eurocommercial Paper and U.S. Commercial Paper: Converging
Money Markets?," Quarterly Review, Federal Reserve Bank of New York (Autumn 1987):
24-35.
Officer, D., and Hoffmeister, R. "ADRs: A Substitute for the Real Thing?" Journal of Portfolio
Management (Winter 1987): 61-65.
Rao, R., and Aggarwal, R. "Performance of U.S.-based International Mutual Funds," Akron
Business and Economic Review (Winter 1987): 98-106.
Riehl, H. and Rodriguez, R. Foreign Exchange and Money Markets (New York: McGraw Hill,
1983).
Rose, Peter S. Japanese Banking and Investment in the United States: An Assessment of Their
Impact Upon U.S. Markets and Institutions (New York: Quorum Books, 1991).
Rosenberg, H. "The New Lure of Foreign Bonds," Institutional Investor (March 1988): 145-47.
Sato, I., and Kanovsky, E.M. "Historical Development of the Japanese Bond Market," Chapter 13
in Frank J. Fabozzi (ed.), The Japanese Bond Markets (Chicago: Probus Publishing, 1990).
Scarlata, J. "Institutional Developments in the globalization of Securities and Futures Markets,"
Review, Federal Reserve Bank of St. Louis (January-February 1992): 17-29.
Solnik, B. International Investments (Addison-Wesley Publishing Company, 1988): 94-176.
Tucker, A.L., Madura, J., and Chiang, T.C. International Financial Markets (St. Paul, MN: West
Publishing, 1991): 157-196.
Vertin, J. (ed.) International Equity Investing, (Homewood, IL: Dow Jones-Irwin, 1984).
20
EXHIBIT 4.2-1
HISTORY OF THE SECONDARY CD MARKET
Prior to 1961, commercial banks lacked an effective instrument to compete for the temporary
excess cash funds of corporations and state and local governments. At that time, there was no
interest paid on demand deposits, and corporations were reluctant to tie their funds up in
nonnegotiable CDs. Also with the rates paid on time deposits fixed by the Fed's Regulation Q,
sometimes at a level below T-bill rates, banks had no security to offer corporations.
Consequently, corporations tended to opt for T-bills instead of bank deposits when they invested
their excess funds.
The solution to the problem for banks came in 1961 when First Bank of New York (now
Citibank) issued a negotiable CD, accompanied by an announcement by First Boston
Corporation and Salomon Brothers that they would stand ready to buy and sell the CDs. Thus,
the first secondary market for CDs was born. Moreover, what the secondary market provided
was a way for banks to circumvent Regulation Q and offer investors rates competitive with Tbills. Specifically, with Regulation Q setting higher maximum rates on longer-term CDs, the
existence of a secondary market meant that an investor could earn a rate higher than either the
short or longer-term CD, by buying the longer-term CD and selling it later in the secondary
market at a higher price associated with the short-term maturity. For example, if a one-year CD
paid 5% and a 2-year CD yielded 6%, then an investor could buy the 2-year CD at a par of say $1
million, hold it for one year, and sell it in the secondary market. The investor's one -year return
would include $60,000 from the first year's interest on the 2-year bond plus a capital gain of
$9524 realized from the sale of the bond. Specifically, if rates did not change -- an event with a
high probability, given the fixed rates required under Regulation Q -- then the investor would be
able to sell the bond at a premium over par since the market required only 5% on one year
instruments and the bond pays 6%. In this example, investors, to earn 5%, would pay $1,009,524
and would receive $1,000,000 par plus $60,000 interest (rate =
($1,060,000-$1,009,524)/$1,009,524 = .05). Moreover, the investor with $60,000 interest and
$9,524 gain ($1,009,524-$1,000,000) would realize a one year rate of return of 7%
($69,524/$1,000,000), which exceeds either the one or two year annualized rates. Thus, to
recapitulate, the significance of the secondary market for CDs was that it provided a way for
banks to increase their CD yields to customers without violating Regulation Q.
Following First Bank of New York, Salomon Brothers, and First Boston's lead, other banks,
brokers, and dealers quickly entered into the market for negotiable CDs. As a result, the CD
market grew in the 1960s, albeit somewhat unsteadily. Specifically, in 1966 the market decline
when T-bill rates increased, and also in 1969 when the interest ceiling on Regulation Q was
lowered by the Fed. In both instances the market was saved by the sale of Eurodollar CDs
(discussed later). Moreover, with stability, the market grew substantially to a $90 billion market
in 1975 and to the $400 billion market of 1993.
21
EXHIBIT 4.2-2
HISTORY OF THE EUROCURRENCY MARKET
The origin of the Eurocurrency market is political. It started in the 1950s when the
U.S.S.R., in order to participate in world trade, maintained large dollar deposits in U.S. banks.
However, U.S. claims on the Russians originating from Lend-Lease Policy, poor political
relations, and the freezing of foreign assets by the Eisenhower administration because of the
British-French-Israeli attack on Egypt led to fears by Soviet Union that their deposits could be
expropriated by the U.S. government. As a result, the U.S.S.R., with the aid of some U.S. banks,
transferred their dollar deposits to banks in Paris and London, thus creating the first Eurodollar
deposit. Subsequently, the increase in international trade, the rise of multinationals, the role of
the dollar under the old Bretton Wood's exchange rate system, and the desire of some
governments to maintain dollar deposits led to a substantial increase in the amount of Eurodollar
deposits abroad during the 1960s.
During this period most of the deposits were in foreign banks who, in turn, used the deposits
to make dollar loans to many U.S. companies, directly competing with U.S. banks. [In 1963
there were only 11 U.S. banks with foreign operations in Europe, and these banks were there
principally to facilitate their corporate customers' international business.] In the mid-1960s,
though, U.S. banks began to go after Eurodollar deposits and loans by establishing foreign
subsidiaries. However, what brought these American banks to Europe en masse was probably
not so much the loss of business to European banks as it was the opportunity around Federal
Reserve rules. Specifically, with no reserve requirements or regulations governing the maximum
rates payable on time deposits, U.S. banks, by offering Eurodollar deposits and loans, now had a
way of offering their customers better rates on loans and higher rates on time deposits. By 1969
there were 40 American banks with branches abroad lending approximately $14 billion in
Eurodollars. This market, in turn, grew, despite a crisis in 1973, to a $270 billion market in
1974.
By the 1980s the market had become the second largest market in the world, extending
beyond Europe (although the Euro prefix remained) and intermediating in currencies other than
the dollar. Accordingly, the market gave rise to the offshore banking centers in such areas as
Nassau, Singapore, Luxembourg, and Kuwait. These areas had less-restrictive banking laws and
thus became a place for intermediation between both foreign lenders and foreign borrowers.
22
EXHIBIT 4.5-1
MUTUAL FUND QUOTES
Source: Wall Street Journal, October 2, 1995.
23
EXHIBIT 4.5-2
CLOSED-END FUNDS QUOTES
Source: Wall Street Journal, October 2, 1995
24
EXHIBIT 4.5-3
SOURCES OF MUTUAL FUND INFORMATION
Wiensenberger Investment Company Services
Vickers Guide to Investment Company Services
Mutual Fund Almanac
Mutual Fund Fact Book, Investment Company Institution
Lipper Mutual Fund Investment Performance Average
Donoghue's Money Fund Report
Donoghue's Money Fund Directory
25
EXHIBIT 4.5-4
PENSION ASSETS
*
YEAR
TOTAL ASSETS
OF ALL FUNDS*
1960
1970
1980
1990
$108.2 Billion
$262
$712
$2,956
Includes Private and Government (including Social Security).
TYPE OF PENSION
1990 TOTAL ASSETS (billions)
PRIVATE
Insured
Noninsured
Total
$ 713
1,125
$1,838
GOVERNMENT
State and Local
Federal Civilian
Railroad
Social Security (OASDI)
Total
$ 635
247
10
225
$1,118
$2,956
TOTAL
Source: Securities Exchange Commission; 1992
Life Insurance Fact Book
26